Securities Fraud Actions Research Articles

Defining Economic Losses in Securities Fraud Actions

Defining Economic Losses in Securities Fraud Actions

What Counts as Price Impact for Securities Fraud Purposes?

The Supreme Court has ruled that in a securities fraud action arising under Rule 10b-5, class action status will be denied if the defendant can show that the alleged deception had no impact on market price. In a related development, the courts have also held that investors cannot recover for losses from materialization of risk – from occurrence of an event whose risk was misrepresented – but rather may recover only for the difference between the price paid and the price that would have obtained if the truth had been known about the risk when the investor bought or sold. Taken together, these developments will require the courts to address the component parts of any decrease in price that gives rise to a fraud claim. As shown here, a change in the market price of a particular stock may come from several different sources. A decrease (or increase) in price may result from new information as to expected return or cost of capital or one-time outflows (or inflows) of cash – including those attributable to materialization of risk. Moreover, changes in expected return or cost of capital may be attributable either to company-specific news (and clearly compensable) or more general economic conditions (and not clearly compensable). Once it is recognized that a price change may flow from any one of these sources or a combination thereof, it becomes apparent that some such claims are derivative in nature and should give rise to an action for the benefit of the corporation – and all of the stockholders – and not just for the buyers (or sellers). Moreover, after derivative recovery, stockholders will be in the same position they would have occupied in the absence of fraud. So there is no reason to compensate for the supposed direct claims that remain. This is especially so since most investors are diversified and since assessing damages against the company merely transfers the loss from one group of investors (buyers or sellers) to another (holders). The bottom line – and the implication of parsing the elements of damages in a claim for securities fraud – is that such claims should be litigated as derivative actions.

Do Institutional Investors Value the Rule 10b-5 Private Right of Action? Evidence from Investors’ Trading Behavior following Morrison v. National Australia Bank Ltd.

In Morrison v. National Australia Bank Ltd., the US Supreme Court limited investors’ ability to bring private Rule 10b-5 securities fraud actions to cases involving securities purchased on a US stock exchange or otherwise purchased in the United States. Because many foreign firms’ securities trade simultaneously on non-US venues and on US exchanges, institutional investors claimed after Morrison that they would look to such firms’ US-traded securities to preserve their rights under Rule 10b-5. This paper tests this prediction using proprietary trading data from 378 institutional investors. The analysis reveals no evidence that investors reallocated trades in cross-listed issuers to the United States, nor did they reallocate foreign trading to cross-listed issuers that are now clearly subject to 10b-5 securities suits. This persistence in trading appears across both money managers and pension plan sponsors, notwithstanding sponsors’ more vocal criticism of Morrison and their prominence in 10b-5 litigation.

Misleading Employer Communications and the Securities Fraud Implications of the Employee as Investor

This Article addresses the securities fraud implications of the employee as investor. It first demonstrates that employee investors are particularly vulnerable to securities fraud committed by company management. Company management can capitalize on the employment relationship and communicate directly with their employees, through such media as employee newsletters, employee meetings, and employer e-mails. These communications are often promotional in nature. They may also be misleading. Unfortunately, employees are more likely to believe misleading employer communications because of the natural tendency of employees to trust the senior management of their employer. The Article then demonstrates that the anti-fraud provisions of the federal securities laws do not adequately address the vulnerability of employee investors. In particular, I point out that because employer communications are not publicly made, securities fraud actions are unlikely to be brought, either by the SEC or by private plaintiffs. To fill this regulatory gap, I propose that certain types of employer communications should be disclosed to the Securities and Exchange Commission. Requiring disclosure of employer communications would have a disciplining effect on senior management without chilling the disclosure of information by employers to their employees.

