In We Have a Consensus on Fraud on the Market – And It’s Wrong, James Spindler argues that the near universal disdain among legal scholars for securities fraud class actions (SFCAs) is based on two mistaken ideas: (1) that compensation for securities fraud is impossible because recovery against the issuer means that defrauded buyers effectively pay themselves (the circularity critique); and (2) that most investors are diversified and thus suffer no real harm from securities fraud since buy-side losses wash out from sell-side gains, on average and over time (the diversification critique).
Spindler purports to refute both of these arguments. But the arguments he refutes are not exactly the arguments against SFCAs. In other words, Spindler resorts to the time-tested technique of misstating the opposing argument in order to attack it. This is not to say that the arguments addressed and refuted by Spindler have never been made. Rather, these arguments have been supplanted by a more refined critique of SFCAs that is far more compelling.
Regarding circularity, Spindler recognizes that because the company pays, its value and thus stock price declines even more than it would have done because of a corrective disclosure alone – a process that I have called feedback (See Richard A. Booth, The End of the Securities Fraud Class Action as We Know It). Spindler argues that SFCAs are workable because it is possible, even with circularity, for investors to be compensated in full even though compensation is funded by the defendant company and thus the wealth of its stockholders – including those who are compensated. But that is old news.
What Spindler fails to recognize is that feedback magnifies buyer claims, induces investors to spend more on wasteful precautions, and increases already excessive deterrence. Moreover, it results in a transfer of wealth from index investors to stock-pickers even though the law should encourage investors to diversify.
Regarding diversification, Spindler argues that SFCAs are necessary because one cannot diversify away fraud. Not quite. The loss from securities fraud is a mixture of diversifiable losses that someone will suffer one way or the other (when the truth comes out) and undiversifiable losses that derive from the cover-up of bad news. Bad things happen to good companies. Sales decline. Risks increase. But such losses can be diversified away because unexpectedly good things happen to other companies. In contrast, if an ordinary loss is exacerbated by a cover-up leading to a loss of investor trust (and an increased cost of capital) or cash outflows (from litigation expenses or fines), such additional losses cannot be offset by unexpected gains. There is no potential for gain from the absence of fraud.
The extant rule is that buyers may recover the difference between purchase price and the price following corrective disclosure (as adjusted for any changes attributable to other causal factors including background changes in market prices generally). But this measure of damages comprises several different components of loss, some of which are diversifiable. It turns out that the losses that cannot be diversified away are all derivative in character and should give rise to a claim on behalf of the company rather than against the company. Moreover, derivative actions are perfectly tailored to compensate and deter without the collateral damage caused by feedback.
For the law to provide a recovery for inevitable and diversifiable losses (simply because the company misspeaks in some way) constitutes a windfall for investors who just happen to buy during the fraud period: buyers end up better off than they would have been in the absence of fraud. To be sure, buyers never recover in full. But the problem is that the company pays at all when it is the company that should receive any recovery.
To be sure, the 1933 Securities Act provides expressly for recovery against issuers. Thus, Spindler stresses that investors do not care whether securities fraud involves an offering by an issuer or open-market trading and thus that it does not matter whether the claim arises under the 1933 Act or Rule 10b-5. But the point of the 1933 Act is to return the parties to the status quo ante. Disgorgement is one thing. Feedback is quite another.
In essence, Spindler’s gist is that SFCAs are both workable and necessary. But in the end, his biggest contribution is to show how the arguments against SFCAs have been misunderstood.
Richard Booth is the Martin G. McGuinn Chair in Business Law at the Charles Widger School of Law, Villanova University.