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Larry Ribstein Archives

Selling short: response

February 27, 2006 12:47 PM

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.

Selling short: second response

March 2, 2006 7:28 AM

Moin argues, essentially, that allowing trades by lawyers and plaintiffs in advance of suing (1) violates 10b-5, and (2) allows �double recovery� of fees.

On (1), I pointed out in my previous post that these trades do not violate 10b-5 and regulating them would abandon an important principle limiting liability for trading on nonpublic information to abuse of property rights.

On (2), the double recovery argument assumes that incentives to class action lawyers are optimal in the absence of trading profits, a proposition Bruce Kobayashi and I have questioned in theory. Again, I emphasize that the issue here is not simply the number of lawsuits, but incentives relating to the quality of lawsuits.

Trading may provide such incentives because it operates through the mechanism of the efficient securities markets, which are the best available (even if imperfect) way of valuing information, including information about lawsuits. I argued in my earlier post that the problems inherent in dumping and suing, such as incentives for market manipulation, should be addressed by targeting those problems under existing laws regulating fraud and manipulation.

In his response to the �insider trading� point, Moin shifts ground. Now he wants a special SEC rule targeting dumping and suing, rather than liability under 10b-5. He still doesn�t get it. As I said the last time around, the Supreme Court interprets the securities laws as not extending to this conduct. The SEC can't change the law. Congress could if it wanted to. But then we would have abandoned a fundamental principle limiting insider trading liability, with potentially disastrous consequences for business.

Moin bolsters his argument about insider trading by claiming that by allowing these suits we�re encouraging all kinds of bad acts, akin to allowing the 9/11 terrorists to short the stock market. Here, again, he misses the point. We do not try to curb crimes � even terrorism � by restricting short selling. That�s what the criminal laws are for. Why start down this misguided road with dumping and suing?

As for the �double recovery� argument, Moin simply ignores my incentive argument, preferring to focus on the evils of the trial bar. I share his concerns about excessive litigation, which is why I think we need real and politically feasible solutions. Again, my argument about incentives was about the quality of litigation, not the quantity. Moreover, if there's too much litigation, more securities regulation is not the answer.

Moin spends a lot of time debunking the idea that efficient markets can distinguish good and bad lawsuits, which is what underlies the incentive effect of trading on lawsuits. But Moin misunderstands how efficient markets operate.

First, Moin says that if the market could discern the merits of a lawsuit, there would be no need for a trial. But the market discounts the likely result at trial or pre-trial settlement in the same way that pre-trial settlement discounts the likely outcome of the trial. Both processes operate in the shadow of the likely judgment, and neither process creates a magic remedy out of thin air.

Second, Moin says that the market can distinguish only between fully meritorious or frivolous lawsuits, nothing in-between. He doesn't explain why securities markets would be so much more helpless in the face of litigation than they are in evaluating the countless other events and characteristics that have been shown, in thousands of studies, to affect stock prices. Moin doesn�t help his case by demanding that we disregard so much financial economics.

Third, Moin points out that the market will produce a profit even for a claim in which there�s only a small chance of recovery, painting such a case as �frivolous.� So, it seems, the market can accurately value cases after all. The problem, apparently, is that the market is applying a positive value to a case that has a positive value. So what? No matter what litigation rules we have, there will be a continuous distribution of outcomes. What's the problem?

Fourth, Moin points to a study showing that a big part of the market value of litigation is costs and fees. But that�s a condemnation of our costly and wasteful litigation system, not of the market. We need to fix litigation. We are not going to fix it by eliminating dumping and suing. Instead, as I've said, we may make it worse by reducing the incentive to bring valuable lawsuits and increasing the incentive to bring �strike� suits.

After misunderstanding how efficient markets react to litigation, Moin points to how plaintiffs and lawyers can manipulate markets through short-sales apart from suing. That only emphasizes that dumping and suing is not the problem here. The problem may be market fraud and manipulation, which can and should be addressed under current law.

In short, to the extent lawyers and plaintiffs are manipulating the markets we should punish that conduct. To the extent that efficient markets reveal defects in current litigation rules, we should change those rules. We should not waste time on an ill-considered attack on the capital markets.

Selling short: final comment

March 3, 2006 10:24 AM

Thanks again to the Manhattan Institute for setting up this debate, which I've found interesting.

I don�t want to add much to this already lengthy discussion, and Moin�s last post provides little occasion to do so. He is still flatly wrong that the securities laws prohibit trading on non-misappropriated information. Moin cites the open-ended language of the applicable statute and rule but, incredibly, continues to ignore the Supreme Court�s interpretation of the statute.

