Shareholder compensation as dividend

Michigan Law Review

Volumn 108, Issue 3, 2009, Pages 323-372

  Park, James J ^a  

^a BROOKLYN LAW SCHOOL   (United States)

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EID: 72049109209     PISSN: 00262234     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (302)

1. See, e.g., Jennifer H. Arlen & William J. Carney, Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 U. III. L. REV. 691, 733-34 ("[S]ome existing shareholders are compensated at the expense of the remaining shareholders, but as plaintiffs bear part of the cost of their own judgment.");
2. John C. Coffee, Jr., Reforming the Securities Class Action: An Essay on Deterrence and its Implementation, 106 COLUM. L. REV. 1534, 1556-66 (2006) (describing the circularity problem);
3. James D. Cox, Making Securities Fraud Class Actions Virtuous, 39 ARIZ. L. REV. 497, 509 (1997) ("[A] circularity problem arises for settlements of securities class actions .... [T]he plaintiffs necessarily provide, albeit indirectly, some portion of their own settlement recovery.");
4. Merritt B. Fox, Civil Liability and Mandatory Disclosure, 109 COLUM. L. REV. 237, 280-81 (2009) (describing the circularity problem);
5. Donald C. Langevoort, Capping Damages for Open-Market Securities Fraud, 38 ARIZ. L. REV. 639, 649 (1996) ("[M]oney paid out by the issuer itself is essentially taken from the company's shareholders, who presumably had no direct responsibility for... the fraud.").
6. E.g., In re Cal. Micro Devices Sec. Litig., 168 F.R.D. 257, 272 (N.D. Cal. 1996) ("[S]ettlement payments... are to equity class members little more than the shifting of wealth from their right pocket to their left, and ... class members were to be charged a twenty percent fee by class counsel for this 'service' ...."); Janet Cooper Alexander, Rethinking Damages in Securities Class Actions, 48 STAN. L. REV. 1487, 1503 (1996) ("[P]ayments by the corporation to settle a class action amount to transferring money from one pocket to the other, with about half of it dropping on the floor for lawyers to pick up.");
7. Adam C. Pritchard, 'Basic' Error is Focus on Loss, NAT'L L.J., Sept. 22, 2008, at 26 ("Shareholders effectively take a dollar from one pocket, pay about half of that dollar to lawyers on both sides, and then put the leftover change in their other pocket.");
8. Milberg Weiss: The Boot's on the Other Foot, ECONOMIST, May 27, 2006, at 72 ("The company would typically settle, in effect compensating shareholders with their own money-a slice of which went to Milberg Weiss.").
9. This Article is not the first to liken shareholder compensation to a dividend. See, e.g., Janet Cooper Alexander, The Value of Bad News in Securities Class Actions, 41 UCLA L. REV. 1421, 1444 (1994) ("If the issuer makes the [shareholder compensation] payment, however, it is in effect a dividend."
10. (citing Patricia J. Hughes & Anjan V. Thakor, Litigation Risk, Intermediation and the Underpricing of Initial Public Offerings, 5 REV. FIN. STUD. 709 (1992)));
11. Statement of Joseph A. Grundfest to the Meeting of the Advisory Committee on the Auditing Profession 2 (Feb. 4, 2008) ("Any settlement or judgment paid by the corporation has the effect of a mandatory dividend that is likely to reduce the market value of the issuer's shares."), available at http://www.ustreas.gov/offices/domestic-finance/acap/submissions/02042008/ Grundfest02042008.pdf. But this Article is the first to extensively analyze the issue and contend that some of the arguments used to explain dividends might have applicability to the issue of whether shareholder compensation is justified.
12. Because dividends were taxed as ordinary income by the federal government before 2003, e.g., Katherine Pratt, Deficits and the Dividend Tax Cut: Tax Policy as the Handmaiden of Budget Policy, 41 GA. L. REV. 503, 509-10 (2007) ("Until 2003, investors paid tax on both interest and dividends at ordinary income rates."),
13. the tax rate on dividends for individuals in the highest tax bracket has been well over 50 percent. See Robert A. Wilson, Personal Exemptions and Individual Income Tax Rates, 1913-2002,I.R.S. STAT, OF INCOME BULL., Spring 2002, at 216, 219-20 (compiling historical individual income-tax rates), available at http://ftp.irs.gov/pub/irs-soi/02inpetr.pdf
14. In contrast, there have been few treatments of dividend policy in the legal literature. Zohar Goshen, Shareholder Dividend Options, 104 YALE L.J. 881, 884 (1995) ("[T]he body of legal literature on dividend policy is sparse ....").
15. See, e.g., Amanda M. Rose, Reforming Securities Litigation Reform: Restructuring the Relationship Between Public and Private Enforcement of Rule 10b-5, 108 COLUM. L. REV. 1301, 1302-1303 (2008) ("Most commentators now agree that the private right of action implied under Section 10(b)... cannot be defended on compensatory grounds, at least in its most common form: the fraud-on-the market class action brought against a nontrading issuer."). Despite the academic skepticism, Congress has expressed support for the idea that compensation is an important goal for securities-fraud actions. For example, section 308 of the SarbanesOxley Act allows the SEC to distribute funds collected as penalties to harmed investors. 15 U.S.C. §7246 (2006).
16. See, e.g., Arlen & Carney, supra note 1 (proposing that vicarious liability for securities fraud be replaced with a rule that focuses on agent liability);
17. Richard A. Booth, The End of the Securities Fraud Class Action as We Know It, 4 BERKELEY BUS. LJ. 1 (2007) (proposing that liability for securities fraud be limited to insiders who enrich themselves through false disclosures);
18. Coffee, supra note 1 (proposing elimination of vicarious liability for securities-fraud actions);
19. Alicia Davis Evans, The Investor Compensation Fund, 33 J. CORP. L. 223 (2007) (proposing creation of investor compensation fund); Fox, supra note 1 (proposing that certifying investment banks rather than issuers should be liable for securities fraud);
20. Joseph A. Grundfest, Why Disimply?, 108 HARV. L. REV. 727 (1995) (proposing that the SEC use rulemaking to define the boundaries of liability for securities-fraud action);
21. Rose, supra note 6 (proposing that the SEC play an oversight role in screening securities-fraud actions).
22. See, e.g., Grundfest, supra note 7, at 728 ("[T]he appropriate policy response is to search for strategies that can filter out weaker claims earlier in the process while allowing more meritorious complaints to proceed.").
23. See, e.g., Dura Pharm., Inc., v. Broudo, 544 U.S. 336, 345 (2005) (noting that securitiesfraud actions deter fraud and protect investors from losses caused by misrepresentations);
24. Randall v. Loftsgaardan, 478 U.S. 647, 664 (1986) (noting that securities laws were intended not only to compensate investors but to deter fraud);
25. Berner v. Lazzaro, 730 F.2d 1319, 1323 (9th Cir. 1984) ("Even in situations where an investor is not free from blame, private damage actions under these antifraud and antimanipulation provisions serve not only to compensate injured investors, but also to deter fraud and manipulation by exposing those contemplating unlawful conduct to the threat of private damage liability.");
26. Tucker v. Arthur Andersen & Co., 646 F.2d 721, 727 n.7 (2d Cir. 1981).
27. Though, there is skepticism about whether the current regime is effective in deterring securities fraud. See, e.g., Coffee, supra note 1, at 1536-37, 1548-1556 (arguing that while securitiesfraud actions are needed for deterrence, the current liability structure fails to deter managers who are the primary initiators and beneficiaries of fraud).
28. See supra note 1.
29. Another variant of the circularity problem exists in the context of derivative litigation. If directors and officers are indemnified for judgments in derivative actions, such a payment would be circular because the corporation would both make and receive that payment. Thus, states such as Delaware limit indemnification for judgments relating to derivative actions. DEL. CODE ANN. tit. 8, §145(a)-(b) (2001);
30. see also Arnold v. Soc'y for Sav. Bancorp, Inc., 678 A.2d 533, 540 n.18 (Del. 1996);
31. Sean J. Griffith, Uncovering a Gatekeeper: Why the SEC Should Mandate Disclosure of Details Concerning Directors' and Officers' Liability Insurance Policies, 154 U. PA. L. REV. 1147, 1165 n.58 (2006).
