The Brief: Law School News and Events

A Call for Reform of Securities Laws to Address Class-Action Lawsuits Over Stock Prices

The Honorable Lewis A. Kaplan, Judge Kaplan derided the Securities litigation in this country Securities litigation in this country has become a horse race, replete with "stables of stockholders" craving loss compensation and lawyers jockeying to represent them in court.

That was the verdict of the Honorable Lewis A. Kaplan, U.S. District Judge for the Southern District of New York, in the Distinguished Jurist Lecture hosted by the Institute for Law and Economics in October. Kaplan discussed securities class-action lawsuits — suits filed by groups of stockholders who believe their company fraudulently exaggerated the worth of its stock before it took a plunge — which are controversial because of their enormous cost and high settlement rate.

In his address at the Law School, Kaplan did not promote or condemn securities class-action lawsuits as a whole, but took a more nuanced approach: examining the purposes of such suits and the current system for adjudicating them, then evaluating how well that system has achieved its aims.

Poorly, it turns out. Kaplan derided the "ad hoc way in which we have jerryrigged a system for dealing with the securities law," and issued a call for reform.

For a start, the current system doesn't seem to be adequately compensating stockholders for their losses.<.

Kaplan cited estimates that plaintiffs in securities class-action suits recover, on average, $1 for every $15-50 they allege to have lost — and that's before legal fees, which usually eat up one-third of funds recovered by the lawsuit.

Not only does settling usually leave plaintiffs with underwhelming rewards, Kaplan said, but valid suits "almost inevitably" end in settlements. Since plaintiff lawyers are only paid on recovery of funds, they have an incentive to settle as soon as possible with the company, rather than take a case to trial where they risk losing and not getting paid at all. Kaplan calls this the "bird in the hand over two in the bush" phenomenon, and suggested changing the pay structure to make the lawyers' fee better reflect the amount recovered by the plaintiffs themselves.

An underlying problem with the whole system, Kaplan concluded, may be the concept that it relies on: the "efficient market" hypothesis. According to that paradigm, the prices of stocks reflect all relevant information about a company, and so rational investors won't buy stocks that are unreasonably priced. But according to Kaplan, the hypothesis has been proven wrong. Many studies show that stock prices don't always accurately reflect their value — and that rational investors will buy stocks they think are overpriced if they are confident the price will continue to rise.