Wednesday, August 02, 2006

The End is Nigh?

Want to have your article reviewed (torn apart) in this blog?

Start with an eye catching title:
The End of Securities Fraud Class Action?
Then add a provocative subtitle:
Diversified investors lose more than they gain from securities class actions.
That identifies this recent article (also available from SSRN, here) from Prof. Richard A. Booth of the University of Maryland School of Law.

His thesis:
a securities fraud class action should be dismissed for failure to state a claim unless it appears that insiders (including the company itself) have captured gains from trading during the fraud period.

Only those actions that involve insider trading or the equivalent entail genuine financial harm to the plaintiff class because only those actions involve an extraction of wealth from the public market.
I think that the shareholders of any number of scandal ridden companies would take pause with Prof. Booth's central idea.

Additionally, though he does not define "insiders," a fair interpretation would exclude auditors, underwriters, and others that are proper defendants under the current statutory scheme.

Prof. Booth goes on to state:
At best, an award from [a securities fraud class action] is nothing more than an expensive rearrangement of wealth from one pocket to another (minus a cut for the lawyers). Diversified investors are equally likely to sell an overpriced stock as to buy one. For diversified investors, gains and losses wash out.
This second premise, which is detailed in substantial depth, in effect suggests inflicting a double penalty on investors that are unfortunate enough to have bought artificially inflated shares of a publicly traded company if those shares are part of a portfolio that does NOT contain at least 20 different stocks.

A third premise:
The prospect of payout by the defendant company causes its stock price to fall by more than it otherwise would-even in a perfectly efficient market-and triggers a positive feedback mechanism that has the effect of magnifying the potential payout, sometimes with devastating effects. Indeed, about 30 percent of target companies end up bankrupt.
I think this premise is a bit flawed. Companies that are in serious financial trouble already are potentially more likely to resort to conduct that would be considered securities fraud to prop up their stock price. When the truth emerges, the bottom falls out and all sorts of ills may befall that company, including a death spiral into bankruptcy, as institutional investors bail out, debt obligations may be in default, and credit may be cut off. This will happen with or without the filing of a securities fraud class action. Though Ken Lay and Jeff Skilling suggested in their defense a number of other factors that caused Enron to spiral into bankruptcy, they did not blame the class action lawyers.

Prof. Booth's article appears in the Summer 2006 issue of Regulation, a publication of the Cato Institute. The think tank describes that publication as:
the only magazine accessible to the intelligent layman that brings together the latest academic research on the nature and effects of regulation. It offers cutting-edge analysis of the industries that affect your livelihood, covering nearly every sector of the economy, from agriculture and banking to legal reform and transportation.

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