32. See, e.g., sources cited supra note 1. Another variant of this argument is that shareholder compensation is a circular distribution from current shareholders to selling shareholders.
33. See, e.g., Alexander, supra note 2, at 1505;
34. Barbara Black, Should the SEC Be a Collection Agency for Defrauded Investors?, 63 Bus. LAW. 317, 331 (2008) ("The effect is to take corporate funds away from one group of investors, the current shareholders, and pay it to another group of investors, those who traded in the securities during the class damages period.");
35. Michael A. Perino, Did the Private Securities Litigation Reform Act Work?, 2003 U. III. L. REV. 913, 921 ("[Settlements often benefit former shareholders at the expense of current ones. In effect, they can amount to little more than a transfer payment with enormously high transaction costs in the form of a large contingency fee award.").
36. See, e.g., Coffee, supra note 1, at 1562 ("[I]n the case of at least the 'secondary market' securities class action, the victims and the shareholders are largely the same ....").
37. See, e.g., Frank H. Easterbrook & Daniel R. Fischel, Optimal Damages in Securities Cases, 52 U. CHI. L. REV. 611, 641 (1985) ("An investor with a diversified portfolio will be the hidden gainer in a [fraudulent] transaction ... as often as he will be a loser.");
38. A.C. Pritchard, Markets as Monitors: A Proposal to Replace Class Actions With Exchanges as Securities Fraud Enforcers, 85 VA. L. REV. 925, 939 (1999) ("In fraud on the market, for every shareholder who bought at a fraudulently inflated price, another shareholder has sold: The buyer's individual loss is offset by the seller's gain."). There is some empirical support for this argument. A study found that institutional investors break even from investments in companies where there is securities fraud and may even come out ahead. However, the study acknowledged that individuals who are not diversified are at substantial risk of losses.
39. ANJAN V THAKOR ET AL., U.S. CHAMBER INST, FOR LEGAL REFORM, THE ECONOMIC REALITY OF SECURITIES CLASS ACTION LITIGATION (2005), available at http://www.abanet.org/litigation/sponsors/docs/2005-securities.pdf.
40. But see Evans, supra note 7, at 234-235 (arguing that many investors are not diversified).
41. Plaintiffs' attorney fees for securities-fraud actions are at levels typical for contingency cases. See Theodore Eisenberg & Geoffrey P. Miller, Attorney Fees in Class Action Settlements: An Empirical Study, 1 J. EMPIRICAL LEGAL STUD. 27, 50 (2004) (finding plaintiffs' attorney fees in securities-fraud actions average 25% of recovery). Defense costs may be lower but are still substantial, perhaps reflecting the need to hire sophisticated counsel.
42. See Tom Baker & Sean J. Griffith, The Missing Monitor in Corporate Governance: The Directors' & Officers' Liability Insurer, 95 GEO. L.J. 1795, 1815 (2007) (citing estimates of defense costs of 25-35%, but concluding that average defense costs are likely to be about 11% of recovery);
43. Coffee, supra note 1, at 1546 n.38 (discussing the findings of Baker & Griffith and observing that their 11% estimate seems low).
44. See Coffee, supra note 1, at 1556-1566
45. In contrast, suits brought under Section 11 of the Securities Act of 1933, where the allegation is that the corporation committed fraud with respect to a securities issuance, have not been questioned on circularity grounds.
46. See, e.g., Coffee, supra note 1, at 1556-1557 (limiting criticism of securities compensation to "fraud on the market" suits). In a section 11 case, the corporation allegedly realizes gains from the fraud because it raises more funds than it could have without the fraud. A section 11 case essentially seeks a refund of those fraudulent gains.
47. The circularity problem can be avoided when shareholders recover from the directors and officers of the corporation or third parties involved with the fraud. A number of commentators have persuasively argued that a system where agents are held liable is theoretically preferable to the current system where the corporation is vicariously liable.
48. See, e.g., Arlen & Carney, supra note 1 (arguing that vicarious liability for securities fraud should be replaced with enforcement against agents);
49. Coffee, supra note 1 (same). But such a system has not arisen for a number of reasons. First, directors and officers do not typically have the resources to compensate investors for a significant portion of their losses. Second, it can be expensive and difficult to apportion liability among individual directors and managers. Finally, as a doctrinal matter, it is difficult for shareholders to recover against third parties who aided or abetted the fraud.
50. See Stoneridge Inv. Partners v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008);
51. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164,182 (1994).
52. One study finds that some of this decline comes on the date the lawsuit is filed, while part of it comes before the filing date in anticipation of the suit. Amar Gande & Craig M. Lewis, Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers, J. FIN. & QUANTITATIVE ANALYSIS (forthcoming 2009), available at http://ssrn.com/abstract- 891028.
53. Of course, some of the price decline might be attributed to additional factors. See Baruch Lev & Meiring de Villiers, Stock Price Crashes and 10b-5 Damages: A Legal, Economic, and Policy Analysis, 47 STAN. L. REV. 7,10 (1994) ("In crashes, extraneous factors-such as the type of people investing in a stock, how much information they have, the prevalence of automatic trading mechanisms and hedging (such as programmed trading or stop-loss orders), and the ability of specialists on the trading floor to provide liquidity-greatly affect a stock's price.").
54. For an explanation of how fundamental value is calculated, see RICHARD A. BREALEY et al., PRINCIPLES OF CORPORATE FINANCE 85-106 (9th ed. 2008);
55. MCKINSEY & COMPANY, et al., VALUATION: MEASURING AND MANAGING THE VALUE OF COMPANIES 101-131 (4th ed. 2005).
56. This decline can be extremely significant. One study estimates that on average, for financial misstatements, the decline is 7.5 times the size of the legal penalties imposed on the company. Jonathan M. Karpoff et al., The Cost to Firms of Cooking the Books, J. FIN. & QUANTITATIVE ANALYSIS (forthcoming 2009), available at http://ssrn.com/abstract-652121.
57. If securities-fraud actions are perceived to be without merit, the "Credibility Decline" is likely to be small. There is some evidence that for directors, the reputational effect of fraud allegations is minimal.
58. See Eric Helland, Reputational Penalties and the Merits of Class-Action Securities Litigation, 49 J.L. & ECON. 365 (2006).
59. See, e.g., Alexander, supra note 3, at 1435 ("To the extent that investors predict that litigation will follow an adverse disclosure, the market's reaction to the disclosure will include not only its valuation of the information disclosed, but also the anticipated direct and indirect costs of litigation over the disclosure."). As Richard Booth argues, a 10b-5 Decline increases potential recoverable damages, which in turn could create a feedback effect that further increases the 10b-5 Decline. See Booth, supra note 7, at 19-23. But the size of the feedback effect may be minimal if the market values the stock using fundamental analysis based on its future earnings or dividends. See sources cited supra note 22. If the market perceives the costs associated with a securities-fraud action as a one-time, nonrecurring cost, then shareholder compensation should not significantly affect the future cash flows of the company.
60. See, e.g., James J. Park, Assessing the Materiality of Financial Misstatements, 34 J. CORP. L. 513, 539-541 (2009) (citing literature indicating that the market tends to discount one-time events in valuing a stock).
61. Of course, there are shareholders who are unaffected by the fraud. A shareholder may have both purchased and sold stock within the period when the stock was inflated.
62. 15 U.S.C. §78bb(a) (2006). According to the United States Supreme Court, the " 'correct measure of damages ... is the difference between the fair value of all that the [plaintiff] received and the fair value of what he would have received had there been no fraudulent conduct.' "
63. Randall v. Loftsgaarden, 478 U.S. 647, 661-62 (1986)
64. (quoting Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 155 (1972));
65. see also Green v. Occidental Petroleum Corp., 541 F.2d 1335, 1342 (9th Cir. 1976).
