THE END OF THE SECURITIES FRAUD CLASS ACTION AS WE KNOW IT

In the typical securities fraud class action (SFCA), the subject company either delays the disclosure of bad news or issues an unduly rosy press release. Either way, investors who buy during the fraud period pay too much. When the truth comes out, stock price falls. The investors then sue the company (and maybe the accountants or other agents) for the difference between what they paid and what their shares turn out to be worth.

As many legal scholars have noted, stockholders who sell during the fraud period effectively capture a gain equal to the amount of the loss to those who buy. In other words, securities fraud is a zero sum game. But the sellers are not required to reimburse the buyers. Rather, the company pays. But that means that the price of the company stock will fall still further -- sometimes by much more than it would have fallen but for the threat of litigation. In any event, the real losers are long term stockholders who did not trade during the fraud period. This system of supposed investor protection makes no sense at all. It penalizes rational buy and hold investors and rewards active traders.

If investors could get together and talk it over, they would likely agree to stop this insanity. Individual investors would realize that over time they are equally likely to be a seller/gainer as a buyer/loser. Gains and losses will net out. But the cost of litigating securities fraud is a deadweight loss to the system.

There is one big exception. If insiders sell during the fraud period, they change the odds. Innocent outside investors will realize more losses than gains. So they would want a remedy in such cases. But they would not want the remedy to require the company to make good on their losses. That would cause a further decline in stock price to the detriment of those who did not trade during the fraud period. Rather, it would be enough for the trading insiders to give up their gains to the company. That would have the effect of increasing the value of the company by just enough to rebalance gains and losses for outsiders.

There is a really simple way to achieve this solution. Instead of using a class action in which investors are the members of the plaintiff class and seek recovery individually, securities fraud should be litigated in the name of the company, and the company should recover from the insiders who extracted wealth from the market. If the company refuses to sue, then a stockholder can file a derivative action in the name of the company. Moreover, the courts have the power to decide whether an action is a direct class action or a derivative action in which the company is the true plaintiff. So the courts can fix the problem on their own motion if necessary.

As you might guess, I have a written a full-blown article on this subject:

WHO SHOULD RECOVER WHAT IN A SECURITIES FRAUD CLASS ACTION?

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