INTRODUCTION I. THE SHORTCOMINGS OF CLASS ACTIONS A. The Uncertain Benefits of Securities Class Actions 1. Compensation of Plaintiffs 2. Deterrence B. The High Costs of Securities Class Actions II. THE CASE FOR MANDATORY INDIVIDUAL ARBITRATION A. Benefits of Arbitration B. Responses to Critics of Arbitration 1. Majority Can Bind Minority and Future Stockholders through By-law Amendment 2. Individual-Only Arbitration is Permitted by Federal Arbitration Act 3. Mandatory Individual Arbitration of Securities Claims is Not Unfair 4. Mandatory Arbitration Denies Stockholders a Right to Litigate 5. Mandatory Individual Arbitration Does Not Violate the Securities Laws 6. The Need for Adequate Notice and Other Procedural Protections C. An Alternative CONCLUSION APPENDIX 1: DRAFT STOCKHOLDER RESOLUTION Stockholder Resolution Supporting Statement APPENDIX 2: BY-LAW AMENDMENT INTRODUCTION
Federal Rule of Civil Procedure 23 and the Private Securities Litigation Reform Act of 1995 (PSLRA) 1 together govern securities class actions. These regimes provide that a class representative may bring a claim against a corporation on behalf of all investors who owned a security at a time when there was an alleged misstatement or failure to disclose a material fact that caused loss. By default all potential members of a class--all investors who owned the security during the relevant time (before the misstatement or omission was corrected)--are included in the class unless they take the affirmative step of opting out. Inertia, therefore, works to expand the class.
Allowing stockholders to vote to adopt mandatory individual arbitration gives them a choice whether to accept the uncertain benefits and high costs of securities class actions. Securities class actions have two principal rationales: compensation and deterrence. (2) The case for compensation is weak and generally rejected by commentators. Long-term stockholders end up suing themselves while recoveries are offset by plaintiff attorneys' fees amounting to 25-35% of the settlement (3) and defense costs in the same range. (4) At the same time, choosing which short-term stockholders recover and which pay is decidedly random, given that shares are held on average for just slightly longer than one year. (5) Further, securities class actions generally do not provide redress to smaller stockholders. Indeed, smaller investors often do not bother to collect their settlements because they are so small--we have all experienced throwing class action notices in a wastebasket. Courts left with unclaimed funds often give them to the parties that filed claims in a second round of pro-rata distribution and even sometimes to charity.
The case for deterrence is ambiguous at best. First, private securities class actions supplement the United States' robust system of public civil and criminal enforcement through the actions of the Department of Justice (DOJ), the Securities and Exchange Commission (SEC), and state attorneys general and securities enforcement officials. (6) Second, the settlements and
We are grateful for the substantial contributions of Andrew G. Coombs (Associate, Cleary Gottlieb Steen & Hamilton LLP), Eric M. Fraser (former Executive Director for Research, Committee on Capital Markets Regulation), and Pamela L. Marcogliese (Partner, Cleary Gottlieb Steen & Hamilton LLP). The views expressed in this paper should not be taken as the views of Cleary Gottlieb Steen & Hamilton LLP or the Committee on Capital Markets Regulation. judgments primarily impact stockholders, not management. Managers seeking short-term profits from stock performance are unlikely to be deterred by the later possibility of class actions whose impact will fall on all stockholders. Third, the major deterrence from management misdeeds comes from the disclosure of wrongdoing rather than the bringing of class actions: after disclosing wrongdoing, a firm can be expected to lose about 40% of its value, most of it due to a reputational penalty rather than losses from anticipated litigation, which are estimated to account for less than 9% of the decline in value, (7) and almost all of the responsible parties quit or are fired. (8)
Securities class actions are also a serious problem for the attractiveness of the U.S. public capital markets. The prevalence and cost of such suits drive capital abroad or into the private markets, as the Committee on Capital Markets Regulation (the Committee) documented, (9) and reduce venture capital investment because of the increased liability risk of going public (and getting the multiples that go with such exit). In 2012, investors filed 152 federal class actions alleging securities fraud (10) and courts approved 93 settlements with an aggregate payout of $3.3 billion. (11) In the past, these settlements have risen to as much as $19 billion in a single year. (12) Because stockholder class actions are almost uniquely American, it is not hard to see how these suits dampen the competitiveness of the U.S. capital markets.
