32 Pages Posted: 7 May 2010 Last revised: 23 Jun 2010
Date Written: 2010
In the aftermath of the global economic collapse of 2008, policymakers from around the world have been considering regulations designed to reduce the risk of future economic turmoil. Their focus has been on powers and procedures designed to reduce systemic risk and to help ensure financial stability in the world markets. Although policymakers should explore prophylactic measures and use counterfactual reasoning, they should not confine their analysis to preventing the next crisis. Regulating against the risk of unpredictable disaster - a so called "black swan" - is imprecise and, if done improperly, can hinder economic growth.
Along these lines, policymakers must be cautious to avoid a regulatory overreaction to the current economic problems. In an effort to promote long‐term economic prosperity, policymakers should avoid the temptation to overregulate in the near term. Policymakers also must alleviate unnecessary burdens to economic growth, both in the United States and abroad. But a monetary response, such as a stimulus spending package, provides only short‐term economic relief and could cause a host of problems not discussed in this Article. To promote long‐term and sustainable growth, policymakers must consider regulatory measures designed to facilitate capital formation and encourage investment, while providing appropriate safeguards against fraud to investors. Of course, the legal and regulatory systems may pose the greatest impediment to economic growth.
The United States has its own unique hindrance to economic growth: private securities class‐action litigation. Along with Canada and Australia, the United States is one of three G‐20 nations to permit securities class actions. Although originally envisioned as a means to provide relief to aggrieved investors, securities class-action litigation has become an inefficient and grossly incomplete means of redress for investors, a costly encumbrance to businesses, and a threat to capital formation in the United States.
To be sure, access to a properly administered class‐action framework provides aggrieved plaintiffs with a valuable legal recourse. Despite the drawbacks, class actions - as opposed to individual actions - are necessary to avoid the collective action problem that exists when investors accrue claims against publicly held corporations. In the absence of a class action, an individual shareholder might have little incentive to litigate an alleged securities law violation because he would be forced to bear all the costs of litigation while receiving only a fraction of the potential benefits paid to all shareholders. Class‐action litigation avoids the collective action problem by allowing a class of shareholders, following the efforts of lead plaintiffs and plaintiffs’ attorneys, to share the costs and benefits of a unified action proportionately.
The problem with the existing class‐action framework in the United States is the overuse and abuse of the litigation system. The magnitude of securities class‐action litigation in the United States is astonishing. Nearly half of all class‐action lawsuits in 2004 involved allegations of federal securities law violations. In 2008, 210 securities class‐action lawsuits were filed. The number of securities class‐action lawsuits appears to have doubled in each recent year, and the total number of securities class‐action settlements in 2008 was three times that of 1998.
The threat of securities class actions is more pronounced in periods of increased volatility in stock prices. A two‐year trough in securities class‐action filings from June 2005 through June 2007 - a period characterized by a strong and stable stock market - was followed by a period of increased class‐action filings through June 2008 - during which stock market volatility doubled.
The current system of securities class‐action litigation is an inefficient means to redress the harm to investors. Prominent studies have concluded that securities class‐action litigation fails to compensate adequately those harmed by fraud. The median ratio of settlement amount to total alleged investor loss has ranged between two and three percent. Securities classaction lawsuits are essentially wealth transfers among shareholders and often are circular in nature. Existing shareholders bear the burden of compensating aggrieved shareholders, some of whom also may be existing shareholders.
Although individual class members receive relatively little of the ultimate recovery that is spread across a class, the plaintiffs’ attorneys receive customarily twenty to twenty‐five percent of the total recovery. During the past ten years, plaintiffs’ lawyers, along with other middlemen, have obtained nearly $17 billion in fees from securities class actions. The diffused investors in the class lack the ability to bargain over attorney fees and courts rarely reduce the fees proposed by the plaintiffs’ attorneys.
In class‐action litigation, the interests of the plaintiffs’ attorneys and class members may not be aligned in some instances. The plaintiffs’ attorneys bear the full costs of pursuing the litigation but receive only a portion of the ultimate award. Consequently, the decisions of the plaintiffs’ attorneys may be driven by concern over litigation costs and personal gain rather than by an interest in obtaining the best result for class members. Indeed, the recent scandals involving plaintiffs’ attorneys paying large sums to repeat plaintiffs illustrate how class‐action litigation can be abused at the expense of harmed investors.
Companies and their shareholders incur enormous costs to defend against securities class‐action lawsuits. In one recent study, approximately forty‐one percent of the companies listed on the major stock exchanges had been named as defendants in at least one federal securities class action. The total monetary value of securities class‐action settlements in 2008 was $3.09 billion. The average settlement value from 2002 to 2008 was $45.6 million, which represents approximately a 175% increase from the average value of $16.6 million from 1996 to 2001.