(By the way, had Moin paid attention to the Court�s rulings, he might have fashioned an argument that a class action lawyer who is trading on litigation information is misappropriating information from his �client,� the class, which would provide a basis for regulation under current law. I have not analyzed that argument because Moin explicitly says in his initial post that in his view �who does the short selling is immaterial.�)

Moin also continues to assert that the market does not accurately value the litigation on which the plaintiff or his lawyer is trading. (This is relevant to my argument that dumping and suing can provide efficient incentives to plaintiffs and their lawyers.) But the well-known fact that markets reflect noise does not mean that they do not also reflect information, including information about litigation. For an analysis of the relationship between behavioral finance and market efficiency see my article, Fraud on a Noisy Market,

In the end, as I�ve said repeatedly, this debate has not been about whether there is a litigation problem, but about how to solve it. Dumping and suing alone is not the problem. At best it may provide incentives that produce higher-quality lawsuits. At worst, it reflects underlying problems with class actions. To the extent that it is accompanied by fraud and manipulation, we already have the necessary tools. It would be perverse and not a little ironic to try to deal with the problem of excessive litigation by adding a whole new area of securities regulation.

The NYT's Joe Nocera writes about "the anguish of being an analyst." The problem is that it's hard for analysts to get paid in an efficient market, where the value of information is dissipated as soon as it's used. This means, among other things, that analysts are more likely to get paid for buy recommendations than for sells. So what to do?

As discussed here, we should avoid regulation that reduces the few incentives that exist to produce valuable securities market information. Don't restrict use of nonpublic information in an elusive quest for "fairness." Get rid of Regulation FD. And if we're concerned that there's too little incentive to produce negative information, then we shouldn't attack the shorts.

Jonathan Wilson says that licensing protects the public and the courts from incompetent and immoral lawyers. Although I have proposed a limited and tentative defense of licensing based on motivating lawyers to participate in law reform, I question licensing laws designed to address the broad goals Jonathan articulates. Although licensing doubtless contributes to these goals, my questions are: how much, at what cost, and compared to what?

As for protecting clients, the problem with legal representation is that it's hard for the client to judge the lawyer, so the client needs some assurance of the lawyer�s quality. But how much assurance does a license provide? As a law professor it would be hard for me to deny that three years of law school do say something about legal competence. But passing a bar exam doesn't guarantee the lawyer�s willingness and ability years later to attend to clients' problems. A fitness investigation at the outset of a lawyer�s career is likely to reveal more about youthful indiscretions than about how the lawyer will face up to the temptations of an adult career. And keep in mind that, unlike a physician, a lawyer need not have any hands-on experience to be licensed.

Yet while a license arguably communicates little useful information, in many respects licensing sets too high a bar. How much legal history, philosophy and economics, to name a few of the subjects students learn in law school, does a lawyer need to handle a real estate conveyance, to name one of the subjects few students learn in law school?

Because all this costly learning reduces the availability and raises the costs of legal advice, licensing hurts the poor and lower income people licensing it is supposed to help. Their only recourse may be self-help. I�m reminded here of a study showing that regulation of electricians increased electric shocks to do-it-yourselfers.

And remember that lawyer licensing turns regulation of the legal profession over to, guess who, the legal profession. In other words, it creates a legalized cartel. How likely is it that lawyers themselves will come up with precisely the regulation that protects the public and no more?

There are better ways to protect clients. Big law firms provide a strong reputational "bond" (see my article, Ethical Rules, Agency Costs and Law Firm Structure, 84 Virginia Law Review 1707 (1998)). Lawyers can be certified by private organizations, including existing bar associations, which can compete with each other by earning reputations for reliability. These are market-oriented, consumer-friendly, ways of dealing with information asymmetry. Private organizations could accommodate a variety of standards, suitable for the range of clients' needs. The main regulation that would be necessary in this market regime is protection against practitioners misrepresenting their level of certification.

What about protecting the courts from the unskilled? Here�s where the anti-litigation folks like Jonathan and the free marketers like me really seem to divide on lawyer licensing. Again I�m skeptical about how much help licensing can provide. After all, abusive litigation has been brought to us by licensed attorneys. Jonathan asks how �an unlicensed attorney, perhaps with no legal training [could] distinguish between those arguments that are valid and those that are not?� The answer is common sense. Only trained lawyers could come up with, and vigorously defend in court, the legal theories and clever tactics that litigation critics deplore. We're not going to get more ethics and common sense from beginning-of-career character and fitness exams. Licensing, which turns regulation over to the very people who got us into this mess, is not likely to be the best way out of it.

There are better ways to deal with excessive litigation. We could have stricter pleading rules, or require losers to pay winners� fees. Or how about this: let anybody into court, but adopt a loser pays rule for parties that come into court represented by anything less than a lawyer with the highest possible trial certificate.

