Sense and Nonsense About Securities Litigation

Richard A. Booth
2018 Social Science Research Network  
In We Have a Consensus on Fraud on the Market -And It's Wrong, " A " and the fraud-on-the-" " arguments that have been cited by numerous scholars: (1) the circularity (feedback) critique and (2) th gist is that SFCAs are both workable and necessary. But, in the end, Spindler exposes weaknesses in the usual arguments against SFCAs that point the way to still stronger arguments against SFCAs. Regarding circularity, Spindler argues that SFCAs are workable because it is possible, even with
more » ... even with circularity, for investors to be compensated in full, even though compensation is funded by a reduction in the aggregate value of the defendant company, and thus the wealth of its stockholders (including those who are compensated). But he fails to recognize that because feedback magnifies buyer claims, it induces investors to spend that much more on precaution and increases already excessive deterrence. Moreover, it effects a transfer of wealth from diversified investors to stockpicking investors even though the law should encourage investors to diversify. Regarding diversification, Spindler argues that SFCAs are necessary because one cannot diversify away fraud. But as shown here, the loss from securities fraud is a mixture of diversifiable losses that someone will suffer one way or the other (when the truth comes out) 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 the absence of fraud. The only losses that really matter are the losses that cannot be diversified away. But these are losses suffered by the corporation that should 2 U. OF PENNSYLVANIA JOURNAL OF BUSINESS LAW [Vol. 21:1 give rise to a derivative action. Moreover, it turns out that derivative actions are perfectly tailored to compensate investors and to provide perfectly calibrated deterrence without the collateral damage caused by feedback. 3 II. CIRCULARITY AND FEEDBACK Spindler summarizes his argument regarding circularity and feedback as follows: The circularity critique fails mathematically: as shown herein with an economic model, penalties on the firm effectively come out of the pockets of non-plaintiff shareholders, and actually do been turned over during the effective period of the fraud, it is true that the plaintiff class seeks recovery from a firm that they, in part, own. But just as a non-pro-rata dividend transfers wealth, on net, to its recipients, so, too, does the fraud on the market remedy. What is more remarkable is that, under certain conditions, compensation is full and complete. This is so because of a feedback effect between damages and liability: prospective liability decreases stock price, which increases prospective liability, which decreases stock price, and so on. As illustrated mathematically in Part III, infra, the interaction between turnover, stock price, and damages works to fully compensate defrauded purchasers. 2
doi:10.2139/ssrn.3137066 fatcat:skxipvvt2vdofbsiulesxtnvam