The prevailing view among securities regulation scholars is that
compensating victims of secondary market securities fraud is
inefficient. As the theory goes, diversified investors are as likely to
be on the gaining side of a transaction tainted by fraud as the losing
side. Therefore, such investors should have no expected net losses from
fraud because their expected losses will be matched by expected gains.
This Article argues that this view is flawed; even diversified investors
can suffer substantial losses from fraud, presenting a compelling case
The interest in compensation, however, should be advanced by better
means than are currently in place. The present system relies on
securities class action lawsuits to compensate victims, but these suits
not only undercompensate victims, but also underdeter fraud. To improve
compensation and better deter fraud, this Article explores the creation
of an investor compensation fund. Under this proposal, when a share of
stock is sold in the secondary market, a fee, payable by the selling
shareholder, will be placed into a fund for fraud victim restitution.
The size of the fee will vary by the fraud risk rating assigned to the
firm whose stock is sold and, naturally, will affect that stock's
trading price. Therefore, firms will have incentives to institute
corporate governance practices that minimize the likelihood of fraud.
In 1985, Frank Easterbrook and Daniel Fischel, in an influential
article, asserted that active traders with diversified portfolios are as
likely to be on the gaining side of a transaction tainted by securities
fraud as on the losing side. (1) Therefore, diversified investors should
have no expected net losses from fraud because their expected losses
will match their expected gains. (2) The idea of compensation for
securities fraud losses has been under attack in the legal academy
virtually ever since this article was published. Though Easterbrook and
Fischel ultimately argue against ending compensation for securities
fraud losses, (3) scholars, nevertheless, have used Easterbrook and
Fischel's insight to decry the provision of securities fraud
compensation as inefficient and to promote reforms that would eliminate
it from the securities regulation regime. (4) In 2005, the U.S. Chamber
of Commerce Institute for Legal Reform commissioned an empirical study
to test the theoretical assertion that securities fraud risk can be
diversified away. The study purported to find that large diversified
institutional investors generally break even on their investments in
firms accused of fraud. (5) The study captured mainstream media
attention, (6) reflecting the importance of the issue to the business
community and the public more broadly.
This Article challenges the idea that fraud compensation for
investors is not warranted. All investors, including diversified
investors, can suffer substantial injury from securities fraud, and
because there is measurable harm from fraud, there is a basis for
granting compensation to its victims. This Article also contends that,
as a practical matter, political exigencies make achieving the end of
shareholder compensation in the post-Enron era unlikely. Therefore, what
is most appropriate at this time, in my view, is an exploration of ways
to provide compensation more effectively and efficiently.
The current compensatory mechanism, the securities class action
lawsuit, has important shortcomings. Defrauded shareholders currently
rely primarily on class actions (so called "fraud on the market
suits") filed against corporations and corporations' officers
and directors for compensation for securities fraud losses. However,
these suits provide limited compensation. The average securities fraud
settlement award is trivial in relation to shareholder losses, with
recovery of as little as 2%-3% of estimated damages. (7) Shareholder
losses stemming from fraud at a large firm with actively traded stock
can total billions of dollars, easily dwarfing the amounts available for
shareholder compensation from current sources, i.e., payouts under
directors' and officers' (D&O) liability insurance
policies, company funds, and, occasionally, the personal resources of
officers and directors. Moreover, not only do fraud on the market suits
provide minimal compensation, but they also do a poor job of deterring
fraud. These suits often allow the perpetrators (e.g., corporate
officers) to evade personal responsibility by settling such suits, with
no admission of wrongdoing, using the corporation's money or the
proceeds of D&O insurance policy payouts. (8) This seriously
undermines the purported deterrence effect of such lawsuits on corporate
To improve compensation and better deter fraud, this Article
explores the creation of an investor compensation fund (ICF). Under this
proposal, fraud on the market suits will be eliminated, and a special
purpose insurance fund will be created to provide investor restitution
for fraud-related losses. Every time a share of stock or similar
security is sold in the secondary market, a fee (premium) will be
collected from the selling shareholder and placed into the fund. A
firm's fraud risk rating, reflecting the likelihood of fraud
occurring, will determine the size of the fee to be paid by each selling
shareholder. The ICF premium feature acts as a fraud deterrent because
the size of the ICF premium will be reflected in a company's share
price, providing incentives for managers to institute the control
mechanisms necessary to minimize the likelihood of fraud. The ICF also
offers the promise of a large source of funding for defrauded
In addition to setting forth a reform proposal, this Article makes
another contribution to the literature. Exploring the creation of an
investor compensation fund provides an opportunity to consider the
advantages and disadvantages of ex ante (9) (i.e., regulation through
the use of fraud risk ratings) and ex post (i.e., litigation) approaches
to limiting harm from securities fraud. There are costs and benefits to
both approaches to managing the securities fraud problem. The ICF, with
elements of both approaches, can be used as a vehicle to highlight some
of the more salient issues and tradeoffs in this area.
The Article proceeds as follows. Part II addresses what, given the
current state of securities regulation scholarship, is likely to be one
of the principal objections to the ICF Proposal by responding to the
argument against compensation for securities fraud losses. The section
does not include a full discussion of all of the considerations relevant
to compensation for securities fraud losses, but rather outlines
responses to those who argue that such compensation is unnecessary. Part
III of the Article briefly examines the securities class action
mechanism and describes its shortcomings. Part IV sets forth the ICF
Proposal and addresses potential objections and key implementation
challenges. Creation of the ICF, though in all likelihood an improvement
over the current regime as a theoretical matter, would entail
significant implementation and administrative challenges. This Article,
by design, does not address fully all of these challenges, but rather
suggests what the primary concerns about implementation of a proposal of
this type might be. Finally, Part V of the Article considers several
alternative reform proposals. After reviewing these proposals, it should
become clear that the ICF is not as unorthodox as it may seem initially.
All of the proposals are in some respects similar to the ICF and have
attractive features. However, in comparing these schemes to the ICF, one
will be able to recognize the unique advantages of the ICF and its
ability to provide superior compensation to securities fraud victims and
II. RESPONSE TO THE ANTI-COMPENSATION ARGUMENT
Many leading scholars oppose the idea of compensation for
securities fraud losses. The following statement, made by Janet Cooper
Alexander in a well-known article, is representative of the prevailing
Under this theory, active traders with diversified portfolios will
benefit as often from securities fraud as they will be harmed by it.
Therefore, investors should have no expected overall losses from
securities fraud, making efforts to provide compensation inefficient.
Under the capital asset pricing model (CAPM), investors receive
compensation (investment returns) only for bearing systematic risks. A
systematic risk is a risk that affects almost all stocks trading on the
market to a greater or lesser degree (e.g., inflation, interest rates,
general economic conditions). An unsystematic, or idiosyncratic, risk,
on the other hand, is a risk that affects one or a small number of
stocks trading on the market (e.g., a failed product launch, the loss of
a key executive). Under this model, proper diversification virtually
eliminates an investor's exposure to unsystematic risk and thus is
a prudent investment strategy.
The argument set forth by those who oppose compensation for
securities fraud is not merely that fraud risk is idiosyncratic, like
many other business risks, and hence can be largely eliminated by
diversification. Their claim is different. They suggest that, with
respect to securities fraud risk specifically, the risk of loss from
fraud is, on average, equal to the prospect of gain from fraud elsewhere
(not just a gain from any other type of business occurrence). (11) The
focus by compensation opponents on the purported equality of gains and
losses, rather than diversification generally, serves as a tacit
acknowledgement that securities fraud risk is different in kind from
other types of business risks and that its effects should be considered
separately. (12) Indeed, securities fraud risk is different. Even
risk-seeking investors who intentionally fail to diversify feel
legitimately cheated by securities fraud. Investors understand that the
market entails risk and that some investment decisions will lead to
losses. However, buying a stock while fraud is ongoing disadvantages an
investor in an unfair way. Fundamental company analysis is meaningless
when the information upon which that analysis is based is fraudulent.
Those who oppose compensation for securities fraud losses
effectively assert that, on average, investors are not harmed by fraud
on the market. This is a type of corrective justice argument, though
generally not expressed as such. (13) Corrective justice requires
compensation in the face of harm. (14) Thus, even if it were true that,
in the aggregate, gains and losses from fraud are equal, (15) there are
a number of instances in which this will not be true for any individual
investor. (16) The examples that follow illustrate that securities fraud
can cause substantial injury to investors of all types. Compensation,
therefore, is justified to make these investors whole.
A. Asymmetries Stemming from the Market's Reaction to Fraud
The losses of the investors on the losing side of trades tainted by
fraud are more likely to exceed the gains of the investors on the
winning side of such trades, without regard to diversification or
trading activity. While fraud is ongoing, but before it is revealed,
investors who sell fraud-tainted stock have an "improper" gain
equal to the sale price of the stock minus the price at which the stock
would trade in the absence of fraud. At the time of the trade, the
investor that buys the fraud-tainted stock has an equivalent unrealized
loss in the form of overpayment. However, when the fraud is revealed,
the price of the stock generally does not decline only to where it would
have been in the absence of fraud. Instead, the stock declines further,
as the market discounts the price of the stock for the uncertainty
surrounding what additional bad news may be forthcoming from the
company. (17) There is a fundamental asymmetry here. Under this
scenario, for gains and losses from fraud to be equivalent over time, an
investor has to find herself on the winning side of fraud-tainted trades
more, by dollar volume, than she finds herself on the losing side. Being
on either side in roughly equal proportions is not sufficient to avoid
net overall losses.
Even if the market's response upon the fraud disclosure is a
temporary overreaction, compensation for loss is still justified. It may
be true that if the market overreacts to the news of fraud by lowering
the stock price too much, then investors who purchase at the excessively
low price are achieving a gain. This result then leads to a situation
where shareholder gains and losses again are equal in the aggregate.
However, the type of investor that decides to sell upon a fraud
announcement because of fears of additional bad news to come is of a
different type than the speculative trader who buys the stock precisely
at that moment because she believes she is receiving a bargain. The
shareholder who sells after the fraud revelation suffers harm, and the
gain of the speculative trader does not diminish that harm in any way.
B. The Potential for Loss is Substantial for all Investors
There is empirical evidence that demonstrates that, in any
individual case, even large, diversified investors can suffer
significant net harm from securities fraud. In 2005, the U.S. Chamber of
Commerce Institute for Legal Reform, a vocal foe of the current
securities litigation regime, (18) commissioned an empirical study (the
"U.S. Chamber Study") to test the theoretical assertion that
aggregate trading gains and losses from fraud, over time, are
equivalent. The authors of the study, which review trades over a
ten-year period, find that large, diversified institutional investors
(19) have an average (median) fraud-related net trading loss of $5
million ($0.25 million). (20) The authors acknowledge the potentially
devastating effects of securities fraud on undiversified investors, (21)
but conclude the theoretical assertions of the anti-compensation camp
are correct--over time, net losses from securities fraud for large,
diversified investors will be approximately zero. However, the U.S.
Chamber Study, while purportedly providing evidence that compensation
for securities fraud is unnecessary for large, diversified investors,
finds results that are telling: even large, diversified investors can be
large net losers from securities fraud.
The data reproduced in the U.S. Chamber Study show that several
large institutional investors suffered significant trading losses during
the ten-year study period. Though one investor (out of 2,596) enjoyed a
net gain of over $200 million, 18 investors suffered net losses
exceeding $200 million. (22) Eight of these 18 investors had net losses
exceeding $500 million, and one investor suffered a net loss of over $1
billion. (23) No investor enjoyed gains exceeding $300 million. (24)
These findings are significant because the U.S. Chamber Study, which
purports to describe trading gains and losses from every securities
fraud case involving common stock,25 shows that even professional
investors with large, diversified portfolios can find themselves on the
losing side of trades tainted by fraud more often than on the winning
side and incur net losses of $1 billion or more over a ten-year period.
Thus, if the study's authors are correct, not only is it possible
for gains and losses to fail to be exactly equivalent or even
approximately equivalent over time, they can be significantly different.
The existence of losses of this magnitude ($5 million on average or as
much as $1 billion) suggests that securities fraud risk is
significant--too significant for a prudent investment manager to ignore.
Indeed, potential uncompensated losses of this magnitude can lead to
allocative efficiency losses, as investors expend resources attempting
to guard against the harm from securities fraud. (26) Specifically,
these traders will spend time ferreting out information related to fraud
risk, at the expense of gathering information that bears on company
fundamentals (e.g., sales growth potential and market competition). (27)
Even diversified investors want to avoid being on the losing side of a
trade tainted by fraud (28) and will take the necessary steps to achieve
Of course, if the U.S. Chamber Study is correct, for large,
diversified institutions, expected net losses from fraud should be
approximately zero, even if reality can differ and differ substantially.
If the managers of institutions believe the findings of the U.S. Chamber
Study (i.e., believe that gains and losses, over time, will be equal)
and act rationally, eliminating compensatory mechanisms for securities
fraud loss would have no effect on their behavior. We would expect to
see no resources expended by such investors to guard against the harm of
uncompensated (ex post) losses because they have no reason to believe
that their outcomes will differ from the average. However, managers of
institutional investors do not always behave rationally. (29) This
suggests that these managers indeed will engage in what some may term
inefficient behavior by expending resources to minimize their downside
exposure. No manager wants to suffer large investment losses of any
sort, including from fraud, regardless of any gains from fraud she
unknowingly may have enjoyed in the past or may enjoy in the future. In
fact, because of loss aversion, (30) investors are likely to be far more
worried about fraud losses than they are pleased by the prospect of
fraud gains. Loss aversion applies in many contexts, but it is
reasonable to conclude that its effect would be magnified in the
securities fraud context because the investors that achieve
"gains" do not know they are receiving a gain at the time they
receive it and, indeed, may never realize it.
C. Buy-and-Hold Investors are Likely to Suffer Significant Harm
from Securities Fraud
The fraud losses of buy-and-hold investors, even those who are well
diversified, are likely to exceed any gains from fraud. (31) Those who
assert that expected gains and losses from fraud over the long-term will
be approximately equal assume active trading. (32) This is because one
must sell stocks with prices that are inflated by fraud as often (by
approximate dollar volume) as one buys stocks with prices that are
inflated by fraud. Alexander, a proponent of the anti-compensation
argument, acknowledges that the purported offsetting of fraud-related
gains and losses is a reflection of "statistical
probabilities." (33) As Alexander states, "The more trades
that are made and the more diversified the investments, ... the more an
individual's experience is likely to approach the statistical
mean." (34) Thus, if an investor is risk averse (which is generally
the case), she will want to reduce the variance (a measure of the extent
to which potential outcomes may differ from expected returns) and have
her actual outcome be as close to the expected outcome as possible. (35)
This is achieved by active trading, rather than holding a constant
portfolio, no matter how well diversified. (36) Thus, the only way for
an investor to "protect" herself from being a "net
loser" from securities fraud is not only by diversifying, but also
by trading frequently.
Imagine the extreme case of the buy-and-hold investor that buys,
but never sells (i.e., she holds the stocks in her portfolio until
infinity). If this investor purchases a stock with a price that is
inflated by fraud, the amount of this overpayment will never be recouped
by a gain from selling a stock that also has an inflated price. This
investor never sells. It is, of course, somewhat unrealistic to speak of
an investor that never sells stock. Liquidity needs prompt virtually
every investor to sell some stock eventually. However, the net buyer
(rare seller) is not likely to have equivalent gains and losses from
fraud. Thus, it is clear that this type of investor, who is following a
rational investment strategy, is not going to be economically
indifferent to the incidence of fraud. (37)
The evidence suggests that the typical buy-and-hold investor is a
retail investor. (38) Therefore, retail investors are more likely to
suffer harm from securities fraud than institutions because individuals
generally trade less frequently than institutions. Though annual market
turnover exceeds 100%, (39) suggesting highly active trading in the
market overall, one survey of 2,187 retail investors conducted by the
Investment Company Institute and the Securities Industry Association
found that 60% of these investors did not trade at all in 2004; 57% of
those that did trade made fewer than six trades that year. (40) Other
studies have found similar levels of trading activity among retail
investors. (41) Though they trade infrequently, retail investors,
according to a 2000 report on share ownership by the New York Stock
Exchange (NYSE), directly own approximately 40% of the value of U.S.
stocks (42) and therefore comprise a significant portion of the
investment community. Therefore, the assumption of active trading is not
a valid one for a meaningful segment of the investor population.
One could argue that, even if active trading is required to
eliminate the risk of securities fraud, we simply could encourage retail
investors not only to diversify, but to diversify and trade frequently.
However, doing so would have adverse consequences. Frequent trading is
costly for retail investors, and not only because of transaction costs;
(43) there is evidence that frequent trading leads to lower overall
returns for such investors. (44) In addition, for at least the past 70
years, financial economists have warned against the risk of excessive
trading and have worried that investors focused on achieving short-term
gains through speculation would hinder the primary purpose of the market
(i.e., allocating capital to American businesses). (45) So, were
compensation for securities fraud discontinued, investors, in effect,
would have incentives to trade more, perhaps more than is justified by
company fundamentals, in order to sell some "lemons" to others
and protect themselves from the risk of fraud. (46)
D. The Undiversified Investor Has a Legitimate Claim to Protection
There is no question that undiversified investors can suffer
substantial harm from securities fraud. Despite the oft-repeated call to
diversify, many retail investors in the United States do not hold
well-diversified portfolios. According to the most recent Survey of
Consumer Finances published by the Federal Reserve Board, almost 60% of
individual investors (households) surveyed hold stock in three or fewer
companies, and approximately 35% hold stock in only one company. (47)
Another study of retail investor diversification finds similar results
and shows not only that individuals invest in low numbers of stocks, but
also that even those individuals investing in larger numbers of stocks
invest in the wrong mix of stocks for sufficient diversification. (48)
In this study, the researchers find no evidence that retail investors
make up for their lack of diversification by mutual fund or
"safe" investing elsewhere, (49) suggesting the figures
reported, in all likelihood, accurately reflect the lack of
diversification in the United States. Though reasons for the lack of
diversification vary (50) and may be economically irrational, the
reality is that many retail investors, who as a group directly hold over
40% of the value of U.S. stocks, are not well diversified. Thus, even if
being diversified would make one as apt to be on the winning side of a
trade tainted by fraud as on the losing side, this would not be the case
for many retail investors who simply are not diversified. Thus, failing
to provide compensation for securities fraud losses would harm a large
segment of the investment community and could discourage more widespread
participation in securities markets. (51)
One of the fundamental tenets of our legal system is that when
someone is harmed by the misconduct of another, she should receive
compensation for her loss. The commission of securities fraud can lead
to real human suffering, primarily in cases where retail investors are
not properly diversified and lose virtually all of their savings because
of an investment in a company engaging in fraud. Richard Booth, in
accord with the conventional wisdom in this area, argues that the law
should provide no compensation to investors for fraud-related losses.
(52) According to Booth, "it is irrational for an investor not to
diversify," (53) and diversified investors, in the absence of
insider trading, will suffer no harm from securities fraud. (54)
Therefore, because "[s]ecurities law should protect only reasonable
investors," (55) no compensation for securities fraud losses is
As previously discussed, not only the undiversified or irrational
are harmed by securities fraud; even diversified investors can suffer
measurable harm. However, even if it were the case that only investors
who failed to diversify adequately could suffer fraud-related losses, it
does not necessarily follow that compensation is not warranted. When
corporate officers commit fraud by intentionally misleading shareholders
who lose money on their investments, the investors have a legitimate
claim to be made whole, without regard to whether they could have
self-insured against the loss by diversifying. (56)
E. Political Considerations
Even if one remains unconvinced of the necessity or appropriateness
of compensation in this context, it seems clear that current political
exigencies make achieving the end of shareholder compensation unlikely.
The 1995 Republican-led Congress enacted, over President Clinton's
veto, sweeping reforms to the securities class action system through the
Private Securities Litigation Reform Act (PSLRA) in an effort to make
securities fraud suits more difficult to bring and win. (57) However,
despite the broad nature of the reforms, neither the PSLRA, nor any
proposed legislation leading up to passage of the PSLRA, eliminated or
even substantively reduced the compensation available for fraud losses.
(58) This suggests that Congress may have been far from enamored with
securities litigation, but still saw some value in providing damages for
losses, or found it politically unviable to limit them. If Congress in
1995 was unwilling to abolish compensation, it is unlikely that any
post-Enron era Congress would consider doing so. If Congress declared an
end to compensation for victims of securities fraud, there undoubtedly
would be expressions of outrage from investors. The economic arguments
against investor compensation would not be able to withstand the ensuing
political pressure amid the public demand for justice. (59) Thus, in my
view, it is appropriate for securities regulation scholars to consider
ways to provide compensation effectively and efficiently.
III. SECURITIES CLASS ACTIONS
In the prior section, I argue that compensation is a necessary
feature of securities regulation. However, the primary means of
providing compensation to defrauded shareholders, the securities class
action lawsuit, is largely ineffective. (60) Under Rule 10b-5 of the
Securities Exchange Act of 1934 (the "Exchange Act"), (61)
private litigants may sue a corporation and its officers and directors
for securities fraud if the private litigants either purchased or sold
securities during a period when fraud affected the price of the
securities. These so-called "fraud on the market" suits,
however, provide limited compensation for fraud-related losses.
According to Cornerstone Research, the average securities fraud
settlement award in each of 2006 and 2005 represented only 2.4% and
3.1%, respectively, before plaintiffs' attorneys' fees, of
estimated shareholder damages. (62) Despite the small recoveries, the
securities class action provides more compensation for investors than
any other means. The Securities and Exchange Commission (SEC) itself
concluded, "private litigation [rather than SEC enforcement action]
remains the best mechanism for investor recovery of losses." (63)
This is an unfortunate fact, indeed, given the small amounts available
for investor restitution.
The low level of compensation to the shareholder class is driven in
part by the nature of the insurance market. Damages in securities fraud
cases equal the difference between the price paid (64) for the share of
stock and what the price would have been in the absence of fraud,
multiplied by the number of shares traded while the fraud is ongoing.
(65) For a large firm with actively traded stock, these damages can
total billions of dollars. For example, 18 (out of over 90) of the
securities litigation cases settled in 2006 had estimated damages, as
defined by Cornerstone Research, of over $5 billion; half of these cases
had estimated damages exceeding $10 billion. (66) Though there are
notable exceptions, (67) research shows the overwhelming majority (96%,
by one estimate) of securities class actions settle within D&O
insurance policy limits. (68) Corporations cannot afford the premiums
on, and insurers are not willing to offer, policies with liability
limits that even would begin to approach the total measure of damages in
large-scale fraud cases. (69) In fact, there is evidence that insurers
generally do not offer policy limits in excess of $300 million. (70)
Therefore, the limits imposed by the D&O insurance marketplace
generally preclude full compensation for investor losses. (71)
Not only are fraud on the market suits ineffective at providing
meaningful compensation, they are also largely ineffective at deterring
fraud. The securities class action supplements the efforts of the SEC
and the U.S. Department of Justice (DOJ), the two government agencies
tasked with securities regulation and anti-fraud enforcement, and serves
as an additional fraud deterrent. On the surface, given the relative
pervasiveness of securities class action suits, one would think they
would be effective fraud deterrents. (72) According to NERA Economic
Consulting, within a five-year period, the average public company has a
6.4% chance of being named a defendant in a securities class action.
(73) Thus, such suits, particularly given their sometimes high profile
nature, occur with sufficient regularity to capture the attention of
corporate managers. (74)
However, the reality of securities class actions is different from
their promise. (75) These suits suffer from several deficiencies brought
on by the incentives of the plaintiffs' attorneys and the corporate
managers that control the course of the litigation. Plaintiffs'
attorneys, who, as independent entrepreneurs, are primarily motivated by
the size of the potential recovery and attorneys' fees, bring and
largely manage fraud on the market suits. All things being equal, the
potential recovery in a class action lawsuit involving a large firm with
actively traded shares is likely to exceed the recovery in a case
involving a small firm with thinly traded stock. Thus, securities class
actions can underdeter small firms because such firms are less likely to
face suit. (76)
In addition, fraud on the market suits often allow wrongdoers to
evade financial responsibility. The typical class action lawsuit is
settled. During the settlement process, the claims against the officers
and directors are settled along with those of the corporation.
Settlement agreements often are structured such that there is no finding
of intentional wrongdoing by the corporate officers, thus preserving the
officers' eligibility for D&O insurance coverage. (77)
Therefore, as stated by Adam Pritchard, "managers [may] avoid
personal liability by paying the claims with the corporation's
money." (78) Empirical evidence shows that corporate officers
rarely contribute to settlements, and when they do contribute, there are
special circumstances surrounding such agreements (e.g., the defendant
corporation is judgment proof because it has declared bankruptcy, the
D&O insurance is inadequate or has been rescinded due to fraud in
the application, or individual defendants agree to contribute to the
settlement to receive a reduced jail sentence or avoid indictment). (79)
This state of affairs significantly undermines the deterrence benefits
that could flow from securities class actions. (80)
Finally, conducting securities litigation is costly. In securities
fraud class actions, though judges and lead plaintiffs monitor attorney
awards, studies have shown that plaintiffs' attorneys' fees
can equal from 16% to 32% of class recovery. (81) These figures, while
high, do not take into account the additional costs exacted by the
system, including defense attorneys' fees, (82) litigation
expenses, court costs, as well as lost productivity of the defending
corporation while the litigation is ongoing. (83) In addition, these
suits consume significant judicial resources. (84) According to data
collected by the Federal Judicial Center, from July 1, 2001--June 30,
2006, securities class actions represented approximately 30% of all
class actions filed in federal court and were the largest single
category of class actions. (85) Moreover, due to their complexity,
securities class action suits demand a great deal of judicial time and
attention. (86) As John Coffee says, "[S]ecurities class actions
[because of their impact on the federal court system] are essentially
subsidized by the U.S. taxpayer, and thus, they raise the question of
whether society is receiving an adequate return on its investment."
(87) Therefore, though there are compelling reasons to provide
compensation for securities fraud victims, the securities class action
is an inefficient way to do so.
IV. THE INVESTOR COMPENSATION FUND PROPOSAL
This Article proposes eliminating fraud on the market suits (88)
and explores the creation of an investor compensation fund to better
achieve not only the compensatory, but also the deterrence goals of
securities regulation. This Article is not intended to, and does not,
address all of the many considerations that accompany a major overhaul
of the U.S. securities regulation regime. It is not possible to address
all potential concerns in a single piece. The purpose of this Article,
thus, is to suggest that, despite challenging administrative and
implementation issues, creating a compensation fund is worthy of serious
consideration. Though I will outline some of the primary issues in Part
IV.C., infra, I leave to future work a consideration of solutions to
some of these challenges. (89)
B. The Proposal
Under the ICF Proposal, a newly created division of the SEC (the
"ICF Division") will administer an investor compensation
system, whose funding will come from assessments on equity securities
transactions. Every time a share of stock of, or similar security (90)
related to, a U.S. listed corporation is sold in the secondary market
(except sales made by exchange specialists and market makers), (91) the
selling shareholder (92) will pay a fee, set as a percentage of the
dollar value of the sale transaction (the "ICF premium"), that
will be placed into a fund to be used for investor restitution in the
event of losses from securities fraud. Selling shareholders will not pay
these fees directly to the ICF Division; instead, the ICF Division will
collect the fees in the aggregate from the securities exchanges and
associations where the transactions occur in a manner similar to that
currently employed for collecting Section 31 fees. (93) All funds
collected will be pooled; there will be no individual company accounts.
No selling shareholders will receive a refund of any amounts deposited
into ICF, even if no shareholder of a particular company ever makes a
claim for recovery. (94) Participation in the ICF scheme will be
mandatory for public corporations and investors.
The size of the fee paid upon sale will vary by underlying
corporation and depend on a corporation's fraud risk rating. An
independent, private fraud risk rating agency (95) that has been
designated by the ICF Division will be tasked with generating fraud risk
ratings for each corporation traded in the United States. Each year,
(96) the designated rating agency will examine the governance and
disclosure-related business practices of companies under review,
specifically considering factors such as a company's internal
control processes, history of fraud investigations or government
enforcement actions, and ICF damage payouts. The ICF Division also will
require input from a firm's auditor and D&O insurer on some of
the "soft factors" related to corporate governance. (97) The
fraud risk rating given will reflect the rating agency's assessment
of whether the appropriate safeguards are in place to minimize the
chances of securities fraud occurring. (98)
Currently, a similar government designated rating agency mechanism
is employed with respect to credit rating agencies. Since 1975, the SEC
has recognized a select number of credit rating agencies as
"Nationally Recognized Statistical Rating Organizations"
(NRSROs). (99) The ratings from these agencies not only provide guidance
to debt securities investors, but also are used as benchmarks for
investment quality and safety in a number of federal and state laws and
regulations. (100) Though not without its critics, (101) this agency
designation process serves as a long-standing example of private actors
performing a function that furthers the government's regulatory
ICF premiums will be set at level equal to (1) a fixed percentage
of expected fraud-induced losses plus (2) an assessment for fund
administrative expenses. (102) No corporation's related ICF premium
will be zero. (103)
The assessment of differing ICF premiums on sales of stock is
designed to deter fraud. Lower fraud risk ratings will result in lower
premiums paid by selling shareholders, while shareholders of companies
with a history of fraudulent activities or a lack of mechanisms to
prevent such occurrences will pay higher premiums into the ICF. Imposing
a fraud risk-related fee every time an investor sells a share of stock
will be reflected in a company's stock price. Corporate managers
are extraordinarily focused on share price, (104) and, under the ICF
Proposal, managers will have ample incentive to maintain the best fraud
risk rating possible. Investors will know the ICF premium before the
purchase of securities, so they generally will be able to factor a
company's ICF premium into their investment decisions. (105)
The dollar value of premiums collected will vary with market
activity, so predicting the amount collected and, hence, the amount
market participants will pay is difficult, as many factors affect market
activity. However, assuming recoveries equal to 75% of provable losses,
(106) and based on the level of market transactions in 2006, (107) a
weighted average premium of approximately 0.035% will be required to
provide recovery for victims of securities fraud. (108) Thus, for
example, if a shareholder sells 100 shares of Company XYZ stock at $20
per share, the total premium to be paid into the ICF from this trade is
$0.70 (100 shares * $20/share * 0.00035). Using 2006 trading volume and
estimated damages (109) in securities class actions filed (with an
assumption that 50% of these suits (by dollar volume) are
meritorious),110 total ICF collections would have been $15.3 billion in
The ICF holds the promise of providing significant additional
compensation for securities fraud losses, well in excess of the limited
compensation (as little as 2%-3% of losses) available today. However,
shareholders will continue to bear some risk of loss. As is the case
with most insurance, the recovery from the ICF will be equal to less
than 100% of provable losses. The specific level of investor recovery
will be determined by techniques similar to those employed in other
insurance contexts (112) that will attempt to strike the proper balance
between the benefits of preventing an investor from losing almost
everything on an investment, on the one hand, and maintaining incentives
for the investor to monitor the companies in which she invests, on the
The ICF Division will determine the amount of shareholder recovery
in individual cases. Operating similarly to other government agencies,
(114) the ICF Division will not act on its own initiative to investigate
secondary market securities fraud, but instead will respond to charges
filed by the SEC's enforcement division or by defrauded
shareholders holding, either individually or in combination with other
shareholders, a minimum ownership of 1% of the outstanding equity of the
company in question for a minimum of one year. (115) The minimum
ownership requirement will ensure that those bringing charges have a
significant stake in the corporation. (116) Because it is unlikely that
any one retail investor will hold a 1% stake in a public company,
generally institutions will be the only stockholders with the
independent power (i.e., not as a part of a group) to initiate
proceedings. The managers of such institutions, as sophisticated
businesspeople, are unlikely to file charges that lack merit. (117) In
addition, the ICF Division will have the power to assess appropriate
penalties for investors that submit claims that are later shown to lack
any foundation. (118) The threat of a penalty, coupled with the high
ownership threshold for filing charges, should deter frivolous claims.