66. The law is unclear as to the precise meaning of "actual damages." See Robert B. Thompson, "Simplicity and Certainty" in the Measure of Recovery Under Rule 10b-5, 51 Bus. LAW. 1177, 1179 (1996). The Private Securities Litigation Reform Act of 1995 ("PSLRA") limits any recovery to the difference between the purchase price and the average trading price of the security ninety days after a corrective disclosure, 15 U.S.C. §78u-4 (2006), but neglects to provide much substantive guidance as to damages.
67. Thompson, supra, at 1177-78. The legislative history to the PSLRA suggests that damages should include "losses caused by the fraud and not by other market conditions." H.R. REP. NO.104-369, at 42 (1995) (Conf. Rep.), reprinted in 1995 U.S.C.C.A.N. 730, 741. Commentators have differed as to whether 10b-5 Declines might be considered "losses caused by fraud." Compare Alexander, supra note 3, at 1434 (implying that 10b-5 Decline is not recoverable), with Booth, supra note 7, at 8 (implying that 10b-5 Decline is recoverable). Also, it is unclear whether the Credibility Decline is caused by the fraudulent statement, or would be considered a subsequent market event.
68. Like Class Shareholders, some Non-Class Shareholders sell and others hold onto their stock.
69. Alexander, supra note 2, at 1497-98 (noting that Benefiting Shareholders are "not required to refund their windfalls");
70. see also Easterbrook & Fischel, supra note 15, at 639-640 ("Because the sellers are no longer investors in this firm, and because there are bystander-investors, a payment of damages by the firm would not be a wash. Damages computed on the basis of the investors who purchased [on the basis of fraud] would greatly exceed the optimal sanction."). 31. Because of the Credibility and 10b-5 Declines, the amount that the Benefiting Shareholders benefit by (usually equal to the Fundamental Decline) is likely to be less than the losses to investors.
71. Evans, supra note 7, at 229 (arguing that the losses of investors are likely to be greater than gains of investors on winning side).
72. Of course, there will be cases where some of the Benefiting Shareholders are insiders who know of the fraud and sell. A securities-fraud action might recover those gains directly from such parties, either on an insider-trading theory, or if the insider participated in the fraud, a securities-fraud action.
73. Some Damaged Shareholders will sell before shareholder compensation is actually paid. They still contribute to shareholder compensation in that the stock they sold is discounted by the 10b-5 Decline.
74. Lawrence Mitchell questions the assumption that such shareholders should be seen as "innocent." Given the trend toward shareholder empowerment, there is a case for making shareholders accountable for failures in corporate governance. Lawrence E. Mitchell, The "Innocent Shareholder": An Essay on Compensation and Deterrence in Securities Class-Action Lawsuits, 2009 Wis. L. REV. 243, 287-291
75. See, e.g., Fischer Black, The dividend puzzle, J. PORTFOLIO MGMT., Winter 1976, at 5 (concluding that literature does not provide compelling explanation for dividend payments).
76. Open-market repurchases of the corporation's own stock have similar effects as dividends. By increasing demand for the firm's shares, such repurchases might increase the firm's stock price. But the repurchases must be financed from the firm's own capital, reducing the amount of capital that could be invested on behalf of shareholders.
77. See William W. Bratton, The New Dividend Puzzle, 93 GEO. L.J. 845 (2005). In addition to buying its own shares in the market, a company can make a repurchase tender offer, where the company offers a fixed price for shares, usually at a premium over the market price.
78. Jesse M. Fried, Insider Signaling and Insider Trading with Repurchase Tender Offers, 67 U. CHI. L. REV. 421 (2000).
79. BREALEY et al., supra note 22, at 444 (describing special dividend);
80. Bratton, supra note 36, at 877 (same). Special dividends are now rarely paid by companies.
81. See Harry DeAngelo et al., Special Dividends and the Evolution of Dividend Signaling, 57 J. FIN. ECON. 309, 310 (2000) ("[S]pecial dividends were once commonly paid by NYSE firms but have gradually disappeared over the last 40 to 45 years and are now a rare phenomenon.").
82. See BREALEY et al., supra note 22, at 396;
83. Ronald J. Gilson & David M. Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 116 HARV. L. REV. 874, 882 (2003) ("Put simply, a dividend preference in favor of preferred stock prohibits the payment of a common dividend before the payment of a preferred dividend.").
84. See Merton H. Miller & Franco Modigliani, Dividend Policy, Growth, and the Valuation of Shares, 34 J. Bus. 411 (1961);
85. see also Victor Brudney, Dividends, Discretion, and Disclosure, 66 VA. L. REV. 85, 86-87 (1980) (describing irrelevance theory);
86. Frank H. Easterbrook, Two Agency-Cost Explanations of Dividends, 74 AM. ECON. REV. 650, 650 (1984) (same);
87. Daniel R. Fischel, The Law and Economics of Dividend Policy, 67 VA. L. REV. 699, 701-02 (1981) (same).
88. Bratton, supra note 36, at 861.
89. See, e.g., Fischer Black & Myron Scholes, The Effects of Dividend Yield and Dividend Policy on Common Stock Prices and Returns, 1 J. FIN. ECON. 1, 1-2 (1974) ("[T]he existence of differential taxes on income and capital gains should make the shares of corporations that pay low dividends more desirable, and thus a corporation can increase the value of its shares by reducing its payout ratio.").
90. Pub. L. 108-27, 117 Stat. 752 (codified as amended at 26 U.S.C. §1 (2006)).
91. 26 U.S.C. §1(h)(11) (2006).
92. See, e.g., Pratt, supra note 4, at 509-10. Prior to 1986, there was a significant difference. The Tax Reform Act of 1986 equalized the tax rates on dividend and capital gains, but the gap reappeared in 1992.
93. See Aswath Damodaran, Dividends and Taxes: An Analysis of the Bush Dividend Tax Plan 4 (March 23, 2003) (unpublished manuscript), available at http://pages.stern.nyu.edu/-adamodar/pdfiles/papers/divtaxes.pdf.
94. See Wilson, supra note 4, at 216, 219-220
95. See, e.g., Dwight Drake, Transitioning the Family Business, 83 WASH. L. REV. 123, 174 (2008) (noting that dividend tax could increase after 2010).
96. However, it appears that the percentage of companies paying dividends has significantly declined from over 60% to about 40% over the last thirty years.
97. See BREALEY et al., supra note 22, at 443;
98. see also Eugene F. Fama & Kenneth R. French, Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?, 60 J. FIN. ECON. 3, 22 (2001) (finding proportion of industrial companies paying dividends declined from 60% to 20%).
99. The leading corporate-finance textbook utilizes this model. BREALEY et al., supra note 22, at 88-97.
100. See, e.g., John Y Campbell & Robert Shiller, Stock Prices, Earnings, and Expected Dividends, 43 J. FIN. 661 (1988) (finding that historical averages of earnings predict future dividends).
101. BREALEY et al., supra note 22, at 456.
102. Another difference may be that dividends tend to be consistent while shareholder compensation is a one-time payment. In terms of frequency, shareholder compensation may be more similar to open-market repurchases of a stock, which tend to be sporadic.
103. See Murali Jagannathan et al., Financial Flexibility and the Choice Between Dividends and Stock Repurchases, 57 J. FIN. ECON. 355 (2000) (finding that dividends are paid consistently from "permanent" operating cash flows while repurchases are made periodically by firms with " temporary" nonoperating cash flows).
104. Loss spreading occurs even when insurance covers the shareholder- compensation payment. While all shareholders bear the costs of insurance premiums, only Class Shareholders receive the insurance payout.
