Unfortunately, this system of private securities litigation is nowhere near
as good as it should be or used to be.
In the late 1980s and early 1990s, as a result of a mass of securities
frauds in Silicon Valley and in the Drexel Milken world and in the S&L's,
there were hundreds of securities law private class action suits against
managers, directors, lawyers, and accountants. The recoveries in these cases
were in the tens of billions. The accountants were called to account and
hated it. Their insurers on their malpractice policies hated the suits. So
did Silicon Valley.
The defendants did a smart cost-benefit analysis. They figured out that they
would be better off if they got new laws to hinder lawsuits against them
than if they actually went to the immense trouble of doing their work
properly. It was far cheaper to pay campaign contributions to Congress than
to forgo their freewheeling ways. So money was paid, promises were made, and
the law was changed in 1995. The Private Securities Litigation Reform Act,
possibly the most anti-capitalism law ever passed in Congress since the New
Deal, greatly cut down on the rights of shareholders. Powerful restraints
were put in place about discovery, who could sue, who could represent
shareholders (and sometimes bondholders), and how one would prove a case
against malfeasors of great wealth, as one might say. The ability of
shareholders to keep control over their own capital and their own managers
was greatly hindered.
We now see a part of the result: massive fraud in the tech sector, and giant
super fraud at Enron and Global Crossing. (At least as I see it in my humble
opinion.) The human heart did not change. The calculus changed, though.
Managers knew it would be very hard to sue them, and they ran wild at
companies far bigger than any that had been in securities fraud trouble
since the Depression.
As we saw when Krugman peddled this story, the facts are otherwise:
The above Stanford Law School site gives the following figures for number of
1991 -- 164
1992 -- 202
1993 -- 163
1994 -- 231
1995 -- 188
For the 5 years following passage of the legislation Krugman claimed, "made
such suits far more difficult", and Ben Stein now says;
"Powerful restraints were put in place about discovery, who could sue, who
could represent shareholders (and sometimes bondholders), and how one would
prove a case against malfeasors of great wealth, ...."
the numbers are:
1996 -- 110
1997 -- 178
1998 -- 236
1999 -- 209
2000 -- 216
AND, for the year 2001 the number was 486 (more than double any year
None of my letter would be news to readers of sci.econ, but here's Stein's
<< Ben Stein replies: The answer to this is that it is to be expected that
there would be an increase in fraud claims after a spectacular stock bubble
and its bursting. The numbers by themselves without reference to what was
happening in the world outside, where fraud had become a commonplace, are
<< And of course one expects anti-shareholders comments from Stanford Law
School, where major anti-shareholder sentiments are rooted in certain
faculty members. >>
Of course, Stein provided no numbers (or any other evidence) in his original
article, to support his claim:
> The defendants did a smart cost-benefit analysis. They figured out that
> would be better off if they got new laws to hinder lawsuits against them
> than if they actually went to the immense trouble of doing their work
> properly. It was far cheaper to pay campaign contributions to Congress
> to forgo their freewheeling ways. So money was paid, promises were made,
> the law was changed in 1995.
The truth being that there was overwhelming support, and for very good
reasons, for what was known as Dodd-Domenici in the Senate, and as the Cox
Bill in the House (even Clinton, in his veto message, said he favored the
Here is a fascinating chronology of how that bi-partisan bill came to be:
Prior to 1988, shareholders had to demonstrate the specific information they
relied on was fraudulent and specify the losses they incurred as a result of
their reliance on that information. That was until the Supreme Court
decision re: Basic v. Levinson, a case which centered on corporate
disclosure obligations during pre-merger negotiations and the truth of those
In that decision the Court embraced a concept called 'fraud on the market',
saying that financial analysts played a key role in gathering and
interpreting information from a company and that information was ultimately
reflected in the company's stock price. In effect, the Court said that
investors, in order to participate in class action cases, did not have to
demonstrate reliance on specific corporate information but need only rely on
the stock price.
This opened the gates for securities class action suits to be filed on the
basis of a precipitous drop in stock price (usually in the 10% range or
more) as preliminary evidence that the company had provided fraudulent
information to investors. The allegation was usually that the company made
optimistic public statements and knew the statements were incorrect or the
statements had became invalid and the company failed to publicly correct or
Since the drop in stock price became the trigger, plaintiffs' attorneys,
particularly those firms specializing in these suits, would file within
hours of a precipitous drop in stock price, making general allegations of
fraud with the expectation that they could later prove fraud during the
discovery process. Also, allegations of insider trading were usually thrown
in whereby the plaintiffs hoped to show, also during discovery, that key
executives traded on the knowledge that the stock was worth less than what
was reflected in the market.
Moreover, these firms had stables of professional plaintiffs who owned a few
shares in a number of companies and would lend their names to be used, often
without their immediate knowledge, as the named class plaintiff. Moreover,
they were often paid a bounty for the use of their name. These were suits
initiated by plaintiffs' attorneys for the benefit of plaintiffs' attorneys.
It was also important to be the first to file since the lead attorney
received more of the settlement fees than the lawyers who subsequently filed
on behalf of their plaintiffs.
And, here's Arthur Levitt on how the PSLRA of 1995 corrected for these and
other abuses by Krugman's and Stein's (and Pat Leahy's and Ralph Nader's)
Most of the interaction between the SEC and Capitol Hill
centered on the bill's safe harbor provisions. Our goal was to
encourage companies to provide more meaningful forward-looking
information to the market by affording them greater protection.
At the same time, if a call was close, we tried to err in favor of
plaintiff investors, in view of the important role they have
traditionally played in policing fraud our markets.
As finally adopted, the general safe harbor applies only to
companies that are subject to SEC reporting, and to people who are
making statements on behalf of such a company or on the basis of
information provided by such a company. It doesn't apply to
initial public offerings or partnership offerings. It doesn't
apply to tender offers or going-private transactions. It doesn't
apply to often-problematic penny stock or blank check companies,
or to companies that have been found to have violated the
securities laws within the past three years. It doesn't apply to
financial statement information. These exclusions, as well as some
others I didn't mention, ended up in the legislation because the
SEC asked for them.
The safe harbor provision underwent several critical changes.
In earlier drafts, a company that offered any reasons their
projections might not materialize would have gained the protection
of the law. We felt this was a formula for fraud. The final
version, as you know, generally requires that companies identify
important reasons why their projections might fail to come true.
The additional requirement that the disclosure be "meaningful"
should work to discourage the omission of important information.
I also note that the safe harbor doesn't provide any protection
from SEC enforcement action. And nothing in the safe harbor
permits misrepresentations or omissions about existing facts.
Where do we go from here? The Private Securities Litigation
Reform Act of 1995 is now the law of the land. If it succeeds,
investors can expect two distinct benefits: more and better
forward-looking information coming into the marketplace from public
companies, and less shareholder assets siphoned away by meritless
litigation. This would be a very positive achievement in behalf
of American investors. Of course, only time will tell whether the
bill will achieve the aims set out by its authors.