Finally, claim administration costs will be lowered by requiring a
certain threshold overall shareholder loss before the ICF Division will
initiate a proceeding. (119)
When a shareholder files charges with the ICF Division, the ICF
Division will conduct an investigation to determine whether there is
reasonable cause to believe a securities violation has occurred.
Employing a civil-style inquisitorial model, (120) administrative law
judges (ALJs) (121) will make fraud and damage award determinations. The
decisions of the ALJs will be subject to limited federal court review.
The ICF Division will grant damage awards in cases involving securities
fraud, without regard to whether the company in question is bankrupt.
The ICF Division will compute damages in a manner similar to that
currently employed in calculating damages in fraud on the market
lawsuits. (122) All damage payouts will be made from the fund, with any
shortfalls payable through loans from the U.S. Treasury. (123) With
limited exceptions, (124) all shareholders who suffer a loss and submit
a claim to the ICF Division will be eligible for recovery from the fund.
Generating credible estimates for the costs of administering the
ICF is difficult, but there is evidence to suggest the costs will be
significantly lower than the costs incurred in conducting fraud on the
market suits. The ICF, as proposed, has elements of both an insurance
program and a litigation system. One of the advantages of insurance
systems is their ability to provide compensation to victims at lower
costs than litigation systems. (126) There are a number of studies that
show that average administrative costs in private lawsuits, including
those for settled and litigated claims, are almost equal to or greater
than the compensation received by victims. (127) This means that for
every dollar a victim receives as compensation, a dollar or more is
spent providing that dollar to the victim. (128) As described previously
in Part III, plaintiffs' attorneys' fees in securities class
actions can total almost one-third of fraud victim recovery, and defense
costs can be comparable. These fees do not account for the judicial
resources employed disposing of such cases.
The cost of insurance tends to be significantly lower than the cost
of litigation. At one extreme are government insurance programs, such as
the federal Old Age and Survivors Insurance Program (OASI), federal
disability insurance, the SIPC, and the FDIC, whose administrative costs
are quite low in comparison to total program expenditures or fund size.
(129) These programs may be administered relatively inexpensively
because there is no need to determine "fault" as we think of
it in a litigation context. (130)
Another government insurance program, unemployment insurance, which
shares some important similarities with the ICF, has higher
administrative costs on a relative basis than the aforementioned
programs, but still appears to operate in a cost-effective manner.
Briefly reviewing the UC system's operations may be instructive.
The unemployment compensation (UC) system's (131) fiscal year 2007
estimated administrative costs are $3.9 billion, or 8.7% of the
estimated $44.9 billion in collections. (132) Under the UC system,
employers are taxed on their payrolls. (133) Experience rating in the UC
system requires employers with a history of higher layoffs and firings
to pay higher taxes into the system. (134) Experience rating, therefore,
discourages layoffs and other forms of involuntary unemployment. (135)
Though the specific laws differ across states, generally, if an employee
voluntarily resigns (other than for good cause attributable to the
employer) (136) or is fired for gross misconduct, (137) she is not
eligible for unemployment benefits. (138) The determination of
eligibility for UC benefits is handled initially by an investigator
employed by a state agency. (139) Both the employer (140) and the
employee have the right to appeal the investigator's decision and
have a brief hearing, (141) generally without counsel and no pre-hearing
discovery, on the merits before an ALJ or similar official. (142)
The decision of the ALJ may be appealed to a higher authority
within the UC system. (143) Any party that is dissatisfied with this
review process may appeal to the state circuit court, with further
appeals from there permitted, though generally rare. Thus, resolution of
disputes is handled largely within the administrative process. The UC
system is able to set tax rates through experience rating, collect
funds, disburse benefits, coordinate program administration efforts with
53 different state and jurisdictional offices, and adjudicate contested
factual issues regarding benefits eligibility (excluding court appeals)
at a cost of less than 10% of collected funds annually.
Administering the ICF program, of course, will be more costly than
administering the UC. The ICF's administrative procedures will
contain a mix of insurance and litigation elements, like the UC program.
However, the costs of the ICF still will be significantly higher in all
likelihood. Though the UC must set experience ratings for taxation
purposes, generating fraud risk ratings will be a much more complex
process, given the numerous variables that comprise the rating and the
annual reviews that must be conducted on each publicly traded company.
In addition, determining whether a claimant has met the standard for UC
benefits is not as complex as the determination that will have to be
made by the ICF. Determining eligibility for payment under the ICF
(i.e., that investment losses were due to fraud, as opposed to, for
example, negligent misstatements) requires an investigation into state
of mind and the intent to defraud (scienter) of corporate officers. This
can be costly as corporate officials must be deposed and corporate
records reviewed. Finally, in the UC system, the parties usually (though
not always) appear before the ALJ without counsel. Under the ICF,
corporations, like employers in the UC system, will have an interest in
intervening to contest fraud allegations, but not only because of the
effect on the fraud risk rating. Managers also will be concerned about
the potential damage to the corporation's reputation from an
adverse fraud determination. (144) In addition, the corporation almost
certainly will insist on being accompanied by counsel, and, under the
ICF Proposal, will be able to do so. On the other hand, of course, the
ICF will not have to process the volume of cases that the UC system has
to, which will offset the costs of the complexity to some degree. (145)
In any event, it seems likely that the costs of administering the
ICF will be significantly lower than the costs accompanying private
securities fraud litigation. Because of the non-adversarial nature of
the ALJ proceedings, costs for fraud determinations under the ICF
Proposal should be lower than the costs of private litigation, even
after factoring in the costs of appeals of ICF decisions. Fraud
securities class actions are very costly. In addition to the costs
payable directly to plaintiffs' and defense counsel, as mentioned
previously, administering such suits consumes a great deal of judicial
resources. There are a number of costs incurred in litigation that will
not exist if the ICF is adopted. For example, under the PSLRA, in a
securities class action, the court is required to select a lead
plaintiff, which initially requires a determination of which potential
plaintiff suffered the greatest loss from the alleged fraud. (146)
Deciding this issue, which essentially involves deciding among competing
teams of lawyers, (147) will not be required under the ICF. Also,
pursuant to the PSLRA, plaintiffs do not have the right to discovery
unless they get past the motion to dismiss, which requires pleading with
particularity facts that give rise to a strong inference of fraud. (148)
As John Coffee explains, "Often, this process ... involve[s]
multiple motions in which the parties contest whether this heightened
pleading standard has been satisfied (with the plaintiffs typically
receiving at least one leave to replead their complaint if their initial
pleadings fail this test)." (149) Discovery disputes are also
costly, as the individuals to be deposed (e.g., corporate officers,
directors, and accountants) all have their own counsel who can put forth
arguments limiting the plaintiffs' attorneys' access. (150)
The settlement process also imposes costs as lawyers for all the parties
attempt to negotiate a settlement with which they are comfortable and
the court will approve. Complicating this process are any
objectors--class members who believe the proposed recovery under the
settlement is insufficient or those who attempt to hold up the process
in hopes of extracting some unique personal benefit. Moreover, in recent
years an increased number of institutional investors have chosen to opt
out of class actions altogether to pursue individualized actions because
they believe they can achieve a higher recovery through this process.
(151) Compounding the issue is the pursuit of some of these
individualized cases in state court. Congress passed the Securities
Litigation Uniform Standards Act (SLUSA) in 1998 to prevent plaintiffs
from circumventing the strict pleading requirements of the PSLRA by
filing an action in state court. However, SLUSA only pre-empts class
actions, not individual suits brought under Rule 10b-5. Thus, a
plaintiff that opts out of the class action is free to pursue a state
action, which has the effect of adding to the defendants'
litigation costs. Indeed, these opt out suits can lead to disputes
between federal and state courts,152 which can add even more costs to an
already costly system. None of the processes described above (153) would
exist under the ICF. (154) Thus, even if one is inclined to suggest that
the ICF will be "expensive" to administer, it seems unlikely
that the costs would approach those of securities class actions.
Complexity can exist even in securities fraud cases where it is not
clear that the additional costs yield significant benefits to
shareholders. Consider the Blue Rhino Corporation case, (155) in which
the class action period lasted 22 days (inclusive), (156) and the
settlement amounted to $1.25 million (with 21.5% of that amount plus
expense reimbursement of up to $230,000 going to the plaintiffs'
attorneys). (157) The civil docket contains 112 entries with dates from
May 2003 to October 2005, and many of these entries include various
briefs, reply briefs, stipulations, and orders related to procedural
rather than substantive determinations. (158) According to the
settlement notice, the estimated average distribution per share is $0.78
before deducting fees and expenses. (159) I offer no opinion on the
complexity of the issues requiring resolution or the adequacy of the
settlement. However, despite the apparent expense and complexity of the
process, shareholders were entitled to receive limited compensation.
Moreover, as of this writing almost five years after the end of the
class action period, this compensation still has not been disbursed to
shareholders. (160) This example is admittedly anecdotal, (161) but it
demonstrates that securities class actions have the potential to consume
a great deal of judicial resources, even in cases where it is not clear
that shareholders receive a significant benefit from the process.
Though the ICF offers significant cost savings potential over fraud
class actions, it has some costs that class actions do
not--administering the fund and setting fraud risk ratings. In addition,
one cost will, in all likelihood, be very similar--the fraud
determination. The ICF must conduct an investigation and the ALJs, just
like federal judges at the motion to dismiss stage in securities class
actions, will need to review the evidence and determine whether fraud
occurred. Of course, under the ICF, there will not be multiple teams of
lawyers filing multiple motions, but the basic process of adjudging the
commission of fraud will be the same. (162)
One efficiency from implementing the ICF can come from eliminating
redundant investigation costs. Under the ICF Proposal, the ICF Division
will work closely with the SEC's Division of Enforcement, which
currently carries out fraud investigations, so incremental investigation
costs will be minimized to some extent. In addition, the SEC currently
does not cooperate or share discovery with plaintiffs' lawyers
pursuing claims against the defendants that the SEC is investigating.
(163) Thus, the duplication of effort and costs to police the same
behavior would end under the ICF Proposal. (164)
On the other hand, the existence of the ICF could lead to
additional costs because of the possibility that the number of instances
of fraud alleged will increase under the ICF from current levels because
of the easier filing process and potential for increased recovery. As
discussed in Part III, securities fraud class actions often are not
brought against small corporations because the expected damages are too
low to be attractive to plaintiffs' attorneys. Also, the SEC,
because of its limited enforcement budget, is unable to pursue many of
such cases, despite its relatively recent initiative to combat microcap
fraud. (165) One benefit of the ICF is that, unlike the current
securities fraud class action regime, the government will police fraud
at large and small corporations through fraud risk ratings and ICF
proceedings, hence increasing overall deterrence. However, with this
benefit comes the potential added expense of more claims requiring
Ultimately, the costs of administering the ICF are uncertain.
Further study in this area is necessary. I submit, however, that in all
likelihood, the costs of our current securities class action regime
exceed those of the ICF as proposed.
C. Possible Objections and Implementation Challenges
The ICF Proposal is designed to provide the deterrence and
compensation benefits outlined above at lower administrative costs than
those existing under the current regime. However, there are a number of
factors that must be considered in a proposal of this magnitude. In this
section, I address some possible objections to the ICF Proposal, as well
as some key implementation challenges.
1. Mandatory Nature of the Program
One potential criticism of the ICF proposal is that participation
in the ICF scheme will be mandatory for all corporations in the United
States. One could argue that the absence of fraud risk insurance of this
type in the marketplace suggests that investors do not want the
insurance and that it is not value-enhancing. A number of scholars
advocate contractual freedom in corporate law (i.e., the ability of
corporations and shareholders to opt out of the laws that will apply to
the corporation). (166) The basic argument for the "freedom of
contract" view is that investors know their own interests better
than regulators and are capable of contracting for the protections they
desire. (167) If firms do not provide the features that stockholders
desire, their stock prices will reflect that failure. (168) Thus, one
also could argue that even if the government were to offer such
insurance, it would be most efficient to allow corporations to opt out
of the ICF scheme if they did not believe their shareholders would value
The first argument is a familiar critique of reform proposals.
(169) However, as Lucian Bebchuk points out, "If [this] argument
were valid, it would have far-reaching consequences. It would imply that
much of the protection U.S. investors now enjoy--which results from
arrangements introduced by federal rules and exchange requirements and
not previously offered ... is value-reducing and should be
dismantled." (170) In this context, in particular, the absence of
fraud insurance does not imply that the ICF Proposal has no merit.
First, organizations such as RiskMetrics Group (171) and The Corporate
Library (172) produce corporate governance ratings and sell them to
investors. This suggests that corporate governance matters to investors
and that they view external judgments on the quality of governance as
adding value to their investment decisions. Of course, as discussed in
Part IV.C.4., infra, the evidence does not suggest that the currently
available ratings would be able to predict with any degree of certainty
the likelihood of fraud occurring. That is irrelevant for present
purposes. The fact that private actors are trying to provide more
information about corporate governance risk suggests that if the ICF
program could develop a method for generating accurate fraud risk
ratings, it would be value-enhancing.
Second, a fraud insurance mechanism exists today--D&O
insurance, which provides third party insurance for corporations. (173)
However, as discussed in Part III, supra, the level of compensation
received by shareholders is inadequate and highly unlikely to increase
under this system. Of course, one response might be that government
intervention is not needed because investors are satisfied with the
current level of recovery, small though it may be. If that were not the
case, they would "force" corporations to provide them with
greater protection from fraud losses. However, what this position
ignores is the growing trend of institutional investors opting out of
class actions and pursuing individual cases. This suggests that
investors are dissatisfied with current levels of recovery, and some are
pursuing means to achieve greater compensation that impose high costs on
the legal system. (174) In addition, under the status quo, there is not
much that investors can do to "force" corporations to give
them additional protection. As discussed in Part III, supra, private
insurers generally lack the capacity to insure investors up to the full
(or even almost full) extent of their losses, and, given the potential
for astronomical losses, in all likelihood, would be reluctant to enter
the first party insurance market for investors without government
guarantees of some sort. (175) Thus, just as is the case with various
catastrophic risks, government intervention is likely needed for this
protection to be provided.
The chief response to the second argument is that mandatory
corporate participation is a necessary feature of the ICF. Though I have
outlined several benefits of the ICF in this Article, it is possible
that not all corporate managers would agree with my assessment,
particularly if they worry about the effects of the ICF premium on their
stock prices. (176) If participation were optional, many corporations
could choose to opt out of the scheme. Low participation rates make for
an unattractive insurance market because insurers seek large risk pools,
allowing them to set premiums with greater confidence. (177) Thus, to
have a large risk pool and an appealing insurance market, participation
in the ICF must be mandated. Certainly, not every public company in the
United States must participate for there to be a viable insurance
market, but if participation is not mandatory, there is no way to know
ex ante whether sufficient numbers of corporations will opt in
A related potential criticism of the ICF proposal is that
participation in the ICF scheme will be mandatory for all investors, as
well. One could argue that some investors will not want to pay the ICF
premiums and would prefer to self-insure through diversification to the
extent possible, or just bear the risk of loss. It, therefore, is
unreasonable to force them to take a "benefit" that they would
rather not have. This argument is not without some force, and it is
likely that some investors would prefer to opt out of the ICF scheme.
However, this criticism rests on the mistaken notion that implementing
the ICF Proposal would lead to imposing a tax to which investors were
not previously subject. For sure, the form of the tax under the ICF
scheme is new, but a tax for securities fraud compensation exists
currently. It exists in two forms--first, in the premiums paid by
corporations to their D&O insurers for protection against secondary
market fraud lawsuits (meritorious or not) and second, in the form of
direct and indirect (179) costs incurred by companies in defending such
suits (which affect earnings and ultimately stock prices). Therefore, a
more appropriate question for an investor evaluating the ICF Proposal is
not whether she wants to pay a tax; she already is doing so, albeit
indirectly. The better question, in my view, is whether the tax paid
under the ICF scheme is more efficient than the alternatives, and this
Article provides some evidence that it is. (180)
Furthermore, making investor participation voluntary also would
undermine the deterrence effects of the ICF. The investors who would be
most likely to opt for the protections of the ICF are individual
investors because, as mentioned previously, they are generally less
diversified than institutional shareholders and are more risk-averse.
Though holding approximately 40% of the value of stocks in the United
States, individuals account for a very small percentage of total trading
volume. (181) Thus, any trading behavior that is altered due to the
level of the ICF premium is unlikely to have much effect on a
company's stock price, since investors trading a small percentage
of a particular company's stock will be considering the
company's related ICF premium when making trading decisions.
Without significant stock price effects, the deterrence benefits of the
ICF Proposal largely disappear.
In addition, as a practical matter, voluntary investor
participation is not administratively feasible. Buyers and sellers are
brought together anonymously to trade securities. In the public markets,
there is no practical way to determine which buyer has been matched with
which seller. Thus, premiums cannot be collected only from sellers that
have opted into the ICF or who are selling to buyers that have done so.
This analysis, of course, is premised on the idea that there has to be a
matching of sellers and buyers. Intuitively, this makes sense because of
the implicit nature of this compensation fund (i.e., a seller leaves
behind a payment in case the stock price was inflated by fraud). This,
however, does not have to be the case because all ICF funds are
fungible. However, funding would be more predictable if there were no
worry that a disproportionate number of frequent buyers (or rare
sellers) would opt in and lead to a funding shortfall. An additional
administrative problem relates to collecting the premiums. As proposed,
the ICF will require the exchanges to remit periodic payments based on
trading volume. It would be much more difficult administratively for the
exchanges to collect ICF premiums only from investors that have opted in
to the program.
2. The Role of the Federal Government
Another potential criticism of the ICF Proposal relates to the role
of the government in the ICF scheme. Some view government involvement
with skepticism. Thus, one concern is that implementing the ICF Proposal
would result in the creation of a federal bureaucracy, unconstrained by
competition and unaccountable to shareholders. Indeed, other government
managed compensation funds, including the FDIC, (182) SIPC, (183) and
the Pension Benefit Guaranty Corporation (PBGC), (184) have been
criticized extensively, which suggests there are valid reasons to be
concerned about government involvement in this context. However, some
design elements of the ICF should give potential critics some comfort.
First, the SEC will oversee the ICF. Despite recent corporate governance
lapses among academics, practitioners, politicians, and the public, the
SEC generally enjoys a positive reputation. (185) Though sometimes
subject to criticism, many attribute any of the SEC's shortcomings
to its lack of funding (186) rather than any incompetence of its
officials. Thus, the SEC should be able to manage the ICF well, assuming
adequate funding. Second, the ICF will conduct high salience work. In
the post-Enron era, the media spotlight is focused on the efforts of the
SEC to police corporate fraud. Thus, it is less likely that the ICF
would be able to carry on its activities with no accountability to the
One still may remain skeptical of the efficacy of government
intervention in private markets, despite the features of the ICF
designed to minimize such concerns. However, because the government has
pricing and coverage advantages over private insurers, the federal
government is the most efficient provider of securities fraud insurance
and its involvement in the ICF scheme is justified.
First, the government can mandate corporate and investor
participation. As described previously, small markets are unattractive
insurance markets, so insurance coverage must be mandated, something
only the government can do. Of course, the government could mandate the
purchase of private market insurance, (187) resulting in many of the
same benefits as would accrue from government provision of mandatory
insurance. However, doing so would result in a loss of the advantages
Government provision of insurance results in pricing advantages
over provision by private insurers. The ICF, by design, will be
self-financing. However, if actual damage payouts exceed expected
losses, under the proposal, the U.S. Treasury will provide an
interest-bearing loan to the ICF to make up any shortfall on damages
payouts that are due. (188) The ICF, therefore, will be able to charge
lower premiums than private insurers would be able to. The
government's size and borrowing capacity allow it to
"produce" insurance at a lower cost than private insurance
markets. (189) Because the level of the economic capital charge borne by
the government effectively amounts to zero, it only has to set premiums
at the level of expected loss if the intent is to price the insurance at
cost. (190) Premiums charged for private fraud risk insurance would have
to include not only an actuarial charge for expected losses, but also a
charge for the economic capital required to absorb loss volatility.
(191) This also could lead to inefficient pricing because the presence
of large corporations in the insurance pool would require a private
insurer to hold more incremental economic capital, irrespective of the
relevant proportion of expected loss, thus leading to the possibility of
the insurance premiums far exceeding the expected losses. (192) Though
the organizations are criticized on many grounds, (193) commentators
generally agree that the FDIC and SIPC are able to provide depositor and
investor protection at lower costs than private markets. (194) Thus, it
is likely that, overall, the ICF would have the ability to insure
against securities fraud risk at a lower cost than private insurers.
Moreover, government or single-provider fraud insurance can achieve
administrative cost savings. Competing private insurers must incur
duplicative costs related to marketing and underwriting, which can
increase the price of insurance. (195) In addition, having a single
provider can be more efficient because, before an insurer pays any
claims, it will have to conduct an investigation into whether securities
fraud occurred. It would be highly inefficient for individual insurers
to conduct multiple independent fraud investigations. Of course,
cooperation agreements among insurers are possible, but insurers in all
likelihood would not relish taking on what has traditionally been the
role of a judge in determining whether the requisite state of mind
(scienter) was present to warrant a finding of fraud. This is outside
the scope of their competence.
In addition, having the government serve as the sole insurer in
this context makes collecting premiums more feasible administratively.
The per-trade fee assessment is a key component of the ICF Proposal;
without it, issuer-funding would be required and compensation would be
limited significantly. (196) Collecting premiums on trades and then
remitting them to various private insurers based either on issuer or,
worse, by trader, adds another layer of complexity to the administration
of the fund (197) and substantial costs.
Despite the administrative cost benefits of government management,
there are also disadvantages. Private sector competition and profit
motives might lead to innovation and administrative cost cutting in the
private fraud insurance market--things that are less likely to exist
with the ICF because of its use of government-employed managers who may
be less sensitive to spending public dollars. (198) While this is a
valid criticism of the ICF Proposal, on balance, because of the
government's ability to "produce" insurance at a lower
cost than the private sector, as discussed above, it is likely that any
potential administrative inefficiencies will be outweighed by the
government's other pricing advantages.
In addition, government insurance precludes market price
competition, which is usually believed, by market enthusiasts, to
provide substantial benefits. However, it is not clear that pricing
competition would advance the deterrence goals of the ICF Proposal.
Currently, competitive pressures appear to make it impossible for
D&O insurer premium prices to reflect governance risk fully. (199)
There is no reason to think that these pressures would not exist if the
insurance were sold to investors rather than corporations.
One also may argue that governmental involvement will impede the
development of accurate fraud risk ratings. First, though an
independent, private company will perform the risk assessments that
determine the ICF premium, this government-hired ratings agency may have
poorly aligned incentives. The primary downside to getting the risk
assessment wrong will be reputational loss and, eventually, loss of the
government contract. Though these are significant risks, the rating
agency will not have its capital at risk, as is the case with private
market insurers (200) or investors. Also, as a government-sanctioned
contractor, the agency will not have to compete in the marketplace for
clients. (201) Thus, it will have reduced incentives to perform
competently. Second, the agency will have no incentive to work to refine
its pricing model. Private insurers compete to underwrite accounts, so
they can obtain a significant benefit from refining their pricing models
to allow them to underwrite accounts profitably that other insurers turn
away (or price inappropriately). This will not be the case with the
ICF-appointed rating agency. These are all valid concerns. However, it
is clear that the government oversees a number of insurance programs
(e.g., the FDIC, PBGC, SIPC, unemployment insurance) and has
demonstrated that, even in the absence of competition, risk assessment
can be handled competently. To be certain, government insurers have made
pricing errors, but the same can be said for private market insurers. On
balance, given the other benefits accruing from government oversight,
concerns about the government's ability to oversee the ratings
process are insufficiently strong to mandate private insurance in this
Finally, regardless of one's views on the efficacy of
governmental involvement in private markets, it is clear that, thus far,
private market solutions have not emerged to address effectively the
serious problem of securities fraud. For sure, implementing the ICF
carries some risks. I submit, however, that the ICF is likely to be a
better alternative to the status quo.
3. Deterrence Effects
Though I have argued that implementing the ICF and imposing fraud
risk ratings on corporations will increase deterrence, there are
questions about whether that necessarily will be the case. One could
argue that the establishment of fraud risk ratings will do little to
deter fraud. The variations in premiums among companies necessarily will
be only fractions of one percent. Therefore, one could argue that such
small variations will not have much effect on the trading behavior of
investors and, by extension, the behavior of corporate managers. Perhaps
on small trades made by individuals, the premium differentials will be
too small to have much of an impact because, in dollar terms, the
differences will be small. However, this is not the case for
institutional investors that are active traders. According to recent
studies, trading commissions for institutional investors average
approximately 10 basis points (bp) or 0.10% (a bp is one one-hundredth
of one percent). (202) Thus, for example, a one bp difference in ICF
premium could mean a 10% difference in sell-side transaction costs for
an institutional investor. (203) Therefore, even slight differences in
ICF premiums among corporations in which an institution is considering
investing, when multiplied over the large volume of likely trades, can
be significant because of the effect on overall transaction costs.
Shares of stock are largely fungible, (204) and differences in
transaction costs can make a difference in investment choices.
Another potential concern is that implementing the ICF will have a
negative effect on deterrence; an end of respondeat superior (205) will
accompany an end to fraud on the market lawsuits. This, however, should
not be a serious concern because, under the ICF Proposal, instances of
fraud committed by an employee will have a negative impact on a
company's fraud risk rating, and by extension, its share price.
Corporations, therefore, will have ample incentive to monitor their
employees' actions. Another pro-respondeat superior argument, made
in the torts arena by Guido Calabresi, is that respondeat superior leads
to a better allocation of resources because it allows the price of goods
sold in the market to reflect injury costs. (206) Under this theory,
implementing the ICF also will lead to a better allocation of resources.
A firm's fraud risk rating will affect its share price and cost of
capital directly. In the secondary market securities fraud area, share
price is where this cost should be reflected. (207)
One also could argue that, in many contexts, lawsuits, despite
their drawbacks, provide more deterrence than is available under
insurance regimes. (208) The ex post determination of liability can
result in more accurate outcomes than an ex ante insurance premium,
which is necessarily based on the insurer's estimate of the likely
behavior of the insured. The deterrence effects of the ICF Proposal
rely, in large part, on the ability of the rating agency to generate a
rating that reflects the actual risk of securities fraud. As discussed
in Part IV.C.4., infra, generating fraud risk ratings will be one of the
biggest challenges for the ICF program. One of the strengths of lawsuits
is the potential for more information to be available after the fact
about whether there was fraud than is available ex ante about the likely
propensity for fraud. (209) Accurate outcomes, while beneficial in their
own right, also generally result in better deterrence.
This is a weighty concern, but one that is mitigated somewhat by
the context of securities regulation. As described in Part III, supra,
securities litigation does a poor job of deterrence given its failure to
affect a significant portion of firms (i.e., small firms) and the fact
the perpetrators of the fraud generally do not pay the judgment. Thus,
while the idealized version of litigation may provide superior
deterrence to an insurance regime, it is not clear that would be the
case with respect to securities litigation. (210)
Ultimately, the best deterrence against fraud is likely strong
enforcement action by government regulators. According to one securities
plaintiffs' lawyer with whom I spoke, "There is no question
that the best [fraud] deterrent is a more heavily funded SEC."
(211) A D&O insurance executive I interviewed expressed a similar
sentiment by indicating that, in his view, the presence or absence of
D&O insurance has little effect on managerial behavior; corporate
managers worry more about actions initiated by the SEC and the DOJ.
(212) The reputational sanctions from a government investigation and the
threat of civil penalties and jail time likely will provide a much more
powerful deterrent than the fraud risk rating and level of ICF premiums.
Thus, in connection with the ICF proposal, it would be prudent to
increase government fraud enforcement budgets significantly. (213)
4. Fraud Risk Ratings
Perhaps the strongest possible criticism of the ICF proposal is its
reliance on fraud risk ratings. The efficacy of the ICF proposal
depends, in large part, on the ability to generate fraud risk ratings
that are accurate and substantially tied to the risk of fraud occurring.
Corporate governance rating systems, which share some similarities with
fraud risk ratings as proposed in this Article, currently exist.
However, no study, to my knowledge, ties the ratings generated by those
mechanisms to the risk of fraud. Indeed, my own preliminary empirical
analysis, described below, suggests there is no correlation between
ratings from one leading corporate governance rating system and the
incidence of fraud.
Moreover, recent work by Tom Baker and Sean Griffith suggests that
many of the structural factors typically used in corporate governance
ratings (e.g., number of independent directors) are poorly correlated
with D&O insurers' assessments of securities litigation risk.
(214) This suggests that the metrics currently employed in existing
corporate governance rating systems will be of limited value for the
ICF. One could argue that there are significant market incentives for a
private entity to develop an effective corporate governance rating
system and the failure of one to emerge suggests that this is a
difficult undertaking. One could argue further that there is no reason
to think that governmental oversight of the process will simplify the
task. This is a strong objection and one for which there is no easy
Admittedly, it is unclear which corporate governance mechanisms
most affect the likelihood of fraud occurring at any individual company.