105. Because most frauds occur over discrete time periods, it may be more likely that there will be fewer Class Shareholders than Non-Class Shareholders. On the other hand, one article argues that it is likely that Class Shareholders will outnumber Non-Class Shareholders: Because of the high volume of shares traded on the national stock exchanges, the number of shares in the potential plaintiff class is likely to exceed the number of shares held by the defendant shareholders. Accordingly, it is likely that the number of victims exceeds the number of the defendant firm's shareholders, in which case the loss spreading argument implies that losses should remain with the victims.
106. Arlen & Carney, supra note 1, at 719. However, the study acknowledges that it is difficult to know the ratio of Class to Non-Class Shareholders because many securities-fraud actions do not specify the exact dimensions of the Class.
107. See id. at 731 ("Fraud on the Market cases are class actions and the plaintiffs, at the time the suit is filed, do not know the size of the class or the potential damages for each class member.").
108. See Park, supra note 25, at 539-541
109. See, e.g., Coffee, supra note 1, at 1557 ("[Securities litigation in this context inherently results in a wealth transfer between two classes of public shareholders-those in the class period and those outside it-and typically neither class is culpable.").
110. 421 U.S. 723 (1975).
111. Id. at 754-755
112. Id. at 737.
113. See id. at 746-747
114. See generally Imán Anabtawi & Lynn Stout, Fiduciary Duties for Activist Shareholders, 60 STAN. L. REV. 1255, 1288-1290 (2008) (noting that conflicts can arise when activist shareholders invest in various parts of a corporation's capital structure).
115. See, e.g., Goshen, supra note 5, at 913.
116. See Bratton, supra note 36, at 889. Of course, if the company purchases stock at a time when the stock is undervalued, such repurchases may benefit current shareholders.
117. As discussed earlier, this is a result of the Supreme Court's decision in Blue Chip Stamps. See supra notes 56-59 and accompanying text.
118. See Lev & de Villiers, supra note 21. By limiting damages to the Fundamental Decline, securities-fraud actions would avoid the feedback effect that might occur by compensating shareholders for 10b-5 Declines.
119. See, e.g., Booth, supra note 7.
120. See Alexander, supra note 2, at 1497-1498
121. This Article is not the first to note that shareholder compensation serves a loss-spreading function. See Merritt B. Fox, Why Civil Liability for Disclosure Violations When Issuers Do Not Trade?, 2009 Wis. L. REV. 297, 304 ("Through loss spreading, compensation can, however, somewhat reduce the amount of disutility in society arising from the risks of loss created by issuer misstatements.");
122. Langevoort, supra note 1, at 649 ("Loss spreading, of course, is what insurance is all about; there is nothing about self-funding that is necessarily objectionable."). But given the skepticism about the effectiveness of shareholder compensation, it is the most recent to extensively defend loss spreading as the rationale for shareholder compensation.
123. See GUIDO CALABRESI, THE COSTS OF ACCIDENTS 39 (1970) ("The justification found most often among legal writers today for allocation of accident losses on a nonfault basis is that accident losses will be least burdensome if they are spread broadly among people and over time."). 68. The commentators who have noted the loss-spreading function of shareholder compensation are skeptical about whether it is cost effective.
124. See Arlen & Carney, supra note 1, at 730-34;
125. Langevoort, supra note 1, at 649.
126. See, e.g., Arlen & Carney, supra note 1, at 719 ("Victims of Fraud on the Market are usually fully diversified investors, as are the shareholders who ultimately bear the costs under a rule of enterprise liability.");
127. Baker & Griffith, supra note 16, at 1822 ("The basic lesson of modern portfolio theory is that shareholders can eliminate idiosyncratic risk-that is, firm-specific losses not simultaneously experienced by other firms in the market-by holding a diversified portfolio of equity securities.");
128. Booth, supra note 7, at 7 ("[M]ost investors are diversified and as a result are effectively protected against simple securities fraud."). An investor might also spread out its purchases of stock over time, the so-called dollar cost-averaging technique, so that it is less likely that any one purchase will be affected by fraud. Indeed, it is possible that some shareholders will simultaneously own stock that falls within and outside of the class.
129. Coffee, supra note 1, at 1558-1559
130. Of course, there are other rationales for securities-fraud actions such as deterrence. See Coffee, supra note 1, at 1548-1556
131. See Evans, supra note 7, at 234-235
132. See, e.g., Donald C. Langevoort, On Leaving Corporate Executives "Naked, Homeless and Without Wheels": Corporate Fraud, Equitable Remedies, and the Debate Over Entity Versus Individual Liability, 42 WAKE FOREST L. REV. 627, 634-635 (2007) (describing how Enron employees were encouraged to purchase company stock).
133. See, e.g., Nicholas L. Georgakopoulos, Frauds, Markets, and Fraud-on-the-Market: The Tortured Transition of Justifiable Reliance from Deceit to Securities Fraud, 49 U. MIAMI L. REV. 671, 702 (1995) ("If misrepresentations raise or lower prices on average, then uninformed traders averse to risk will not trade, lest they buy inflated stocks or sell undervalued stocks.").
134. See generally KRISHNA G. PALEPU et al., BUSINESS ANALYSIS & VALUATION: USING FINANCIAL STATEMENTS 1-7 (2d ed. 2000) ("Not being able to undo accounting distortions completely, investors 'discount' a firm's reported accounting performance.").
135. Access to information might explain the results of the Thakor study, supra note 15, which found that institutions tend to be net beneficiaries of fraud.
136. See, e.g., Georgakopoulos, supra note 73, at 696 ("[E]ven diversified (uninformed) trading is subject to the risk of fraud if the resulting mispricings are biased or correlated.").
137. See id.;
138. Zohar Goshen & Gideon Parchomovsky, The Essential Role of Securities Regulation, 55 DUKE L.J. 711 (2006);
139. see also Jill E. Fisch, Confronting the Circularity Problem in Private Securities Litigation, 2009 Wis. L. REV. 333, 345-348 (arguing that securities litigation is needed despite the circularity problem to compensate nondiversified informed traders).
140. Of course, some shareholders may own stock purchased both in and out of the class period. The economic benefit of shareholder compensation to those shareholders will depend on the circumstances. See Alexander, supra note 2, at 1505.
141. Goshen & Parchomovsky, supra note 77.
142. Id. at 723-724
143. E.g., Jeffrey N. Gordon & Lewis A. Kornhauser, Efficient Markets, Costly Information, and Securities Research, 60 N.YU. L. REV. 761, 802 (1985) ("Expenditures on security research by institutional investors will play a major role in any mechanism that leads to efficient markets.").
144. See, e.g., id. at 789 ("If [the sophisticated trader] fails to acquire any costly information, however, the market might fail to be efficient.").
145. See, e.g., Georgakopoulos, supra note 73, at 676 ("Market efficiency depends on informed trading that cannot be diversified.").
146. See, e.g., id. at 698 ("Informed traders must be compensated for losses they incur due to misrepresentations, or they will not service the market and correct prices.").
147. See, e.g., Goshen & Parchomovsky, supra note 77, at 737, 741.
148. Of course, it is unlikely that the shareholder compensation payment will cover all of the losses from fraud. Evans, supra note 7, at 237-38 (noting that recoveries represent roughly 2-3 percent of losses).
149. E.g., Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 VA. L. REV. 669, 677 (1984) ("A rule against fraud can reduce these [verification] costs, especially for new firms."). One might also argue that mitigating the risk of fraud might not be a good thing because it reduces the incentives of sophisticated investors to seek out fraud. But there is still an incentive because of the risk that an investor will not be totally compensated for its loss. Moreover, there is still such an incentive for short sellers. Short sellers can benefit disproportionately if they discover fraud and so have an incentive to invest in detecting fraud. It might be better to leave fraud detection to specialists who can develop an expertise in fraud detection.
150. Admittedly, encouraging frequent trading might increase speculation and volatility. But speculation may be an important mechanism by which stocks adjust to their fundamental value. Such speculation might be limited by compensating Class Shareholders for only Fundamental Declines. By limiting compensation to declines that reflect misinformation affecting valuation models, shareholder compensation would be less likely to subsidize speculative trading.
