Basic Objections

Larry’s basic objections to my proposal to deem plaintiff’s temporary insiders prohibited from short-selling until they disclose their intent to sue can be summarized as follow:

1. A rule forcing plaintiffs to disclose their intent to sue could eventually capture all outsiders who possess some information.
2. Double recovery is needed to create the right incentives for lawyers to find meritorious suits.
3. There is no danger from frivolous litigation negatively affecting the stock price, because the market is efficient, and it can tell good suits from bad ones.

I will deal with these objections in sequence.

1. The Slippery Slope

Larry’s argument amounts to a slippery slope argument.  If we stop the “bad” guys, “good” guys might be harmed.  This is because my rule, according to Larry, could be converted to hold any possessor of non-public material information liable for trading on the information without disclosure.  My response is twofold.  First, my proposal was to have the SEC promulgate a narrowly tailored rule that specifically covers plaintiffs.  Such a rule would be ideal in that it would avoid any common law expansion of a judicially created rule that Larry fears.  But even a judicially created rule can be contained, for as Larry pointed our the courts have curtailed the expansion of insider trading liability since the early 80s.

Additionally, there is a substantial difference between short-selling plaintiffs and other outsiders who possess non-public material information:  plaintiffs do not just possess information; they also intend to act in a way that will undoubtedly destroy the value of the shares.  When someone normally short-sells the stock, both sides (the short-seller and the purchaser) are taking a risk that the price will not perform according to expectations.  But here, not only is the bet one-sided (in that one side will surely profit while the other will not), the one side (the short-seller) is the very cause of the stock price’s demise.  Imagine if someone sold you a car that had a bomb activated by the seller once the deal was completed.  This is precisely what is happening here.  Suppose, the 9/11 terrorists had sold short airline stock, would Larry say that (aside from the obvious terrorism charges) there was nothing wrong with their short-selling?  There are numerous cases that state that selling a good or service with knowledge that a third-party is about to destroy its value is actionable under tort or contract law.  I see no reason why that analogy should not extend here, when there is more than mere knowledge of a third party’s actions; in fact, the very seller is about to be the cause of the decline in price.

In the real life examples of the short-sellers teaming up with lawyers, the short-sellers initially sold-short and then spread bad news about their targets, most of the time, to no avail.  Finally, they either sued or convinced a government entity to announce an investigation, which then led to the drop in price.  Again, to reiterate, outside trading on non-public information is fine; doing so and being the cause of the fall in price is not.

Because short-selling plaintiffs take that extra step of acting to lower the value (as opposed to merely trading on the information), I do not see how any possessor of information can be caught under a slippery slope argument.  Larry’s fears may be correct, but they are akin to a farmer being afraid of shooting the wolf attacking the sheep, because one day the farmer may start shooting his sheep, because they will start appearing similar.

Double Recovery Provides Incentives

This is one of those points where we will have to agree to disagree.  Clearly I believe what Walter Olson and other tort-reformers believe, which is that the civil justice system is out of control and rigged in favor of the plaintiff’s bar.  The idea that we need to provide more incentives to them to find meritorious lawsuits boggles my mind.  One just has to peruse the websites of most major plaintiffs’ law firms’ websites to be nauseated by the claims of the billions and hundreds of millions that they have recovered.  Awards of attorneys’ fees to plaintiffs but not to defendants is another asymmetry in the incentive to sue.  States whose judges receive campaign donations from the plaintiffs’ bar (and yes there are some states where the opposite is true) and where fraudulent joinder prevents removal to federal court; state courts that entertain the most absurd theories of liability; and the list goes on of how much the deck is stacked against defendants.  The idea that we need to give them one more set of incentives, therefore, defies logic. 

Larry’s suggestion that sanctions and disqualifying lead plaintiffs who short-sell would only work if we actually knew that the plaintiff was short-selling.  In many of the real life examples, the short-selling plaintiffs sometimes have been detected and disqualified but always escaped sanction.  And many times, they were not even detected or at least not until after the suit was over.

The quality of lawsuits will not come from making it more profitable to sue; rather it will come from reforming the underlying substantive legal principles that have been perverted by many courts.  I will address this issue later in the next section.  [As an aside, the idea that reputation effects will allow the screening of good from bad lawsuits should then apply to firms – in other words, reputational effects can also sort out the honest and dishonest firms, and there would be no need for the plaintiffs’ bar.]

Efficient Markets will Sort the Good from the Bad

Larry’s reliance on the efficient market hypothesis (EMH) is misplaced for a variety of reasons.  The idea of efficient markets does not mean perfect markets or instantaneous markets.  All that it means is that the market absorbs all publicly available information (in the semi-strong form of the EMH) so that no one is able to consistently profit (i.e. outperform the market) by devising trading strategies using publicly available information.  EMH says that the market absorbs the collective beliefs of investors, and that the stock prices will ultimately reflect this.  While EMH says that the current price may be the best predictor of what the objective value of the stock is, EMH says nothing about the market being able to be the correct predictor.  The market sometimes will not be able to assess the quality of a lawsuit if there insufficient publicly available information.  If the market could truly discern the merits of each lawsuit, there would be no need for a trial – simply look at the market reaction, and we could judge the winner of the case. 

