Last month, Adam Pritchard, a Professor at the University of Michigan Law School, published a paper in the Cato Supreme Court Review that proposes a way for shareholders of public corporations to “fix” what he calls the mistake of Basic v. Levinson through a shareholder proposal. Basic is the U.S. Supreme Court case that established the fraud on the market theory (FOTM) of damages in securities class action lawsuits. Pritchard writes that Basic “effectively eliminated the reliance requirement for plaintiffs suing large companies whose stock is actively traded — and unwittingly released the floodgates for securities class actions. Plaintiffs, instead of having to allege that they read and relied upon the misstatement before purchasing, could instead claim that the market relied on the lie and it was reflected in the stock price.”
Pritchard believes that the current damages formula flowing from Basic “compensates the shareholders on the losing end of trades — which can amount to billions of dollars — while ignoring the equivalent windfall gain that the selling shareholder got from selling at an inflated price. Compensation only makes sense when the defendant’s gain roughly corresponds to the plaintiff’s loss.”
Pritchard proposal to change all of this centers upon Exchange Act Rule 14a-8, which permits shareholders to make proposals to be included in the company’s proxy statement, including suggestions that the directors amend the articles of incorporation. Pritchard argues that shareholders “could adopt an unjust enrichment model by making a partial waiver of the FOTM presumption of reliance in the corporation’s articles of incorporation. The waiver would stipulate to a disgorgement measure of damages, requiring violators to give up the benefits of the fraud, if the FOTM presumption were invoked in a securities class action.”
In short, Pritchard’s proposal drastically reduces the incentive for plaintiffs to file securities class actions by reducing the possible damages from the overall plaintiffs’ loss to the defendants’ gain. It also shifts the focus from the corporation to its executives, as they are typically the ones who will have gained from fraudulent conduct.
Securities Docket reached out to Professor Pritchard to learn more about his proposal. Our discussion, as well as a copy of his recent paper and his model Shareholder Proposal, follows below.
SD: If a proposed amendment like you are suggesting was adopted by a company, what percentage chance do you think it would have of withstanding a challenge in court?
Prof. Pritchard: I think there is a pretty good argument that the amendment rebuts the presumption of reliance. How can you say you are relying on the integrity of the market price if there is a provision in the articles of incorporation essentially saying that you should not? I am more confident on the Section 29 issue. My reading of Central Bank and the Exchange Act (particularly Section 18) is that I have the right measure of damages, and the out-of-pocket measure should only apply in cases of actual reliance.
My guess is that no company will buy on to it unless it gets past the SEC first, in response to a no-action letter attempting to exclude the proposal as inconsistent with federal law. I’ll concede that the chances of ultimate success are probably less than 50%, but I don’t see a big downside from trying.
SD: As a practical matter, what kind of shareholder could be counted on to make such a proposal? Where would these proposals come from, who would pay for the preparation and shepherding, etc? Who would be the champion of this on a company level?
Prof. Pritchard: I don’t personally own any shares, or I would do it myself. It’s not very difficult. The most likely to give it a try: small shareholders who have received class action settlement check and were underwhelmed at receiving pennies on the dollar. I am also trying to reach out to some activist hedge fund types who might give it a try. I expect companies to resist the proposal; it puts their officers in the cross-hairs of the plaintiffs’ bar.
SD: What is the main policy argument you would expect to hear from opponents of such a proposal, i.e., why this is a bad idea on a policy level?
Prof. Pritchard: The policy argument is that if we abandon compensation people will not participate in the equity markets. Given the level of compensation that is currently paid, and the high levels of stock market participation before Basic was decided, I think this argument is specious, but it is what I would expect.
SD: What do you think the chances are of such a proposal being made at some public company in the foreseeable future, say by the end of 2009?
Prof. Pritchard: It depends on how effective my efforts at publicity are. I only need one shareholder to get it started. Proxy season is just around the corner, so now is the time to submit a proposal. If the proposal gets made — and succeeds — I expect the number to increase exponentially. Posting the model proposal makes it very easy for anyone who would like to submit it to a company to do so on their own. They just need to have owned $2000 worth of the shares for a year.
SD: How do you think the market would react to a company that adopted such a proposal? Is your gut that the stock would move materially and, if so, which way?
Prof. Pritchard: I’m reasonably confident that a firm adopting the proposal would receive a positive stock price increase, and a material one. The response to the PSLRA and to Silicon Graphics was significantly positive for firms most at risk of suit. Those were incremental changes; my proposal radically reduces the risk of frivolous suit for the company adopting it.
SD: What kind of reaction have you received to your recent article (available here) in the NLJ about this same topic?
Prof. Pritchard: Some hits in the blogosphere, but not as much as I had hoped. If I can find a shareholder to make the proposal, I would expect that would generate some mainstream media coverage.