Thanks to Jim Copland and the Manhattan Institute for inviting this debate between me and Moin Yahya over dumping and suing, which started over at my blog. I hope to show that this relatively narrow issue has broader implications for the debate on the litigation crisis, and on public policy generally.

First, there’s a fundamental problem with Moin’s analysis: it presupposes a division between the long-term and “principled,” on the one hand, and the “pragmatic,” on the other. In fact, there is no great divide. Policy doesn’t work pragmatically unless it’s principled.

Second, Moin’s initial point – that short-selling without disclosure that you are going to sue is, per se, a violation of 10b-5 and fraudulent – is simply inaccurate.

Focusing, as Moin does, on 10b-5, the Supreme Court held in the O’Hagan case that liability for insider trading under these circumstances requires the misappropriation of information from its owner. Merely trading on information the rest of the market does not have is not enough for liability. While I believe that even the Court’s theory is too broad (stealing shouldn’t be a federal offense), what matters for now is that even the Court wouldn’t go as far as Moin does. This rule is significant because it recognizes the fundamental principle that liability for insider trading does not extend beyond cases that involve misappropriation or other violations of property rights in information. Moin’s approach would instead base 10b-5 liability on trading because it involves the exploitation of an informational advantage. This approach has been rejected by the Court and by financial economists as detrimental to market efficiency.

Here is where principle meets pragmatism. Moin has unfortunately succumbed to the temptation to do something about the government’s and trial bar’s “attack” on corporate America (pragmatism) by discarding a vital principle -- limiting liability for insider trading -- that actually protects business against harmful lawsuits. Consider what harm Moin’s theory would do to business: without any limitation based on property rights, liability for insider trading could expand almost infinitely, as it threatened to do before the series of court opinions beginning in 1980 that recognized the property right limitation.

Sure, one might hope that Moin’s new “pragmatic” rule would be limited to dumping and suing. But can we rely on the trial bar to be principled when business seizes on pragmatism to attack it? Liability based on inequality of information would surely spread like a virus beyond this narrow situation. The only reliable pragmatic weapon against the endlessly expansionary ambitions of the trial bar is adherence to strong principle.

Moin’s policy basis for regulating dumping and suing – that plaintiffs and trial lawyers would be “doubly enriched” – is also misguided.

This argument has some pragmatic appeal to those who believe that litigation is excessive. Of course, if litigation is excessive, we don’t want to provide even more incentives to trial lawyers and plaintiffs.

The problem with this argument is not (unlike Moin’s first argument) that it is wrong, but that it is weak and incomplete. Any trial lawyer could think of a comeback in about a millisecond: lawsuits are valuable instruments of social policy, and therefore we need better and stronger incentives. Class action plaintiffs may expect recoveries that are too small to justify individual action – that’s why we have class actions. Their lawyers may seem egregiously overcompensated, and therefore have a powerful incentive to bring too many suits. But the fact is that, because they only get a piece of the action, they may have inadequate incentives to maintain high-quality litigation. The result is not necessarily that we get too many lawsuits, but that we get the wrong kind -- “strike” suits for fees, and settlements that do not adequately reflect the legal damage to the class.

Continuing the argument, class action plaintiffs and lawyers might say that what would fix this would be if we could get another piece of the actual value of the suit, as measured by the effect of the suit on the company. This compensation would be valuable in meritorious cases based, but worth little in frivolous suits.

This last point illustrates another error in Moin’s analysis. He assumes that lawyers can profit simply by announcing any suit – that any suit, no matter how “improbable,” will have stock price effects. But this ignores another principle that defenders of business would do well to keep in mind – that securities markets are fairly efficient, in the sense that they reflect public information about traded firms. This principle is important, because it suggests that markets already protect securities investors and others, and therefore that significant liability and regulation is unnecessary. Efficient markets can distinguish between silly lawsuits and good ones – and between good and bad lawyers that bring them.

So, in theory at least, if we gave lawyers or plaintiffs a piece of the stock market action, this would give them an incentive to develop the sort of reputations by selecting and diligently prosecuting cases that would increase stock price effects when suits were filed. In fact, Bruce Kobayashi and I in a recent working paper see some general theoretical merit in such an argument.

In other words, Moin’s “double recovery” argument is subject to dead-easy rebuttal. All we have to do is to say Moin’s assumptions about litigation and stock markets are wrong. Since Moin doesn’t defend these assumptions, he’s left with no principle to fall back on.

The better attack on dumping and suing is based, not on false assumptions or on incorrect statements of the law, but on the specific harms that we can show it causes. For example, one way to enhance the effect of the filing of a suit is to accompany it with false statements about the stock. This is already actionable under the federal securities laws. Also, a plaintiff who sells short the stock held by other class members is probably not an adequate class representative – his interests in prosecuting the suit are not aligned with the interests of the other class members.

Concentrating on the real causes of harm in such cases will avoid the error inherent in Moin’s approach of using the blunt instrument of the securities laws to attack lawsuits regardless of their merit.

This relates to Moin’s policy prescriptions.

1. Yes, the SEC can investigate. But let’s make sure the investigation doesn’t lead to an expansion of the already overbroad securities laws. Limit the investigation to violations of current law, including misrepresentations and market manipulation.

2. Let’s make clear that lawyers and plaintiffs who merely dump and sue are not thereby violating the securities laws, and establish that principle as a bulwark against further expansions of the securities laws.

3. If plaintiffs and their lawyers are doing something wrong, a fortiori, insiders should not be allowed to do the same thing. Again, principle rules. Let’s not go back to the pre-1980 days when the courts failed to make this crucial distinction between insiders and outsiders, with the result that the insider trading laws threatened to impose costs on business people far in excess of anything we could fear from dumping and suing.