Some people think that private securities fraud litigation is in trouble. Lower courts are struggling to interpret and implement the Supreme Court's 2005 decision in
Dura Pharmaceuticals which created new challenges for plaintiffs seeking to establish loss causation. Many lower courts have interpreted Dura to require that plaintiffs establish both a corrective disclosure and a drop in stock price resulting from that disclosure. Consequently, it has become virtually obligatory for plaintiffs to present expert testimony at the pleading or class certification stage-usually in the form of an event study-distinguishing the effect of the defendants' fraud from market-wide developments or industry downturns. The task is complicated by the fact that some defendants have been able to control the stock price reaction by manipulating the timing of their disclosure or simultaneously disclosing other material developments.
Last spring, the Supreme Court arguably continued its efforts to restrict private litigation with its decision in Tellabs v. Makor Issues & Rights, Ltd case. Tellabs involved the interpretation of the heightened pleading requirement of the Private Securities Litigation Reform Act (PSLRA) under which plaintiffs must plead in the complaint facts giving rise to a strong inference that the defendants acted with scienter. The Court held that, in evaluating the plaintiffs' allegations, courts were required to weigh competing inferences, and that the complaint could survive dismissal only if the inference of fraud was cogent and at least as compelling as any opposing inference of non-fraudulent intent. The decision places the trial courts in the unusual position of weighing the strength of the evidence alleged in the pleadings at the motion to dismiss stage, before discovery has commenced.
Concededly Tellabs itself might be characterized as a moderate decision. The Court explicitly rejected a more stringent interpretation of the statute that would have required the inference of scienter to be more compelling than any opposing inferences. The impact of Tellabs has already been expanded however by some lower courts. This summer, the Seventh Circuit held in the Higginbotham v. Baxter International Inc. case that a complaint based on information provided by confidential witnesses could not meet the Tellabs standard. Judge Easterbrook concluded that anonymity frustrated the court's ability to implement the PSLRA and prevented the court from determining whether the information was compelling or even credible. Because the motion to dismiss is resolved in securities fraud cases prior to discovery, many complaints rely on confidential sources such as current or former employees in order to make the necessary showing to survive dismissal. If Judge Easterbrook's analysis is followed by other courts, this task will be increasingly difficult.
Of greater concern is the Supreme Court's recent decision in the Stoneridge case. Stoneridge involved "scheme liability" and raised the question of whether defendants who had not themselves made fraudulent disclosures upon which public investors relied could be subjected to private liability for securities fraud. The Supreme Court rejected scheme liability, holding that, although the defendants may have engaged in deceptive conduct barred by the statute, private liability did not extend to defendants whose acts or statements were not directly relied upon by investors.
The Stoneridge decision has several important implications. First, the decision reflects the Supreme Court's continued skepticism about the public value of private securities litigation. The Stoneridge Court reiterated the concern (despite the reforms implemented by the PSLRA) that securities litigation often involves weak claims brought in an effort to "extort" settlements. Moreover, the Court explained that it was necessary to protect this class of defendants from the risk of such litigation in order to maintain the competitiveness of the U.S. financial markets. It was disappointing that a majority of the Court so clearly bought into the misplaced argument made by some business interests that scheme liability inappropriately burdens outside professionals. Scheme liability- as pled by the Stoneridge plaintiffs-required each defendant to make deceptive statements or engage in deceptive conduct in order to be held liable. This critically distinguishes scheme liability from aiding and abetting and protects professionals engaged in legitimate business transactions.
Although the Court observed that its holding did not preclude SEC enforcement actions or even criminal prosecutions, government enforcement against third party defendants is uncommon, and the SEC's resources for such enforcement are limited. As a result, the Court's decision threatens to reduce the effectiveness of gatekeepers in safeguarding the integrity of the securities markets. Reducing the ability of investors to hold wrongdoers accountable will make it more difficult for reputable professionals to withstand their clients' requests for assistance in engineering financial fraud.
This concern is illustrated most clearly by the Enron litigation, which will obviously be affected by the Stoneridge decision. Enron involves analogous issues concerning the potential liability of the accountants, investment banks, lawyers and others who structured the special purpose entities and off balance sheet transactions that were integral to committing and perpetuating the massive fraud at Enron. Under the Court's reasoning, private investors may have no recourse against those professionals even if they knowingly created and documented transactions that had no economic substance or legitimate business objective for the sole purpose of misleading investors as to Enron's true financial condition.
