Document Type

Article

Publication Date

December 2005

Keywords

securities fraud, class action, derivative action, reasonable investor, diversified investor, insider trading, scienter, damages, feedback, turnover

Comments

Working Paper

Abstract

In this article, I argue that securities fraud class actions (SFCAs) should not be treated as class actions but rather should be treated as derivative actions. In addition, I argue that such actions should be dismissed unless it appears that insiders (including the company itself) have enjoyed gains from trading during the fraud period. Both of these conclusions are based on the fundamental argument that (1) securities law seeks to protect the interests of reasonable investors, (2) reasonable investors diversify, and (3) diversified investors are effectively protected against the supposed financial harms of securities fraud by virtue of being diversified, except in cases in which insiders have extracted gains by trading during the fraud period. Only those actions that involve insider trading or the equivalent by directors, officers, or agents of the defendant company (or the company itself) entail genuine financial harm to the plaintiff class, because only those actions involve an extraction of wealth from the public market. Accordingly, only SFCAs that allege insider trading or the equivalent should survive a motion to dismiss.

In addition to the fact that diversified investors suffer no compensable harm in the absence of insider trading or the equivalent – simple securities fraud -- SFCAs visit serious collateral damage on defendant companies, ultimately reducing investor return. In an action based on failure to disclose bad news, the prospect of payout will cause stock price to fall by more than it otherwise would -- even in a perfectly efficient market – and will trigger a positive feedback mechanism that will have the effect of magnifying the potential payout. This feedback effect can be quantified with precision using a simple formula. For example, in a case in which the release of bad news should cause market price to fall by 10 percent, the SFCA feedback effect will result in a price decline of about 20 percent if share turnover has been 50 percent during the fraud period. Thus, by their very nature SFCAs cause additional damage to defendant companies and stockholders.

It is easy to fix the feedback problem. If the case does not involve insider extraction of gains, it should be dismissed. If the case does involve insider extraction of gains, it should be litigated in the name of the corporation by which the corporation, and the corporation should recover any gain extracted by insiders. Specifically, treating a securities fraud action as an action by the corporation (whether it is maintained by the corporation itself or derivatively by a representative stockholder) will make stockholders whole and will avoid collateral damage to the issuer corporation.

Finally, the argument here suggests a new rationale for why insider trading should be illegal, namely, that it involves the extraction of wealth from the market and presumptively diversified investors. In turn, this suggests that diversified investors and largely undiversified insiders should be viewed as two different classes of investors with distinct interests. Thus, I also explore the public policy reasons for recognizing such a distinction and some of its other implications.

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