In a forthcoming article, I contend that Professor James Spindler has it wrong in his recent critique[1] of scholarly opposition to securities fraud class actions (SFCAs). Spindler argues that the opposition is based on two mistaken ideas: (1) that compensation for securities fraud is impossible because recovery against the issuer means that defrauded buyers effectively pay themselves (the circularity critique) and (2) that most investors are diversified and thus suffer no real harm from securities fraud since buy-side losses wash out from sell-side gains on average and over time (the diversification critique).
Spindler purports to refute both of these arguments. But the arguments he refutes are not exactly those against SFCAs. In other words, Spindler resorts to the time-tested technique of misstating the argument in order to attack it. This is not to say that the arguments addressed and refuted by Spindler have never been made. Rather, they have been supplanted by a more refined and far more compelling critique of SFCAs.
To be clear, the assumption here is that SFCAs involve the cover-up of bad news — a decline of stock price upon corrective disclosure — and buyer claims. Although there are notable examples of good-news fraud followed by seller claims, bad-news cases outnumber good-news cases 50 to one.
Spindler argues that SFCAs play a valuable role in our scheme of securities law. He says that without SFCAs, investors would take costly precautions against the possibility of fraud. With SFCAs, the cost of fraud is shifted onto issuers who can bear the cost of disclosure more cheaply (as a single-payer, so to speak) as opposed to investors, who would bear the cost individually and many times over. Thus, Spindler sees SFCAs as a vital part of a system of mandatory disclosure. But he assumes that a class action is the only way to enforce this result.
Regarding circularity, Spindler recognizes that because the company pays, its value and thus stock price declines even more than it would have done because of a corrective disclosure alone – a process that I have called feedback. See Richard A. Booth, The End of the Securities Fraud Class Action as We Know It, 4 Berkeley Bus. L. J. 1 (2007). Spindler argues that SFCAs are workable because it is possible despite circularity for investors to be compensated in full even though compensation is funded by the defendant company and thus the wealth of its stockholders – including those who are compensated. But that is old news. See Id.
What Spindler fails to recognize is that feedback magnifies buyer claims, induces investors to spend more on wasteful precautions, and increases already excessive deterrence. Thus, SFCAs have a chilling effect on voluntary disclosure. Moreover, SFCAs result in a transfer of wealth from diversified investors to stock-pickers even though the law should encourage investors to diversify. The bottom line is that investors are worse off with SFCAs than without them.
Regarding diversification, Spindler argues that SFCAs are necessary because one cannot diversify away fraud. Wrong. Again, Spindler paints with a brush too broad. The loss from securities fraud is a mixture of diversifiable losses that someone will suffer one way or the other – think musical chairs – and undiversifiable losses that derive from the cover-up of bad news. Bad things happen to good companies. Sales decline. Risks increase. But such losses can be diversified away because unexpectedly good things happen to other companies. In contrast, if an ordinary loss is exacerbated by a cover-up leading to a loss of investor trust (and an increased cost of capital) or cash outflows (from litigation expenses or fines), such additional losses cannot be offset by unexpected gains. There is no potential for gain from good behavior – except maybe in prison.
The extant rule is that buyers may recover the difference between purchase price and the price following corrective disclosure (as adjusted for background changes). But this measure of damages comprises several different components of loss, some of which are diversifiable. Moreover, the losses that cannot be diversified away are all derivative in character and should give rise to a claim on behalf of the company rather than against the company. And derivative actions are perfectly tailored to compensate and deter without the collateral damage caused by feedback.
For the law to provide a recovery for inevitable and diversifiable losses simply because the company misspeaks in some way constitutes a windfall for investors who just happen to buy during the fraud period. Assuming full recovery, buyers end up better off than they would have been in the absence of fraud. Buyers never recover in full, but the problem is that the company pays when it should receive compensation.
To be sure, the 1933 Act provides expressly for recovery against issuers. Thus, Spindler stresses that investors do not care whether securities fraud involves an offering by an issuer or open-market trading and thus that it does not matter whether the claim arises under the 1933 Act or under Rule 10b-5. But the point of the 1933 Act is to return the parties to the status quo. Disgorgement is one thing. Feedback is quite another.
The fallacy in Spindler’s response to the diversification critique is that he sees all mispricing as equally worrisome for investors whether it derives from bad luck or genuine fraud. It may be true that diversified investors worry about random mispricing, but the question is whether they would (or should) spend anything to identify mispriced stocks given that they have hedged away firm-specific risk by virtue of being diversified. In other words, if one knows that occasional mispricing will wash out, would one nevertheless spend to identify mispriced stocks so as to squeeze out a little more return? After all, the fact that one is protected from loss does not necessarily mean that one would leave money on table.
Or does it? The little-noticed flip-side of eliminating downside risk is eliminating upside potential. It may be that confusion about how diversification works is partly a result of confusion about the meaning of risk itself. The essence of risk is volatility. It is not solely about the danger of loss. It is also about the danger of gain (so to speak). Diversification is a two-edged sword. While one can eliminate company-specific risk by holding a diversified portfolio of stocks, diversification also eliminates the possibility of extraordinary gains. In other words, a diversified investor is protected against the risk of loss from normal (random) fluctuations in price. But the protection is purchased using the random gains that come from the same source.
Spindler is correct that it is not irrational for investors to spend on research if the cost thereof is less than (or even equal to) the benefit. But if the benefit is zero, no cost can be justified. The point is NOT that one cannot beat the market but rather that there is no reason even to try if risk can be eliminated. Diversified investors might want to win with every trade but only if it is completely costless to do so
It follows that a diversified investor must minimize expenses. Since there is no benefit that can come from spending on research, to spend anything more than the minimum for investment management is a waste of money that serves only to reduce net return. Thus, it also follows that most investors should invest in index funds. And increasingly they do.
But wait. There’s more. Given that diversified investors have hedged away all firm-specific risk, they are willing to pay more for the stocks in which they invest. Thus, diversified investors drive market prices: Indeed, the growth of diversification (and indexing) has effectively bid up the price of equities generally. The bottom line is that investors who choose not to diversify effectively pay too much by assuming more risk than necessary for the same return. In short, investors have no real choice but to diversify.
Diversified investors should be opposed to SFCAs for these same reasons insofar as they purport to compensate investors for ordinary losses coincident with fraud – unavoidable losses from bad luck that someone must suffer. For diversified investors, the cost of this protection is a deadweight loss. As for any portion of a loss that is attributable to true fraud, index investors would prefer recovery by the company by means of a derivative action.
In the end, Spindler exposes weaknesses in the usual arguments against SFCAs that point the way to still stronger arguments against SFCAs. Thus, Spindler’s piece is a valuable contribution to the extensive body of legal scholarship focusing on securities litigation. But only because it is wrong.
ENDNOTE
[1] We Have a Consensus on Fraud on the Market – And It’s Wrong, 7 Harv. Bus. L. Rev. 67 (2017).
This post comes to us from Richard A. Booth, the Martin G. McGuinn Chair in Business Law at Villanova University’s Charles Widger School of Law. It is based on his forthcoming article, “Sense and Nonsense about Securities Litigation,” available here.