When Congress enacted the PSLRA in 1995, one of the goals was to try to deter frivolous litigation. As time has passed, it has also become clear that many of the PSLRA’s procedural reforms also created a structure of incentives for plaintiffs’ lawyers. For example, the PSLRA’s most adequate plaintiff requirement created an incentive for plaintiffs’ lawyers to seek to represent institutional investors. However, according to a recent academic study, with the passage of time, some of the incentives have had a distorted impact, as the incentives motivate plaintiffs’ lawyers to try to get hold of a mega-case “lottery ticket” that will produce a jackpot outcome – for the lawyers. These distortions in turn are creating many of the ills we are now seeing the securities class action litigation arena, justifying, according to the academic authors, another round of securities litigation reform.
The February 2019 paper, written by Stephen Choi of New York University Law School, Jessica Erickson of University of Richmond Law School, and Adam Pritchard of the University of Michigan Law School, entitled “Risk and Reward: The Securities Class Action Fraud Class Action Lottery,” can be found here. The paper was released by the U.S. Chamber Institute for Legal Reform in connection with its February 26, 2019 event focused on securities class action reform at the National Press Club in Washington, D.C. Professor Pritchard discussed the paper on a panel at the Institute event. I discussed a companion paper released in connection with the event and written by Andrew Pincus of the Mayer Brown law firm in an earlier post, here.
In order to review the PSLRA’s impact, the authors collected data on every securities class action lawsuit between 2005 and 2016 that involved a disclosure claim. The authors also gathered information on the specific allegations raised; the efforts to select the lead plaintiff; and the case outcomes.
The authors begin their analysis by considering the frivolous cases that the PSLRA sought to discourage. They noted that these low-value cases continued to be filed in significant numbers, adding that “the evidence is unclear on whether [the PSLRA] effectively screened out frivolous cases.”
While the PSLRA was focused on addressing frivolous cases, it was “largely silent with respect to another category of cases: high-value cases.” The legislation was “not aimed at perceived problem with these suits.” And these kinds of suits have continued to be filed. Indeed, because of the possibilities in these kinds of cases for a jackpot payout, the system creates incentives for these kinds of cases to be filed. Indeed, in high-value cases, “there will frequently be a scramble of investors competing to serve as lead plaintiff,” for the simple reason that the plaintiff’s counsel that is selected as lead plaintiff likely will be awarded with hefty fees. Often these fees are awarded with little or no court supervision. These “home run fee awards” undermine the PSRLA’s deterrence goals “by skewing litigation incentives for plaintiffs’ attorneys, creating an incentive for law firms to pursue a wider array of cases in the hopes of hitting the fees jackpot if the case settles.”
To substantiate these findings, the authors first divide the case outcomes in the cases in their database into deciles, reflecting the range for the smallest to the largest recoveries. This analysis (reflected graphically in the article) shows that the most of decile groupings, the recoveries are modest, while the recoveries in the tenth decile are staggering. This analysis shows that “a small number of outliers have outsized importance” in the plaintiffs’ lawyers aggregate recoveries in these kinds of cases. As a result, the plaintiffs’ lawyers have a “disproportionate incentive to obtain the lead counsel position in the mega-actions.”
The authors then ask whether the merits of these mega-cases warrant the eye-popping settlements (and plaintiffs’ lawyers’ fee recoveries). The authors identified four types of allegations they say represent objective indicia of fraud. The four allegations are: financial restatements; SEC investigations; other government investigations; and termination of top officers. The authors then looked at the frequency of these types of allegations across the decile division of case outcomes.
The authors found that by assigning each case a “composite score” reflecting the incidence of these kinds of allegations, they were able to score the case outcomes by settlement decile. The authors found that the cases producing the largest settlements also have the highest incidence of objective factors related to fraud. The authors called this a “good news/bad news” message. The good news is that “the merits seem to matter in determining settlement amounts.” The bad news is that in these more serious cases, the plaintiffs’ lawyers “do little to uncover the objective fraud factors” as the existence of these factors is publicly disclosed. The plaintiffs’ lawyers, according to the authors, are merely “piggy-backing” on the problem already known to investors and to regulators.
Because the biggest lawyer paydays are in the biggest cases, the plaintiffs’ lawyers have incentives to try to file these kinds of cases. When the authors arranged the cases into deciles according to market capitalization of the company sued (as opposed to organizing the cases by the size of any eventual settlement), they found, ironically, that they cases against the largest companies are the likeliest to be dismissed. The authors said that the because of the “higher stakes, and thus the prospect of a bigger eventual settlement,” plaintiffs are motivated “to file suits in cases with less substantial evidence of fraud.” The high dismissal rate for suits against the largest companies “is driven by the lure of the mega-settlement, the lottery ticket of securities fraud class actions.”
