Why civil liability for disclosure violations when issuers do not trade?

Wisconsin Law Review

Volumn 2009, Issue 2, 2009, Pages 297-332

  Fox, Merritt B ^a  

^a The Earth Institute at Columbia University   (United States)

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EID: 72049111314     PISSN: 0043650X     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Conference Paper

References (67)

1. See, e.g., ANJAN V. THAKOR ET AL., U.S. CHAMBER INST. FOR LEGAL REFORM, THE ECONOMIC REALITY OF SECURITIES CLASS ACTION LITIGATION 5 (2005) [hereinafter THAKOR, ECONOMIC REALITY], available at http://www.instituteforlegalreform.com/ index.php?option=com-ilr-docs&issue-code=SLI&doc-type=STU&itemid=29 (critiquing fraud-on-the-market class-action lawsuits because of the weakness of the compensation rationale);
2. ANJAN V. THAKOR, THE UNINTENDED CONSEQUENCES OF SECURITIES LITIGATION 14 (2005) [hereinafter THAKOR, UNINTENDED CONSEQUENCES], available at http://www.instituteforlegalreform.com/index.php?option=com-ilr-docs&issue- code=SLI&doc-type=STU&itemid=29 (same);
3. INTERIM REPORT OF THE COMMITTEE ON CAPITAL MARKETS REGULATION 5, 72, 81-82, 109-10 (Nov. 30, 2006), available at http://www.capmktsreg.org/pdfs/11. 30Committee-Interim-ReportREV2.pdf (pointing out reforms which effectively would significantly reduce such actions, and arguing that these reforms should be undertaken because the cost of such suits hurts the competitiveness of U.S. capital markets and that the compensatory justification for them is small);
4. see also John C. Coffee, Jr., Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation, 106 COLUM. L. REV. 1534, 1556-66, 1585-86 (2006) (critiquing such actions because of the inadequacy of the compensation rationale);
5. Donald C. Langevoort, Capping Damages for Open-Market Securities Fraud, 38 ARIZ. L. REV. 639, 646-47 (1996) (same);
6. Paul G. Mahoney, Precaution Costs and the Law of Fraud in Impersonal Markets, 78 VA. L. REV. 623, 625-26, 632 (1992) (same).
7. There are exceptions. Professor Rose considers the advantages and disadvantages of relying, at least in part, on civil litigation to deter issuer misstatements in furtherance of a proposal that the Securities and Exchange Commission (SEC) supervise such suits. Amanda M. Rose, Reforming Securities Litigation Reform: Restructuring the Relationship Between Public and Private Enforcement of Rule 10b-5, 108 COLUM. L. REV. 1301, 1306-07 (2008). Professor Arlen considers issuer liability primarily as a device to deter issuers from failing to report disclosure violations by their agents to governmental officials, and wishes authorities to be able to immunize cooperating issuers from such liability. Jennifer Arlen, Public Versus Private Enforcement of Securities Fraud 2-5 (unpublished manuscript, on file with author). This Paper avoids the issue of whether the SEC can reliably play the screening roles contemplated by Professors Rose and Arlen. It instead starts with the assumption that if a country chooses to have civil liability, the system will operate independently of public enforcement, and asks whether, at least under this assumption, having civil liability is in fact worthwhile.
8. There is a growing literature, applicable across countries, that private damages lawsuits play a helpful role in enforcing securities disclosure laws. Bernard S. Black, The Legal and Institutional Preconditions for Strong Securities Markets, 48 UCLA L. REV. 781, 796 (2001); (Pubitemid 33656708)
9. Rafael La Porta et al., What Works in Securities Laws?, 61 J. FIN. 1, 1-2 (2006) (conducting an empirical study finding a relationship between the availability of private enforcement of securities laws and capital-market development);
10. Katharina Pistor et al., Law & Finance in Transition Economies, 8 ECON. OF TRANSITION 325, 326-28 (2000);
11. Arlen, supra note 2, at 1-2; Erik Berglöf & Stijn Claessens, Enforcement and Corporate Governance, (World Bank Pol'y Research, Working Paper No. 3409, 2004), available at http://papers.ssrn.com/sol3/papers.cfm?abstract- id=625286.
