Moin Yahya has posted The Legal Status of Dump and Sue. Here's the abstract:
There is some evidence that plaintiffs and their attorneys are profitably short-selling the stock of the companies they intend to sue. The status of such short sales is undecided in the law. Lawsuits against companies can cause large drops in market value, and hence such an action by the plaintiff should cause concern. Plaintiffs, however, are not traditional insiders, and they do not owe the shareholders any fiduciary duties. They can therefore consent to their attorneys also short-selling the stock of the defendant corporation. The attorneys need to receive such permission to avoid misappropriating the information concerning their client's decision to sue. A plaintiff's decision to sue after short-selling does not constitute market manipulation in the traditional sense, since the decision to sue is a true fact that causes the drop in the share price as opposed to those who commit fraud by spreading false negative stories about the company. Plaintiffs need, therefore, to be legally deemed temporary insiders until they publicly reveal their intention to sue or actually sue. The reasons for deeming them insiders, and hence prohibiting them from short-selling, are threefold. First, allowing such activities would raise the same concerns regarding market integrity raised by those opposed to insider trading. Second, allowing such short-selling is a form of fraud by silence against those who purchase the shares. Third, allowing short-selling would give the plaintiffs double recovery for their lawsuit, as they could gain a large share of their claim against the company from the profitable short sales in addition to any verdict or settlement. Furthermore, proposals to extend Regulation FD to plaintiff's attorneys would be ineffective in combating the harm from such short-selling. The law, therefore, through either developments by the courts, regulatory promulgations by the SEC, an act of Congress, or a combination of any of the preceding three mechanisms should be used to treat plaintiffs as insiders until they sue or announce their intention to sue.
If a plaintiff or his lawyer (with the plaintiff’s permission, so no misappropriation) is short-selling based on the true information that a suit is forthcoming I don’t see how this is illegal under current law – it’s not fraud without a duty to disclose, and it’s probably not illegal insider trading or manipulation.
Should it be illegal? Yahya argues that this trading in effect permits “double recovery.” Assuming there’s extra-compensatory recovery, is this a problem? That depends on whether there are excessive incentives to sue. Where the suit is representative, and the plaintiff must share recovery with others, the incentives otherwise may be too weak rather than too strong to encourage the socially optimal amount of litigation. Even in an individual claim the recovery may not reflect the full deterrence value, and therefore the social benefit, of the suit.
It follows that allowing short-selling theoretically might compensate the plaintiff or the class lawyer for producing the information that led to the suit where capitalizing on the information before it becomes public otherwise might be difficult.
Bruce Kobayashi and I explored a similar issue in Class Action Lawyers as Lawmakers. We suggested incentivizing lawyers who write socially valuable class action complaints through fee awards that do not depend on the winner-take-all lead plaintiff selection under the current version of the Private Securities Litigation Reform Act. I wonder if short-selling might be an alternative approach to the same problem.
Now, I can already hear the moaning about evil plaintiffs’ lawyers, and I sympathize. But litigation abuse might be better resolved through procedural rules that filter out the bad cases.
This is basically an issue of property rights in information. Law and economics types who argue for recognizing such property rights in, e.g., tender offers and insider trading, should similarly be willing to devise reward systems to encourage adequate production of litigation information.
Here's an update.
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