There is, however, some limited empirical evidence that may prove useful
in this context. For example, one study shows that firms subject to SEC
enforcement actions were, relative to a control group, more likely to
have a higher proportion of insiders on the company's board,
greater ownership of company stock by these insider directors, no large
outside stockholder, founder-CEOs and combined CEO and board chair
positions. (215) A number of other studies find similar relationships
between corporate governance practices, on the one hand, and fraud
and/or accounting restatements on the other. (216) Therefore, there is
limited evidence that corporate governance mechanisms bear some
relationship with the incidence of fraud. (217)
In addition, insurance companies have developed mechanisms to help
them decide whether to extend D&O insurance coverage and, if so, at
what premium. (218) Indeed, one factor in determining D&O insurance
premiums is a company's corporate governance rating. (219) If the
insurers find the metrics useful when making their own pricing and
coverage decisions, it seems reasonable to conclude that the ICF
Division would be able to generate, in collaboration with an outside
entity, a meaningful rating system. However, the challenge will be
determining exactly which factors are most likely to affect the
incidence of fraud.
A review of one corporate governance rating system currently in use
may be instructive. The "pre-meltdown" RiskMetrics Group (then
ISS) (220) CGQ (corporate governance quotient) index score (221) of a
selected group of scandal-plagued companies appears below: (222)
The CGQ index score compares the corporate governance rating of the
company in question to the ratings of other companies in the relevant
market index (e.g., S&P 500 firms). Tyco, for example, had a CGQ
index score of 5.5%. This means that, at the time of the rating (i.e.,
before the fraud revelation), 94.5% of companies in the S&P 500 had
a higher corporate governance rating than Tyco, suggesting that
Tyco's corporate governance practices were lacking vis a vis other
In general, the corporate governance processes of the companies
listed above, as assessed by RiskMetrics, were poor relative to those of
companies in the market at large. (223) However, these data provide only
anecdotal evidence with regard to whether corporate governance ratings
can assess the likelihood of fraud.
To gauge whether the RiskMetrics CGQs are correlated more broadly
with the incidence of fraud, I analyze a proprietary data set (224)
consisting of the CGQs of all 100 companies that were the subject of
settled securities class action lawsuits involving secondary market
fraud, as of August 2006, with class periods between January 2002 (when
CGQs were instituted) and August 2006. I observe that the CGQs at both
the beginning and end of the class periods for the alleged fraudsters,
as a group, failed to vary significantly from the CGQs of the overall
universe of rated corporations. The average (median) CGQ index score at
the beginning of the class period is 48.8% (48.8%), and the average
(median) CGQ index score at the end of the class period is 51.2%
(56.5%). This analysis reveals that, as the fraud continued, as a group,
the firms' scores got somewhat better relative to the rest of the
universe of rated companies.
These results cast substantial doubt on the predictive value of
this metric for the typical fraud case. This is not a condemnation of
RiskMetrics' CGQ; the metric was not designed specifically to
predict fraud, but rather to assess broadly the quality of corporate
governance practices, which have value apart from their effect on fraud
risk. (225) However, this evidence does highlight the fact that the ICF
probably will not be able to employ a rating system currently in use
without significant modification.
It is possible that the factors most likely to affect the risk of
fraud (e.g., firm culture and character and integrity of the managers)
(226) are things that are not readily observable or quantifiable by an
external rating agency that has limited time to devote to developing
each individual firm rating. (227) Therefore, to enhance the quality of
the fraud risk ratings used by the ICF Division, under this proposal,
D&O insurers and auditors will be required to provide the ICF's
designated rating agency with firm-specific information on some of the
"softer issues" that cannot be captured in traditional
corporate governance metrics.
During an audit, auditors have the ability to assess the potential
for accounting fraud, and the insights gleaned from these processes can
be useful in developing the appropriate fraud risk rating for a
particular company. (228) While it is not reasonable to believe that
auditors will always be able to predict fraud or even provide accurate
indications of all the "soft factors" that affect fraud risk,
they are much closer to the company than any ICF representative ever
would be and thus could provide valuable inputs into the rating process.
As mentioned previously, D&O insurers, to some extent, consider
fraud risk when underwriting D&O insurance policies. Though these
insurers do not have formalized underwriting standards to assess the
risk of fraud, insurers, particularly now in the post-Enron era,
explicitly factor corporate governance variables into D&O premium
pricing. (229) While insurers generally do not want to reveal their
private pricing algorithms publicly, (230) the ICF, as a division within
a government agency, will be able to compel disclosure of these factors.
Though the pricing models of D&O insurers will not be dispositive
with respect to fraud risk (because underwriting competition and
firm-specific factors, such as susceptibility to non-meritorious suits,
can affect pricing), (231) the information gleaned from D&O insurers
can be separated into components, with the factors most applicable for
the ICF Division's purposes used to generate fraud risk ratings.
(232) Moreover, because the ICF fraud risk ratings, unlike D&O
insurance premiums in the United States, will be public, the ratings
will be subject to testing and analysis by academic researchers and the
investment community. (233) This should lead to an improvement in the
quality of fraud risk ratings over time. In sum, generating accurate
fraud risk ratings will be a challenge, but the evidence suggests that
it may not be an insurmountable one.
The prior discussion focuses on assessing the governance mechanisms
that could lessen the opportunity for fraud to occur. However,
researchers have found other metrics, outside of traditional corporate
governance characteristics, that appear to affect the incidence of
fraud. Thus, it is fruitful to explore these characteristics (which in
many cases may be thought of as providing a "motive" to commit
fraud) in connection with a discussion of the fraud risk rating process.
As one might expect, studies show a correlation between the existence of
equity-based incentives for managers (e.g., stock options) and the
incidence of financial misreporting. (234) However, perhaps somewhat
surprisingly, (235) according to one study, relative to other public
corporations, firms that restate their financial reports as a result of
what the authors conclude is likely to be intentional misconduct have
higher market multiples, are more likely to raise equity capital while
the alleged earnings manipulation is ongoing, and have longer periods of
positive earnings growth and positive earnings surprises immediately
preceding the alleged manipulation. (236) The authors suggest that, at
the time of the alleged misconduct, managers of such firms were under
tremendous pressure from the capital markets to continue to maintain
prior good performance. (237)
Though more empirical evidence is required to assess which measures
do, in fact, affect a manager's propensity to commit fraud, these
studies suggest that it may be possible, after separating out the
effects of litigation risk, to provide reasonably accurate fraud risk
ratings. The question, of course, is whether, in the context of a
government-sponsored insurance fund, these "motive-based"
measures should be used. (238) In the private insurance market,
activities that are not inherently "wrong" (e.g., driving a
particular type of car) can lead to higher insurance premiums, and
society appears to accept that. However, it is questionable whether it
would be politically feasible (and it is clear that it would not be
economically wise) to charge higher premiums for, as an example, sales
of stocks of high growth and highly profitable companies. This practice
would be akin to levying a "success tax." Thus, using such
factors in fraud risk ratings could distort economic incentives. (239)
5. Creation of a Fund Instead of Publication of Ratings Only
One may question the necessity of creating an investor compensation
fund when the government simply could mandate the creation and
dissemination of fraud risk ratings for public companies. According to
traditional economic theory, an accurate stock price is one that is
equal to the present value of expected future cash flows. In an
efficient market, according to traditional theory, the current price
will reflect fully all relevant information on these expected future
cash flows. (240) The risk of expected future cash flows not
materializing, including because the market has been misled due to
fraud, is the sort of information that would be reflected in the price.
Therefore, in an efficient market, if the market were supplied with a
reliable fraud risk rating, (241) the stock price would reflect the
risk, and there would be no need for a compensation fund to levy a
premium because the price paid by investors would take the risk of fraud
into account (i.e., be lower).
As stated above, for the accurate price adjustments described above
to occur, stocks must operate in an efficient market. Market efficiency
is one of the most highly contested issues in finance, (242) and there
is a great deal of evidence that is inconsistent with the notion that
current prices accurately reflect current information. (243) For
example, studies have shown that markets are slow to incorporate bad
news, including, for example, analyst sell recommendations, going
concern opinions (244) and credit downgrades. (245) Thus, even if the
information contained in fraud risk ratings were released, there is no
guarantee that it would be incorporated quickly and fully into stock
prices as would be the case with ICF premiums, which operate as direct
offsets against share prices.
Some market efficiency adherents acknowledge that there may be
times when prices deviate from value (one of the most notable examples
of which occurred during the Internet bubble of the late 1990s). (246)
However, they suggest that, over the long-term, markets are efficient,
primarily because it is not possible to exploit any inefficiencies in a
way that will provide excess returns. (247) Even if this is true, under
the ICF system, if the premium assessments are accurate (which,
admittedly, will be a challenge), the risk of fraud (and any changes
thereto) will be reflected immediately in stock price, without the
possibility of it taking weeks or months (or longer) for stock prices to
adjust appropriately. Therefore, implementing the ICF can lead to a more
accurate reflection of the risk of fraud in markets.
6. Equitable Considerations
Another possible critique of the ICF centers on the fairness of the
way ICF premiums will be assessed. As described in Part IV.B., supra,
all sellers of stock will be required to pay premiums into the ICF fund.
The premium will be assessed, therefore, even on sales of the stock of
corporations with excellent fraud risk ratings. One could argue that
this system would lead to some unfair subsidization of shareholders of
companies that are likely to engage in fraud by shareholders of
companies where fraud is not likely to occur. Though the potential for
some subsidization is present, this subsidization is necessary for
accurate premium pricing. Just as a driver with an unblemished record
(e.g., no traffic accidents) and the characteristics of a prototypical
"safe driver" does not have zero-cost auto insurance premiums,
companies with "clean" records still will have a cost levied
against their shares because they will have expected fraud losses that
are greater than zero.
One may argue further that it is unfair to tax the shareholders of
all corporations for the frauds that will occur only in a subset of
corporations. However, this critique ignores the nature of insurance. No
public shareholder can know with any certainty that she is investing
only in companies that will never engage in fraud, just as no homeowner
can know that her house will never catch fire. Homeowners generally do
not feel cheated or treated unfairly when their insurance premiums are
used to pay claims to other homeowners who have suffered losses from
fire; the homeowners are paying for the peace of mind in knowing that
they will be protected should calamity strike. (248) The ICF is
similarly fair. The ICF will assess different premiums based on risk,
but provide the same benefit to all shareholders--compensation when
calamity (i.e., fraud) strikes.
One might even argue that the ICF, by design, is unfair to most
shareholders because it subsidizes the investment in risky companies; an
investor can now much more comfortably invest in fraud-prone companies
because of the insurance protection offered by the ICF. This should not
be of great concern, however, because if an investor seeks to purchase
shares in companies that have high fraud risks in hopes of making
profits from arbitrage, she is unlikely to succeed. She will internalize
the cost of fraud if she sells the shares before any fraud is uncovered
because she will be required to pay the ICF premium (which will be
significantly higher than the average premium). Of course, if the
investor buys while the stock is inflated by fraud and holds until the
fraud revelation, it is true that she will be entitled to compensation
under the ICF. However, the investor will have to bear some portion of
her losses (assumed here for exposition purposes to be 25%). (249) Thus,
it is not clear that, if the ICF premiums are accurate, the efforts of
an investor who intentionally seeks out fraud-prone companies will be
subsidized by the ICF. Of course, if the premiums are inaccurate and
systematically undercharge shareholders of likely fraudsters, traders,
who are able to assess the pricing inaccuracy (which is questionable),
may be more confident investing in risky companies. This further
underscores the need for accurate fraud risk ratings.
Finally, one might argue that the appropriate tax base for the ICF
premium is stock holdings, rather than stock transactions, because the
risks and rewards of stock price movements are functions of holding
stocks. One could argue further that it is unfair to tax an investor who
frequently buys and sells stocks in very safe companies more heavily
than an investor who buys and holds stocks in fraud-prone companies.
However, trade-based payment is a necessary feature of this insurance
program. (250) The more an investor trades, the more likely she will be
to sell the stock of a company engaging in fraud to a shareholder who
will need compensation from the ICF.
7. Effect on Financial Markets
One of the most serious potential objections to the ICF proposal is
the effect implementing the ICF proposal, which levies fees on capital
markets activity, will have on the United States' well-functioning
securities markets. Specifically, one could argue that levying the ICF
premium, which is similar to a securities transactions tax (STT), (251)
would lead to increased market volatility, (252) lower trading volume,
and lower (or less accurate) overall securities prices. (253) While
there is no existing compensation system similar to the ICF from which
to draw valid conclusions, one may glean some insights from a review of
the literature on STTs. There currently is no consensus among
researchers on the effects of STTs on financial markets. (254) Several
empirical studies of STTs in foreign markets have been undertaken, but,
thus far, they have not resolved the long-standing debate. (255) This
section considers volatility, volume, and price effects below in turn.
Several researchers have studied the relationship between STTs and
volatility. A primary appeal of STTs for their proponents is the
potential to reduce market volatility, generally because of a decrease
in destabilizing or noise trading. However, critics of STTs assert that
STTs increase market volatility because increased transaction costs make
it more expensive for dealers and market makers to perform their market
stabilizing functions. (257) Dealers, like all profit-seeking
professionals, require compensation for their services and for the risks
they undertake. (258) As trading becomes more expensive, as is the case
when trades are subject to an STT, dealers are unable to manage their
risks as effectively and, correspondingly, are "less willing to put
their own capital at risk." (259) Hence, as the theory goes, after
implementation of an STT, there are fewer dealers willing to stabilize
securities prices, leading to higher overall volatility. However,
despite the plausibility of this theory, several researchers find that
imposition of an STT has no significant effect on volatility. (260) For
purposes of evaluating the ICF Proposal, it will be difficult to
determine ex ante what effect the ICF premium will have on market
volatility. However, since sales undertaken by professional market
makers will be exempt from the ICF scheme, (261) the chief
volatility-related concern with STTs (i.e., that higher transaction
costs will deter dealers from performing their market stabilizing
functions) will not be present.
Critics of STTs also generally assert the claim that imposition of
the taxes reduces trading volume as investors migrate to other markets
or instruments where they can avoid the tax. This migration affects
liquidity and informational efficiency. (262) Trading volume can be
affected primarily in one of three ways. (263) Investors may (1) reduce
the frequency with which they trade (which is the result desired by
proponents of STTs), (2) change the location of their trading, (264) or
(3) migrate their investment dollars to other securities (265) that are
not subject to the tax. (266)
Critics of the ICF proposal may raise similar concerns. The average
ICF premium will be small on a percentage basis, but the aggregate
amount collected under the ICF will be large. Those most affected by the
ICF Proposal will be institutional investors. Transaction costs matter
to frequent traders, and creating the ICF will add to those costs
significantly. In 2005, total commissions on institutional trades
totaled $13.2 billion. (267) Using recent sales data as a guide,
aggregate annual ICF premiums for mutual funds would total approximately
$754 million, while aggregate premiums for pension funds would total
approximately $238 million. (268) Imposing the ICF premium, representing
an approximately 7.5% increase in overall direct trading costs, will
have a significant effect on the market's largest investors. (269)
Thus, one could argue that implementation of the ICF will encourage
investors to modify their trading behavior or leave the U.S. markets,
which ultimately would result in a decline in U.S. trading volume.
Concerns about the effects of the ICF premium on trading frequency
are valid. Though the evidence on the market impact of STTs is mixed,
one example from the U.S. markets may be instructive. In 1975, pursuant
to the mandates of the Securities Acts Amendments of 1975, the SEC
prohibited fixed (minimum) brokerage rates on the New York Stock
Exchange and ended what had been a 180-year old pricing practice. (270)
Immediately following this prohibition and the advent of negotiated
commissions, average commission rates fell by 25% (271) and trading
volume increased substantially (272) (an estimated 30%-100%, depending
on the time period and estimation technique employed). (273) Though
there is reason to question whether a reduction in brokerage commissions
is analogous to imposing the ICF premium, (274) these data do suggest
that increased transaction costs have the potential to affect U.S.
market liquidity significantly. (275)
There are, however, features of the ICF premium that should lead
one to conclude that its market effects will not be identical to those
of a traditional STT (or brokerage commissions) and could be positive.
The ICF premium, unlike commissions or a general securities transaction
tax, is an escrow in anticipation of a benefit (and an exchange of
uncertainty regarding securities fraud risk for certain costs and
benefits) rather than a direct cost without an immediately corresponding
benefit. (276) The ICF premium is highly targeted (277) and designed to
provide direct compensation to those who suffer losses from securities
fraud, and is, therefore, more akin to an insurance premium. (278) Thus,
trading frequency may not decline because the additional transactions
cost will be offset by greater investor confidence in a significantly
safer market. However, further study of this issue is required; the
liquidity concern cannot be minimized.
Migration to other markets, however, is of far less concern. Even
if investors do not view the ICF premium as a payment in exchange for a
benefit, it is unlikely that they will leave U.S. markets in large
numbers. Even with the ICF premium, trading transaction costs will be
significantly lower in the U.S. than in foreign markets, as the United
States enjoys a significant cost advantage over most foreign markets.
(279) In addition, many foreign exchanges impose securities transactions
taxes (280) that would exceed the costs (estimated, for exposition
purposes, at 0.035%) (281) imposed by ICF premiums. Thus, U.S. trader
migration to foreign markets following the imposition of the ICF premium
is an unlikely occurrence.
Because of concerns about migration of investment to substitute
securities, under the ICF Proposal, sales of equity derivatives (the
primary substitute for stock investment) are subject to the ICF premium.
Though there may be valid theoretical reasons for excluding equity
derivative sales from the ICF scheme, (282) because of the easy
substitution of equity derivatives for stock, a failure to include
equity derivatives in the ICF scheme could lead to a significant amount
of volume migration. (283)
A related concern about imposition of the ICF is that even though
the U.S. capital markets are the strongest in the world, U.S. companies
nevertheless may choose to de-list from U.S. exchanges and list abroad
in order to avoid participation in the ICF. Additionally, foreign
issuers may forego listing in the United States, which would lead to a
decrease in transaction volume in our market. However, these issues are
unlikely to be of significant concern.
It is unlikely that a significant number of U.S. corporations will
exit U.S. markets if the ICF is adopted. Companies tend to exhibit a
bias toward listing in their home countries. (284) This is not to say
that we should have no concerns about the U.S. capital markets becoming
uncompetitive, but, as a practical matter, U.S. corporations are
unlikely to exit U.S. markets in large numbers (particularly in the
short-term) regardless of their views on the efficacy of the ICF.
It also is unlikely that the ICF and its related premium would
discourage foreign listings. According to one study, listing on a U.S.
exchange reduces a foreign corporation's cost of capital by 70 to
110 basis points (0.70% to 1.1%). (285) Thus, if the study's
authors are correct, there are significant benefits that accompany a
U.S. listing, and in all likelihood they would exceed the perceived
costs of the ICF scheme.
Commentators have taken note of the increased competition the U.S.
capital markets are getting from the London Stock Exchange (LSE), (286)
which has a securities transaction tax of 0.5%. (287) Despite this STT,
(288) London has captured global initial public offering (IPO) market
share from the U.S. exchanges, and even a few U.S. companies have chosen
to list their IPOs on the LSE. (289) This suggests that the existence of
an STT has not substantially affected London's ability to attract
foreign issuers. The ICF premium likely would not diminish the U.S.
exchanges' ability to do so either. Indeed, it is possible that the
implementation of the ICF actually would encourage foreign companies to
list in the United States. Some suggest that one possible reason for the
decline in the United States' market share is the fear of legal
liability that accompanies a U.S. listing, particularly the threat of
securities class actions. (290) Though actual legal liability has
changed little in recent years, the perception of increased risk still
exists, due in part to the increasingly high value of securities class
action settlements and the rare, but high profile, cases in which
directors are required to fund part of the settlements with personal
funds (i.e., beyond that which is payable by D&O insurance or the
corporation). (291) It seems apparent that the litigation burden can
affect listing choices. Thus, it is not certain that the ICF premium,
which imposes a modest fee on shareholders in exchange for the end of
secondary market securities class actions, would be unwelcome by
corporations. Indeed, the ICF could make U.S. markets more attractive to
both foreign and domestic issuers. (292)
c. Accuracy and Overall Level of Prices
Finally, another potential concern is the effect the ICF premium
will have on stock prices. For many years, researchers have tried to
assess the impact securities transactions taxes have on market prices.
Opponents of such taxes cite two primary concerns. First, critics assert
that STTs decrease overall price accuracy because the increased
transaction costs from the STT can make repeated rebalancing in search
of the correct price prohibitively expensive. (293) One, therefore,
could argue that implementing the ICF would reduce share price accuracy.
In my view, while this is an important consideration, the assertion
that the ICF premium would lead to less accurate prices relies on two
assumptions: (1) the ICF premium will cause trading frequency to
decrease and (2) the constant turnover in stocks is moving the market
toward a more accurate price. As discussed previously, it is not clear
that imposition of the ICF premium will reduce trading frequency to any
significant extent. Furthermore, while it is true that trades reveal
information about fundamental firm values and can help to set accurate
prices, some trades reflect speculation that is injecting no information
into market prices. (294) Researchers, when studying the effects of
STTs, find it difficult to separate trading that is
"stabilizing" and hence leading prices closer to fundamental
values from trading that is destabilizing noise. (295) Thus, in the
context of the ICF, just as with STTs, if trading frequency is decreased
because of imposition of the ICF premium, which may not be the case, it
is not clear that the trading that declines will be the type of trading
that helps generate more accurate share prices. (296)
Second, critics assert that STTs result in a decline in the overall
level of market prices because investors will price in future
transaction tax payments when they are making investment decisions.
Accounting for the tax will result in a lower price paid for the
security in question. Several empirical studies have been undertaken to
determine the effect such taxes have on stock prices. Many researchers
found decreases (e.g., in the range of 1% to 3%) in stock market prices
in selected markets following the imposition of STTs. (297) However, the
results, taken together, are inconclusive, and some question the
methodology by which they were obtained. (298)
In any event, this should be less of a concern under the ICF
Proposal because, if the ICF premium is set appropriately (i.e., the
premium accurately reflects fraud risk), there should be no overall
lowering of market prices. Currently, investors discount stocks for the
risk of fraud (299) (even if such discounts are imperfect), (300) so
imposition of ICF premiums that accurately reflect fraud risk should not
result in any further discounting overall and may decrease such
discounting substantially if investors currently are prone to
overestimate the likelihood of fraud occurring. (301) However, if the
ICF premiums are inaccurate and set at levels higher than the expected
losses from fraud and there is a lowering of overall stock prices
because of the imposition of an ICF premium, (302) then this effect may
be offset by higher overall prices due to increased investor confidence,
less management time spent on litigation, and lower D&O insurance
premiums (because they will no longer cover secondary market fraud
lawsuits, either meritorious or frivolous). Most importantly, however,
is that companies with better fraud risk ratings will experience less of
a negative share price impact from the imposition of the ICF
premium--the desired effect to achieve the ICF's deterrence
8. Political Considerations
Implementing the ICF would be a challenge politically. In theory,
the ICF should appeal to those occupying various points on the political
spectrum. It eliminates secondary market securities class actions
(something that generally would appeal to the corporate community and
conservatives) and also provides meaningful compensation to defrauded
small investors (something that likely would appeal to those with more
liberal political leanings). (303) However, the ICF premium will be
viewed by many as a pure tax (despite the fact that the premium confers
an insurance benefit). New taxes generally are unattractive to
conservatives and the business community. (304) In addition,
implementing the ICF will eliminate the need for trial attorneys in
secondary market class actions, something likely to be opposed by the
plaintiffs' bar. I leave a more fulsome discussion of such
political considerations to future work. However, it is clear that such
factors must be taken into account when determining the political
viability of the ICF.
D. Summary and Concluding Thoughts on the ICF and Securities
The evidence provided in this Article suggests that implementing
the ICF, with its mix of ex ante and ex post elements, would yield
significant benefits over securities class actions. (305) First, the
perpetrators of harm (i.e., the corporate managers who commit securities
fraud) are unable to bear the full costs of the harm they create.
Neither their personal resources, nor D&O insurance proceeds, are
sufficiently large to compensate investors for the losses they suffer.
Second, given the financial incentives of the chief enforcers of the
securities laws (i.e., plaintiffs' lawyers), an entire class of
likely perpetrators (i.e., small firms with thinly traded stock) are
insufficiently deterred because they face no credible threat of suit,
(306) and managers of larger firms often are able to escape personal
liability even when sued. Third, the administrative costs of securities
class actions are extremely high. Current experience notwithstanding,
generally, one thinks of litigation as having the potential to impose
lower costs than regulatory regimes because litigation costs are
incurred only when harm occurs, while regulation involves an ongoing
cost that affects all market participants. However, the ICF Proposal
suggests a regulatory mechanism that has potential costs that are
substantially lower than those existing under the current regime.
The lower costs associated with the ICF, however, provide only
illusory benefits if the scheme provides less deterrence than that of
securities litigation. One might argue that the securities litigation
regime is more complex and costly than an insurance regime, but the
litigation requires the parties to engage in the time-consuming and
complex exercise of determining fault. With the additional cost, one
might argue, should come additional (or more accurate) deterrence. As
the discussion on fraud risk ratings in Part IV.C.4. makes clear, it is
easier to determine if fraud has occurred ex post than it is to predict
the propensity for fraud ex ante. Thus, if the benefits of accurate
deterrence exceed the administrative costs of litigation, the additional
expense is justified. The ICF, however, holds the promise of superior
deterrence because its fraud risk-rating mechanism, unlike securities
litigation, subjects all corporations to sanction. In addition, the
ICF's ex post fraud determinations can fulfill the fact-finding
role currently played by the litigation process. That said, further
study on the likely deterrent effects of implementing the ICF is
Ultimately, as discussed previously, the best deterrent in this
area is likely to be government enforcement and punishment directed at
managers, rather than corporations. Therefore, combining increased
funding for the SEC and DOJ with implementation of the ICF offers the
promise of fewer losses from securities fraud and meaningful
compensation for the inevitable losses that will occur.
V. A CONSIDERATION OF ALTERNATIVE REFORM PROPOSALS
The securities regulation regime is a frequent target of reform
proposals. In this Part, I consider several recent proposals that are
somewhat similar to the ICF and designed to enhance investor
A. Fair Fund Expansion
Under Section 308(a) of the Sarbanes-Oxley Act, also known as the
"Fair (Federal Account for Investor Restitution) Fund
Provision," Congress authorized the SEC to take civil money
penalties and add them to disgorgement funds (307) to create a separate
fund for each instance of securities fraud. (308) These so-called Fair
Funds are designed to provide compensation to investors injured by
securities law violations. While this is a laudable effort, the SEC
itself has acknowledged that collecting sufficient amounts to compensate
shareholders in securities fraud cases is "especially problematic,
if not impossible" because the investor losses caused by the fraud
tend to dwarf any profit accruing to the wrongdoer. (309) This is
because when fraud is ongoing, the gains from selling stock at an
inflated price accrue not only to the wrongdoer who sells her shares on
the open market, but also to the innocent investor who, by chance,
happens to sell also while the fraud is ongoing. Thus, there is a
substantial gap between total losses (which include the losses of all
the investors on the other side of the trades with the "lucky"
investors) and gains to the wrongdoer.
From 2002 through fiscal year 2006, the SEC collected $8 billion
for distribution through the Fair Fund process. (310) However, the
amounts included in the Fair Funds for large scale frauds still have
been small when compared with the magnitude of total shareholder losses.
(311) To try to increase compensation available to shareholders, the SEC
suggested an amendment to the Fair Fund Provision. (312) As enacted, the
Fair Fund Provision only allows civil penalty amounts to be set aside in
a fund for injured investors if such penalty amounts are added to
disgorgement funds. (313) However, there are cases where penalty amounts
are ordered from a defendant without a corresponding disgorgement order.
Therefore, under current law, such civil penalty amounts are not
available for distribution to injured investors. (314) The proposed
amendment would make it possible for the SEC to distribute these civil
penalty funds to defrauded shareholders even when there are no
disgorgement proceeds. (315)
Though allowing civil penalties to be added to Fair Funds even when
there is no disgorgement order would be a positive development,
unfortunately, the amounts available for shareholder compensation still
would be extremely small in comparison to investor losses. The sources
of civil money penalties (e.g., corporations, officers) lack the
capacity to provide restitution for the full level of investor harm, and
with several parties potentially staking a claim on their funds (e.g.,
plaintiffs' lawyers in securities class actions, the SEC, and
possibly the bankruptcy court), the amounts available for Fair Fund use
will continue to be inadequate.
Creation of the ICF, which collects a premium pegged to expected
fraud losses ex ante rather than collecting illicit profits from
wrongdoers ex post, as is the case with the Fair Funds, would provide a
great deal more compensation to defrauded investors. All defrauded
investors will be entitled to participate in damage recoveries through
the ICF because the fund will be adequate to provide such compensation.
Despite the current limitations of Fair Funds, under the ICF Proposal,
the SEC will combine the funds collected by the ICF and Fair Funds
efforts to provide even greater investor compensation for securities
fraud losses. Combining the Fair Funds and ICF premiums provides the
benefit of having the actual wrongdoers (i.e., the corporate managers
that perpetrated the fraud) provide compensation to the victims of that
fraud. This combination furthers the aims of corrective justice. (316)
Recently, the SEC announced the creation of a new specialized
office to coordinate the distribution of Fair Funds to defrauded
investors. (317) The experience garnered from managing this new office
could allow for an easier transition to administering the ICF were the
ICF Proposal adopted.
