We Have a Consensus on Fraud on the Market—And It’s Wrong

James C. Spindler is Sylvan Lang Professor of Law at University of Texas Law School; and Professor, University of Texas McCombs School of Business. This post is based on a forthcoming article by Professor Spindler. Related research from the Program on Corporate Governance includes Rethinking Basic by Lucian Bebchuk and Allen Ferrell, discussed on the Forum here.

Fraud on the market litigation has faced existential challenges in recent years, fueled by a broad academic policy consensus that it “just doesn’t work.” This consensus has, in large part, focused on two theoretical critiques of private securities litigation, the “diversification critique” and the “circularity critique.” The diversification critique holds that potential fraud losses to investors may be eliminated through diversification: an investor will lose from fraud on some trades, but gain on others, and this ought to even out in the end. [1] The circularity critique argues that, since plaintiffs are typically shareholders of the defendant firm, the fraud on the market remedy amounts to shareholders suing themselves, achieving no meaningful compensation, and merely shifting money from one pocket to the other. [2]

These critiques have flourished among academics, and have found their way into policy papers, court opinions, Congressional testimony, and even the recent Halliburton pleadings. Clearly, if fraud does not harm investors (diversification), and fraud on the market remedies do not compensate them anyhow (circularity), the implications for reform are vast and profound. These critiques are arguably the most important innovations in theoretical securities law of the past quarter century.

However, as discussed in a forthcoming article, [3] the diversification and circularity critiques are themselves fatally flawed. They should be abandoned, and the reform proposals springing from them rethought.

The diversification critique reflects a fundamental mistake as to what diversification can and cannot do: neither expected losses to better-informed traders, nor resources expended to avoid such expropriation, can be diversified away. Consider the case where two investors, a seller and a buyer, are deciding whether to transact a share of stock whose price is uncertain. If neither of the investors has an informational advantage over the other, then each may expect to be a winner as often as a loser—and, indeed, here the diversification critique appears to be correct. However, suppose that one of the investors has the ability to expend resources investigating the share’s true value (“precaution costs” or “search costs”): this will provide her with a better estimate of the firm’s value, and she can refuse to buy/sell when the share is overpriced/underpriced. In this case, she (the “informed trader”) has positive expected gains, and her counterparty (the “uninformed trader”) has positive expected losses. This would be true no matter how many independent iterations of the game occur—that is, even in a diversified setting, the informed trader expects to win on average, and the uninformed expects to lose. Further, the best response of the uninformed trader may be to engage in precaution costs himself: expend resources becoming informed, abstain from trading, or pay a securities professional to manage his money. In reality, these costs are substantial. [4] This is a form of Prisoners’ Dilemma or collective action problem. These precaution costs are socially inefficient, and of course they do not diversify away.

The circularity critique fails because, as it turns out, the fraud on the market remedy is compensatory and, under plausible conditions, is perfectly compensatory. Just as a non-pro-rata dividend transfers wealth among shareholders, so too does the fraud on the market remedy provide a net transfer to the plaintiff class. Further, the fraud on the market remedy accounts for the degree to which plaintiffs fund their own recoveries, and automatically adjusts via the stock price. While the paper derives a complete mathematical solution, consider here the following example: Suppose that of a firm’s 10 shares outstanding, 2 shares are held by a fraud on the market plaintiff. If the fraud inflated the firm’s value by $1, a first cut would estimate a per share recovery of $1 (for $2 total). However, the anticipation of paying out $2 causes all shares (including plaintiff shares) to decline by another $0.20, so that the total payout will be $2.40, which increases the decline, and so on. This process asymptotes to a total payout of $2.50, which restores the plaintiff to the status quo ante. [5] Hence, compensation of defrauded plaintiffs is complete. This is important, not just because the circularity critique is wrong, but because a compensatory remedy reduces or removes the incentive to engage in precaution costs in the first place. Hence, fraud on the market is potentially, in theory, a valid way to avoid a Prisoners’ Dilemma of precaution costs and restore the social optimum.

What are the lessons to be drawn from this? First, the diversification and circularity critiques should be abandoned because they are, simply, wrong. Second, the trend of cutbacks and existential challenges fueled by these critiques should be rethought. Even if there are problems with securities litigation as it currently exists, it is important to understand correctly what those problems are—which, as scholarship currently stands, we do not.

The full article is available for download here.


[1] The following is representative of the diversification critique: “For every shareholder who bought at a fraudulently inflated price, another shareholder has sold: The buyer’s individual loss is offset by the seller’s gain, investors can expect to win as often as lose from fraudulently distorted prices. With no expected loss from fraud on the market, shareholders do not need to take precautions against the fraud; they can protect themselves against fraud much more cheaply through diversification. Losses from the few fraudulent bad apples will be offset by the gains from the honest companies.” Adam C. Pritchard, Evaluating S. 1551: The Liability For Aiding and Abetting Securities Violations Act of 2009: Hearing Before the Committee on the Judiciary, Subcommittee on Crime and Drugs of the United States Senate, September 17, 2009 at 3-4.
(go back)

[2] The circularity critique takes various forms; a fairly strong form was stated by the so-called Paulson Committee. “[Securities class action] recovery is largely paid by diversified shareholders to diversified shareholders and thus represents a pocket-shifting wealth transfer that compensates no one in any meaningful sense and that incurs substantial wasteful transaction costs in the process.” Interim Report of the Committee on Capital Markets Regulation, Section III, November 30, 2006, at 79 (available at http://capmktsreg.org/wp-content/uploads/2014/08/Committees-November-2006-Interim-Report.pdf).
(go back)

[3] James Cameron Spindler, We Have a Consensus on Fraud on the Market—And It’s Wrong, forthcoming Harvard Business Law Review 2017, (available at http://ssrn.com/abstract=2781578).
(go back)

[4] One conservative estimate of fund management fees alone puts them at over $600 billion. See Charles M.C. Lee, Eric S. So, Alphanomics: The Informational Underpinnings of Market Efficiency, 9 Foundations and Trends in Accounting 59, at 80—81 (2015).
(go back)

[5] The derived formula is that the per share remedy equals the per share fraudulent price inflation (here, $1) divided by 1 minus the proportion of plaintiff shares (here, 20%).
(go back)

Both comments and trackbacks are currently closed.