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Accountability and Competition in Securities

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Electronic copy available at: http://ssrn.com/abstract=1113845 - 1 -The Center for Law and Economic Studies Columbia University School of Law 435 West 116th Street New York, NY 10027-7201 (212) 854-3739 Accountability and Competition in Securities Class Actions: Why “Exit” Works Better than “Voice” John C. Coffee, Jr. Working Paper No. 329 July 2, 2008 Do not quote or cite without author’s permission. This paper can be downloaded without charge at: The Social Science Research Network Electronic Paper Collection http://papers.ssrn.com/paper.taf?abstract_id=1113845 An index to the working papers in the Columbia Law School Working Paper Series is located at http://www.law.columbia.edu/lawec/Electronic copy available at: http://ssrn.com/abstract=1113845 - 2 -Accountability and Competition in Securities Class Actions: Why “Exit” Works Better than “Voice” John C. Coffee, Jr. * Introduction A sizable literature on class actions has long suggested that the plaintiff’s attorney is an independent entrepreneur over whom the class members have only limited control.1 But the analysis cannot stop here. Why does this state of affairs exist? This essay will give two connected answers to this question as a prelude to evaluating what reforms are likely to work: (1) The rules of “litigation governance” differ diametrically from those of corporate governance. An entrepreneur seeking capital for a business venture must convince investors to “opt in” and buy the securities of the entrepreneur’s start-up corporation. But, in contrast, a plaintiff’s attorney can file a class action which, if successful, will entitle this legal entrepreneur to a mandatory court-awarded fee award, and class members can escape inclusion only by “opting out.”2 This stark difference between an “opt in” rule for corporate governance and an “opt out” rule for litigation governance explains, at least in part, why agency costs are higher in the latter context. * John C. Coffee, Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance. 1 See, e.g., John C. Coffee, Jr., Understanding the Plaintiff’s Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Litigation, 86 Colum. L. Rev. 669 (1986); Jonathan Macey & Geoffrey Miller, The Plaintiff’s Attorney’s Role in Class Action and Derivative Litigation: Economic Analysis and Recommendations for Reform, 58 U. Chi. L. Rev. 1 (1991). 2 Actually, there is only a right to “opt out” – that is, exit the class – in the case of class actions certified under Rule 23(b)(3). See Rule 23(c)(2)(B). If an action is instead certified under Rule 23(b)(1) or (b)(2), Rule 23 does not mandate a right to opt out. But see Molski v. Gleich, 318 F.3d 937, 948-49 (9th Cir. 2003) (right to opt out may be constitutionally required when class members have substantial monetary claims); Beckert v. TPLC Holdings, Inc., 221 F.3d 870, 873-874, 881-882 (7th Cir. 2000). The Supreme Court has not yet decided whether the right to opt out from a class action for money damages is of constitutional stature. For a review of recent decisions, see Rima Daniels, Monetary Damages in Mandatory Classes: When Should Opt-Out Rights Be Allowed, 57 Ala. L. Rev. 499 (2005). Because most class actions for money damages are certified under Rule 23(b)(3), this limitation on the right to opt out in the case of Rule 23(b)(1) and (b)(2) classes has only modest implications and will receive no further attention herein.Electronic copy available at: http://ssrn.com/abstract=1113845 - 3 -(2) The market for class action counsel has long been characterized by relatively weak competition. To be sure, some competition exists, but, as explained later, it is today fought, not for the loyalty of class members, but rather over the choice of the lead plaintiff. Brief and incomplete as these two assertions are, they frame important policy questions. Because the “opt out” rule for class actions gives plaintiff’s attorneys much of their bargaining leverage in class actions, it is not easily modified or discarded. But it also implies imperfect accountability and high agency costs because class members neither selected their attorney nor chose to sue nor are necessarily even aware of the existence of the action. Thus, the usual vocabulary used to describe the attorney/client relationship fits only awkwardly with this joint venture in which the attorney represents a class that has not retained the attorney in return for a basically predictable share of the recovery that a court will award if the action is successful. Still, what alternative is there? Can we design alternative institutional arrangements that will reduce the agency costs surrounding reliance on the attorney/entrepreneur who today dominates class action practice? This essay’s answer is that by encouraging opt outs, public policy can stimulate greater competition and compel the attorneys representing the class to be a more faithful champion for its members. This focus on competition is somewhat heretical. For some time, public policy has been guided by the implicit assumption that an all-inclusive class was desirable (because it minimized repetitive litigation and so conserved judicial resources) and that greater accountability should be encouraged by giving dispersed class members a stronger voice in the governance of the class action. Thus, the “lead plaintiff” reform, introduced by the- 4 -Private Securities Litigation Reform Act of 1995 (“PSLRA”), assigned presumptive control over the securities class action to the class member with the largest stake in the action.3 The premise here was that the investor with the largest stake in the action could best monitor the class’s attorney. Although an original and cogent idea,4 this reform appears to have had only modest impact on settlement size to date.5 Indeed, this essay will predict that similar efforts to appoint a class-wide champion to represent all class members will yield only similarly marginal and disappointing results. If so, what measures might work better? Using a nomenclature first developed by the economist Albert O. Hirschman,6 this essay will argue that the fallacy in recent reforms has been their emphasis on increased “voice” for class members, instead of increasing their ability to


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