B. U.S. Insurance-Based Proposals
Two leading scholars recently set forth innovative insurance policy
proposals to provide compensation for shareholders' fraud-related
loses. David Skeel proposed creating a federal insurance fund to provide
compensation for shareholder losses stemming from corporate fraud. (318)
Skeel envisions an optional investor insurance scheme funded by
corporate contributions and administered by a new federal agency, the
Federal Investor Insurance Corporation. (319) In addition, Joshua Ronen
set forth a proposal under which public companies would purchase
financial statement insurance (FSI) that would compensate shareholders
that suffered losses stemming from financial statement
misrepresentations. (320) Under this proposal, insurance carriers would
hire auditors to audit the books of their policyholders, and companies
would disclose to the public the amount of insurance coverage obtained
and the premiums paid therefor. (321)
Though commendable in many respects and worthy of serious
consideration, the Ronen and Skeel proposals suffer from the same key
deficiency--shareholder compensation for accounting fraud in all
likelihood would not be much (if at all) higher under these proposals
than is currently the case. Under the Skeel proposal, funding would be
generated by fees levied on corporations and hence would be limited by
the capacity of corporations to contribute. Given trading dynamics,
investor losses from securities fraud occurring over an extended period
easily can be of such a magnitude that a corporation would be unable to
afford insurance premiums that would capture fully the risk of investor
losses from fraud. (322) Thus, compensation for fraud under the Skeel
proposal is unlikely to be higher than that which is currently available
through D&O insurance payouts. (323)
Similarly, though providing an important improvement in auditor
incentives (since the auditors' clients would be insurance
companies, not the companies being audited), the Ronen proposal in all
likelihood would not result in increased compensation. Under the
proposal, companies would pay the premiums on the financial statement
insurance. (324) Ronen explores two possibilities with respect to the
level of insurance coverage: (1) the level of coverage under FSI is the
same as it is under the current regime or (2) the level of coverage
increases. (325) If the former were to be the case, of course, for
reasons discussed above in connection with the Skeel proposal, the
payouts under the Ronen scheme are likely to be small fractions of total
investor losses. If coverage were to increase significantly over current
levels, Ronen suggests insurers would have the capacity to pay for this
increased coverage by hedging, in the capital markets, the losses the
carriers are insuring. (326) Specifically, he states that insurers could
buy special put options from institutional investors such as pension
funds and mutual funds. (327) Such puts, which would have durations
corresponding to the insurance coverage period, would be exercisable
upon a decline in the stock price of the insured company caused by
financial statement misrepresentations or omissions. (328)
There is, however, reason to doubt that the insurers would be able
to hedge against these losses effectively. (329) Institutional investors
of the sort identified by Ronen (i.e., pension funds and mutual funds)
in all likelihood would have little interest in taking on the risk
inherent in acting as a counterparty to this sort of hedge, (330) and
there is reason to question whether a sufficiently large group of new
institutions (e.g., hedge funds) would emerge to perform this function
because of the potential for catastrophic losses from a large-scale
fraud. Selling a put to the carrier insuring a company whose fraud
generated multi-billion dollar shareholder losses could signal financial
ruin for an institution. Thus, it is unlikely, as Ronen implicitly
acknowledges, (331) that any one institution would be willing to take on
such a risk. For sure, several institutions could agree to assume the
risk jointly. However, this could lead to difficult coordination issues,
and, unless the group were of substantial size, still may not
satisfactorily spread the risk. This type of risk would be best spread
across numerous participants in the broader financial markets and may be
what Ronen envisions. However, thus far, with limited exceptions, (332)
the financial markets have played only a limited role in traditional
insurance, (333) and there is some question as to whether a financial
product linked to FSI would be viable when no similar product has
emerged with respect to most other types of insurance. The market
appetite for these securities fraud puts simply may not exist in
sufficient amounts to provide a robust public reinsurance market.
In sum, it is not clear that there would be substantial additional
compensation beyond current levels under the Ronen proposal. The ICF
Proposal, in contrast, because of the collection of premiums with each
stock sale, promises a ready source of funding for investor
compensation. That said, because the Ronen proposal has the potential to
minimize the likelihood of misrepresentations in financial statements,
there is no reason why elements of the Ronen proposal could not be
implemented in conjunction with the ICF.
C. Canadian Securities Misinformation Insurance (334)
Tom Baker, a leading U.S. insurance law scholar, developed an
innovative proposal for what he terms "securities misinformation
insurance," a program designed to compensate Canadian market
investors for losses stemming from securities law violations. (335)
Baker, in a report to The Task Force to Modernize Securities Legislation
in Canada, describes various ways in which the insurance program could
be structured. These methods include (1) a government-sponsored, primary
insurance program, funded by both per-trade fees (336) payable by
investors and annual risk-based assessments payable by issuers, with the
fund having subrogation (337) rights against responsible parties, (338)
(2) company-provided excess insurance (339) funded by annual issuer-paid
risk-based premiums, with the fraud protection fund having subrogation
rights (340) against responsible parties, (341) and (3) mandatory (342)
private market (343) excess insurance (344) funded by market-priced
issuer premiums, with subrogation rights (345) against the responsible
parties for the securities protection insurer. (346) Baker's report
does not make a specific recommendation to the task force with respect
to adopting any particular option. However, Baker does conclude that,
although a securities misinformation insurance program could provide
systemic benefits for the Canadian capital markets, including increased
investor confidence and better securities law compliance, (347)
increased compensation (or "loss spreading") is not a valid
basis for this type of insurance. (348) Baker argues that the risk of
securities fraud can be mitigated substantially (though not eliminated)
much more inexpensively by diversification. (349) Even undiversified
investors, according to Baker, would not want, ex ante, the protection
of securities misinformation insurance (what he calls "an expensive
risk distribution strategy") to protect them from fraud risk. (350)
This Article has attempted to make the case for investor
compensation, including the compelling case for corrective justice, and
to explain the many benefits of a compensation fund. However,
Baker's proposal differs significantly from the ICF Proposal, and
it is understandable that he characterized the three options he set
forth as "expensive risk distribution strateg[ies]." (351) One
of the most attractive characteristics of the ICF Proposal lies in the
elimination of secondary market securities class actions. This design
feature affords significant administrative cost savings over the current
regulatory regime. In contrast, the three options for Baker's
proposal listed above all include subrogation rights and, in options two
and three, the continued existence of civil litigation as fraud
victims' first recourse for compensation. Thus, the costs of
administering the insurance schemes would be additional costs above
those of conducting litigation. In all likelihood, the costs of a single
insurer suing the corporation and its officers pursuant to the
insurer's subrogation rights as contemplated by option one would be
less than the costs of securities class actions as we know them in the
United States because of the reduced complexity of such suits. However,
most of the costliest aspects of litigation (e.g., discovery disputes)
still remain. In addition, allowing civil litigation to continue under
these proposals results in the likelihood of the company paying damages,
something that, as noted by other commentators, has the effect of
punishing the innocent shareholders remaining in the corporation. (352)
For sure, the threat of litigation can serve as a fraud deterrent.
However, the ICF provides deterrence through the use of fraud risk
ratings without the costs of the civil litigation system.
The conventional academic wisdom on securities fraud losses holds
that shareholder compensation is unnecessary. However, the conventional
wisdom ignores the substantial harm that defrauded shareholders, both
diversified and undiversified, can suffer from securities fraud. The
Investor Compensation Fund offers a way to compensate shareholders for
fraud-related losses, while also increasing fraud deterrence. Of course,
implementing the ICF would be a challenging and ambitious undertaking at
best, and perhaps politically infeasible. Still, the ICF Proposal offers
a promising avenue for a fundamental rethinking of the way we compensate
securities fraud victims.
(1.) Frank H. Easterbrook & Daniel R. Fischel, Optimal Damages
in Securities Cases, 52 U. CHI. L. REV. 611, 641 (1985).
(2.) See id.
(3.) Id. Easterbrook and Fischel state,
Id. Easterbrook and Fischel, however, do argue that "the
optimal [damage] award is surely a good deal smaller than the gross
transfer of wealth." Id. at 641-42.
(4.) See, e.g., Janet Cooper Alexander, Rethinking Damages in
Securities Class Actions, 48 STAN. L. REV. 1487 (1996) (proposing a
shift from traditional securities litigation to a system of civil
penalties to deter fraud); A.C. Pritchard, Markets as Monitors: A
Proposal to Replace Class Actions with Exchanges as Securities Fraud
Enforcers, 85 VA. L. REV. 925, 983 (1999) (advocating an end to
securities litigation and outlining an alternative enforcement regime
run by stock exchanges with no damages to be paid to victims of fraud).
(5.) ANJAN V. THAKOR ET AL., THE ECONOMIC REALITY OF SECURITIES
CLASS ACTION LITIGATION 12-14 (2005), available at
(6.) See Jonathan D. Glater, Critics of Shareholder Suits Aim at
Big Holders, N.Y. TIMES, Oct. 27, 2005, at C (describing the U.S.
Chamber study); Kenneth M. Lehn, Commentary, Private Insecurities, WALL
ST. J., Feb. 15, 2006, at A16 (providing commentary that refers to the
U.S. Chamber study).
(7.) See LAURA E. SIMMONS & ELLEN M. RYAN, CORNERSTONE
RESEARCH, SECURITIES CLASS ACTION SETTLEMENTS, 2006 REVIEW AND ANALYSIS
6 (2007) (finding settlements represent a median 2.4% of "estimated
damages" in 2006 and 3.6% of "estimated damages" in
1996-2005), available at
Cornerstone Research cautions that its damages estimates should not be
assumed to be the amount of actual damages borne by shareholders, as the
figure is derived using a highly simplified methodology. Id. at 4. Thus,
one should employ caution when comparing investor recoveries to this
measure of damages. Nonetheless, it is clear that, on average, there is
a sizable difference between typical settlement recoveries and investor
losses. It should be noted, however, that there are exceptions to this
general rule and that recovery as a percentage of total losses is
generally higher in smaller settlements. See id. at 6.
(8.) For exceptions to this general rule, see, e.g., Bernard Black
et al., Outside Director Liability, 58 STAN. L. REV. 1055, 1057 (2006)
("In [the Enron and WorldCom settlements], outside directors agreed
to make substantial payments out of their own pockets to settle
securities class action lawsuits....").
(9.) Of course, the securities laws now employ a robust regulatory
mechanism. However, implementing the ICF would add to this regime
(10.) Alexander, supra note 4, at 1502. There are two investors
(ignoring for present purposes the role of any "market maker"
that matches buy and sell orders) involved in each trade of a stock
artificially inflated by securities fraud. The shareholder (Shareholder
A) who purchased stock before the commencement of any fraud and then
sold that stock to another investor (Shareholder B) at an artificially
inflated price while the fraud was occurring but before the fraud was
uncovered benefited from the fraudulent scheme and enjoyed a
(11.) A CAPM adherent could make the claim that diversification
alone would provide investors with substantial protection from fraud.
Just as an investor could lose 75% of her investment in a company
because of fraud, an investor could see the value of her investment in
another company increase because of some unexpected good news (e.g., a
company in which she is invested has discovered the cure for cancer). I
leave to future work exploration of whether securities fraud is fully
diversifiable generally. However, because in my view, as described in
this section, fraud risk is different in nature from other business
risks, the answer to this question does not affect the basic thesis of
(12.) But see Richard A. Booth, The End of the Securities Fraud
Class Action as We Know It, 4 BERKELEY BUS. L.J. 1, 13 (2007) (arguing
that "[t]he risk of simple securities fraud is like any other
ordinary business risk").
(13.) These are notable exceptions, however. For examples of works
in which corrective justice is discussed in connection with securities
litigation, see Elizabeth Chamblee Burch, Reassessing Damages In
Securities Fraud Class Actions, 66 MD. L. REV. 348, 371-72 (2007)
(describing, but ultimately rejecting, the corrective justice argument
for private securities class actions); William M. Sage, Some Principles
Require Principals: Why Banning "Conflicts Of Interest"
Won't Solve Incentive Problems in Biomedical Research, 85 TEX. L.
REV. 1413, 1462 (2007) (briefly discussing the failure of fraud on the
market suits to advance corrective justice).
(14.) See, e.g., Jules L. Coleman, The Practice of Corrective
Justice, 37 ARIZ. L. REV. 15, 15 (1995) ("[T]hose who are
responsible for wrongful losses of others have a duty to repair them
...."). In the discussion that follows, the Investor Compensation
Fund will be described as advancing the aims of corrective justice by
requiring the wrongdoers (i.e., the corporate officers participating in
the fraud) to contribute to the fund, while providing an insurance
mechanism to cover the gap between the wrongdoers' ability to pay
and the total losses caused. See text accompanying infra note 316.
(15.) It should be noted that the gains-equals-losses in the
aggregate argument does not hold with respect to non-insiders in the
presence of insider trading. ("Insider trading" is trading by
insiders (e.g., company officers) while in possession of material,
non-public information.) If insiders commit securities fraud by
deceiving the market about a firm's prospects and do so to be on
the winning side of trades tainted by fraud, then outside shareholders,
by definition, will be on the losing side of these trades. Thus, when
factoring in trades by insiders, on average, outsiders will be net
losers. See generally Pritchard, supra note 4, at 946 n.78 (stating that
"investors cannot diversify away wealth transfers to" traders
with an asymmetric information advantage); see also Booth, supra note
12, at 14 ("Fraud with insider trading constitutes a net loss to
investors in the aggregate.").
(16.) "Individual" in this context means
"single," as opposed to multiple. As used here,
"individual" does not refer only to natural persons.
(17.) See Shantaram P. Hegde et al., The Financial Impacts of Fraud
and Securities Class Action Suits 41 (Jan. 7, 2003) (unpublished
manuscript) ("Overall, the [study's] findings are consistent
with the proposition that investors faced with fraud allegations and
ongoing uncertainty about a firm's reputation and prospects will
exit en-masse such firms, almost without regard to price. Investors are
clearly 'frightened' by concerns over agency costs,
information asymmetry, bad reputation and uncertainty."), available
at http://184.108.40.206/Denver/Papers/10b5.pdf; see also Booth, supra
note 12, at 5 (describing the negative effect the anticipation of the
company paying damages in a securities class action suit can have on
stock price upon a fraud revelation).
(18.) For an example of the securities litigation issues on which
the Institute for Legal Reform focuses, see, Inst. for Legal Reform,
visited Sept. 18, 2007).
(19.) Defined as those investors required by the SEC to file
quarterly Form 13F statements detailing their investment holdings. See
THAKOR ET AL., supra note 5, at 10-11. Investors that are required to
file 13Fs are investment managers with $100 million or more in assets
under discretionary management. SEC, Division of Investment Management:
Frequently Asked Questions About Form 13F, May 2005, available at
http://www.sec.gov/divisions/investment/13ffaq.htm. Managers must report
all long common stock positions of at least 10,000 shares or $200,000 in
fair market value. Id. One of the limitations of the U.S. Chamber study
is that it must rely on Form 13Fs, which aggregate data for fund
families (e.g., all of the Fidelity funds or all of the Janus funds). No
data is available for individual funds within the organization.
Investors do not invest in fund families, but rather in individual
funds. Therefore, any insights derived from this study cannot fairly be
described as giving us a sense for what any individual investor would
have experienced as a result of securities fraud over the ten-year study
period. However, the study is useful in that it attempts to simulate the
experience of large, diversified investors.
(20.) This figure does not factor in any potential recoveries from
litigation. THAKOR ET AL., supra note 5, at 12.
(21.) Id. at 19.
(22.) Id. at 12 fig.2, as confirmed by study authors.
(24.) Id. The sample in this study includes corporations that
issued shares during the class action period, and the study's
results show that, overall, investor net losses are likely to be greater
when the defendant corporation issues shares during the class action
period. See THAKOR ET AL., supra note 5, at 15-17 (discussing this
finding). As the authors explain, this is because, under this scenario,
the corporation itself sells shares to the market, which creates a
situation under which the number of shares purchased by investors will
exceed the number of shares sold by investors while the fraud is
ongoing. Id. at 15. This finding may explain, in part, the reason for
the asymmetry between the number of extreme net gainers and extreme net
losers in the study. One must note that because the study does not limit
its sample exclusively to frauds that affect secondary market prices
only, but also includes cases that affect primary market purchases, the
results are somewhat less relevant to a consideration of the creation of
the Investor Compensation Fund, which, as described infra, will provide
recovery for instances of fraud that affect secondary market prices
only. It is clear that investors suffer net losses when purchasing
shares at artificially inflated prices directly from the corporation.
(25.) The cases studied exclude analyst and IPO cases. Id. app. I
(26.) See Easterbrook & Fischel, supra note 1, at 641.
(27.) See generally Pritchard, supra note 4, at 941-42 (discussing
the effect of fraud on research and verification efforts by traders).
(28.) Easterbrook & Fischel, supra note 1, at 641.
(29.) See Stephen J. Choi & A.C. Pritchard, Behavioral
Economics and the SEC, 56 STAN. L. REV. 1, 17-20 (2003) (describing the
ways in which institutional managers "suffer from behavioral
(30.) Under the theory of "loss aversion," the loss of,
for example, $100 hurts an investor more than gaining $100 will provide
pleasure. Richard H. Thaler, Mental Accounting Matters, 12 J. BEHAV.
DECISION MAKING 183, 185 (1999).
(31.) This analysis relies on the assumption that there are more
instances of "bad news" fraud (i.e., fraud that results in an
artificially high stock price because bad news is concealed) than
"good news" fraud (i.e., fraud that results in an artificially
low stock price because good news is concealed). This is generally
understood to be the case. See, e.g., Booth, supra note 12, at 6
("There are notable examples of both types of fraud, but bad news
fraud is far more common ....").
(32.) See, e.g., Donald C. Langevoort, Capping Damages for
Open-Market Securities Fraud, 38 ARIZ. L. REV. 639, 646 (1996) ("At
least active traders with large, diversified portfolios have roughly the
same chance of being winners as losers from securities fraud ....")
(33.) Alexander, supra note 4, at 1502 n.58.
(35.) See RONALD J. GILSON & BERNARD S. BLACK, THE LAW AND
FINANCE OF CORPORATE ACQUISITIONS 84-85 (2d ed. 1995) (discussing how
variance decreases with increased numbers of transactions (coin flips in
their simplified example)).
(36.) Recall the anti-compensation argument is not that fraud risk
is diversifiable just like any other business risk, but that gains and
losses from the same risk--namely fraud risk--will be equal.
(37.) For other arguments that buy-and-hold and long-term investors
suffer net losses from securities fraud, see Booth, supra note 12, at 11
n.23 (describing the "intergenerational conflict" that,
according to Julian Velasco, affects the "equivalent gains and
losses" argument). Velasco suggests that younger buy-and-hold
investors are net buyers and suffer disproportionately from fraud that
inflates stock prices because they may not sell as often as they buy.
Id. Though they will sell periodically for tax or rebalancing reasons,
there is some question as to whether the number of purchases will
outweigh the number of sales. Id. Velasco points out that these
investors will become net sellers as they age, and then the bias will
reverse. Id. However, this "may not be enough to overcome the
time-value of earlier lost returns." Id; see also Jill Fisch,
Criminalization of Corporate Law: The Impact on Shareholders and Other
Constituents, 2 J. BUS. & TECH. L. 91, 94 (2007) (arguing,
generally, that though short-term "in and out" traders benefit
from fraud, investors in indexed mutual funds suffer because index funds
do not "get out of [the stock of] a company [engaging in
fraud].") [hereinafter Fisch, Criminalization of Corporate Law].
(38.) "Retail investors" are natural persons.
(39.) See, e.g., New York Stock Exch., NYSE Group Turnover
Statistics, http://www.nysedata.com/nysedata/Home/FactsFigures/tabid/115/Default.aspx (follow "Market Activity" hyperlink; then follow
"NYSE Group Turnover" hyperlink) (last visited Sept. 18,
(40.) INV. CO. INST. & SEC. INDUS. ASS'N, EQUITY OWNERSHIP
IN AMERICA 25 fig.34 (2005), available at
survey defines an equity trade as either the sale or purchase of a
corporate stock or shares in a mutual fund. Id. at 39. Thus, these
figures overstate the level of direct trading by retail investors.
(41.) For example, one study analyzing retail trading behavior
between 1991 and 1996 finds that the average turnover rate in portfolios
at a retail brokerage house was 7.59% and that the typical retail
investor made fewer than ten trades per year. Alok Kumar & William
N. Goetzmann, Equity Portfolio Diversification 8 (Yale ICF, Working
Paper No. 00-59, 2002), available at
study, which followed the trading behavior of individual investors over
a six-year period, finds that the median number of stocks traded by
retail investors in a month was 0.37. Gina Nicolosi et al., Do
Individual Investors Learn from Their Trading Experience? 19 tbl.1
(unpublished manuscript) (2004), available at
http://faculty.gsm.ucdavis.edu/~nzhu/papers/learning.pdf; cf. Brad M.
Barber & Terrance Odean, Trading is Hazardous to Your Wealth, 55 J.
FIN. 773, 781 (2000) (analyzing a set of discount brokerage data and
finding that "[t]he average household turns over more than 75
percent of its common stock portfolio each year"). Barber and Odean
further note that the high turnover rate among the individuals in their
study contributed to lower returns. Id. at 773. Even if the Barber and
Odean study sample is more representative of the overall individual
investor population with respect to trading frequency than those in the
studies described above, and this is not clear, there are still valid
reasons, as described in this section, not to provide incentives for
excessive trading by eliminating compensation for fraud losses.
Moreover, an investor that owns a small number of stocks (e.g., four
stocks) can turn over 75% of her portfolio in a year by making only a
few sell/buy trades (e.g., three) in that year. Thus, for purposes of
this discussion, this still would represent a low level of trading
(42.) NEW YORK STOCK EXCH., SHAREOWNERSHIP 2000: BASED ON THE 1998
SURVEY OF CONSUMER FINANCES 34 (2000), available at
http://www.nyse.com/pdfs/shareho.pdf. This figure on "household
sector" ownership (41.1%) includes ownership by individuals and
nonprofit institutions. Id. at 33. Nonprofit holdings are estimated to
be approximately 5% of the household sector total. Id. It also should be
noted that the corporate stock represented in this data includes some
closely held stock. Id. at 32-33.
(43.) See, e.g., Barber & Odean, supra note 41, at 775
("Trading costs are high. The average round-trip trade in excess of
$1,000 costs three percent in commissions and one percent in bid-ask
(44.) See, e.g., id. at 774 (stating that their study evidence
shows "households that trade frequently earn a net annualized
geometric mean return of 11.4 percent, and those that trade infrequently
earn 18.5 percent").
(45.) See Dean Baker et al., The Case for a Securities Transactions
Tax: Taxing the Big Casino 1-2 (Econ. Pol'y Inst., Technical Paper
No. 229, 1995).
(46.) Doing so, of course, would accomplish nothing with respect to
lessening overall investor losses from fraud, but each investor would
have incentives to try to avoid being on the losing side of
(47.) Brian K. Bucks et al., Recent Changes in U.S. Family
Finances: Evidence from the 2001 and 2004 Survey of Consumer Finances,
FED. RES. BULL. 2006, at A15 (2006), available at
(48.) See, e.g., Mark S. Rzepczynski, Portfolio Diversification:
Investors Just Don't Seem to Have Enough, JWH J. (John W. Henry
& Co., Boca Raton, Fla.), 2003, at 2, available at
http://www.jwh.com/Documents/JWHJournal_2003.pdf (discussing results of
study performed by Kumar and Goetzmann, described in note 41, supra). As
Rzepczynski explains, the study finds that even for the portfolios that
hold larger numbers of stocks, there is no "appreciable difference
in the average correlation across the stocks." Id. Thus, the
holders of these portfolios do not appear to do a better job at
diversifying (other than because of the higher numbers of stocks owned)
than do the holders of portfolios with a small number of stocks. Id.
(49.) Kumar & Goetzmann, supra note 41, at 4 (noting that
mutual fund allocation was approximately 15% of the investors'
overall portfolios, on average, and that such allocation did not vary
significantly by investor based on diversification of the studied
(50.) See id. at 31-32 (stating that the reasons for the lack of
diversification include (1) search and monitoring costs, (2) the
"false perception" by investors "that they can manage
their portfolio risks better by a thorough understanding of a small
number of firms rather than diversifying," (3) an illusory sense of
control stemming from direct involvement in the investment process in
lieu of reliance on others (e.g., through mutual funds) to make
investment decisions, and (4) gambling tendencies).
(51.) There is evidence that individual investors already believe
that they are protected against losses from securities fraud. See
OPINION RESEARCH CORP., INVESTOR SURVIVAL SKILLS SURVEY: AN EXAMINATION
OF INVESTOR KNOWLEDGE AND BEHAVIOR 8 (2005) (showing that 92% of
individual investors surveyed do not know that their investments are not
insured against losses from securities fraud by the government),
available at http://www.sipc.org/pdf/121305_SIPC_IPT_survey.pdf.
Approximately 80% of those surveyed believe their investments are
insured by the Securities and Exchange Commission (SEC), the Federal
Deposit Insurance Corporation (FDIC), and/or the Securities Investor
Protection Corporation (SIPC), which only protects investors against
loss of property (e.g., cash and securities) at failed brokerage firms.
Id. One possible source of the confusion may stem from the reforms
passed following the spate of accounting scandals in connection with the
Sarbanes-Oxley Act, such as the creation of Fair Funds, discussed in
Part V.A, infra. In any event, if there is another major accounting
scandal that leaves investors largely uncompensated for their losses (as
will be the case, with respect to the lack of compensation, in the
absence of reform), investors will be disabused of their mistaken belief
in the existence of meaningful insurance protection and may exit the
markets. It is worthwhile to note that the survey participants are
current investors. It is, therefore, conceivable that a belief in the
existence of an insurance mechanism gives these investors greater
confidence to invest. Providing a real insurance fund, such as the ICF,
discussed in Part IV, infra, and publicizing its existence, may
encourage more individuals to enter the market.
(52.) Booth, supra note 12, at 11. For a description of exceptions
to this view, see id. at n.40.
(53.) Id. at 12. Booth offers limited exceptions to this general
view. See id. at 14-15 & n.40.
(54.) Id. at 12, 14.
(55.) Booth, supra note 12, at 10.
(56.) One might argue that what would be most appropriate given the
foregoing arguments is for compensation for fraud losses to be provided
only to undiversified investors. However, such a regime could have
negative unintended consequences. First, it could result in companies
eschewing investments by individual investors on the margin. If managers
intend to engage in fraud, in such a regime, they would prefer to have
diversified investors (such as large institutions) in the pool of
potential claimants. (To discourage individual stock ownership, firms
could fail to do stock splits after significant stock price increases or
fail to market their shares to individual investors. Of course, one may
argue that a manager intent on engaging in fraud would prefer an
investor base consisting more of retail investors than institutional
investors because retail investors are less likely to serve as effective
monitors. However, there is reason to question whether an investor base
comprised exclusively (or almost so) of institutions would engage in
substantially more monitoring than occurs now. See infra note 113 for
further discussion of this point.) In addition, providing compensation
for only undiversified investors could provide incentives for individual
investors to avoid mutual fund investments in favor of direct
investment. Though the benefits of diversification that may be achieved
through a mutual fund are substantial, investors may forego that benefit
if they feel they will have more protection from fraud by investing
directly in stocks. Finally, administering such a scheme would be very
challenging because claimants would have to prove not only that they
were shareholders in the subject company, but also prove that they lack
sufficient additional investments, so as to be considered a true
"undiversified investor." Compensation for all fraud losses
suffered by all investors, therefore, should be an integral part of our
securities regulation regime.
(57.) Private Securities Litigation Reform Act of 1995, Pub. L. No.
104-67, 109 Stat. 737. (1995) (codified as amended in scattered sections
of 15 U.S.C. and 18 U.S.C.).
(58.) See Alexander, supra note 4, at 1488 (recognizing that,
despite "the sweeping changes that won approval in one or both
houses," no reform "addressed the measure of damages").
One limited exception to the foregoing is the so-called
"bounceback" provision (codified at 15 U.S.C. [section]
78u-4(e)) which affects damages awards by separating fraud-related
losses from losses caused by market conditions at the time of the
corrective disclosure. John Finnerty & George Pushner, An Improved
Two-Trader Model for Measuring Damages in Securities Fraud Class
Actions, 8 STAN. J.L. BUS. & FIN. 213, 224 (2003). The PSLRA
accomplishes this by requiring that plaintiff damages in "bad
news" fraud cases be no more than the difference between the price
paid for the stock and (1) the average trading price during the 90-day
period following the corrective disclosure or (2) the average price
during the period the stock is held by the investor following the
corrective disclosure if shorter than 90 days. 15 U.S.C. [section]
78u-4(e)(1)-(2). Comparable provisions apply in "good news"
fraud cases. Despite the enactment of the bounceback provision, the
basic calculation of damages for securities fraud losses was unchanged
by the PSLRA.
(59.) Of course, the creation of an investor compensation fund, as
described infra Part IV.C.8., poses its own set of political challenges.
(60.) Securities class actions have been highly criticized along a
number of dimensions. In this section, I focus only briefly on their
effectiveness with respect to compensation and deterrence and on the
cost of administration.
(61.) 17 C.F.R. [section] 240.10b-5 (2007).
(62.) SIMMONS & RYAN, supra note 7, at 6. See text accompanying
note 7, supra, for cautionary language regarding these damages
estimates. Plaintiffs can pursue parties other than the corporation and
its officers, such as auditors, in hopes of achieving higher recoveries.
However, according to one plaintiffs' attorney with over 25 years
of securities litigation experience, with whom I spoke on condition of
anonymity, establishing liability for non-insiders and winning such
cases is typically more difficult. Telephone Interview with
plaintiffs' attorney (June 21, 2007) [hereinafter Telephone
Interview #1]. See also John C. Coffee, Jr., Reforming the Securities
Class Action: An Essay on Deterrence and its Implementation, 106 COLUM.
L. REV. 1534, 1550 (2006) (stating, "Auditors ... appear to be
named as defendants in only a very low percentage of securities class
(63.) SEC, REPORT PURSUANT TO SECTION 308(C) OF THE SARBANES-OXLEY
ACT OF 2002, at 20 (2003) [hereinafter SEC, SECTION 308(C) REPORT],
available at http://www.sec.gov/ news/studies/sox308creport.pdf.
(64.) This also can be the price sold if the allegation of fraud
involves the withholding of "good news" that would have made
the price higher than the one at which the investor sold. These claims,
however, occur much less frequently than claims that the price was
inflated by the nondisclosure of bad news. See discussion in note 31,
(65.) This definition of damages, though accurate, oversimplifies
the complicated damages calculation. See note 122, infra, for further
discussion on the damages calculation.
(66.) SIMMONS & RYAN, supra note 7, at 4.
(67.) Coffee, supra note 62, at 1556.
(68.) Id. at 1550-51.
(69.) Id. at 1556.