Arbitration, by contrast, is a means of resolving stockholder disputes that does not present the same concerns of high cost and uncertain benefit inherent in securities class actions. Arbitration is a common means of dispute resolution in other securities laws disputes, for instance, between broker-dealers and their customers. (13) By its nature, mandatory individual arbitration requires more engaged stockholders, which may result in larger settlements for those that are so engaged.
Nonetheless, arbitration has many vocal opponents. These opponents question whether a majority of stockholders in a corporation can bind the minority through a by-law provision like the one we propose; they claim arbitration is unfair; and finally, they assert that mandatory arbitration would deprive individual plaintiffs of their right to litigate. In response to these arguments, as discussed below, Delaware law is clear that a majority of stockholders have the right to bind a minority and that an arbitration requirement is permitted in a corporation's by-laws. This conclusion arguably has been reinforced by the recent Supreme Court's decision in AT&T Mobility LLC v. Concepcion, (14) which makes clear that mandatory individual arbitration provisions are enforceable in the consumer contract context. (15) Furthermore, there are strong counterarguments to the claim that arbitration is inherently unfair. Finally, regarding the argument that arbitration denies individual stockholders their rights, it is these same individuals that are likely to throw their class action settlement paperwork in the wastebasket--they have very little to gain from participation. In light of the enormous potential benefits of an arbitration regime for stockholders as a whole, it seems unwise to give excessive deference to a lost "right" for stockholders who, as evidenced by their failure to collect settlement proceeds, clearly do not value the opportunity to participate in the class.
Part I of this Article discusses in detail the shortcomings of the modern class action system, including its uncertain benefits (in terms of compensation and deterrence) as well as its indisputable high costs. Part II then presents the benefits of the mandatory individual arbitration stockholder proposal and why it is likely to be upheld if challenged in court, as well as certain procedural protections contained in our proposal. We also present an alternative to arbitration, our Opt-In Proposal, and discuss its shortcomings and why we believe arbitration is a preferable approach. Finally, our stockholder resolution, supporting statement and model by-law amendment are attached in two Appendices.
THE SHORTCOMINGS OF CLASS ACTIONS
The Uncertain Benefits of Securities Class Actions
Compensation of Plaintiffs
There is a broad consensus that securities class actions are a poor method of compensating stockholders for losses due to securities fraud. (16) Since the passage of the PSLRA in late 1995, there have been only twenty securities class action trials, as compared to a total of over 3900 filings. Almost all suits, if not dismissed, settle. In fact, less than 0.5% of securities class action filings result in a verdict. (17) When securities class actions do settle, they settle for a very small percentage of the damages claimed. According to one study, the median class action in 2011 settled for only 2.1% of "estimated damages" (a calculation method typically used by plaintiffs to estimate claim values in securities class actions) or 7.0% of "disclosure dollar loss" damages (a more conservative calculation of damages based on decline in market capitalization during the class period). (18) The median and average securities class action settlements in 2012 were $12 million and $36 million, respectively. (19) From this amount, plaintiffs' attorneys customarily receive between 25% and 35%. (20) Plaintiffs' attorneys have an incentive to encourage their clients to settle cases for much less than an amount that would compensate them for their losses, in order to avoid the cost and risk of a trial.
In all securities class actions, a significant part of the funds recovered, either at trial or through a settlement, is not distributed to members of the class. This may occur because class members cannot be located, because they fail to submit claims as required by the court's orders, or because the costs of distributing a small amount of funds would exceed the value of the claim. (21) An examination of seventy-five random securities class action settlement distributions between 2001 and 2008 revealed that holders of only 40-60% of the potentially eligible shares submitted a claim for a distribution. (22) That a large percentage of funds is not claimed speaks volumes about the current class action system. Although plaintiffs' attorneys must make reasonable efforts to notify potential class members of a settlement, some members will never...