The political economy of fraud on the market.

• Author: Bratton, William W.

The fraud-on-the-market class action no longer enjoys much academic support. The justifications traditionally advanced by its defenders--compensation for out-of-pocket loss and deterrence of fraud--are thought to have failed due to the action's real world dependence on enterprise liability and issuer-funded settlements. The compensation justification collapses when considered from the point of view of different types of shareholders. Well-diversified shareholders' receipts and payments of damages balance over time and amount to a wash before payment of litigation costs. The shareholders arguably in need of compensation--fundamental value investors who rely on published reports--are undercompensated due to pro rata distribution of settlement proceeds to all class members. The deterrence justification fails when enterprise liability is compared to alternative modes of enforcement, such as actions against individual perpetrators, which deter fraud more effectively. If as the consensus view now has it, fraud on the market makes no policy sense, then its abolition would seem to be the next logical step. Yet most observers continue to accept the action on the same ground cited by the Supreme Court when it first implied a private right of action under the Securities and Exchange Act of 1934 in 1964's J.I. Case v. Borak: a private enforcement supplement is needed in view of inadequate Securities and Exchange Commission (SEC) resources. In other words, even a private-enforcement supplement that makes no sense is better than no private-enforcement supplement at all.

This Article questions this backstop policy conclusion by highlighting the sticking points retarding movement toward fraud on the market's abolition and mapping a plausible route to a superior enforcement outcome. We recommend that private plaintiffs be required to meet an actual-reliance standard. We look to the SEC, rather than to Congress or to the courts, to initiate the change because the SEC is the lawmaking institution most responsible for the unsatisfactory status quo and best equipped to propose corrective action. Because an actual reliance requirement would substantially diminish the flow of private litigation, we also suggest a compensating increase in public-enforcement capability. More specifically, the SEC Division of Enforcement needs enough funding to redirect its efforts away from the enterprise and toward culpable individuals.

The Article addresses three barriers standing between here and there. First, there is a new justification for fraud on the market circulating in the wake of the failure of the original justifications: fraud-on-the-market litigation enhances the operation of the corporate governance system. We show that this line of reasoning, while well suited to justify the federal mandatory-disclosure system, does not support--and even detracts from--the case for fraud on the market. Second, we turn to politics to explain why fraud on the market retains political legitimacy despite the failure of its policy justifications. Third, we assess the contention that inadequacy of public enforcement resources justifies maintaining a fraud-on-the-market action. To that end, we show that circumstances have changed materially since the Supreme Court first invoked the justification in 1964. The SEC budget has grown elevenfold in real terms in the intervening forty-seven years, with much of the growth coming in the wake of the Enron fraud. The SEC's enforcement resources, like those of the plaintiffs' bar, ultimately are funded with dollars drawn from shareholder pockets, inviting direct comparison between the two. We show that public enforcement offers the shareholders more value than private enforcement. Private resources are tied to a low-deterrence, enterprise-liability framework. Public enforcement, even now, yields the shareholders comparable damage returns per dollar invested in enforcement. It can be deployed more flexibly, and it can be refocused against individual wrongdoers to enhance deterrence.

We conclude that increased public enforcement makes sense for shareholders even if it implies a diminished volume of private litigation and propose a political trade-off for the SEC to present to Congress: double the enforcement budget in exchange for an SEC-promulgated regulation replacing fraud on the market with an actual-reliance requirement.

INTRODUCTION I. FRAUD ON THE MARKET AS COMPENSATION A. Calculating Out-of-Pocket Damages under FOTM 1. The Price Drop 2. The Value Line 3. Complicating Factors B. Pocket Shifting 1. Modern Portfolio Investors 2. Underdiversified Investors a. Uninformed Traders b. Long-term Investors c. Underdiversified Information Traders C. Summary, Analysis, and Implications 1. The Failure of the Compensation Justification and Actual Reliance 2. Litigation Incentives II. FRAUD ON THE MARKET AS DETERRENCE A. Motivations for Fraud B. The Penalty Alternative C. Institutional Constraints D. Empirical Results E. Evaluation III. FRAUD ON THE MARKET AS GOVERNANCE A. The Governance Framework B. The Governance Case for FOTM 1. FOTM and Transparency 2. FOTM and the Shareholder-Manager Agency Relationship C. The Governance Case Against FOTM D. Fraud on the Market and the Mandatory-Disclosure System IV. POLITICS AND LEGITIMACY A. Management Accountability B. Shareholder Solicitude C. Agency Problems D. Summary and Analysis V. THE SEC AND REFORM A. Enforcement Resources 1. The SEC's Budget 2. Comparing the Public and Private Sectors 3. Sources of Funds 4. Bang for the Buck B. The SEC as Agent for Reform 1. A Quid Pro Quo 2. Rulemaking Power, Job Opportunities, and the Management Interest C. Summary CONCLUSION INTRODUCTION

