A study by the U.S. Chamber of Commerce Institute for Legal Reform highlights the problem of �deadweight loss� in securities class action litigation.
The Economic Reality of Securities Class Action Litigation, authored by Professor Anjan V. Thakor of Washington University in St Louis, concludes that the U.S. securities class action system does not compensate investors appropriately for alleged securities fraud, overcompensating some investors but undercompensating others.
According to the study, the current system creates excessive �deadweight loss� through the decline in price in the defending company�s stock and by draining value from any settlement in the form of attorneys� fees. The net effect is to undercompensate long-term holders of the company's stock and to overcompensate larger, more diversified investors.
U.S. Chamber Institute for Legal Reform President Lisa Rick said, �The average American investor gets the short end of the stick in the securities class action system as compared to large institutional investors. The stock holdings of individual investors are generally too few in number to offset losses in stock value that follow allegations of securities fraud.�
�We�ve seen a dramatic surge in the number of securities class actions because the plaintiffs� bar has seized on this arena as another way to game the system for its own benefit,� continued Rickard. �Just five law firms have collected more than $2.75 billion in fees over the last ten years. Class members who remain invested in the defendant companies are the real losers."
Professor Thakor, the study�s author, highlights the role of deadweight loss: �In conventional cases of fraud, the wrongful gain received by one party is the loss suffered by the other. So redressing the initially wrongful wealth transfer through litigation essentially reverses what should not have occurred in the first place.�
But in the securities class action context, investors who own shares in companies that have allegedly defrauded the market are punished twice. For example, an investor who purchases a share of Company ABC for $100 on the basis of allegedly fraudulent information suffers a loss equal to the difference between what the stock would have cost (were it not for the fraudulent information) and the stock�s actual value. Subsequent disclosure of the alleged fraud drives the stock value down to a level below what it would otherwise have been, causing the investor to lose additional value that is not included in the calculation of damages.
At the same time, investors who purchase stock before the alleged fraud benefit to the extent the alleged fraud pushes up the stock price.
Although the study does not advocate any particular reforms, it concludes that �a litigation system so distanced from economic reality arguably cannot adequately serve the purposes for which it was initially created.� Under the current system, the only net winners are the five largest plaintiffs� firms who generated more than $2.75 billion in legal fees in securities class action litigation over the past ten years.