In 2009, the Securities and Exchange Commission charged that the top executives of Bank of America, in connection with asking their shareholders to approve the bank’s $50 billion acquisition of Merrill Lynch, defrauded those shareholders by failing to reveal the full extent of Merrill’s huge and growing losses and by secretly agreeing to pay Merrill’s executives year-end bonuses of up to $5.8 billion. That is, the SEC charged that the bank was obliged by law to reveal these important facts to its shareholders and did not. If the shareholders had known these facts, they might have voted against the acquisition.
The SEC, which sued only the bank and none of its executives, settled the case in early 2010 for $150 million, to be paid to the defrauded shareholders. Meanwhile, however, a private class action on behalf of those same shareholders was brought against the bank and certain of its officers and directors, based on the same allegations. To mount such a suit requires considerable effort, usually undertaken and financed by law firms that specialize in such cases. The class action was settled in 2012 for $2.4 billion, or sixteen times the SEC settlement.
At first glance, this would suggest that the private class action was a much better vehicle for bringing justice to the victims of the alleged fraud (which the bank and its management “neither admitted nor denied”) than the relatively paltry efforts of the SEC. Many other similar cases over the past two decades would seem to suggest the same. For example, in 2002, the SEC settled its fraud cases against Enron for $450 million, while the parallel class action was settled for $7.2 billion, or again about sixteen times the SEC settlement.
More recently, in 2010, the SEC settled for $75 million its case against Citigroup for concealing the riskiness of the securitized mortgages sold by the bank, while the parallel class actions were settled for $1.3 billion, or more than seventeen times the SEC settlement. In an even more extreme example, the SEC in 2006 settled its fraud case against Tyco—in which two executives were shown to have illegally taken $600 million—for $50 million while the parallel class action was settled for $3.2 billion, or a full sixty-four times the SEC settlement.
But the story is not quite that simple. In most such class action suits, the monies awarded to the victim shareholders are paid not by the executives responsible for the frauds, but by the companies themselves—which means, in effect, by the current shareholders (or, if the company is in bankruptcy, by its secured creditors).
These current shareholders (or other stakeholders) are as blameless for the fraud as the shareholders they are paying. Indeed, in many instances they are classic small shareholders who purchased their shares before the fraud (and are therefore not part of the plaintiff class) and held on to their shares not only throughout the period of the fraud but thereafter. Unlike hedge funds, which are more adept at getting in and out of an investment, these “retail” investors are now punished twice for the fraud they had no role in committing, first by the decline in the value of their shares upon the fraud’s exposure and second by the large payments subsequently made by the company they own to settle the class action.
From this standpoint, many securities class action settlements have a circular quality—one group of innocent shareholders paying another group of innocent shareholders—and the prime beneficiaries appear to be the lawyers who brought the cases and who typically receive very large fees in return. In the Tyco case the lawyers obtained $464 million of the $3.2 billion settlement. In the Bank of America case the plaintiffs’ lawyers received over $150 million in fees, plus another $8 million in expenses.
As one might infer from these examples, class actions are among the most controversial forms of litigation in the United States today. To their advocates, they provide an opportunity for interested private citizens to have a meaningful role in combating corporate misconduct, to serve in effect as “private attorney generals,” supplementing or even substituting for inadequate regulatory oversight. To their detractors, however, class actions are not much more than a racket, doing little to penalize the executives responsible for the alleged misconduct and chiefly serving, instead, to line the pockets of self-interested lawyers, who get a large share of the settlements.
Two recent trends exemplify these competing views. On the one hand, Congress and the Supreme Court have repeatedly taken steps in the past two decades to limit class actions substantially, though not to eliminate them entirely. On the other hand, foreign governments, which had long regarded class actions with suspicion, have over the past decade or so begun to recognize their benefits, so that no fewer than twenty-one countries now permit class action lawsuits to be brought at least in some circumstances.
What has been largely missing from this debate over the merits and demerits of class action litigation is a judicious appraisal of its strengths and weaknesses, unaffected by ideological biases. That gap has now been filled by the publication of Entrepreneurial Litigation by John C. Coffee Jr. A Columbia Law School professor, Coffee has long been regarded as perhaps the preeminent expert on US securities law, but his book is not limited to securities class actions. Rather, it covers the full spectrum of class actions, including mass tort class actions, employment discrimination class actions, antitrust class actions, consumer class actions, merger and acquisition class actions, and much more. Not only is the book more comprehensive than prior studies of class actions, it also probes more deeply, placing today’s class actions firmly within the setting of the modern trend toward turning the practice of law ever more into a business. Perhaps most impressively, Coffee’s book offers specific prescriptions (the most original of which is discussed below) for reducing the weaknesses of modern class action litigation while enhancing its strengths.
