The investor compensation fund.

• Author: Evans, Alicia Davis

The prevailing view among securities regulation scholars is that compensating victims of secondary market securities fraud is inefficient. As the theory goes, diversified investors are as likely to be on the gaining side of a transaction tainted by fraud as the losing side. Therefore, such investors should have no expected net losses from fraud because their expected losses will be matched by expected gains. This Article argues that this view is flawed; even diversified investors can suffer substantial losses from fraud, presenting a compelling case for compensation.

The interest in compensation, however, should be advanced by better means than are currently in place. The present system relies on securities class action lawsuits to compensate victims, but these suits not only undercompensate victims, but also underdeter fraud. To improve compensation and better deter fraud, this Article explores the creation of an investor compensation fund. Under this proposal, when a share of stock is sold in the secondary market, a fee, payable by the selling shareholder, will be placed into a fund for fraud victim restitution. The size of the fee will vary by the fraud risk rating assigned to the firm whose stock is sold and, naturally, will affect that stock's trading price. Therefore, firms will have incentives to institute corporate governance practices that minimize the likelihood of fraud.

1. INTRODUCTION II. RESPONSE TO THE ANTI-COMPENSATION ARGUMENT A. Asymmetries Stemming from the Market's Reaction to Fraud Announcements B. The Potential for Loss is Substantial for all Investors C. Buy-and-Hold Investors are Likely to Suffer Significant Harm from Securities Fraud D. The Undiversified Investor Has a Legitimate Claim to Protection From Fraud E. Political Considerations III. SECURITIES CLASS ACTIONS IV. THE INVESTOR COMPENSATION FUND PROPOSAL A. Overview B. The Proposal C. Possible Objections and Implementation Challenges 1. Mandatory Nature of the Program 2. The Role of the Federal Government 3. Deterrence Effects 4. Fraud Risk Ratings 5. Creation of a Fund Instead of Publication of Ratings Only 6. Equitable Considerations 7. Effect on Financial Markets a. Volatility b. Volume c. Accuracy and Overall Level of Prices 8. Political Considerations D. Summary and Concluding Thoughts on the ICF and Securities Litigation V. A CONSIDERATION OF ALTERNATIVE REFORM PROPOSALS A. Fair Fund Expansion B. U.S. Insurance-Based Proposals C. Canadian Securities Misinformation Insurance VI. CONCLUSION APPENDIX I APPENDIX II I. INTRODUCTION

   In 1985, Frank Easterbrook and Daniel Fischel, in an influential article, asserted that active traders with diversified portfolios are as likely to be on the gaining side of a transaction tainted by securities fraud as on the losing side. (1) Therefore, diversified investors should have no expected net losses from fraud because their expected losses will match their expected gains. (2) The idea of compensation for securities fraud losses has been under attack in the legal academy virtually ever since this article was published. Though Easterbrook and Fischel ultimately argue against ending compensation for securities fraud losses, (3) scholars, nevertheless, have used Easterbrook and Fischel's insight to decry the provision of securities fraud compensation as inefficient and to promote reforms that would eliminate it from the securities regulation regime. (4) In 2005, the U.S. Chamber of Commerce Institute for Legal Reform commissioned an empirical study to test the theoretical assertion that securities fraud risk can be diversified away. The study purported to find that large diversified institutional investors generally break even on their investments in firms accused of fraud. (5) The study captured mainstream media attention, (6) reflecting the importance of the issue to the business community and the public more broadly.

   This Article challenges the idea that fraud compensation for investors is not warranted. All investors, including diversified investors, can suffer substantial injury from securities fraud, and because there is measurable harm from fraud, there is a basis for granting compensation to its victims. This Article also contends that, as a practical matter, political exigencies make achieving the end of shareholder compensation in the post-Enron era unlikely. Therefore, what is most appropriate at this time, in my view, is an exploration of ways to provide compensation more effectively and efficiently.