(70.) See Tom Baker & Sean J. Griffith, The Missing Monitor in
Corporate Governance: The Directors' and Officers' Liability
Insurer, 95 GEO. L.J. 1795, 1806 (2007) (noting that, based on the
results of interviews with D&O insurance executives, "the
largest available [D&O] coverage limit is $300 million"), cited
in Coffee, supra note 62, at 1556 n.83. However, one D&O insurance
executive (with over 25 years of experience in various aspects of the
industry), with whom I spoke on condition of anonymity, stated that
corporations generally could obtain more insurance than they do. The
question is how much protection they are willing to purchase given the
cost. The executive suggested that it might be possible to put together
a package of D&O insurance for a large corporation of as much as
$1.1 billion if backed by contingent pools of capital from reinsurers.
Telephone interview with D&O insurance executive (July 11, 2007)
[hereinafter Telephone Interview #2]. Of course, the premiums on this
level of insurance coverage would be extremely high and in all
likelihood not cost-effective for the corporation. See Coffee, supra
note 62, at 1556 (stating, "No corporation can afford to insure its
board for $1 billion ..."). Moreover, this level of insurance,
while a significant improvement over current levels, still would
represent only a portion of investor losses in large-scale fraud cases.
(71.) Researchers have found the same limiting effect of insurance
in medical malpractice lawsuits. See Kathryn Zeiler et al.,
Physicians' Insurance Limits and Malpractice Payments: Evidence
from Texas Closed Claims, 1990-2003, J. LEGAL STUD. (forthcoming 2007)
(manuscript at 39) ("Although most legislatures have shied away
from capping economic damages, insurance policy limits appear to be an
important source of soft caps on malpractice plaintiffs' total
recoveries."), available at http://ssrn.com/abstract=981192. The
fact that the same phenomenon occurs in two different, but prominent
litigation areas--securities class actions and medical malpractice
suits--suggests that it is unlikely that much more in payments can be
extracted from corporate defendants through securities litigation.
(72.) See Coffee, supra note 62, at 1548 (stating,
"[S]ecurities class actions do seem sufficiently pervasive to
constitute a deterrent threat for most public corporations").
(73.) TODD FOSTER ET AL., RECENT TRENDS IN SHAREHOLDER CLASS ACTION
LITIGATION: FILINGS STAY LOW AND AVERAGE SETTLEMENTS STAY HIGH--BUT ARE
THESE TRENDS REVERSING? 7 (2007), available at
based on filing rate from 2005-2007 (projected). Id. at 7, 16, n.6.
Because of the decline in the number of securities class action filings
over the last two years, the probability of facing suit is lower than it
has been in prior years. Id. at 7.
(74.) Coffee, supra note 62, at 1548.
(75.) See id.
(76.) See id. at 1543 (noting that, because attorneys' fees
are related to the size of recovery, small market capitalization
companies are not as likely to be sued); see also Telephone Interview
#1, supra note 62 (stating that small market capitalization companies
with thinly traded stocks are less likely to be sued because expected
damages, due to the low trading volume, are not high and because class
certification issues are more challenging in these cases because
reliance on the alleged fraudulent statements by the individual members
of the class must be shown); cf. Basic Inc. v. Levinson, 485 U.S. 224
(1988) (setting forth rebuttable presumption of reliance on
misstatements where stock is traded in an efficient market). The SEC,
however, has a renewed focus on prosecuting fraud in smaller companies.
See Testimony Concerning A Review of Investor Protection and Market
Oversight with the Five Commissioners of the Securities and Exchange
Commission: Hearing Before the H. Comm. on Financial Services, 110th
Cong. (2007) (statement issued by the witnesses representing the SEC:
Christopher Cox, Chairman, Paul S. Atkins, Comm'r., Roel C. Campos,
Comm'r., Annette L. Nazareth, Comm'r., Kathleen L. Casey,
Comm'r.) ("We have created [a] special working group ...
within our Enforcement Division to deal with ... microcap fraud."),
available at http://www.sec.gov/news/testimony/2007/ts062607sec.htm.
Thus, the extra enforcement resources from the SEC could offset to a
limited degree the lack of attention from plaintiffs' lawyers.
(77.) Pritchard, supra note 4, at 957.
(78.) Id. at 928.
(79.) Coffee, supra note 62, at 1550-51.
(80.) However, as Coffee notes, nonfinancial consequences flowing
from securities class actions such as the "risk of ouster" for
insiders also can have deterrent effects. Id. at 1554.
(81.) See THAKOR ET AL., supra note 5, app. III, at Exhibit A
(finding total plaintiffs' attorney fees of $3.1 billion in
connection with total gross settlements of $19.8 billion, which reflects
attorney fees of approximately 16% of class recovery); Coffee, supra
note 62, at 1546 & n.37 (citing a study by Denise N. Martin et al.
and noting that the figure for attorneys' fees as a percentage of
recovery for suits in the 1990s--32%--may have declined in recent years
due, in part, to today's larger recoveries).
(82.) One group of commentators suggests that defense attorney fees
are roughly equivalent to those of plaintiffs' attorneys, who they
assert generally receive 20%-30% of shareholder recovery. Elliott J.
Weiss & John S. Beckerman, Let the Money Do the Monitoring: How
Institutional Investors Can Reduce Agency Costs in Securities Class
Actions, 104 YALE L.J. 2053, 2080 (1995). More recently, one insurance
industry executive estimated that defense costs of 25%-35% of the
settlement amount are common; however, defense costs can be
significantly higher. Baker & Griffith, supra note 70, at 1815 n.95,
cited in Coffee, supra note 62, at 1546 n.38.
(83.) See Pritchard, supra note 4, at 953-54 for further discussion
of these costs.
(84.) Coffee, supra note 62, at 1540.
(85.) E-mail from Emery G. Lee III, Senior Research Associate,
Federal Judicial Center, to author (Sept, 10, 2007, 12:17:42 EDT) (on
file with author). These figures include all securities class actions,
not just class actions related to secondary market fraud, the subject of
this Article. Figures represent actual class actions filed before
consolidation. Id. After consolidation, securities class actions
represent 9.4% of all class actions filed in federal court. Id. Though
this is a significantly lower percentage of class actions than the
percentage on a preconsolidation basis, judicial time must be expended
in the consolidation process. Thus, considering the number of single
filings is worthwhile in the context of this debate. Data were collected
as part of a study by the Federal Judicial Center of "The Impact of
the Class Action Fairness Act of 2005 on the Federal Courts." Id.
For a brief description of how the data were collected and the types of
actions included in the study, see THOMAS E. WILLGING & EMERY G. LEE
III, THE IMPACT OF THE CLASS ACTION FAIRNESS ACT OF 2005 ON THE FEDERAL
COURTS: THIRD INTERIM REPORT TO THE JUDICIAL CONFERENCE ADVISORY
COMMITTEE ON CIVIL RULES 23 (2007), available at
$file/cafa0407.pdf. See note 111, infra, for a discussion of the decline
(and recent rebound) of securities class action filing activity.
(86.) Coffee, supra note 62, at 1540.
(88.) Under this proposal, class actions for primary market fraud
(i.e., fraud in connection with initial public offerings and seasoned
equity offerings) will remain. Claims that a related set of
misrepresentations affected both purchasers in an offering and secondary
market purchasers will have to be bifurcated into two cases, with only
the secondary market purchasers being eligible for recovery from the
(89.) I acknowledge that the administrative problems inherent in
creating an investor compensation fund may be too difficult to overcome.
Therefore, no matter how prudent creating a compensation fund may be as
a theoretical matter, it may not be very practicable. Further study will
provide illumination of this important issue.
(90.) Specifically, the ICF premium also will be levied on equity
derivatives. Derivatives are securities that "derive" their
value from other underlying assets. Equity derivatives include
securities such as call options (which give holders the right, but not
the obligation, to buy a share of stock) and put options (which give
holders the right, but not the obligation, to sell a share of stock).
(91.) Exchange specialists and market makers are market liquidity
providers that match buy and sell orders and help stabilize markets as
necessary. Sales of stock by exchange specialists and market makers in
connection with making a market in the stocks for which they are
contractually bound to provide liquidity will be exempt from the ICF
(92.) The seller of the security will pay the ICF premium. Hence,
the "statutory incidence" or legal responsibility for the
payment lies with the seller. However, statutory incidence tells us
nothing about who, as between the seller and the buyer, actually will
bear the burden of the premium (the "initial economic
incidence") because the price to be paid by the buyer may in fact
increase to compensate for the premium levied on the seller. Given stock
market dynamics (e.g., the demand and supply curves of stock), it is
likely that the buyer will have to pay for as much as half of this
(93.) Section 31 of the Exchange Act authorizes the SEC to collect
transaction fees to recover the costs incurred by the federal government
in supervision and regulation of the securities markets. 15 U.S.C.
[section] 78ee(a) (2000 & Supp. II 2002). Currently, the
transactions subject to the fee include sales of publicly traded equity
securities (15 U.S.C. [section] 78ee(b)-(c) (2000 & Supp. II 2002)),
and the fee is assessed at a rate of 0.0011% of the dollar value of
transactions. Order Making Fiscal Year 2008 Annual Adjustments to the
Fee Rates Applicable under section 6(b) of the Securities Act of 1933
and sections 13(e), 14(g), 31(b), and 31(c) of the Exchange Act,
Securities Act Release No. 8794, Exchange Act Release No. 55682, 72 Fed.
Reg. 25,809 7 (April 30, 2007), available at
http://www.sec.gov/rules/other/2007/33-8794.pdf. Rather than investors
paying the SEC the amount owed directly, the national securities
exchanges and associations where the transactions occur report covered
transactions and remit the appropriate payment to the SEC. Id.; 15
U.S.C. [section] 78ee(e) (Supp. II 2002); 17 C.F.R. [section]
240.31(b)(1), (a)(17) (2007). Since collection of the ICF premium will
occur in a manner similar to that which is used to collect Section 31
fees and largely assess the same transactions, the systems for
transaction reporting and fee collection are currently in place. Thus,
the exchanges and associations will not have to make large investments
in infrastructure for ICF premium collection. However, the collecting
agencies will have to develop software to enable them to collect
different amounts upon the sale of different stocks (as opposed to a
fixed rate for large categories of securities, as is the case with
Section 31 fees).
(94.) This practice would be consistent with that of the Federal
Deposit Insurance Corporation (FDIC), which gives no rebates. As long as
the government correctly sets the ICF premium at the level of expected
losses, there will be no need for rebates. See generally Andrew
Kuritzkes, Til Schuermann & Scott Weiner, Deposit Insurance and Risk
Management of the U.S. Banking System: How Much? How Safe? Who Pays? 36
(Wharton Fin. Inst. Ctr., Working Paper No. 02-02-B, 2002) (discussing
this point in connection with FDIC insurance), available at
(95.) See Part IV.C.4., infra, for a discussion of the challenges
in generating fraud risk ratings.
(96.) In addition to the required annual assessment, an interim
review will be possible, upon petition by the corporation or upon
recommendation from the ICF Division if a "governance event"
(e.g., an accounting restatement due to fraud) occurs before the next
regularly scheduled review date.
(97.) See Part IV.C.4., infra, for further discussion of the role
of auditors and D&O insurers in this process.
(98.) Just as with private credit ratings, a company will have no
right to appeal the rating it receives, but it will be given an
opportunity to correct any factual errors influencing the rating before
the rating becomes effective.
(99.) Historically, SEC recognition of NRSROs followed a relatively
informal determination by the SEC, that "among other things, ...
the credit rating agency [seeking NRSRO status] [was] recognized
nationally by the predominant users of credit ratings as issuing
credible and reliable ratings." Oversight of Credit Rating Agencies
Registered as Nationally Recognized Statistical Rating Organizations,
Exchange Act Release No. 55,875, 72 Fed. Reg. 33,563, 33,564 (June 18,
2007) [hereinafter Oversight of Credit Rating Agencies], available at
http://www.sec.gov/rules/final/2007/34-55857.pdf. Amid claims that the
NRSRO designation process led to anti-competitive behavior and a lack of
innovation in credit rating processes, Congress enacted the Credit
Rating Agency Reform Act of 2006. Laura Blinkhorn, CQ Bill Analysis:
HR2990--Credit Rating Agency Duopoly Relief Act of 2006, CONG. Q., Oct.
13, 2006. Under the new statute, a rating agency seeking NRSRO status
must undertake a formal application process and be granted registration
by the SEC. Oversight of Credit Rating Agencies, supra, available at
http://www.sec.gov/rules/ final/2007/34-55857.pdf. As of this writing,
the SEC has recognized seven credit rating agencies as NRSRO's.
Press Release, SEC, Seven Credit Rating Agencies Register with SEC as
Nationally Recognized Statistical Rating Organizations (Sept. 24, 2007),
available at http://www.sec.gov/news/press/2007/2007-199.htm.
(100.) Definition of Nationally Recognized Statistical Rating
Organization; Securities Act Release No. 8570, Exchange Act Release No.
51,572, Investment Company Release No. 26,834, 72 Fed. Reg. 21,307
(proposed Apr. 25, 2005), available at
http://www.sec.gov/rules/proposed/33-8570fr.pdf. For example, certain
types of offerings for securities that are rated investment grade by at
least one NRSRO may be registered on a short-form registration statement
without the issuer having to meet the normally applicable minimum public
float requirements. Id. In addition, under the rules of the Investment
Company Act of 1940, money market funds generally are limited to
investing in securities that have received one of the two highest
ratings for short-term debt from an NRSRO. Id.
(101.) The NRSRO credit rating agency designation and the use of
NRSRO ratings in regulation have been subject to extensive criticism in
the past. See, e.g., Frank Partnoy, The Siskel and Ebert of Financial
Markets?: Two Thumbs Down for the Credit Rating Agencies, 77 WASH. U.
L.Q. 619, 624 (1999) ("In place of ratings-dependent regulation, I
recommend a replacement: simply substitute credit spreads, the market
risk measure of bonds, for credit ratings."); Claire A. Hill,
Regulating the Rating Agencies, 82 WASH. U. L.Q. 43, 93 (2004) (stating,
"The easiest proposal to defend on theoretical grounds is probably
the elimination of the NRSRO designation and replacement with a more
market-based solution[,]" while cautioning "there are
considerable perils of eliminating NRSRO designation too quickly").
However, the reforms enacted in the Credit Rating Agency Reform Act of
2006 should alleviate at least some of the concerns of critics of
NRSROs, and lessons from this process will be transferable to a
consideration of similar issues that may arise in the context of the
(102.) The premium levels will not be capped. One could argue that,
in the absence of caps, the premium for repeat offenders theoretically
could become so large as to decimate the company's stock price.
This would be akin to effecting bankruptcy through ICF premiums (because
no investor would want to buy the stock). This is a serious concern, as
this practice could harm innocent shareholders and employees (much as
securities litigation can today). However, adequate funding is essential
for the survival of the ICF. With caps on premium levels, the premiums
in risky companies would not reflect fully the risk they pose and would
require increased premiums from shareholders of other, safer firms. In
addition, employing caps would not provide appropriate managerial
incentives, as the full extent of the firm's fraud risk would not
be reflected in its stock price.
(103.) See Part IV.C.6., infra, for a discussion of the equitable
considerations related to this design feature.
(104.) See LOUIS LOSS & JOEL SELIGMAN, FUNDAMENTALS OF
SECURITIES REGULATION 41 (5th ed. Supp. 2007).
(105.) With an average annual market turnover rate of over 100%,
most investors (by volume) will have sold their shares before the next
annual ICF determination. Shareholders who own stocks for more than a
year will not know in advance of the purchase exactly how much the
premium will be upon sale. However, in the absence of a fraud revelation
or radical changes in the corporate governance practices of a firm, the
ICF premium should not vary dramatically from year to year.
(106.) See infra note 112 and accompanying text for a discussion on
determining the appropriate level of recovery.
(107.) This represents all capital market sales subject to Section
31 fees. See infra Appendix I for additional information on how the
figure is used to calculate the estimated premium. See supra note 93 for
a discussion of Section 31 fees.
(108.) This figure includes an assessment for administrative costs
equal to 10% of claim payouts, but excludes fund investment income and
effects of the lack of premiums from market makers and specialists. See
infra Appendix I for a full description of assumptions underlying this
calculation and for calculations under additional assumptions.
(109.) The source of the "estimated damages" figure is
Cornerstone Research data. The figure represents the "disclosure
dollar loss amount," defined as the difference in market
capitalization of a defendant firm as of the trading day immediately
before the end of the class period (with the end of the class period
being generally when the fraud is revealed) and the market
capitalization of the same firm the trading day following the end of the
class period. CORNERSTONE RESEARCH, SECURITIES CLASS ACTION CASE
FILINGS, 2006: A YEAR IN REVIEW 1 (2007) [hereinafter SECURITIES CLASS
ACTION CASE FILINGS], available at
20070102-01.pdf. This number is not intended to be a measure of
liability for securities fraud, as factors unrelated to fraud could have
affected the prices on these two dates. See id. However, the figure does
provide an approximate sense for the losses suffered by investors.
(110.) For purposes of calculating the ICF premium, the disclosure
dollar loss amounts are adjusted to reflect an assumption that 50% of
suits filed are meritorious. For data on the number of securities class
actions that survive a motion to dismiss and hence generally move on to
settlement negotiations, see Joseph A. Grundfest & A.C. Pritchard,
Statutes with Multiple Personality Disorders: The Value of Ambiguity in
Statutory Design and Interpretation, 54 Stan. L. Rev. 627, 685, 691
(2002) (finding, in a study of 167 federal court securities fraud
decisions that address the "strong inference standard," that
34.1% of motions to dismiss are denied in their entirety, and 36.5% are
granted either in part or in their entirety without prejudice, thus
making it possible for the plaintiff "to replead in such a manner
as to allow the litigation to continue."); A.C. Pritchard &
Hillary A. Sale, What Counts as Fraud? An Empirical Study of Motions to
Dismiss Under the Private Securities Litigation Reform Act, 2 J.
Empirical Legal Stud. 125, 142 (2005) (finding that 52% of motions to
dismiss are granted in a study of 1996-2002 Second and Ninth Circuit
decisions in securities fraud class actions); FOSTER ET AL., supra note
73, at 7 (finding the dismissal rate to be 39.1% in 2004-2006, but
acknowledging that this rate could be overstated as a practical matter
because it includes suits dismissed without prejudice and suits
dismissed "with prejudice that will be successfully
appealed"). It should be noted, however, that the figure used
reflects a simplifying assumption. The fact that a suit gets past the
motion to dismiss phase does not mean that 100% of the estimated market
capitalization decline of the corporation upon the fraud revelation
equals compensable damages.
(111.) Traditional (i.e., excluding IPO allocation, analyst, and
mutual fund-related claims) securities class action filing activity has
been on the decline in recent years (falling, for example, 38% from
2005-2006). See SECURITIES CLASS ACTION CASE FILINGS, supra note 109, at
3. In addition, the level of losses associated with the filings (defined
on the basis of market capitalization losses upon disclosure of the
alleged fraud) also has declined substantially. Id. at 1. Thus, if this
downward trend in fraudulent (or at least detected fraudulent) activity
continues, using 2006 data may overstate the premium required to fund
the ICF. On the other hand, if the incidence of fraud returns to
historical levels, this premium estimate, depending on the level of
market activity relative to the amount of fraud, may be understated.
Recent data compiled by NERA Economic Consulting suggests that the
downward trend in filings may be reversing. FOSTER, supra note 73, at 3
(describing the substantial increase (47% more in the first six months
of 2007 than the last six months of 2006) of traditional or
"standard" case filings and suggesting the downward trend in
filings may be reversing). In addition, as discussed in Part III, supra,
lawsuits often are not brought against small corporations because it is
often uneconomical for plaintiffs' lawyers to do so. If the ICF
proposal is adopted, though there will be screens designed to limit
frivolous suits and suits that would lead to a de minimus recovery, see
discussion, infra, it is quite possible that the level of claims under
the ICF will exceed the estimated damages of lawsuits today. Moreover,
the premium level assumed for exposition purposes (0.035%) includes an
assumption of annual administrative costs of 10% of claim payouts. This
could understate the expense of administering the fund. Finally, the
premium does not account for the fact that market makers and specialists
will be exempt from payment of the ICF premium. Offsetting this, of
course, is that the deterrent effects of the ICF may cause the incidence
of fraud to decline, that there is increased trading because of greater
investor confidence, or that the fund will earn sufficiently high
investment income to offset a significant portion of its administrative
costs. Nonetheless, it is possible that the average ICF premium could
exceed 0.035%, perhaps significantly so. For a calculation of premiums
under various assumptions, see infra Appendix I.
(112.) For a discussion of the techniques used in the insurance
industry, see, e.g., Michael L. Smith & George L. Head, Guidelines
for Insurers in Pricing Deductibles, 45 J. RISK & INS. 217 (1978)
(describing how, among other things, to price deductibles to minimize
adverse selection and deter nuisance claims in property insurance);
Frank M. Bakker et al., Deductibles in Health Insurance: Can the
Actuarially Fair Premium Reduction Exceed the Deductible, 53 HEALTH
POL'Y 125, 130-31 (2000) (describing efforts to relate the level of
out-of-pocket payments of insureds to the precise amount by which the
demand for health care declines). Setting the precise level of recovery
to minimize moral hazard concerns will be a significant challenge facing
(113.) Requiring shareholders to bear some risk of loss will
minimize moral hazard concerns (i.e., concerns about the incentives of
investors to monitor fraud-prone companies). The degree to which we must
be concerned about this type of moral hazard depends on our confidence
with respect to the ability of shareholders to monitor corporate
conduct. Retail investors are unlikely to have the ability to serve as
effective monitors of corporate conduct. See Fisch, Criminalization of
Corporate Law, supra note 37, at 93. However, many believe institutional
investors are well suited to provide some monitoring of the corporate
governance-related activities of corporations, but that such investors
do not perform this role effectively. See, e.g., John C. Bogle, Remarks,
The Mutual Fund Industry 60 Years Later: For Better Or Worse?, 61 FIN.
ANAL. J., Jan./Feb. 2005, at 18-19 ("With their long record of
passivity and lassitude about corporate governance issues, [mutual] fund
managers must accept a large share of the responsibility for the ethical
failures in corporate governance and accounting oversight...."),
available at http://www.vanguard.com/bogle_site/sp20050102.htm. But see
Jill E. Fisch, Relationship Investing: Will It Happen? Will It Work?, 55
OHIO ST. L.J. 1009, 1011 (1994) (raising questions about whether
institutions have the proper incentives to monitor corporations and
whether they can do so effectively), cited in Fisch, Criminalization of
Corporate Law, supra note 37, at 93. It may seem unfair to make retail
investors responsible for some portion of their losses when they are not
as effective at corporate monitoring as institutions. However, providing
additional compensation for individuals, but not institutions, through
the ICF, in effect, would be providing incentives for individuals to
invest independently, rather than through funds, which could lead to
individuals being less diversified. Another moral hazard concern relates
to the incentives of investors to invest in fraud-prone companies. The
degree to which we must be concerned about this type of moral hazard
depends on how confident we are that non-insider shareholders are able
to assess, with some degree of accuracy, which firms have a greater
propensity for fraud. See Tom Baker, Insurance Against Misinformation in
the Securities Market, in 2 CANADA STEPS UP 363, 381 (2006), available
at http://www.tfmsl.ca/. See Part IV.C.6., infra, for further discussion
of this point.
(114.) For example, the ICF Division will operate in a manner
similar to the National Labor Relations Board (NLRB). The NLRB is an
independent federal agency that was created by Congress in 1935 to
administer the National Labor Relations Act (NLRA), the statute that
governs union/employer relations. NLRB Fact Sheet,
http://www.nlrb.gov/about_us/overview/fact_sheet.aspx (last visited
Sept. 18, 2007). The NLRB does not act on its own motion, and its
administrative law judge decisions (issued failing a prior settlement by
the parties or dismissal by the NLRB Regional Director that was not
successfully appealed) are subject to review by the NLRB Board and U.S.
Courts of Appeals. Id.
(115.) Option holders will be unable to file claims because they
lack an ownership interest in the corporation, but they will be eligible
for damages awards.
(116.) This is similar to the ownership requirement for eligibility
for submitting shareholder proposals for inclusion in a public
corporation's proxy statement under 17 C.F.R. [section]
240.14a-8(b) (2007). Note, however, that under Rule 14a-8, a shareholder
must hold at least $2000 in dollar market value of voting securities in
the corporation or 1% of the corporation's outstanding voting stock
in order to be eligible to submit a shareholder proposal, which makes
the Rule 14a-8 standard significantly easier to meet than the one
(117.) One could argue that institutions often will face conflicts
of interest that keep them from filing claims. The possibility of
institutional investor conflicts of interest has been raised previously
in other contexts. Many believe private sector investors currently have
conflicts of interest (e.g., banks or insurance companies that want to
do business with companies in which they hold investments) that may
prevent them from voting their shares against management and in a way
that maximizes shareholder value due to fear of management reprisal. See
generally Roberta Romano, Does Confidential Proxy Voting Matter?, 32 J.
LEGAL STUD. 465, 467, 506 (2003) (providing a brief background on the
arguments of those who advocate confidential corporate proxy voting, but
finding that the practice has no significant effect on election
outcomes). However, the high potential recovery under the ICF (e.g.,
possible recovery of 75% of fraud losses) and the fact that the company
will not be paying the claims directly (though its shareholders will pay
higher ICF premiums in the future) may overcome the disincentive to file
claims. In addition, any company subject to a fraud enforcement action
at the SEC will automatically have its case referred to the ICF. Thus,
if the SEC Enforcement Division decides to pursue a fraud case, the
failure of a shareholder to emerge to file a claim will not prevent
investors from receiving compensation from the ICF. Finally, if the SEC
still feels that claims are not being filed in meritorious cases, the
SEC could design a process (e.g., website filing) to make it easier for
retail investors to make a joint claim. A related concern is that there
will be a free-rider problem (i.e., no investor will want to incur the
time and expense to make a claim because the investor's
proportional recovery will be no higher than that of any other
shareholder). To address this possibility, the ICF will make the filing
process as simple as possible and will reimburse reasonable expenses
incurred in filing a claim.
(118.) So as not to deter potentially meritorious claims, liability
will attach only if no rational person could have thought fraud had
(119.) Since this determination would have to be made before a
formal investigation is launched, the metric would have to involve
something akin to a "disclosure dollar loss" as defined by
Cornerstone Research (the difference in market capitalization of a firm
as of the trading day before the alleged fraud is revealed and the
market capitalization of the same firm the trading day following the
revelation). See Appendix I, note 4, infra, for further discussion of
(120.) See Amalia D. Kessler, Our Inquisitorial Tradition: Equity
Procedure, Due Process, and the Search for an Alternative to the
Adversarial, 90 CORNELL L. REV. 1181, 1188 (2005) for a description and
history of inquisitorial proceedings ("[I]n the inquisitorial
model, the court itself initiates the litigation and undertakes
significant responsibility for gathering evidence, not just for ruling
on the conclusions that should be drawn from it."). Though the
proceeding will be non-adversarial, the corporation accused of fraud, in
all likelihood, will retain counsel to help it respond to inquiries from
the ICF Division. However, the shareholder filing the claim will not
need to hire counsel or "present a case" during the
(121.) The use of an administrative law judge (ALJ) is intended to
reduce concerns about politicization (e.g., instances of elected
officials pressuring the ICF Division to make unwarranted fraud
determinations to satisfy angry investors that have lost money),
competence and agency capture. ALJs generally are less subject to
political pressures than are elected officials or political appointees
and, under the Administrative Procedure Act, in a formal adjudication,
ex parte communications (e.g., a conversation between a Congresswoman
and an ALJ with the intent of influencing such judge's decision)
are prohibited. 5 U.S.C. [section] 554(d)(1) (2000). Competence also
should not be a concern. Almost all securities fraud cases settle.
Pritchard & Sale, supra note 110, at 128 ("[With rare
exception,] [c]ases that are not dismissed on a motion to dismiss or at
summary judgment, and that survive class certification ...
settle.") Thus, as a practical matter, the rulings of judges with
respect to motions to dismiss and summary judgment determine if
plaintiffs recover damages. There is no reason to believe that ALJs
would lack the competence to make accurate and fair decisions. Finally,
because, in the post-Enron era, the media spotlight is trained on the
efforts of the SEC to police corporate fraud, it is highly unlikely that
the SEC would be able to use the ICF as a vehicle for serving the narrow
interests of those it regulates. A related concern may be that the ALJs
will have an incentive to rarely make fraud determinations, so as to
protect the ICF from liability. To minimize the likelihood of such an
occurrence, under the ICF proposal, a formal "ethical" wall of
separation will be maintained between the ALJs and the ICF
(122.) See Finnerty & Pushner, supra note 58, for a discussion
of damages calculations under the current securities litigation regime.
As currently performed, this is a complex process. Alexander, supra note
4, at 1488 (stating "the amount of damages is a complex and
intractable issue at trial. Expert testimony is required to calculate
damages, and that testimony is contradictory even when the experts
purport to be using the same methodology"). In designing this
feature of the ICF, a tradeoff between providing shareholder recovery
equal to the theoretically "accurate" amount of damage
suffered by an investor and administrative tractability will be
required. I leave detailed consideration of this issue to future work.
(123.) See infra note 188 for discussion of a consideration of
equitable considerations related to this feature of the proposal.
(124.) Directors and executive officers of the corporation, as well
as company employees involved in the fraud, will be ineligible for
recovery from the ICF.
(125.) A claims administrator appointed by the ICF Division will be
responsible for disbursing payments to eligible investors in a similar
manner to that which occurs today for securities fraud class action
settlements and Fair Funds (Fair Funds, SEC-administered funds for
investor restitution following instances of securities fraud, are
described in more detail in Part V.A., infra). These processes (i.e.,
finding individual investors and verifying claims) are administratively
complex and rife with problems. For a description, written in 2005, of
the problems accompanying the Fair Funds distribution process, see
Deborah Solomon, Paper Trails: Plan to Give Defrauded Investors Money
from Fines Faces Hurdles, WALL ST. J., July 7, 2005, at A1. The SEC
acknowledges and has begun to address the Fair Fund distribution
problem. See SEC, 2006 PERFORMANCE AND ACCOUNTABILITY REPORT 23 (2007)
[hereinafter SEC 2006 PAR], available at
http://www.sec.gov/about/secpar2006.shtml. The SEC recently announced
the creation of a new office dedicated to Fair Funds distribution. See
infra note 317. For a description of the claims administration process
in securities class actions, see James D. Cox & Randall S. Thomas,
Letting Billions Slip Through Your Fingers: Empirical Evidence and Legal
Implications of the Failure of Financial Institutions to Participate in
Securities Class Action Settlements, 58 STAN. L. REV. 411, 419-20
(2005). Consistent with the reform proposal of Cox and Thomas, see id.
at 444-45, the ICF will maintain a web-based centralized clearinghouse
for claim notices and claim forms to facilitate the filing of claims.
