The loss suffered by buyers in a typical securities fraud class action may come from several distinct sources: lower expected return or a higher cost of capital or a one-time outflow of cash or a combination of such factors. For example, a stock price decrease may flow in part from the probability of a fine resulting from a misrepresentation about expected earnings. Needless to say, the market will react quickly to news about lower expected earnings. But it will also react quickly to the probability of a fine even though it may be paid months later. Under US federal securities law (Rule 10b-5), a buyer may recover the entire difference between purchase price and market price after corrective disclosure. But, as I argue in my paper, ‘Claim Character and Class Conflict in Securities Litigation’, some of this loss should properly give rise to a derivative claim on behalf of the corporation (and thus all stockholders) rather than a direct claim on behalf of a buyer class. While the company itself has no claim for damages based on lower expected earnings, the additional loss from a fine resulting from managerial misconduct is a harm suffered pro rata by all of the stockholders that should give rise to a derivative claim on behalf of the corporation.
In most cases, non-derivative losses can be traced to events that just happen. Neither buyers nor the company itself has a claim based (say) on the loss of a major customer absent a positive misrepresentation by company agents. Ditto for an increase in the cost of capital from newly discovered risk factors or a cash outflow from a freak accident. Thus, for buyers to recover for the part of a loss that comes from bad business luck (simply because of the timing of disclosure) is to restore them to a better position than if there had been no fraud, resulting in over-deterrence. Indeed, investors can protect themselves against bad-luck losses through diversification. Sometimes good luck results in unexpected returns and unexpected increases in stock price. In contrast, the extra loss that derives from managerial misconduct (such as fines) cannot be diversified away: While stock price may sometimes increase because of good business luck, there is no potential for gain from the absence of misconduct.
Coincidentally, the extra loss is always derivative. Moreover, if stock price does not fall by some extra amount over and above a loss that would happen anyway, there should be no cognizable claim. If management has not somehow made matters worse, an action should be dismissed if only for lack of loss causation. In other words, the only losses that really matter are those that are non-diversifiable – which losses also happen to be derivative.
The question is why the courts and litigants have failed to characterize investor claims properly as derivative actions. The answer is a combination of historical factors, conflicts of interest, and market failures. The most promising solution is for index funds acting on behalf of investors to intervene to oppose class certification. Index funds – which trade infrequently and only for purposes of portfolio balancing – lose more as holders (because the defendant corporation pays) than they recover as buyers. They should thus oppose a direct class action remedy in favor of a derivative remedy by which the corporation recovers to the extent of avoidable losses. Because it is impossible to sort out diversified investors who would thus oppose a direct buyer remedy from those who may favor such a remedy, the courts should decline to certify securities fraud class actions on grounds of class conflict. Rather, such actions should be recast as derivative actions (as the courts have the power to do even on their own motion), because a derivative action constitutes a superior form of class remedy under established rules of civil procedure, since a derivative action benefits all stockholders proportionally and only for non-diversifiable losses. For the same reason, derivative actions would provide optimum deterrence against securities fraud.
Richard A. Booth is the Martin G. McGuinn Chair in Business Law at Villanova University – Charles Widger School of Law.