April 03, 2012
The following op-ed by HLS Professor Hal Scott and Leslie N. Silverman appeared in the Apr. 1 edition of The Wall Street Journal.
The Alternative to Shareholder Class Actions
The SEC blocks arbitration without any explanation.
by Hal Scott and Leslie N. Silverman
Last month, the Securities and Exchange Commission rejected attempts by the Carlyle Group, and proposals by stockholders of Pfizer and Gannett, to mandate arbitration rather than litigation in disputes between investors and management. The SEC gave no explanation for its action on Carlyle (related to an upcoming public offering), and it said opaquely the Pfizer and Gannett proposals might violate the securities laws.
Arbitration has opponents inside the agency, of course, and among plaintiffs lawyers. They claim stockholders will receive less for management wrongdoing, and that this will lead to less deterrence of such wrongdoing. But this argument ignores some important facts. And it does not address the problem identified by the Committee on Capital Markets Regulation—that securities class-action litigation may be the most burdensome feature of U.S. capital markets.
From 2000 through 2011, the total value of all U.S. securities class-action settlements was approximately $64.4 billion, according to NERA Economic Consulting. These settlements do little to accomplish the class action's traditional goals of compensation and deterrence.
Unlike mass tort litigation, securities class actions involve stockholders who are often both plaintiffs and investors in the defendant corporation. The suits are invariably settled before trial, generally for pennies on the dollar. Small investors recover so little they often do not bother to file for their money: 40%-60% of settlement funds generally go unclaimed, according to research prepared for the Committee on Capital Markets. Regardless, plaintiffs attorneys take up to 35% of the total settlement.
The lawsuits do little to deter wrongdoing. The stockholders funding a settlement generally have no knowledge of management misdeeds—they simply held the wrong stock at the wrong time. Managements—the actual wrongdoers and proper objects of deterrence—rarely pay a dime, as the corporation's directors' and officers' insurance picks up the settlement cost.
Real deterrence comes from whistleblowers and the media, whose reports of fraud send share prices plunging. Deterrence also comes from the strongest public-enforcement system in the world—administered by the Department of Justice, the SEC and the state officials.
Securities class actions undercut the competitiveness of the U.S. capital markets. Plaintiffs attorneys have demonstrated a clear tendency to target the largest public companies, and because insurance firms will not provide settlement coverage over a few hundred million dollars, public companies face substantial risk. Further, foreign corporations are reluctant to list and trade here, while private U.S. corporations have grown wary of going public.
In 2011, 7% of U.S. companies that did go public did so abroad. They were no doubt motivated in part by the litigiousness they can avoid under the Supreme Court's decision in Morrison v. National Australia Bank (2010), which does not permit securities claims by private plaintiffs for shares purchased or sold on a foreign exchange. Historically, it was almost unheard of for American companies to go public outside the U.S.
It does not have to be this way. Companies and their stockholders have recently begun exploring mechanisms by which disputes must be settled in individual, private arbitration, taking advantage of the lower costs and quicker results such arbitration affords. They are following the national policy in favor of arbitration embodied in the Federal Arbitration Act of 1925 and confirmed by the Supreme Court in AT&T Mobility v. Concepcion (2011), which struck down a California anti-arbitration law. Other important Supreme Court cases include Rodriguez de Quijas v. Shearson American Express (1989), which held that arbitration does not violate federal securities laws that prohibit waivers of substantive rights guaranteed by law, such as anti-fraud provisions.
Despite arbitration's endorsement by Congress and the Supreme Court, the SEC has rebuffed efforts to substitute arbitration for securities class actions. So in the recent cases cited above, investors—prospective, in the case of Carlyle, and existing, in the case of Pfizer and Gannett—were deprived of the opportunity to decide upon the dispute-resolution procedure they preferred.
The SEC prides itself on ensuring that U.S. markets are transparent, but in ruling out arbitration it has said no without any explanation. The matter deserves a fair hearing.
Mr. Scott is a professor at Harvard Law School. Mr. Silverman is a partner in the law firm of Cleary Gottlieb Steen & Hamilton LLP. Mr. Scott is the director of the Committee on Capital Markets Regulation, on which Mr. Silverman is a member.