Efforts to cut back on private litigation extend beyond the courts. The Paulson Commission Report advocates drastically reducing private litigation, claiming that such a reduction is necessary to maintain the competitiveness of the US capital markets. Legislation introduced into Congress would replace the securities fraud class action with arbitration. Even advocates of private enforcement have questioned whether the current system is structured to maximize its effectiveness. The use of D&O insurance to pay most securities settlements, for example, reduces the ability of plaintiffs to hold individual officers and directors accountable.
The future of securities litigation is not as bleak as it appears, however. Regulatory reforms and institutional involvement appear to have increased the effectiveness of private litigation. Studies show that average settlement amounts reached a record high in 2006 due, in part, to the Enron settlement fund-the largest securities case settlement to date. At the same time, researchers have found that post-PSLRA cases more frequently involve hard evidence of fraud, often targeted at financial disclosures. Private litigation now imposes greater reputational sanctions on corporate officials. Recent academic studies find a substantial percentage of corporate executives lose their jobs when their company has engaged in securities fraud. New provisions in Sarbanes-Oxley may enable issuers to reclaim bonuses and other compensation paid to those executives as well.
Empirical evidence suggests that private enforcement contributes to the significant equity premium issuers can obtain by listing their securities for trading in the U.S. markets. Statistical analyses of securities filings indicate that, over the past two years, the number of filed cases has decreased substantially. One possible explanation is that recent enforcement efforts have been successful-more focused private litigation coupled with increased SEC enforcement efforts and the greater sanctioning authority afforded by Sarbanes-Oxley have reduced levels of fraud.
The growing involvement of institutional investors in securities fraud class actions has also changed the nature of private litigation. Following the lead of several large public pension funds, a range of institutional investors have accepted the role of lead plaintiff. Cornerstone Research reported that more than half of the cases settled in 2006 had an institutional investor serving as lead plaintiff. In a recent survey of public pension funds, Professor Stephen Choi and I found that 55% reported having served as lead plaintiff in securities fraud litigation. This involvement is no longer limited to the largest such funds; smaller pension funds as well as Taft-Hartley Act funds have found that they can be effective lead plaintiffs.
Institutional involvement in securities fraud cases has several consequences. It often serves as a signal of the seriousness of a case, because many institutions are unwilling to serve as lead plaintiff absent strong evidence of fraud. As institutions acquire experience in monitoring securities fraud litigation, they have become knowledgeable and sophisticated repeat players, introducing efficiencies into the full spectrum of litigation decisions ranging from selecting counsel and structuring an appropriate fee agreement to negotiating a settlement. Academic studies find that institutional involvement is correlated with higher recoveries and lower attorneys' fees.
Institutions have also introduced innovative methods to increase the social value of private litigation. These methods include carefully structured fee agreements that both limit attorneys' fees to a reasonable percentage of the recovery and align the incentives of the attorneys and the plaintiff class. An example is the Cendant case in which the settlement was, at the time, the largest ever recovered, and in which the fee agreement, negotiated by three large public pension funds, provided for the attorneys to receive a fee of only 8.275% of the class recovery. Institutions have also sought to increase the accountability of individual wrongdoers and third party defendants. The New York State public pension funds required WorldCom's outside directors to contribute personally to the settlement, and the University of California demanded a similar provision in Enron. Finally, institutions have attempted to reduce future opportunities for fraud through the adoption of corporate governance reforms. Most commonly these governance reforms focus on financial changes and greater director independence. In the recent Bristol-Myers Squibb settlement, plaintiffs, led by lead plaintiff Amalgamated Bank, went further and obtained extensive and ongoing public disclosures of information concerning all BMS's drugs, including clinical trial results.
These developments suggest that efforts to further reduce the viability of securities litigation may be misguided. Perhaps most problematic are obstacles aimed at reducing or eliminating securities fraud class actions. Institutional investors, after all, do not require the economies of the class action mechanism in order to litigate their claims-indeed, a substantial number of institutions are opting out of cases in which they are dissatisfied with the settlement terms and pursuing their own direct actions. The investors who will lose by the elimination of the class action are those whose claims are too small to litigate individually. The US capital markets are distinguished, in part, by their accessibility to and protection of the retail investor, and policy-makers should be wary of sacrificing these qualities.