The Two Faces of Materiality

To make out a claim for securities fraud under federal law, a plaintiff must plead and prove the misrepresentation of a material fact. The Supreme Court has repeatedly defined a material fact as one that would be important to a reasonable investor in deciding how to act in that it would change the total mix of information — although it need not necessarily change the ultimate decision of the investor as to how to vote or whether to trade. The courts have also defined a material fact as one that would affect market price — which clearly implies that it must have changed the decisions of some investors. Although these two definitions of materiality appear to conflict, they can be reconciled as alternative expressions of the same standard, the former referring to individual investors and the latter referring to investors in the aggregate. Indeed, the Supreme Court has held a fact cannot be material if it cannot matter to the ultimate outcome, suggesting that a fact cannot be material if it does not affect the behavior of a number of investors sufficient to move the market. Arguably, it would be appropriate to consider price impact in connection with the decision to certify a securities fraud action as a class action under the fraud on the market (FOTM) theory since a class action involves the claims of investors in the aggregate and since price impact need not be dispositive as to the merits of the individual claim of the lead plaintiff who may be able to recover under the individual investor standard. The Supreme Court foreclosed that option in its Amgen decision, possibly for fear that failure to determine materiality in the context of a class action might lead to a multiplicity of lawsuits. Nevertheless, the Amgen Court stated that determination of the question may be appropriate on summary judgment even though earlier decisions have emphasized that materiality is a matter of fact that should not be decided by any bright line test. Moreover, in focusing on materiality as a matter of merit, Amgen says nothing about when a court should consider other grounds for rebutting the FOTM presumption of reliance based on the likelihood that the plaintiff class includes significant numbers of atypical investors who may have been indifferent to company-specific market prices and thus may not be adequately represented in a class action.

Do Institutional Investors Value the 10b-5 Private Right of Action? Evidence from Investor Trading Behavior Following Morrison v. National Australia Bank Ltd.

In Morrison v. National Australia Bank (2010), the U.S. Supreme Court limited investors’ ability to bring private 10b-5 securities fraud actions to cases where the securities at issue were purchased on a United States stock exchange or were otherwise purchased in the U.S. Because many foreign firms’ securities trade simultaneously on non-U.S. venues and on U.S. exchanges, institutional investors claimed after Morrison that they would look to such firms’ U.S-traded securities to preserve their rights under 10b-5. This article tests this prediction using proprietary trading data from 378 institutional investors. The analysis reveals no evidence that investors reallocated trades in cross-listed issuers to the U.S., nor did they reallocate foreign trading to cross-listed issuers that are now clearly subject to 10b-5 securities suits. This persistence in trading appears across both money managers and pension plan sponsors, notwithstanding sponsors’ more vocal criticism of Morrison and their prominence in 10b-5 litigation.The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2537125

A Framework for Analyzing Attorney Liability Under Section 10(b) and Rule 10b-5

This article analyzes recent developments in the law of secondary party liability under the general antifraud provision of the Securities Exchange Act of 1934, section 10(b), and its corresponding Securities and Exchange Commission rule, Rule 10b-5. The article focuses on a specific type of secondary party, securities lawyers, who make their living representing securities issuers and face a myriad of challenges in doing so. Among those challenges are defrauded investors seeking recovery of their losses from both the issuer of the failed investment securities and from the lawyers who represent the issuer.These securities fraud actions against lawyers raise serious questions about the proper scope of liability under the federal securities laws. The recent developments discussed in the article indicate that the standard for secondary party liability is increasingly becoming one that attorneys acting in the traditional role of adviser and draftsperson to securities issuers will not satisfy.

