Securities fraud class-actions are down. In an op-ed in yesterday’s WSJ, Joseph Grundfest observed that both the number of such actions and the dollar value of total damages claims have dropped dramatically since mid-2005. Why has this decline occurred? Grundfest considers several possible reasons.
First, the decline might be due to the criminal prosecution of Milberg Weiss, the leading securities fraud plaintiff firm. Grundfest rejects that explanation:
[T]here is no shortage of plaintiff class-action lawyers in America, and the barriers to entry in class-action securities fraud are quite low. The lawyers who abandoned Milberg in droves haven’t forgotten how to file class action complaints, and their incentives to sue every firm in sight remain as strong as ever.
Next, Grundfest considers whether the decline is due to recent “strong equity markets, combined with low volatility.” He rejects that explanation because “the change in the litigation market is rather sudden in comparison to a relatively smooth shift in the larger stock market patterns” and because “current activity levels are low even when measured by pre-boom standards” (i.e., even when compared to levels preceding the boom-bust period of the late 1990s).
Finally, Grundfest considers a theory he deems more plausible: there are fewer securities fraud class actions because there is less fraud, and there is less fraud because the government (post-Enron, WorldCom, and Sarbanes-Oxley) has more effective tools for prosecuting fraud:
From this perspective, class-action securities litigation is in decline because there is a new, tougher and superior enforcement mechanism in place. The SEC and the Department of Justice now insist that any corporation suspected of a sufficiently serious fraud conduct an internal investigation that will finger the executives responsible. The corporation must also cooperate in prosecuting these executives. This enforcement technique is stunningly effective, if often overbearing. It eliminates the government’s need to conduct expensive and lengthy investigations and provides the authorities with extraordinary leverage over every executive suspected of wrongdoing. Private litigation doesn’t have an equivalent deterrent effect because it can’t threaten executives with jail and because damages are almost always paid by corporations and insurers, not the executives who cause the fraud.
I’m wondering what others think about this theory. It would be interesting to see whether both accounting fraud and non-accounting fraud claims have decreased by similar proportions. The recent government enforcement efforts have been focused on accounting fraud, so if we’re seeing a greater decrease in accounting fraud claims than in non-accounting fraud claims, then Grundfest’s “supply side” story may be plausible. If non-accounting fraud claims have been decreasing by a similar proportion, then it would seem the decrease should be attributed to something else.
In any event, I’d be reluctant to infer from Grundfest’s statistics that increased prosecutorial activity is desirable. I’d echo Larry Ribstein’s query:
Does the dip in securities litigation suggest that the corporate criminal prosecutions have been worth these costs? … [E]ven if we do have less fraud to litigate, I’d wonder whether it’s been worth the price. Do we have less risk-taking? A zero fraud world is not necessarily paradise.
Grundfest, of course, is well-aware that stepped up prosecutorial activity can have serious negative effects. Not too long ago, he wrote eloquently about the downsides of such prosecutorial activity in the New York Times. Some highlights:
The Supreme Court has overturned Arthur Andersen’s conviction for obstruction of justice in the Enron case. But to Andersen, the court’s ruling doesn’t matter, the original trial at which it was convicted didn’t matter and the verdict at any coming trial won’t matter. Andersen was destroyed when it was indicted.
… Andersen’s demise did serve as a stern reminder to corporate America that prosecutors can bring down or cripple many of America’s leading corporations simply by indicting them on sufficiently serious charges. No trial is necessary.
… Prosecutors are aware of their power, as are potential corporate defendants. Both sides have therefore reached an entente cordiale in which no major corporation has been forced out of business since Andersen’s demise. Instead, corporations have entered into deferred-prosecution agreements, paid huge penalties, and undertaken fundamental internal reforms, all under conditions that allow the corporation to survive.
… The upside of this arrangement is clear. Corporations now have an even more powerful incentive to abide by the law, to root out wrongdoing, and to cooperate with governmental authorities. Unbridled prosecutorial discretion will not end fraud in corporate America, but wrongdoing will certainly decline as executives learn that they are expendable if a prosecutor simply threatens the corporation.
… The downside is just as clear. The prosecutor’s decision to indict is largely immune from judicial review. The prosecutor acts as judge and jury. Traditional due process safeguards, like the right to confront witnesses, can’t protect the potential corporate defendant. The innocent can therefore be punished as though they are guilty, and penalties imposed in settlements need not bear a rational relationship to penalties that would result at a trial that will never happen.