Coffee begins by tracing the rise of class actions in the US. The general reader—and his book is aimed at the general reader—may be surprised to learn how recently that rise has occurred. While there were vague precedents going back to medieval times, and more specific US provisions dating from 1842, a real need for class actions was not perceived until the rise of large corporations and mass production. A mass-produced product with a hidden defect, for example, might not be worth the price paid for it, but no reasonable purchaser was about to spend hundreds of dollars in legal fees to recover the few dollars she had been, in effect, overcharged. She had what Coffee terms a “negative value” claim. Yet if the defective product had been sold to several million purchasers, the collective economic injury was considerable.
Legal systems might deal with such collective injuries in any of several ways. For example, a legal system geared to a capitalist economy might choose to ignore such claims altogether, on the basis that one by one they were too “de minimis” to be worth the expenditure of legal resources, while collectively they would cause the manufacturer to lose customers and so be “self-correcting” in the long term. Alternatively, a legal system geared to a welfare-state approach might create governmental administrative agencies with powers to regulate and discipline errant manufacturers.
The first approach was typical of most Western countries well into the nineteenth century, while the second approach came to greater prominence in the twentieth century; but neither was wholly satisfactory. The laissez-faire approach ignored the fact that many sophisticated frauds, such as those in financial markets, might go undetected for years, if not forever, in the absence of regulatory disclosure requirements. But regulation had its limitations as well, for regulatory agencies, in addition to being perennially underfunded and therefore unable to monitor more than a small fraction of those they were supposed to supervise, were constantly subject to political pressures and occasionally subject to being “captured” by those they were supposed to regulate.
A third alternative, the class action—by which a single consumer, shareholder, or the like could sue on behalf of all those injured by the corporate misconduct—originated in the United States, largely for historical reasons centered around the strategies of lawyers who specialized in litigation. Personal injury lawyers in the US had already introduced the concept of the “contingent fee,” by which an impecunious but injured plaintiff could be afforded free legal services, in return for agreeing to pay the lawyer a sizable percentage of any monies obtained. Since the lawyer thereby assumed the risk and expense of a litigation loss, he was motivated to hedge his bet by bringing a large volume of cases, as did his fellow plaintiff’s lawyers.
Thus, where a common injury was suffered by many individuals—as, for example, in the case of a prescription drug that caused undisclosed side effects—many similar cases would be brought in many different jurisdictions. This in turn created pressure on the courts to find a way to deal with the flood of separate but similar cases. Different solutions were eventually devised, such as, for example, consolidating all separate but similar cases before a single judge in a single jurisdiction; but since the courts in the United States were split among numerous jurisdictions, this was a halfway measure at best when the alleged misconduct was national in scope.
An initial response at the federal level was to include a form of class action, modeled on an 1842 rule, in the code of federal civil procedure enacted in 1912, and this provision was broadened in 1938 during the Great Depression. But it was not until 1966 that the federal code of civil procedure was amended in a way that opened the door to class actions as we know them today. The driving force was that most intractable of all US problems: combating racial prejudice. In particular, the civil rights movement of the 1960s, to the extent that it sought reform by means of judicial rulings, could be effective only if those rulings benefited similarly situated black persons, i.e., the class of those affected by the racism the litigation was intended to correct, such as segregation in schools or exclusion from obtaining mortgages. Rule 23 of the Federal Rules of Civil Procedure was accordingly modified to make it easier for a litigant to sue on behalf of all those similarly situated except for those who chose affirmatively to “opt out” (i.e., not to be covered)—and in the case of suits seeking injunctive relief, even them.
As the drafters of the amended Rule 23 intended, the number of class actions in the federal courts hugely increased in the years following the amendment. Less foreseen was that the increase would not be limited to civil rights cases. According to a study undertaken by the federal judiciary in the early 1970s, in 1972 there were 3,148 class actions pending in the federal courts, up nearly 20 percent from just the year before; but while about 43 percent of these were civil rights cases, another 20 percent were securities cases, and still another 10 percent were antitrust cases.
