The U.S. Supreme Court decided on June 21 that under federal law governing shareholder suits alleging securities fraud (Tellabs v. Makor Issues and Rights), “an inference of scienter must be more than merely plausible or reasonable—it must be cogent and at least as compelling as any opposing inference of non fraudulent intent.” Newspaper commentary on the case correctly suggests that this will make shareholder suits more difficult. However, other aspects of economic reasoning in these stories has been woefully lacking.
Exhibit A is Stephen Labaton’s Page One article in the New York Times.
Labaton commits a fundamental error in economic reasoning in his lede:
The Supreme Court on Thursday dealt a blow to investors who want to sue companies and executives because of suspected fraud, setting a higher standard for class-action lawsuits to go forward.
The decision was the second one this week by the court that was a defeat for shareholders and a victory for the defendant companies.
For “investors” to have been “dealt a blow” by the opinion, or for “shareholders” to have suffered a “defeat,” it must be the case that a finding of securities fraud with monetary damages would come at the expense of someone other than investors or shareholders. But that is precisely who would have borne the cost. Senior executives may also be named as defendants, but in few if any cases are executives alone expected to bear liability.
Shareholder suits are contests among different classes of shareholders. There are plaintiff shareholders and defendant shareholders. the only question to be sorted out is whether the latter should be held financially responsible for any adverse effects suffered by the former.
Moreover, there is no defensible equity argument for holding current shareholders liable. Even if securities fraud is presumed to have occurred in the past, current shareholders did not necessarily benefit from it. It’s past shareholders who benefited — in particular, shareholders of record before the conduct that gave rise to the suit became publicly known. Stock prices would have fallen to incorporate the cost of an expected settlement or judgment, taking into account the probability that the allegations were meritorious . All stockholders of record as of the day after disclosure would have suffered a pro rata share of these costs. Similarly, it is stockholders of record as of yesterday who gained from the Supreme Court’s opinion.
That gain appears to have been small. Yesterday, Tellabs’ stock price rose from about $10.70 to $10.80 per share, and as of 9:30 am today it had declined $0.05 for the day. A year ago Tellabs traded at over $14.00 per share.