Giving Shareholders the Right to Say No: Shareholders should be able to vote against pursuing securities class action suits.

• Author: Choi, Albert H.

When a public company releases misleading information that distorts the market for the company's stock, investors who purchase at the inflated price lose money when (and if) the misleading information is later corrected. Under Rule 10b-5 of the Securities Exchange Act of 1934, investors can seek compensation from corporations and their officers who make materially misleading statements that the investors relied on when buying or selling a security. Compensation is the obvious goal, but the threat of lawsuits can also benefit investors by deterring managers from committing fraud.

The value of deterrence accrues to all investors and the market more generally, and only fractionally (based on share ownership) to the investor filing suit. A retail investor with only a few hundred shares will expect a minimal benefit from any recovery while bearing the entire cost of litigating a claim. This mismatch of individual and collective incentives means that, although the group of investors might collectively favor bringing a suit against a public company that releases misleading information, most individual investors will not be inclined to sue. Moreover, a fraud lawsuit against a public company can easily cost millions of dollars, so few investors can afford to litigate on their own.

The class action mechanism helps overcome these disincentives to bringing suit: the class representative represents the class members' collective interests. Individual class members need not expend their own resources to obtain a recovery. Plaintiffs' attorneys, compensated on a contingency basis, will bankroll the litigation and bear the risk of loss if the case does not settle. Investors do not even need to pay attention to the litigation until a settlement is reached. All they need to do is submit a claim form once the lawsuit is concluded.

The class action ameliorates the collective action problem facing dispersed investors, but aggregation of claims brings its own set of problems. These problems stem from the incentives of the plaintiffs' attorney firms that serve as class counsel. The class counsel is paid--as a percentage of the recovery--only if there is a settlement or judgment. Typically, class counsel receives a fee of 10% to 33% of the settlement fund, a number that dwarfs the interest of any investor class member. Although in theory the class representative makes decisions on behalf of the class, in practice plaintiffs' attorneys make the critical decisions regarding the litigation. He who pays the piper calls the tune.

With potentially large sums at stake, plaintiffs' attorneys enjoy a lucrative practice, but the societal benefits of Rule 10b-5 class actions are less obvious. Particularly troublesome are suits alleging that corporate defendants have made public disclosures that distorted the price of the company's securities in the secondary market, but the company itself did not sell any securities. These "open market" fraud cases make up the lion's share of suits against public companies (approximately 80%). Investors who transact with other investors can recover from the company for their trading losses under the typical "out of pocket" measure of damages. Their counterparties--investors usually unconnected to the company other than through share ownership--make corresponding trading profits. The immediate net social cost of these trades, apart from the cost of executing them, is zero. Consequently, the out-of-pocket damages formula substantially overstates the social loss from the misstatements.

For companies with large trading volume, Rule lOb-S damages in a class action can be enormous. Moreover, shareholders who find themselves on the losing end can often protect themselves at low cost through diversification: when an investor holds a well-diversified portfolio, even though the investor may be on the losing side of a trade because of one company's misleading statement, she may be on the winning side of a trade with a different company.

Outsized potential damages encourage nuisance litigation. Even when a company has not intentionally or even negligently made a materially misleading disclosure, the company may have reasons to settle a nuisance suit. Settlement not only allows the company to save the costs of defending the suit, but also avoids even a small possibility of losing. A loss after trial means paying potentially bankrupting damages. If companies are willing to settle nuisance litigation, opportunistic plaintiffs' attorney firms are encouraged to file such suits to exploit this corporate vulnerability.

Many of the developments in Rule 10b-5 legal doctrine over the past several decades have focused on filtering out nuisance litigation while allowing meritorious litigation to proceed. Doctrinal reforms to Rule 10b-5 implemented by both Congress and the courts--most notably the Private Securities Litigation Reform Act of 1995 (PSLRA)--have attempted to screen meritless suits. These reforms, however, have had only limited efficacy in more precisely distinguishing meritorious suits from frivolous ones.

We propose a new decision-maker for screening securities class actions involving corporate defendants: the corporation's shareholders. Our proposal would allow shareholders to vote on whether to limit or modify class actions across the board. Shareholders could also vote on whether to terminate a particular class action or allow it to move forward. We argue that empowering shareholders to make the key decisions about securities fraud class actions cannot only discourage nuisance litigation, but also can give shareholders the ability to encourage meritorious litigation that serves the deterrence purposes of the securities laws.

DECIDING WHO SHOULD DECIDE

Currently, two players largely decide whether a securities fraud class action should proceed from the filing of suit to past the motion to dismiss (which typically occurs soon after the selection of lead plaintiff for the class action and the filing of a complaint by the lead plaintiff):

* the plaintiffs' law firm, which decides to invest the resources in bringing a suit (including finding a shareholder-plaintiff with standing); and

* the court, which decides whether the complaint has enough indicia of merit to proceed past the motion to dismiss.

Plaintiffs' lawyers have incentive to bring suit whenever they think they can extract a settlement at a reasonable cost, which can leave plenty of room for nuisance settlements. So, the judge's decision on the motion to dismiss becomes the critical screening device. But that decision is necessarily a constrained one, restricted to the facts as...