Taking Certification Seriously - Why There is No Such Thing as an Adequate Representative in a Securities Fraud Class Action

Securities fraud class actions (SFCAs) arising under Rule 10b-5 are well established as a feature of the legal landscape, but they are a vestige of a largely outdated view of investor behavior and preferences. In the 1960s, most investors were undiversified stock pickers. Today, most investors hold stock through well diversified institutions. As a result, most investors are net losers from SFCAs. Moreover, it is arguable that it is irrational for most investors not to be diversified. A passive investor who fails to diversify assumes unnecessary risk for the same expected return that diversified investors enjoy. Given that federal securities law is intended to protect reasonable investors, it follows that it should be interpreted and applied consistent with the interests of diversified investors where the interests of diversified and undiversified investors diverge. For a diversified investor, gains and losses from securities fraud net out over time. But they lose to the extent of attorney fees and they lose when they are holders (which is most of the time) to the extent that defendant companies must compensate purchasers. In short, diversified investors would prefer that SFCAs be abolished. The one exception arises when insiders gain from the fraud such as by selling their shares before the release of bad news. But the appropriate remedy in such a case is a derivative action by which the company recovers from the wrongdoers. The thesis here is that the courts should decline to certify securities fraud actions as class actions under FRCP 23 because of the conflicting interests of class members. Undiversified stock pickers - usually a minority of the plaintiff class - may favor SFCAs. But many diversified investors - particularly those who follow a portfolio balancing strategy - would prefer that the courts refuse to certify such actions as class actions because such investors usually lose more on stock they hold than they gain on stock they bought during the class period. To be sure, many diversified investors (including institutional investors) engage in some stock picking (although some such as index funds eschew it altogether). Such an investor might favor certification of actions in which he has bought a large amount of the subject stock during the class period relative to preexisting holdings even though the same investor would favor the abolition of SFCAs generally. Moreover, not even a strict portfolio balancing investor who would oppose certification because she loses more on stock she holds than she gains on stock she bought would dare to opt out of the SFCA if it is certified. Thus, it does no good for the courts to rely on investors to vote with their feet. Investors who opt out of the action effectively pay those who stay in by forgoing compensation for their losses. The bottom line is that the courts should refuse to certify securities fraud actions as class actions unless it is shown that the plaintiff class is composed wholly of undiversified investors. If the action involves allegations that insiders have somehow gained from the fraud or that the corporation itself has been damaged by the fraud, the action should proceed as a derivative action. And given that a derivative action is a form of class action, it is quite clear that the courts have the power under FRCP 23 (and FRCP 23.1) to recast any purported SFCA in such terms. This is not to say that individual investors should not continue to have standing to sue under Rule 10b-5. Indeed, an investor who seeks to gain control or influence over a target company is likely to be undiversified. If such an investor suffers a fraud in connection with his purchase of target stock, he has standing to sue the wrongdoers if he can make out a claim. Nor does the argument here imply that there is a fundamental problem with remedies under the 1933 Act. In essence, the 1933 Act provides for disgorgement by issuers in cases in which they have effectively misappropriated capital from the market by false pretenses. Similarly, in the context of an SFCA under Rule 10b-5 in which insiders have gained from misappropriation (such as insider trading) during the fraud period or have visited loss on the issuer by damage to reputation or otherwise, the appropriate remedy if for the issuer to seek compensation. In other words, the approach advocated here is wholly consistent with the general scheme of federal securities law.