Re-Evaluating Holder Actions: Giving Defrauded Securities Holders a Fighting Chance

INTRODUCTION On November 8, 2001, Enron admitted that it had overstated its profit by more than half a billion dollars over the previous five years. (1) For many months leading up to this admission--and even the day of--the vast majority of securities analysts, relying on the fraudulent information provided by Enron, had recommended buying or holding Enron's stock. (2) Less than a month after investors learned the truth about Enron's financial condition, the company filed for Chapter 11 bankruptcy. (3) While the destructive fallout from Enron's collapse is difficult to overstate, perhaps no one suffered more direct and palpable harm than those who relied on Enron's fraudulent misrepresentations and invested in the company. (4) Enron's shareholders included not only independent individual and corporate investors, but also those who held shares in mutual funds--which widely invested in Enron (5)--and thousands of Enron employees, who had significant portions of their retirement savings tied up in Enron stock and held in their 401 (k) accounts. (6) Thousands of Enron investors turned to the judicial system for relief, bringing class action suits to seek redress for the losses they suffered because of Enron's fraud. (7) While these actions initially achieved a considerable amount of success, (8) later efforts at recovery were thwarted by recent developments in federal law, leaving countless defrauded shareholders with little recourse. (9) The problem largely centers on the existence and application of the "purchaser-seller rule," or the Birnbaum rule, in federal law. (10) Originally articulated by the Second Circuit in Birnbaum v. Newport Steel Corp. (11) and later endorsed by the U.S. Supreme Court in Blue Chip Stamps v. Manor Drug Stores, (12) the rule holds that a person who is neither a purchaser nor a seller of securities may not bring an action under the Securities and Exchange Commission's (SEC) Rule 10b-5. (13) In other words, a company's fraudulent misrepresentation regarding its financial condition must induce the plaintiff to either purchase or sell that company's securities in order for the plaintiff to have standing to sue under federal securities law. (14) This rule was intended to prevent various problems believed to be inherent in securities fraud suits that are not tied to a specific transaction. In establishing the rule, courts primarily feared "strike suits'' (15) or vexatious litigation brought for the purpose of forcing an inequitable settlement as well as conjectural or speculative claims. (16) While the rule may have been the product of good intentions, its effect has been to severely limit meritorious "holder" causes of action--that is, actions where the shareholder-plaintiff alleges that the defendant's misrepresentation induced him to continue holding his stock when he would have otherwise purchased or sold and seeks to recover for the diminished value of the stock suffered as a result. (17) Since holders of stock are neither purchasers nor sellers for purposes of Rule 10b-5, (18) the Birnbaum rule and subsequent judicial and congressional actions have deprived countless numbers of shareholders of redress for their injuries. And while the injuries suffered by holders do not stem directly from an induced purchase or sale of stock, they are no less palpable. In the case of Enron, the company's stock traded near ninety dollars per share at its height in August 2000--when the company was artificially inflating its stock prices through fraudulent statements (19)--but by December 2002, after the fraud had been disclosed, the price fell to just over six cents. (20) For long-term stockholders who had invested significant portions of their wealth in the company, Enron's fraudulent scheme was devastating. (21) While many of the concerns that courts have expressed about holder actions are legitimate, (22) the dangers of such actions are largely overstated, and as this Note will show, taking away holders' right to sue creates far greater dangers and potential for injustice. …