Even if only licensing would effectively deal with this problem, the licensing scheme should be designed specifically to protect the courts. Instead of requiring the same all-purpose license to handle a real estate transaction and to prosecute a billion-dollar class action, we could have a special licensing law for courtroom practice, backed by tight regulation of trial lawyers� conduct � something like the traditional barrister/solicitor distinction in the UK.

As I noted above, I don�t propose completely eliminating lawyer licensing. My limited licensing proposal would not impose high legal representation costs on those who can least afford them. Moreover, even without a broad licensing requirement, there would (I certainly hope!) be a significant demand for trained legal professionals. The difference is that the market, and not the legal profession itself, would determine the extent of that demand.

As Jonathan pointed out, the pro-licensing folks won the WSJ poll on lawyer licensing by around 60-40. That�s not an impressive win given all the lawyers and other professionals who read the WSJ. There�s a lot of discontent with lawyers. The masses are ready to storm the citadel. The time has come to contemplate the end of the lawyers' cartel.

In responding to Jonathan Wilson's latest post, I think it's useful to discuss the defects of lawyer licensing in terms of its distinct objectives.

1. Protecting clients from dishonest and incompetent lawyers.

As I said in my initial post, licensing communicates little useful information to the client and serves mainly as an entry barrier. Indeed, the exhaustive research that I did for Lawyers as Lawmakers: A Theory of Lawyer Licensing, 69 Mo. L. Rev. 299 (2004) revealed no credible arguments or data in support of the client protection rationale for lawyer licensing. Of course legal training provides important skills, as Jonathan argues in his recent post, and as I said in my post. But that doesn�t support licensing. Clients could be protected by markets, including certification by private organizations.

The challenge in defending lawyer licensing is that it's not enough to argue that licensing addresses the problem of incompetent and immoral lawyers. This is true. The question is whether legally enforcing the lawyer cartel does a better job than markets alone would � a much more dubious proposition.

Jonathan says the poor and middle class will be hurt if they can hire unlicensed practitioners. But, again, there�s no evidence that licensing is a cost-effective remedy for this problem.

I can�t guarantee that the legal profession and journalists won�t demand regulation when the inevitable horror stories occur. But that�s an argument for appropriate skepticism about such demands, not for regulation.

2. Protecting against abusive and irresponsible litigation.

As I argued Monday, there is no reason to believe that our current licensing system protects against excessive litigation. Anybody with a grievance can find somebody to argue it. I suggested some possible reforms, but whether they would work or are politically feasible is tangential to the present debate.

3. Enforcing ethical rules.

The legal profession has been notoriously lax at disciplining itself. Bribing litigants, as alleged in the Milberg case, is serious misconduct (though I don�t think the nuclear option against the firm is appropriate). Where was the state bar? Where, indeed, is Eliot Spitzer? Even with lawyer licensing we had to rely on federal criminal prosecutors. Moreover, as I�ve argued in Ethical Rules, Agency Costs and Law Firm Structure, 84 Virginia Law Review 1707 (1998), ethical rules often disable the very market mechanisms that could provide real protections.

4. Ensuring that lawyers fulfill their obligations to the public, as by monitoring corporate clients.

The appropriate extent of such obligations is an open question, in my view. In any event, since the bar has refused to impose meaningful obligations in this regard, we now have SOX 307.

5. Giving lawyers incentives to engage in lawmaking.

This is the argument I made in my lawyer licensing article. Some would say that if licensing encourages lawyers to make law, that�s a reason not to have licensing, given lawyers� perverse effects on the law. I agree that this argument for licensing is a close call. In any event, even if I�m right, this argument supports only a limited licensing requirement for high-end law practice, mainly for transactional lawyers. It would not impose significant constraints on the availability of legal services for the poor and middle class.

* * *

Having said all that, I�m hardly sanguine about the prospects for meaningful reform of our current system, supported as it is by our most powerful interest group. Nevertheless, I support Jonathan�s recommendation of a blue ribbon commission. However, I would argue that we need a commission focused on problems in the market for legal services, not just one for abusive litigation. The commission I have in mind would be explicitly tasked with analyzing the functions of lawyer licensing, and whether it is fulfilling its goals. The case for such a commission is made, in my view, by concerns about excessive litigation and by significant changes in the markets for legal services and the functions of lawyers. These changes should prompt a reexamination of our more than 100-year-old system that the profession, on its own, would be unlikely to undertake.

This is the final post in the featured discussion. Thanks to Jonathan and the folks at the Manhattan Institute for making it all possible.

In my last post, I listed supposed problems in the legal marketplace that lawyer licensing is supposed to deal with, and summarized why it is at best a flawed response to these problems.

Jonathan persists in his claims that mandatory licensing would work better than the market, but has no support for those claims other than repetition. I can only again point to my lengthy article on the subject cited in early posts and repeat that the absence of mandatory regulation does NOT mean that there would be no mechanisms for dealing with these problems, but only that they would be dealt with through a competitive market rather than by the lawyer�s cartel.

