The Virtues of Private Securities Litigation: An Historic and Macroeconomic Perspective

Financial market crashes of historic proportions and swindles and frauds of historic proportions go hand in hand. Two giants in the field of economics made essentially this point long ago: Harvard economist John Kenneth Galbraith in The Great Crash 1929 and MIT economist Charles P. Kindleberger in Manias, Panics and Crashes. Each of these books notes that fraud temptations expand during euphoric economic times (for the fraudfeasor as well as the victim) and that the revelation of market chicanery after the inevitable crash deals further blows to investor confidence causing rapid contraction in capital flows. Economic devastation follows. These books are classics and should be read by every business student and economic policymaker.

Recent evidence from the world of finance and economics demonstrates the wisdom of these works. Thus, a recent paper in The Review of Financial Studies found that firms engaged in fraud pretend to be legitimate and invest and hire excessively during the period of ill-gotten gains and then shed employees and investment when the inevitable crash follows, exacerbating the boom and the bust. MIT finance professor, Andrew Lo, states that booms induce "cocaine addict" responses where profits lead many to underestimate risks (including lawmakers and regulators). Another study found that the Private Securities Litigation Reform Act (which made securities fraud difficult to impossible to prove) led to more accounting chicanery, like that seen during the Enron and WorldCom era of massive securities fraud.

This is all consistent with the massive frauds underlying the subprime lending frenzy. In the largest settlement in history, JPMorgan Chase paid the US Government $13 billion for admitted material misrepresentations in connection with mortgages peddled to Fannie Mae and Freddie Mac as well as other investors. (Better Markets filed a challenge to this deal.). BOA paid $9 billion to settle similar claims just last month. The Wall Street Journal estimates that total bank exposure for bogus mortgage backed securities totals $85 billion. Other massive frauds committed by subprime lenders, including the megabanks, have consistently been noted on this blog. It is beyond cavil that much of the capital flowing into the subprime mortgage business came from duped investors, victims of Wall Street fraud.

The simple truth is that our lawmakers and the judiciary diluted enforcement of the federal securities laws pursuant to the PSLRA as well as a series of draconian cases and thereby gave the green light to more securities fraud. More securities fraud means more financial instability with all its consequent macroeconomic devastation.

We must restore private rights of action under the securities laws.

All of this sums up a law review article entitled The Virtues of Private Securities Litigation that I just posted on SSRN (available here for free download) that applies all of this evidence to the subprime debacle and concludes that there is an overwhelming case that PSLRA materially contributed to the crisis and that restrictions on private securities litigation should be lifted.

Here is the abstract:

In the wake of the Great Depression, the federal securities laws operated to mandate disclosure of material facts to investors and extend broad private remedies to victims of securities fraudfeasors. The revelation of massive securities fraud underlying the Great Depression animated the federal securities laws as investment plunged after 1929 and failed to recover for years. For over sixty years after the enactment of the federal securities laws, no episode of massive securities fraud with significant macroeconomic harm occurred. The federal securities laws thereby operated to facilitate financial stability and prosperity, in addition to a superior allocation of capital. Unfortunately, as memories faded and inequality soared, corporate and financial elites (with the active aid of lawmakers) launched a sustained attack upon private enforcement of the securities laws. Soon thereafter the horrors of the Great Depression returned and massive securities fraud triggered the Great Recession of 2008 as economists would predict. This Article argues for a rollback of the war on private securities litigation to at least the 1980s based upon history and economic science. This would at least restore sensible pleading standards, impose liability on all participants in securities frauds (including aiders and abettors) and allow the states to impose more demanding standards of liability on wrongdoers in financial markets.