In our post dated June 17, 2015, we discussed the March 26, 2015 decision of the Supreme Court of Canada denying leave to appeal from the judgement of the Ontario Court of Appeal (“ONCA”) in Kaynes v. BP Plc, 2014 ONCA 580 (“Kaynes”). Kaynes endorses a “transactional” test for securities fraud class actions in Canada and in so doing threatens to reverse Canada’s growing trend of Global Class Action certification. For the purposes of this article a “Global Class Action” is any securities fraud class action brought with respect to securities purchased on a foreign exchange.
A key element from our first post was a study by Professor Robert P. Bartlett III of the University of California Berkeley School of Law which suggests that institutional investors, at least as evidenced by their investment decisions, are indifferent to private rights of action for securities fraud. Robert P. Bartlett, Do Institutional Investors Value the Rule 10b-5 Private Right of Action? Evidence from Investors Trading Behaviour following Morrison v. National Australia Bank Ltd, 44 J. Legal Stud. 183 (2015).
In this post, we will revisit Bartlett’s findings and address the questions and problems raised by Bartlett’s research. We focus on the current structure of global securities fraud class actions and evaluate academic commentary suggesting that global securities fraud class actions fail to effectively compensate shareholders for the costs of securities fraud. Critically, while management typically perpetrates securities fraud, it is shareholders who generally bear the costs of securities fraud class actions. This asymmetry undermines the effectiveness of any securities fraud class action as either a compensatory or deterrent mechanism. Moreover, since most institutional shareholders hold a diversified portfolio, some commentators have suggested that securities fraud class actions have little long-term impact on shareholder wealth, since, over the long run, the shareholders can expect to win such class actions as often as they lose. These weaknesses are only amplified in the Global Class Action context where imposing criminal sanctions on managers is often impractical and shareholders are even more likely to be large institutions holding a diversified portfolio of stocks. Because of these factors, we consider Bartlett’s findings to be best viewed as symptoms of fundamental problems with the current structure of the securities fraud class action regime.
Bartlett’s Study Explained
Bartlett’s study constitutes a novel and useful examination of the value, if any, that investors place on the private right of action for securities fraud. In the United States, a judicially created private right of action for securities fraud is implied from SEC Rule 10(b)-5. Bartlett tested the value of Rule 10(b)-5 through a detailed examination of institutional investor behaviour in the aftermath of the United States Supreme Court’s decision in Morrison v. National Australia Bank Ltd., (“Morrison”).
Morrison involved a so-called “foreign-cubed” class action. A foreign-cubed class action is a Global Class Action on behalf of foreign investors who had acquired the common stock of a foreign corporation through purchases effected on foreign securities exchanges. In Morrison, the plaintiffs alleged that a foreign corporation made false and misleading statements outside of the United Sates to the plaintiff-investors based on false financial figures that had been generated in the United States by a wholly-owned US subsidiary. Prior to Morrison, US Courts routinely certified Global Class Actions pursuant to a conduct and effects test whereby individuals who purchased securities on a foreign exchange could participate in a Rule 10(b)-5 action provided that the alleged fraud has a sufficent connection to the United States. In Morrison, the United States Supreme Court decided to replace the conduct and effects test with a “transactional” test pursuant to which the Rule 10(b)-5 private right of action for securities fraud only applies to frauds perpetrated in connection with “the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.” In the immediate aftermath of Morrison, some commentators speculated that Morrison might be confined to its facts. However, subsequent US cases have now established that Morrison applies broadly to disqualify individuals who purchased securities on a foreign exchange from participating in a Rule 10(b)-5 securities fraud class action. Moreover, under Morrison, an investor in a US and foreign cross-listed security cannot maintain a Rule 10(b)-5 action if they purchased the security on a foreign exchange. Therefore, if you want the protection of the 10(b)-5 private right of action for securities fraud, then you must purchase a security on an American exchange.
In essence, the Morrison decision provided institutional investors with a unique opportunity to take advantage of Rule 10(b)-5 by concentrating their portfolio holdings of cross-listed American firms in those firms’ American listed securities. Using a proprietary data set of equity trading by 378 institutional investors, Bartlett examined 11.7 trillion USD worth of stock trades made over a 30 month period following the Morrison decision. Bartlett’s study detected “no significant change in investor trading in response to the Morrison decision.” A key implication of these findings is that institutional investors place little value in a private right of action for securities fraud.
The Oddity of Bartlett’s Findings
Bartlett’s study was in part prompted by the broad hostility of institutional investors to the Morrison decision. In a 2012 post to the Harvard Law School Forum on Corporation Governance and Financial Regulation titled Morrison’s Impact on Institutional Investors, the Council of Institutional Investors (the “Council”) asserted that Morrison significantly “alters the risk profile of foreign investors, stripping institutional investors of the significant protection previously afforded by federal securities law.” The Council went on to explicitly endorse the Rule 10b-5 private right of action as “a vital tool for deterring and combating securities fraud.” Observing that the SEC was underfunded and overburdened, the Council asserted that the Rule 10b-5 private right of action provided a level of protection to institutional investors against transnational securities fraud that simply could not be achieved by government alone.
Bartlett’s Findings are Consistent with a Wide Body of Academic and Judicial Commentary.