   The current compensatory mechanism, the securities class action lawsuit, has important shortcomings. Defrauded shareholders currently rely primarily on class actions (so called "fraud on the market suits") filed against corporations and corporations' officers and directors for compensation for securities fraud losses. However, these suits provide limited compensation. The average securities fraud settlement award is trivial in relation to shareholder losses, with recovery of as little as 2%-3% of estimated damages. (7) Shareholder losses stemming from fraud at a large firm with actively traded stock can total billions of dollars, easily dwarfing the amounts available for shareholder compensation from current sources, i.e., payouts under directors' and officers' (D&O) liability insurance policies, company funds, and, occasionally, the personal resources of officers and directors. Moreover, not only do fraud on the market suits provide minimal compensation, but they also do a poor job of deterring fraud. These suits often allow the perpetrators (e.g., corporate officers) to evade personal responsibility by settling such suits, with no admission of wrongdoing, using the corporation's money or the proceeds of D&O insurance policy payouts. (8) This seriously undermines the purported deterrence effect of such lawsuits on corporate managers.

   To improve compensation and better deter fraud, this Article explores the creation of an investor compensation fund (ICF). Under this proposal, fraud on the market suits will be eliminated, and a special purpose insurance fund will be created to provide investor restitution for fraud-related losses. Every time a share of stock or similar security is sold in the secondary market, a fee (premium) will be collected from the selling shareholder and placed into the fund. A firm's fraud risk rating, reflecting the likelihood of fraud occurring, will determine the size of the fee to be paid by each selling shareholder. The ICF premium feature acts as a fraud deterrent because the size of the ICF premium will be reflected in a company's share price, providing incentives for managers to institute the control mechanisms necessary to minimize the likelihood of fraud. The ICF also offers the promise of a large source of funding for defrauded shareholder compensation.

   In addition to setting forth a reform proposal, this Article makes another contribution to the literature. Exploring the creation of an investor compensation fund provides an opportunity to consider the advantages and disadvantages of ex ante (9) (i.e., regulation through the use of fraud risk ratings) and ex post (i.e., litigation) approaches to limiting harm from securities fraud. There are costs and benefits to both approaches to managing the securities fraud problem. The ICF, with elements of both approaches, can be used as a vehicle to highlight some of the more salient issues and tradeoffs in this area.

   The Article proceeds as follows. Part II addresses what, given the current state of securities regulation scholarship, is likely to be one of the principal objections to the ICF Proposal by responding to the argument against compensation for securities fraud losses. The section does not include a full discussion of all of the considerations relevant to compensation for securities fraud losses, but rather outlines responses to those who argue that such compensation is unnecessary. Part III of the Article briefly examines the securities class action mechanism and describes its shortcomings. Part IV sets forth the ICF Proposal and addresses potential objections and key implementation challenges. Creation of the ICF, though in all likelihood an improvement over the current regime as a theoretical matter, would entail significant implementation and administrative challenges. This Article, by design, does not address fully all of these challenges, but rather suggests what the primary concerns about implementation of a proposal of this type might be. Finally, Part V of the Article considers several alternative reform proposals. After reviewing these proposals, it should become clear that the ICF is not as unorthodox as it may seem initially. All of the proposals are in some respects similar to the ICF and have attractive features. However, in comparing these schemes to the ICF, one will be able to recognize the unique advantages of the ICF and its ability to provide superior compensation to securities fraud victims and deter fraud.

2. RESPONSE TO THE ANTI-COMPENSATION ARGUMENT

   Many leading scholars oppose the idea of compensation for securities fraud losses. The following statement, made by Janet Cooper Alexander in a well-known article, is representative of the prevailing view:

   The chance of being on the losing or winning side of a transaction when the stock price is distorted by a securities violation can be assumed to be random. The more trades investors make, the more likely that, in the aggregate, their gains from trading while material facts are withheld will equal their losses. (10) Under this theory, active traders with diversified portfolios will benefit as often from securities fraud as they will be harmed by it. Therefore, investors should have no expected overall losses from securities fraud, making efforts to provide compensation inefficient.

   Under the capital asset pricing model (CAPM), investors receive compensation (investment returns) only for bearing systematic risks. A...