Claim Character and Class Conflict in Securities Litigation

Abstract

The loss suffered by buyers in a typical securities fraud class action may come from several distinct sources including lower expected return or a higher cost of capital or one-time outflows of cash or a combination thereof, all of which are quickly impounded in market price even though prospective. Under federal securities law (Rule 10b-5), a buyer may recover the entire difference between purchase price and market price after correction. But some of this loss should properly give rise to a derivative claim on behalf of the corporation (and all stockholders) rather than a direct claim on behalf of a buyer class. In addition, some sources of stock price decrease are losses that would happen even in the absence of fraud. Thus, for buyers to recover for such a loss is to restore them to a better position than if there had been no fraud, resulting in over-deterrence. Moreover, investors can protect themselves against such losses through diversification. In contrast, the extra loss that derives from fraud or misconduct – loss over and above the loss from bad business luck – cannot be diversified away because such losses can result only in a decrease in stock price. Although stock price may sometimes increase because of good business luck, there is no potential for gain from the absence of fraud or misconduct. The bottom line is that the only losses that really matter are those that are non diversifiable – which losses also happen to be derivative. The question is why the courts have failed to characterize investor claims properly. The answer is a combination of historical factors, conflicts of interest, and market failures. The most promising solution seems to be for index funds acting on behalf of investors to intervene to oppose certification. Index investors who trade infrequently – and only for purposes of portfolio balancing – lose more as holders (because the corporation pays) than they recover as buyers. They should oppose a direct class action remedy in favor of a derivative remedy by which the corporation recovers to the extent of actionable losses that give rise to a decrease in stock price. The same is true for diversified investors in general who comprise a large majority of investors. And because it is impossible to sort out investors who would thus oppose a direct buyer remedy from those who may favor such a remedy, the courts should decline to certify securities fraud class actions on grounds of class conflict. Rather, such actions should be recast as derivative actions, which constitute a superior form of class remedy under established rules of civil procedure, because they benefit all stockholders proportionally and only for non-diversifiable losses.