What was common to virtually all these cases was that they were “lawyer-driven.” Sometimes this was ideological in nature. Legal action groups—such as the NAACP’s Legal Defense Fund—would identify broad areas of concern and then seek out interested plaintiffs who, because they were personally affected, had standing to bring a class action to rectify the concerns. But more often the lawyers’ impetus was financial. By combining contingent fees with class actions involving monetary damages, lawyers created a situation where, if they were successful, the financial return to them could be huge. They were therefore motivated to investigate different kinds of commercial and financial misconduct and, once convinced that they had a case, seek out individual plaintiffs in whose names a class action could be brought.
Litigation originated by lawyers does not fit comfortably with the assumptions of most legal systems, including that of the United States. But in this instance it was thought to be justified by the concept of the “private attorney general.” At least since the time of the Civil War, various federal laws had provided “bounties,” i.e., financial incentives, for private parties to bring actions that would supplement federal enforcement. Thus, the False Claims Act, enacted in 1863, provided that a private party could bring a lawsuit for a fraud committed against the federal government that the government itself had not yet detected; and if the case was successful, the private party could receive as much as 50 percent of the recovery. The Sherman Antitrust Act, enacted in 1890, guaranteed that victims of antitrust violations who successfully sued the violators would receive mandatory treble damages, plus their attorneys’ fees—the theory being that these rewards would both motivate antitrust victims to expose violations of which the government was not yet aware and enhance deterrence of violations even in those instances where the government had already discovered the misconduct.
Based on such precedents, proponents of private class actions argued that while the cases might be originated by lawyers, those lawyers—who had an incentive to ferret out misconduct not yet known to undermanned government regulators, as well as to supplement the deterrence provided in cases that “piggybacked” on government investigations—were serving the “established” role of private attorney generals.
Although critics have claimed that this argument is simply a rationalization for a system by which class action lawyers line their pockets, many judges with whom I have spoken have come to believe that, particularly in the civil rights matters that gave rise to the modern expansion of class actions, this rationale has a modicum of truth. For example, class actions against employment discrimination appear to have led to a considerable increase in minority hiring and promotion well beyond what would have likely occurred in their absence.
Even in non–civil rights cases, class actions have sometimes served to illuminate the magnitude of misconduct that otherwise went undetected or underprosecuted. Thus, as the cases cited at the outset of this article suggest, securities class actions, for all their limitations, have served to spotlight the substantial abuse evident in many recent cases of corporate misconduct that the SEC’s much more modest approach appeared to trivialize.
The problem, of course, is that the huge financial incentive provided to lawyers by combining class actions with contingent fee arrangements easily leads to abuses. One such abuse is a form of legalized extortion known as a “strike suit,” which takes advantage of the considerable cost of modern litigation and the perceived unpredictability of juries. A corporation facing a weak class action claim that nevertheless will cost millions of dollars to defend and, if somehow successful, will result in possible damages of hundreds of millions of dollars is motivated to settle the suit, even if the company has committed no wrong.
A related problem is that of collusion between the class action attorney and the company he is suing. In a weak class action case like the one just described, an unscrupulous attorney, recognizing the long odds or just wanting a quick buck, and secure in the knowledge that his free-riding client will agree to whatever the lawyer recommends, may be motivated not only to settle cheap but also to agree to terms binding on the class that will preclude future related litigation by lawyers and plaintiffs who might have much better cases—thereby saving the defendant a great deal of money down the road.
Much of the legislation and Supreme Court limitations on class actions in recent years have been directed at curbing such abuses, and Coffee is more optimistic than some that illegitimate suits have been substantially curtailed as a result. But he points to a more insidious problem. Even the best class action lawyers, as well as their clients, are primarily interested in suing the “deep pockets” from which they can recover the most money. In practice, this means focusing on the corporation, rather than the executives actually responsible for the misconduct.
To be sure, a few executives might also be named as defendants, but the settlement with them, if any, will typically be limited by the limits on their company-paid insurance. The big money will come from the settlement with the company. However, because of the circularity problem previously described, that money will effectively come from the pockets of innocent shareholders. Sometimes, as in the case of people who purchased both before and during the period of the fraud, they will even be the same shareholders who are suing—in effect, suing themselves.
