Sense and Nonsense About Securities Litigation

Abstract

In We Have a Consensus on Fraud on the Market – And It’s Wrong, James Spindler has attempted to defend securities fraud class actions (SFCAs) and the fraud-on-the-market (FOTM) doctrine by purporting to refute two arguments that have been cited by numerous scholars: (1) the circularity (feedback) critique and (2) the diversification critique. In essence, Spindler’s gist is that SFCAs are both workable and necessary. But in the end, Spindler exposes weaknesses in the usual arguments against SFCAs that point the way to still stronger arguments against SFCAs. Regarding circularity, Spindler argues that SFCAs are workable because it is possible even with circularity for investors to be compensated in full even though compensation is funded by a reduction in the aggregate value of the defendant company and thus the wealth of its stockholders (including those who are compensated). But he fails to recognize that because feedback magnifies buyer claims, it induces investors to spend that much more on precaution and increases already excessive deterrence. Moreover, it effects a transfer of wealth from diversified investors to stock-picking investors even though the law should encourage investors to diversify. Regarding diversification, Spindler argues that SFCAs are necessary because one cannot diversify away fraud. But as shown here, the loss from securities fraud is a mixture of diversifiable losses that someone will suffer one way or the other (when the truth comes out) and undiversifiable losses that derive from the cover-up of bad news. Bad things happen to good companies. Sales decline. Risks increase. But such losses can be diversified away because unexpectedly good things happen to other companies. In contrast, if an ordinary loss is exacerbated by a cover-up leading to a loss of investor trust (and an increased cost of capital) or cash outflows (from litigation expenses or fines), such additional losses cannot be offset by unexpected gains. There is no potential for gain from the absence of fraud. The only losses that really matter are the losses that cannot be diversified away. But these are losses suffered by the corporation that should give rise to a derivative action. Moreover, it turns out that derivative actions are perfectly tailored to compensate investors and to provide perfectly calibrated deterrence without the collateral damage caused by feedback.