12. Actions by Canada and some countries in Europe suggest at least some movement toward making securities actions based on issuer disclosure violations more effectively available. See INT'L FIN. L. REV., GUIDE TO THE WORLD'S LEADING CAPITAL MARKETS LAWYERS 28-30 (5th ed. 2006), available at http://www.goodmans. ca/pdfs/Article%20%20Canada%20Introduces%20Securities%20Disclosure%20Liability. pdf;
13. Stefano M. Grace, Strengthening Investor Confidence in Europe: U.S.-Style Securities Class Actions and the Acquis Communautaire, 15 J. TRANSNAT'L. L. & POL. 281, 290-97 (2006);
14. Peter Geier, A Wary Europe Moves a Step Closer to Class Actions, LAW. COM, Dec. 5, 2006, http://www.law.com/jsp/article.jsp?id=1165244464820#.
15. This statement needs refinement in the case of the buy-and-hold investor. Alicia Davis Evans, The Investor Compensation Fund, 33 J. CORP. L. 223, 232 (2007).
16. Professor Mitchell argues in this same Symposium issue that the shareholders of the issuer are in fact not innocent because the misstatement was made by managers whom the shareholders elected and failed to adequately monitor. Lawrence E. Mitchell, The "Innocent Shareholder": An Essay on Compensation and Deterrence in Securities Class-Action Lawsuits, 2009 WIS. L. REV. 243, 287-90. Innocence is in the eye of the beholder, however. Most commentators, including myself, would probably not think that each of the dispersed shareholders of the typical U.S. issuer has a moral obligation to become informed as to the qualities and behavior of the issuer's managers and that as a result the shareholder gets what she deserves when the issuer's shareholders, as a group, fail to do so. From my perspective, Mitchell's underlying argument really rests on deterrence, not fairness. Imposing liability on the issuer for a violation of the securities laws when a manager makes a misstatement deters such behavior in just the same way as imposing liability on the issuer when a manager decides to violate any other rule, for example by illegally emitting noxious pollutants into the air. Because, in each case, these losses are ultimately borne by the shareholders, the same market mechanisms that in general create incentives for managers to make decisions that enhance share value create incentives for managers to comply with the law. The question, therefore, is not whether it is fairer for the shareholders at the time of suit to bear the losses than for the purchasers who initially incurred the losses to do so. The question is whether imposing these losses on the shareholders is an appropriate, cost-effective way of improving compliance with securities-law rules against misstatements.
17. Turnover for an issuer's shares in a given period is the number of shares traded in the period divided by the total number of the issuer's shares outstanding. In 2005, the annual turnover of the average New York Stock Exchange issuer was 103 percent. Nyxdata.com, NYSE Overview Statistics, http://www.nyxdata.com/factbook (last visited Feb. 11, 2009). Assuming 250 trading days per year, this implies a turnover of 0.42 percent per day. This means that for the average issuer, 99.58 percent of the outstanding shares do not trade each day. The percentage of shares that do not trade in any given period is thus 0.9958 raised to the power of the number of trading days in the period. Thus, in six months, 59.69 percent would not have traded at least once, and 40.31 percent would have traded. In two years, 12.69 percent would not have traded at least once and 87.31 percent would have. In four years, the corresponding figures are 1.61 percent and 98.39 percent. Casual empiricism suggests that in the vast majority of fraud-on-the-market class-action lawsuits, the class period, which normally corresponds to the length of the claimed period of price inflation, runs from between six months to two years.
18. Of the 688 securities class actions filed from 2002 to 2008 that have settled or been dismissed, the class period has averaged about 1.5 years. NERA Economic Consulting, http://www.nera.com (proprietary database on securities class actions).
19. See generally Brian R. Cheffins & Bernard S. Black, Outside Director Liability Across Countries, 84 TEX. L. REV. 1385 (2006).
20. See generally THAKOR, ECONOMIC REALITY, supra note 1.
21. See CORNERSTONE RESEARCH, SECURITIES CLASS ACTION FILINGS: 2008: A YEAR IN REVIEW (2009), available at http://securities.cornerstone.com/pdfs/YIR 2008.pdf.
22. For the years 2000-05, total annual securities class-action settlements have averaged about $4.1 billion. LAURA E. SIMMONS & ELLEN M. RYAN, POST-REFORM ACT SECURITIES SETTLEMENTS: 2005 REVIEW AND ANALYSIS (2006), available at http://securities.cornerstone.com/pdfs/Settlements-2005.pdf.
