Do private securities lawsuits play an important role in deterring fraud and compensating defrauded investors, or are they simply wasteful and ineffective? These were the questions that on October 23, 2008 Stanford Law School Professor Joseph Grundfest and Duke Law School Professor James Cox debated in New York at the Forum for Institutional Investors sponsored by the Bernstein Litowitz Berger & Grossman law firm.
The professors’ discussion, moderated by Bernstein Litowitz partner Sean Coffey, addressed some of the perennial questions concerning private securities litigation. I have summarized the professors’ comments below, followed by my own observations.
The Professors’ Debate
Professor Grundfest: Professor Grundfest addressed the issues first. He characterized private securities litigation as a process "for moving money around for the benefit of the people moving the money around." Professor Grundfest was particularly emphatic in arguing that private securities litigation is a poor deterrent of misconduct. He pointed to the many allegations of wrongdoing that have accompanied the current financial crisis as evidence that private securities litigation is not a deterrent to misconduct.
Professor Grundfest argued that because the vast preponderance of private securities litigation is settled with insurance proceeds or company money, there is no "individual responsibility," because the "wrongdoers" are not "hit in the pocketbook."
In order for the system to provide deterrence, Professor Grundfest suggested, the process should be changed so that rather than having as its objective simply to be to produce "the largest pot of money" from whatever source derived, the objective should be geared toward settlements funded directly out of individuals’ pockets, even if it results in a much smaller settlement.
Professor Grundfest described the current system as a "drug induced fantasy," as it essentially involves institutional lead plaintiffs suing companies in which institutional investors are the primary shareholders. Professor Grundfest asserted that this system produced nothing more than a very elaborate and costly pocket shifting, as a result of which it is mathematically impossible for a fully diversified investor to come out ahead. The only effective deterrent, Professor Grundfest argued, would be to require individual settlement contributions as a regular part of private securities litigation settlements.
Professor Cox: Professor Cox challenged the assertion that private securities litigation provides no deterrence, stating that it is not enough to look at litigation defendants alone to determine whether securities litigation has a deterrent effect. Rather, Professor Cox argued, the question is whether the threat of litigation raises the standard of conduct across the marketplace, among all companies. Professor Cox said that it is difficult to measure the benefit to the entire marketplace of increased disclosures and other conduct calculated to avoid litigation.
Professor Cox specifically observed that the performance of the U.S. markets in the current financial crisis demonstrates that these safeguards do work. He noted that while the markets around the world are all down, the U.S. markets are down less than other markets because the U.S. markets generally are viewed as more transparent and more trustworthy.
Professor Cox also noted that as it has evolved, our system of securities enforcement has come to require a public/private partnership. He cited research that looked at circumstances where both public enforcement and private litigation were involved, as well as circumstances where only one or the other initiative was involved. He said this research shows that the SEC has tended to pursue enforcement cases against securities violations involving smaller companies where fewer dollars are involved, while the private securities litigation bar has concentrated on the larger companies where more is at stake, where both the costs and the incentives for private action are greater. Professor Cox argued that this private/public partnership has contributed to a more comprehensive enforcement of the securities laws.
Professor Cox was dismissive of the portfolio theory against the effectiveness of private securities litigation. He noted first that Chamber of Commerce research had shown that the analysis that diversified institutional investors could not come out ahead, at a minimum, does not apply in the IPO and M&A context. He also pointed out that this portfolio theory is not raised as an objection to other types of commercial litigation, where one company sues another to recover damages. The same pocket shifting argument could be applied to all commercial litigation, but no one is suggesting that all commercial litigation be eliminated as unjustified under portfolio theory.
In the end, however, Professor Cox is not opposed to the idea of having individuals contribute toward class settlements, and he even suggested that the judiciary should have their consciousness raised about asking what the individual defendants have contributed towards settlement.
Sean Coffey: The panel moderator, Sean Coffey, commented that he believed that in order for private securities litigation to be most effective, individuals need to feel that they are "at risk." Coffey commented that he believed that the spectacle of the individuals being required to contribute to the WorldCom settlement did produce the kind of heightened awareness that could deter improper behavior.
But at the same time, Coffey noted, "because you don’t want to deter people from serving" on boards, the instances when individuals should be required to contribute should be "rare."
Professor Grundfest closed by commenting that individual responsibility is "the message that needs to go out" and he asked rhetorically, "why is it so rare?" He also asked "isn’t it was really works?" — adding that motivating behavior is a more important goal than moving money around.
Discussion
Anyone who has had a close look at the securities litigation process can only be appalled at the wasteful expense, most of which has little to do with the merits or anything else important that is at stake, but has more to do with the enrichment of the process participants. But as profligate as the process inefficiency is, this costliness is not unique to securities litigation. Our system of litigation may not have been designed to enrich the lawyers, but that certainly is one of its most apparent effects.
But while there undoubtedly are ways our securities litigation system could be improved, that does not mean that the system overall fails to achieve its intended goals. In particular, I believe that private securities litigation does have a deterrent effect.
My perception is that most corporate officials have a strong desire to avoid accusations of fraud, even if the accusation were to come only in the form of a private securities lawsuit. For most corporate officials, the idea of their name and picture appearing in the local newspaper accompanied by the word "fraud" is their worst nightmare. Most corporate officials work hard to prevent this from happening. Of course there are those individuals whose greed overcomes their fear, and about this group I have further comments below.
