Resident Fellow Ted Frank
The plaintiffs had sought to hold third parties liable for Enron's fraud. Though the Supreme Court had rejected the theory of "secondary liability" in 1994, and Congress ratified that decision when it passed the Private Securities Litigation Reform Act, a federal district court certified a class and permitted the plaintiffs to proceed on a theory of "scheme liability." The alleged "scheme"--consisting of nearly a hundred defendants and non-defendants and 60 separate financial transactions--was implausible, given the fortunes lost by banks that had invested in what turned out to be worthless Enron securities.
Nevertheless plaintiffs sought to hold the defendants jointly and severally liable for the entire Enron collapse, some $40 billion worth, by alleging a common "scheme." Even a bank that had performed a minor financial transaction where Enron may have committed fraud could find itself liable for the entire collapse.
It is important for markets to be free from fraud, but trial lawyers have incentives other than the optimal operation of the market.
Lead plaintiffs attorney William Lerach, who pleaded guilty this October to a felony from other securities litigation mischief, crowed that the banks would be forced to settle: "If they want to go to the gallows in front of a Houston jury, they can be my guest." Many were given an offer they could not refuse: pay billions to Lerach, or risk solvency at trial.
Several, including Citibank and JPMorgan Chase, paid the protection money. After all, Lerach offered to settle for pennies on the dollar. Even a defendant who believes it has a 90% chance of prevailing in a trial over complex financial instruments is hard-pressed to refuse the opportunity to escape the "gallows." And the settlement amounts show Lerach's true opinion of the case: what well-funded trial lawyer worth his salt leaves billions of dollars on the table if he has a legitimate claim against a solvent defendant?
But other investment banks, including CSFB and Merrill Lynch refused to settle. They appealed the class certification to the Fifth Circuit federal appellate court. The Fifth Circuit's decision was vindicated last week, when the Supreme Court used similar reasoning to reject "scheme liability" in Stoneridge v. Scientific-Atlanta.
But the original legal error by the trial court had a cost. The pennies on the dollar against multiple defendants added up. Several defendants paid a total of $7.3 billion in settlements. The trial lawyers took a $688 million fee from the defendants' innocent investors, money that will be used to finance the next round of extortionate litigation.
It is important for markets to be free from fraud, but trial lawyers have incentives other than the optimal operation of the market. Civil securities litigation plaintiffs' attorneys' incentives are to devote entrepreneurial energies to creating the perception of fraud even where none exists, because the expense of litigation and the risk to a defendant of a mistaken legal judgment means that even a meritless suit has settlement value.
It is hard to see how this benefits shareholders. A well-diversified investor will find herself a plaintiff half of the time and owning shares in a defendant the other half of the time. The Lerachs of the world transfer money from the investor's left-hand to the right-hand pocket and charge a commission for the privilege.
To take a notorious example, when former Comptroller Alan Hevesi's New York State Common Retirement Fund was lead plaintiff in the similarly extortionate WorldCom litigation, it recovered less than what it cost itself because the value of its holdings in defendant investment banks were deflated by the settlement. But the trial lawyers, many of whom were generous contributors to Mr. Hevesi, made more than $300 million.
Trial lawyers claim that such lawsuits are needed to ensure investor confidence in the market. But the market has spoken otherwise: across the political spectrum, reports from Treasury Secretary Henry Paulson, Senator Schumer, and Mayor Bloomberg correctly worry that the "Achilles heel" of litigation is endangering the global competitiveness of American financial markets as investors rationally decide they are better off with litigation overhang that is less capricious.
The Supreme Court's decision is to be celebrated for shutting the door on further extortion in the Enron litigation, but it can do nothing to help Citibank's or JPMorgan Chase's shareholders recover the money Lerach already took from them.
The Supreme Court and appellate court can correct errors made by the trial courts, but rarely fast enough to prevent those errors from costing innocent shareholders huge sums. The problem of destructive securities litigation will only be solved when Congress takes contingent-fee trial lawyers and their perverse incentives out of the equation.
Ted Frank is a resident fellow at AEI and the director of the AEI Legal Center for the Public Interest.