23. Studies suggest that contingent-fee awards to plaintiffs' lawyers in securities class-action lawsuits average around 30 percent. FREDERICK C. DUNBAR & VINITA M. JUNEJA, RECENT TRENDS II: WHAT EXPLAINS SETTLEMENTS IN SHAREHOLDER CLASS ACTIONS?., at tbl.4 (1993) (reporting that attorneys' fees averaged 31.32 percent of settlements in a sample of 135 cases from July 1991 through June 1993);
24. FREDERICK C. DUNBAR ET AL., RECENT TRENDS III: WHAT EXPLAINS SETTLEMENTS IN SHAREHOLDER CLASS ACTIONS?, at ii (1995) (reporting that although average settlements fell from 1993 to 1994, plaintiffs' attorneys' fees stayed constant, averaging one-third of the settlement awards, and that plaintiffs' attorneys' fees averaged "$1.96 million in 1993 and $2.03 million in 1994"). If we assume that defendants' lawyers are paid fees comparable in amount, this would suggest that the total annual legal expenses associated with these actions averaged about $2.5 billion ((0.30 + 0.30) x $4.1 billion). The plaintiffs' expenses come out of the judgment or settlement and hence diminish what would otherwise be paid to members of the class. The issuer defendant's expenses are ultimately borne by its shareholders at the time suit is brought.
25. I have considered the points discussed here in significantly more detail elsewhere. See Merritt B. Fox, Securities Disclosure in a Globalizing Market: Who Should Regulate Whom, 95 MICH. L. REV. 2498, 2532-44 (1997).
26. See HOMER KRIPKE, THE SEC AND CORPORATE DISCLOSURE: REGULATION IN SEARCH OF A PURPOSE 123 (1979).
27. See MERRITT B. FOX, FINANCE AND INDUSTRIAL PERFORMANCE IN A DYNAMIC ECONOMY: THEORY, PRACTICE, AND POLICY 282-87 (1987).
28. See generally LARRY HARRIS, TRADING AND EXCHANGES: MARKET MICROSTRUCTURE FOR PRACTITIONERS 287-91, 299-302 (2003);
29. Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. FIN. ECON. 71 (1985).
30. For models working these points out more rigorously, see generally Robert E. Verrecchia, Essays on Disclosure, 32 J. ACCT. & ECON. 97 (2001) (noting that disclosure reduces information asymmetries and lowers a firm's cost of capital);
31. Maureen O'Hara & David Easley, Information and the Cost of Capital (Nov. 2001) (unpublished manuscript), available at http://papers.ssrn.com/sol3/ papers.cfm?abstract-id=300715&high=%20maureen%20ohara (same).
32. This is a question that has given rise to much scholarly debate. Scholarly opposition to the U.S. mandatory disclosure regime began with empirical work by certain economists purporting to show that it had no benefit. See, e.g., George J. Benston, Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934, 63 AM. ECON. REV. 132, 149, 153 (1973);
33. George J. Stigler, Public Regulation of the Securities Markets, 37 J. BUS. 117, 122-24 (1964). Signaling - the idea that issuers with good news will want to disclose it and that the market will infer from the silence of the rest that they do not have good news - added a theoretical component to the case against mandatory disclosure.
34. See Steven A. Ross, Disclosure Regulation in Financial Markets: Implications of Modern Finance Theory and Signaling Theory, in ISSUES IN FINANCIAL REGULATION 177, 182 (Franklin R. Edwards ed., 1979).
35. Despite their challenges, however, most law-and-economics-oriented scholars concluded, based on market-failure theories, that on balance the U.S. system should be retained. See, e.g., John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 VA. L. REV. 717, 725-28 (1984);
36. Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 VA. L. REV. 669, 684-85 (1984).
37. In the late 1990s, the issue was raised again in a somewhat different form by scholars arguing that issuers should be able to avoid the U.S. regime if they chose instead the regime of any of the fifty states or any foreign country. Stephen J. Choi & Andrew T. Guzman, Portable Reciprocity: Rethinking the International Reach of Securities Regulation, 71 S. CAL. L. REV. 903, 921-24 (1998); (Pubitemid 128429204)
38. Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 YALE L.J. 2359, 2361-62 (1998).
