A Brief (and Partial) History of Securities Litigation

Most legal scholars who have focused on securities fraud class actions seem to agree that such lawsuits ill-serve both investors and issuers. Since most investors can diversify, they have little need for such a remedy. And because any settlement is paid by the corporation—thus causing stock price to decline further—index funds (which do very little trading) almost always lose more on the shares they held from before the fraud period than they recover for any shares they bought that are covered by the class action. Moreover, in most cases the deterrent effect is both excessive and misplaced, chilling voluntary disclosure. Deterrence is excessive because under the prevailing approach to damages—the difference between price paid and price following corrective disclosure—the class can recover for consequential losses from any event that exposes a concealed risk and not just the difference in price that would have prevailed at the time of purchase if the market had known the whole truth about the company. And deterrence is misplaced because any recovery for the materialization of a concealed risk that should have been addressed by management should go to the corporation by means of a derivative action—which would mitigate any class claim (not to mention depleting the insurance pot that largely motivates such actions).

To understand how we ended up with this dysfunctional system—and perhaps how to fix it—my paper traces the evolution of federal securities law and private civil actions thereunder from the Securities Act of 1933 to Rule 10b-5 of the Securities & Exchange Act of 1934 and beyond. Although it is tempting to look for some unique decision or event—a wrong turn that explains everything—the truth tends to be messy. There are several factors that led us to where we are today. It would be an exaggeration to call it a perfect storm. It is more accurate to see it as the result of a series of seemingly minor events with bizarre cumulative consequences. Nevertheless, there is one central misconception at the heart of the problem: That investors should be compensated when they buy (or sell) at a price affected by misinformation emanating from the issuer. To be sure, the 1933 Act permits an investor who purchases securities directly from a corporation to recover from the corporation if there is a material misstatement of fact in the registration statement or prospectus. In other words, the corporation is required to give back the money. That is a perfectly fair and symmetric result. But disgorgement of ill-gotten capital by the issuer is at least equally important as making investors whole.

In contrast, Rule 10b-5 is a catch-all anti-fraud rule that applies to all trading in securities—including trades in which the corporation itself does not participate. The crucial mistake was extending the narrowly tailored remedy under the 1933 Act to situations in which the corporation itself is neither seller nor buyer. As will be seen, this error was the result of a series of court decisions, which seem quite sensible when considered one at a time. For example, requiring plaintiffs to trace the shares they bought to the offering makes sense given the statutory scheme. And there is little doubt about the provenance of shares in most initial public offerings. But if the issuer has shares already outstanding—as before a follow-on offering—it may be impossible for buyers who buy in the aftermarket to trace shares to the offering, leaving them without a remedy under the 1933 Act. It is thus no wonder that plaintiffs sought to use Rule 10b-5 to assert their claims, albeit at the cost of proving scienter, reliance, and other elements of fraud that do not figure into a strict liability claim under the 1933 Act. And it is no wonder that courts, whose attention was focused for them on investor compensation, were sympathetic to the plight of hundreds or thousands of aggrieved buyers. But with the fraud claim of aftermarket purchasers established, there is no obvious reason why it should be limited to the happenstance of a more or less contemporaneous offering. The result is the event-driven claims we see today.

Moreover, the effect of these decisions was compounded by changing procedural rules relating to class actions and derivative actions that interacted with substantive law. The most obvious was the 1966 revision to Rule 23 of the Federal Rules of Civil Procedure allowing for opt-out class actions, which was prompted in no small part by the need to deal with securities litigation. Although the rule also embodied a requirement that a class action for damages be superior to other modes of resolving a dispute—which should divert any derivative element of damages to an action on behalf of the defendant corporation—the rule also induced the courts to seek (and find) a market-based measure of damages that ultimately obscures the true nature of buyer claims for compensation.

Taken together such discrete steps in the evolution of securities law—none of which are really mistaken—have led the courts horribly astray such that the Supreme Court has heard 86 cases involving Rule 10b-5 alone since 1967. While that record may also reflect the extraordinary growth of the equity market, it nonetheless suggests something awry in the law. To be sure, the market has also evolved from one in which individual stock-picking investors predominated to one in which most shares are held in well-diversified (if not indexed) portfolios. But that suggests an even more pressing need to consider the path taken by securities law that got us to where we are today.

Richard A. Booth is the Martin G. McGuinn Professor of Business Law at Villanova University Charles Widger School of Law.

The author’s paper can be found here or here.