The Political Economy of Fraud on the Market
William W. Bratton
Institute for Law and Economics, University of Pennsylvania Law School; European Corporate Governance Institute (ECGI)
Michael L. Wachter
University of Pennsylvania Law School
December 20, 2011
University of Pennsylvania Law Review, Vol. 160, p. 69, 2011
U of Penn, Inst for Law & Econ Research Paper No. 11-17
The fraud on the market class action no longer enjoys substantive academic support. The justifications traditionally advanced by its defenders - compensation for out-of-pocket loss and deterrence of fraud - are thought to have failed due to the action’s real world dependence on enterprise liability and issuer funding of settlements. The compensation justification collapses when considered from the point of view of different types of shareholders. Well-diversified shareholders’ receipts and payments of damages even out over time and amount to a wash before payment of litigation costs. The shareholders arguably in need of compensation, fundamental value investors who rely on published reports, are undercompensated due to pro rata distribution of settlement proceeds to all class members. The deterrence justification fails when enterprise liability is compared to alternative modes of enforcement. Actions against individual perpetrators would deter fraud more effectively than does enterprise liability. If, as the consensus view now has it, fraud on the market makes no policy sense, then its abolition would seem to be the next logical step. Yet most observers continue to accept it on the same ground cited by the Supreme Court in 1964 when it first implied a private right of action under the 1934 Act in J.I. Case v. Borak - a private enforcement supplement is needed in view of inadequate SEC resources. Restating, even a private enforcement supplement that makes no sense is better than no private enforcement supplement at all.
This Article questions this backstop policy conclusion, highlighting the sticking points retarding movement toward fraud on the market’s abolition and mapping a plausible route to a superior enforcement outcome. We recommend that private plaintiffs be required to meet an actual reliance standard. We look to the Securities and Exchange Commission (SEC), rather than Congress or the courts, to initiate the change - it is the lawmaking institution most responsible for the unsatisfactory status quo and best equipped to propose a corrective. Because an actual reliance requirement would substantially diminish the flow of private litigation, we also look to a compensating step up in public enforcement capability. More specifically, the SEC enforcement division needs enough funding to redirect its efforts away from the enterprise toward culpable individuals.
The Article addresses three barriers standing between here and there. First, there is a new justification of fraud on the market circulating in the wake of the failure of the original justifications - that fraud on the market litigation enhances the operation of the corporate governance system. We show that this line of reasoning, while well-suited to justify the federal mandatory disclosure system, does nothing for the case for fraud on the market, even detracting from it. Second, we turn to politics to explain why fraud on the market retains political legitimacy despite the failure of its policy justifications. Third, we look into the facts supporting the backstop justification - inadequate public enforcement resources. We show that circumstances have changed materially since the Supreme Court first invoked the justification in 1964. The SEC budget has grown 11-fold in real terms in the intervening 47 years, with much of the growth coming in the wake of Enron. The SEC’s enforcement resources, like those of the plaintiffs’ bar, ultimately are funded with dollars drawn from shareholder pockets, inviting direct comparison between the two. We show that, as between the public and private sector, public enforcement offers the shareholders more value than private enforcement. Private resources are tied to a low-deterrence, enterprise liability framework. Public enforcement even now yields the shareholders comparable damage returns per dollar invested in enforcement. It can be deployed more flexibly, and it can be refocused against individual wrongdoers so as to enhance deterrence.
We conclude that stepped up enforcement in public enforcement makes sense for shareholders even if it implies a diminished volume of private litigation. We accordingly propose a political trade-off for the SEC to moot to Congress - double the enforcement budget in exchange for an SEC rule-making replacing fraud on the market with an actual reliance requirement.
Number of Pages in PDF File: 101
Keywords: Antifraud, class actions, corporate governance, law reform, Securities and Exchange Commission, securities regulation, shareholder rights
JEL Classification: G30, G38, K22Accepted Paper Series
Date posted: April 28, 2011 ; Last revised: December 20, 2011
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