Class Conflict in Securities Fraud Litigation

Although securities fraud class actions are a well-established legal institution, few (if any) such actions in fact meet the requirements of Rule 23 of the Federal Rules of Civil Procedure for certification as a class action. Among other things, Rule 23 requires the court to find that the representative plaintiff will fairly and adequately protect the interests of the class and that a class action is superior to other means of resolving the dispute.In the typical securities fraud case, the plaintiff class consists of investors who buy the subject stock at a time when the defendant corporation has negative material information that should be publicly disclosed. When the truth comes out, stock price declines, and those who bought during the fraud period sue the corporation for damages equal to the difference between the price they paid and the price at which the stock finally settles. Only buyers have standing to sue in such circumstances. Mere holders have no claim.The problem is that most buyers are also holders. Most investors are well diversified. More than two-thirds of all stock is held through mutual funds, pension plans, and other institutional investors, who trade mostly for purposes of portfolio balancing. As a result, most of the buyers in the plaintiff class will also be holders as to more shares than the number of shares bought during the fraud period. Because the defendant corporation pays any settlement – further reducing the value of the corporation and its stock price through what I call feedback damages – most of the plaintiff class will lose more as holders than they gain as buyers. Thus, many members of the plaintiff class would prefer that the action be dismissed. It is therefore impossible for anyone to be an adequate representative of a class composed of both members who support the action and members who oppose the action. Even if a court would permit a plaintiff class to be gerrymandered to include only those buyers who would gain more than they lose, there is no practical way to identify such investors.In addition, it is likely that in most meritorious securities fraud actions, part of the decrease in stock price will come from expenses associated with defending and settling the securities fraud claim and from harm to the reputation of the defendant company resulting in an increase in its cost of capital. But these claims are derivative rather than direct. Accordingly, it is the corporation – and not individual buyers – who should recover for this portion of the damages. Aside from the fact that such claims are derivative in nature and presumably must be litigated as such, a derivative action is clearly superior to a class action because recovery by the corporation from individual wrongdoers – rather than payment by the corporation to buyers – eliminates feedback damages and thus reduces the size of the aggregate claim. Moreover, a derivative action is much more efficient in that there is a single plaintiff – the corporation – rather than hundreds or thousands of individual buyers. Finally, policy considerations also militate against certification. Diversified investors are hedged against securities fraud by virtue of being diversified and have no need for a remedy. A diversified investor is just as likely to sell a fraud-affected stock as to buy one. It all comes out in the wash. Thus, the expenses associated with securities fraud class actions are a deadweight loss that serves only to reduce investor return. Because the vast majority of investors are diversified – and because it is irrational for most investors not to diversify – the interests of diversified investors should trump those of any undiversified investors who would favor a class action remedy. Moreover, class actions constitute excessive deterrence, whereas derivative actions provide a response that is proportional to the true harm suffered by investors. Diversified investors are completely protected against any true loss by the prospect of derivative litigation, which also provides an effective deterrent against securities fraud.In short, when faced with a motion to certify a securities fraud action as a class action, a court should ordinarily treat the action as derivative and proceed accordingly. To be clear, this approach would effectively abolish securities fraud class actions and replace them with derivative actions. But as demonstrated here, investors would be better off as a result.

The Unjustified Judicial Creation of Class Certification Merits Trials in Securities

The class action device is vital to deterring securities fraud and remedying its victims, who almost never suffer losses sufficient to justify an individual suit. Nonetheless, the federal courts have begun to convert the class certification process into a premature trial on the merits, thereby precluding victims of securities fraud from pursuing otherwise valid claims of financial wrongdoing. In particular, in a series of important decisions, the federal courts have required plaintiffs to prove the essential elements of their securities fraud claims at the preliminary class certification stage. This Article demonstrates why this trend should end. The judicial creation of class certification merits trials in securities fraud cases is inconsistent with the federal securities laws and Supreme Court precedent. Moreover, judicial resolution of the merits of a securities fraud claim at the class certification threshold infringes on the Seventh Amendment right to trial by jury. Nor can class certification merits trials be excused by any legitimate policy concerns. The harm purportedly averted by these trials is illusory. The supposed threat that class certification and post-certification discovery costs will produce in terrorem settlements is unfounded and illogical. Finally, this Article concludes that the harm caused by class certification merits trials is substantial. This new procedure will over-deter the very type of private securities fraud actions that both supplement Securities and Exchange Commission enforcement actions and compensate victims for losses caused by securities fraud.

Rule 10b-5 and the Statute of Limitations: Actual Knowledge Not Inquiry Notice. An Amicus Brief Filed at the US Supreme Court in Merck v. Reynolds

