One of the legal issues that attracts continuous vigorous debate is the question of whether or not class actions in general, and securities class actions in particular, produce a social benefit sufficient to justify their sometimes enormous costs. This question receives an interesting and readable analysis in an article in the November 19, 2015 issue of The New York Review of Books entitled “The Cure for Corporate Wrongdoing: Class Actions vs. Individual Prosecutions” (here) in which Southern District of New York Judge Jed Rakoff reviews Columbia Law Professor John Coffee’s new book, Entrepreneurial Litigation: Its Rise, Fall, and Future (here). While Judge Rakoff provides his (quite positive) assessment of Professor Coffee’s book, he also delivers his own analysis of the issues Professor Coffee raises, as well as of the prescriptions Professor Coffee proposes for the class action defects he has identified, as discussed below.
Judge Rakoff starts his review by noting the dramatic discrepancy between the relatively modest recoveries the SEC achieved in the enforcement actions it pursued in the era of corporate scandals and in the credit crisis, on the one hand, and the significantly larger settlements reached in the securities class action lawsuits that paralleled the SEC actions, on the other hand. For example, even thought the SEC recovered $450 million in connection with the Enron scandal, the parallel class action lawsuit settled for $7.2 billion. In the credit crisis era cases involving Citigroup, the SEC settled its case for $75 million, which the parallel class action lawsuit settled for $1.3 billion.
While the massive recoveries might be interpreted to suggest that the private securities class actions are a more important part of the overall securities enforcement effort, Judge Rakoff noted that “the story is not quite that simple.” The problem, Judge Rakoff says, is that the victim shareholders are not paid by the wrongdoing executives at these companies, but rather by the companies themselves, in effect making current shareholders, themselves blameless, responsible for footing the costs of the fraud (a concern he calls the “circularity problem” because one group of innocent shareholders is paying another). In light of these concerns, the “prime beneficiaries” from this litigation appears to be “the lawyers who brought the cases and who typically receive very large fees in return” – in the largest securities class actions cases, the fees amount to tens and in some cases even million of dollars.
Advocates nevertheless defend class action litigation because of its role in “combatting corporate misconduct,” in effect transforming the class action claimants and their attorneys into “private attorneys general,” supplementing or even substituting for regulatory oversight. Others remain convinced that the class action lawsuits do little to penalize the wrongdoing executives and chiefly serve to line the pockets of self-interested lawyers.
What has been missing from this debate, Judge Rakoff says, is “a judicious appraisal” of the strengths and weaknesses of class action litigation, “unaffected by ideological biases.” That gap, Judge Rakoff says, has now been filled by Professor Coffee’s book. The book is not limited to a consideration of securities class action lawsuits alone, but rather considers the full spectrum of class action lawsuits, including mass tort litigation, employment discrimination lawsuits, and antitrust lawsuits. The book, according to Judge Rakoff, is “more comprehensive than prior studies of class actions” and it “probes more deeply, placing today’s class actions firmly within the setting of the modern trend toward turning the practice of law ever more into a business.”
Professor Coffee’s book opens with a review of the origins of modern class action litigation in the U.S. Most readers of this blog will be interested to know that the current form of class action litigation as embodied in the Federal Rules of Civil Procedure that “opened the door to class actions as we know them today” came about as a result of the litigation campaign to combat racial prejudice. The judicial rulings in the civil right advocates’ lawsuit could only be effective if the benefited all similarly situated black persons. After the Rules were modified to permit litigation on behalf of “similarly situated” persons, the class action floodgates opened – not just in connection with civil rights litigation, but also other types of cases as well.
What proved to be the case is that most of these lawsuits were “lawyer-driven.” In some cases, that drive was ideological, as was true of the civil rights litigation. However, in other cases, the motivation was purely financial, because the massive aggregation of litigants’ damages that the class action procedures facilitated massively increased the potential rewards for the lawyers bringing the cases.