The authors then turned to the lawyers’ fee awards in settled cases. Again looking at the cases by market cap decile, the authors found that the fees awarded increased for the settlements in the largest deciles, but the fees awarded as a percentage of the settlement amount decreased as the size of the settlements increased. While the fees awarded a as a percentage of the settlement decreased for the largest cases, the fees awarded in absolute dollar amounts were enormous. In reviewing the fee petitions by settlement size decile, the authors found that the plaintiffs’ hours worked, and even more significantly, the hourly rates claimed, skewed upward dramatically for the largest cases. These cases generated more work and higher fees “despite the evidence that the mega-cases tend to have stronger objective indicia of fraud” and the fact that “stronger evidence of fraud at the outset means that lawyer skill and effort play less of a role in generating a settlement.”
What the authors found is “a strong pattern of judges rewarding class action lawyers for the size of the settlement,” even though “the variation in settlement amounts is driven in large part by differences in market capitalization.” The plaintiffs’ lawyers in effect are “reaping huge paydays for suing the biggest companies.”
In turning to thinking about possible reforms based on these findings, the authors note that the appointment as lead counsel in the largest cases is “akin to receiving a winning lottery ticket,” because these cases will almost certainly result in a large settlement and a large fee award. The plaintiffs’ attorneys reap these awards even though “the risks in the most lucrative mega-cases are not that great.” The system, according to the authors may “overcompensate plaintiffs’ attorneys in securities class actions with the largest settlements.” The lottery aspect of these settlements “skews the selection of cases toward larger companies and away from the most egregious fraud.” The plaintiffs’ lawyers also have incentives to “direct significant amounts of time to attracting institutional clients.”
The authors suggest reforms that are calculated to try to alter these incentives. Their first suggestion is to reform the way fees are awarded. The authors note that in practice judges tend to “rubber stamp” plaintiffs’ attorneys’ fee requests. Recent revelations, the authors suggest, there could be significant value in incorporating greater oversight into this process. In the recent case involving the settlement of a consumer class claim against State Street Bank & Trust, an investigation of the plaintiffs’ fees found a number of problems, including the fact that the plaintiffs’ counsel had double-counted the hours of several attorneys. The investigation also found that a large part of the fee award was paid to another attorney who had referred the institutional investor claimant to the lead plaintiff firm but had not actually done any work on the case.
The authors suggest that “to curb these practices, judges should scrutinize fee requests far more carefully,” or perhaps refer them to magistrates or special masters. The judges, the authors suggest, should also “probe the marginal contributions of the attorneys and the risk of non-settlement the attorneys face.” The authors suggest that Congress can also help curb exorbitant fee requests by setting presumptive limits on fees in the largest cases; for example, Congress might specify that in settlements over $100 million, the presumptive limit on fees should be limited to 10 to 15 percent of the settlement award and adjusted upward if the court finds there was extraordinary effort by lead counsel.
The authors further suggest that Congress should take a look at the lead counsel process, noting that “the profits of plaintiffs’ law firms depends less on the firms’ skill and hard work and more on their ability to amass a stable of institutional investors as clients.” The pressure to establish these kinds of relationships has led to questionable practices, such as the payment of fees to other attorneys simply for referring a potentially lucrative institutional investor plaintiff relationship without connection to any other actual services performed. The authors suggest Congress should amend the PSLRA to prohibit lead counsel from sharing its fee with law firms that do not actually do legal work. The authors suggest that the lead counsel should disclose how the requested fee award will be distributed.
The authors’ final suggestion is to put a cap on damages to suppress the lottery aspect of securities class action. A premise of this suggestion is based largely on prior research suggesting that the goal of securities litigation providing compensation is rarely achieved in practice, and therefore the deterrent effect of securities litigation is its primary purpose and goal. The authors suggest that plaintiffs’ lawyers can be induced to file suit, and therefore to provide deterrence, even where the potential recoveries are smaller. The authors suggest a sliding scale damages cap tailored to a percentage of market capitalization, but with the added proviso that these caps would not apply in IPO cases and in other offering cases and would not apply to individuals. A sliding scale percentage cap would still allow for large recoveries in the most egregious cases. The goal with the sliding scale is to incentivize plaintiffs’ counsel in cases with the most egregious fraud, and not just in cases involving the largest companies.
