SEC bounties should supplant securities class actions: law prof

By Alison Frankel
August 13, 2013

There are a lot of plaintiffs lawyers out there hoping to reap big rewards from the Securities and Exchange Commission’s 2-year-old whistle-blower program. When the SEC, acting at the direction of Congress in the Dodd-Frank Wall Street Reform and Consumer Protection Act, implemented procedures last August to pay tipsters a bounty for information leading to sanctions of more than $1 million, law firms started running advertisements targeting corporate insiders with evidence of securities violations at their companies. If you run a Google search using the phrases “whistle-blower” and “SEC,” you’ll see exactly what I mean.

Those bounties – and accompanying legal fees for whistle-blower lawyers – have been slow to materialize. So far, the SEC has rewarded only two tipsters, though according to The Wall Street Journal, the agency’s regional director in Los Angeles, Michele Wein Layne, told the American Bar Association on Saturday to expect more (and more substantial) bounty payments. There’s certainly been no shortage of prospective whistle-blowers reaching out to the SEC. In fiscal year 2012, the Journal reported, the agency received about 300 whistle-blower tips, from all 50 states and several foreign countries. The time lag between tips and rewards, Layne reportedly said, is because it takes a while for the agency to check out and act upon the information it receives.

Despite the SEC bounty program’s slow start, a professor at Vanderbilt University Law School, Amanda Rose, is arguing in a new working paper that if the agency efficiently handles tips, the whistle-blower program should make shareholder securities class actions obsolete. Rose, a onetime associate at Gibson, Dunn & Crutcher, is no fan of private securities fraud litigation. In 2011 she published a University of Pennsylvania law review paper entitled “Fraud on the Market: An Action Without A Cause,” which should give you a good indication of her point of view. I’m pretty sure her latest hypothesis isn’t going to win over the shareholder class action bar. Nevertheless, Rose makes a provocative case, and with the fundamental viability of securities class actions under threat from U.S. Supreme Court justices who have questioned the fraud-on-the-market reasoning of 1988′s Basic v. Levinson, plaintiffs lawyers should take care to know their enemies. (Hat tip to the CLS Blue Sky Blog, where I first heard about Rose’s paper.)

Rose’s paper is based on the premise that securities class action settlements don’t actually deter corporate fraud, but the revelation of wrongdoing does. She considers class action settlements merely a transfer of money from one group of innocent shareholders – those who pay for the corporate insurance coverage that funds just about every settlement – to another group, with legal fees an unfortunate and inefficient transactional cost. Shareholders with diverse portfolio don’t see any real returns, since sometimes they’re in the group paying insurance premiums and sometimes they’re in the group that receives settlement money. Meanwhile, settlements accomplish little in the way of deterrence, Rose believes, because corporate officers are almost never required to contribute their own money.

But officials can be dissuaded from engaging in wrongdoing by the knowledge that their equity stake in their company (and their personal reputations) will suffer from the exposure of fraud in a securities class action, according to Rose. The only shareholder fraud suits that have true deterrent value, she argues, are the very rare cases that reveal misconduct previously unknown to the market and regulators. Plaintiffs lawyers’ contribution to the process, in Rose’s view, is just in their ability to detect fraud based on public filings and to convince corporate insiders to give them information.

The SEC bounty program, according to Rose, can accomplish the same deterrence objectives without the transactional costs of securities class actions. Corporate insiders are provided incentives to expose wrongdoing to the SEC, and corporate officials – knowing that such incentives exist – are, in turn, incentivized not to put their wealth, reputation and perhaps freedom at stake by committing fraud. “The effect of the (SEC whistle-blower program) will therefore be to tip the cost-benefit scales against the social desirability of (private) suits, warranting their elimination,” Rose argues.

Rose told me in an interview that she’s not looking to put class action lawyers out of work. If they use their personal expertise to detect fraud, she said, they can themselves tip the SEC and receive the 10 percent to 30 percent bounty the program offers. Or, she told me, they can become whistle-blower lawyers. Many of the big securities class action firms, she noted, have started whistle-blower practices in response to the SEC program.

To her credit, Rose duly considers counterarguments defending securities class actions, including the plaintiffs lawyer refrain that the SEC tacitly relies on private lawyers to assist in policing corporate misconduct. Rose discounts that point by citings studies asserting that a minimal number of private suits actually disclose unknown fraud. She also raises what she calls “a more serious concern,” namely that the whistle-blower program might perversely permit fraud to persist because it encourages tipsters to run to the SEC rather than reporting concerns up the chain of command, thus delaying a quick investigation and correction of misconduct. (That concern should be heightened by the recent ruling of the 5th Circuit Court of Appeals that Dodd-Frank’s anti-retaliation provisions cover only whistle-blowers who report wrongdoing to the SEC.)Rose told me that if the SEC follows through on its promise to inform corporations when it receives a credible tip, the bounty program won’t delay fraud eradication.

Cynics and plaintiffs lawyers will, of course, point out that the elimination of securities class actions would vest all of the responsibility for corporate fraud detection and deterrence in the SEC, which, as demonstrated by the whistle-blower program’s slow start, is a resource-strapped bureaucracy. Rose has an answer: Congress can establish what she calls a “safety valve,” a securities version of qui tam litigation. If the SEC whistle-blower program doesn’t fulfill its promise, she says, the law should be amended to permit tipsters to bring actions on behalf of the agency. Her plan would be to give the SEC a set amount of time to respond to whistle-blower tips. Under certain scenarios in which the agency opts not to proceed based on the tip, whistle-blowers could sue. Even relying on qui tam relators, Rose argues, is better than relying on securities class actions.

Like I said, this is a provocative paper that’s written from a distinctly anti-class action vantage point. I don’t share that perspective, but Rose did make me think.

(Reporting by Alison Frankel)

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