As for whether the system compensates investors or simply moves money around, all I can say is that there are a large number of sophisticated, well-informed and profit motivated institutional investors that continue to actively participate in securities litigation, some serving frequently as lead plaintiffs. These institutional investors believe that the litigation is in their financial interest, notwithstanding what modern portfolio theory might purport to suggest. In addition, many of these investor plaintiffs are often interested in using litigation to achieve governance changes or other nonmonetary objectives. They clearly believe that private securities litigation helps them to achieve those goals.
And as for the idea that individuals should be forced to contribute routinely out of their own assets towards civil litigation settlements, I think we need to take a giant step back and look at what we are talking about. Most securities cases settle in their early stages, often even before motions for summary judgment have been determined. Rarely at the time of settlement have there been any factual determinations of any kind, much less any findings of culpability.
Most securities lawsuits settle because of the costs and burdens of litigation and because of the catastrophic loss potential involved if the case were to go forward through trial. Given these virtually universal settlement dynamics, it would, in my view, be a miscarriage of justice if individuals were to be required routinely to contribute out of their own funds toward settlement. Indeed, in the absence of culpability findings, any mandate requiring individual contribution arguably would be confiscatory and could violate due process, at least when there otherwise would be indemnity and insurance available.
We do not bar defendants in other contexts from availing themselves of liability insurance. We do not bar, say, defendants in auto accident cases from availing themselves of auto liability insurance, though one might hypothesize that drivers would be more careful if liability insurance were unavailable. Similarly, doctors are permitted to insure against allegations of malpractice, though mandated uninsured liability might motivate greater caution (or, more probably, result in fewer doctors). Why should defendants in securities lawsuits be any less able to benefit from contractual indemnity or liability insurance provisions?
There are of course those individuals whose greed outweighs their fear, and for whom the threat of litigation is no deterrent. These kinds of people undeniably are out there, but these people are not going to be forestalled by any deterrence mechanisms, even the threat of direct personal liability. The most effective approach to these kinds of bad actors is prevention, not deterrence. Meaningful transparency requirements and effective systems of internal controls monitored by independent watchdogs– that is how to fight bad actors’ misconduct.
Finally, even if there are occasional circumstances where individuals’ behavior theoretically might dictate their individual contribution toward private securities litigation settlements, these occasions should be rare. In that respect, I agree with the Sean Coffey’s comments that if these kinds of impositions were to become routine, talented individuals correctly might conclude that it is not in their personal financial interest to serve on a corporate board.
Looking Ahead
Regardless who wins the upcoming Presidential election, that there will be significant postelection efforts to strengthen regulatory mechanisms to try to prevent future financial marketplace crises and misconduct. There is some danger in this environment, where scape-goating is in high gear, that the idea of mandating the imposition of financial burdens directly onto individual directors and officers might gain some traction. Indeed, the Wall Street Journal op-ed column discussed below underscores that risk.
If this initiative were premised on the idea of requiring individual contributions toward settlement even in the absence of findings of culpability, any initiatives along these lines would inappropriately and unfairly shift costs to individuals. Attention more appropriately should be focused on mechanisms designed to improve monitoring, oversight and disclosure, so that greater transparency will allow the marketplace to do more to police behavior and prevent misconduct.
It will in any event be interesting to watch what unfolds after the election. There is little doubt that there will be an enormous effort to overhaul the financial markets’ regulatory structure. The outcome of these efforts will substantially affect markets and market participants, and could even affect the liability exposures of corporate officers and directors.
Where Were the Directors?: If early indications are any gauge, the idea that board members should be held individually accountable is likely to be a featured part of the regulatory reform discussions that undoubtedly lie ahead. By way of illustration, in an October 25, 2008 Wall Street Journal op-ed column entitled "Where Were the Boards?" (here), Papa John’s founder and Chairman John Schnatter asked, with respect to the current financial crisis "Where were the boards of directors of the companies that helped create this mess?"
Schnatter noted that boards "have a clear-cut fiduciary responsibility to provide oversight," as a result of which he observed that "we should not ignore their roles in contributing to this financial meltdown."
Schnatter conludes that "politicians in Washington would be wise" to "adjust their focus upward" (where, as Schatter noted "true power lies") and "set greater accountability for boards, requiring stringent oversight by those who are empowered to set the ground rules for American companies." He does, however, allow that penalties should not be so "harsh" that "no sensible business person would become a director."
Regardless of the level of authority with which Schnatter may speak, the concept of "greater accountability" at the director level undoubtedly will be part of the regulatory reform dialog that will follow the upcoming election. The practical usefulness of any conversation along these lines will depend critically on the extent to which the concern about the willingness of sensible business people to serve as directors is appropriately respected.
To Encourage the Others: The very idea that a few individual directors should be punished periodically as deterrent against the misbehavior of all others reminds me of the unfortunate British admiral, John Byng, who was court-martialed and shot to death for "failing to do his utmost" during the Battle of Minorca at the outset of the Seven Years’ War.
Voltaire included this incident in his novel, Candide, in which the main character, Candide himself, witnesses Admiral Byng’s execution in Portsmouth. Candide is told "Dans ce pays-ci, il est bon de tuer de temps en temps un amiral pour encourager les autres." (In this country, it is wise to kill an admiral from time to time to encourage the others.)