The authors’ interesting paper covers a lot of ground and raises a number of interesting points. The authors’ analysis is also thought-provoking. I am not sure I have yet decided what I think of all of the authors’ points or of the authors’ recommendations. I do have a few preliminary thoughts, though.
First, there are a number of positive take-aways from the authors’ analysis. The first is that the plaintiffs’ lawyers have definitely responded to at least some parts of the incentive structure in the PSLRA. This fact does show that Congress can influence behavior by creating or changing incentives. Another positive take-away is that the cases with more indicia of misconduct are likelier to result in larger recoveries, and that cases with fewer indicia of misconduct are likelier to be dismissed. These top level observations seem to be at least consistent with the PSLRA’s overall goals.
A slightly different thought I have about the authors’ analysis is that so much of it is premised on trying to understand the plaintiffs’ counsel’s incentives by analyzing counsel’s actions in isolation. While this approach has produced a number of interesting observations, there is a risk that it omits to consider other important context. In particular, the analysis doesn’t always consider the possibility that the actions of others are also important to understand. To cite just one example, the role of institutional investors in the selection of cases to be filed is insufficiently considered. Institutional investors obviously have the largest interest in seeing claims filed where their investment losses were largest. Many institutional investors are quite sophisticated about their litigation interests – sufficiently sophisticated that they may, can, and often do direct their lawyers’ activity. The institutional investors’ interest in recoveries in cases where their losses were largest could well be a significant factor in explaining how the cases to be pursued are selected.
Similarly, with respect to the authors’ observation that the plaintiffs’ lawyers activities are greatest in cases involving the largest market capitalization companies (and therefore where the possibilities of recoveries are the greatest) are also the cases where the defendants have the largest incentive to fight, even if just to try to reduce the size of the eventual settlement. In these larger cases the defendant companies and their insurers are willing to authorize greater defense activities because of the greater stakes. This greater defense activity in turn could require greater plaintiffs’ activity; the plaintiffs’ lawyers are working harder in bigger cases not (or at least not only) to justify a larger fee request, but they are working harder because the actions of their adversaries require them to do so.
All of that said, overall I am on board with many of the authors’ suggestions. I agree there could be a great deal of merit in having a fee award process involving greater judicial scrutiny. The fee award after all is at the expense of the members of the plaintiff class, and the court definitely has a role to play in ensuring that the fees awarded are fair to the class members. A sliding scale presumptive fee cap would provide the courts with a useful rule of thumb measure to asses settlements while allowing courts to award higher fees where merited. I also agree that there could be merit in reforming the lead plaintiff process by eliminating finders’ fees and by requiring the intended fee-sharing to be disclosed as well.
The question of the cap on damages is one that I would want to think about more. For one thing, the proposal is premised on a conclusion that the compensatory function of securities litigation is rarely achieved and therefore of less importance (or at least of less importance relative to the deterrence function of securities litigation). I am not sure I agree with this premise, regardless of what the prior research supposedly shows. I have been in meetings with institutional investors in which they discuss their interest in the outcome of various cases; they are very well informed about the possible recovery and are keenly interested in maximizing their recovery. As far as they are concerned, the compensatory function of securities litigation is extremely important. Because their recovery is proportionate to their losses, I am not sure it is fair to them that their recovery should be capped. I know for sure that institutional investors would have a very different view than the authors on the desirability of a damages cap.
One final thought. The authors’ analysis is focused on the larger cases, which they also seem to conclude are not only the more serious cases but also (at least with respect to the cases that settle) the more meritorious cases. The analysis is interesting. But I still think there is a lot of work to be done, and also possibly some important opportunities for reform involving the smaller cases and the less meritorious cases.
The fact is that as the number of securities class action lawsuits has ramped up in the last two years, a very small number of “emerging” plaintiffs’ firms are profligately filing increasing numbers of cases, many against smaller companies, on behalf of individual investors rather than institutional investors, with a dismissal rate much greater than historical levels. This flood of new, less-meritorious cases against smaller companies is also a very serious problem and arguably one that perhaps more urgently needs to be addressed.
I think the authors’ suggestions have merit, but the authors’ suggestions would not reach the currently growing problem with the flood of cases filed by “emerging” firms against smaller companies. I hope that any future conversation about securities class action litigation reform will not overlook these other important problems in the securities litigation arena.