Commentary: Do Shareholder Class Actions Make Sense?

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Instead, it causes a wealth transfer among equally innocent third parties." Other critics have referred to this as "circularity" or "pocket shifting."

On June 30, Judge Rakoff's courthouse colleague, U.S. District Court Judge Denny Chin, designated a group of five pension funds to lead the proposed class action in the case against BofA. While the SEC seeks to mete out discipline—through civil, not criminal proceedings—the case spearheaded by the pension funds seeks compensation for investor losses. As if having one group of investors pay another isn't odd enough, the situation gets even more twisted. Securities filings show that a number of funds sold a portion of their BofA shares but continued to hold large positions in the bank after the mid-January stock drop. Some, like the Teacher Retirement System of Texas (TRS), were also big holders of Merrill shares, which as of Jan. 1 were converted into BofA stock. The result: A portion of any compensation they get will come from themselves.

There's another reason to question the idea of allowing investors to collect for securities fraud losses. Even though neither side in an aftermarket transaction participates in the fraud that inflates the price of a stock, the seller still benefits, while the buyer loses. A number of scholars contend that investors who are diversified in the market (as is common) will on average be the beneficiaries of fraud as often as victims. This means that, over time, their gains and losses will net out at close to zero. It also means that any recovery in a lawsuit is likely to be an undeserved windfall. TRS, for example, wants money back for its losses allegedly caused by BofA's fraud. Yet last year, TRS sold shares in SunTrust Banks during a time when another lawsuit alleges SunTrust's share price was artificially high because of fraud. (BofA and SunTrust say the fraud allegations are without merit.)

The contradictions and costs of shareholder class actions as a means to compensate investors for fraud-related losses might be deemed acceptable if they effectively served another key social goal—deterring fraud in the first place. It's hard to find anybody (outside the plaintiffs' bar) who thinks they do.

Why? Because the costs of litigation, including settlements and attorneys' fees, are generally paid for by the corporation's shareholders, not the executives who committed the fraud. And settlements of investor class actions are so routine, either because they are costly to fight or because a company doesn't want to risk a potentially massive jury verdict, that they carry little or no opprobrium. After all, in settlements of shareholder suits—just as with the SEC's proposed deal with BofA—the defendants do not admit any wrongdoing. No cost to the perpetrators, no shame—where's the deterrence?

Any comprehensive reform of the financial system should include a fundamental reconception of shareholder lawsuits. Rather than compensating secondary-market investors, their aim should be to deter fraudulent conduct. That means directors and officers need to be far more than just titular defendants—they need to have skin in the game.

Orey covers corporations for BusinessWeek.

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