It is hard to believe that the settlements in such cases have much of a deterrent effect on the individual executives who actually committed the alleged misconduct. This is why, in my view, class actions are no real substitute for criminal and regulatory prosecution of the individuals actually responsible for corporate misconduct. In recent years, however, such governmental prosecution of high-level executives has been notoriously rare. It is true that on September 9 of this year, the Justice Department—in reaction to public criticism of this failure—announced that prosecution of such individuals would be given priority “effective immediately,” but only eight days later, on September 17, the Justice Department entered into a “deferred prosecution” agreement with General Motors for intentionally concealing a defective ignition switch linked to at least 169 deaths. Although those responsible for this purposeful concealment would seemingly be responsible, at a minimum, for manslaughter, no individuals were named.
Coffee, while also strongly advocating for more governmental action against individuals, proposes an interesting innovation that he thinks would make class actions more socially useful and less liable to abuse. Overall, he suggests making good on class action’s promise of a “third way” by combining its profit-seeking tendencies with oversight of the class actions themselves by public agencies. Specifically, he proposes, among other reforms, that government regulators in matters where class actions are common should employ private class action lawyers, on a contingent fee basis, to bring class actions supervised by the regulatory authority but for the benefit of the victims, to whom any recovery would be distributed.
As a result, the regulator could bring many more and bigger cases than it does currently and would be represented by lawyers with considerable expertise in suing large companies. The lawyers would be motivated by the contingent fee to achieve the best results. But at the same time, the government agencies overseeing the lawyers would have the power not only to prevent suits, but also to direct that more attention be paid to pursuing individuals than at present. And the agencies would be more motivated than they currently are to pursue individuals along with the companies, since they could do so without any additional expenditure of their own resources. All this, moreover, could be achieved without new legislation.
In my view, this is a sound proposal. Indeed, as Coffee points out, some smaller governmental agencies, such as the FDIC, have already arranged for private attorneys to bring similar actions with the agency overseeing the cases but the lawyers being paid as a percentage of any money recovered. And while the proposal would pose more problems if undertaken by state and local agencies, where the selection of counsel would likely be affected by political considerations and campaign contributions, at the federal level agencies like the SEC enjoy sufficient independence that selection of counsel would likely be on the merits.
It must be acknowledged that Coffee had already floated this idea before publishing his book, but it failed to attract much support. Why is this? He suggests that big agencies like the SEC have too much invested in their self-image to acknowledge that private counsel could do a better job than their own staff in litigating these cases. He also acknowledges that his suggested approach might be subject to public and corporate criticism that it favored a particular part of the bar. For these and other reasons, I am not optimistic that Coffee’s idea, good though it may be, will be widely adopted in anything like the near future.
But this hardly means that class action litigation will be the same tomorrow as it is today. A conservative majority of the Supreme Court remains skeptical that the benefits of the class action lawsuit outweigh its shortcomings, although they have refrained from killing it altogether. At the same time, foreign nations, especially those with common law legal systems like Australia and Canada, have increasingly widened the opportunities to bring class actions, a clear recognition that they believe the class action serves important functions not otherwise served. But each country has its own variations. In Canada, if the plaintiff loses the case, he must pay the defendant’s often considerable legal fees. And in Australia—which has the most robust class action bar outside the US—contingent fees are prohibited, but private companies, though not themselves plaintiffs, are permitted to fund such actions and thereby absorb the risk.
In short, class action litigation continues to evolve, all the while remaining highly controversial. To predict how it will operate even ten years from now, in the US let alone elsewhere, would be foolhardy. Its lucrative nature virtually guarantees that it will not disappear, short of judicial or governmental prohibition. Nor is it likely that even a conservative judiciary or legislature will accept the nineteenth-century view that large groups of people who sustained losses that are individually too small to warrant their own lawsuits should be left with no remedy whatever.
How much class actions will actually serve as a private attorney general remains more questionable. Yet at least when it comes to securities class actions, this deterrence function should arguably be the chief measure of class actions’ value—not the number of zeroes on settlement agreements that largely reflect a recycling of money from one innocent group of shareholders to another, sometimes overlapping group of innocent shareholders. The contrast between SEC settlements and private class action settlements, though revealing in its own right, should not obscure the real question of deterring future misconduct.
While I am personally persuaded, as is Coffee, that securities class actions do serve such a function, the proof is anecdotal and the extent of such deterrence may be quite modest. If the proponents of class actions cannot better perfect its use for this purpose, as for example by closer coordination between the government regulators and the class action bar, the “private attorney generals” will in effect be no better than private attorney privates.