After more than a half century of judicial monopoly, Congress in 2002 adopted Section 1658(b), thereby creating a statute of limitations and repose for fraud actions brought under Section 10(b) and Rule 10b-5. The five year period of repose represents an outside cut-off that commences at the time of the violation. The two year limitations period begins upon “discovery of the facts constituting” the fraud. See 28 U.S.C. § 1658(b). Under the self-evident meaning of this language, the limitations period begins only when plaintiffs discover - that is, actually know - that they have been defrauded. The legislative history confirms this actual-knowledge standard. The limitations period was not meant to be used to investigate whether a fraud occurred, but to address the “obstacles” that exist “after the fraud is discovered,” including the need to unravel the complexities of the violation and address the logistical concerns in bringing a claim, particularly the need to marshal the facts sufficient to meet the heightened pleading standards set out in the Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (PSLRA). See S. Rep. No. 146, 107th Cong., 2d Sess. 9 (May 6, 2002). This Court in Lampf adopted an actual-knowledge, not an inquiry-notice, standard for determining the accrual date of the one year limitations period. This was apparent from this Court’s express reliance on Section 9(e) of the Exchange Act, 15 U.S.C. § 78i(e), with its actual knowledge standard, as the appropriate model, and the explicit rejection of Section 13 of the 1933 Act, with its inquiry notice standard. Lampf’s reliance on an actual knowledge standard was also apparent in this Court’s treatment of equitable tolling. Tolling had allowed courts to ensure fairness by using equity to delay the accrual date where plaintiffs were unaware of the fraud through no fault of their own. Lampf concluded, however, that equitable tolling would henceforth be “unnecessary,” an approach that could only be understood as a direct consequence of an accrual standard that depended upon plaintiffs’ actual knowledge of the fraud. With plaintiffs aware of having been defrauded, a tolling doctrine designed to provide additional time to uncover the violation had become superfluous or “unnecessary.” The actual-knowledge standard does not interfere with the goals of finality and the elimination of stale claims. Those concerns are addressed through the adoption of a five year statute of repose. As for the assertion that the actual knowledge standard somehow allows plaintiffs to delay the onset of the limitations period through inactivity, this concern is misplaced. First, the modern realities of class action securities fraud suits against public companies provide considerable practical incentive to investigate the mere suspicion of a violation. Any delay in investigation could result in the expiration of the period of repose or the failure to meet the heightened pleading standards contained in the PSLRA. The possibility of deliberate inactivity is also belied by the competitive reality of class action securities litigation. SOX sought to increase the role of institutional investors, those plaintiffs with the resources available to conduct investigations. In addition, law firms that delay investigating the possibility of fraud could find themselves at a competitive disadvantage. The first firm to become aware of the fraud and discern the applicable class will be in a position to identify possible lead plaintiffs, the investors with the largest financial interest in the relief sought, increasing the potential likelihood that it will be designated lead counsel. See 15 U.S.C. § 78u-4. Second, a legal standard that determines actual knowledge through reference to the entire class will essentially eliminate even the possibility of the strategic use of inactivity. In the context of class actions against public companies for securities fraud, actual knowledge is most appropriately considered through resort to the information known to the class as a whole. To the extent known to the class, plaintiffs will be unable to rely on their own unawareness to delay the onset of the limitations period. This also provides plaintiffs with an additional incentive to investigate even the possibility of fraud in order discover facts known to the market. This use of the inquiry notice standard on the one hand permits the elimination of potentially meritorious claims and on the other hand encourages the filing of meritless claims. Meritless claims do more than waste resources. They open plaintiffs and their counsel to the possibility of sanctions under Rule 11. See 15 U.S.C. § 78u-4(c)(making mandatory consideration of sanctions under Rule 11 upon final adjudication of a securities fraud action).

Eliminating Securities Fraud Class Actions Under the Radar

At least since Basic, Inc. v. Levinson, the business community and many influential scholars have challenged the existence of the securities fraud class action on a variety of grounds. Recently, two proposals have been advanced to “fix” the problem of “abusive” securities fraud class actions. One proposal requires arbitration of all securities fraud actions; the other eliminates the corporate defendant in most actions. Proponents assert that shareholders should have the right to adopt these proposals through amendment of the company’s certificate of incorporation. Both these proposals have attracted more than academic interest. In reality, adoption of either proposal would substantially curtail, if not eliminate, the securities fraud class action. Part II of this paper first reviews the two rationales – compensation and deterrence–for the federal securities class action, sets forth the critics’ principal arguments as to why these goals are not achieved, and argues that the post-PSLRA securities fraud class action is reasonably effective in achieving both compensatory and deterrence goals. Part III then describes the two proposals. Part IV explains why these proposals are impermissible under the anti-waiver clause, Section 29(a) of the Securities Exchange Act of 1934. Part V explains why these proposals are also, under state law, illegal, unfair to shareholders that do not vote in favor of them, and unenforceable as to future stock purchasers. Part VI concludes by calling for a national debate on the future of the securities fraud class action. The arguments for and *803 against the securities fraud class action involve complexities and uncertainties that make “quick and dirty” solutions like these two proposals inappropriate.