Jonathan asserts in response to my argument that licensing inflates the price of legal services that, in fact, lawyers charge a wide variety of prices, and it�s not clear lawyers are �overpriced;� that legal services �don�t seem to be that expensive;� that �I often see a line at the counter at McDonald�s. I�ve never seen a line outside a lawyer�s office. I would be interested to see alternative data but my experience tells me there is no shortage of legal services in the marketplace and therefore no effective cartel created by lawyer licensing;� and that �I can see no evidence that lawyer licensing is driving up the cost of legal services. Legal services of the kind often purchased by the poor and the middle-class seem to be readily available at more-or-less reasonable prices.�

I would prefer a more scientific approach to the problem. I don't know what the �right� price for lawyers is. We have markets for that. What is the �length of line� test supposed to prove? Those who can�t afford a lawyer are not waiting at the lawyer�s office � they�re doing without the advice.

I do know that reducing the supply of something usually raises the price. Ideally this would invite more supply, unless it�s restricted by a licensing law. The law of supply and demand suggests that the price is higher given licensing than it would be without regulation. I suspect that an unregulated market would look very different at the lower end, maybe not so different at the higher end. The big question is whether the higher prices are worth it, which gets back to the value of licensing.

As for evidence, the best measure of the economic effect of lawyer licensing that I�m aware of is Dean Lueck et al., Market and Regulatory Forces in the Pricing of Legal Services, 7 J. Reg. Econ. 63 (1995). They show no correlation between barriers to entry (e.g., bar passage rates) and the price of legal services, but they do show a correlation between sets of regulatory barriers and lawyer earnings. A detailed analysis of this paper is in my article.

There is a lot of analysis of the discriminatory effects of licensing laws: Milton Friedman, Occupational Licensure, in Capitalism and Freedom 137, 150-51 (1962); S. David Young, The Rule of Experts: Occupational Licensing in America, 75-80 (1987); Richard B. Freeman, The Effect of Occupational Licensure on Black Occupational Attainment, in Occupational Licensure and Regulation 1 (Simon Rottenberg ed., 1980) at 165; Benjamin Hoorn Barton, Why Do We Regulate Lawyers?: An Economic Analysis of the Justifications for Entry and Conduct Regulation, 33 Ariz. St. L.J. 429, 444 (2001); Walter Gellhorn, The Abuse of Occupational Licensing, 44 U. Chi. L. Rev. 6, 18 (1976).

Josh Wright, over at Truth on the Market asks:

"I am curious as to the state of the empirical evidence with respect to lawyer licensing and its impact on consumers. If I recall, the Federal Trade Commission has recently been involved in some advocacy efforts in favor of limiting the scope of unauthorized practice of law statutes. My sense is that a number of states must have relaxed unauthorized practice of law restrictions (I think Arizona is one), or similarly relaxed restrictions on lawyer licensing, such that one could directly test the impact of these restrictions on consumers in terms of prices and quality of service. There must be work on this somewhere. My quick Google search did not return anything right away, but does anybody know of empirical work in this area?�

Good questions. Joyce Palomar, The War Between Attorneys and Lay Conveyancers�Empirical Evidence Says �Cease Fire!�, 31 Conn. L. Rev. 423 (1999) found little evidence of risk to the public from lay providers of real estate settlement services. But there�s obviously a lot more work to be done. Fred. S. McChesney & Timothy I. Muris, The Effect of Advertising on the Quality of Legal Services, 65 A.B.A. J. 1503 (1979) and Advertising and the Price and Quality of Legal Services: The Case for Legal Clinics, 1979 Am. B. Found. Res. J. 179 found that a legal clinic using advertising in high-volume practice reduced costs without compromising quality.

There�s obviously a lot more empirical work to be done.

This gets to Jonathan�s question about �transition� to a market regime. Actually, it would be a fairly simple matter for states to simply decide to allow people to do what they previously couldn�t do. Most of the adjustment would be for the previously protected class of lawyers.

But that doesn�t mean we shouldn�t proceed carefully, and our federal system allows us to do just that. Jonathan decries the fact that �With 50 separate state regimes to manage, policy-makers would either have to endure a decades-long transition in which some states deregulated and others didn�t or there would have to be some kind of nationwide, federally-mandated deregulation that trumped state law. How would that work? How could it work?�

In fact, these separate regimes are a blessing, not a curse. With 50 (actually, 51) different regulators we have an opportunity to test how reforms actually work, as Josh Wright suggests. This sort of test doesn�t have to wait � and indeed shouldn�t wait � for some �blue ribbon commission� to complete its work. I don�t see a problem with such a commission, as I said before, but the best possible commission is the formidable laboratory enabled by our federal system. The time to start is now.