Despite this feature, the distribution process will be one of the most
significant challenges faced by the ICF.
(126.) See, e.g., Jeffrey O'Connell & John Linehan, Neo
No-Fault Early Offers: A Workable Compromise Between First and
Third-Party Insurance, 41 GONZ. L. REV. 103, 133 (2005/06) (praising
workers' compensation plans for "largely eliminat[ing] the
administrative and transaction costs derived from expensive litigation
over fault and payment for pain and suffering").
(127.) STEVEN SHAVELL, FOUNDATIONS OF ECONOMIC ANALYSIS OF LAW 281
(129.) For example, in 2005, the administrative costs of OASI
equaled 0.7% of total OASI expenditures, and comparable costs for
federal disability insurance represented 2.6% of total expenditures.
SOC. SEC. ADMIN., ANNUAL STATISTICAL SUPPLEMENT TO THE SOCIAL SECURITY
BULLETIN, 2006 at 4.2, 4.4 (2007) (calculated by dividing
"Administrative Expenses" by "Total
[Expenditures]"), available at
http://www.ssa.gov/policy/docs/statcomps/supplement/2006/supplement06.pdf. Similarly, from 2001-2005, total administrative expenses (including
overhead expenses and administrative expenses related to liquidation
proceedings) averaged approximately 2.0% of fund size for the SIPC, a
quasi-governmental agency that oversees the liquidation of failed
brokerage firms and insures brokerage customer property. Calculated
using data from SEC. INVESTOR PROT. CORP., 2005 ANNUAL REPORT 16, 21
(2006) [hereinafter SIPC 2005 ANNUAL REPORT], available at
http://www.sipc.org/pdf/2005AnnualReport.pdf; SEC. INVESTOR PROT. CORP.,
2004 ANNUAL REPORT 14 (2005), available at http://www.sipc.org/pdf/
2004_AnnualReport.pdf; SEC. INVESTOR PROT. CORP., ANNUAL REPORT 2003
(2004), available at http://www.sipc.org/ pdf/2003_Annual_report.pdf;
SEC. INVESTOR PROT. CORP., ANNUAL REPORT 2002, at 14 (2003), available
at http://www.sipc.org/pdf/SIPC_Annual_Report_03.pdf; and SEC. INVESTOR
PROT. CORP., ANNUAL REPORT 2001 (2002) [hereinafter SIPC 2001 ANNUAL
REPORT], available at http://www.sipc.org/pdf/SIPCAnnualReport02.pdf.
The FDIC's corporate operating budget expenses were 1.9% of fund
size in 2006. Calculated using data from FED. DEPOSIT INS. CORP., ANNUAL
REPORT HIGHLIGHTS 2006 at 32, 35 (2006), available at
(130.) The SIPC must evaluate investor claims and provide
recoveries where warranted, but its task (i.e., determining if a
claimant was a customer at a brokerage firm and had securities that were
missing) is more ministerial than the task of the ICF will be (i.e.,
determining if securities fraud occurred).
(131.) The UC system was created by the Social Security Act of
1935. It is a federal program that is administered by the states under
state law. OFFICE OF WORKFORCE SEC., U.S. DEP'T OF LABOR,
UNEMPLOYMENT COMPENSATION 1 (2007), available at
(132.) Calculated using data from id. at 2. This figure includes
some administrative costs not directly related to operating the state UC
system. Estimated fiscal year 2007 administrative costs for the state UC
system only are $2.64 billion. Id.
(133.) Three states in the United States also collect taxes from
employees. Id. at 1.
(134.) See Katherine Baicker et al., A Distinctive System: Origins
and Impact of U.S. Unemployment Compensation, in THE DEFINING MOMENT:
THE GREAT DEPRESSION AND THE AMERICAN ECONOMY IN THE TWENTIETH CENTURY
227, 245 (Michael Bordo et al. eds., 1998). No state has
"complete" experience rating (i.e., a system with no minimum
or maximum rate). Id.
(135.) See id. at 246 & n.46.
(136.) An example of good cause may include a worker who suffered
harassment or was forced to work in unsafe conditions. Telephone
Interview with Frank Gumina, Partner, Whyte Hirschboeck Dudek S.C.,
Milwaukee, WI (August 9, 2007) (Mr. Gumina has 16 years of experience in
labor and employment law).
(137.) In most states, "gross misconduct" is defined as
behavior that evinces an intent against the employer's interest.
Gross misconduct can range from one instance of theft to habitual
tardiness or rule breaking. Id.
(139.) The account set forth here is that of the Wisconsin
unemployment compensation system. Though state processes vary, this
account is representative of the administration of UC benefit disputes
in the United States. Id.
(140.) The employer, of course, has an interest in the outcome
because benefit payouts affect the employer's experience rating and
level of UC taxes. Id.
(141.) In Wisconsin, these hearings generally last no longer than
two hours. Telephone Interview with Frank Gumina, supra note 136. Across
the UC system generally, the hearings typically last 20-45 minutes. Emp.
& Training Admin., U.S. Dep't of Labor [hereinafter ETA].
(142.) The parties generally opt not to be represented by lawyers
unless another related claim is pending (e.g., a discrimination suit).
Telephone Interview with Frank Gumina, supra note 136. Also, pre-hearing
discovery generally is not permitted, though the parties have the right
to file for discovery at the hearing. Id. During the hearing, both
parties are permitted to call witnesses and present exhibits. Id.; see
also Wisconsin Dep't of Workforce Dev., Requesting a
Hearing--Frequently Asked Questions,
http://www.dwd.state.wi.us/uibola/FAQs-12-01/ (answering general
questions about unemployment benefit hearings).
(143.) In Wisconsin, this body is the three-person Labor and
Industrial Review Commission (LIRC). Telephone interview with Frank
Gumina, supra note 136. Appeals are briefed only; there are no live
witnesses. Id. No new evidence is permitted, but LIRC confers with the
lower ALJ on various issues, including credibility of the witnesses, and
does a de novo review. Id. In five states or U.S. jurisdictions (Hawaii,
Minnesota, Nebraska, the District of Columbia, and the Virgin Islands),
there is no second level of appeal within the UC system. ETA, supra note
(144.) This may even be more likely under the ICF than under the
current class action regime because the reputational penalty from a
government action is likely to exceed that from a class action filed by
a private plaintiffs' attorney. See Part IV.C.3, infra.
(145.) In each of the last three years, the UC system, nationwide,
issued an average of 1,411,028 decisions in appeals (1,230,039 lower
authority decisions and 180,988 higher authority decisions, on average),
a number that dwarfs any plausible estimation of the number of annual
ICF claims. ETA, supra note 141. According to Cornerstone Research, from
1996-2005, an average of 193 securities class actions (including
non-secondary market fraud cases that will not be administered by the
ICF) were filed each year. SECURITIES CLASS ACTION CASE FILINGS, supra
note 109, at 1. Even if the existence of the ICF (because of the ease of
filing and equality afforded to frauds of varying sizes not existent
under the current regime) led the number of securities fraud cases
administered each year to increase more than five-fold from current
levels, which seems unlikely, approximately 1000 cases is significantly
fewer than the number of cases processed by the UC system each year.
(146.) Coffee, supra note 62, at 1540.
(148.) Id. at 1541.
(149.) Id. at 1541.
(151.) Anecdotal evidence suggests they may be correct. See Kevin
M. LaCroix, Opt-Outs: A Worrisome Trend in Securities Class Action
Litigation, in INSIGHTS (Oakbridge Ins. Servs., Bloomfield, Conn.), Apr.
2007 (discussing institutional investors who claim to have received many
times more in their opt out cases than they would have received as a
participant in the related securities class actions), available at
(152.) See Coffee, supra note 62, at 1541 n.17 (citing Ret. Sys. of
Ala. v. J.P. Morgan Chase & Co., 386 F.3d 419, 431 (2d Cir. 2004),
in which a federal court of appeals invalidated a federal district
courts' injunction ordering Alabama state court to postpone its
trial until after the conclusion of the district court's related
securities litigation trial).
(153.) This is not an exhaustive list. There are other procedural
aspects of litigation (e.g., motions related to jurisdictional or venue
issues) that will have no place under the ICF.
(154.) One, of course, could argue that reforming securities class
actions, rather than instituting the ICF, could solve these problems.
However, that is a "second best" solution. Reforming class
actions likely would do little to increase investor compensation for
reasons described in supra Part III.
(155.) In re Blue Rhino Corp. Sec. Litig., No. 03-3495 (C.D. Cal.
Oct. 7, 2005), available at
(156.) The initial complaint alleged a 175-day class action period
(August 15, 2002--February 5, 2003, inclusive). Complaint at 1, In re
Blue Rhino Corp. Sec. Litig., No. 03-3495 (C.D. Cal. May 19, 2003),
available at http://securities.stanford.edu/1028/RINO03-01/2003519_o01c_033495.pdf.
(157.) Inst. S'holder Servs., Securities Class Action Services
Database [hereinafter SCAS Database].
(158.) See Civil Docket, In re Blue Rhino Corp. Sec. Litig., No.
03-3495 (C.D. Cal., filed May 19, 2003), available at
Total entries figure includes three error notices, but excludes four
items placed in the file that were not used. Id.
(159.) Notice of Settlement of Class Action at 1, In re Blue Rhino
Corp. Securities Litigation, No. 03-3495 (C.D. Cal. June 22, 2005),
available at http://securities.stanford.edu/1
028/RINO03-01/2005622_r01n_033495.pdf. Attorneys' fees and expense
reimbursement are estimated to average $0.18 per share. Id. at 2.
(160.) See SCAS Database, supra note 157 (indicating that the
status of the case is "settled" rather than "settled
(161.) Though this example is unusual due to the small absolute
dollar value of shareholder recovery and the short class action period,
the recovery is not that different from that which investors receive in
many securities fraud class actions. According to Cornerstone Research,
the median settlement value, in 2006 dollars, of class actions settled
over the approximately 10-year period since the passage of the PSLRA
through 2005 (excluding the Enron, WorldCom and Cendant
mega-settlements) is $6.7 million. SIMMONS & RYAN, supra note 7, at
(162.) One possible way to reduce administrative costs would be to
eliminate the scienter requirement so that damages could be awarded for
losses induced by gross negligence. Some suggest that, in practice,
juries (though rarely party to securities fraud determinations) and
judges may find fraud liability when there is merely gross negligence,
rather than an intent to defraud or recklessness, as required under the
law. See, e.g., Donald C. Langevoort, Reflections on Scienter (and the
Securities Fraud Case Against Martha Stewart that Never Happened), 10
LEWIS & CLARK L. REV. 1, 9 (2006) (stating, "[J]udges and
juries may be applying the law as if [negligence or gross negligence]
were the standard"). Gross negligence, in all likelihood would be
easier to prove--a material misstatement exceeding a certain threshold
likely would suffice--and hence more administratively efficient for the
ICF. The obvious drawback is that this would increase the number of loss
payouts significantly. In addition, while it is easy to justify
compensation for fraud losses when shareholders have been victimized by
intentional misconduct, it is more difficult to defend providing
compensation when corporate managers merely have been careless (even
grossly so). This is true even though one could argue that even innocent
misstatements lead to the inefficient allocation of capital. In
addition, lowering the standard in this context may lead to managers
taking excess precautions because of fear of liability. There are
obvious trade-offs that must be made in this regard, but, on balance,
removing the scienter requirement, though expedient, would not be
(163.) One rationale for the SEC not sharing information with
private plaintiffs is that corporate defendants are more likely to
comply with disclosure requests from the SEC if they know the
information will not be shared with plaintiffs' lawyers. Telephone
Interview #1, supra note 62. SEC investigative files are exempt from
disclosure under the Freedom of Information Act (FOIA). Id.; see also 5
U.S.C. [section] 552(b)(7) (2000) ("records or information compiled
for law enforcement purposes, but only to the extent that the production
of such law enforcement records or information ... could reasonably be
expected to interfere with enforcement proceedings ..." are exempt
(164.) It should be noted, however, that with the end of private
class actions, the SEC's enforcement budget would have to be
(165.) See supra note 76 (discussing the SEC's "renewed
focus on prosecuting fraud in smaller companies").
(166.) See Lucian Arye Bebchuk, The Case for Increasing Shareholder
Power, 118 HARV. L. REV. 833, 875 (2005) ("In my own view, there
are good reasons for limiting contractual freedom in corporate law. Some
scholars, however, advocate complete or very broad contractual
(167.) See Lucian Arye Bebchuk, The Debate on Contractual Freedom
in Corporate Law, Foreword, 89 COLUM. L. REV. 1395, 1404 (1989)
(describing the arguments of proponents of contractual freedom). 168.
(169.) See Lucian A. Bebchuk, Letting Shareholders Set the Rules,
Reply, 119 HARV. L. REV. 1784, 1805 (2006) (describing what he terms
"the standard contractarian argument that the marketplace can be
expected to produce on its own all optimal governance terms" and
which "can be rolled out against any proposed legal rule (whether
default or mandatory) that changes current arrangements").
(171.) See note 221, infra, for a description of RiskMetrics
Group's corporate governance ratings.
(172.) The Corporate Library (TCL) employs an "A-F "
scale to indicate the degree of governance risk at a rated corporation.
TCL uses ratings from four primary component categories ("board
composition and succession planning, CEO compensation practices,
takeover defenses, and board-level accounting concerns") to
generate an overall governance rating. The Corporate Library, TCL
Ratings, available at
visited October 11, 2007).
(173.) Baker, supra note 113, at 379.
(174.) Even if one were to argue that opt out suits are motivated
for non-pecuniary reasons (e.g., public pension fund manager hoping to
demonstrate a pro-corporate governance stance in a more prominent
fashion), the fact remains that these suits impose additional costs on
the litigation system.
(175.) See notes 187 & 343, infra, for further discussion of
(176.) It is possible that a number of corporate managers would
welcome the end of the threat of secondary market securities class
actions and happily opt in to the ICF.
(177.) See Marcus Radetzki & Marian Radetzki, Private
Arrangements to Cover Large-Scale Liabilities Caused by Nuclear and
Other Industrial Catastrophes, 25 GENEVA PAPERS ON RISK & INS. 180,
182 (2000) ("[S]imilar but uncorrelated risks insured must be
numerous. The greater the number of such risks, the nearer the total
damage cost will approach the underlying probability.").
(178.) Similarly, though there are ways to mitigate the risk of
adverse selection (e.g., by charging appropriate risk-based premiums),
making participation in the insurance scheme mandatory eliminates
adverse selection concerns. See Baker, supra note 113, at 383
("Mandatory participation requirements, if enforced, always take
care of adverse selection.").
(179.) "Direct" costs include the costs specifically
related to litigation such as attorneys' fees and court costs.
"Indirect" costs include items such as management inattention
to the firm's core business during the litigation process. See
Richard M. Phillips & Gilbert C. Miller, The Private Securities
Litigation Reform Act of 1995: Rebalancing Litigation Risks and Rewards
for Class Action Plaintiffs, Defendants and Lawyers, 51 BUS. LAW. 1009,
1027-28 (1996) (discussing direct and indirect costs of litigation),
cited in Pritchard, supra note 4, at 953, n.106 (describing the indirect
(180.) It is, of course, possible for an investor to argue that she
does not want to pay a tax for compensation of any sort, whether it be
through the class action mechanism, the ICF, or any other compensation
scheme. However, as discussed previously, eliminating compensation for
securities fraud losses is not politically feasible. Thus, investors
will continue to pay the costs of fraud protection for the foreseeable
(181.) Though precise data on the level of retail trading in the
U.S. capital markets overall is not available, reviewing retail trades
on the NYSE may be instructive. For the 15 trading days between October
15, 2007 and November 2, 2007, inclusive, trades by retail investors
represented, on average, approximately 1.7% of total NYSE trading
volume. (Calculated by author as the greater of retail buy volume or
sell volume, divided by total NYSE volume. Underlying data (the
availability of which changes daily) was obtained from New York Stock
Exch., NYSE Retail Trading and NYSE Dollar Volume Summary, available at
http://www.nysedata.com/nysedata/default.aspx (follow "Retail
Trading--Click here for more" hyperlink; also follow "Dollar
Volume Summary--Click here for more" hyperlink) (last visited Nov.
3, 2007).) It is generally believed that retail trading as a percentage
of total volume is higher on the NASDAQ than on the NYSE.
(182.) See, e.g., Anthony M. Santomero, Deposit Insurance: Do We
Need It and Why? i (The Wharton Fin. Inst. Ctr., Working Paper No.
97-35, 1997) (arguing that "[D]eposit insurance has its own set of
problems. It encourages: (i) risktaking by insured institutions; (ii)
neglect by depositors; (iii) intervention by regulatory
agencies."), available at http://fic.wharton.upenn.edu/fic/papers/
(183.) See, e.g., U.S. GEN. ACCOUNTING OFFICE, SECURITIES INVESTOR
PROTECTION: STEPS NEEDED TO BETTER DISCLOSE SIPC POLICIES TO INVESTORS
14 (2001) (describing how critics have claimed that the SIPC's
primary goal is not brokerage customer protection, but rather protection
of its industry-supplied fund); Thomas W. Joo, Who Watches the Watchers?
The Securities Investor Protection Act, Investor Confidence, and the
Subsidization of Failure, 72 S. CAL. L. REV. 1071, 1114, 1126 (1999)
(arguing, among other things, that the Securities Investor Protection
Act (SIPA), which created the SIPC, "subsidizes the broker-dealer
industry by shifting the costs of failures" and does not attempt to
attack the root cause of brokerage firm failure, but rather provides for
merely reacting once such failures occur"). But see U.S. GEN.
ACCOUNTING OFFICE, SECURITIES INVESTOR PROTECTION: UPDATE ON MATTERS
RELATED TO THE SECURITIES INVESTOR PROTECTION CORPORATION (2003) (noting
that the SIPC has implemented significant reforms to improve its
(184.) See, e.g., RICHARD A. IPPOLITO, THE ECONOMICS OF PENSION
INSURANCE 10 (1989) (criticizing the PBGC's pricing structure,
benefit guarantees and failure to address moral hazard effectively).
(185.) David C. Nixon et al., With Friends Like These: Rule-Making
Comment Submissions to the Securities and Exchange Commission, 12 J.
PUB. ADMIN. RES. THEORY 59, 73 (2002). Admittedly, the SEC oversees the
SIPC, which has been subject to criticism. See note 183, supra.
(186.) See generally James D. Cox et al., SEC Enforcement
Heuristics: An Empirical Inquiry, 53 DUKE L. J. 737, 757 (2003)
(describing the SEC as the "heroic David").
(187.) The question remains whether private insurers would have an
interest in participating in this market. According to one D&O
insurance executive, some private insurers would be reluctant to provide
first party insurance for securities fraud. However, some insurers might
consider participating in the program if a government mandate for
coverage assured them of a market. See Telephone Interview #2, supra
note 70. See also infra note 343, for further discussion of the likely
interest of private insurers in this market.
(188.) The U.S. Treasury would provide this loan only after the ICF
exhausted other funding possibilities, such as borrowing under a line of
bank credit. A similar pre-arranged loan guarantee is in place with the
SIPC. If the SIPC fund's assets (including its ability to borrow on
a revolving line of bank credit) are insufficient to meet its
obligations, the SIPC may borrow up to $1 billion from the SEC, which
the SEC would borrow from the U.S. Treasury. See SIPC 2005 ANNUAL
REPORT, supra note 129, at 4. Though a benefit of this proposal, the
government guarantee raises equitable considerations because following
any extension of government credit (if it becomes necessary), future ICF
premiums will have to be increased above projected expected losses in
order to have sufficient funds available to repay the loan, thus
disadvantaging investors post-loan vis-a-vis investors pre-loan.
However, having a government guarantee in place is an important feature
of the proposal because the government's guarantee provides
benefits for all investors (both present and future), as it allows all
ICF premiums to be lower than what they would be without such a
guarantee. In addition, the equitable considerations are mitigated
significantly (though certainly not entirely) when one considers that
the overwhelming majority of trading volume on U.S. markets is
undertaken by large institutional investors who are repeat players in
the market and are likely to be both pre- and post-loan investors.
Despite the benefits of the government guarantee, other methods to
protect against funding shortfalls, such as securitization, should be
explored. See Harry Panjer, Insurance Against Misinformation in the
Securities Market: Actuarial Aspects, in 2 CANADA STEPS UP 423, 452
(2006) (discussing securitization (specifically selling to public market
investors high-yield bonds, the yield on which is reduced to reflect
losses) in connection with securities misinformation insurance in
Canada), available at http://www.tfmsl.ca/. (See Part V.C., infra, for a
description of securities misinformation insurance.) But see infra notes
332 and 333 and accompanying text for a discussion of the potential
limits on public market participation in a securities fraud insurance
(189.) For a similar discussion with respect to FDIC insurance, see
Kuritzkes et al., supra note 94, at 34-35.
(190.) For a parallel argument in the context of FDIC insurance
that notes that this point is arguable because "[t]he United States
government ultimately has a finite borrowing capacity, at least at a
given cost of funds," see id. at 34. One may argue that even though
the government does not have to charge as high a premium in advance, its
ability to do so is due to its power to tax. If the ICF premium pricing
is accurate, this will not be an issue. However, if the pricing is
wrong, and the government has to make up for any shortfalls in premium
collections, it will have to tax (or alternatively, use previously
collected tax revenue). There are distortionary costs to taxing (i.e.,
taxes can alter the behavior of citizens, so if taxes have to be raised
to bail out the ICF, it could impose other costs on society beyond the
amount of the taxes). One response is that the ICF has ample incentive
to get the pricing right, though admittedly correct pricing will be a
challenge. (Part IV.C.4. explores some of these concerns in more
detail.) Another response is that the government runs a number of
insurance programs (e.g., the FDIC, unemployment insurance, flood
insurance), and though its track record is not perfect, the government
has proven itself competent to manage an insurance mechanism. Finally,
even when the government has gotten the pricing wrong in the past in an
extreme failure, such as the savings and loan crisis when it had to
execute a large bailout, the effects were not long-term. The FDIC, which
took over the responsibility for S&L deposit insurance from the
Federal Savings & Loan Insurance Corporation (FSLIC), is now
self-supporting. Of course, one cannot argue that enduring another
crisis of the order of magnitude of the S&L crisis would be welcome.
However, I use this example to show that, even in this extreme case,
there appears to be no long-term effect from distortionary taxation.
That said, this concern should be explored more fully in any further
consideration of implementing the ICF.
(191.) See id. at 34 for a similar discussion in connection with
FDIC insurance. Insurers calculate expected losses, but actual losses
may be more or less than expected (i.e., be "volatile"). Thus,
private insurers must maintain sufficient capital not only to meet
expected losses, but also to cover losses that are higher than expected.
(192.) See generally id. at 37 for a discussion of this concept in
connection with FDIC insurance.
(193.) See supra notes 182 and 183.
(194.) See, e.g., Joo, supra note 183, at 1115 ("It is unclear
whether the private insurance market could provide satisfactory investor
insurance, particularly at a low cost comparable to that of SIPC
assessments."); Kuritzkes et al., supra note 94, at 35 (stating
that the government's size means it can provide insurance at a
lower cost than private markets).
(195.) Each insurance company must engage in underwriting and risk
assessment, resulting in a duplication of effort not present if the
government alone performs the function. See generally Timothy Stoltzfus
Jost, Our Broken Health Care System and How to Fix It: An Essay on
Health Law and Policy, 41 WAKE FOREST. L. REV. 537, 577 (2006) (stating,
in the health insurance context, that administrative costs such as
marketing and underwriting are higher for individual insurance policies
than for group or government-provided insurance).
(196.) See supra Part III (discussing the limits of a
corporation's ability to provide compensation for fraud losses);
see also infra Part IV.C.6 (discussing why the fee should be based on
trades and not holdings).
(197.) See Baker, supra note 113, at 415-16 (stating that, in
connection with evaluating one possible scheme for Canadian securities
misinformation insurance (described in Part V.C. infra), "There are
no per-trade fees in the private market approach because of the
administrative complexity involved in collecting the fees on behalf of
multiple private market insurers").
(198.) See generally Jost, supra note 195, at 579 (discussing,
generally, these considerations in the context of public health
insurance); Michael B. Rappaport, The Private Provision of Unemployment
Insurance, 1992 WIS. L. REV. 61, 105-06 (discussing, generally, some of
these considerations with respect to the provision of unemployment
(199.) See Posting of Kevin Lacroix, director of OakBridge
Insurance Services, to D&O Diary,
http://dandodiary.blogspot.com/2006_12_01_archive.html (Dec. 03, 2006,
21:47 CST). Lacroix wrote:
Id.; see also Tom Baker & Sean J. Griffith, Predicting
Corporate Governance Risk: Evidence from the Directors' and
Officers' Liability Insurance Market, 74 U. CHI. L. REV. 487, 531
(2007) ("[T]he market for D&O insurance operates as a
constraint on the ability of underwriters to factor risk into
price."); id. at 526 (suggesting, based on their findings from
interviews with D&O professionals, that there may be
"short-term pressure on underwriters to generate premium volume
notwithstanding possible long-term losses").
(200.) Sean J. Griffith, Uncovering a Gatekeeper: Why the SEC
Should Mandate Disclosure of Details Concerning Directors' and
Officers' Liability Insurance Policies, 154 U. PA. L. REV. 1147,
1179 (2006) ("[I]nsurers stake their own capital on their
governance assessments and suffer directly from any error in evaluating
(201.) The rating agency, however, will have to compete for the
government contract and be subject to the rigors of a competitive
bidding process. This, of course, differs substantially from competing
for the business of corporations.
(202.) See Sugato Chakravarty et al., Did Decimalization Hurt
Institutional Investors? 8 J. FIN. MARKETS 400, 411 tbl. 3 (2005)
(finding dollar-weighted average trading commissions of approximately 9
bp (post-decimalization of stock prices) to 11 bp (pre-decimalization)
for a sample of 34 large institutional investors trading NYSE-listed
stocks in the years 2000 and 2001); Michael Goldstein et al., Brokerage
Commissions and Institutional Trading Patterns 50 tbl. 1 (Oct. 16, 2006)
(unpublished manuscript) (showing a range of trading commissions, based
on trading activity, of approximately 9-12 bp for a sample of 306
institutional investors in 1997, calculated by author by dividing the
average commission per share (shown in cents) by the average price per
share), available at http://ssrn.com/abstract=528288. Note that the
study's authors state that average commissions decreased
substantially from 1997 to 2003 (the final period in study). Id. at 31.
(203.) It should be noted that commissions are not the only trading
costs incurred by investors. See Chakravarty et al., supra note 202, at
409 (discussing non-commission trading costs such as price impact on
trade and administrative costs of "working an order" and the
"opportunity costs of missed trades"). However, commissions
are direct trading costs and hence more similar to the ICF premium than
other, indirect types of trading costs.
(204.) As Claudio Loderer et al. explain, "[a] common
assumption in finance theory is that individual assets have perfect
substitutes." Claudio Loderer et al., The Price Elasticity of
Demand for Common Stock, 46 J. FIN. 621, 621 (1991). In other words,
shares of stock are fungible; a buyer easily can find a number of stocks
with similar characteristics in which to invest. However, more recent
finance scholarship has called this assumption into question. See id. at
623-625 (describing theories and studies related to this question,
including, among others, that stocks are not perfect substitutes for one
another if the stock of one firm provides hedging opportunities for an
investor that cannot be duplicated with the stock of any other firm).
Nonetheless, the fact remains that investors have a number of investment
choices, and different transaction costs will affect investment
(205.) Robert A. Prentice, Conceiving the Inconceivable and
Judicially Implementing the Preposterous: The Premature Demise of
Respondeat Superior Liability Under Section 10(b), 58 OHIO ST. L.J.
1325, 1381-82 (1997) (explaining that respondeat superior is a common
law doctrine that holds employers responsible for the actions of their
employees in order to provide corporations and other principals with
incentives to take care in hiring and monitoring their employees).
(206.) Guido Calabresi, Some Thoughts on Risk Distribution and the
Law of Torts, 70 YALE L.J. 499, 544 (1961), cited in Prentice, supra
note 205, at 1391 n.309.
(207.) Of course, higher fraud risk ratings will translate into
lower stock prices and a higher cost of capital. This can affect product
prices to some degree because, for certain projects to be profitable,
companies with higher costs of capital will have to charge higher
(208.) See, e.g., Jon D. Hanson & Kyle Logue, The First-Party
Insurance Externality: An Economic Justification for Enterprise
Liability, 76 CORNELL L. REV. 129, 163-64, 166-68 (1990) (concluding, in
the torts context, that, although first-party insurance theoretically
could provide optimal levels of deterrence, insurers fail to perfectly
classify risks according to consumption choices, thus leading to
litigation (specifically an enterprise liability regime) promoting
deterrence goals better than insurance). The context in which this
debate is often conducted is with respect to automobile accidents and
the efficacy of tort litigation over no-fault insurance (under which
insurers pay the claims of their insureds, rather than litigating
fault). Many studies related to the question of whether no-fault plans
provide as much deterrence as exists under a tort regime offer
contradictory results. James C. Harris, Why the September 11th Victim
Compensation Fund Proves the Case for a New Zealand-Style Comprehensive
Social Insurance Plan in the United States, 100 NW. U. L. REV. 1367,
1385 (2006) ("[N]o consensus at all has emerged regarding the
effect of no-fault plans on accident rates.").
(209.) See generally Steven Shavell, Liability for Harm Versus
Regulation of Safety, 13 J. LEGAL STUD. 357, 359 (1984) (discussing this
concept in the context of tort liability).
(210.) In addition, one problem with an ex post litigation regime
is the defendant corporation may be bankrupt and hence judgment proof at
the time of litigation, which means the threat of a damages award is not
much deterrent to the corporate managers contemplating fraud. See
generally Coffee, supra note 62, at 1551 n.64 ("Securities class
actions tend less frequently to be filed in the wake of bankruptcy
because the usually deep-pocketed corporate defendant can no longer be
sued once it has entered bankruptcy."). Indeed, fraud is often
caused by the "last period" problem (i.e., managers, fearing
the consequences of poor corporate performance, engage in fraud to give
them enough time to turn the company's results around). Jennifer H.