Taking Certification Seriously - Why There is No Such Thing as an Adequate Representative in a Securities Fraud Class Action

Securities fraud class actions (SFCAs) arising under Rule 10b-5 are well established as a feature of the legal landscape, but they are a vestige of a largely outdated view of investor behavior and preferences. In the 1960s, most investors were undiversified stock pickers. Today, most investors hold stock through well diversified institutions. As a result, most investors are net losers from SFCAs. Moreover, it is arguable that it is irrational for most investors not to be diversified. A passive investor who fails to diversify assumes unnecessary risk for the same expected return that diversified investors enjoy. Given that federal securities law is intended to protect reasonable investors, it follows that it should be interpreted and applied consistent with the interests of diversified investors where the interests of diversified and undiversified investors diverge. For a diversified investor, gains and losses from securities fraud net out over time. But they lose to the extent of attorney fees and they lose when they are holders (which is most of the time) to the extent that defendant companies must compensate purchasers. In short, diversified investors would prefer that SFCAs be abolished. The one exception arises when insiders gain from the fraud such as by selling their shares before the release of bad news. But the appropriate remedy in such a case is a derivative action by which the company recovers from the wrongdoers. The thesis here is that the courts should decline to certify securities fraud actions as class actions under FRCP 23 because of the conflicting interests of class members. Undiversified stock pickers - usually a minority of the plaintiff class - may favor SFCAs. But many diversified investors - particularly those who follow a portfolio balancing strategy - would prefer that the courts refuse to certify such actions as class actions because such investors usually lose more on stock they hold than they gain on stock they bought during the class period. To be sure, many diversified investors (including institutional investors) engage in some stock picking (although some such as index funds eschew it altogether). Such an investor might favor certification of actions in which he has bought a large amount of the subject stock during the class period relative to preexisting holdings even though the same investor would favor the abolition of SFCAs generally. Moreover, not even a strict portfolio balancing investor who would oppose certification because she loses more on stock she holds than she gains on stock she bought would dare to opt out of the SFCA if it is certified. Thus, it does no good for the courts to rely on investors to vote with their feet. Investors who opt out of the action effectively pay those who stay in by forgoing compensation for their losses. The bottom line is that the courts should refuse to certify securities fraud actions as class actions unless it is shown that the plaintiff class is composed wholly of undiversified investors. If the action involves allegations that insiders have somehow gained from the fraud or that the corporation itself has been damaged by the fraud, the action should proceed as a derivative action. And given that a derivative action is a form of class action, it is quite clear that the courts have the power under FRCP 23 (and FRCP 23.1) to recast any purported SFCA in such terms. This is not to say that individual investors should not continue to have standing to sue under Rule 10b-5. Indeed, an investor who seeks to gain control or influence over a target company is likely to be undiversified. If such an investor suffers a fraud in connection with his purchase of target stock, he has standing to sue the wrongdoers if he can make out a claim. Nor does the argument here imply that there is a fundamental problem with remedies under the 1933 Act. In essence, the 1933 Act provides for disgorgement by issuers in cases in which they have effectively misappropriated capital from the market by false pretenses. Similarly, in the context of an SFCA under Rule 10b-5 in which insiders have gained from misappropriation (such as insider trading) during the fraud period or have visited loss on the issuer by damage to reputation or otherwise, the appropriate remedy if for the issuer to seek compensation. In other words, the approach advocated here is wholly consistent with the general scheme of federal securities law.

