Economic Consequences: The Real Costs of U.S. Securities Class Action Litigation
U.S. Chamber Institute for Legal Reform, February 2014
47 Pages Posted: 5 Mar 2014
Date Written: February 28, 2014
The recent decision of the U.S. Supreme Court to hear an appeal in Halliburton v. Erica P. John Fund has revived the questions about the societal utility of securities fraud class action lawsuits. Since the passage of the Private Securities Litigation Reform Act (PSLRA) in 1995, thousands of such class action lawsuits have been filed alleging trillions in shareholder damages. The principal argument in support of the current system of private securities class action litigation, typically advanced by the securities class action plaintiffs’ attorneys whose fees are contingent on the size of any recovery, is that this type of litigation provides a significant benefit to their clients by winning billions of dollars in settlements from companies to be distributed back to allegedly harmed investors.
Although the merits of such claims are almost never tested at trial as most of these cases settle or are dismissed, the contention that such lawsuits benefit harmed investors has been questioned in several ways. Academics have commented on the cost of such litigation and how securities class actions merely shift money from one group of investors to another. This study provides additional evidence on whether such lawsuits help redress harmed shareholders. If all shareholders at the end of the class period were also class members, the announcement of a lawsuit to recover damages for the class members would at best be a zero-sum game. Their expected recoveries would have an offsetting reduction in the share price by the same amount. If, on the other hand, the overlap is less than perfect, expected settlement payments would represent a wealth transfer from current shareholders to class members who are not current shareholders. However, other costs of class action lawsuits such as plaintiffs’ lawyers’ contingency fees and various direct and indirect costs have no corresponding benefits to the class members, and the share price drop associated with these inefficiencies may dwarf expected recovery by class members. This study finds that shareholders experience a stock price drop associated with the filing of a securities fraud class action lawsuit and that because of the losses associated with the litigation, they lose much more than they gain in any subsequent settlement amount.
Our methodology for the first part of the paper is that we calculate the wealth lost by shareholders upon announcement of such lawsuits soon after the end of the class period, at which time shareholders experiencing this wealth loss are (largely) the same shareholders on whose behalf the lawsuit is being filed. In the second part of the paper, we demonstrate, using actual claimant trading data from a large class action settlement involving allegations of artificial stock inflation, that a significant percent of the settlement proceeds are allocated to plaintiffs who do not trade in a manner consistent with the presumption of reliance upon which the class was certified. In other words, settlement funds go to class members who almost certainly could not recover if the case were litigated. We further show, using this same claimant data and a review of 50 Plans of Allocation (POAs) for other large settlements that the POAs for distributing settlements to allegedly harmed shareholders often lead to a substantial redistribution of wealth across plaintiffs that bears little resemblance to their alleged economic injury.
Shareholder Value Destruction from Filing of Lawsuits: To calculate the costs associated with securities class action lawsuits, we analyze company stock price reactions to announcements of such lawsuits. We use a comprehensive sample of 1,456 federal class action securities cases involving allegations of artificial stock price inflation that were filed since the passage of PSLRA and subsequently settled. Our empirical analysis demonstrates that a private securities class action lawsuit, filed within 30 trading days after the date that the suit defines to be the end of the class period, results in a cumulative loss of 4.44% of the stock’s price.
By focusing on the lawsuits filed soon after the end of the class period, we measure the effect on wealth of the same group of shareholders on whose behalf these lawsuits are filed and who expect to participate in any future recoveries. In our sample of settled cases, the total shareholder wealth loss is at least $262 billion. Extrapolating these findings to not-settled cases (i.e., dismissed and not-yet settled cases) during the same time period and combining the two sets of results, our study calculates the total shareholder wealth loss as a result of securities class action lawsuit announcements to be at least $701 billion compared to the $109 billion in aggregate settlement dollars (before plaintiff attorneys get their cut of about 18% on average) that the shareholders have received on already settled cases ($68 billion) and expected settlements that will be realized on cases not yet settled ($41 billion). The total wealth loss averages to about $39 billion per year, in order to collect an average of $6 billion in settlements per year ($5 billion per year after plaintiff attorneys’ fees). In other words, because of the filing of securities class actions, shareholders incrementally lost more than six times the settlement amount (or more than seven and half times the amount that shareholders would receive after plaintiffs’ attorneys’ fees).
