Shareholder compensation as dividend.

• Author: Park, James J.

This Article questions the prevailing view that securities-fraud actions suffer from a circularity problem. Because shareholder plaintiffs are owners of the defendant corporation, it is commonly argued that shareholder compensation is a payment from shareholders to themselves with substantial transaction costs in the form of attorney fees. But shareholder compensation is no more circular than a dividend, which is a cash payment to shareholders from the company they own with substantial transaction costs in the form of taxes. In fact, shareholder compensation is less circular than a dividend because it is a transfer to shareholders who purchased stock when the price was inflated by fraud from those who did not. Shareholder compensation serves an important loss-spreading function that is facilitated by the insurance market. Shareholder compensation may also capture some of the benefits of paying dividends, such as signaling and reducing agency costs, though it may do so more effectively if companies could resolve securities-fraud actions by paying a preemptive dividend.

TABLE OF CONTENTS INTRODUCTION I. THE CIRCULARITY PROBLEM II. THE DIVIDEND PUZZLE AND SHAREHOLDER COMPENSATION A. The Irrelevance of Dividends B. The Relevance of Shareholder Compensation 1. Shareholder Compensation as Transfer from Non-Class to Class Shareholders 2. Distinguishing Between Non-Class and Class Shareholders 3. The Loss-Spreading Function of Shareholder Compensation C. A Point About Attorney Fees D. Summary III. THE SHAREHOLDER COMPENSATION PUZZLE A. Signaling 1. Dividends 2. Shareholder Compensation B. Agency Costs 1. Dividends 2. Shareholder Compensation C. Diversification 1. Dividends 2. Shareholder Compensation IV. MAKING SHAREHOLDER COMPENSATION MORE LIKE A DIVIDEND A. Distributing Shareholder Compensation Through a Dividend B. Preemptive Dividends CONCLUSION INTRODUCTION

This Article questions the prevailing view that securities-fraud-on-the-market class actions alleging violations of Rule 10b-5 ("securities-fraud actions") are fatally flawed because they suffer from a circularity problem. (1) Shareholder plaintiffs are simultaneously owners of the defendant corporation from which any settlement of a securities-fraud action is paid. Thus, when a corporation compensates shareholders for securities fraud, the payment is seen as a circular transfer from shareholders to themselves with substantial transaction costs in the form of attorney fees and the costs of defending the suit. (2)

But this circularity is no worse than the circularity of a dividend, (3) which is a common way that corporations distribute cash to their shareholders. The economic benefit of a dividend is at best a wash because the cash that is paid out cannot be invested by the corporation, or the corporation must issue new debt or equity to fund the dividend. The prospect of receiving a dividend should thus be irrelevant to an investor's decision to purchase a stock* And like shareholder compensation, a dividend triggers a substantial transaction cost, the dividend tax. (4)

Indeed, shareholder compensation is actually less circular than a dividend. While all shareholders receive a dividend, only shareholders who purchased stock while it was inflated by fraud are entitled to shareholder compensation. Shareholder compensation is thus essentially a transfer from shareholders who were not defrauded to shareholders who were defrauded. In light of this transfer, shareholder compensation is best justified as a loss-spreading mechanism that spreads the risk of buying stock at inflated prices. This loss-spreading function is facilitated by insurance, which ensures that even shareholders who benefited from the fraud by selling stock at inflated prices contribute to funding shareholder compensation. A system that relies on insurance is likely to be more effective in spreading losses from fraud than a system that relies solely on investors to diversify*.

The circularity problem should also be viewed in light of the significant body of finance literature that explores why companies pay dividends despite their circularity, a problem referred to as the dividend puzzle. (5) Three explanations have been articulated for the payment of dividends. First, payment of a dividend sends a signal to the market about the company's future prospects. Second, payment of a dividend may reduce agency costs by reducing free cash flow that might be wasted by managers. Third, payment of a dividend allows shareholders to further diversify.