The PSLRA's Seventh Amendment Problem

This Article is the first to examine the proper role of the jury in private securities fraud litigation. In the Private Securities Litigation Reform Act, Congress required that securities fraud complaint plead a inference of scienter. The courts have disagreed on the standard that satisfies this requirement, and likewise, the involved parties disagree. Defendant corporations argue for stringent standard that would result in the dismissal of many claims, while plaintiff investors support flexible standard that would allow more claims to go forward. Indeed, the Supreme Court's resolution of this issue may have an impact beyond securities litigation. If stringent standard is adopted, special pleading may be permitted in whole variety of other cases, including employment discrimination cases, resulting in many dismissals before any discovery has even been conducted. In the present context, securities law experts have not addressed the constitutional issue posed by the special pleading requirement; whether this requirement violates the Seventh Amendment right to jury trial. The Supreme Court has held that modern procedure must satisfy the substance of the English common law jury trial in 1791 to be constitutional under the Seventh Amendment. Accordingly, the special pleading rules developed in 21st century securities litigation must be viewed through an 18th century common law lens. This Article argues that the scienter standards developed by the courts in securities cases do not comport with substance of the common law jury trial and thus are constitutionally problematic. Contrary to the common law, the courts improperly engage in one or more steps of assessing the reasonableness of facts and corresponding inferences pled by the plaintiffs. This Article proposes constitutionally permissible alternative standard to dismiss securities fraud claim. The Article acknowledges the possible constitutional infirmity posed by the PSLRA's strong inference standard itself and its heightened pleading requirements and argues that because Congress sought to solve problems with the class action nature of securities fraud actions, the focus should have been class actions specifically, instead of the cause of action generally.

Law, Ideology, and Strategy in Judicial Decision Making: Evidence from Securities Fraud Actions

Legal academics and political scientists continue to debate whether the legal, attitudinal, or strategic model best explains judicial decision making. One limitation in this debate is the high‐court bias found in most studies. This article, by contrast, examines federal district court decisions, specifically interpretations of the Private Securities Litigation Reform Act of 1995. Initial interpretations of the Act articulated distinct liberal and conservative positions. The data compiled here support the hypothesis that the later emergence of an intermediate interpretation was the result of strategic statutory interpretation rather than simply judges acting consistently with their ideological preferences, although there is some evidence that judges adopting the most conservative interpretation of the Act were acting consistently with the attitudinal model. There is weaker evidence to support the legal model, an unsurprising result given the severe test the study design creates for that model.

D&O Update Litigation: Be careful what you wish for: The unintended effects of the Private Securities Litigation Reform Act of 1995

Corporations lobbied for the passage of the Private Securities Litigation Reform Act of 1995 (PSLRA) to limit private enforcement of the US securities laws. While the PSLRA has achieved this goal to a certain extent, it has also impacted securities litigation, and related Employee Retirement Income Security Act (ERISA) and derivative litigation, in ways that its proponents never intended. This paper discusses the impact of institutional investor participation in securities litigation, which increased significantly as a result of lead plaintiff provisions in the PSLRA that evince an intent to have institutional investors play a larger role in securities cases. Specifically, the paper focuses on the ability of institutional investors to obtain corporate governance reforms and the contribution of personal funds by outside directors, as components of securities litigation settlements. The paper also provides an overview of ERISA actions that are often litigated in parallel with securities fraud actions. While these actions concern different legal theories, pleading standards and damages formulations to those of securities actions, there is an interplay between the two types of actions in at least two major areas — settlement and discovery. Indeed, the presence of parallel ERISA litigation in several high-profile securities actions has enabled the securities plaintiffs to obtain relief from the PSLRA's discovery stay allowing them to have early access to any materials that have been produced to the ERISA plaintiffs.

Who Should Recover What for Securities Fraud?

