61 Pages Posted: 17 Apr 2011
Date Written: April 16, 2011
Although securities fraud class actions are a well-established legal institution, few (if any) such actions in fact meet the requirements of Rule 23 of the Federal Rules of Civil Procedure for certification as a class action. Among other things, Rule 23 requires the court to find that the representative plaintiff will fairly and adequately protect the interests of the class and that a class action is superior to other means of resolving the dispute.
In the typical securities fraud case, the plaintiff class consists of investors who buy the subject stock at a time when the defendant corporation has negative material information that should be publicly disclosed. When the truth comes out, stock price declines, and those who bought during the fraud period sue the corporation for damages equal to the difference between the price they paid and the price at which the stock finally settles. Only buyers have standing to sue in such circumstances. Mere holders have no claim.
The problem is that most buyers are also holders. Most investors are well diversified. More than two-thirds of all stock is held through mutual funds, pension plans, and other institutional investors, who trade mostly for purposes of portfolio balancing. As a result, most of the buyers in the plaintiff class will also be holders as to more shares than the number of shares bought during the fraud period. Because the defendant corporation pays any settlement – further reducing the value of the corporation and its stock price through what I call feedback damages – most of the plaintiff class will lose more as holders than they gain as buyers. Thus, many members of the plaintiff class would prefer that the action be dismissed. It is therefore impossible for anyone to be an adequate representative of a class composed of both members who support the action and members who oppose the action. Even if a court would permit a plaintiff class to be gerrymandered to include only those buyers who would gain more than they lose, there is no practical way to identify such investors.
In addition, it is likely that in most meritorious securities fraud actions, part of the decrease in stock price will come from expenses associated with defending and settling the securities fraud claim and from harm to the reputation of the defendant company resulting in an increase in its cost of capital. But these claims are derivative rather than direct. Accordingly, it is the corporation – and not individual buyers – who should recover for this portion of the damages. Aside from the fact that such claims are derivative in nature and presumably must be litigated as such, a derivative action is clearly superior to a class action because recovery by the corporation from individual wrongdoers – rather than payment by the corporation to buyers – eliminates feedback damages and thus reduces the size of the aggregate claim. Moreover, a derivative action is much more efficient in that there is a single plaintiff – the corporation – rather than hundreds or thousands of individual buyers.
Finally, policy considerations also militate against certification. Diversified investors are hedged against securities fraud by virtue of being diversified and have no need for a remedy. A diversified investor is just as likely to sell a fraud-affected stock as to buy one. It all comes out in the wash. Thus, the expenses associated with securities fraud class actions are a deadweight loss that serves only to reduce investor return. Because the vast majority of investors are diversified – and because it is irrational for most investors not to diversify – the interests of diversified investors should trump those of any undiversified investors who would favor a class action remedy. Moreover, class actions constitute excessive deterrence, whereas derivative actions provide a response that is proportional to the true harm suffered by investors. Diversified investors are completely protected against any true loss by the prospect of derivative litigation, which also provides an effective deterrent against securities fraud.
In short, when faced with a motion to certify a securities fraud action as a class action, a court should ordinarily treat the action as derivative and proceed accordingly. To be clear, this approach would effectively abolish securities fraud class actions and replace them with derivative actions. But as demonstrated here, investors would be better off as a result.
Keywords: securities fraud, class action, Rule 23, certification, adequate representative, superiority, predominance, diversified investor, index fund, stock-picking, portfolio balancing, buyer-holder, feedback, circularity, reputational harm, cost of capital, derivative action, good faith, scienter
JEL Classification: G10, G20, G30, K22, K41
Suggested Citation: Suggested Citation