Larry seems to take a view that there are either meritorious suits that will be won with 100% certainty or frivolous ones that will lose with 100% certainty – and hence the market can discern which one is which.  Were this the case, then my concerns would be truly misplaced.  Litigation, however, is quite random, so that even a frivolous lawsuit has a small chance of winning, and a meritorious suit has some chance of losing.  The problem, therefore, becomes one of signal to noise.  Suppose a suit is launched against a company that has a 90% chance of losing and a 10% of winning and yielding the amount claimed of $100 million.  The efficient market will still devalue the stock by the expected loss to the firm, which will be $10 million.  If the short-selling plaintiff sold-short some share of the firm’s stock (or potentially all of it if he executed a naked short sale), then the plaintiff stands to gain a portion of the $10 million.  Even though the suit is frivolous, the plaintiff can still profit.  Would a suit that only had a 10% chance of success warrant sanctions?  In some jurisdictions, where the “pure heart – empty mind” standard prevails, the answer is probably no.  It is these suits that even efficient markets will not prevent.  Furthermore, the market will also discount the legal fees that the defendant target company will have to incur.  In my example, in addition to discounting the value of the shares by $10 million, an additional $10 million in legal fees could be added to the lost stock value.  This means, that even the threat of litigation, no matter how frivolous, presents a real threat to the stock’s price.

The classic example to illustrate this is the case where Pennzoil sued Texaco for tortuous interference with contractual relations.  Texaco’s stock fell, but one would have expected Pennzoil to gain all of that loss in stock value, since any loss by Texaco would be a gain for Pennzoil.  Yet in a study by Cutler & Summers,[1] they found that during the litigation, only 1/6 of the loss by Texaco was gained by Pennzoil.  This reflected the market’s huge estimate of legal fees that Texaco would incur.  It is precisely this chasm between the losses and gains, that also make the bringing of low-quality suits even more profitable.  Low-quality suits can be brought by short-selling plaintiffs who make most of their gains not from the loss in stock value due to the claims, but legal fees.  Combing the legal fees with the expected losses from a high payout low probability suit means that even in an efficient market, short-selling plaintiffs can prosper.  Worse they prosper on low-quality suits, thereby belying Larry’s arguments against my concerns about double recovery.

Empirically, the results suggest that the market may not be able to discern which suits are meritorious, which suggests that there is a lot of randomness in determining the outcome of the lawsuits.  In a study by Pritchard and Ferris of securities fraud class actions,[2] they found that the revelation of fraud caused a large and statistically negative reaction in the market, a smaller but significant negative reaction upon the announcement of the suit, BUT no significant reaction to the judicial resolution of the motion to dismiss.  They concluded that “the outcome of litigation is not generally anticipated by stock market participants and that market returns are not influenced by the outcome of litigation.”

The reason for such findings, perhaps, is that not only is the outcome of litigation so complex and random, but all the information needed to resolve these issues may be beyond what is publicly available.  This again dents Larry’s idea that reputational effects alone will allow the bringing of high-quality suits if plaintiffs are allowed to short-sell (which they currently seem to be allowed to do).

Information is also costly to acquire, and hence not all investors can be fully informed.[3]  If information were costlessly available, there would be no need for research departments, and all information would be assessed immediately and accurately.  In fact, all the stock market manipulation schemes such as “pump and dump” and “cyber-smear” would have had absolutely no impact on the market.  So when smearers released false negative information about a company, the market should not have reacted at all.  This is the contrary of what we observe.  In fact, Larry shouldn’t worry about the slippery slope of my proposals, because any outsider who traded on non-public information would not be able to profit, since the information would have been absorbed anyway (and hence would escape sanction since there would be no unjust enrichment). 

Precisely because information is hard to gather, I am asking for the SEC to at least ascertain the magnitude of this practice.  This would add some information to the mix of what is publicly available to investors.  My proposal for disclosure by plaintiffs would also save the market the investment in ascertaining the bona-fides of every suit that the short-selling plaintiff might bring, which the empirical evidence suggests they are not currently able to do.

The existence of uninformed investors means that even a frivolous suit can be brought if coordinated with a large and wealthy short-seller.  The reason is that in the short-run (and this is all that matters for one to profit from short-sales), a large investor can move the market through aggressive short-sales, especially if the short-sales (as some recent evidence suggests) is naked.  Uninformed investors may not be able to determine whether the bad news driving the low stock price is genuine, at least not in the short-term, and the short-seller may be able to profit.[4]  This means that plaintiffs who they team up with short-sellers can actually bring more frivolous suits; for if they can induce an “artificial” drop in the stock-price, they can also induce quick settlements.  A drop in the stock price causes numerous woes for company managers.  It raises the cost of capital, which means that it is hard to raise cash and conduct day to day operations.  If this pressure can be applied on the firm to induce a settlement, the incentive to bring more meritless suits is amplified.

All of my discussion so far has been taking EMH seriously even in its weaker forms.  But if we were to relax the assumption of EMH, which the empirical evidence suggests is more likely the case,[5] than the need for my proposal becomes stronger, and at the very least, Larry’s claim that my “assumptions about litigation and the stock market are wrong” is incorrect theoretically and empirically.

Conclusions

Short-selling plaintiffs do not just possess information; they also intend to act in a way that will destroy value.  This is why my proposal is not a slippery slope, as Larry fears, for other investors that may be caught by an expansion of my rule could easily distinguish themselves on this point (information only – no action).  Additionally, because of the noisy signals litigation sends the market, the market will not make meritless suits unprofitable; rather they will encourage them.  This is true regardless of whether EMH holds or not.  Rather than resisting my call for investigation and some action to curb the plaintiffs’ bar, Larry should join me in fashioning a narrowly tailored proposal that would allay his fears of a slippery slope and that can adequately address the short-selling plaintiffs.