Markets as Monitors: A Proposal to Replace Class Actions with Exchanges as Securities Fraud Enforcers

Fraud in the securities markets has been a focus of legislative reform in recent years. Corporations-especially those in the high-technology industry-have complained that they are being unfairly targeted by plaintiffs\u27 lawyers in class action securities fraud lawsuits. The corporations\u27 complaints led to the Private Securities Litigation Reform Act of 1995 ( Reform Act ). The Reform Act attempted to reduce meritless litigation against corporate issuers by erecting a series of procedural barriers to the filing of securities class actions. Plaintiffs\u27 attorneys warned that the Reform Act and the resulting decrease in securities class actions would leave corporate fraud unchecked and deprive defrauded investors of compensation, thereby undermining investor confidence in the markets. Despite these dire predictions, however, after a brief initial decline securities fraud class actions are now being filed in greater numbers than before the passage of the Reform Act. Reform efforts thus continue. The President recently signed legislation preempting state securities class actions, which were thought to be avenues for circumventing the Reform Act\u27s restrictions. The principal target of reform has been class action lawsuits against corporations. Such lawsuits are based on misstatements by corporate officers that distort the secondary market price of the corporation\u27s securities. In these so-called fraud on the market cases, plaintiffs\u27 attorneys sue the corporation and its officers under Rule 10b-5 of the Securities Exchange Act. They sue on behalf of classes of investors who have paid too much for their shares or (less frequently) sold their shares for too little because of price distortion caused by the misstatements. In the typical case, the corporation has neither bought nor sold its securities, and, accordingly, has not benefited from the fraud. Investors can nonetheless recover their losses from the corporation based on its managers\u27 misstatements. Given the volume of trading in secondary trading markets, the damages recoverable in such suits can be a substantial percentage of the corporation\u27s total capitalization, reaching the tens or even hundreds of millions of dollars. Advocates of reform contend that risk-averse managers are too anxious to settle such suits, even when the suits have little merit. Settlement is attractive because it allows managers to avoid personal liability by paying the claims with the corporation\u27s money. My argument is that we should stop attempting to reform fraud on the market class actions and instead replace them with organizations better suited to the task of antifraud monitoring. In this Article I analyze the social costs created by fraud on the market and the roles of compensation and deterrence in reducing the costs of fraud. I argue that compensation does not play an important role in controlling those costs. Accordingly, a rational investor would not willingly pay for the compensation provided by the class action regime if deterrence could be achieved at a lower cost through alternative means. The lower-cost alternative that I propose is antifraud enforcement by the securities exchanges where the trading affected by the fraud took place. The primary social cost of fraud on the market is less trading by investors who seek to avoid being on the losing end of a trade that occurs at a fraudulently distorted market price. The reduction in liquidity caused by lower trading volume most directly harms broker-dealers, who depend on trading and trading commissions for a substantial portion of their revenues. Broker-dealers hold a property right in their exchange memberships, which effectively makes them the residual claimants of the exchanges. Thus, the incentives of the exchanges\u27 members should push exchanges to enforce vigorously prohibitions against fraud on the market.9 Part I analyzes the causes of fraud in secondary trading markets and the social costs produced by fraud. Part II discusses the roles of compensation and deterrence in controlling those costs and concludes that deterrence, not compensation, should be the primary objective of an antifraud regime. Part II then looks at the compensatory class action regime and shows how the goal of compensation undermines the deterrent value of class actions. Part III assesses the organization and regulation of the exchanges and how they affect the exchanges\u27 potential role as enforcement monitors. Part IV outlines an alternative enforcement regime administered by the securities exchanges where the trading affected by fraud took place. Instead of paying money damages to investors, corporations--along with their managers and outside professionals--would pay civil penalties and disgorge fraudulently obtained benefits to the exchanges. Corporations and their affiliates would also be subject to injunctive relief. Part V discusses potential criticisms of my proposal based on the NYSE\u27s historical enforcement record and the implications of that history for exchange antifraud enforcement. Part VI evaluates potential alternatives to my proposal. Finally, a brief Conclusion summarizes the main advantages of exchange antifraud enforcement