39. For arguments that this issuer choice approach is undesirable, see Merritt B. Fox, Retaining Mandatory Securities Disclosure: Why Issuer Choice Is Not Investor Empowerment, 85 VA. L. REV. 1335 (1999).
40. See Easterbrook & Fischel, supra note 24, at 684. The idea that entrepreneurs have an incentive to obligate the firm to comply with a disclosure regime that maximizes share value is an application of the larger principle, set out in Jensen and Meckling's seminal article, that firms that go public will contract with shareholders to provide the agency-cost-minimizing set of constraints on management. See generally Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976).
41. I have considered in more detail elsewhere the divergence of the private and social costs and benefits of issuer disclosure and the consequent tendency of issuers to disclose below their socially optimal level. See Merritt B. Fox, Securities Disclosure in a Globalizing Market: Who Should Regulate Whom, 95 MICH. L. REV. 2498, 2537-39 (1997);
42. see also Lucian Arye Bebchuk, Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law, 105 HARV. L. REV. 1435, 1490-91 (1992);
43. coffee, supra note 24, at 721-23; easterbrook & fischel, supra note 24, at 684-85; Edmund W. Kitch, The Theory and Practice of Securities Disclosure, 61 BROOK. L. REV. 763, 846-74 (1995).
44. See, e.g., Kate Stith, Congress' Power of the Purse, 97 YALE L.J. 1343, 1352 (1988).
45. See A.C. Pritchard, Markets as Monitors: A Proposal to Replace Class Actions with Exchanges as Securities Fraud Enforcers, 85 VA. L. REV. 925, 928 (1999).
46. The assumption here is that the deterrent value of a damages judgment is proportional to the social harm that the injury causes. The standard plaintiffs' lawyer percentage of recovery would need to be set to achieve the most cost-effective total level of litigation. See Steven Shavell, The Social Versus the Private Incentive to Bring Suit in a Costly Legal System, 11 J. LEGAL STUD. 333, 333 (1982) (discussing both the relationship between who bears legal fees and the level of litigation and the relevance of deterrence value in determining the optimal level of litigation).
47. Professor Shavell's work in turn builds on some classic articles using economics to analyze public versus private enforcement of law and the optimal design of civil liability to promote efficient enforcement. See Gary S. Becker & George J. Stigler, Law Enforcement, Malfeasance, and Compensation of Enforcers, 3 J. LEGAL STUD. 1, 16-17 (1974);
48. William M. Landes & Richard A. Posner, The Private Enforcement of Law, 4 J. LEGAL STUD. 1, 1 (1975);
49. A. Mitchell Polinsky, Private Versus Public Enforcement of Fines, 9 J. LEGAL STUD. 105, 106 (1980).
50. Merritt B. Fox, Civil Liability and Mandatory Disclosure, 109 COLUM. L. REV. (forthcoming 2009).
51. Damages in fraud-on-the-market lawsuits are calculated in accordance with the out-of-pocket measure. Under this measure, the amount of damages owed to a purchaser of a share at a price inflated by a falsely positive misstatement is the amount by which the share price was inflated at the time of purchase (less, if it was sold prior to full revelation of the truth, the amount it was inflated at the time of sale). Randall v. Loftsgaarden, 478 U.S. 647, 661-62 (1986);
52. Green v. Occidental Petroleum Corp., 541 F.2d 1335, 1341-46 (9th Cir. 1976) (Sneed, J., concurring);
53. Estate Counseling Serv., Inc. v. Merrill Lynch, 303 F.2d 527, 532-33 (10th Cir. 1962);
54. LOUIS LOSS & JOEL SELIGMAN, SECURITIES REGULATION 4413-14 (3rd ed. 1998). Thus, for a share purchased just once during the period of inflation and held until revelation of the truth, the damages would equal the amount of the inflation at the time of purchase. For a share that was purchased multiple times during the period, the damages of the multiple purchasers would, in aggregate, equal the amount of inflation at the time of purchase, with each purchaser receiving damages equal to the amount, if any, that the price deflated during her period of holding the share.
