March 2004
Are Shareholder Lawsuits Useful or Frivolous?
Critics of shareholder lawsuits argue that most of these legal actions generate more harm than good, imposing large costs on a firm and its shareholders without doing much to deter fraudulent or negligent behavior on the part of executives. Panelists at this March 18 AEI event evaluated the effects of shareholder litigation and offered suggestions concerning legal reforms that are likely to advance the interests of shareholders.
Jonathan Klick
AEI, Florida State University College of Law
One of the primary failings of the tort reform movement is that without any sort of investigation, its advocates call for reform. They do not specify what reform is, but they know that they need to have it. Today we hope to shed a little bit of light on whether the Private Securities Litigation Reform Act of 1995 has done anything to discourage frivolous lawsuits in the securities area, and then also from a more general perspective, to try to determine whether securities cases do tend to be frivolous or whether they have merit.
Adam Pritchard
University of Michigan Law School
The question about whether the merits matter at all in securities class actions emerged as a debate in the early 1990s. Congress, in its infinite wisdom, decided that the plaintiffs' bar was hurting companies and investors, and the result was the Private Securities Litigation Reform Act (PSLRA). For purposes of discouraging merit-less suits, the Act creates pleading standards requiring particularity as to the misstatement alleged and facts pointing to the defendants' awareness that is was a misstatement, a safe harbor for forward-looking statements, and a discovery stay prohibiting plaintiffs from deposing executives. Those three elements should make it a lot easier to win on a motion to dismiss-at least in theory. But the number of lawsuits has not declined in any measurable way. Our analysis is an attempt to understand the post-PSLRA litigation climate-what has changed and what has stayed the same.
Post-PSLRA, market cap is still important; if you are a big firm, you are more likely to get sued. The stock price drop is still an important predictor of suits, as is an earnings shortfall. But some of the variables that suggest problems, either with the company's accounting or the governance, are significant. In general, it does look like the lawsuit filings are better explained, by some of our variables that attempt to proxy for likelihood of fraud, than they were in the pre-PSLRA period. And there is some evidence that accounting and insider-trading allegations are more closely correlated to accounting and insider-trading problems, which is what you might hope. We conclude that the merits matter somewhat more post-PSLRA, at least in the filing of lawsuits and the allegations made in those lawsuits. But we do not really see a clear shift when we look at the outcomes.
Eric Helland
President's Council of Economic Advisors, Claremont McKenna College
Given the amount of discretion and hidden information implicit in corporate management, outside directors have an interest in maintaining a reputation for trustworthiness. If private securities class actions are meritorious, we would expect directors to pay a reputational penalty when they are accused of fraud; if it comes out that a director has been implicated in a fraud, other companies may find that person a less attractive addition to their board. I compiled data regarding net directorships, new boards minus exits from 1994 to 2002 on publicly traded companies in the United States, and securities cases from 1985 to the present. Out of the three hundred thousand director years available, about sixty-six thousand people have served on a board that, during their tenure, was accused of committing fraud. My results show that a fraud accusation in a private securities case has a statistically significant and positive impact on the reputation of directors. That is, a fraud allegation increases the number of net outside directorships by almost 100 percent.
Becoming the CEO of a Fortune 500 company, which is a very rare event, has a 373 percent increase in the number of boards on which this CEO will sit-but beyond that, nothing is quite as helpful as being accused of fraud. Several plausible explanations come to mind. One, that critics of this type of litigation are correct, and the average case is designed to elicit settlement, not to punish fraud. In that case active directors will be good targets simply because they are too busy to pursue an active defense. An alternative is that most directors are utterly inert, and activity itself makes a director a target by raising his visibility. A third possibility is that the director learns from the unpleasant experience of being accused and becomes more valuable because of his knowledge. The last is that this accused director is more attractive because he is totally unobservant.
This rather unexpected relationship between fraud accusations and reputational benefit is consistent with the average case being a strike suit-one that does not convey actual fraud-and therefore being discounted by the market. But in cases filed after the passage of PSLRA in 1995, the relationship reverses: an accusation of fraud results in damage to a director's reputation. One plausible conclusion is that PSLRA has shifted the distribution of suits away from strike suits and towards more meritorious suits.
Michael Perino
St. John's University School of Law
What do the findings in these papers tell us about how we should structure our system of securities law enforcement and the relative weight we should accord public versus private enforcement? There are three basic models of securities enforcement: a pure public enforcement system, a pure private enforcement system, and another version of the mixed model we have now. Current reforms have preserved this mixed model by using procedural reforms to try to screen out the non-meritorious suits.
Mr. Pritchard and Mr. Helland's papers present good news. The screening device, in the form of PSLRA, seems to work. However, it can only be partially effective in weeding out bad cases because of the necessary discretion of individual judges, differing court standards, and complaints purposefully constructed to obscure the merits (or rather the lack thereof). Despite the crudeness of the current system, however, it is doubtful that we could construct a better one. Consider the "paradox of pleading standards." In order to complement the SEC's enforcement efforts, Congress allowed for private enforcement under a higher pleadings standard aimed at forcing attorneys to select and research cases carefully. But after the adoption of the higher standard, more cases were filed more quickly, suggesting the opposite of the intended effect. It appears that attorneys sought out the most obvious cases of fraud, and in the process duplicated SEC actions rather than complementing them.
So what is the dynamic interaction between the SEC's enforcement efforts and the enforcement efforts of private plaintiffs' attorneys? Does the SEC in some sense structure what they are going to do in enforcement based on what the private actors are already doing? For example, where are we most likely to have under-enforcement in private securities litigation? The answer is in cases where the damages are too small to make it worthwhile for the plaintiff's attorney. That is where the SEC has traditionally focused its enforcement efforts: on cases involving stock manipulation, penny stock fraud, and insider trading. But in some of the more high profile cases, it is reasonable to argue that there may not be enough deterrence from private actions and reputational effect. So perhaps the SEC needs to step in and seek an officer-director bar to prevent a director from holding that position in the future.
The current system appears to have achieved some sort of balance. Before we jump into the next set of reforms, we should attempt to understand how these various enforcement actors work together in this system that we have now.
AEI research assistant Kate Rick prepared this summary.
