The Deterrence Paradox: How Making Securities Fraud Class Actions More Difficult for Plaintiffs Will More Strongly Deter Corporate Fraud
Volume 82, No. 1, Spring 2009
By S. Michael Sirkin

Corporate America has a problem. This problem predates the “Financial Crisis” and “Great Recession” of the past two years. With average securities fraud cases settling for $62 million in 2006, more than double the average settlement of 2004, plaintiffs’ lawyers have it made. The largesse of this growth industry owes its existence to the current securities law regime and the litigation structure in place in federal courts. But while plaintiffs’ lawyers are happy to rake in their share of lucrative settlements, defrauded shareholders lament that they are being inadequately compensated under the current regime and, worse, that the private securities fraud class action no longer provides incentives for companies to refrain from fraudulently manipulating their share prices.

The impetus and engine for this growth is a legal device known as the fraud-on-the-market theory, under which shareholder plaintiffs are entitled to a rebuttable presumption of reliance that the market price at which they are trading is undistorted by corporate fraud. While the theory is potentially useful at a trial on the merits, it is the plaintiffs’ best weapon at the class certification stage of a case, enabling shareholder plaintiffs to win class certification motions based largely on this powerful presumption. Once class certification is granted, the case is headed for settlement regardless of its merits.

While this theory fueled the class action as a powerful tool for enforcement of the securities laws, its use has spun out of control and must be restricted. Because companies pay settlements to end both strong cases and weak cases of securities fraud in order to avoid expensive discovery and litigation costs, there is no incentive to avoid the abhorrent, morally culpable, fraudulent primary corporate conduct that becomes a strong securities fraud case.

If the securities regulation regime required more in the way of proof at the class certification stage, frivolous cases would no longer be profitable for plaintiffs’ attorneys. Rather than creating a diversified portfolio of securities cases, plaintiffs’ lawyers would be best off expending their time and energy on strong claims. Consequently, corporate fraud will be more effectively deterred, as only strong claims based on morally culpable conduct, would be punished. Plaintiffs’ lawyers will have less financial success bringing frivolous cases because these cases will no longer be blessed with settlement value that is inherent in a class certification order. Under the proposed regime, corporations will be able to avoid liability by completely and honestly disclosing information, whereas the current approach punishes innocent companies with settlement costs merely because plaintiffs’ lawyers are able to win class certification motions. Thus, the proposed regime would return to the securities laws their proper and intended deterrent effects.

Therefore, this Comment sets forth a proposal for an altered regime that courts should follow, an approach that is similar to the procedure that the Court of Appeals for the Fifth Circuit has recently established. The proposed approach requires proof of loss causation–proof that the fraudulent misstatement or omission actually distorted the market price–at the class certification stage. By following the proposed regime, courts will reinforce and restore the efficacy of the deterrent role of securities fraud litigation at little or no additional cost. More importantly, requiring proof of loss causation before applying the rebuttable presumption reflects a more complete and sound understanding of the rationale underlying fraud-on-the-market theory.

Parts II.A and II.B provide an overview of the current state of the law governing private securities fraud causes of action, including the elements and history of the cause of action and the fraud-on-the-market theory and its legal development. To develop a comprehensive approach, Part II.C provides a discussion of the economic and financial principles that form the conceptual foundation of fraud-on-the-market theory and that underlie much of securities regulation in general. The remaining sections of Part II demonstrate how the lower federal courts have implemented the theory in practice and how the doctrine has evolved over the last two decades.

Part III of the Comment demonstrates that establishing a requirement that plaintiffs must prove loss causation at the class certification stage as a predicate to earning the fraud-on-the-market presumption of reliance would improve the function of private securities litigation. Part III.A discusses the dispositive nature of class certification decisions on the value of securities fraud claims and sets out the reasons that the suggested change is more than adequate procedurally under the Federal Rules of Civil Procedure and conceptually under current theory and precedent. Lastly, this Comment addresses several counterarguments to the suggested changes and how these counterarguments lack persuasive force considering all the benefits of the proposed change.

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