Originally published by the CLS Blue Sky Blog on August 21, 2017
On July 17, SEC Commissioner Michael Piwowar extended an important invitation to U.S. public companies. “For shareholder lawsuits,” Piwowar offered, “companies can come to [the SEC] to ask for relief to put… mandatory arbitration into their charters.” To some, this idea may be unfamiliar or even controversial. But, as someone who has studied the U.S. securities class action system and its impact on our capital markets extensively, I know this policy is a sound one that serves U.S. investors and markets well.
Indeed, the Committee on Capital Markets Regulation, which I direct, first introduced the idea of corporation-stockholder non-class arbitration in 2006, and I have long supported shareholders’ right to opt out of the costly and ineffective system of securities class action litigation and into a system of mandatory arbitration to resolve issuer-stockholder disputes. Such arbitration provisions may be included in a company’s charter, as Commissioner Piwowar suggests, or adopted through a shareholder proposal to amend a company’s by-laws.
Commissioner Piwowar’s offer is an important one, because it should be up to shareholders to decide whether they wish to resolve securities law disputes through arbitration or class actions. And preserving shareholder choice on this matter is especially critical because of the demonstrated problems that securities class actions create for U.S. investors and markets.
The U.S. system of securities class action litigation is anomalous and extreme—the U.S. is the only developed country where public company stockholders can form a class and sue their own company for securities law violations (typically disclosure failures). Going public in the U.S. exposes companies to litigation risk that can cost them billions of dollars—the mere filing of such a suit can reduce a company’s market value by 10 percent, and public companies have paid $55.6 billion in securities class action settlements in the last 10 years.
Troublingly, these suits are being filed at record rates. In the first half of 2017, 226 federal securities fraud class actions were filed, 135 percent above the semiannual average during the 1997-2016 period. And if filings against U.S. exchange-listed companies continue at their current 2017 pace, these suits will target one in 11 of such firms this year, the highest rate since 1997.
This is a serious problem for U.S. markets, because it discourages U.S. companies from going public and foreign companies from doing so in the United States. These suits also create problems for the shareholders they are supposed to protect, because they fail to accomplish their two major goals: compensating harmed investors and deterring bad behavior.
U.S. securities class actions do a poor job of compensating investors because shareholders themselves bear the costs of these lawsuits. As former SEC Commissioner Paul Atkins explains, “the costs of defending and settling these suits are borne by the company’s shareholders, leading to an absurd situation in which money is merely shifted from one group of innocent investors to another, with plaintiff and defense attorneys siphoning off billions of dollars in the process.”
The data on lawyers’ fees and investor recoveries speak for themselves. Last year, securities class action plaintiffs’ attorneys brought home roughly $1.27 billion in fees and expenses—a healthy chunk out of the $6.4 billion in aggregate U.S. settlements. For smaller settlements, lawyers take an even bigger piece of the pie: For settlements below $10 million, plaintiffs’ attorneys generally walk away with about 30 percent of the value. Of course, because institutional investors effectively sue themselves in these suits, their net recoveries are negative. Potential shareholder recoveries are in fact so small that CCMR found that holders of only 40-60 percent of potentially eligible shares bother to submit a claim.
These shareholder suits also achieve little in the way of deterrence. Securities law violations are committed by individual actors, but it is a company’s shareholders that shoulder the costs of lawsuits seeking corporate damages. In fact, a company’s directors and officers rarely contribute to these payments themselves.
Furthermore, the need for private class actions to deter securities fraud is questionable in light of the country’s robust public system of enforcement. Government agencies like the SEC and Department of Justice are strong enforcers of the securities laws and have ramped up their efforts since the financial crisis. In fiscal 2016, for example, the SEC brought 33 percent more enforcement actions against public company defendants and obtained 68 percent more in monetary penalties and disgorgements from public company defendants than they did in fiscal 2010. And while plaintiffs’ lawyers invariably sue corporations in search of the largest and most likely payout, public enforcement agencies consider cases on the merits, including whether it is appropriate to pursue specific individuals instead of the company, enhancing their ability to deter fraud.
Given the high costs and uncertain benefits of these suits, shareholders may view individual arbitration as a more appropriate mechanism to resolve issuer-stockholder disputes. For example, non-class arbitration involves higher levels of shareholder engagement due to their direct involvement (versus their passive role in class litigation led by lawyers), and this can lead to better investor compensation on an individual basis. The data on disputes involving consumers of financial services and products are illustrative. Consumers who are successful in arbitration receive an average of $5,389 and generally obtain relief within two months; those who receive class action cash payments recover about $32, and these lawsuits usually take years. In any event, Commissioner Piwowar’s policy rightfully puts the ball in the shareholders’ court.
The SEC need not itself take any position on the desirability of securities class actions, it need only permit shareholders to decide on whether they want to permit them.
This post comes to us from Hal S. Scott, the Nomura Professor of International Financial Systems and director of the Program on International Financial Systems at Harvard Law School, and the director of the Committee on Capital Markets Regulation.