Arlen & William J. Carney, Vicarious Liability for Fraud on
Securities Markets: Theory and Evidence, 1992 U. ILL. L. REV. 691, 693,
703 (1992) cited in Pritchard, supra note 4, at 931. This technique, of
course, may be ineffective. One study of 111 fraud on the market cases
decided between 1975 and 1990 showed that almost 25% of the firms
accused of fraud later went bankrupt. Arlen & Carney, supra, at 726.
(211.) Telephone Interview #1, supra note 62.
(212.) Telephone Interview #2, supra note 70.
(213.) For more effective deterrence, additional government budget
increases would have to accompany the implementation of the ICF. The end
of secondary market class actions would mean the end of the
investigatory work of plaintiffs' lawyers in this area. These
lawyers often bring significant resources and expertise to bear when
ferreting out corporate fraud. Telephone Interview #1, supra note 62.
One plaintiffs' attorney I interviewed describes, for example, the
hiring of private investigators to find former employees. The testimony
of a former employee that can support fraud allegations is very useful
in surviving the motion to dismiss. Though a "bad news"
disclosure and a large stock price drop make the possibility of fraud
obvious to most, the harder cases are those in which there are no
obvious signs of fraud, and the plaintiffs' lawyer has to "put
together a case" before filing a complaint. Id. This process takes
a great deal of time and will be lost with the end of class actions. The
ICF Division of the SEC will have to step in to this role. For sure, the
SEC currently performs its own independent investigations. It
occasionally uses funding to hire private investigators, but that is not
typically done. The SEC is able to call on the government's unique
resources, as well (e.g., access to databases with social security
numbers and the ability to subpoena bank records). One plaintiffs'
attorney I interviewed indicated that he believed that when the fraud
case is sufficiently high profile, the SEC is able to marshal the
necessary resources to do a good job investigating the case. Id.
However, what seems clear is that the SEC Enforcement Division, as
currently constituted, does not have the available staffing to replicate
the investigative efforts of plaintiffs' lawyers for the hundreds
of potential instances of fraud that occur each year. Thus, with the
implementation of the ICF would have to come significantly increased
staffing levels at the SEC. One possible source of funds could come from
an assessment of higher Section 31 fees. (See supra note 93 and
accompanying text for a description of these fees.) Of course, this
would have the effect of increasing transaction costs for investors.
(214.) See Baker & Griffith, supra note 199, at 517-25
(describing the importance of firm culture and manager character). Note
that D&O insurers are trying to assess litigation risk, not just
fraud risk, since D&O insurers have to protect corporate managers
and corporations from non-meritorious suits.
(215.) Patricia M. Dechow et al., Causes and Consequences of
Earnings Manipulations: An Analysis of Firms Subject to Enforcement
Action by the SEC, 13 CONTEMP. ACCT. RES. 1, 21 (1996).
(216.) See, e.g., Hatice Uzun et al., Board Composition and
Corporate Fraud, FIN'L ANALYSTS J., May/June 2004, at 41 (finding
"as the number of independent outside directors increased on a
board and in the board's audit and compensation committees, the
likelihood of corporate [fraud] decreased"); Anup Agrawal &
Sahiba Chadha, Corporate Governance and Accounting Scandals, 48 J. L.
ECON. 371, 371 (finding "the probability of restatement is lower in
companies whose boards or audit committees have an independent director
with financial expertise ...," but noting that they find no
relationship between board independence and restatements); Jap Efendi et
al., Why Do Corporate Managers Misstate Financial Statements? The Role
of Option Compensation and Other Factors, 85 J. FIN. ECON. 667, 667
(2007) (finding "[financial] misstatements Are ... more likely for
firms ... that have a CEO who serves as board chair"); Lawrence A.
Cunningham, Rediscovering Board Expertise: Legal Implications of the
Empirical Literature 13 (Oct. 24, 2007) (unpublished manuscript) (There
"is a well-developed body of evidence demonstrating a strong
positive correlation between director independence and financial
reporting quality ..."), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1024261. It should be
noted that a restatement does not necessarily suggest that the restating
firm engaged in securities fraud. See infra notes 234-237 and
accompanying text for additional factors researchers find to be
associated with the incidence of fraud or restatements.
(217.) One challenge in this area stems from the fact that many of
the corporate governance practices of public corporations are required
or strongly encouraged either under the law or exchange listing
requirements. This will make it more difficult to make meaningful
distinctions among companies for the governance variable portion of the
fraud risk ratings, as all public companies will have some minimum level
of "good governance mechanisms."
(218.) In a study analyzing a cross section of Canadian public
companies, a company's D&O insurance premium level was shown to
bear a significant association with the quality of that company's
corporate governance-related variables. John E. Core, The
Directors' and Officers' Insurance Premium: An Outside
Assessment of the Quality of Corporate Governance, 16 J.L. ECON. &
ORG. 449, 475 (2000), cited in Larry E. Ribstein, Market vs. Regulatory
Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of
2002, 28 J. CORP. L. 1, 54 (2002). D&O premiums, however, would not
be a perfect proxy for ICF premiums because, as discussed previously,
D&O premiums have to include not only the risk of fraud being
committed, but also litigation risk more generally. See Core, supra, at
454 ("Business risk (such as firm size, profitability, and relative
exposure to the U.S. legal system) also increases litigation risk. Thus
a firm's D&O premium is hypothesized to be a function of both
the quality of its corporate governance and its business risk.").
The ICF premium will reflect, apart from a charge for administrative
costs, only the risk of actual fraud because corporations will not be
subject to secondary market strike suits (i.e., suits without merit
filed in an effort to extract a settlement).
(219.) Many D&O insurance companies purchase the corporate
governance ratings generated by RiskMetrics Group (then ISS) to assist
them in setting insurance premiums. E-mail from John A. Deosaran, Vice
President, Corporate Ratings, then Inst. S'holder Servs., to author
(Sept. 11, 2006, 07:16:18 EDT) (on file with author). In addition, some
insurers adjust the amount of the insurance premiums charged by up to
15% based on a company's Corporate Library governance score. See
Baker & Griffith, supra note 199, at 522 n.159.
(220.) RiskMetrics Group acquired Institutional Shareholder
Services (ISS) in January 2007. ISS is now a subsidiary of RiskMetrics.
(221.) RiskMetrics is a leading provider of proxy research and
corporate governance services and maintains a database that contains
CGQs for over 8000 companies in 31 countries. RISKMETRICS GROUP,
CORPORATE GOVERNANCE QUOTIENT [hereinafter RISKMETRICS GROUP], available
at http://www.riskmetrics.com/pdf/products/RA10-CGQ.pdf (last visited
Nov. 13, 2007). RiskMetrics uses up to 65 data points in eight broad
categories (board of directors, audit, charter and bylaw provisions,
anti-takeover provisions, executive and director compensation,
progressive practices, ownership and director education) to determine a
company's CGQ. Id. RiskMetrics' CGQs appear to be the most
widely respected set of corporate governance ratings available.
(223.) Enron's relatively higher (though still below the
median) score notwithstanding, had investors incorporated this
information into their investment decisions, perhaps the revelations of
fraud would not have taken the market by surprise. What is unclear is
why investors largely ignored these ratings. One possibility suggested
by commentators for the lack of impact may be because the rating
agencies lack access to nonpublic information, thus failing to add to
the body of knowledge investors could have if they bothered to
investigate. Apparently, however, investors neither heeded the corporate
governance rating nor conducted their own independent investigations.
(224.) Institutional Shareholder Services Securities Class Action
Database and Corporate Governance Quotient Database (data on file with
(225.) See generally INST. S'HOLDER SERVS., BETTER CORPORATE
GOVERNANCE RESULTS IN HIGHER PROFIT AND LOWER RISK 1 (2005) (describing
the results of a study that finds a correlation between good RiskMetrics
(then ISS) corporate governance ratings and superior financial
performance, specifically "lower risk, better profitability and
higher valuation"), available at
(226.) See Baker & Griffith, supra note 199, at 517
("Culture and character, we were regularly told [by D&O market
participants interviewed], are at least as important as and perhaps more
important than other, more readily observable governance factors in
assessing D&O risk.").
(227.) The ICF's rating agency will have to be particularly
careful about attempts by corporations to "game" the system by
studying the inputs to the rating and making themselves appear less
risky than they actually are.
(228.) Statement on Auditing Standards No. 99, Consideration of
Fraud in a Financial Statement Audit (SAS 99) provides standards to
assist external auditors in assessing the risk of management fraud. SAS
contains examples of fraud risk factors classified into three
categories: incentive/pressure (to commit fraud), opportunity (to commit
fraud), and attitude/rationalization (to justify the fraud). Statement
on Auditing Standards No. 99 (2002).
(229.) See Baker & Griffith, supra note 199, at 516-27
(describing how D&O underwriters evaluate corporate governance).
(230.) See id. at 528. However, insurers do disclose a version of
their basic pricing algorithm to state insurance regulators. Id. at 528,
n.183. Even if the ICF proposal is implemented, D&O insurers will
have relevant information for this purpose because they still will
provide insurance for primary market fraud suits, derivative litigation
and similar suits.
(231.) See supra note 199 (discussing how underwriting competition
can affect pricing).
(232.) For a similar discussion in connection with the benefits of
publicizing D&O insurance premiums, see generally Baker &
Griffith, supra note 199, at 536 n.212, who state
(233.) Sean Griffith has urged the public disclosure of D&O
insurance premiums and contract terms for a similar reason. See
Griffith, supra note 200, at 1203-07 (arguing for the required
disclosure of D&O insurance premium amounts and key contract terms
and stating, "[T]he only way to provide researchers and market
participants with the information embedded in the D&O insurance
premium may be to mandate disclosure of such data in U.S. securities
(234.) See, e.g., Natasha Burns & Simi Kedia, The Impact of
Performance-Based Compensation on Misreporting, 79 J. FIN. ECON. 35, 35
(2006) (finding "the sensitivity of the CEO's option portfolio
to stock price is significantly positively related to the propensity to
misreport" financial statements); Efendi et al., supra note 216, at
667 (finding "the likelihood of a misstated financial statement
increases greatly when the CEO has very sizable holdings of in-the-money
stock options"). But see Merle Erickson et al., Is There a Link
Between Executive Equity Incentives and Accounting Fraud?, 44 J. ACCT.
RES. 113, 113 (2006) (finding "no consistent evidence that
executive equity incentives are associated with fraud"). Stock
options are designed to align the incentives of managers with
stockholders. Efendi et al., supra note 216, at 668. As the
company's share price increases, the value of the stock options
increase. Therefore, managers have an incentive to engage in activities
that benefit shareholders. Unfortunately, however, stock options also
have the potential to provide incentives for managers to engage in fraud
to increase the stock price. See id.
(235.) One does not generally think of successful firms as being
more likely to engage in fraud, but as Tracy Wang, a researcher that
finds a positive correlation between profitability and the propensity
for fraud, explains, such firms are more likely to be successful at
misleading the market. Tracy Yue Wang, Investment, Shareholder
Monitoring and the Economics of Corporate Securities Fraud 19
(Weatherhead School of Mgmt., Working Paper No. 2, 2004) ("High
[profitability] seems to increase the likelihood of fraud. This result
may seem counterintuitive at first glance. However, it can be intuitive
because it is difficult for a (known) troubled firm to sell a good
earnings report. A firm will have incentive to fool the market and may
easily succeed when the market believes the firm is profitable based on
previous years' performance, while negative shocks or deterioration
in profitability has already started."), available at
(236.) Scott Richardson et al., Predicting Earnings Management: The
Case of Earnings Restatements 2 (Oct. 2002) (unpublished manuscript),
available at http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=338681.
(238.) It should be noted that there is some basis in current law
for taking motive-based considerations into account in securities fraud
cases. See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct.
2499, 2511 (2007) ("[M]otive can be a relevant consideration, and
personal financial gain may weigh heavily in favor of a scienter
inference ..."). However, rather than the general motives described
in the text above, the courts generally require the motive ascribed to
be specific to the manager (e.g., evidence of significant trading by the
manager in the company's stock during the alleged fraud period).
See, e.g., GSC Partners CDO Fund v. Washington, 368 F.3d 228, 237 (3d
Cir. 2004) ("[M]otives that are generally possessed by most
corporate directors and officers do not suffice; instead, plaintiffs
must assert a concrete and personal benefit to the individual defendants
resulting from this fraud.") (internal quotation marks omitted).
(239.) D&O insurers currently charge different premiums based
on industry group and signs of financial stability. See Baker &
Griffith, supra note 199, at 528-29 (describing how "many" or
"most" insurers include industry group and accounting ratios
in their pricing algorithms). However, D&O insurance, as discussed
previously in note 214 supra, is designed to protect against litigation
risk, even for unmeritorious suits. Historically, firms in certain
industries (e.g., technology companies) have been frequent targets of
litigation, largely due, in the opinion of many, to the volatility of
their stock prices. See Coffee, supra note 62, at 1548-49 ("Whether
an individual corporation will be sued in a securities class action is
likely to depend principally on three factors: (1) its stock price
volatility; (2) its industry classification, with consumer goods,
technology, communications, and finance companies being the recent
preferred targets; and (3) its market capitalization."). Thus, it
is appropriate for a D&O insurer that wants to set prices
appropriately to take industry into account. Under the ICF proposal,
however, pricing should reflect the risk of fraud, not the risk of
(240.) See Eugene F. Fama, Efficient Capital Markets: A Review Of
Theory And Empirical Work, 25 J. FIN. 383, 383 (1970).
(241.) One may question why we need the government to generate
fraud risk ratings at all because of a belief that the market can do a
better job of predicting fraud occurrences than any government-hired
rating agency could. There is reason to believe, however, that a rating
agency, sanctioned by the government, offers distinct advantages. The
rating process can generate more information than the market can obtain
from corporations. The government has the ability to compel
participation in the ratings process and to force companies to provide
relevant information about fraud risk that the corporations may not want
to share with the public markets. This non-public information can be
helpful in the ratings context. This is somewhat similar to the credit
ratings process. Though bond market participants, especially
professional bond fund managers, are capable of performing their own
analyses about default risk, evidence shows that they rely significantly
on credit ratings generated by third parties such as S&P and
Moody's, the leading credit rating agencies. It is believed that
these ratings are beneficial, not only because they confirm the fund
managers' analysis, but also because credit rating agencies are
able to extract more information from companies because they agree to
keep information given to them in connection with the ratings process
confidential. See generally H. Kent Baker & Sattar A. Mansi,
Assessing Credit Rating Agencies by Bond Issuers and Institutional
Investors, 29 J. BUS. FIN. & ACCT. 1367 (2002) (discussing,
comprehensively, the use of credit ratings by institutional investors).
(242.) See generally Burton G. Malkiel, The Efficient Market
Hypothesis and Its Critics, J. ECON. PERSPECTIVES, Winter 2003, at 59
(examining a number of criticisms leveled against the efficient market
(243.) For a description of a number of anomalies considered
incompatible with the Efficient Market Hypothesis, see id. See also
Richard J. Taffler et al., In Denial? Stock Market Underreaction to
Going-Concern Audit Report Disclosures, 38 J. ACCT. & ECON. 263, 264
(2004) ("An increasing body of research suggests that the stock
market takes time to assimilate bad news, in contrast to a more timely
incorporation of good (positive) news.").
(244.) A going concern opinion is an opinion issued by a
firm's auditor expressing "substantial doubt" about the
firm's ability to continue to operate as a viable entity. See
Elizabeth K. Venuti, The Going-Concern Assumption Revisited: Assessing a
Company's Future Viability, CPA JOURNAL ONLINE, May 2004,
(245.) Taffler et al., supra note 243, at 264-65.
(246.) See generally Malkiel, supra note 242, at 61 ("... I do
not argue ... that ... market pricing is always perfect. After the fact,
we know that markets have made egregious mistakes, as I think occurred
during the recent Internet 'bubble.'"). It should be
noted that there is not universal agreement among scholars that there
was a technology bubble. See Lubos Pastor & Pietro Veronesi, Was
There a Nasdaq Bubble in the Late 1990s?, 81 J. FIN. ECON. 61, 62, 64
(2006) (questioning whether there was a bubble (i.e., tech stocks were
overvalued) in the late 1990s because of the high level of uncertainty
regarding company growth rates, an important determinant of fundamental
(247.) See Malkiel, supra note 242, at 61.
(248.) Of course, if homeowners knew that their insurance companies
were using their insurance premiums to subsidize other homeowners
engaging in particularly risky behaviors, this might capture their
(249.) In addition, as discussed in note 92, supra, through the
statutory incidence of the ICF premium lies with the seller, the buyer
in all likelihood will bear some portion of the economic burden for the
ICF premium payment.
(250.) See also note 256, infra, for a discussion of the
administrative benefits of trade-based payments.
(251.) STTs are taxes assessed on securities market transactions.
In addition to providing government revenue, these taxes are designed to
discourage short-term speculation in markets. In general, the theory
underlying securities transaction tax proposals is that a small (on a
percentage basis) fixed transaction cost in the form of a tax represents
a negligible burden for long-term asset holders. However, the STT is
more burdensome for short-term investors who trade frequently and hence
must pay the tax frequently. These investors incur significant
STT-related trading costs. See generally Robert Pollin, Applying a
Securities Transactions Tax to the US: Design Issues, Market Impact and
Revenue Estimates, in FINANCIALIZATION AND THE WORLD ECONOMY 409, 409-10
(Gerald Epstein ed., 2005).
(252.) Baker et al. describe why volatility is undesirable as
Baker et al., supra note 45, at 4.
(253.) See Karl Habermeier & Andrei Kirilenko, Securities
Transaction Taxes and Financial Markets, in TAXATION OF FINANCIAL
INTERMEDIATION: THEORY AND PRACTICE FOR EMERGING ECONOMIES 325, 328-29
(Patrick Honohan ed., 2003) (stating that "[e]mpirical studies seek
answers to three main questions" and briefly describing the results
of studies on the effect of transaction taxes on price volatility,
trading volume, and securities prices).
(254.) Id. at 328.
(255.) One reason offered for this is the difficulty in separating
the effects of STTs on price and volume from other policy or structural
changes that may be occurring simultaneously. Id.
(256.) In addition to the three principal objections typically
expressed in connection with STTs, there is another potential concern in
this context: the lock-in effect. Edward McCaffery describes the lock-in
effect as "a wedge between an owner's willingness to sell a
given asset and a buyer's willingness to pay for it, all on account
of the built-in tax liability." Edward J. McCaffery, A New
Understanding of Tax, 103 MICH. L. REV. 807, 895 (2005). With any
realization-based tax, which the ICF premium is, in effect, because it
is due upon sale of a security, there is a concern about allocative
efficiency. See id. Consider the following example, borrowed in large
part from McCaffery: If Shareholder A has a subjective valuation of $10
per share for stock in Company XYZ, and Shareholder B is willing to pay
her $10.25 per share for such stock, the transaction should occur.
However, if there is a tax upon sale of, say $0.50, Shareholder A,
rationally taking her after-tax proceeds of $9.75 into account, may not
engage in the transaction and hold on to her stock longer than would be
efficient. Thus, if a tax rate is too high, there will be many efficient
deals that do not occur, resulting in assets not being allocated to
their highest and best uses. Id. One way to address this concern
(previously discussed by other commentators for eliminating the lock-in
effect in other contexts) is to impose the ICF premium once a year on
shareholder holdings, rather than on sale transactions. This solution is
not optimal because it would increase overall system administrative
costs, as the ICF would have to process annual statements and collect
payments from every security holder in the country, rather than just
collecting fees from a limited number of securities exchanges and
associations as currently proposed. Though this process could be
streamlined somewhat by tying it into the federal income tax process,
the administrative costs in all likelihood still would outweigh taking
advantage of the current Section 31 fee collection mechanism. In any
event, the lock-in effect is likely to be a modest concern with respect
to the ICF proposal because the ICF premium, as estimated, is a small
percentage of stock price.
(257.) See Habermeier & Kirilenko, supra note 253, at 325-26.
(258.) Id. at 333.
(260.) See id. at 328-29.
(261.) For a discussion of the exclusion of market makers from the
ICF scheme, see supra note 91.
(262.) Under the standard rational expectations model, the
migration of volume to other markets or other instruments does not
result in any efficiency loss, as volume, per se, is just an outcome of
the trading process and does not contain any information about
underlying fundamental values. Researchers recently have questioned this
view and assert that trading volume injects information about the
precision of individual signals about value. Thus, under this view, a
loss of volume can affect a market's ability to aggregate
information. See Habermeier & Kirilenko, supra note 253, at 337-38
(discussing these points).
(263.) See Daniel Waldenstrom, Why Are Securities Transactions
Taxed? Evidence from Sweden, 1909-91, 9 FIN. HIST. REV. 169, 171 (2002)
(discussing three potential outcomes in connection with securities
(264.) The evidence on volume migration is somewhat mixed. For
example, volume on the Swedish stock market declined significantly
following an increase in Sweden's STT, but one study of 14 STT
changes in Asian markets finds no statistically significant differences
in turnover before and after the tax changes. Habermeier &
Kirilenko, supra note 253, at 329. However, the conventional wisdom is
that investors will choose to invest where they can avoid the tax,
assuming a similar quality of execution and access to desired investment
(265.) The concern is, because of the tax, investors could be
encouraged to trade more often overall by using securities that are not
subject to the tax, while achieving the same underlying economic
objectives. See id. at 328. Researchers generally acknowledge that it is
difficult to design an STT that is "neutral" in that one
portfolio of assets is not favored over another with the same payoff.
For the ICF premium to be pay-off neutral, it would have to apply not
only to all securities, but also be set such that a change in the value
of the replicating portfolio (e.g., bonds, call options) would equal the
change of price of the underlying asset (e.g., the stock) exactly. For
this to happen, the ICF premium rates would have to be adjusted
frequently. See id. at 336, for a discussion of this point in connection
with STTs. This is an expensive and infeasible proposition
administratively. Hence, it would not be possible to stem volume
migration completely if the ICF were implemented.
(266.) Waldenstrom, supra note 263, at 171.
(267.) Goldstein et al., supra note 202, at 2.
(268.) See Appendix II, infra, for the calculations.
(269.) This is likely to have a relatively greater effect on index
funds (i.e., funds that generally make portfolio adjustments only to
bring their portfolios in line with the broad market index (e.g.,
S&P 500) they are tracking), whose overall costs tend to be (and
must be for competitive reasons) lower than those of actively managed
funds (i.e., funds that attempt to achieve superior returns through
actively selecting investment opportunities). See, e.g., Michael Maiello
& Meghan Johnston, ETF-O-Mania, FORBES, Sept. 18, 2006, at 142, 142
(citing Financial Research Corp. statistics indicating that the average
expense ratio (the percentage of a fund's assets used to cover
managing the fund, including management fees and operating expenses) for
index funds is 0.54%, while the average expense ratio for actively
managed mutual funds is 1.12%). Individual investors often are
encouraged to invest in index funds as a low-cost way to achieve
diversification. Imposition of the ICF premium on sales of an index
fund, if some of the costs are passed on to the fund's investors,
which is likely, will increase the cost of this investment strategy.
However, index fund managers generally, barring frequent index
composition changes, trade less frequently than actively managed fund
managers (hence, being subject to the ICF premium less frequently),
minimizing this effect somewhat.
(270.) Gregg A. Jarrell, Change at the Exchange: The Causes and
Effects of Deregulation, 27 J. L. & ECON. 273, 273 (1984).
(271.) Id. at 280. The amount of the decline varied by the identity
of the trader, trading frequency, order size, and, stock price. Charles
M. Jones & Paul J. Seguin, Transaction Costs and Price Volatility:
Evidence from Commission Deregulation, 87 AMER. ECON. REV. 728, 730
(272.) Jarrell, supra note 270, at 274.
(273.) Jones & Seguin, supra note 271, at 730 (citing findings
by Jarrell, supra note 270).
(274.) The appeal of analogizing the deregulation of brokerage
commissions to the ICF premium is that deregulation brought a one-time,
substantial transaction cost reduction. See id. at 731 for a comparison
of the deregulation of brokerage commissions and STTs. However, the
analogy may not hold perfectly. The amount by which the commissions were
reduced were not uniform (i.e., "institutional and active traders
enjoy[ed] greater reductions"). Id. The ICF premium will not differ
by type of investor, though the effects will be felt most by
institutions and other active traders.
(275.) On the other hand, in 1996 Congress enacted the National
Securities Markets Improvement Act (NSMIA), which expanded the reach of
Section 31 collections to include trades of NASDAQ securities. Anecdotal
evidence suggests that there was no deleterious effect on NASDAQ market
volume following this change. See The Effects of the Excessive Fees
Collected Under Federal Securities Laws and Their Impact on the
Financial Markets and on the Economy as a Whole: Hearing Before the
Subcomm. on Securities of the S. Comm. on Banking, Housing, and Urban
Affairs, 106th Cong. 3 (1999) (opening statement of Arthur Levitt,
Chairman, SEC) [hereinafter Effects of Excessive Fees] (stating, in
1999, that "the fee rates in the NSMIA were based on projections of
nearly 4 years ago ... Our markets have experienced almost explosive
growth, and the result has been collections that are way above what was
estimated."). Of course, this observation tells us nothing about
how much more the stock market could have grown in the absence of the
Section 31 fee.
(276.) Of course, shareholders receive indirect benefits from tax
receipts (e.g., tax receipts can lower the national deficit and result
in lower interest rates).
(277.) Funds collected through the ICF will be reserved for fraud
compensation, not general government revenue. However, though it is true
that ICF funds are targeted for fraud compensation, the ICF premium may
still feel like a tax to investors since amounts collected will be
pooled and no individual investor accounts will be established. However,
this is no different from the design of traditional insurance products.
(278.) Though difficult to predict, it seems reasonable to conclude
that investors, because of mental accounting effects, will be more
willing to pay a premium for a targeted benefit to a specific class of
beneficiaries (i.e., shareholders who have been defrauded) because they
can imagine themselves as possible recipients of a cash payment from the
fund for their losses. Indeed, many long-term investors have
participated in class action settlements in the past.
(279.) Baker et al., supra note 45, at 23. However, foreign
exchanges are becoming more competitive. See Effects of Excessive Fees,
supra note 275 (statement of Robert H. Forney, President and Chief
Executive Officer, Chicago Stock Exchange) (arguing that foreign
exchanges could pose a threat to U.S. exchanges in the near future); see
also notes 286 and 289 and accompanying text.
(280.) For example, the UK (0.5%), Switzerland (0.15%), France
(0.15%), China (0.5%, 0.8% for Shanghai exchange transactions), Ireland
(1.0%), South Korea (0.3%), India (0.5%), Greece (0.6%), and Austria
(0.15%) all impose STTs on stock transactions that exceed the estimated
ICF premium of 0.035%. See Pollin, supra note 251, at 412-14. Of course,
there are markets, including those in Japan, Italy, Denmark, the
Netherlands, and Sweden, where no transactions taxes are imposed. Id.
However, it is unlikely that a significant portion of U.S. securities
volume will migrate to these markets in response to the imposition of
the ICF premium. U.S. investors tend to overweight U.S. investments in
their portfolios relative to the levels indicated as optimal by finance
models due not only to "home bias" (an irrational preference
for domestic assets), but also due to barriers to international
investment, both direct (e.g., capital controls limiting foreign
investment, transaction costs) and indirect (e.g., information costs due
to asymmetric information). Alan G. Ahearne et al., Information Costs
and Home Bias: An Analysis of US Holdings of Foreign Equities, 62 J.
INT'L ECON. 313, 313-15 (2004). The effects of home bias and
investment barriers still would be present following the imposition of
the ICF premium, lessening the likelihood of large-scale volume
(281.) See supra note 111 for cautionary language in connection
with this estimated premium.
(282.) For example, circuits currently are split as to whether an
option holder may sue the company whose stock underlies the put or call
for securities fraud under Rule 10b-5. Courts that reject option holders
as proper plaintiffs in securities fraud do so generally because (1)
companies cannot control the issuance of derivatives, (2) holding a
derivative is more risky than share ownership, and (3) derivatives,
unlike stock, "do not represent capital investment" in a
company. Robert C. Apfel et al., Short Sales, Damages, and Class
Certification in 10b-5 Actions 28 (Simon Sch. of Bus., Working Paper No.
FR 01-19, 2001), available at
(283.) Under this proposal as currently constituted, debt
securities, credit derivatives, and hybrid securities (with a mixture of
debt and equity characteristics) are not subject to the ICF premium.
Though a wholesale migration from equity securities to debt securities
to avoid the ICF premium is unlikely, it would be prudent to explore
expanding the ICF program to include debt securities in order to avoid
the migration problem. I leave to future work a discussion of how
covering debt securities might affect the administration of the ICF.
(284.) See generally Luigi Zingales, Is the U.S. Capital Market
Losing Its Competitive Edge? 21 (European Corporate Governance Inst.,
Working Paper No. 192/2007, 2007) ("IPOs tend to list in the
country where their business is located, even if this is not the most
competitive market."), available at
(285.) Id. (manuscript at 11) (describing a study conducted by
Luizi Hail and Christian Leuz). According to Zingales, changes in the
cost of capital were computed by comparing corporate valuation and
earnings forecasts in the period surrounding the listing decision. Id.
This benefit may have decreased somewhat in recent years, as some
studies have shown negative market effects from the passage of
Sarbanes-Oxley. See Zingales, supra note 284 (manuscript at 11-14). Cost
of capital reductions from listing on a foreign market have the
potential to come from several sources, including from the enhanced
liquidity on, and visibility afforded by listing on, the foreign market
and because the foreign listing allows a corporation to "bond"
or commit to provide better disclosure or institute better governance
practices. Id. (manuscript at 7-8). Of course, foreign listings also
have costs including listing fees, disclosure costs, and exposure to
additional liabilities. Id. (manuscript at 8).
(286.) See, e.g., id. (manuscript at 6) (stating "[t]he main
beneficiary of this loss [of U.S. global IPO market share] is London.
Rever[s]ing more than a decade of declining market share, in the last
three years London went from a market share of 5% to a market share of
(287.) See Pollin, supra note 251, at 414.
