Special Section

Securities Fraud Class Actions

70 Years Young

By Eric Talley

RAND economist Eric Talley is also a law professor at the University of Southern California.

By most measures, today’s securities fraud class actions—which offer individual investors the chance to seek redress for losses stemming from the violation of federal securities laws — are sophisticated, well organized, and significant. But perhaps more than anything, they are big, big business.

Not only have the sheer number of private securities class actions been trending decidedly upward in the last eight years, but the average settlements have similarly increased, from around $10 million in 1996 to well over $20 million last year. That is more than a 10 percent annual increase in the amount of the average settlement in the United States.

Notwithstanding the enormity of these figures, securities fraud litigation is a relatively youthful species in the world of private class actions. Until the 1930s, private individuals could bring fraud litigation against corporations only in extremely limited circumstances. But after the passage of the Securities and Exchange Acts in 1933 and 1934, courts gradually began to reshape and to expand the opportunities that underlie private class actions.

By the 1970s, the U.S. Supreme Court had recognized the right of individuals to sue under the most general of securities fraud provisions (so-called Rule 10b-5 suits) but restricted such lawsuits to those individuals who had bought or sold securities (such as stocks and bonds) during the period of an alleged fraud. In the 1980s, the court helped catalyze a surge in plaintiff litigation by permitting class actions to go forward even if the plaintiff could not demonstrate that each class member had relied upon (or even knew about) the alleged act of fraud.

This surge in class-action filings continued well into the 1990s. From a legal perspective, though, the pendulum began to swing determinedly in the opposite direction. In 1994, for example, the Supreme Court eliminated “aiding and abetting” theories of liability for private plaintiffs, effectively negating most private actions against lawyers, accountants, and auditors who merely assisted the issuers of securities in committing fraud. In 1995, the U.S. Congress got in on the act, passing a comprehensive statutory reform that introduced pleading and evidentiary protections for defendants and enhanced the safeguards for firms that make misleading forecasts of future earnings.

Because these federal reforms were widely perceived to favor defendants, the immediate (and, in hindsight, obvious) response from the plaintiff’s bar was to relocate some litigation to the state level, resuscitating little-used state antifraud statutes. Congress effectively ended this migration to state law in 1998 by amending its earlier legislation to make federal law preempt state law for class actions.

The increasingly difficult road faced by securities class-action claimants during the late 1990s perhaps helped to fuel a perfect storm for the spate of corporate scandals that came to light beginning in 2001 (see the figure). Now, well into the decade, we are on the cusp of yet another landmark transition in securities class actions with the passage of the Sarbanes Oxley Act of 2002 (or SOX).

Federal Private Securities Fraud Claims Spiked in 2001

The SOX legislation will almost certainly change the future dynamics and characteristics of many securities fraud class actions through a number of different avenues. First, because the legislation extends the time limitations that class-action plaintiffs have to file a private action, filing rates are likely to increase, and dismissal rates may even decrease.

Second (and less directly), the SOX reforms may fundamentally change the way in which private and public enforcement interacts. Historically, private litigants tended to shy away from pursuing the same defendants pursued by the federal Securities and Exchange Commission (SEC), because the fines and penalties collected by the SEC depleted the resources that plaintiffs could claim for themselves. Consequently, private and public litigation largely served as complementary institutions.

SOX, however, specifically advises the SEC to set aside a significant portion of its recovery into a “fair fund” to be used to compensate private litigants. Under this mandate, private litigants are more likely to target the same companies targeted by the SEC, waiting for the government to use its procedural advantages in litigation to obtain verdicts and then drawing on the fund created by the government’s efforts. Ironically, this aspect of SOX may well have the ultimate effect of narrowing the reach of securities fraud laws, because public and private enforcers are now more likely to replicate one another’s efforts.

A third way in which the SOX legislation is likely to alter the dynamics of securities fraud class actions is related to a number of corporate governance and executive compensation reforms embedded within the legislation. The reforms require, among other things, chief executive officer (CEO) certification of financial reports; mandatory reports on internal controls within firms; independence requirements for auditors, boards, and subcommittees; and various prohibitions on the type and timing of CEO compensation.

On first blush, these provisions would not appear to have a direct effect on private class actions, because such cases specifically prohibit private plaintiffs from filing suit after a violation. Nevertheless, if the past few decades have taught us anything, it is that the securities bar is highly creative and adaptive. It is virtually certain that private plaintiffs will attempt to point to SOX violations routinely as evidence for more general securities fraud allegations, even if those specific violations do not immediately give rise to liability. It is hard to imagine that courts will not be at least marginally receptive to such arguments. On the other hand, the SOX reforms might inspire good corporate governance reforms, which could help to reduce litigation risk by making shareholders less reliant on their threat to litigate. All of these are empirically researchable questions.

But even beyond SOX, the face of securities class actions may also change through other forces. For example, the facts that give rise to securities class actions in a typical case are often (though not always) related to claims that shareholders make in “derivative” litigation under state law. As distinct from class actions, shareholder derivative actions involve a single, self-appointed plaintiff who files suit against a company’s managers on behalf of the entire corporation. While class actions have historically proven to be the most lucrative and attractive, recent years have seen a significant increase in the number of shareholder derivative suits that could be brought just as easily as securities fraud actions.

State courts, moreover, are becoming unexpectedly receptive to such claims. In many ways, then, the derivative action has become the chief state-law alternative to the federal class action, at least since the effective elimination of state law securities class actions in 1998. Understanding the trends in federal securities litigation over the next few decades, then, will require that we keep tabs on this additional trend in the state courts as well.

Many of the changes in federal and state laws relating to securities fraud over the past 70 years have shifted the balance between plaintiffs and defendants. The balance is shifting once again, in both intended and unintended ways. Continuing research in these areas will help policymakers shape these still youthful laws into mature ones.