January 20, 2008
Prentice on Scheme Liability
Scheme Liability: Why Should Plaintiffs Be Able to Sue Under Subsection (b) of Rule 10b-5, But Not Subsection (a)?, by ROBERT A. PRENTICE, University of Texas at Austin - McCombs School of Business, was recently posted on SSRN. Here is the abstract:
The Supreme Court is presently considering the Stoneridge case which raises the question of whether private investors who are victimized by schemes to defraud that violate subsection (a) of Rule 10b-5 may sue? It is undisputed that plaintiffs may sue under subsection (b) of Rule 10b-5 if they are defrauded by misrepresentations and omissions in connection with the purchase or sale of securities. Why can they not sue under subsection (a) of the same rule? In this paper, I continue a debate with scheme liability opponent Joseph Grundfest.
Professor Grundfest constructs an arc of history argument which claims that the implied right to sue under §10(b) was frozen in time in 1975 when Cort v. Ash heightened the standard for judicial implication of private rights to sue. Therefore, he claims, plaintiffs claiming under subsection (b) of Rule 10b-5 enjoy a squatter's right to sue, but to recognize scheme liability would be to improperly extend this implied right of action.
Professor Grundfest's argument rests on two false premises, either of which is fatal to his position. First, he assumes that the right to sue for fraudulent schemes in violation of 10b-5(a) did not exist in 1975 when, in fact, it was very well established in numerous cases. Second, he assumes that the §10(b) implied right to sue is frozen in time as of 1975 when, in fact, the Supreme Court has at least twice expressly stated that it is not so frozen, and the conditions specified for extending the private right to sue are precisely met in the case of scheme liability.
In response to Professor Grundfest, I also argue that the right to sue under §10(b), while not originally intended by Congress, now carries such a stamp of Congressional approval that it makes no sense to continue to treat it as if it were purely a judicial invention.
I also show that the common law of fraud that informed Congress's enactment of §10(b) broadly recognized scheme liability in 1934 and indisputably would have imposed liability upon parties who acted as did the defendants in Stoneridge. This is critically relevant, for the Supreme Court has held that where the language of §10(b) does not answer a question regarding interpretation of the private right to sue, the proper way to proceed is to determine what a 1934 Congress would have intended had §10(b) included an express private right to sue.
Booth on The Paulson Report and Securities Litigation
The Paulson Report Reconsidered: How to Fix Securities Litigation by Converting Class Actions into Issuer Actions, by RICHARD A. BOOTH, Villanova University School of Law, was recently posted on SSRN. Here is the abstract:
This short essay considers the findings and recommendations of the Paulson Report relating to securities fraud class actions under the 1934 Act and Rule 10b-5. While the report exposes numerous problems with securities litigation in the United States, it understates the problems inherent in stock-drop actions. As a result, the report fails to propose an effective fix. As the report recognizes, diversified investors gain nothing from stock-drop actions: Because the corporation pays, holders effectively reimburse buyers and sellers keep their gains. In other words, the system suffers from circularity akin to a game of musical chairs in that stock-drop actions ultimately do no more than transfer wealth among investors. Indeed, diversified investors are net losers to the extent of attorney fees and other costs of litigation. But the report fails to note that issuers who are targets of such actions see their stock drop in price by more than it otherwise would because of the prospect of litigation and a feedback effect: When the issuer pays to settle the case, the payment further reduces the value of the company, which leads to a further decrease in stock price and a further increase in the potential for damages. In the end, a target company faces a higher cost of capital than it would in a world without securities fraud class actions. And in some cases it may face financial ruin. The report also fails to note that diversified investors may suffer genuine financial loss when insiders take advantage of nonpublic information for personal gain or when they damage the reputation of the company by failure to be candid with the market. In such cases, stockholders have a real gripe and should have a remedy. The simple solution is for the courts to deem stock-drop actions under the 1934 Act and Rule 10b-5 to be derivative actions rather than direct (class) actions. It is well settled that it is up to the court to decide whether an action is direct or derivative. The fact that the parties style the action as a direct (class) action rather than as a derivative action does not make it so. By recasting stock-drop actions as derivative actions, the courts could in one stroke eliminate the glaring market inefficiency of circular recovery, lower the cost of capital for issuers, emphasize individual responsibility, induce boards of directors and gatekeepers to become more vigilant, and reduce the need for criminal prosecution.
Gordon on Proxy Access
Proxy Contests in an Era of Increasing Shareholder Power: Forget Issuer Proxy Access and Focus on E-Proxy, by JEFFREY N. GORDON, Columbia Law School; European Corporate Governance Institute (ECGI), was recently posted on SSRN. Here is the abstract:
The current debate over shareholder access to the issuer's proxy for the purpose of making director nomination is both overstated in its importance and misses the serious issue in question. The Securities Exchange Commission's new e-proxy rules, which permit reliance on proxy materials posted on a website, should substantially reduce the production and distribution cost differences between a meaningful contest waged via issuer proxy access and a freestanding proxy solicitation. The serious question relates to the appropriate disclosure required of a shareholder nominator no matter which avenue is used. Institutional investors and other shareholder activists should focus their energies on working through the mechanics of waging short-slate proxy contests using e-proxy solicitations. Activist institutions need to prepare the disclosure package required under the existing proxy rules. Such disclosure may be tested (and refined) through litigation, but a standardized package should emerge relatively quickly that the institution could use in proxy contests without a control motive. Institutional investors need to become facile with the e-proxy model (including coordinating a practice for opting-in to web-access) and should appreciate the extent to which proxy advisory services will do much of the actual solicitation work. If institutions are unwilling to make the relatively modest investment to master the mechanics of e-proxy contest, both in their initiation as well as voting in support of them, then their role in corporate governance will necessarily be limited.