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Lyle Roberts Archives

Business Week has a "news analysis" on the impact, or lack thereof, of the Supreme Court on the business community. The article notes that under Chief Justice Rehnquist the Court has rarely taken cases in "vital areas such as antitrust, environmental, intellectual-property, securities, and tax law." The most glaring omission may be in the area of class actions, where the Court has "refused to put substantial hurdles in the way of plaintiffs' attorneys who file these cases."

Two possible causes of the justices' reluctance to take on these cases are their lack of business law experience and their preference for issues that involve constitutional, as opposed to statutory, interpretation. Will one (or two) new justices make a difference? We will find out soon.

An Ounce Of Prevention

How do you limit the potential legal liability for conduct that is inherently risky, but generally beneficial to society? One way is to create regulatory safe harbors that shield individuals from liability if they abide by certain restrictions.

The Washington Post had an interesting article in yesterday's paper on a safe harbor created by the SEC for corporate insider trading. Under SEC Rule 10b5-1, put into place in 2000, a person's purchase or sale of securities is not "on the basis of" material nonpublic information if, before becoming aware of the information, the person enters into a binding contract, instruction, or trading plan (as defined in the rule) covering the securities transaction at issue. The article discusses how the corporate executives of Trex Co, a Va.-based maker of composite deck boards, are likely to benefit from this safe harbor.

"Trex stock plunged more than $10 a share the day after the earnings shortfall was announced June 22, costing stockholders roughly $150 million in the value of their shares. By selling their shares before the problem was revealed, Trex chief executive Robert G. Matheny and directors Anthony J. Cavanna and Andrew U. Ferrari together got almost $1 million more for their stock than they would have if they had waited to sell after the announcement. Insider trading records compiled by Thomson Financial show that in the first three weeks of June, Cavanna sold Trex stock worth $1.4 million, Matheny sold $968,000 and Ferrari sold $381,000. Ordinarily, big insider sales just before bad news is announced would trigger outcries from shareholders and probably an investigation by the Securities and Exchange Commission. That hasn't happened because the Trex officials acted under an SEC rule that allows corporate officers, directors and other insiders to sell stock at any time, under almost any circumstances, without running afoul of insider trading regulations -- so long as the sales are 'pre-arranged.'"

The use of these stock trading plans may also assist Trex in defending against the securities class action that has been brought against the company. Plaintiffs often allege that a company's officers were motivated to engage in securities fraud so that they could profit by selling their company stock at an artificially inflated price. Some courts have begun to cite the existence of stock trading plans as negating any such inference, making Rule 10b5-1 an example of a regulatory safe harbor spilling over into private tort litigation.

Lessons From The PSLRA

Thanks to Walter Olson for inviting me to guestblog and to Jonathan Wilson for posting today about my practice area.

As noted, I am a securities litigator and publish The 10b-5 Daily, a blog devoted to news and analysis related to securities class actions. Jonathan's post raises the question: how do you eliminate the causes of "easy money" litigation? In the area of securities litigation, however, Congress has already tried to do just that.

The Private Securities Litigation Reform Act of 1995 ("PSLRA") was designed to deter abusive lawsuits and encourage the voluntary disclosure of information by corporate issuers. To that end, Congress established heightened pleading requirements for securities fraud, an automatic stay of discovery in securities fraud cases pending the resolution of a motion to dismiss, a system for selecting a lead plaintiff in a case brought as a class action, and a safe harbor from liability for forward-looking statements. Yet "easy money" litigation, in the form of speculative securities class actions alleging fraud and brought on behalf of investors, continues.

It is surprising that tort reformers do not talk more about the PSLRA, because it illustrates the difficulties of reforming the civil justice system. For the moment, let's just look at the lead plaintiff/lead counsel provisions. The PSLRA provides, in a nutshell, that the lead plaintiff in a securities class action shall be the investor who applies for the position and has the largest financial loss. The selected lead plaintiff gets to pick who will act as lead counsel for the proposed class of investors.

The idea was to create an incentive for institutional investors to put themselves forward as lead plaintiffs. In turn, these institutional investors would have the resources and legal sophistication to closely monitor and run the cases. So what actually happened?

First, the only institutional investors that proved to be really interested in acting as lead plaintiffs were union/public pensions funds. A PricewaterhouseCoopers study of securities class actions filed in 2004 found that (a) institutional investors made up about 50% of all lead plaintiffs, but (b) 72% of these institutional investors were union/public pension funds. Whether most union/public pension funds (as opposed, for example, to investment banks) have the legal resources to closely monitor a complex civil litigation is debatable.

Second, the plaintiffs' bar sensibly reacted to the PSLRA by developing close relations with union/public pension funds (some have suggested a bit too close relations), thereby creating a stable of potential plaintiffs. This was much like the lawyer-driven practice, involving individual investors, that Congress had wanted to stop.

Finally, institutional investors naturally gravitated to the best cases (i.e., the cases with the most pre-filing evidence of fraud), leaving more tenuous cases to be led by individual investors. In this sense, the PSLRA's lead plaintiff provisions arguably made good cases even better (by putting in place stronger lead plaintiffs), but had no effect on the potentially frivolous cases that troubled Congress.

In sum, Congress' good intentions suffered from an unwillingness to simply spell out what it wanted and give the courts the power to effectuate it. The "largest financial stake" was probably a poor proxy for "an investor with both the incentive and the means to closely monitor and control the litigation."



Rafael Mangual
Project Manager,
Legal Policy

Katherine Lazarski
Manhattan Institute


Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.