151. See Arlen & Carney, supra note 1, at 733 ("In publicly held companies this would mean that a small group of passive investors would partially compensate a large group of similarly situated investors, when in fact, both groups are without fault.");
152. Coffee, supra note 1, at 1559-60; Langevoort, supra note 72, at 634.
153. See, e.g., Georgakopoulos, supra note 73, at 698 ("The uninformed, through long-term investment, share in the economic growth that propels the stock market. But this participation is only possible because of the intervention of informed traders whose profits effectively come out of the pockets of the uninformed.").
154. E.g., JAMES D. COX et al., SECURITIES REGULATION CASES AND MATERIALS 728 (5th ed. 2006) ("To the extent that shareholders of the issuer fund most or all of the settlements and judgments in fraud on the market-type cases, investors as a group are essentially creating a very expensive-and perhaps inefficient-scheme of self-insurance."). The idea that securities-fraud actions should serve as an insurance mechanism is controversial.
155. See, e.g., Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 347-48 (2005) ("Such a rule [allowing for recovery without economic loss] would tend to transform a private securities action into a partial downside insurance policy.");
156. Donald C. Langevoort, Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to Securities Regulation, 97 Nw. U. L. REV. 135, 181 (2002) ("[T]here is very little reason to use the class action device as what is essentially an insurance system against market mood swings.").
157. In a similar vein, a number of commentators have noted that liability under the Securities Act of 1933 for misrepresentations associated with the issuance of securities creates a mandatory "put" option, where an investor is essentially insured against declines in the stock price. See, e.g., Alexander, supra note 3, at 1447, 1452; James C. Spindler, IPO Liability and Entrepreneurial Response, 155 U. PA. L. REV. 1187, 1190 (2007). The analogy is not a perfect fit because a "put" is exercisable at will, but securities-fraud liability is conditioned on the existence of material misrepresentations that cause investor losses.
158. The burden would vary depending on the ratio of Class to Non-Class Shareholders. See, e.g., Arlen & Carney, supra note 1, at 719.
159. As noted earlier in Section II.B.1, this fact should lessen any 10b-5 Decline.
160. These policies are a variant of directors' and officers' ("D&O") insurance policies and are referred to as Side C coverage. See Griffith, supra note 12, at 1166-68. In addition, there are policies (Side B coverage) that cover the entity's costs of indemnifying individual directors and officers. See id.
161. As Coffee explains: To end these uncertainties, insurers began to write "corporate entity coverage," which directly reimbursed the corporation for its own litigation expenses, its own settlement payments in securities cases, and certain other forms of litigation. This form of insurance appears to have first been offered in 1996, and thus is a relatively new development. Despite its recent appearance, entity insurance caught on quickly, and over 90% of D&O insureds reported having entity coverage as of 2002.
162. Coffee, supra note 1, at 1570 (citations omitted);
163. see also Lawrence A. Cunningham, Choosing Gatekeepers: The Financial Statement Insurance Alternative to Auditor Liability, 52 UCLA L. REV. 413, 443 (2004) ("The entity-insurance variation of D&O insurance first appeared in 1996, during the growth period for this coverage.").
164. See, e.g., Booth, supra note 7, at 8 (assuming that "the company pays the damages");
165. Langevoort, supra note 1, at 648-649 (assuming that issuer pays costs)
166. See, e.g., Fox, supra note 66, at 305 (noting that any insurance-funded settlements facilitate loss spreading);
167. cf. Griffith, supra note 12, at 1163 (noting that D&O insurance spreads risk of loss from directors and officers to the company).
168. See, e.g., Cox, supra note 1, at 514 ("[Insurance serves a useful purpose of spreading the loss over a wider range of individuals than those who were the immediate victims of the managers' misbehavior. Such a result seems entirely consistent with the view that the securities class action is compensatory.");
169. John J. Musewicz, Vicarious Employer Liability and Section 10(b): In Defense of the Common Law, 50 GEO. WASH. L. REV. 754, 796-97 (1982) ("[T]here is a general sense of fairness in expecting all investors, who rely on an honest market, to bear the increased cost of employer insurance premiums, an increase caused by those employees and agents who render the market dishonest."). Insurance companies diversify by insuring a wide range of risks.
170. See, e.g., George L. Priest, The Current Insurance Crisis and Modern Tort Law, 96 YALE L.J. 1521, 1542 (1987) ("Essentially, an insurer is an agent for the diversification of risks."). In addition to loss spreading, a number of commentators have focused on the benefits of monitoring that might come about under certain mandatory insurance schemes.
171. See, e.g., Miriam Hechler Baer, Insuring Corporate Crime, 83 IND. L.J. 1035 (2008) (proposing compliance insurance as an alternative to corporate criminal liability); Cunningham, supra note 96 (proposing financialstatement insurance). While insurance companies can monitor companies for securities fraud, Baker and Griffith find that D&O insurers fail to monitor companies over the life of the insurance policy.
172. See Baker & Griffith, supra note 16, at 1808. Moreover, loss spreading may create a moral hazard that decreases the incentive of the insured to avoid losses.
173. See id. at 1817-1821
174. Assume for the sake of simplicity the premium is charged all in one year rather than every year.
175. To simplify the example, assume there is no deductible.
176. See, e.g., Cox, supra note 1, at 513 ("Insurance companies and casinos are both in the odds business-they earn their profits probabilistically.").
177. See, e.g., Baker & Griffith, supra note 16, at 1822 ("Loading fees mean that the cost of buying insurance always exceeds the actuarial probability of loss (otherwise the insurer would be driven out of business)."). Of course, there have been times when insurers do not find it profitable to provide coverage for certain risks.
178. See, e.g., Roberta Romano, Corporate Governance in the Aftermath of the Insurance Crisis, 39 EMORY L.J. 1155, 1158 (1990) (describing crisis in D&O insurance market from 1984 to 1987).
179. See generally CALABRESI, supra note 67, at 133-197 (discussing allocation of costs to least cost avoider).
180. Of course, it is likely that the benefits the Benefiting Shareholder captures from the fraud will be greater than the cost of contributing to insurance coverage.
181. See Baker & Griffith, supra note 16, at 1808.
182. See sources cited supra note 69.
183. See Griffith, supra note 12, at 1171 ("[E]ntity-level coverage for the risk of shareholder litigation is particularly puzzling since the corporation controls the governance processes that create litigation risk.").
184. Id. at 1173; see also Baker & Griffith, supra note 16, at 1832-1833.
185. Cox et al., supra note 91, at 728; see also Langevoort, supra note 72, at 634-635
186. See, e.g., Rebecca M. Kysar, Listening to Congress: Earmark Rules and Statutory Interpretation, 94 CORNELL L. REV. 519, 542-548 (2009) (describing how special-interest groups take advantage of earmark rules).
187. See, e.g., Mitchell, supra note 34, at 246 n.8 ("It is worth noting that, as with all transaction costs, these are only waste if the recipients (in this case, plaintiffs' lawyers), put the money to less good use than do the corporation and insurance companies paying damages.").
188. See Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. L. No.108-27, 117 Stat. 752 (codified as amended at 26 U.S.C. §1 (2006)).
189. See, e.g., John C. Coffee, Jr., Understanding the Plaintiff's Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Actions, 86 COLUM. L. REV. 669, 726 (1986) ("[T]he basic goal of reform should be to reduce the agency costs incident to this attorney-client relationship.").
190. Merton H. Miller & Kevin Rock, Dividend Policy under Asymmetric Information, 40 J. FIN. 1031, 1031 (1985);
191. see also Bratton, supra note 36, at 862-63 (describing signaling theory);
192. Martin Feldstein & Jerry Green, Why Do Companies Pay Dividends?, 73 AM. ECON. REV. 17, 18 (1983) ("[D]ividends are a signal of the sustainable income of the corporation: management selects a dividend policy to communicate the level and growth of real income because conventional accounting reports are inadequate guides to current income and future prospects.");
193. Fischel, supra note 39, at 709 ("[B]oth theory and empirical evidence seem to indicate that, although dividend policy has no independent impact on the value of the firm's shares, changes in dividend payout frequently convey new information about the prospects of the firm.").
