An economic analysis of the Private Securities Litigation Reform Act: auctions as an efficient alternative to judicial intervention.

• Jurisdiction: United States
• Author: Gray, Charles H.
• Date: 01 December 2002

INTRODUCTION

In 2001, the Third Circuit affirmed a district court's approval of a $3.2 billion settlement in a securities class action case brought principally against Cendant Corporation. (1) The district court selected lead counsel in this "mega case" through an auction (2)--a new, innovative tool for class action litigation. (3) Although the Court of Appeals for the Third Circuit ultimately held that the lower court erred in conducting an auction to determine who would represent the class, (4) use of court ordered auctions in securities litigation is on the rise. The law firms who represented the class in this case received a court-approved $262 million in fees and an additional $14.6 million in expenses. (5) With the realistic possibility of billions of dollars at stake, it is imperative that individual investors, institutional investors, and law firms that anticipate representing potential classes know and understand the implications of the Private Securities Litigation Reform Act (PSLRA) (6) and, specifically, the role court-ordered auctions could play in securities litigation.

The PSLRA was designed to combat perceived failures in class action securities litigation. The legislative history behind the PSLRA, passed in 1995, reveals that Congress intended to reduce "abuse in private securities lawsuits," especially "the manipulation by class action lawyers of the clients whom they purportedly represent." (7) Through the PSLRA, Congress tried to correct the typical scenario of lawyers seeking clients instead of clients seeking lawyers. (8) To further this goal, the PSLRA provides increased access to the litigation system to more savvy and involved potential plaintiffs. (9) Lead plaintiffs under the PSLRA are now chosen not based on the timeliness of their filing, but upon the stake that they have in the litigation. (10) These plaintiffs, given an increased ability to control their own fate, began to participate with greater frequency in the class action process. (11)

Congress wished to provide the whole class, instead of a select few, with the best, most efficient litigation tools and measures. In every class action litigation, the plaintiff class is comprised of the lead plaintiff, who has the single largest stake in the litigation, and other nonparticipatory parties. To ensure that the rights of nonactive parties are represented, Congress has provided some limitations on the power vested in lead plaintiffs. The PSLRA provides that, upon the appointment of the lead plaintiff, she "shall, subject to the approval of the court, select and retain counsel to represent the class[,]" (12) thereby explicitly involving the court in the process of deciding who will represent the class. A qualified lead plaintiffs power to select counsel for the class is thus far from absolute.

Early interpretations of the PSLRA gave a broad range of freedom to lead plaintiffs in selecting and retaining counsel. (13) The only perceived limitation was that the counsel chosen withstand judicial approval. Still, the fact that courts maintain authority to approve or reject a lead plaintiff's selection indicates that the power of the lead plaintiff to choose legal counsel for the class is not absolute. Instead, lead counsel must be qualified to best represent the class in the eyes of the court.

The PSLRA still has wrinkles. The potential for corruption in choosing and retaining counsel still exists. Infirmities such as overbilling, inadequate representation of the class, and improper focus on the needs of the lead plaintiff are problems still remaining, even after enactment and enforcement of the PSLRA. These problems arise, not because of the inherent nature of the PSLRA, but because the language of the Act allows self-interested lead plaintiffs to ignore the interests of the rest of the class.

A competitive bidding system for the determination of lead counsel is the most effective way to close the gaps left open by the PSLRA. Auctions effect an administrative allocation of sources as an alternative to deficient market forces. (14) This Note argues that the best, and most efficient, way to combat races to court and to protect nonparticipating plaintiffs is to open the lead counsel role to a competitive bidding process. (15)

How far does a court's power stretch when dealing with the issue of who represents the class? Under the terms of the PSLRA, courts maintain veto power over the selection of lead counsel. (16) This Note will show that a competitive bidding process is an efficient market clearing mechanism for the selection and retention of lead counsel, and that such a process is encompassed under the powers granted to the court by the PSLRA. (17) Court-ordered auctions are not only permissible, they should be used with greater frequency. (18)

This Note will (1) provide a brief discussion of the history of the PSLRA; (2) determine Congress' intent in passing the Act, emphasizing its consideration of the possibility of "competitive bidding;" (3) examine the economic rationale of a competitive bidding process and discuss the role it can have in securities litigation; (4) analyze courts' experimentation with the auction process and evaluate whether auctions, in their present form, are an adequate answer to the concerns reflected in the PSLRA; (5) discuss the effect that auctions have had on prospective lead plaintiffs and prospective lead counsel; and finally, (6) suggest what should be done to correct the inconsistent interpretations regarding auctions and the PSLRA.