Private securities litigation has become a real concern, particularly for new businesses that do not have the resources to handle a large lawsuit. A major lawsuit could sound the death knell for new companies that already bear a disproportionate amount of the total business tort costs in the United States. Although small companies account for nineteen percent of business revenue in the United States, they bear sixty‐nine percent ($98 billion) of the business tort costs. To cope with the cost of securities litigation, companies must raise the prices of their goods and services. Doing so, in turn, logically harms the competitiveness of U.S. businesses in a global marketplace that is dominated by low‐cost goods and services in the nations where providers do not face such threats.
Securities class actions impose a competitive disadvantage on U.S. capital markets relative to markets in other countries. Indeed, foreign companies are reluctant to list in U.S. markets due to concerns with the American litigation system. According to the Committee on Capital Markets Regulation - an independent, bipartisan body composed of twenty‐two corporate and financial leaders from business, finance, law, accounting, and academia - since the late 1990s the percentage of the world’s Initial Public Offerings (IPOs) conducted in the United States has dropped from forty‐eight percent to six percent in 2005. Of the world’s twenty‐five largest IPOs in 2005, only one of them took place in the United States. That trend continued in 2006, when a report dated November 30 observed that, in the year to date, nine of the ten largest IPOs had occurred in markets outside of the United States. Dollar figures are also staggering: Between 2000 and 2005, the percentage of dollars raised in global IPOs in the United States decreased by a factor of ten, dropping from fifty percent to five percent.
Where is the IPO activity going? The Committee report states that over the same time, London’s share of the global IPO market nearly quintupled from five percent to almost twenty‐five percent. United States exchanges attracted only about one‐third of the share of the global IPO volume in 2006 that they had in 2001 and only three of the twenty largest IPOs of 2008 were listed on U.S. stock exchanges. In 2009, the United States regained the global lead in amount of funds raised in IPOs, boasting a robust twenty‐seven percent share of global capital raised. But this number may be of little comfort when one considers that the share is mostly attributed to the $19.6 billion Visa IPO - the largest IPO in U.S. capital market history. Looking beyond this single outlier, it is apparent that capital formation has moved overseas in droves.
An unwieldy class‐action regime impacts not only the market for public offerings, but also the market for private offerings. The success of the venture capital industry relies, in large part, on how readily a start‐up or other privately held company can be taken public. Absent a desire to access the public equity markets in the United States, the amount of private equity activity in the United States also suffers. In contrast to federal litigation, securities arbitration appears to provide a more efficient and cost‐effective mechanism to resolve disputes with integrity while minimizing the burdens on our judicial system. Arbitration ensures that all relevant facts are presented to the panel without the evidentiary hurdles of federal court. In addition, the use of arbitrators knowledgeable about the securities industry may reduce the uncertainty of resolving securities claims in jury trials.
The arbitration system used by the Financial Industry Regulatory Authority (FINRA), the self‐regulatory organization that oversees certain securities firms, could be a model for the resolution of class actions, but an arbitration forum for securitie class‐action claims would have to account for the unique circumstances of those claims. Unfortunately, the federal court system provides the only permissible avenue at present to resolve class‐action claims under the federal securities laws. Although arbitration is an avenue to adjudicate scores of different types of claims, the self‐regulatory organizations expressly prohibit arbitration of securities class‐action claims.
This Article analyzes the impediments to arbitration of securities class‐action claims. It describes the concerns with the current system of shareholder class actions and discusses the benefits and criticisms associated with arbitration. Finally, this Article recommends that policymakers explore options to use arbitration for securities class‐action claims. One option is to permit arbitration of a limited number of securities class‐action lawsuits following a federal court’s denial of a defendant’s motion to dismiss. Another option is to allow new public companies the opportunity to choose between arbitration and litigation at the time of the initial public offering of securities. By providing new public issuers the choice of forum at the time of the IPO and then providing sufficient ongoing notice to the marketplace of the chosen forum, investors can decide for themselves the significance of the arbitration forum prior to the decision to purchase the stock. This scenario may provide relief to smaller companies from the class action lawsuits that have plagued them, while protecting investors and providing the opportunity to further study and evaluate the use of class‐action arbitration in a real‐world context.
Keywords: Securities Class-Action Litigation, Class-Action Lawsuits, Class Action, Securities, Arbitration, Class Arbitration, Issuer Arbitration, Securities Arbitration, Financial Crisis, FINRA, Litigation Reform, Capital Markets, Financial Services Forum
JEL Classification: E00, E22, E44, G18, K00, K22, K41, O47, P51, O00
Suggested Citation: Suggested Citation
Bondi, Bradley J., Facilitating Economic Recovery and Sustainable Growth through Reform of the Securities Class-Action System: Exploring Arbitration as an Alternative to Litigation (2010). Harvard Journal of Law and Public Policy, Vol. 33, pp. 607-638, 2010. Available at SSRN: https://ssrn.com/abstract=1601305