194. This was especially so in the early part of the twentieth century when there was weak financial disclosure. Steven A. Bank, Is Double Taxation a Scapegoat for Declining Dividends? Evidence From History, 56 TAX L. REV. 463, 471 (2003) ("Given the weakness of [early twentiethcentury] financial disclosure, a liberal dividend policy served an important signaling function for current and potential stockholders.").
195. See, e.g., Bratton, supra note 36, at 865-66 (summarizing finance literature establishing that dividend signal is weak); Easterbrook, supra note 39, at 651; Miller & Rock, supra note 115, at 1046 ("But in a world with rational expectations, dividends, for all their pleasant connotations, cannot turn a loser into a winner.").
196. See supra note 47.
197. See Bratton, supra note 36, at 865.
198. See, e.g., Brudney, supra note 39, at 109-11 (describing different messages that could be conveyed by dividend decisions). Victor Brudney thus proposes that management be required to make disclosures about the basis for certain types of dividend decisions. See Brudney, supra note 39;
199. see also William W Bratton, Dividends, Noncontractibility, and Corporate Law, 19 CARDOZO L. REV. 409 (1997) (discussing Brudney's disclosure proposal in light of incomplete-contracts model).
200. But see Fischel, supra note 39 (criticizing Brudney's proposal).
201. See Joseph Aharony & Itzhak Swary, Quarterly Dividend and Earnings Announcements and Stockholders' Returns: An Empirical Analysis, 35 J. FIN. 1 (1980) (finding empirical link between dividends and earnings);
202. David J. Denis et al., The Information Content of Dividend Changes: Cash Flow Signaling, Overinvestment, and Dividend Clienteles, 29 J. FIN. & QUANTITATIVE ANALYSIS 567 (1994).
203. But see Paul M. Healy & Krishna G. Palepu, Earnings Information Conveyed by Dividend Initiations and Omissions, 21 J. FIN. ECON. 149 (1988) (finding abnormal 4 percent rise in stock price following dividend announcements by companies paying dividends for first time).
204. See, e.g., Bratton, supra note 36, at 868 (reporting that dividend cuts on average cause 6 percent drop in stock price); Miller & Rock, supra note 115, at 1046 ("[T]he best place for empirical researchers to look for evidence of dividend signalling may well be among firms falling into adversity, not because they then start signalling, but because they stop.").
205. Though, in times of economic turmoil, many corporations reduce their dividends.
206. See, e.g., Bratton, supra note 36, at 866 ("The corporate governance system holds out plenty of ways to signal confidence about future performance.").
207. And the credibility of a dividend decision may be lessened if management does not make additional commitments to signal their belief. See Harry DeAngelo et al., Reversal of Fortune: Dividend Signaling and the Disappearance of Sustained Earnings Growth, 40 J. FIN. ECON. 341 (1996). 126.
208. See id. at 364-365 ("[A]nother possibility is that ... managers suffer from a behavioral bias-over-optimism-that leads them to overestimate future earnings when growth prospects fade.").
209. At least in terms of signaling, shareholder compensation is more analogous to a decision to cut a dividend than the decision to pay a dividend.
210. The size of the settlement might provide some signal as to the merit of the case, but the signal is difficult to precisely interpret. Janet Cooper Alexander famously argued that settlements of securities-fraud actions are unrelated to the merits, pointing to a small sample of settlements that fell within a similar range.
211. See Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements in Securities Class Actions, 43 STAN. L. REV. 497, 514-15 (1991). More recent studies have criticized Alexander's methodology, and a study in 2008 establishes that settlements of securities-fraud actions vary significantly in size.
212. See James D. Cox et al., There Are Plaintiffs and ... There Are Plaintiffs: An Empirical Analysis of Securities Class Action Settlements, 61 VAND. L. REV. 355, 384 (2008);
213. see also Grundfest, supra note 7, at 743 (finding variance in settlement amounts, but also finding that a significant number of suits were likely to have been without merit). A key metric, according to Joseph Grundfest, is the difference between the settlement amount and the cost of defending the lawsuit.
214. See id. at 740-41. If the settlement amount is lower or equal to the defense costs that would be incurred in defending the suit, it may signal that the parties believe that the case is likely without merit. See id. at 741. To the extent that the settlement amount is greater than the potential defense costs, the company may be signaling that it has identified an issue that must be addressed through a substantial payment. See id. And indeed, there appears to be evidence that directors and officers pay some reputational penalty for significant settlements, indicating that larger settlements may send a signal.
215. See Helland, supra note 24. Though settlements differ in size, it is still difficult to conclude that settlements clearly signal the merit of a case. A large settlement might only reflect that a lawsuit was associated with a large stock price decline and that the risk of not settling the case was high rather than that management is truly culpable.
216. To the extent that directors or officers are named in the suit, a board may have an incentive to settle the case to protect their peers. See Coffee, supra note 1, at 1566-1567
217. See id. at 1569-1570
218. There is evidence that policy limits often influence the size of settlements. See Tom Baker & Sean J. Griffith, How the Merits Matter: Directors' and Officers' Insurance and Securities Settlements, 157 U. PA. L. REV. 755 (2009). On the other hand, while a large settlement might indicate simply that the insurance company does not want to fight, or faces a significant amount of exposure, it can also be read as a recognition that there is enough merit to the claim that a substantial payment is necessary to resolve the case. Baker and Griffith found evidence that parties consider the "sex appeal" of the case in assessing settlements.
219. Id. at 787-788
220. See Grundfest, supra note 7, at 739 ("At the core of any settlement calculation lie the parties' assessments of the probability and magnitude of any potential verdict.").
221. Studies differ on whether scandals result in significant manager turnover. Compare Anup Agrawal et al., Management Turnover and Governance Changes following the Revelation of Fraud, 42 J.L. & ECON. 309 (1999) (finding little evidence of higher management turnover in firms charged with fraud),
222. with Greg Niehaus & Greg Roth, Insider Trading, Equity Issues, and CEO Turnover in Firms Subject to Securities Class Action, 28 FIN. MGMT. 52 (1999) (finding higher CEO turnover in firms accused of fraud compared to other firms that experience large stock price drops).
223. See, e.g., Bratton, supra note 36, at 866-67 (describing agency-cost explanation); Feldstein & Green, supra note 115, at 18 ("[Shareholders distrust the management and fear that retained earnings will be wasted in poor investments, higher management compensation, etc.").
224. Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 AM. ECON. REV. 323, 323 (1986).
225. See, e.g., id. ("Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow.").
226. See, e.g., Goshen, supra note 5, at 889 ("[Dividend] distributions themselves decrease funds available for suboptimal managerial investment and perquisite consumption.").
227. See, e.g., Goshen, supra note 5, at 896-97 (describing disciplining effect of debt); Jensen, supra note 135, at 324 ("[D]ebt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers.").
228. Easterbrook, supra note 39, at 654 ("The principal value of keeping firms constantly in the market for capital is that the contributors of capital are very good monitors of managers."); see also Bratton, supra note 36, at 869-870
229. See Delayed or Continuous Offering and Sale of Securities, 17 C.F.R. §230.415 (2008).
230. The study's authors summarize its findings as follows: Empirically, we find that dividend policies vary across legal regimes in ways consistent with a particular version of the agency theory of dividends. Specifically, firms in common law countries, where investor protection is typically better, make higher dividend payouts than firms in civil law countries do. Moreover, in common but not civil law countries, high growth firms make lower dividend payouts than low growth firms. These results support the version of the agency theory in which investors in good legal protection countries use their legal powers to extract dividends from firms, especially when reinvestment opportunities are poor.