Of these theories, the agency-costs explanation is most applicable to shareholder compensation. If a company does not have insurance, paying shareholder compensation can significantly reduce the amount of free cash flow available to managers who committed fraud. If a company does have insurance, the costs of shareholder compensation are spread out over time, but such costs may have a disciplining effect similar to debt. While in practice it is unlikely that reducing free cash flow is always beneficial to a company, the circularity problem must come to terms with the possibility that reducing free cash flow may reduce agency costs.

The remaining explanations for the payment of dividends apply with less force to the context of shareholder compensation. Rather than signaling that a company is doing well, shareholder compensation signals that a company may have committed fraud. Thus, managers have an incentive to obscure the signal of any shareholder compensation payment. Because shareholders typically receive compensation only for a fraction of their losses, any diversification effect of shareholder compensation is likely to be trivial.

However, the impact of shareholder compensation as a signal might be enhanced by changing the distribution mechanism of shareholder compensation so it more closely resembles a dividend. Corporations, acting through a committee of independent directors, could be permitted to preemptively pay a dividend that would cover some or all of the cost of the fraud to shareholders. Plaintiffs' attorneys would receive a fee only if they recover an amount greater than the preemptive dividend, reducing the transaction cost of attorney fees and creating incentives to recover more for shareholders. A preemptive dividend would send a much stronger signal that the corporation treats fraud seriously than payment of a settlement by an insurance company.

The wide acceptance of the circularity problem has led to skepticism about whether securities-fraud actions fulfill a meaningful compensatory function. (6) As a result, there have been a significant number of proposals to revamp them. (7) Ultimately, thinking of shareholder compensation as a dividend by itself is not enough to establish that securities-fraud actions are desirable for policy reasons. Indeed, it may be impossible to conclusively determine whether the benefits of shareholder compensation--loss spreading and reduction of agency costs--outweigh the substantial transaction costs of litigation.

But at the very least, the analogy shows that shareholder compensation should not be rejected on circularity grounds. Neutralizing the circularity problem will mean that deterrence will not have to play such a heavy role in justifying securities-fraud actions. The arguments for reform should shift from totally restructuring or even doing away with securities-fraud actions to incremental reforms such as continuing to clarify the law so that meritorious claims are more likely to survive while nonmeritorious claims can be screened out at the motion to dismiss stage by judges. (8)

Part I of this Article describes the circularity problem. Part II describes the dividend puzzle and demonstrates that shareholder compensation is actually less circular than a dividend and serves an important loss-spreading function that is facilitated by the insurance markets. Part III examines whether some of the arguments justifying dividends, such as signaling and the reduction of agency costs, may be relevant to the payment of shareholder compensation. Part IV proposes that some of the signaling benefits of dividends might be better captured if companies had the option of distributing shareholder compensation through a preemptive dividend.

1. THE CIRCULARITY PROBLEM

   In theory, securities-fraud actions compensate investors when they purchase stock at prices inflated by fraud, while deterring corporations and their agents from committing fraud. (9) Though the deterrence rationale is largely accepted, (10) most scholars have concluded that securities-fraud actions are inherently unable to compensate investors because of a circularity problem. (11)

   While the precise form of the argument varies and is usually mentioned only in passing, the circularity problem generally criticizes securities-fraud actions as resulting in meaningless transfers from a company to its shareholders. (12) There are two variants of the circularity problem. The first is that shareholder compensation is circular because shareholders receive a payment from the corporation they own, which reduces funds that the corporation could use to make investments that might benefit those shareholders. (13) In other words, the shareholder victims of the fraud pay for their own remedy. (14) The second is that shareholder compensation is circular because diversified shareholders over time do not suffer harm from fraud because, while they may be victims of fraud with respect to some transactions, they may be beneficiaries of fraud with respect to other transactions. (15) Both variants essentially criticize shareholder compensation on the ground that it involves a transfer with benefits that do not outweigh the substantial transaction cost of attorney fees. (16)

   The circularity problem arises in part because while the corporation is usually the primary defendant in a securities-fraud action, it arguably does not directly commit the fraud or realize the gains...