Profound disagreements persist about how to get the nation’s financial markets into better working order. The left wants federal regulators to come down harder on Wall Street. The right wants to reduce the burden of regulation. Washington is unlikely to embrace any significant financial reforms, unless of course we have another crisis.
But we can take steps this year to enhance the integrity of the financial markets without adopting a single new law or waiting for the next catastrophe. All we have to do is to make the private sector police itself more aggressively.
How? By standardizing the process by which lawyers’ fees are set in securities fraud class action lawsuits. The tools for doing that are already available, and it won’t cost another dime in taxes.
Private enforcement of the securities laws is governed by the Private Securities Litigation Reform Act, which Congress enacted in 1995. The statute’s key private enforcement mechanism takes advantage of a simple fact: All investors hate fraud, but bigger investors hate it more and are willing to do more to prosecute those who commit fraud.
The Act thus gave large institutional investors the power to control securities fraud class action lawsuits. The hope was that those investors would secure the greatest possible compensation for those harmed while also generating the strongest possible pressure against fraud.
The Act has worked well during the past 20 years. The ratio of attorneys’ fees to recoveries has fallen, meaning that defrauded investors are getting more bang for the buck. But the private enforcement mechanism would be even more efficient if all federal judges followed the same, simple process for setting attorneys’ fees in these cases.
The Act directs the large investors, who will be appointed by the court to lead the litigation, to choose their lawyers at the outset and set the lawyers’ fees. Judges are there to ensure that lead investors perform those tasks.
Yet, our study of 400 settled cases, just published in the Columbia Law Review, found that lead investors rarely provide judges information about fees up front, and judges almost never ask for it. Instead, fees only come up when a settlement is proposed, and the typical judge sets them with no apparent concern for the terms of the fee agreement negotiated at the outset of the case.
This is like asking people to gamble without telling them what they’ll get if they win. If you’re a lawyer thinking of putting $1 million worth of time and money into a risky securities fraud class action lawsuit, you’d like to know the expected return.
But if you study the cases as we did, the answer you’ll get goes something like this: “You’ll probably get 25 percent of the settlement, unless you’re in front of Judge X, in which case you’re more likely to wind up with 20 percent. But if you’re lucky enough to get Judge Y on a good day, you could take home 30 percent.”
Real gambles are not run this way, and few business ventures are either. A startup company may lose money or make money, but the owners know how the losses and the profits will be split.
We know what happens if we leave lawyers’ fees uncertain — lawyers take fewer risks and invest less of their time and money than they should, which weakens private law enforcement. As a result, too many financial frauds occur, and securities class actions lawsuits may settle too quickly and too cheaply.
The fix is easy: At the start of litigation, federal judges should demand information about fees. This would force investors to bargain with their lawyers for reasonable rates up front — which is what the Private Securities Litigation Reform Act requires them to do anyway. Once approved by the court, those terms will apply throughout the litigation. The lawyers’ fees will be predictable, and their incentives will be improved.
Our proposal does not mean that lawyers will get paid more. In fact, our study found that average fees were lower in the cases in which judges followed the procedure we suggest.
Better enforcement, but no more regulation. It’s a solution both parties should embrace.
Charles Silver holds the Roy W. and Eugenia C. McDonald Endowed Chair in Civil Procedure at The University of Texas at Austin. Lynn A. Baker holds the Frederick M. Baron Chair in Law at The University of Texas at Austin.
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