Milberg, the big securities class action firm, recently paid the government $75 million to avoid prosecution for bribing “professional plaintiffs” to serve as stalking horses for its lawsuits. This settlement followed the guilty pleas of two of the firm’s former partners, Bill Lerach and Melvyn Weiss, for their parts in the scheme. The convictions of these deans of the plaintiffs’ bar have brought the predictable calls to crack down on class action lawyers. The truth, however, is that lawyers are simply responding to the perverse incentives created by our system of securities fraud litigation. The problem is the system, not the lawyers.
It should come as no surprise that the plaintiffs’ bar would need to bribe shareholders to get them to bring suits: Securities fraud class actions are a “pocket shifting” exercise for shareholders. In most fraud cases, a plaintiff alleges that a misstatement made by a company’s executives distorted the company’s stock by 10% to 20% or more. The corporation itself typically has not benefitted from the fraud that inflated the price, except in the rare case in which it was selling securities. The motive usually lies with the executives, who were trying to hold on to their jobs or maximize the value of their stock options by goosing the earnings numbers. But the dollars paid in these suits come from the corporation, either directly in the settlement or indirectly in the form of premiums for insurance policies. The corporate officers who actually committed the fraud are sued, but they almost never pay. The settlements paid out by corporations mean fewer dollars available for dividends and investment. Shareholders effectively take a dollar from one pocket, pay about half of that dollar to lawyers on both sides, and then put the leftover change in their other pocket.
The U.S. Supreme Court set the groundwork for this circular and costly exercise 20 years ago in Basic Inc. v. Levinson. The court effectively eliminated the reliance requirement for plaintiffs suing large companies whose stock is actively traded — and unwittingly released the floodgates for securities class actions. Plaintiffs, instead of having to allege that they read and relied upon the misstatement before purchasing, could instead claim that the market relied on the lie and it was reflected in the stock price.
Damages for defendant’s gain
Basic ignored the question of damages. The current damages formula compensates the shareholders on the losing end of trades — which can amount to billions of dollars — while ignoring the equivalent windfall gain that the selling shareholder got from selling at an inflated price. Compensation only makes sense when the defendant’s gain roughly corresponds to the plaintiff’s loss.
Measuring damages by the defendant’s gain would accomplish two things. First, it would scale back the stakes in securities class actions. Currently, the enormous potential damages are a powerful incentive for plaintiffs’ lawyers to bring even weak suits and a powerful incentive for the company to settle, even if it believes that it will win at trial. It takes a gutsy (or foolhardy) board to bet the business on a jury’s hindsight. If stakes are limited to millions of dollars, rather than billions, going to trial is a viable option. Second, measuring damages by the defendant’s benefit would focus deterrence on the executives who actually lied. Instead of going after the corporation, which usually does not benefit from the fraud, plaintiffs’ lawyers would be forced to pursue the actual culprits, making them give up the bonuses and stock-options profits that they obtain as a result of the fraud. Forcing the actual fraudsters to pay would go a long way toward deterring fraud.
Billions are being passed around in securities fraud class actions, to no apparent purpose other than the enrichment of lawyers. Shareholders have waited too long for Congress or the high court to fix this mess; they have the power to make the necessary reform themselves. The U.S. Securities and Exchange Commission’s proxy proposal rule allows shareholders to recommend amendments to a company’s articles of incorporation. An amendment limiting damages in secondary market cases and requiring actual reliance for claims of compensation would undo the harm caused by the Supreme Court in Basic. Corporations would face billion-dollar lawsuits only if they had been fraudulently selling billions of dollars in securities.
More importantly, it would end the absurdity of shareholders compensating themselves and sanction the actual wrongdoers. Here, shareholder democracy has the potential to actually increase returns for shareholders. Any takers?
Adam C. Pritchard is a securities law professor at the University of Michigan Law School.