A Brief (and Partial) History of Securities Litigation

Most legal scholars who have focused on securities fraud class actions seem to agree that such lawsuits ill-serve both investors and issuers. Since most investors are diversified, they have little need for such a remedy. And because the settlement (if any) is paid by the corporation-thus causing stock price to decline further in most cases the deterrent effect is both misplaced and excessive, chilling voluntary disclosure. To understand how we ended up with this dysfunctional system-and perhaps how to fix it-this article traces the evolution of federal securities law and private civil actions thereunder from the Securities Act of 1933 to Rule 10b-5 of the Securities & Exchange Act of 1934 and beyond. Although it is tempting to look for some unique decision or event-a wrong turn that explains everything-the truth tends to be messy. There are several factors that led us to where we are today. It would be an exaggeration to call it a perfect storm. It is more accurate to see it as the result of a series of seemingly minor events with bizarre cumulative consequences. Nevertheless, there is one central misconception at the heart of the problem: That investors should be compensated when they buy (or sell) at a price affected by misinformation emanating from the issuer. To be sure, the 1933 Act permits an investor who purchases securities directly from a corporation to recover from the corporation if there is a material misstatement of fact in the prospectus. In other words, the corporation is required to give back the money. In contrast, Rule 10b-5 is a catch-all anti-fraud rule that applies to all trading in securities-including trades in which the corporation itself does not participate. The crucial mistake was extending the narrowly tailored remedy under the 1933 Act-disgorgement by the corporation-to situations in which the corporation itself is neither seller nor buyer. As will be seen, this error was the result of a series of court decisions, which seem quite sensible when considered one at a time. Moreover, the effect of these decisions was compounded by changing procedural rules relating to class actions and derivative actions that interacted with substantive law. Taken together these missteps have led the law horribly astray.