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Working Paper

Abstract

This short essay considers the findings and recommendations of the Paulson Report relating to securities fraud class actions under the 1934 Act and Rule 10b-5. While the report exposes numerous problems with securities litigation in the United States, it understates the problems inherent in stock-drop actions. As a result, the report fails to propose an effective fix. As the report recognizes, diversified investors gain nothing from stock-drop actions: Because the corporation pays, holders effectively reimburse buyers and sellers keep their gains. In other words, the system suffers from circularity akin to a game of musical chairs in that stock-drop actions ultimately do no more than transfer wealth among investors. Indeed, diversified investors are net losers to the extent of attorney fees and other costs of litigation. But the report fails to note that issuers who are targets of such actions see their stock drop in price by more than it otherwise would because of the prospect of litigation and a feedback effect: When the issuer pays to settle the case, the payment further reduces the value of the company, which leads to a further decrease in stock price and a further increase in the potential for damages. In the end, a target company faces a higher cost of capital than it would in a world without securities fraud class actions. And in some cases it may face financial ruin. The report also fails to note that diversified investors may suffer genuine financial loss when insiders take advantage of nonpublic information for personal gain or when they damage the reputation of the company by failure to be candid with the market. In such cases, stockholders have a real gripe and should have a remedy. The simple solution is for the courts to deem stock-drop actions under the 1934 Act and Rule 10b-5 to be derivative actions rather than direct (class) actions. It is well settled that it is up to the court to decide whether an action is direct or derivative. The fact that the parties style the action as a direct (class) action rather than as a derivative action does not make it so. By recasting stock-drop actions as derivative actions, the courts could in one stroke eliminate the glaring market inefficiency of circular recovery, lower the cost of capital for issuers, emphasize individual responsibility, induce boards of directors and gatekeepers to become more vigilant, and reduce the need for criminal prosecution.

Disciplines

Secured Transactions | Securities Law

Date of this Version

January 2008

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