1. HISTORY OF THE PRIVATE SECURITIES LITIGATION REFORM ACT

   With the enactment of the PSLRA, Congress addressed two distinct interests: preventing securities fraud and ensuring that the "litigation process is not used for abusive purposes." (19) Still another purpose of the PSLRA is to protect and inform all members of the class. (20) Before enacting the PSLRA, lawyers who represented "lead plaintiffs" (21) would strive to be the first to file a claim, obviously dreaming of large rewards that could accrue as a result of litigation. This "race to the courthouse" had numerous adverse affects on the litigation process. For example, in an effort to expedite the filing process, firms representing potential lead plaintiffs often neglected to conduct an adequate investigation of the facts or likelihood of success. (22) Congress, therefore, had a strong desire to reform attorney-driven litigation.

   To combat this problem, the PSLRA first mandated that, absent evidence to the contrary, the individual, institutional investor, or even group of investors with the largest stake in the action should represent the class. (23) The result of this provision of the Act is that large, institutional investors often have an increased role in the litigation process. (24) This appears, on its face, to have a favorable effect on class action lawsuits. The theory behind involving large investors, especially pension funds, mutual funds, or large corporate entities, is that they are presumed to be shrewd investors and sophisticated consumers of legal advice.

   The second measure Congress established in the PSLRA was one allowing the lead plaintiff, "subject to the approval of the court, [to] select and retain counsel to represent the class." (25) Following the appointment of a lead plaintiff, the chosen counsel must withstand the protective scrutiny of the court. Courts, understandably, have shown much deference to the lead plaintiffs choice of counsel. (26) For example, the United States District Court for the Northern District of Texas took only cursory note of the lead plaintiffs choice of retained counsel. (27) The theory underlying such "blind" approvals of lead counsel is that the lead plaintiff, typically a sophisticated and knowledgeable investor who holds a large claim in the action, will be able to adequately choose and retain counsel that will best represent the class' interests. (28) These courts assume that the interests of the largest investor will coincide with the interests of the whole class; however, this argument does damage to the intent of the Act. Congress recognized that the interests of the class and the interests of the lead plaintiff may not always coincide. This is the reason Congress granted to the courts the power to approve or disapprove of the lead plaintiff's selection. (29) The objective of protecting the minority of the class' interest in the litigation is the underlying purpose of the PSLRA.

   The possibility that the selected lead counsel will not act in the best interests of the class, but instead act for the sole interests of the lead plaintiff who selected the counsel, is ever present in securities litigation. (30) Conflicts of interest are likely to arise among lead counsel's various duties. These conflicts could result in a possible breach of fiduciary duty owed by lead counsel to the rest of the class because counsel could understandably favor its relationship with lead plaintiff. As large investors often use the same law firm for different matters, the duties a firm owes to the absent members of the class may become blurred with prior or continuing fiduciary duties owed to the lead plaintiff. (31) The Cendant court maintained that the "ultimate inquiry is always whether the lead plaintiffs choices were the result of a good faith selection and negotiation process and were arrived at via meaningful arm's-length bargaining." (32) At all times, the court holds the option to disapprove, with cause, any selected counsel. (33) The court, for example, could disqualify the selection of lead counsel and require that the lead plaintiff select a new counsel or, alternatively, require that the current firm revise its fee structure and resubmit it to the court. (34) In theory, the process of a lead plaintiff selecting counsel and the court rejecting her choice could go on forever, dramatically increasing legal costs and unnecessarily prolonging the litigation...