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February 28, 2014

Securities Class Actions: Bad for Investors, Bad at Stopping Fraud

by Lisa A. Rickard
President, U.S. Chamber Institute for Legal Reform

Next week, the Supreme Court will hear oral arguments in Halliburton v. Erica P. John Fund to determine the future of the “fraud on the market” theory, the judicially-created construct in Basic Inc. v. Levinson that is the foundation of our securities class action lawsuit system.  

If Basic is overturned, investors should cheer. Far from helping them, securities class actions destroy on average $39 billion in shareholder wealth per year while only recovering $5 billion for investors, according to a study the Institute for Legal Reform is releasing today by Navigant Consulting. 

That is a seven-to-one loss ratio. You don’t have to be Warren Buffett to see securities class actions are a bad investment.

Securities class actions do not do a good job of deterring fraud either. The Navigant research shows that, of the nearly 4,000 cases filed in the previous 19 years, only 20 went to trial and of those only 14 reached a verdict.  The rest are settled or dismissed. 

A few years ago in Madison County, Illinois, there was a story about a prolific lawyer who sued so much, that he accidentally sued himself. The story made national headlines and provided a good laugh. But the reality of today’s securities class action system is sadly similar. 

By their very nature, securities class actions are one group of innocent shareholders of a company—those who bought stock during the class period—suing another group of innocent shareholders—those who owned stock at the time of settlement.  

But there is one group that benefits: plaintiffs’ lawyers. They benefit handsomely. Last year alone, they were paid out more than $1 billion in legal fees.

A better system should compensate the victims of fraud, not create windfall profits for lawyers and target actual fraud, not expose shareholders and companies to costly lawsuits when no fraud occurred.

Scrapping the “fraud on the market” theory will not eliminate all securities suits, but would help deter those without merit. We can and must do better. The Supreme Court has the chance to move us forward in the right direction. 

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