The fraud-on-the-market (FOTM) cause of action just doesn't work. At least that is the consensus view (1) among academics respecting the primary class action vehicle under the federal securities laws. FOTM came forth making two promises: (1) it would compensate present fraud victims, and (2) it would operate as a deterrent against future fraud. FOTM is now generally seen to have altogether failed to deliver on the first promise. Real-world FOTM actions proceed on an enterprise-liability theory with corporate--as opposed to individual--defendants funding the compensation; investor "victims" are accordingly compensated from the pockets of other innocent investors. It follows that not only does FOTM fail as a compensatory mechanism, it doesn't even make sense. As to the deterrent promise, FOTM is thought to deliver, but only a little. Enterprise liability causes the problem once again: if FOTM were serious about deterrence, the funding would come from individual miscreants.

FOTM is an artifact of history. It follows from two ideas, both bound up in the securities law concept of investor protection. The first dates to the 1960s and 1970s. It holds both that investor protections under the securities laws' antifraud provisions, in particular section 10(b) of the Securities and Exchange Act of 1934 (2) (1934 Act) and Securities and Exchange Commission (SEC) Rule 10b-5 thereunder, (3) need a private enforcement mechanism (4) and that the class action is the procedural mode best suited for that purpose. (5) The second idea emerged as the courts elaborated the terms of the implied private right of action by reference to the common law of fraud. (6)

The common law fraudster compensates the victim by paying his out-of-pocket losses. Thus, the securities fraud defendant should pay the out-of-pocket losses of those who buy (or sell) a stock that is over(or under-) priced due to a misrepresentation (or omission). But the common law template also threw up substantive hurdles. The tort of fraud presupposes parties dealing face-to-face and requires a showing of reliance on the misrepresentation, (7) a showing that cannot be made as a practical matter in a class action. FOTM, which the Supreme Court adopted in Basic Inc. v. Levinson, (8) patched over the problem by relaxing the reliance requirement. With a famous citation to the Efficient Capital Market Hypothesis (ECMH), the court ruled that a showing of reliance on the integrity of the market price would suffice. (9)

It seemed like a good idea at the time. But FOTM simply did not work in practice. The consensus to that effect is notable in itself because big-ticket causes of action tend to have squads of academic cheerleaders. (10) But that consensus fosters only a limited menu of policy alternatives. On the one hand, FOTM's opponents argue that FOTM and the entire mandatory-disclosure regime should be abolished together. On the other hand, FOTM's proponents strenuously try to make it work. They take two routes in this pursuit. The first route treats FOTM as a misunderstood cause of action in need of fresh policy justification: if FOTM makes no sense as a compensatory tort, then a conceptual framework that does make sense of it needs to be substituted. (11) Corporate governance and agency-cost reduction have been suggested as this conceptual curative. (12) The second approach focuses on FOTM's meager deterrent properties and then looks away from theory to focus on practice. Under this view, FOTM is a necessary enforcement supplement, (13) despite its attendant conceptual problems: even if it doesn't work as promised, we are better off with it than without it. Meanwhile, we can try to make it work a little better.

This Article takes a new look at FOTM and its conceptual and practical failures with a view toward expanding the list of policy alternatives. We reject the all-or-nothing connection that the opponents make between FOTM and the mandatory-disclosure system. (14) In our view, disclosure mandates are necessary, but how best to enforce them is a separate question. We also reject FOTM proponents' conceptual strategy for the action's rehabilitation. (15) As will be discussed below, the switch from compensation to corporate governance does solve a few...