231. Rafael La Porta et al., Agency Problems and Dividend Policies around the World, 55 J. FIN. 1, 2 (2000).
232. One study finds that the market reacts more favorably to dividend announcements for firms that may be overinvesting than for firms that may not be overinvesting.
233. Larry H.P. Lang & Robert H. Litzenberger, Dividend Announcements: Cash Flow Signalling vs. Free Cash Flow Hypothesis?, 24 J. FIN. ECON. 181 (1989).
234. See Easterbrook, supra note 39, at 651 ("The problem here is that it is unclear just what dividends signal, how they do so, or why dividends are better signals than apparently cheaper methods."). But see Goshen, supra note 5, at 894 (arguing that dividends are a cheaper and less drastic way of disciplining management than takeovers).
235. One barrier to the use of dividends to discipline managers is that managers might influence the board to pay a suboptimal level of dividends. One way to address this concern advanced by Zohar Goshen is to give shareholders more power in deciding whether earnings are retained by the company or paid out in dividends. See Goshen, supra note 5. Companies could be required to adopt shareholder dividend options, where a shareholder could periodically choose to exercise the option for a cash or stock dividend. If shareholders believe that management is likely to use free cash flow wisely, they will not exercise the shareholder dividend option. If shareholders believe that management will waste free cash flow, they will choose to exercise the shareholder dividend option. As a result, the capital markets rather than management would decide the allocation of earnings.
236. Of course, the potential for reducing agency costs is not unique to shareholder compensation. The same effect could be achieved by imposing monetary penalties. But penalties are less feasible a remedy in the absence of evidence of malicious intent. See Statement of the Securities and Exchange Commission Concerning Financial Penalties (Jan. 4, 2006), http://www.sec.gov/news/press/ 2006-4.htm.
237. While the agency-costs rationale may sound like a variant of the deterrence rationale, the two concepts are not entirely the same. Deterrence seeks to prevent actors from bad acts by making them directly bear the costs of their bad acts. Shareholder compensation does not impose direct costs on managers, but instead takes away resources that might be used for acts that are not in the best interest of shareholders.
238. This effect would be in addition to any reduction in agency costs resulting generally from a mandatory-disclosure regime. See Paul G. Mahoney, Mandatory Disclosure as a Solution to Agency Problems, 62 U. CHI. L. REV. 1047 (1995) (arguing that disclosure statutes help reduce agency costs).
239. See Coffee, supra note 1, at 1562-1563
240. See Arlen & Carney, supra note 1, at 694, 702-703
241. See Baker & Griffith, supra note 131, at 796-798
242. U.S. CHAMBER INST. FOR LEGAL REFORM, SECURITIES CLASS ACTION LITIGATION: THE PROBLEM, ITS IMPACT, AND THE PATH TO REFORM 17 (2008), available at www.instituteforlegalreform.com/get-ilr-doc.php?doc.Id-1213 ("Even when a company's insurance covers the settlement and litigation costs, the company ultimately ends up footing much of the bill because insurance premiums inevitably increase to reflect the higher risk of liability.").
243. See Tom Baker & Sean J. Griffith, Predicting Corporate Governance Risk: Evidence from the Directors'& Officers'Liability Insurance Market, 74 U. CHI. L. REV. 487 (2007).
244. See, e.g., Feldstein & Green, supra note 115, at 17 ("[T]here is the desire on the part of small investors, fiduciaries, and nonprofit organizations for a steady stream of dividends with which to finance consumption."); Fischel, supra note 39, at 703 ("A dividend payment does not affect risk; rather, it reduces the proportion of the investor's assets in equities.").
245. E.g., Brudney, supra note 39, at 88 ("[D]ividend distributions on share prices rest on the assumption that stockholders rationally tend to value a dividend in hand more highly than they do the capitalized value of the earnings expected from management's reinvestment of the amount thus paid out.");
246. id. at 95 ("[T]here is evidence to suggest a systematic stockholder preference for individual investor power to make the reinvestment decision, and there are grounds to explain such a systematic preference.").
247. See BREALEY et al., supra note 22, at 456.
248. Prior to the reduction of the dividend tax, dividends were more attractive for retired individuals who are more likely to pay lower marginal tax rates. One explanation for the dividend puzzle is that mutual funds do not pay attention to the tax consequences of their investment decisions. Thus, they may not sufficiently influence companies to reduce dividend payments.
249. See Mitchell L. Engler, A Missing Piece to the Dividend Puzzle: Agency Costs of Mutual Funds, 25 CARDOZO L. REV. 215 (2003).
250. See Merton H. Miller & Myron S. Scholes, Dividends and Taxes, 6 J. FIN. ECON. 333, 334-335 (1978).
251. 170 N.W. 668 (Mich. 1919).
252. Margaret M. Blair & Lynn A. Stout, A Team Production Theory of Corporate Law, 85 VA. L. REV. 247, 301 (1999).
253. Easterbrook, supra note 39, at 651.
254. See, e.g., Lawrence E. Mitchell, Close Corporations Reconsidered, 63 TUL. L. REV. 1143, 1152-1153 (1989) (discussing characteristics of close corporations).
255. See, e.g., Bank, supra note 116, at 472 ("For the 19th century investor, dividends frequently comprised the only foreseeable source of return on a stockholder's investment.").
256. See supra note 47.
257. However, losses may be more significant for retail investors. See, e.g., Evans, supra note 7, at 226.
258. See A.C. Pritchard, Who Cares?, 80 WASH. U. L.Q. 883 (2002).
259. See, e.g., Evans, supra note 7, at 226.
260. See Stephen J. Choi & Jill E. Fisch, On Beyond CalPERS: Survey Evidence on the Developing Role of Public Pension Funds in Corporate Governance, 61 VAND. L. REV. 315, 332 (2008).
261. Private litigants can seek injunctive relief through a securities-fraud action. See, e.g., Simon De Bartolo Group, L.P. v. Richard E. Jacobs Group, Inc., 186 F.3d 157, 170-71 (2d Cir. 1999). Rather than setting up a common fund, the parties could agree to injunctive relief requiring the corporation to pay a dividend to cover shareholder damages from the fraud. While it does not appear to be common, it is not unprecedented for a class-action settlement to be distributed as a dividend to shareholders.
262. See, e.g., Wood v. Coastal States Gas Corp., No.5719, 1978 WL 2514, at *2 (Del. Ch. Nov. 9, 1978) (describing settlement plan to distribute stock as a dividend);
263. see also Dodge v. Ford Motor Co., 170 N.W. 668 (Mich. 1919) (requiring payment of dividend by Ford). The lack of a common fund should not prevent collection of reasonable attorney fees. While fee awards have been premised on the creation of a common fund,
264. see, e.g., Boeing Co. v. Van Gemert, 444 U.S. 472, 478 (1980), the Federal Rules of Civil Procedure were amended in 2003 to add FED. R. CIV. P. 23(h), which provides that "the court may award reasonable attorney's fees ... by the parties' agreement." This provision does not condition payment of attorney fees on the creation of a common fund.
265. This Article is not the first to note the possibility of a dividend as a mechanism for compensating shareholders. See, e.g., Pritchard, supra note 15, at 947 ("Shareholders as a group would be further ahead if the resources spent on the lawsuit were simply paid to them as a dividend, without the lawsuit's transaction costs."). But this Article is the first in-depth treatment of the possibility.
266. James D. Cox & Randall S. Thomas, Leaving Money on the Table: Do Institutional Investors Fail to File Claims in Securities Class Actions?, 80 WASH. U. L.Q. 855 (2002) [hereinafter Cox & Thomas, Leaving Money on the Table];
267. James D. Cox & Randall S. Thomas, Letting Billions Slip Through Your Fingers: Empirical Evidence and Legal Implications of the Failure of Financial Institutions to Participate in Securities Class Action Settlements, 58 STAN. L. REV. 411 (2005) [hereinafter Cox & Thomas, Letting Billions'].