(288.) Of course, there are those who believe the abolition of the
0.5% STT would enhance the UK market and economy. See, e.g., Don
Cruickshank, Chairman, London Stock Exch., Address at the Second City of
London Biennial Meeting: The Increasing Impact of Stamp Duty on the UK
Economy (Dec. 13, 2001) (stating, with respect to the UK's STT,
"no modern economy, or aspiring modern economy, imposes such a
burden on its wealth producing companies"), available at
(289.) Zingales, supra note 284 (manuscript at 2). According to
Id. (manuscript at 2). He goes on to state,
Id. (manuscript at 2-3).
(290.) See, e.g., id. (manuscript at 18-19); see generally COMM. ON
CAPITAL MARKETS REG., INTERIM REPORT OF THE COMMITTEE ON CAPITAL MARKETS
REGULATION 4-5 (2006) [hereinafter INTERIM REPORT] (stating that
"differences in the legal rules governing the U.S. public markets
and the foreign and private alternatives" are part of the reason
for the loss of U.S. public capital market competitiveness), available
(291.) Zingales, supra note 284 (manuscript at 18-19). Another
potential reason for the decline set forth by some observers relates to
the extensive regulatory requirements imposed on U.S.-listed companies
by Sarbanes-Oxley. Corey Boles, London Remains an IPO Draw, U.S. Changes
Notwithstanding, WALL ST. J., Aug. 8, 2006, at C4 ("Officials at
NYSE Group Inc.'s New York Stock Exchange say [Sarbanes-Oxley] has
been a major reason why the U.S. exchange has lost ground in luring
foreign listings."). But cf. Zingales, supra note 284 (manuscript
at 17-18) (suggesting that the cost of compliance with Sarbanes-Oxley is
unlikely to be the sole cause of the decline in U.S. global IPO market
share because such costs do not appear to exceed the benefits of listing
in the United States).
(292.) See INTERIM REPORT, supra note 290, at 71. The report
Id. Of course, one could argue that we should have no interest in
encouraging firms that fear legal liability to list in the United
States. Indeed, keeping such companies out may help to minimize the
amount of fraud in U.S. markets. See Zingales, supra note 284
(manuscript at 20) (exploring, but then rejecting, the possibility that
the loss of global IPO market share is the effect of "benign"
regulation). Though this argument is plausible, it is possible for
honest managers to fear being subject to securities class action
lawsuits that lack merit.
(293.) See Habermeier & Kirilenko, supra note 253, at 335.
(294.) See generally J. Bradford De Long et al., Noise Trader Risk
in Financial Markets, 98 J. POL. ECON. 703 (1990) (describing the role
of noise traders in financial markets).
(295.) Habermeier & Kirilenko, supra note 253, at 328.
(296.) See generally id. ("[I]t is hard to say which part of
the volume [fundamental or noise] is more affected by [an STT]."
(297.) Id. at 329.
(298.) See, e.g., id. at 329-30 (discussing the lack of appropriate
data and methodological concerns).
(299.) See generally Paul A. Griffin et al., Stock Price Response
to News of Securities Fraud Litigation: An Analysis of Sequential and
Conditional Information, 40 ABACUS 21, 22 (2004) ("[I]nformed
investors assess [securities fraud] litigation risk generally as part of
their overall evaluation of a stock.").
(300.) See supra Part IV.C.5. for a discussion of market efficiency
and the market's ability to price fraud risk.
(301.) This certainly is possible in the post-Enron era. See
generally Arthur E. Wilmarth, Jr., Controlling Systemic Risk in an Era
of Financial Consolidation, in 3 CURRENT DEVELOPMENTS IN MONETARY AND
FINANCIAL LAW 557, 578 (International Monetary Fund ed., 2005)
("[F]inancial markets often seem to be ineffective in predicting
the onset of economic crises and indiscriminate in punishing risky firms
after crises occur.").
(302.) It is worth noting that any price impact would not be
limited to secondary market prices. Prices at issuance are also subject
to the effects of the ICF premium, as buyers, anticipating the payment
of the ICF premium upon exit, may discount the price they are willing to
pay the corporation for its shares.
(303.) This is not to say that compensating investors is not a
priority for some conservatives. See, e.g., Solomon, supra note 125
(quoting Michael Oxley, former Republican U.S. House Representative from
Ohio who co-authored the Sarbanes-Oxley legislation that created the
Fair Funds (see Part V.A., infra, for a description of Fair Funds) as
saying the following: "When corporate executives make out like
bandits, the money ought to go back to the investors ...").
(304.) A particularly appropriate example of this sentiment
involves the reaction from the investment community when invited to
participate in hearings on the amount of Section 31 fees (Section 31
fees are described in supra note 93). See, e.g., Effects of Excessive
Fees, supra note 275 (containing testimony of several leading members of
the investment community pointing to their perception of the Section 31
fee as "excessive" because total collections exceeded the cost
of funding the SEC and thus was akin to a "tax"). Congress
subsequently reduced Section 31 fee amounts by enacting the Investor and
Capital Markets Fee Relief Act in 2002. One source of dissatisfaction
with Section 31 fees, namely their effect on market making activity,
will not exist under the ICF, because sales of market makers and
specialists are exempt from the ICF premium, as described in supra note
(305.) The framework employed in this section is borrowed, in large
part, from Steven Shavell. See Shavell, supra note 209, at 359-64
(discussing when regulation is superior to legal liability for
controlling risks in the torts context and arguing that (1) regulation
is superior to liability when (a) the potential perpetrator is unable to
pay for the full extent of the harm caused and when (b) there is a
chance that she will not face suit for the harm caused, and (2)
liability is superior to regulation when (a) the would-be regulated
party has more "knowledge about risky activities" than the
regulatory authority and when (b) factoring in administrative costs
because, in the litigation context, most of such costs are borne only
after harm occurs).
(306.) As discussed in note 76, supra, the SEC has a renewed focus
on microcap fraud, but the agency, at current staffing levels, will not
be able to provide the level of deterrence necessary to minimize
substantially the risk of fraud occurring.
(307.) Wrongdoers can be ordered to disgorge profits from their
illegal activities (e.g., profits on stock sales by an officer that
perpetrated the fraud).
(308.) Sarbanes-Oxley Act, 15 U.S.C. [section] 7246(a) (Supp. II
(309.) SEC, SECTION 308(C) REPORT, supra note 63, at 20-21.
(310.) SEC 2006 PAR, supra note 125, at 23.
(311.) See, e.g., Solomon, supra note 125 ("Investors are
never going to be made whole by the SEC's settlement with WorldCom,
which is just a small fraction of the billions of dollars investors lost
in the fraud.").
(312.) U.S. GOV'T ACCOUNTABILITY OFFICE, SEC AND CFTC
PENALTIES 31 (2005) [hereinafter 2005 GAO REPORT], available at
(313.) Sarbanes-Oxley Act, 15 U.S.C. [section] 7246(a) (Supp. II
(315.) Id. The Securities Fraud Deterrence and Investor Restitution
Act of 2003, H.R. 2179, 108th Cong. (2003), contained the SEC
legislative recommendation. 2005 GAO REPORT, supra note 312, at 32. No
vote on the bill ever took place. Id. However, there is no reason to
believe the measure could not be reconsidered in the future.
(316.) See Ernest J. Weinrib, Corrective Justice in a Nutshell, 52
U. TORONTO L.J. 349, 350 (2002) ("A remedy directed at only one
party does not conform to corrective justice. For the court merely to
take away the defendant's wrongful gain does not suffice because
the plaintiff is still left suffering a wrongful loss."). Unlike
under the current regime, investors, because of the ICF, will have the
opportunity for meaningful compensation that is well above the amounts
that the wrongdoers have the capacity to pay. As described above, the
ICF would provide protection in this context because the defendants
generally will lack the resources to pay the claims of the victims
(317.) See Testimony Concerning Fiscal 2008 Appropriations Request:
Hearing Before the S. Subcomm. on Financial Services and General
Government of the S. Comm. on Appropriations, 110th Cong. (2007)
(statement of Christopher Cox, Chairman, SEC) ("I have ordered the
creation of a new office that will focus the efforts of all of the
SEC's offices around the country, and work full-time to return
these [Fair Funds] to wronged investors."), available at
(318.) DAVID SKEEL, ICARUS IN THE BOARDROOM: THE FUNDAMENTAL FLAWS
IN CORPORATE AMERICA AND WHERE THEY CAME FROM 214 (2005).
(320.) Joshua Ronen, Post-Enron Reform: Financial Statement
Insurance and GAAP Re-Visited, 8 STAN. J.L. BUS. & FIN. 39 (2002).
Lawrence Cunningham also has set forth a proposal for financial
statement insurance. See Lawrence A. Cunningham, Choosing Gatekeepers:
The Financial Statement Insurance Alternative to Auditor Liability, 52
UCLA L. REV. 413 (2004).
(322.) See supra Part III (describing the limits on D&O
insurance which lead, in large part, to limits on investor
(323.) See generally Sean J. Griffith, Daedalean Tinkering, 104
MICH. L. REV. 1247, 1257 (2006) (reviewing SKEEL, supra note 318, and
stating that Skeel's investor protection proposal does not seem to
add much to the current compensation regime (i.e., securities class
actions funded largely by D&O insurance)).
(324.) Ronen, supra note 320, at 59.
(325.) Id. at 54.
(329.) See also Cunningham, supra note 320, at 472-73 (questioning
this aspect of the Ronen proposal and describing some potential risks
associated with using the capital markets for reinsurance).
(330.) In general, the core competence of these institutions is
investing in companies, not engaging in speculative activities. There is
also evidence that these investors do not have an interest in pursuing
such activities. According to one study of derivatives use by equity
mutual funds, 79.2% of funds do not use derivatives at all. Jennifer
Lynch Koski & Jeffrey Pontiff, How are Derivatives Used? Evidence
from the Mutual Fund Industry, 54 J. FIN. 791, 795 tbl. 1 (1999). Only
8.5% of the funds that use derivatives engage in activities in which
derivatives are used strictly for speculative purposes. Id. at 795.
There is no reason to think that this market opportunity (i.e.,
speculating on the likelihood of securities fraud) would change that
appetite dramatically. After Koski and Pontiff conducted this study,
Congress enacted the Taxpayer Relief Act of 1997, which repealed a rule
that prohibited, in order for favorable tax status to be maintained,
more than 30% of a mutual fund's gross income being derived from
gains on short-term investments, including derivatives. Alan L. Kennard,
The Hedge Fund Versus the Mutual Fund, 57 TAX LAW. 133, 136 (2003).
Theoretically, this tax law change could encourage more use of
derivatives by these institutional investors. However, there is some
evidence to suggest that tax changes are not enough to change the risk
appetite of traditional mutual funds. See generally Laura Santini, Hedge
Fund Strategies Just Too Risky: SEC Thinks Mutual Funds Might Mimic
Them, but So Far They Haven't, INV. DEALERS DIGEST, Oct. 20, 2003,
at 9, 9 (stating, in an article written approximately six years after
enactment of the Taxpayer Relief Act of 1997, "mutual fund analysts
contend that many mutual funds ... have the ability to engage in
hedge-like strategies [which employ derivatives]--and don't. The
reason, they argue, is that regulation or no regulation, it's just
(331.) Ronen, supra note 320, at 55 ("The put sellers can
minimize their exposure on these written puts by constructing portfolios
that are well diversified with respect to the risk of misrepresentations
(332.) One such exception is the limited use of catastrophe bonds.
David M. Cutler & Richard Zeckhauser, Extending the Theory to Meet
the Practice of Insurance, BROOKINGS-WHARTON PAPERS ON FIN. SERVICES,
2004, at 4, available at http://muse.jhu.edu/journals/
Catastrophe bonds are high-yield debt instruments, the interest and/or
principal on which generally is fully or partially forgiven upon
catastrophic losses (e.g., losses due to a hurricane) to the issuer (the
insurance company) or upon "catastrophic losses measured on some
composite index of insurer losses." Neil A. Doherty, Financial
Innovation in the Management of Catastrophe Risk, J. APPLIED CORP. FIN.,
Fall 1997, at 84, 89-90.
(333.) Cutler & Zeckhauser, supra note 332, at 4 (stating that
financial markets have played a limited role in insurance and arguing
that the reason lies with "contracting difficulties,"
including the challenge of "marry[ing] insurance expertise with
ready pools of capital"). For additional discussion on this point,
including an expression of the belief that some of these challenges will
be overcome in the future, see also id. at 39.
(334.) The securities misinformation insurance program described in
this section is not a concrete reform proposal, but rather an
exploration of a potential reform, and was not intended to be applied to
the U.S. market. However, because of the similarities between this
program and the ICF, the program merits discussion.
(335.) Baker, supra note 113, at 370.
(336.) The fee will be proportional to the size of the trade, but
not risk-rated. Id. at 405. However, in a separate report on the
actuarial aspects of securities misinformation insurance, Harry Panjer
notes that a flat percentage-based fee may be most appropriate
initially, but could be replaced with a risk-rated fee at some point in
the future. Panjer, supra note 188, at 430.
(337.) See Baker, supra note 113, at 401 ("Subrogation is the
legal term given to the right of an insurer to step into the shoes of a
beneficiary in order to recoup from the other liable parties what the
insurer has paid to, or on behalf of, the beneficiary.").
(338.) Id. at 404-07. In addition to annual assessments paid by the
corporations, issuers may be called on to pay additional assessments if
losses reduce reserves "below a target level." Id. at 405.
These additional assessments also would be payable under option two. Id.
(339.) This "excess" insurance provides compensation for
investors that brought successful litigation, but were unable to collect
100% of awarded damages. Id. at 408.
(340.) Baker notes that because this is excess insurance,
subrogation generally will be used only to collect damages that had
already been assessed in the initial litigation. Baker, supra note 113,
(341.) Id. at 407-10.
(342.) Issuers would be required to either purchase the insurance
or disclose, in all investor communications, that they did not purchase
the insurance. Id. at 410.
(343.) Baker's conversations and personal experiences with
private insurers indicate such insurers would have no interest in this
type of insurance unless it were backed by some form of government or
company-sponsored reinsurance (e.g., shortfalls could be made up with
issuer assessments). Id. at 411 n.76.
(344.) This insurance functions as an excess to issuers' (and
other potential defendants') existing liability policies, dropping
down only if the basic insurance is uncollectible or if insurance funds
have been exhausted. Id. at 411.
(345.) As with scenario two, subrogation generally will be used to
collect damages already assessed in litigation. In addition, subrogation
against the corporation that purchased the insurance for "fraud in
the application" would be permitted. Baker, supra note 113, at 413.
(346.) Id. at 410-13.
(347.) Id. at 419.
(349.) Id. at 386.
(350.) Baker, supra note 113, at 387-88.
(351.) Id. at 387 (emphasis added).
(352.) See Coffee, supra note 62, at 1561 n.96 for variations on
this argument made by leading securities regulation scholars.
Alicia Davis Evans, Assistant Professor, University of Michigan Law
School. J.D., Yale Law School; MBA, Harvard Business School. The author
thanks Cindy Alexander, Reuven Avi-Yonah, Scott Baker, Tom Baker, Omri
Ben-Shahar, Laura Beny, Al Brophy, Sam Buell, Bill Carney, Steve Choi,
Ed Cooper, Larry Cunningham, Demetrius Evans, Tom Evans, Jill Fisch,
Sean Griffith, Mitu Gulati, Tim Hall, Ellen Katz, Vic Khanna, Don
Langevoort, Jessica Litman, Kyle Logue, Don Herzog, Jim Hines, Doug
Laycock, Nina Mendelson, Jeff Nielsen, Richard Primus, Adam Pritchard,
Gil Seinfeld, Noah Stoffman, Mark West, James J. White, Cynthia Williams
and conference participants at Washington University School of Law, St.
Louis University School of Law and The University of Connecticut Law
School for helpful suggestions and comments on prior drafts; Joseph
Mead, Yiping Qian and the research staff of the University of Michigan
Law Library for excellent research assistance; and Al LaGrone for
excellent administrative assistance. The Cook Fund of the University of
Michigan Law School provided financial support for this project.
II. RESPONSE TO THE ANTI-COMPENSATION ARGUMENT
A. Asymmetries Stemming from the Market's Reaction to Fraud
B. The Potential for Loss is Substantial for all Investors
C. Buy-and-Hold Investors are Likely to Suffer Significant Harm
from Securities Fraud
D. The Undiversified Investor Has a Legitimate Claim to
Protection From Fraud
E. Political Considerations
III. SECURITIES CLASS ACTIONS
IV. THE INVESTOR COMPENSATION FUND PROPOSAL
B. The Proposal
C. Possible Objections and Implementation Challenges
1. Mandatory Nature of the Program
2. The Role of the Federal Government
3. Deterrence Effects
4. Fraud Risk Ratings
5. Creation of a Fund Instead of Publication of Ratings Only
6. Equitable Considerations
7. Effect on Financial Markets
c. Accuracy and Overall Level of Prices
8. Political Considerations
D. Summary and Concluding Thoughts on the ICF and Securities
V. A CONSIDERATION OF ALTERNATIVE REFORM PROPOSALS
A. Fair Fund Expansion
B. U.S. Insurance-Based Proposals
C. Canadian Securities Misinformation Insurance
The chance of being on the losing or winning side of a transaction
when the stock price is distorted by a securities violation can be
assumed to be random. The more trades investors make, the more
likely that, in the aggregate, their gains from trading while
material facts are withheld will equal their losses. (10)
Name CGQ Index Score
Adelphia Communications 15.9%
Global Crossing 5.9%
Estimated ICF Premium Calculations (1)
Equity Est. Suits/
Case (2) Sales (3) Damages (4) Losses (5)
(A) (B) (C)
A. 2006 $43.9 trillion $37.0 billion 50%
B. 2005 $34.6 trillion $86.5 billion 50%
C. Base Case - $39.5 trillion $37.0 billion 50%
D. Base Case - $33.0 trillion $37.0 billion 50%
E. Base Case - $43.9 trillion $55.4 billion 50%
F. Base Case - $43.9 trillion $73.9 billion 50%
G. Base - Case $43.9 trillion $147.8 billion 50%
H. Base Case $43.9 trillion $37.0 billion 50%
+ 10% Admin.
I. Base Case + $43.9 trillion $37.0 billion 50%
J. Base Case - $43.9 trillion $73.9 billion 50%
Increase + 25%
K. Base $43.9 trillion $37.0 billion 50%
L. Base $43.9 trillion $73.9 billion 50%
Case (2) Recovery Costs Est. Premium
(D) (E) (((B*C*D)+E)/A)
A. 2006 75% -- 0.032%
B. 2005 75% -- 0.094%
C. Base Case - 75% -- 0.035%
D. Base Case - 75% -- 0.042%
E. Base Case - 75% -- 0.047%
F. Base Case - 75% -- 0.063%
G. Base - Case 75% -- 0.126%
H. Base Case 75% $1.4 billion 0.035%
+ 10% Admin.
I. Base Case + 75% $3.5 billion 0.039%
J. Base Case - 75% $6.9 billion 0.079%
Increase + 25%
K. Base 75% $6.9 billion 0.047%
L. Base 75% $13.9 billion 0.095%
(1) Above figures are rounded and designed to be estimates of possible
premium levels. Calculations do not factor in investment income
(which, to the extent such investments include equity securities, must
be those of a market index such as the S&P 500 to minimize any
appearance of impropriety), which would have the effect of reducing
the required premium to fund the ICF. In addition, calculations do not
reflect the impact of exempting sales related to professional market
making activities from the ICF scheme or any additional collections
required to maintain an adequate reserve of funds. Though precise
figures on the level of market making on all U.S. exchanges is not
available, researchers estimate that specialist or market maker trading
represents approximately 10% of the volume on the New York Stock
Exchange (Anne M. Anderson & Edward A. Dyl, Trading Volume: NASDAQ
and the NYSE, FIN'L ANALYSTS J., May/June 2007, at 79) and as much as
50% (or possibly more) of trading on the NASDAQ, historically a dealer
market in which a market maker acts as a transaction intermediary.
Id. The premium figures above, because they include volume attributable
to market making activity, understate the premiums required to fund
payouts equal to the amount assumed above. However, were the ICF
adopted, as a practical matter, excluding market makers and specialists
from the ICF scheme would decrease not only the premiums collected,
but also the number of potential claimants and the amount of
(2) The 12 case scenarios are:
(A) Base Case--2006: Data based on 2006 market sales and estimated
damages (see, infra, note 4 below) in lawsuits filed in 2006.
Assumes that all claims are related to inflated prices in 2006, the
year the lawsuits are filed.
(B) 2005: Data based on 2005 market sales and estimated damages in
lawsuits filed in 2005. Assumes that all claims are related to
inflated prices in 2005, the year the lawsuits are filed.
(C) 10% Volume Decline: Base Case, assuming a reduction of 10%
of market sales volume due to imposition of ICF premium.
(D) 25% Volume Decline: Base Case, assuming a reduction of 25%
of market sales volume due to imposition of ICF premium.
Note the following: if the volume does decrease following the
implementation of the ICF Proposal, we also should expect to see
a relatively proportional decrease in the number of claims for
compensation from the ICF, which means the percentage premium
estimates may remain constant over some range of volume assumptions.
(E) 50% Increase in Estimated Damages: 2006 estimated damages are
assumed to be 50% higher, holding 2006 sales volume constant. 2006
estimated damages are low relative to prior periods. In 2006,
estimated damages were approximately $37 billion. On average,
from 1996-2005, the estimated damages were $123.7 billion. Of
course, this 10-year period includes several large-scale fraud
cases, so it is not clear that the average figure from that
period is representative of what one might expect in the future.
(F) 100% Increase in Estimated Damages: 2006 estimated damages
are assumed to be 100% higher, holding 2006 sales volume constant.
(G) 300% Increase in Estimated Damages: 2006 estimated damages
are assumed to be 300% higher, holding 2006 sales volume constant.
(H) Base Case + 10% Admin. Costs: Base Case, assuming additional
assessments for administrative costs totaling 10% of estimated
fund payouts. This case provides the estimated ICF premium used
throughout the text.
(I) Base Case + 25% Admin. Costs: Base Case, assuming additional
assessments for administrative costs totaling 25% of estimated fund
(J) 100% Damage Claims Increase + 25% Admin. Costs: Assumes 2006
estimated damages are 100% higher, holding 2006 sales volume constant,
and additional assessments for administrative costs totaling 25% of
estimated fund payouts.
(K) Base Case + 50% Admin. Costs: Base Case, assuming additional
assessments for administrative costs totaling 50% of estimated fund
(L) 100% Damage Claims Increase + 50% Admin. Costs: Assumes 2006
estimated damages are 100% higher, holding 2006 sales volume
constant, and additional assessments for administrative costs totaling
50% of estimated fund payouts.
(3) This figure includes equity and derivatives sales on U.S.
securities exchanges currently subject to the SEC's Section 31 fee.
Data Source: Order Making Fiscal Year 2008 Annual Adjustments to
the Fee Rates Applicable under Section 6(b) of the Securities Act
of 1933 and Sections 13(e), 14(g), 31(b), and 31(c) of the
Exchange Act, Securities Act Release No. 8794, Exchange Act Release
No. 55682, 72 Fed. Reg. 25,809 (April 30, 2007), available at
(4) Data Source: CORNERSTONE RESEARCH, SECURITIES CLASS ACTION CASE
FILINGS, 2006: A YEAR IN REVIEW (2007), available at
20070102-01.pdf. Figure represents "disclosure dollar loss amount,"
defined as the difference in market capitalization of a defendant
firm as of the trading day before the end of the class period and the
market capitalization of the same firm the trading day following the end
of the class period. This number is not intended to be a measure of
liability for securities fraud, as factors unrelated to fraud could
have affected the prices on these two dates. Id. at 5. However,
the figure does provide an approximate sense for the losses suffered
by investors from securities fraud. This figure is adjusted to
exclude class action lawsuits that are unrelated to secondary market
fraud. The figure is adjusted by using the data on the percentage
of filings with 10b-5 claims. This percentage is based on number
of filings, rather than dollar value of claims. Thus, it is merely
an approximation for the disclosure dollar loss amount attributable
to secondary market fraud cases. The figure excludes suits related
to option backdating cases.
(5) For purposes of calculating the ICF premium, the disclosure
dollar loss amounts are adjusted to reflect an assumption that 50%
of suits filed are meritorious. For data on the number of securities
class actions that survive a motion to dismiss and hence generally
move on to settlement negotiations, see Joseph A. Grundfest &
A.C. Pritchard, Statutes with Multiple Personality Disorders: The
Value of Ambiguity in Statutory Design and Interpretation, 54 Stan.
L. Rev. 627, 685, 691 (2002) (finding, in a study of 167 federal
court securities fraud decisions that address the "strong inference
standard," that 34.1% of motions to dismiss are denied in their
entirety, and 36.5% are granted either in part or in their entirety
without prejudice, thus making it possible for the plaintiff "to
replead in such a manner as to allow the litigation to continue");
A.C. Pritchard & Hillary A. Sale, What Counts as Fraud? An Empirical
Study of Motions to Dismiss Under the Private Securities Litigation
Reform Act, 2 J. Empirical Legal Stud. 125, 142 (2005) (finding that
52% of motions to dismiss are granted in a study of 1996-2002 Second
and Ninth Circuit decisions in securities fraud class actions);
Foster, supra note 73, at 7 (finding the dismissal rate to be 39.1%
in 2004-2006, but acknowledging that this rate could be overstated
as a practical matter because it includes suits dismissed without
prejudice and suits dismissed "with prejudice that will be
successfully appealed"). It should be noted, however, that the figure
used reflects a simplifying assumption. The fact that a suit gets
past the motion to dismiss phase does not mean that 100% of the
estimated market capitalization decline of the corporation upon
the fraud revelation equals compensable damages.
Estimated Annual ICF Premiums for Mutual Funds and Pension Plans
Industry in U.S.
U.S. Assets Equities
Institutions (A) (B)
Mutual $10.4 trillion (1) 44% (2)
Public $4.0 trillion (5) 44% (6)
Private $2.2 trillion (5) 43% (8)
Assets in Weighted
U.S. U.S. Equities Turnover
Institutions (A * B) = (C) (D)
Mutual $4.6 trillion 47% (3)
Public $1.8 trillion 19% (7)
Private $956.1 billion 36% (7)
Sales of U.S. Est. ICF
U.S. Equities Premium (4)
Institutions (C * D) = (E) (F)
Mutual $2.2 trillion 0.035%
Public $334.5 billion 0.035%
Private $344.2 billion 0.035%
Mutual $754 million
Public $117 million
Private $121 million
(1) INV. CO. INST., 2007 INVESTMENT COMPANY FACT BOOK 16 (2007),
available at http://www.icifactbook.org/pdf/2007_factbook.pdf.
(3) Id. at 23.
(4) See supra Appendix I.
(5) Appendix: Additional Data on the U.S. Retirement Market,
2006, RESEARCH FUNDAMENTALS (Inv. Co. Inst., Washington, D.C.),
July 2007, at 3, http://www.ici.org/stats/mf/fm-v16n3_appendix.pdf.
Figures calculated by author. Numbers adjusted to account for the
overlap of mutual fund holdings by defined benefit pension plans
(estimated as 1.5% of total retirement assets). Id. at 4.
(6) JULIA K. BONAFEDE ET AL., 2006 WILSHIRE REPORT ON STATE RETIREMENT
SYSTEMS: FUNDING LEVELS AND ASSET ALLOCATION 11 (2006), available at
Allocation rate for federal pension plans assumed to equal that of
state pension plans.
(7) The Conference Board, INSTITUTIONAL INVESTMENT REPORT: TURNOVER,
INVESTMENT STRATEGIES AND OWNERSHIP PATTERNS 11 (1998), cited in
William Dale Crist & Kayla J. Gillan, Patient Pension Capital,
CalPERS Commentary, http://www.calpers-governance.org/viewpoint/
speeches/crist.asp (last visited Sept. 28, 2007).
(8) Ronald J. Ryan & Frank J. Fabozzi, Rethinking Pension Liabilities
and Asset Allocation, J. PORTFOLIO MGMT., Summer 2002, at 1, 3 exhibit
2, available at http://www.ryanalm.com/portals/5/press/20020701_
(showing equity allocation of 43% in 2001).
[T]he optimal damages in [secondary market fraud] cases are [not]
zero just because most gains and losses net out. There will be the
usual net harms of the costs of guarding against and litigating
about the wrong, and there will be an allocative efficiency loss if
transactions of a particular sort create uncompensated risk. The
larger the transfer among investors, the more they will spend
guarding against the problem.
It might be possible for a D & O insurer to insist on corporate
governance reforms if the insurer could offer demonstrable
insurance cost savings for qualifying companies, but the reality is
that the D & O insurance sector has been and remains so competitive
that it is impossible to show cost savings. There is always a
competitor willing to offer the same or similar coverage at the
same (or better) discount, and so companies who might otherwise
accept their insurer's loss prevention requirements have little
monetary incentive to do so.
In order for the premium to have [a] signaling [of governance
quality] effect, market analysts would have to control for the
financial and industry factors that predict the likelihood of
investment loss generally. These adjustments would control for each
of the factors in the base price algorithm, leaving only the
Volatility in financial markets is generally considered
undesirable, since it creates an additional element of risk for
investors. If, for example, an asset was expected to give an
average real rate of return of 5% per year, but its price could
fluctuate randomly by large amounts (e.g., 20%) for significant
periods, then there is a large risk that the owner of such an asset
would have to sell it for a loss, since she may be forced to sell
it when it is below its trend value. For this reason, assets that
fluctuate a great deal in price must offer a higher rate of return
than assets whose prices are relatively stable.... If the
financial markets as a whole become less stable, then in general
the cost to firms of raising capital will increase.
[W]hile in the late 1990s the U.S. capital market was attracting
48% of all the global IPOs, its share ... dropped to 6% in 2005 and
is estimated to be only 8% in 2006. Even more surprisingly, in
recent years we have observed [that] some U.S. companies choose to
list in London rather than in the United States.
While this trend is too recent to be attributable to any single
factor, it does not seem to be caused by a shift in the sectoral
distribution of global IPOs, nor by a change in their geographical
distribution. That almost all these companies sought to be marketed
in the United States suggest[s] that the U.S. capital market
retains some attractiveness. But the additional benefits derived
from listing do not seem to be worth the direct and indirect costs
associated with this decision.
Securities class actions do not exist in the United Kingdom, or in
the markets of our major competitors. Indeed, [D&O] insurance costs
are six times higher in the United States than in Europe. Foreign
companies commonly cite the U.S. enforcement system as the most
important reason why they do not want to list in the U.S. market.