The fraud-on-the-market class action no longer enjoys much academic support. The justifications traditionally advanced by its defenders-compensation for out-of-pocket loss and deterrence of fraud-are thought to have failed due to the action's real world dependence on enterprise liability and issuer-funded settlements. The compensation justification collapses when considered from the point of view of different types of shareholders. Well-diversified shareholders' receipts and payments of damages balance over time and amount to a wash before payment of litigation costs. The shareholders arguably in need of compensation--fundamental value investors who rely on published reports--are undercompensated due to pro rata distribution of settlement proceeds to all class members. The deterrence justification fails when enterprise liability is compared to alternative modes of enforcement, such as actions against individual perpetrators, which deter fraud more effectively. If, as the consensus view now has it, fraud on the market makes no policy sense, then its abolition would seem to be the next logical step. Yet most observers continue to accept the action on the same ground cited by the Supreme Court when it first implied a private right of action under the Securities and Exchange Act of 1934 in 1964's J.I. Case v. Borak: a private enforcement supplement is needed in view of inadequate Securities and Exchange Commission (SEC) resources. In other words, even a private-enforcement supplement that makes no sense is better than no private enforcement supplement at all.
This Article questions this backstop policy conclusion by highlighting the sticking points retarding movement toward fraud on the market's abolition and mapping a plausible route to a superior enforcement outcome. We recommend that private plaintiffs be required to meet an actual-reliance standard. We look to the SEC, rather than to Congress or to the courts, to initiate the change because the SEC is the lawmaking institution most responsible for the unsatisfactory status quo and best equipped to propose corrective action. Because an actual reliance requirement would substantially diminish the flow of private litigation, we also suggest a compensating increase in public-enforcement capability. More specifically, the SEC Division of Enforcement needs enough funding to redirect its efforts away from the enterprise and toward culpable individuals.
The Article addresses three barriers standing between here and there. First, there is a new justification for fraud on the market circulating in the wake of the failure of the original justifications: fraud-on-the-market litigation enhances the operation of the corporate governance system. We show that this line of reasoning, while well suited to justify the federal mandatory-disclosure system, does not support-and even detracts from-the case for fraud on the market. Second, we turn to politics to explain why fraud on the market retains political legitimacy despite the failure of its policy justifications. Third, we assess the contention that inadequacy of public enforcement resources justifies maintaining a fraud-on-the-market action. To that end, we show that circumstances have changed materially since the Supreme Court first invoked the justification in 1964. The SEC budget has grown elevenfold in real terms in the intervening forty-seven years, with much of the growth coming in the wake of the Enron fraud. The SEC's enforcement resources, like those of the plaintiffs' bar, ultimately are funded with dollars drawn from shareholder pockets, inviting direct comparison between the two. We show that public enforcement offers the shareholders more value than private enforcement. Private resources are tied to a low-deterrence, enterprise-liability framework. Public enforcement, even now, yields the shareholders comparable damage returns per dollar invested in enforcement. It can be deployed more flexibly, and it can be refocused against individual wrongdoers to enhance deterrence.
We conclude that increased public enforcement makes sense for shareholders even if it implies a diminished volume of private litigation and propose a political trade-off for the SEC to present to Congress: double the enforcement budget in exchange for an SEC-promulgated regulation replacing fraud on the market with an actual-reliance requirement.
William Wilson Bratton and Michael L. Wachter, The Political Economy of Fraud on the Market, 160 U. Pa. L. Rev. 69 (2011).