January 01, 2016
Class Actions: Time for a Change
M. Todd Henderson
If you went to law school in the 1970s or 1980s, the class action mechanism was likely sold to you as a savior. The revised Rule 23, adopted in 1966, enabled private lawyers to bring claims on behalf of large groups of individuals. There were many new causes of action in areas ranging from consumer law to environmental regulation to civil rights, and without a class action tool, there was concern no one would sufficiently press these rights. The logic was simple: without some means of consolidating many small claims, the economics of litigation would mean many large harms would go unremedied. In theory, a company could impose $100 in damages on 10 million Americans—causing $1 billion in social losses—but get away with it because no one would have an incentive to sue. Class action suits, which dramatically lower the costs for individuals pursuing these claims, could force actors to internalize the costs of their activities, resulting in improved efficiency and social welfare.
The wellspring of the class action was a 1941 article in the University of Chicago Law Review by Harry Kalven Jr. and Maurice Rosenfield, “The Contemporary Function of the Class Suit.” They argued that the class action mechanism could be an important supplement to government regulation. Government is the typical solution to the collective action problem, but it may be less effective than private lawyers at pursuing these claims because of low budgets, less talented lawyers, political pressures, and a host of other reasons. Private “attorneys general” would have high-powered incentives (especially in light of the fee structure of the typical class action), and would, by virtue of the type of lawyers attracted to government versus private work, be more innovative and comfortable with risk.
That private lawyers would innovate and press new claims aggressively turned out to be true, but the downside of the class action system was seriously underestimated. The problems of the class action system are not just too many suits, but also too few of other types of suits and, perhaps worst of all, a distortion of legal principles. To illustrate these points, consider the field that first inspired Kalven and Rosenfield—securities regulation.
Although the Securities Exchange Act of 1934 lacks an explicit private right of action in its principal antifraud provision, the courts created an implicit one that has generated thousands of cases. Over just the past two decades, over 4,000 securities fraud suits have been filed, and companies have paid out over $90 billion in settlements. Unfortunately, the consensus among observers is that many of these suits are of little merit, and those that are meritorious end up mostly lining the pockets of lawyers without doing much to deter fraud.
The economics of the problem are simple. If a stock price drops and an alleged misrepresentation is even remotely plausible, a suit against the company is possible. Such suits can allege billions in damages and are very costly to defend. Thus, even extremely confident defendants can save money (not to mention time and distraction) by settling. Knowing this, plaintiffs’ lawyers have incentives to bring cases of marginal merit, and, importantly, direct their efforts against large, well-heeled defendants. After all, if the game is about getting a settlement—none of these cases ever go to trial—issues of wrongdoing are subsidiary to the expected costs and benefits of settling. Like Willie Sutton, plaintiffs’ lawyers target large companies—regardless of merit—because that’s where the money is.
Court-made doctrine has made matters worse. In Basic Inc. v. Levinson, the Supreme Court invented the so-called “fraud on the market” (FOTM)theory of reliance in order to facilitate securities fraud class actions. See 485 U.S. 224 (1988). The FOTM presumption relieves plaintiffs from the obligation to prove they relied on alleged misrepresentations. But it only applies for stocks traded in an “efficient” market, where disclosures are quickly incorporated into market prices. Although this might makes sense as a matter of logic, it biases such suits toward large firms traded on public exchanges. Perversely, these companies are subject to much more intense scrutiny by auditors, analysts, and the media, and therefore less likely to engage in securities fraud, all else being equal. Smaller companies trading in illiquid markets can commit fraud without much fear of a private suit, while many larger companies in liquid markets get sued for business reversals, even when they commit no fraud.
In recognition of this, the Supreme Court has twisted itself in knots trying to tame the beast it created with the FOTM theory. In Central Bank of Denver v. First Interstate Bank of Denver, the Court held that there was no aiding and abetting liability for private securities fraud suits. See 511 U.S. 164 (1994). The Court extended this ruling to cover alleged schemes to defraud in Stoneridge Investment Partners, LLC v. Scientific Atlanta, Inc., 552 U.S. 148 (2008).
In another series of cases, the Court narrowly interpreted the concept of causation. In Dura Pharmaceuticals, Inc. v. Broudo, the Court held that it was not enough for plaintiffs to show they bought shares at prices inflated by lies; they also had to show that the revelation of the lies caused the stock price to drop. See 544 U.S. 336 (2005). Finally, in Tellabs, Inc. v. Makor Issues & Rights, Ltd., the Court interpreted the Private Securities Litigation Reform Act’s pleading standard to require that plaintiffs show in their complaint that the inference of a fraudulent intent was as strong as any innocent explanation. See 551 U.S. 308 (2007).
Evaluated solely on their own terms, none of these cases makes much sense. Consider Dura. Under the Court’s analysis, a company that deliberately lies to inflate its stock price cannot be sued for this fraud, even if it results in losses for shareholders, if the stock price drop is for reasons unrelated to the fraud. The ruling can only be explained by hostility to class actions.
Circling back to Kalven and Rosenfield, while it may be true in theory that private attorneys general are an attractive alternative to government regulation, in practice, the last several decades of experience tell us that the benefits of this system are outweighed by the costs. One solution would be to scrap the FOTM theory in the hopes of better targeting actual fraudsters. Another would be to change the damages regime to require individuals (such as corporate managers) who benefited from the fraud to disgorge their gains. Most radically, we could get rid of the implied private cause of action and leave matters to the SEC and state prosecutors. Although the SEC may not have the current resources or talent to bring these cases, a dramatic increase in the budget could be part of a broader legislative deal to amend the securities laws. The United States pioneered the modern class action and today remains exceptional in its reliance on private lawyers to enforce social policy through private litigation. The experiment is a failure, and it is time to provide a new generation of lawyers with better tools to make the world a better place.