55. It is difficult to conjure up a relationship between the rate of turnover and the damage a misstatement makes to an issuer's corporate governance, at least in the case of larger issuers that are reasonably thickly traded. An exception applies, perhaps, in the case of an issuer whose turnover is sufficiently low that relevant actors put less faith in the informativeness of its share price as a predictor of its future distributions to shareholders discounted to present value. With such an issuer, price-related market mechanisms for controlling the agency costs of management are less effective in any event, and so the inaccuracies introduced by the misstatement would be less important. Liquidity is more complex and so it is harder to dismiss the possibility of a relationship between turnover and social damage. A higher rate of turnover during the period that the misstatement affects price would suggest a higher rate of turnover more generally, and so the experience of the misstatement would have an effect thereafter on the bid/ask spread with regard to a larger volume of transactions. This might suggest more social damage. The effect of a bid/ask spread with regard to transactions that actually occur is purely a wealth transfer, however, and so a higher volume of transactions could merely mean more wealth would be transferred. The primary social harm from lower liquidity comes from the situations when a buyer or seller would wish to transact but for the unfavorable impact of the bid/ask price on the price he would have paid or received. Consider two issuers, X and Y, with the same increase in their respective bid/ask spreads due to a misstatement, but X has a higher rate of turnover than Y. If the higher turnover rate of X is the result of buyers and sellers rationally having reasons more often to want to buy and sell X's shares, the increase in the bid/ask spread is going to block more such sales and purchases, and in the process do more social harm. If the higher turnover in X is due to some kind of irrational frenzy, it would not. For a discussion of reasons why different issuers might have different rates of turnover, see Andrew W. Lo & Jiang Wang, Stock Market Trading Volume (Sept. 5, 2001) (unpublished manuscript), available at http://home.uchicago.edu/ ~lhansen/vol4-4.pdf.
56. Pamela H. Bucy, Private Justice, 76 S. CAL. L. REV. 1, 32-33 (2002);
57. Jill E. Fisch, Class Action Reform, Qui Tam, and the Role of the Plaintiff, LAW & CONTEMP. PROBS. 167, 169 (1997).
58. There is in fact evidence that, for issuers below a certain size, almost all enforcement action is brought by the SEC. See Stephen J. Choi, Company Registration: Toward a Status-Based Antifraud Regime, 64 U. CHI. L. REV. 567, 588-99 (1997). These are cases where the expected damage award is too small to make the private costs of bringing suit worthwhile. Id. at 588. However, the deterrence value of the public actions, which private parties cannot capture, may well justify the resources devoted by the SEC. (Pubitemid 127445763)
59. See also Matthew C. Stephenson, Public Regulation of Private Enforcement: The Case for Expanding the Role of Administrative Agencies, 91 VA. L. REV. 93, 109 (2005) (commenting that the delegation of enforcement to private parties allows an agency's "scarce resources to [be put toward] detecting and prosecuting ⋯ violations where private plaintiffs lack sufficient incentives").
60. See, e.g., OLIVER HART, FIRMS, CONTACTS, AND FINANCIAL STRUCTURE 51 (1995).
61. Richard B. Stewart & Cass R. Sunstein, Public Programs and Private Rights, 95 HARV. L. REV. 1193, 1298 (1982).
62. Barton H. Thompson, Jr., The Continuing Innovation of Citizen Enforcement, 2000 U. ILL. L. REV. 185, 199 (opining that citizen suits under the environmental laws combat the tendency of a public enforcement agency to display the pathologies of monopoly).
63. 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, 224 (1983).
64. The downside to this innovation is the inconsistencies and incoherence that can develop from a hydra-headed authority, such as the courts, making rules as opposed to a single specialized agency. See Richard J. Pierce, Jr., Agency Authority to Define the Scope of Private Rights of Action, 48 ADMIN. L. REV. 1, 14-15 (1996). (Pubitemid 126408792)
65. See Alan L. Beller et al., Looks Can Be Deceiving - A Comparison of Initial Public Offering Procedures Under Japanese and U.S. Securities Laws, 55 LAW & CONTEMP. PROBS. 77 (1992);
66. George F. Parker, The Regulation of Insider Trading in Japan: Introducing a Private Right of Action, 73 WASH. U. L.Q. 1399 (1995).
67. A similar contrast between the United States and Japan, attributable to the difference in the prevalence of private actions, has been noted with respect to the antitrust laws. Harry First, Antitrust Enforcement in Japan, 64 ANTITRUST L.J. 137, 179-80 (1995).