In the typical securities fraud class action under Rule 10b-5, the plaintiff class consists of buyers who seek damages equal to the difference between the price paid for the stock during the fraud period and the lower price that prevails after corrective disclosure. The argument here is that this claim is really an amalgam of direct and derivative claims and that the derivative claims should result in recovery by the corporation for the benefit of all stockholders. There are three types of losses that arise in the typical stock-drop action. First, part of the loss may be attributable to lower expected earnings (fundamental loss). Second, part of the loss may be attributable to an increase in the cost of equity because of increased risk associated with the corporation (capitalization loss). Third, part of the loss may be attributable to the class action itself which if successful will result in a payout by the corporation to settle the litigation (feedback loss). It is not clear that fundamental loss should be actionable since it is a loss that will occur whether or not there is fraud. Capitalization loss may or may not be actionable. If it arises because of harm to the reputation of the corporation as a result of fraud or similar wrongful acts that cause the market to lose trust in the corporation resulting in an increased cost of capital for the corporation, the loss is derivative because it affects the corporation as a whole and affects all stockholders in the same way. On the other hand, the corporation may also suffer a capitalization loss in the absence of any fraud because the market learns new information about firm-specific risk. This loss – like fundamental loss – arises whether or not there is fraud. It should not be actionable. Finally, feedback loss arises only because the corporation pays if the class action is successful. But if the only actionable loss is capitalization loss for which the corporation should recover, there is no justification for a class action, no reason for the corporation to pay, and no feedback loss. In other words, feedback loss goes away if the class action goes away. In short, the only genuine loss in a stock-drop action under Rule 10b-5 is attributable to claims that should be characterized as derivative.

The mystery is why the courts and litigants have failed to characterize such claims as derivative rather than direct. Although there is some doubt whether capitalization loss is actionable as a matter of federal securities law, such claims are clearly actionable under the state law of fiduciary duty, particularly when there is insider misappropriation involved. The fact that such claims are litigated as direct class claims rather than derivative claims is especially puzzling because most stock is held by well-diversified institutional investors that lose from class actions. Such investors are equally likely to sell (gain) as to buy (lose) during the fraud period. Gains and losses net out over time. So the cost of litigation is a deadweight loss that reduces portfolio return. Moreover, because the corporation pays if the action is successful, the net effect is that holders pay buyers. A diversified investor who buys a few shares during the fraud period to add to existing holdings may lose more on its holdings than it gains from any recovery. Thus, diversified investors should be opposed to direct class actions in principle. They should favor derivative actions that seek recovery by the corporation for any loss such as capitalization loss from fraud. But each of the constituencies that might advocate for derivative actions – institutional investors, defendant corporations, and the plaintiff bar – is afflicted by a disabling conflict that discourages reform. An institutional investor cannot afford to opt out of securities fraud class action because by doing so it would effectively pay as a holder without the benefit of an offsetting recovery as a buyer. Defendant corporations may be reluctant because insurance may not cover claims made in the context of a derivative action. And the plaintiff bar may be disinclined to prosecute derivative actions with much vigor because attorney fees are likely to be significantly greater in a class action. As a result, reform is unlikely unless the courts take the initiative. But this is arguably as it should be. It is well settled that procedure is a matter for the courts. And the characterization of claims as direct or derivative is a judicial function governed by the rules of procedure. Besides, the securities fraud class action is a judicial invention. Thus, the courts have the power and the duty to clean up the mess.


Business Organizations Law | Securities Law

Date of this Version

May 2009