Litigation driven by the lawyers, Judge Rakoff notes, “does not sit comfortably with the assumptions of most legal systems, including that of the United States.” The defenders of the class action regime cite the role of the claimants and their attorneys’ as “private attorneys general” as a defense against these kinds of concerns, and Judge Rakoff notes that “many judges with whom I have spoken have come to believe that, particularly in the civil rights matters …, this rationale has a modicum of truth.” Even on non-civil rights cases, the class action lawsuits have “served to illuminate the magnitude of misconduct.” Even securities class action lawsuits, Judge Rakoff notes “have served to spotlight the substantial abuse evident in many recent cases of corporate misconduct that the SEC’s much more modest approach appeared to trivialize.”
The problem, Judge Rakoff says, is that the “huge financial incentive provided to lawyers … easily lead to abuses,” such as the “form of legalized extortion” known as the “strike suit,” where the sheer threat of class action damages allows plaintiffs lawyers to extract, even in non-meritorious cases, significant settlements. In this enterprise, the companies and their attorneys may even be complicit with the plaintiffs’ lawyers, as the companies are eager to pay off the plaintiffs’ lawyers in order to buy peace and extract a release that would cut off any other claimants’ claims.
Congress and the Supreme Court have spent the better part of the last two decades trying to curb these perceived abuses. Professor Coffee, Judge Rakoff notes, “is more optimistic than some than illegitimate suits have been substantially curtailed as a result.” But a more insidious problem remains, which is that even the best class action lawyers are “primarily interested in suing the ‘deep pockets’”, which in practice means the corporate defendants, rather than the wrongdoing executives.
To be sure, some complaints name individuals as defendants, but the settlement with the individuals typically will be restricted to “the limits on their company-paid insurance.” The “big money” will come from a settlement with the company, which presents the “circularity problem” arising from the fact that the corporation’s settlement contribution comes out of the pockets of its innocent shareholders.
Judge Rakoff says that it is “hard to believe that the settlements in such cases have much of a deterrent effect on the individual executives who actually committed the alleged misconduct.” That is why in Judge Rakoff’s view “class actions are no real substitute for criminal and regulatory prosecution of individuals actually responsible for corporate misconduct.”
In this connection Judge Rakoff makes a very interesting aside. He notes that early this fall the Department of Justice has made a great deal of noise announcing its commitment going forward to emphasizing the prosecution of wrongdoing individuals. Despite the fanfare, however, just eight days after the DoJ’s ballyhooed announcement, the agency announced its deferred prosecution agreement with General Motors, in connection with the company’s use of faulty ignition switches linked to 169 deaths. “Although,” Judge Rakoff noted, “those responsible for this purposeful concealment would seemingly be responsible, at a minimum, for manslaughter, no individuals were named.”
In response to these concerns, Judge Rakoff notes, Professor Coffee has proposed “an interesting innovation” that combines the profit-seeking tendencies underlying much modern class action litigation with oversight of class action themselves by public agencies. Basically, Coffee proposes that regulators employ private class action lawyers on a contingent fee basis, to bring class actions supervised by the regulators but for the benefit of the victims. The agencies could bring more cases than their current limited resources allow, and the regulators could direct that more attention is paid to pursuing individuals.
Judge Rakoff calls this idea a “sound proposal,” noting that some governmental agencies, such as the FDIC, already have instituted the use of private attorneys to bring these kinds of actions subject to agency oversight. On the other hand, Judge Rakoff also notes that Coffee floated this idea even before he published them in this book and it has “failed to attract much support.” Coffee suggests that the SEC has resisted the idea because it has too much invested in its self-image to acknowledge that private counsel could do a better job than their own staff. For his part, Rakoff is “not optimistic that Coffee’s idea, good though it may be, will be widely adopted in anything like the near future.”
Instead, Judge Rakoff speculates, while there may be further class action litigation reform in Congress and in the Supreme Court, class action litigation is not going away. Instead, it will continue to evolve, “all the while remaining highly controversial.” Its lucrative nature “virtually guarantees that it will not disappear, short of judicial or governmental prohibition.” Even a conservative judiciary or legislature will not want large number of injured persons each one of which lacking a large enough economic incentive to act alone to be left with no remedy whatsoever.
