The Irrationality of Shareholder Class Action Lawsuits: A Proposal for Reform

Abstract

This article examines shareholder class actions and offers a proposal for reforming this area of litigation. After describing the nature and dynamics of these lawsuits (see Part II), the article in Part III outlines the criticisms of shareholder class actions. These criticisms take two basic forms, one of which mirrors those made against class action lawsuits in general, and another which is unique to shareholder lawsuits. As to the former, shareholder class actions often result in relatively trivial payments to the class members, while plaintiffs' lawyers receive millions of dollars in fees; and the class members have virtually no say in the conduct of the lawsuit or the terms of any settlement. As to the latter type of criticism made against shareholder class actions, the lawsuits often contain an inherent irrationality, at least from the standpoint of the plaintiffs themselves. The lawsuits are brought by stockholders against their own corporation. Since any settlement basically comes out of the shareholders' own assets, accompanied by an extremely high transaction price in the form of lawyers' fees, the lawsuit can actually yield a net negative return to the class members.

Evidence suggests that shareholder class action litigation results more from a company's stock price movements than from the actual commission of fraud by the corporation. The connection between stock market movements and shareholder class action filings is discussed in Part IV, as are various studies analyzing the underlying merits of such lawsuits.

In Part VI, a reform proposal is offered, which aims to take advantage of the unique role that shareholders occupy vis-à-vis the corporation. Most other class actions involve plaintiffs who have no legal or economic connection to defendants. Most, for instance, involve lawsuits brought by consumers against the manufacturers of allegedly defective products. In shareholder litigation, however, the plaintiffs are the owners of the defendant corporation, and hence in a unique position to remedy past misdeeds of the corporation and to deter future wrongdoing. Recognizing that shareholder class actions have failed to produce any real compensatory relief to injured investors and that such actions can actually have negative effects on shareholders, the reform proposal offered in Part VI concentrates exclusively on the goal of deterring future securities fraud.

Keywords: Shareholder Class Actions, Direct Actions, Derivative Actions, Shareholder Reform, Corporations, SEC, Private Securities Litigation Reform Act

JEL Classification: G30, G34, G38, G39, K20, K22, K29