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How to fix securities class actions? Ask shareholders

The securities-fraud lawsuit business has now become one of America's biggest industries.

In late September, a federal judge in Manhattan certified a securities fraud class action against JPMorgan with potential damages of up to $10 billion. This is about the entire economic output of Nicaragua, and would make the damages alone here larger than the GDP of more than sixty countries. JPMorgan is not alone: since 1996, nearly 4,000 similar suits have been filed. The settlements of the biggest ten cases alone totaled $35 billion, and this doesn't count the billions spent defending these cases.

U.S. Supreme Court Building in Washington, D.C.
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U.S. Supreme Court Building in Washington, D.C.

If these suits deterred fraud, the costs might be worth it. But defendants' have strong reasons to settle, even if they are confident they would win at trial. The math is simple: even if JPMorgan thinks it is 99 percent likely to prevail at trial it is economically rational for them to cut a check for $100 million, even ignoring the massive costs of mounting a defense. Even supremely confident defendants will settle meritless cases. This encourages plaintiffs' lawyers to bring too many suits.

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Although the problem of frivolous suits is well known, no one seems willing to fix the problem. The Supreme Court, which created the securities class action industrial complex out of whole cloth three decades ago, refused this past summer to do away with it entirely. In fact, the Supreme Court arguably made the problem worse by reaffirming the "fraud on the market" theory from its 1988 case Basic Inc. v. Levinson, and adding a new defense to these cases that will entail an expensive battle of economics experts. Despite the added expense, the court's "reform" will do little to deter the filing of suits with only nuisance value. Nor is Congress likely to clean up the court's mess, since a diffuse group of shareholders cannot counteract the lobbying influence of trial lawyers. The SEC could reform class actions through its official rulemaking, but the agency staff sees plaintiffs' lawyers as allies in investor protection and has repeatedly endorsed the status quo.

Perhaps shareholders should take matters into their own hands. Shareholders have the right incentives, because they reap the benefits and pay the costs of these suits. Shareholders benefit from reduced corporate fraud and receive any payouts. But shareholders also pay for the trial lawyers (on both sides), as well as billions more spent flyspecking disclosure documents, not to mention the costs of new projects that are rejected because of the risk of being sued.

One option would be to allow the shareholders to change the damage measure in securities fraud class actions. The measure courts use — the "out-of-pocket measure" — focuses on compensating shareholders who lose when they sell at prices inflated by alleged fraud. But this damage measure makes little sense. Focusing on compensation vastly overstates the actual harm, since no offset is made for the windfall gain on the other side of the trade. For every shareholder who bought at a fraudulently inflated price, another shareholder has sold: the buyer's individual loss is offset by the seller's gain. The net losses from these trades are essentially zero.

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Rather than trying to make shareholders whole after the fact, it would be better to deter the fraud in the first place, which should be investors' primary interest anyway. To refocus these suits on deterrence, shareholders could stipulate to a "disgorgement" measure of damages in their corporate charter. A disgorgement system would set damages not based on the losses to shareholders, but the gains of the executives who actually committed the fraud. Taking away the benefit will discourage fraud.

Shareholders could also amend the corporate charter to require such disputes to be settled in arbitration, without the ability to consolidate individual cases into a class action. The SEC takes the position that such a waiver would be illegal. But a consistent series of decisions from the Supreme Court interpreting the Federal Arbitration Act strongly supports the enforceability of such a provision.

An arbitration clause is something of a nuclear option, perhaps dramatically reducing both the deterrent value of these suits and the waste they engender. But we will get prompt feedback if investors make the wrong call in voting to adopt an arbitration clause, since stock prices should reflect whether such a move is good or bad for shareholders.

The SEC's open hostility to these potential reforms is likely chilling companies from experimenting to improve securities-fraud suits. But the risks of innovation are low, since the SEC can always bring its own suits against fraudsters in the event shareholders go too far. Given this safety net, the SEC should encourage experimentation so we can find out whether shareholders value the current system as much as lawyers do.

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Commentary by M. Todd Henderson and Adam C. Pritchard. Henderson is the Michael J. Marks Professor of Law and Aaron Director Teaching Scholar at the University of Chicago Law School. His research interests include corporations, securities regulation, bankruptcy, law and economics, and intellectual property. Adam C. Pritchard is the Frances & George Skestos Professor of Law at the University of Michigan Law School and specializes in corporate and securities law.