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Martha is free, but securities fraud is back in court. The issue pending before the Supreme Court in Dura Pharmaceuticals Inc. v. Broudo is whether a disappointed investor must prove that a company’s false statement caused his loss. One would think that such an easy question would have an easy answer. But in the high-stakes world of securities fraud class actions, nothing is that simple. In the typical securities fraud case, plaintiffs claim that they bought the stock on the open market at too high a price because the company either had “puffed up” the stock or had withheld negative information. When the truth came out, the price of the stock fell. The connection between disclosure and decline is immediate and apparent. But in Dura Pharmaceuticals, the price of the stock fell before the corrective disclosure. When the facts came out, the stock price just sat there. Either the market had already divined the truth or the information did not matter. Plaintiff investors argue that it’s enough that a stock was overvalued when they bought. The fact that the efficient market somehow figured out the truth before it was made public is irrelevant. Defendant companies argue that it must be shown that the disclosure itself caused the price to fall. Otherwise investors may be able to recover whenever they lose money on an investment as long as they can find some misstatement or omission in the recent past. But loss causation is a red herring here. The real problem is the idea that disappointed investors should be able to sue the issuer for losses, period. A ZERO-SUM GAME Securities fraud in connection with open-market trading is a zero-sum game. For every buyer-loser, there is a seller-winner. Gains and losses net out. But buyers cannot sue innocent sellers. So buyers sue the company because when its employees committed fraud, the company thereby misled the market � a legal theory that the Supreme Court itself blessed in 1988 in Basic Inc. v. Levinson. Besides the company, the real losers become those investors still holding the stock: They see their share prices fall still further because now the company must compensate some buyers. Still, someone must lose � right? Wrong. The whole idea of a securities fraud class action is misguided because it’s based on the unrealistic notion of a “reasonable investor” who owns a single company’s stock. The truth is that a reasonable investor diversifies, by purchasing many different stocks or, more commonly, by investing in mutual funds representing as many as 200 stocks. Over time, a diversified investor will be a seller-winner about as often as a buyer-loser. More often, he will be a holdover investor. Accordingly, for a reasonable investor, there is nothing to gain and much to lose from securities fraud class actions (unless he also happens to be a securities lawyer). To borrow an illustration from Stanford law professor Joseph Grundfest, a former commissioner of the Securities and Exchange Commission, imagine that you are in a crowded room in which everyone has $200 in one-dollar bills in his pocket. Dobby, the invisible house elf of Harry Potter fame, flits about the room, randomly picking a single bill from the pocket of one individual and inserting it into the pocket of another. How much would you pay for elf insurance to avoid the risk of ending up a dollar short at the end of the day? Not much. Even though Dobby may redistribute hundreds of dollars, it’s highly unlikely that any individual will suffer a significant loss. Indeed, the most likely outcome is that one will end precisely where one starts � with $200. And it’s almost impossible that one would end up more than a couple of dollars short or long. To pay even a dollar for elf insurance would be a waste of money. DIVERSIFIED CONFLICT Now suppose that a few folks in the room have two $100 bills in their pockets. If Dobby’s practice is to lift a single bill at a time from any one individual, an individual with two $100 bills would likely be worried enough to buy elf insurance. Although the odds remain even that each person will end up with no profit or loss, the risk that certain persons will lose $100 or even $200 is significant. But there’s a cheap and easy way to avoid that risk: An individual can protect himself by getting change and holding only singles. As the story illustrates, a diversified investor shouldn’t be too worried about securities fraud, whereas an undiversified investor (one who can lose half his wealth from a single fraud) will be very worried about it. Undiversified investors might favor hiring a securities guard (so to speak) with sophisticated elf-detection equipment and taxing all investors to pay for protection. On the other hand, diversified investors would be opposed to any such tax for the same reason that they would decline to buy elf insurance. They would argue that the undiversified investors should simply get change for their big bills and stop worrying. Now suppose Dobby keeps every second dollar for himself. Even a diversified investor would worry a bit, because a speedy elf might subtract wealth from the aggregate in the room. In short, although a diversified investor might favor some form of protection in any circumstance, he would be willing to pay for it only when Dobby keeps the money. Protection that covers mere redistribution among investors would still be a waste of money. This allegory captures one of the major problems with securities fraud class actions: the fundamental conflict between diversified and undiversified investors. Simply put, diversified investors should be opposed to expensive insurance in the form of securities litigation, except in situations in which an insider has kept some of the money by trading on withheld information. If they could, diversified investors would get together and agree not to sue except in such cases. But because diversified investors can’t get together and can’t keep undiversified investors from suing, they must go along and file their claims too. An economist would call this market failure. But it’s noteworthy that, according to recent reports, many mutual funds seem to ignore their rights to file claims in class actions. PROTECTING THE RATIONAL The Supreme Court should take the opportunity presented by Dura Pharmaceuticals to institute genuine reforms in the area of private securities litigation � an area ruled largely by judge-made law anyway. The law should stop seeking to protect undiversified investors at the expense of others. It’s costless to diversify. And because diversification eliminates company-specific risk with no sacrifice of expected return, one can safely say that it’s irrational not to diversify. (While investing it all in one company pays off big on rare occasion, that does not change expected return. That’s a bet, not an investment.) The law can’t serve the interests of rational and irrational investors at the same time. Given that securities law is designed to protect rational investors and given that diversified investors are effectively protected against securities fraud by virtue of being diversified, simple securities fraud without insider trading is a classic case of no harm, no foul. Such cases should be dismissed for failure to allege any loss at all. So forget about loss causation. Only those actions that involve insider trading or the equivalent entail genuine financial harm to the plaintiff class, because only these actions involve an extraction of wealth from the public market. Accordingly, only cases that allege insider trading or the equivalent should survive a motion to dismiss. Coincidentally (or not), most cases that survive a motion to dismiss do seem to involve insider trading or the equivalent. So it may be that the courts already apply such a standard, albeit in deciding whether company management acted with intent in (and presumably benefited from) withholding material information. CAUGHT IN THE FEEDBACK The other major problem with all securities fraud class actions is that the defendant company pays the damages. As a result, the value of the company is reduced by the amount of the payout in addition to any decline in stock price that results from the disclosure of negative information. Moreover, this reduction in value itself can result in a further decline in stock price. A negative feedback mechanism is set up that can lead to a total decline in price several times greater than the decline that would have resulted simply from the disclosure of negative information. No doubt, the prospect of such devastation deters companies from lying to the market. But for holdover investors, this loss is a significant cost over and above the cost of securities fraud litigation. It does nothing to recoup the gains extracted by elfin insiders. And it may well make companies gun-shy about being more frank with the market. Now, limiting securities fraud actions to cases involving insider trading does not fix the feedback problem. If the company pays for any kind of fraud, feedback happens. But the solution is simple: The company itself should recover the insider gain. Treating a securities fraud action as an action by the company (whether it is maintained by the company itself or derivatively by a representative stockholder) will make stockholders whole at the same it avoids collateral damage to the company. Curiously, that is exactly the solution prescribed by Congress in 1934 when it outlawed short swing trading by directors, officers, and major stockholders. What a long strange trip it’s been. Richard A. Booth is a professor at the University of Maryland School of Law. The forthcoming law review article on which this piece is based can be read at www.ssrn.com.

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