In this article, I argue that securities fraud class actions (SFCAs) should not be treated as class actions but rather should be treated as derivative actions. In addition, I argue that such actions should be dismissed unless it appears that insiders (including the company itself) have enjoyed gains from trading during the fraud period. Both of these conclusions are based on the fundamental argument that (1) securities law seeks to protect the interests of reasonable investors, (2) reasonable investors diversify, and (3) diversified investors are effectively protected against the supposed financial harms of securities fraud by virtue of being diversified, except in cases in which insiders have extracted gains by trading during the fraud period. Only those actions that involve insider trading or the equivalent by directors, officers, or agents of the defendant company (or the company itself) entail genuine financial harm to the plaintiff class, because only those actions involve an extraction of wealth from the public market. Accordingly, only SFCAs that allege insider trading or the equivalent should survive a motion to dismiss. In addition to the fact that diversified investors suffer no compensable harm in the absence of insider trading or the equivalent - simple securities fraud - SFCAs visit serious collateral damage on defendant companies, ultimately reducing investor return. In an action based on failure to disclose bad news, the prospect of payout will cause stock price to fall by more than it otherwise would - even in a perfectly efficient market - and will trigger a positive feedback mechanism that will have the effect of magnifying the potential payout. This feedback effect can be quantified with precision using a simple formula. For example, in a case in which the release of bad news should cause market price to fall by 10 percent, the SFCA feedback effect will result in a price decline of about 20 percent if share turnover has been 50 percent during the fraud period. Thus, by their very nature SFCAs cause additional damage to defendant companies and stockholders. It is easy to fix the feedback problem. If the case does not involve insider extraction of gains, it should be dismissed. If the case does involve insider extraction of gains, it should be litigated in the name of the corporation by which the corporation, and the corporation should recover any gain extracted by insiders. Specifically, treating a securities fraud action as an action by the corporation (whether it is maintained by the corporation itself or derivatively by a representative stockholder) will make stockholders whole and will avoid collateral damage to the issuer corporation. Finally, the argument here suggests a new rationale for why insider trading should be illegal, namely, that it involves the extraction of wealth from the market and presumptively diversified investors. In turn, this suggests that diversified investors and largely undiversified insiders should be viewed as two different classes of investors with distinct interests. Thus, I also explore the public policy reasons for recognizing such a distinction and some of its other implications.

The End of the Securities Fraud Class Action as We Know It

In this article, I argue that securities fraud class actions (SFCAs ) should not be treated as class actions but rather should be treated as derivative actions. In addition, I argue that such actions should be dismissed unless it appears that insiders (including the company itselj have gained from trading during the fraud period. Both of these conclusions are based on the fundamental argument that (1) securities law seeks to protect the interests of reasonable investors, (2) reasonable investors diversify, and (3) diversified investors are effectively protected against the supposed financial harms of securities fraud by virtue of being diversified, except in cases in which insiders have extracted gains by trading during the fraud period. Only those actions that involve insider trading or the equivalent by directors, officers, or agents of the defendant company (or the company itselJ) cause genuine financial harm to the plaintiff class, because only those actions involve an extraction of wealth from the public market. SFCAs visit serious collateral damage on defendant companies, ultimately reducing investor return. In an action based on failure to disclose bad news, the prospect of payout will cause stock price to fall by more than it otherwise would-even in a perfectly efficient market-and will trigger a positive feedback mechanism that will magnify the potential payout. It is easy to fix the feedback problem. If the case does not involve insider extraction of gains, it should be dismissed. If the case does involve insider extraction of gains, it should be litigated in the name of the corporation, and the corporation should recover any gain extracted by insiders. Treating a securities fraud action as an action by the corporation will make stockholders whole and will avoid collateral damage to the issuer corporation. t Marbury Research Professor of Law, University of Maryland School of Law. Berkeley Business Law Journal Vol. 4.1, 2007

Strategic Decision Making in Federal District Courts: Evidence from Securities Fraud Actions

Scholars employing the tools of public choice theory hypothesize that judges are strategic actors whose decisions, while goal oriented, are influenced by the anticipated reactions of other political actors and by their institutional settings. Critics argue, however, that attempts to find empirical evidence of strategic decision making at the U.S. Supreme Court or Courts of Appeals have been spectacularly unsuccessful. This paper expands the search for strategic decision making by looking at federal district court decisions, specifically interpretations of the higher pleading standard contained in the Private Securities Litigation Reform Act of 1995. Initial interpretations of the Act articulated polar liberal and conservative positions. The evidence compiled here supports the hypothesis that the later emergence of an intermediate approach was the result of strategic decision making, rather than simply judges acting consistently with their strict ideological preferences. Using a much more nuanced measure of judicial ideology than previously employed in the legal literature, the article finds that liberal and conservative judges sitting in ideologically dissimilar circuits were significantly more likely to adopt the intermediate standard than other judges. There is also evidence that the likelihood of strategic decision making is a function of the likelihood of appeal and reversal and that changes in reversal rates had the largest influence on moderate judges. While there is some evidence that horizontal precedents also influenced the decision, those correlations are generally weaker than for strategic variables and are not consistently significant across model specifications.