It is important to note that the wealth loss we document is measured on events that are already largely anticipated by the market. Thus, while it is beyond the scope of this paper to quantify how much additional wealth loss may have resulted from anticipation of such lawsuits, we believe the $701 billion wealth loss represents an extremely low estimate of the total cost of these lawsuits to the very same shareholders on whose behalf they are filed.
Post-Settlement Distortions: We also analyze distortionary effects that occur after a securities class action settlement is reached. Even when allegedly affected shareholders do finally have the opportunity to recover (which is virtually always through settlement as trials rarely occur), the distribution of settlement dollars back to allegedly affected shareholders bears little relationship to the economic theory behind the presumption of reliance used to certify the class and is disconnected from the economics of plaintiff’s own theories of alleged harm these shareholders purportedly suffered. It seems that once a settlement is reached and the “hydraulic pressure” is relieved, whether some participants in the settlement had ever relied on integrity of market price in the first place or whether the settlement amounts claimed by class members are well matched to their alleged economic injury become an afterthought.
The presumption of reliance based on the “fraud-on-the-market” (FOTM) doctrine for class certification purposes, as authorized by the U.S. Supreme Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988), relieves plaintiffs from having to demonstrate individual reliance on (or even awareness of) any alleged misstatements in order to claim damages resulting from the alleged fraud, even though this presumption can be rebutted by defendants after class-wide damages have been determined in a trial. It is important to note that as posited by modern financial theory, the prototypical investor that believes in market efficiency of the kind envisioned in Basic should invest in a diversified portfolio and only has two reasons to trade: (1) net investment or divestment for consumption purposes; and (2) rebalancing of the diversified portfolio between asset classes. Such trading would by definition be infrequent and account for only a small fraction of the total volume observed. On the other hand, consider a more frequent (or “active”) trader who might try to “beat the market” such as a sophisticated institutional investor who might apply a proprietary trading model or who might trade using a volatility-based rather than a price-based strategy. As a result of more frequent trading this type of investor would likely have a much higher share of the alleged total damages. And hence, it is precisely such active traders that may be shown not to have relied on the integrity of the market price or on the allegedly false statement but nevertheless remained in the class through settlement (because of the presumption at the certification stage) that might collect the largest share of the settlement.
To empirically examine whether class members did in fact rely on the efficiency of the market, we analyzed the actual trading patterns of class claimants in a typical major securities class action settlement and found that some of the claimants who were allocated the largest share of the settlement distribution traded hundreds of times during the class period and traded in a manner indicating that they did not rely on the integrity of the market price even though they claimed reliance on efficient market for class certification.
We also analyzed the same class action trading data for the POA for settlement distribution in order to explore whether the settlement monies were actually distributed to those who suffered net harm from the alleged stock inflation. We find that because this POA ignored the netting of each claimant’s total potential gains from selling at allegedly inflated prices against any alleged losses, there was little relationship between the claimants’ total net economic loss from the alleged fraud and their share of the settlement distribution. Our findings on this POA are not unique. We also reviewed POAs for the 50 largest settlements in our sample, which collectively represent about 60% of the total $68 billion in total settlements in our database, and found that not one of these POAs used stock inflation-based netting of gains to calculate the respective plaintiff’s share of the settlement fund(s).
Our overall conclusion is that private securities class actions significantly harm investors and the economy, and they do not provide an efficient mechanism to compensate victims of alleged wrongdoing. Instead, they further harm the alleged victims (as well as other innocent shareholders). Ultimately, the current securities litigation system results in arbitrary wealth redistribution and the settlement amounts paid are relatively minor when compared to the actual investor wealth destroyed by such lawsuits.
Keywords: securities class action litigation, stock market response, economic impact, class certification, reliance, fraud-on-the market, event studies, settlement
JEL Classification: G14, G28, G38, K22, K41
Suggested Citation: Suggested Citation