Dumping and suing yet again

Moin Yahya has a WSJ op-ed criticizing the practice of dumping and suing – that is, short-selling on advance knowledge of filing a class action lawsuit. He’s concerned that this “constitutes market manipulation of the first order.” The manipulation, he thinks, lies in the non-disclosure of the foreknowledge of the suit, and in the possibility that the plaintiff might have incentive to dump, sue, sell, and then withdraw the suit.

I criticized Yahya’s article on this topic here. Bruce Kobayashi and I have a longer article (draft out soon) analyzing this and similar examples of outsider trading as incentive devices. The bottom line, as I said in my initial post

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.

Yahya’s WSJ oped persists in his blanket claim of illegality despite this fairly elementary principle of securities law. As a result, he allows his polemic against the practice to obscure some real, and more important, issues.

To begin with, there is actually something to be said for using the markets to compensate people who bring in new information, such as the information underlying a lawsuit. Yahya calls this double-compensating class action lawyers. But the question is whether the fee the lawyer receives provides a socially optimal incentive to sue. 

More broadly, in the interests of efficient markets, we could hardly want to have broad liability merely for trading on undisclosed information.

Now I can already hear the howls: how could I possibly be suggesting that securities class action lawyers are under-compensated? Well, I’m not saying that. I’m only positing the correct analytical approach. Assuming over-compensation is an incorrect way to analyze this issue.

In fact, in later messages here, and here, I indicate that this practice may lead to overcompensating the lawyers because – and here’s the kicker – the suits don’t serve a valuable social function. In other words, the big question here is how much we want these suits. If, as I suspect may be the case, their net value, even including deterring fraud, is negative, the way to deal with these problems is to get rid of the suits.

Assuming we’re stuck with the present system, what should we do about dumping and suing? Well, we’ve got adequate tools under current law. Courts may, and at least one has, dismiss a dumping and suing plaintiff an inadequate class representative. This sort of ruling effectively gives the plaintiff or his lawyer the option to dump or sue – no double recovery.

Also, Yahya is worried about the dumping with the idea of suing and then withdrawing the lawsuit. If the dumper-suer never intended to follow through with the lawsuit, that might be manipulation under current law, or lead to an abuse of process claim. And to the extent that Yahya is concerned that dumping and suing provides incentives to lie about the stock to drive the price down, that's fraud under current law.

I wish Yahya would finally focus on the real issues in dumping and suing rather than diverting attention by overbroad claims of manipulation and fraud. Moreover, consider that a rule broadly charactering undisclosed material information (in this case, about the intent to sue) as fraud could seriously extend the reach of the fraud laws. We have to remember that a rule intended to "catch" the people we don't like could end up "catching" those we do.

I know that trial lawyers aren't cool in some circles. But let's make sure the weapons we fashion against them don't circle back on the rest of us.

Comments

[Robert Schwartz]

Why isn't a trial lawyer who claims to representative for a class a fiduciary for the class. Shouldn't he be required to report and hold for the class the trading profits he makes as their reprentative?

[Larry E. Ribstein]

Yahya dials with trading before the suit, and therefore before the creation of any fiduciary relationship. But there still may be an obligation to disclose the trading in connection with the court's determination of the class representative.

[Robert Schwartz]

"Yahya dials with trading before the suit, and therefore before the creation of any fiduciary relationship."

I think that is excsivley formalistic. I think the fiduciary relationship should be deemed to begin when the lawyer begins to prepare the pleadings.

[Ann]

This is a minor point, but why call this 'dumping' rather than shorting (or short-selling)?