Pleading Securities Fraud

In roughly five years since Private Securities Litigation Reform Act of 1995 became law, courts and commentators have devoted considerable attention to two questions relating to requirement, set forth in section 21D(b)(2), that a complaint alleging securities fraud must with particularity facts giving rise to a strong inference that defendant acted with required state of mind. Those questions concern: (1) What constitutes the required state of mind in suits under section 10(b) and Rule 10b-5? And (2) Are facts indicating a defendant had a motive and opportunity to engage in fraud, standing alone, sufficient to create a strong inference that that defendant acted with required state of mind? Courts and commentators have devoted far less attention to what I call Basis Requirement - portion of section 21D(b)(1) that requires a plaintiff to specifying not only each statement alleged to have been misleading and the reason or reasons why statement is misleading, but also, with respect to every allegation made on information and belief, all facts on which that belief is formed. This article argues that issues relating to Basis Requirement in long run will prove to be far more significant than issues relating to motive, opportunity and degrees of recklessness that have preoccupied courts and commentators to date. A threshold question is amount and quality of corroborating information a plaintiff must include in her complaint. The article explains why, in order to implement Congress' goal of discouraging filing and prosecution of speculative claims of securities fraud, courts must adopt an interpretation of Basis Requirement similar to that adopted by Ninth and First Circuits in In re Silicon Graphics Securities Litigation and Greebel v. FTP Software, respectively. Only by doing so will courts prevent plaintiffs from continuing to make speculative allegations of fraud and then relying on discovery process to seek evidence to support their claims. The article next highlights two additional holdings in Greebel: (1) A court must consider nature of corroborating information plaintiff has provided when evaluating whether plaintiff has pled facts sufficient to create a strong inference of scienter. (2) The Reform Act effectively rejects notice pleading philosophy reflected in Conley v. Gibson by requiring plaintiffs in securities fraud actions to plead facts that give rise to a strong, rather than merely a reasonable, inference of scienter. Using analytic framework created by Greebel and Silicon Graphics, article then considers two cases currently pending in courts in Second and Third Circuits. The first is Novak v. Kasaks, in which Second Circuit reversed and remanded a district court decision granting a motion to dismiss. The article points out that Second Circuit's opinion is rather muddled, but can be reconciled with Silicon Graphics and Greebel, and notes that whether Second Circuit so interprets Novak will provide an important indication of whether inferior federal courts are going to adopt a uniform or a fragmented approach to interpreting Reform Act's pleading requirements. (The article also notes that a petition for a writ of certiorari was filed in Novak after article was completed.) The second case is In re Cell Pathways, Inc. Securities Litigation, in which defendants have petitioned Third Circuit for a writ of mandamus to reverse a clearly incorrect district court decision denying their motion to dismiss. As is case with Novak, how Third Circuit deals with this petition will provide an important indication of approach inferior federal courts are going to take to interpreting and enforcing pleading requirements of Reform Act. The article concludes by discussing some potential policy consequences of imposing on plaintiffs in securities class actions these stringent pleading requirements. The article observes that evaluating impact of Reform Act is largely an empirical question and that, because first appellate decisions interpreting Act's pleading requirement were issued relatively recently and legal landscape in several circuits remains unclear, it will be several more years before sufficient data are available to support any informed conclusions as to whether Act's pleading requirements - assuming they are interpreted uniformly - make it too difficult for victims of securities frauds to secure appropriate relief.

Recent Developments Regarding the Misappropriation Theory in Securities Fraud Actions

On 25th June, 1997, the US Supreme Court issued an important decision in which it endorsed an expanded theory of insider trading liability under the federal securities laws. In United States v O'Hagan, the Court held, in a 6‐3 decision, that a person who misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information, may be found liable for securities fraud under s. 10(b) of the Securities Exchange Act of 1934 (the ‘Exchange Act’) and SEC Rule 10b‐5, which prohibit the use of fraud or deception ‘in connection with the purchase or sale of any security’. In endorsing the ‘misappropriation’ theory, the Court resolved a longstanding split among the federal Circuit Courts of Appeal and upheld an important tool in the prosecution of securities fraud. Separately, the Court held that the Securities and Exchange Commission (SEC) did not exceed its rulemaking authority under s. 14(e) of the Exchange Act when it adopted Rule 14e‐3(a), which prohibits trading on the basis of material, non‐public information concerning a tender offer, without requiring the government to show a breach of fiduciary duty.