The debate whether class action claimants and their attorneys actually serve as “private attorneys general,” Judge Rakoff says, “remains more questionable.” While Judge Rakoff, as is the case with Professor Coffee, is persuaded that securities class actions do serve a deterrent function, “the proof is anecdotal” and “the extent of such deterrence may be quite modest.” If class action proponents cannot better perfect the use of class action for deterrence purposes, as, for example, through close coordination between government regulators and the class action bar, the efforts of supposed “private attorneys general” will fall short of their aspirational goal.
It has been my privilege the last several years to have been able to travel around the world to participate in various industry events and legal education programs. Often I am the only American in the room. I am by now quite inured to the usual dialog that often ensues, in which the locals admit that while they recognize the need for litigation reforms in their jurisdiction, the last thing in the world anybody wants is for their country’s judicial processes to take on any of the characteristics of the cursed and dreaded American system – especially the American class action litigation system (with its opt-out model, contingency fees, and routine massive settlements).
But a funny thing has happened over the years. As time has gone by, more and more countries are adopting litigation reforms that include procedural attributes that bear a remarkable resemblance to at least some aspect of the U.S. procedural approach to civil litigation.
Judge Rakoff even notes this phenomenon in his review of Professor Coffee’s book. These reforms in other countries are not limited to common law countries such as Canada and Australia, that already have legal systems with many features in common with the U.S., but include many other countries as well. Many of these other countries’ reforms include provision for class action litigation as well. As Judge Rakoff notes, “no fewer than twenty-one countries now permit class action lawsuits to be brought at least in some circumstances.” And while none of these counties have adopted procedures that encompass all of the aspects of the U.S. class action litigation system, there are unquestionably similarities.
I make this point because, as much as class action procedures are reviled, they are often the best way to accomplish the work that needs to be done. That was true in the U.S. during the civil rights era. It is true in other countries when they experience a significant scandal involving one of their domestic companies. Brazilian investors are encountering these issues now as they scramble to try to recoup their losses from the Petrobras scandal. In the same way, litigants in the U.K., Netherlands and Germany are trying to transform existing mechanisms into tools to recover their investment losses in connection with the Tesco and Volkswagen scandals. Other countries grappling with problems of their own will seek to develop procedural mechanisms for aggrieved persons to achieve recompense. Don’t be surprised – as I am no longer surprised – when countries that have long reviled the U.S. litigation system wind up adopting procedures that start to look an awful lot like those used here.
My point is that we should not throw the baby out with the bathwater. For all of the problems associated with our system of class action litigation system, it has a valuable role to play in our system of providing redress for grievances.
Before I close, I want to address one final question that Judge Rakoff raised, which is his question of whether or not securities class action lawsuits actually have any deterrent effect, given that individuals so rarely pay for the damages they cause out of their own pockets because insurance covers the amounts of their settlement contributions. I have my own observations about the deterrent effect of this litigation, based on years of working with corporate executives and directors. My observations may be merely, as Judge Rakoff put it, anecdotal, but I think they are nevertheless relevant.
My observation is this. I know from years’ worth of discussions with corporate officials that the vast majority of them want to do everything the can to avoid becoming involved in securities class action litigation. They are willing to invest – and do invest—a great deal of effort, energy, and expense into trying to avoid anything that might attract the unwanted attention of the securities class action plaintiffs’ bar. These steps include careful, even painstaking, disclosure. These steps include rigorous control of trading by insiders in their company shares, so that trades to not occur at suspicious times or in suspicious amounts. The steps include the way the companies communicate with analysts and they ways the companies disseminate bad news. In my view, the existence of private securities class action litigation is having a deterrent effect on well-meaning executives at other companies that want to avoid trouble of any sort.
My view is that while, yes, the current system is subject to abuses, and while the current system can create enormous and sometimes unjustifiable costs, the overall result is that, because the class action system really does supplement our regulatory system by providing real deterrent effects, we have system in which companies’ shares trade freely on widely respected financial markets. All companies in the financial system benefit, as do all investors. Yes, the class action system is costly, but I would argue that the costs are more than offset by the value of having a well-policed regulatory system that facilitates the effective operation of respected financial markets.
For what it is worth, I like Professor Coffee’s idea of government sponsored private litigation, subject only the proviso that it would have to be closely supervised and reviewed regularly. As Judge Rakoff correctly noted, the FDIC has been using this model for years. It has generally worked well, but it has also note been without its abuses.