The End of the Securities Fraud Class Action as We Know It

In this article, I argue that securities fraud class actions ("SFCAs ") should not be treated as class actions but rather should be treated as derivative actions. In addition, I argue that such actions should be dismissed unless it appears that insiders (including the company itselj have gained from trading during the fraud period. Both of these conclusions are based on the fundamental argument that (1) securities law seeks to protect the interests of reasonable investors, (2) reasonable investors diversify, and (3) diversified investors are effectively protected against the supposed financial harms of securities fraud by virtue of being diversified, except in cases in which insiders have extracted gains by trading during the fraud period. Only those actions that involve insider trading or the equivalent by directors, officers, or agents of the defendant company (or the company itselJ) cause genuine financial harm to the plaintiff class, because only those actions involve an extraction of wealth from the public market. SFCAs visit serious collateral damage on defendant companies, ultimately reducing investor return. In an action based on failure to disclose bad news, the prospect of payout will cause stock price to fall by more than it otherwise would-even in a perfectly efficient market-and will trigger a positive feedback mechanism that will magnify the potential payout. It is easy to fix the feedback problem. If the case does not involve insider extraction of gains, it should be dismissed. If the case does involve insider extraction of gains, it should be litigated in the name of the corporation, and the corporation should recover any gain extracted by insiders. Treating a securities fraud action as an action by the corporation will make stockholders whole and will avoid collateral damage to the issuer corporation. t Marbury Research Professor of Law, University of Maryland School of Law. Berkeley Business Law Journal Vol. 4.1, 2007