While the results of Bartlett’s study might seem counter-intuitive, there is a significant and growing body of empirical research consistent with his findings. In The Unintended Consequences of Securities Litigation, Anjan Thakor of the U.S. Chamber Institute for Legal Reform presents evidence that securities fraud-related litigation destroys on average 3.5% of the equity value of a company. Complementing the findings of Thakor, research by Katherine Spiess and Paula A. Tkac casts doubt on the value of securities fraud class actions by demonstrating that stock prices tend to improve in response to political developments curtailing private rights of action for securities fraud. Katherine D. Spiess and Paula A Tkac, The Private Securities Litigation Reform Act of 1995: The Stock Market Casts Its Vote…, 18 Managerial and Decision Econ. 545 (1997). In Shareholder Litigation and Changes in Disclosure Behaviour, Jonathan L. Rogers and Andrew Van Buskirk of the University of Chicago School of Business examined the disclosure behavior of 827 firms subject to class-action securities litigation and found no evidence that firms improve their disclosure practices in response to a securities class action. Jonathan L. Rogers and Andrew Van Buskirk, Shareholder Litigation and Changes in Disclosure Behavior, 47 J. Accounting and Econ. 136, (2009). In fact, Rodgers and Buskirk concluded that firms responding to securities class actions actually tend to decrease the volume of information they provide to investors out of fear that enhanced disclosure will only exacerbate the risks of a lawsuit.
Compared to the apparent ineffectiveness of private enforcement as a deterrent to securities fraud, recent research suggests that enhanced public enforcement of securities laws has a material and positive impact on firms’ compliance behavior. Tim Lohse, Razvan Pascalau, and Christian Thomann, Public Enforcement of Securities Market Rules: Resource Based Evidence from the Securities and Exchange Commission, 106 J. of Econ. Behavior & Org. 197 (2014). Similar findings have led some academic commentators to question the utility of a private right of action for securities fraud and and ask whether we might be better off with exclusively public enforcement. Amanda M. Rose., Reforming Securities Litigation Reform: Restructuring the Relationship between Public and Private Enforcement of Rule 10B-5, 108 Colum. L. Rev. 1301 (2008); Eric C. Chafee, An Oak is An Oak is An Oak is An Oak: The Disappointing Entrenchment in Halliburton Co. v. Erica P. John Fund of the Implied Private Right of Action Under Section 10(b) and Rule 10(b)-5, 9 New York Univ. J. of Law & Liberty, 92 (2015). Such questions are consistent with the current line of US Supreme Court cases on the issue which hold that “though it remains the law, the 10(b) private right should not be extended beyond its present boundaries….” Stonebridge Investment Partners LLC v. Scientific-Atlanta Inc et al., 552 U.S. 1, 14-16 (2008).
Why Don’t Investors Care? Fundamental Problems with the Current Securities Class Action Regime
Compensation and deterrence are the two traditional grounds upon which a private right of action for securities fraud has been justified. Under the traditional formulation, private rights of action for securities fraud perform a compensatory function by providing shareholders with a means to recover losses they suffer as a result of securities fraud. Additionally, the threat of steep penalties has traditionally been thought to provide management with a meaningful incentive towards proper disclosure. Indeed, private securities class actions currently represent the principal means by which financial penalties are imposed in cases of securities fraud and manipulation.
However, as professor John C. Coffee of Columbia University Law School explains in Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation, the current structure of securities fraud class actions, considered in conjunction with the current structure of the market, makes it impossible for these suits to serve as either a compensatory mechanism or a meaningful deterrent. John C. Coffee, Jr. Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation, 106 Colum. L. Rev. 1534 (2008). Coffee’s central insight is that rather than penalize the individuals who are typically responsible for a securities fraud, securities class actions produce nothing more than a wealth transfer among shareholders. In the typical securities class action, both the settlement payments and the costs of litigation fall largely on the defendant corporation, meaning shareholders ultimately bear the cost of securities fraud. Therefore, securities fraud class actions cannot fairly be considered compensatory.
Moreover, the fact that the ultimate cost of securities fraud litigation is born by shareholders ensures that private securities fraud class actions fail in their deterrent function as well. Deterrence works best when it is focused on the culpable but liability insurance generally protects managers from the direct financial costs associated with a securities fraud suit. Moreover, in the international context, the deterrent effect of any criminal prosecution of management that might arise from evidence uncovered in the course of securities fraud class action is mitigated by material distinctions in the criminal law regimes of different countries and associated difficulties in obtaining extradition. Having said this, the recent extradition of Douglas Wayne Schneider from California to Alberta to face trial for securities fraud is an important reminder that extradition is not impossible in securities fraud cases.
One might assume that shareholders would be incentivized to aggressively monitor management given the risk of a significant financial penalty associated with securities fraud class actions. But this is unlikely in a world in which the majority of shares are held by large institutions in a diversified portfolio. As Frank Easterbrook (now a judge with the US Seventh Circuit Court of Appeal) has noted, diversified investors can expect zero long run net gains resulting from securities fraud class action litigation because “any reasonably diversified investor will be a [winner] half the time and a [loser] half the time. Such an investor perceives little good in a legal rule that forces his winning self to compensate his losing self over and over.” Frank H. Easterbrook and Daniel R. Fischel, Optimal Damages for Securities Fraud,” 53 U. Chi. L. Rev. 611, 639 (1985).
Conclusion and Next Steps
According to Bartlett’s study, institutional investors proved largely indifferent to the end of Global Class Actions certification in the United States. While Bartlett’s findings are in some respects puzzling, they are also consistent with the observations of Coffee and others with respect to the effectiveness of private securities fraud class actions. This is unsurprising considering that the structural deficiencies highlighted by Coffee are magnified in an international context. As in the US domestic context, shareholders ultimately bear the costs of Global Class Actions. If domestic securities fraud class actions are ineffective in remedying securities fraud for the reasons cited by Coffee, then we can expect future global class actions to be equally ineffective.