268. See, e.g., Alexander, supra note 2, at 1501 ("Though reliable empirical information is difficult to obtain, it appears that a significant number of class members-representing as many as forty percent of the shares in the class-do not file claims.");
269. Christopher R. Leslie, The Significance of Silence: Collective Action Problems and Class Action Settlements, 59 FLA. L. REV. 71, 119-120 (2007) ("When settlements require class members to file statements or proofs of claim in order to receive their share of the common fund, 'response rates are often very small, and rarely exceed 50%.' ").
270. See Pritchard, supra note 165, at 884 (concluding that Cox and Thomas's results undermine the compensation rationale for securities-fraud class actions).
271. On the other hand, after the publication of the Cox and Thomas study, about forty institutional investors that failed to collect shareholder compensation were sued for breach of fiduciary duty. See Choi & Fisch, supra note 167, at 332.
272. Class Shareholders would be in a similar position as holders of preferred stock who are entitled to payment of a dividend before common shareholders.
273. Notice of a settlement would be circulated prior to payment of the preferred dividend. A Class Shareholder could still opt out of the settlement prior to payment of the preferred dividend. Any Class Shareholder who did not opt out would be considered to have accepted the terms of the settlement.
274. However, any such benefits would be offset by the dividend tax. In order for this proposal to be economically viable, legislation that exempts a dividend that distributes shareholder compensation from a tax might be necessary.
275. See, e.g., Cox & Thomas, Letting Billions, supra note 170, at 419-420 (describing the difficulty of identifying possible claimants).
276. See, e.g., Masters v. Wilhelmina Model Agency, Inc., 473 F.3d 423 (2d Cir. 2007);
277. Democratic Cent. Comm. v. Wash. Metro. Area Transit Comm'n, 84 F.3d 451, 455 (D.C. Cir. 1996). For example, courts have distributed unclaimed settlement funds to charity.
278. E.g., Jones v. Nat'l Distillers, 56 F. Supp. 2d 355, 359 (S.D.N.Y 1999).
279. 421 U.S. 723 (1975).
280. Cy pres distributions that have gone to causes unrelated to the litigation such as charities have been controversial.
281. See, e.g., George Krueger & Judd Serotta, Our Class Action System is Unconstitutional, WALL ST. J., Aug. 6, 2008, at A13 (criticizing distribution of settlement proceeds to charity). But a dividend distributed to shareholders would be a more relevant use for settlement funds than a charity donation.
282. On the other hand, such a payment would be more circular than restricting the payment of funds, claimed and unclaimed, to Class Shareholders. An objection to a cy pres dividend may be that the Class Shareholders should receive any unclaimed funds because they were the ones who suffered from a Fundamental Decline. In theory, a cy pres dividend could be limited to those Class Shareholders who submitted a claim. Such a dividend, however, might lead to overcompensation of the Class Shareholders. Another question is whether a cy pres dividend is necessary. In some cases, unclaimed shareholder-compensation funds could be returned to the company. Those funds could then be invested to benefit all shareholders. A cy pres dividend may have the same effect as simply returning the funds, but with greater transaction costs. In a sense, this question brings us full circle to the issue of whether companies should pay dividends. There might be some modest diversification and agencycost benefits to paying any remaining funds to shareholders rather than returning the funds to the corporation.
283. A general dividend is more likely because of the difficulty of identifying Class Shareholders before a case has been resolved.
284. See DEL. CODE ANN. tit. 8, §170 (2001). Board decisions with respect to the payment of dividends are given a great amount of deference and are protected by the business judgment rule.
285. See, e.g., David Michael Israel, Note, The Business Judgment Rule and the Declaration of Corporate Dividends: A Reappraisal, A HOFSTRA L. REV. 73, 73 (1975) ("The application of the business judgment rule to the declaration of corporate dividends is one of the oldest and most widely accepted principles of corporation law.").
286. See Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981).
287. See Weinberger v. UOP, Inc., 457 A.2d 701, 709 n.7 (Del. 1983).
288. See Minor Myers, The Decisions of Corporate Special Litigation Committees: An Empirical Investigation, 84 IND. L.J. (forthcoming 2009) (Brooklyn Law Sch. Legal Studies Working Paper Series, Research Paper No. 112, 2008), available at http://ssrn.com/abstract-1162858 (finding that special litigation committees do not invariably choose to dismiss derivative suits).
289. This would be a separate law firm from the firm retained to defend the company against the securities-fraud action. The internal investigation conducted by such a firm could be conducted in a way so that attorney-client privilege and the work-product doctrine protect information from disclosure.
290. See, e.g., Admiral Ins. Co. v. U.S. Dist. Court, 881 F.2d 1486 (9th Cir. 1989) (holding that the attorney-client privilege covers interviews conducted with corporate employees).
291. The independent directors in making such a decision would be protected from liability for their decision. Either liability would be precluded, or the decision to pay a preemptive dividend would be protected by the business judgment rule. As a practical matter, a shareholder who is unhappy with the decision still has the remedy of the securities-fraud action. Thus, if the independent committee decides not to pay a preemptive dividend, it would be unlikely that a shareholder would have a valid derivative action against the committee.
292. A more radical proposal might preclude further liability if a preemptive dividend is paid as long as the amount of the preemptive dividend is reasonable.
293. See 15 U.S.C. §78bb(a) (2006) ("[N]o person permitted to maintain a suit for damages under the provisions of [section 10(b)] shall recover, through satisfaction of judgment in one or more actions, a total amount in excess of his actual damages on account of the act complained of.");
294. see also Jean C. Love, Actions for Nonphysical Harm: The Relationship Between the Tort System and No-Fault Compensation (With an Emphasis on Workers' Compensation), 73 CAL. L. REV. 857, 860 (1985) (noting that in tort suits where plaintiff has received workers compensation, "benefits are set off against the tort judgment to avoid double recovery").
295. Cf. Shapiro v. Midwest Rubber Reclaiming Co., 470 F. Supp. 173 (E.D. Mo. 1979) (applying 15 U.S.C. §78bb to prohibit recovery when plaintiffs received bonds as part of merger worth more than loss).
296. Scienter is a prerequisite to liability under Rule 10b-5. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976).
297. As noted earlier, these costs can be substantial. See supra note 16.
298. Plaintiffs' attorneys may have an incentive to settle cases for too little because they are risk averse. See, e.g., John C. Coffee, Jr., Rescuing The Private Attorney General: Why The Model Of The Lawyer As Bounty Hunter Is Not Working, 42 MD. L. REV. 215, 230-232 (1983).
299. As a result, a preemptive dividend might not be as effective in spreading losses. Accordingly, it might make sense to limit use of a preemptive dividend to cases where the need for a strong signal is more compelling than the need for loss spreading.
300. One problem could arise if an independent committee could pay a preemptive dividend after plaintiffs' attorneys have litigated a case for years, incurring substantial costs that might not be reimbursed. See, e.g., Zapata Corp. v. Maldonado, 430 A.2d 779, 787 (Del. 1981) (expressing concern that special litigation committee had been formed four years after start of litigation). But that may simply be part of the risk of bringing a securities-fraud action. Plaintiffs' attorneys would have to assess the risk of a preemptive dividend in bringing suit. And if the case is strong, plaintiffs' attorneys might still have some leverage if the dividend does not cover the full amount of damages suffered by Class Shareholders.
301. In addition, there will always be companies who deny that they have done anything wrong and refuse to pay a preemptive dividend. To the extent that plaintiffs' attorneys do not know ex ante which companies will fight and which will pay a preemptive dividend, they will have incentives to file suits, though they might be more selective about doing so.
302. For example, the standard for determining what statements are considered to be material should be further clarified. See Park, supra note 25. Limiting damages to the Fundamental Decline might also help make securities-fraud actions more manageable. See supra note 64 and accompanying text. Finally, plaintiff and defense attorney fees relating to securities-fraud actions should also be reduced. See supra note 114 and accompanying text.