Do We Need Private Securities Lawsuits?

In a widely-circulated and much discussed February 7, 2007 Wall Street Journal op-ed column entitled “The Class Action Market” (here, subscription required), former SEC Commissioner and Stanford Law Professor Joseph Grundfest (pictured above) takes a look at the declining number of securities fraud lawsuits in 2006 (see prior D & O Diary posts here and here) and reaches the startling conclusion that perhaps it is time to do away with private securities lawsuits altogether.

Grundfest’s views are based on his position that the declining number of suits is due to improved corporate behavior. As he says, “perhaps fewer companies are being sued for fraud because there is less fraud.” He attributes this to the “government’s criminal and civil enforcement strategy.” Not only has this enforcement activity been effective, Grundfest writes, but as a means to protect shareholders’ interests, it is superior to private securities class actions, since private suit recoveries are diminished by the amount of the plaintiffs’ attorneys’ fees. “Investors,” Grundfest writes, “could come out ahead if they simply allowed the SEC to control the process and eliminated the private bar’s cut of the action.”

In addition to the elimination of the lawyers’ costs, the exclusiveness of SEC enforcement would provide superior deterrence: “Private litigation does not have an equivalent deterrent effect because it can’t threaten executives with jail and because damages are almost always paid by corporations and insurers, not the executives who cause the fraud.” In summary, Grundfest writes, “the private class action can be viewed as an expensive, wasteful and unnecessary sideshow that generates little deterrence and offers questionable levels of compensation.”

Grundfest’s proposal to eliminate private securities lawsuits is not entirely original. {UPDATE: Please see the comment below about the origin of this idea; The D & O Diary stands corrected!}The idea of disimplying a private cause of action under Section 10 was circulated in the early stages of the work of the Committee on Capital Markets Regulation (popularly known as the Paulson Committee), as discussed here. Grundfest is a highly respected figure in the securities law arena, and for that reason his views are likely to attract significant attention. But that does not necessarily mean that the private securities lawsuits will disappear any time soon.

First of all, we don’t hear the SEC clamoring to increase its workload; to the contrary, the SEC clearly depends on the private securities bar as a way to outsource part of the burden of enforcing of the securities laws. The SEC’s hands are already pretty full; the SEC could not take on categorically increased responsibilities without a major hike in its budget and in the size of its enforcement staff. {UPDATE: As Adam Savett notes on the newly revitalized Securities Litigation Watch blog (here), the SEC went so far as to state in its amicus brief in the Tellabs case that "meritorious private actions are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by DOJ and the SEC." Savett presents additional "gentle rebuttal" against Grundfest's proposal as well. }

In addition, the introduction of an exclusive public remedy for securities fraud entails significant costs. While shareholders may have to pay attorneys in order to be able to pursue lawsuits, those costs at least are borne by the most interested parties rather than by taxpayers as a whole. And how would taxpayers and corporate American react to a greatly enlarged securities regulator? There is a thin line between respect and fear, and an enlarged and empowered SEC would be even more fearful than it is now. Could deterrence become oppression?

And while Grundfest is correct that the SEC’s enforcement activity has a greater deterrent effect than private litigation, that does not mean that private litigation has no deterrent effect. Most corporate officials want to do the right thing, and they also want to be perceived as doing the right thing. For the typical CFO or CEO, nothing could be more mortifying than finding their name linked in the press to the word “fraud,” even if the accusation comes only from a plaintiffs’ lawyer. This deterrent effect is real and an important part of life for most corporate officials.

Without a doubt, the securities class action lawsuit has been abused. It is an expensive and cumbersome tool for the enforcement of the securities laws. But it nevertheless continues to have an important role to play in protecting investors’ rights. Simply put, investors who are angry don’t have to depend on the government to redress their economic grievances; they can do something about it themselves. For all of the excesses of securities class action lawsuits over the years, it is still a tool of empowerment for investors. Readers who find my defense of the securities class action surprising should understand that I simply prefer the continued availability of a private remedy to the prospect of an even more enlarged and even more empowered SEC with a monopoly on the right to protect shareholders' rights. There was a time, before the courts implied a private right of action, when the sole agent for enforcing the securities laws was the SEC, but private litigants whose interests were not redressed sought a private right of action in order to be able to pursue actions that SEC had not taken up. Without a private cause of action, investors would have no remedy if the SEC failed to act.

I also happen to disagree that the SEC’s enforcement activity alone explains the decline in the number of lawsuits; unlike Professor Grundfest, I think the Milberg indictment is part of the explanation, not for its affect on the Milberg firm alone, but for its effect on the entire plaintiffs’ bar (see my prior post here). I also think the current relatively healthy economy is also part of the explanation. Look at the auto parts industry; that sector has been under pressure lately, and not too surprisingly, just about every public auto parts company has been sued in a securities class action lawsuit in the last 18 months. Just this week, subprime lenders announced deteriorating results, and like clockwork one of the companies (New Century Financial) was sued in a securities class action lawsuit. (here). There are numerous causes for the decline in securities lawsuits, many of which appear to be temporary, so to the extent that Grundfest’s proposal depends on his theory that SEC enforcement activity alone explains the declining number of lawsuits, the proposal should be viewed with caution. Certianly, if the downturn proves to be temporary, the basis of his argument is eroded.

I am surprised that we have not heard a reaction out of the plaintiffs’ bar yet. I suspect we will before too long.

For a good discussion of Grundfest's column, see the Truth on the Market blog (here).

CalSTRS Completes Another Opt-Out Settlement: As I previously noted (here), the increasing prevalence of institutional investor opt-out settlements has important implications for projected severity assumptions and even for appropriate D & O insurance limits. In the latest example of this phenomenon, the California State Teachers’ Retirement System (CalSTRS) announced (here) on February 7, 2007 that it had reached a $105 million settlement of the $135 million investment losses it claimed in its individual action, brought after the retirement fund opted out of the $2.65 billion class settlement. (Refer here for a description of the class settlement.) CalSTRS announcement in the AOL Time Warner case come just days after it announced a $46.5 million settlement in the case it filed against Quest.

In an article on CFO.com (here), counsel for CalSTRS is quoted as saying that if CalSTRS had not opted out of the class, it would have recovered only $15.5 million to $16 million. In other words, its recovery of its investor loss supposedly was increased 6.5 times by pursuing a separate action. The $105 million settlement represents about 78% of its claimed investment loss.

As I noted in my prior post linked above, separate settlements of this type, even if limited exclusively to the largest securities lawsuits, could have an enormous impact on the complexity and cost of private securities litigation.