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"Capital Complaints"

AEI's Peter Wallison in the Wall Street Journal on Sarbanes-Oxley and securities class actions:

Foreign companies are still coming to the U.S. to raise funds, but much less so in the public securities markets where class-action liability lurks. In 2006, for example, for the first time, more equity financing was raised in private transactions under the SEC's Rule 144A ($162 billion) than was raised in IPOs on the NYSE, Nasdaq and the Amex combined ($154 billion).

So what are the benefits of the class-action litigation system? Precious little. Companies are often compelled to settle meritless class actions in order to avoid even more costly legal fees and drains on management time. Class actions do not always punish the actual wrongdoers, who are often indemnified by their companies or covered by insurance. And with recoveries averaging 2% to 3%, class actions don't even compensate the people who actually suffered losses--the defendant company's settlement is in effect a transfer to the complainants and their lawyers from the innocent long-term shareholders of the company. Perhaps most significant of all, a single successful class action judgment could result in the destruction of one of the Big Four auditing firms--a catastrophic loss for the global financial community.

With so little to recommend them, why have securities class actions survived for so long? One reason may be a misperception that they are part of the pattern of the securities laws. Some people even think of them as constitutional rights. But this is wrong. A private right of action under Rule10b-5 was created by a court in 1946, and since then Congress and the Supreme Court have been trying unsuccessfully to place some limit on them. (Congress has authorized private rights of action under some sections of the securities laws, but not for the section on which Rule 10b-5 was based.)

Yet the odd mystique of this costly compensation system lives on. Despite all the reports indicting securities class actions, only Mayor Bloomberg and Senator Schumer called for more than a mere study: "The SEC," they said "should make use of its broad rulemaking and exemptive powers to deter the most problematic securities-related suits."

It's doubtful that the SEC will pick up this baton, but even if it did history shows that courts cannot discipline themselves to distinguish effectively between the well-founded suits and the "problematic" ones. The only solution is restoring what Congress originally intended--enforcement of Rule 10b-5 only by the SEC. The fact that a Democratic senator has stepped forward to press this issue should encourage those who know what the problem is but have thus far been reluctant to address it.

Wallison has more detail in the March Financial Services Outlook.



Rafael Mangual
Project Manager,
Legal Policy

Manhattan Institute


Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.