John emailed me as followes:
Professor Bainbridge,
Hope you recover from your cold shortly. Happy new year, and thanks for the great blogging in the past year. [ProfB: Thanks. I'm starting to feel a bit better. It was a bad one.]
I have a question regarding a Supreme Court ruling in J.I. Case Co. v. Borak 377 U.S. 426 (1964). Is this:
"We, therefore, believe that under the circumstances here it is the duty of the courts to be alert to provide such remedies as are necessary to make effective the congressional purpose. As was said in Sola Electric Co. v. Jefferson Electric Co., 317 U.S. 173, 176 (1942):'When a federal statute condemns an act as unlawful, the extent and nature of the legal consequences of the condemnation, though left by the statute to judicial determination, are nevertheless federal questions, the answers to which are to be derived from the statute and the federal policy which it has adopted.'"
...an example of judicial activism, or was there a solid argument to be made regarding the treatment of remedies? If you get a chance to respond, I'd appreciate it.
Great question. In the extended post, I'm putting up an excerpt from my book Corporation Law and Economics, in which I addressed that very question.
No matter how closely one scrutinizes Securities Exchange Act ? 14(a), one will not find anything relating to a private party cause of action under the statute or rules. In J. I. Case Co. v. Borak,[1] however, the Supreme Court implied a private right of action from the statute. Case proposed to merge with American Tractor Co. Borak owned around 2000 shares of Case stock and sought to enjoin the merger on the grounds, inter alia, that the company?s proxy materials were false and misleading. Borak claimed that the merger was approved by a small margin and would not have been approved but for the false and misleading statements. Case argued that Borak had no standing to sue, as the federal proxy rules provided no private party cause of action.
Despite the lack of any statutory authorization for a private party cause of action, Justice Clark?s opinion for the Court found that such an action in fact existed. As a fig leaf to cover the otherwise naked exercise of judicial activism, Justice Clark purported to find a statutory basis for the cause of action in Exchange Act ? 27. Noting that ? 27 gives district courts jurisdiction over ?all suits in equity and actions at law brought to enforce any liability or duty? under the Act, Justice Clark contended that ?[t] he power to enforce implies the power to make effective the right of recovery afforded by the Act. And the power to make the right of recovery effective implies the power to utilize any of the procedures or actions normally available to the litigant . . . .? His argument, however, is spurious. Section 27 speaks of liabilities imposed by the Act, but nothing in ? 14(a) or the rules thereunder creates such liabilities vis-�-vis shareholders.
Borak is better understood as an exercise of judicial fiat. A private right of action exists not because Congress intended it, but because a majority of the Supreme Court said so. The general legitimacy of implied private rights of action is beyond our purview, however.[2] Instead, we are concerned solely with Justice Clark?s policy justification for this particular cause of action.
Justice Clark was quite above-board as to his motivation?he wanted to deter fraud and other proxy violations. According to Justice Clark, private enforcement provides ?a necessary supplement? to SEC efforts. He implied that shareholders are in a better position than the SEC to detect proxy violations?they have fewer proxy statements to review and presumably are better informed about the company. Again, however, the argument is spurious. Most shareholders do not carefully review proxy materials. Instead, they are rationally apathetic. They lack both the desire and the incentive to closely monitor the firm. Justice Clark doubtless knew that individual shareholders were unlikely to emerge as champions of corporate truth and justice. Instead, it seems probable that he was trying to provide incentives for the plaintiffs? bar to become more active in proxy litigation.
At this point, we must digress briefly to discuss the economics of deterrence. Following Jeremy Bentham, many modern deterrence theorists assume that man is a rational calculator of costs and benefits. A rational calculator will not violate the law if the costs of illegal activity exceed the benefits to be derived from it. To be sure, the idea that criminals are rational calculators seems improbable, but there is some evidence that criminals behave as though they were rational calculators, especially with respect to economic crimes like securities fraud.[3] The economic theory of deterrence therefore argues that the number of offenses reflects the expected benefits and sanctions associated with crime. Where potential offenders perceive that the potential gains from the activity are greater than the potential penalties, offenses will increase. In contrast, offenses will be reduced when the expected sanction exceeds the expected benefit. The expected benefit depends on the probability of success and the likely gain. Similarly, the expected sanction is a function of the nominal penalty and the probability of conviction or settlement.[4]
The express nominal sanctions for violations of the proxy rules are fairly severe. Violations can be referred to the Justice Department for criminal prosecutions, the SEC can bring an action to enjoin violations or to enjoin actions taken because of the violations (such as a merger based on false proxy materials), and the SEC can institute administrative proceedings to require compliance with its rules. However, as Justice Clark pointed out, the SEC has limited resources. The chances that the SEC will detect and successfully prosecute proxy violations are rather small. Because the expected sanction is a multiple of the nominal sanction and the probability of conviction, the expected sanction for violations of the proxy rules is relatively low. Accordingly, we would not expect SEC enforcement to provide an adequate level of deterrence.
The various forms of equitable and monetary relief made available by creating a private right action would increase the level of the nominal sanction. More important, however, if the plaintiffs? bar could be encouraged to act as so-called ?private attorneys general,? the probability of detection and conviction would increase substantially.
That Justice Clark was concerned with creating incentives for the plaintiffs? bar is suggested by his characterization of the implied private right of action as being both direct and derivative in nature. (Strikingly, he did so over Borak?s strong argument that the suit was only direct in nature.) At the time Borak was decided, the modern federal class action procedure had not yet been adopted. If proxy actions were allowed to proceed only directly, and plaintiffs? lawyers were limited to representing individual shareholders, the contingent fees generated by proxy litigation would be insufficient to attract quality lawyers. (The situation would be even worse in cases like Borak, where plaintiff sought only equitable relief.) Because the implied cause of action had a derivative element, however, a plaintiffs? lawyer could effectively sue on behalf of all shareholders, by nominally suing in the corporation?s name, generating larger damage claims and bigger contingent fees.
The Supreme Court?s emphasis on promoting private attorneys general became even more pronounced in its next major proxy decision, Mills v. Electric Auto-Lite Co.[5] Mergenthaler Linotype Company owned over 50% of Auto-Lite?s stock. About one-third of Mergenthaler?s voting stock, in turn, was owned by American Manufacturing Co. American had voting control of Mergenthaler and through it Auto-Lite. Auto-Lite and Mergenthaler agreed to merge. The merger agreement required approval by two-thirds of Auto-Lite?s outstanding shares, which therefore required affirmative votes from at least some of the minority shareholders. Plaintiffs alleged that the proxy materials used to solicit those votes were false and misleading and sued to enjoin the shareholder vote.
In the portion of its opinion dealing with remedies, the Supreme Court created a strong incentive for members of the plaintiffs? bar to act as private attorneys general. The Court opined that shareholder- plaintiffs ?who have established a violation of the securities laws by their corporation and its officials, should be reimbursed by the corporation or its survivor for the costs of establishing the violation.? Note carefully that plaintiffs? counsel was entitled to attorney?s fees simply for finding a violation?there was no requirement that the plaintiff ultimately prevail in the sense of recovering damages. Indeed, in Mills, the shareholders ultimately recovered nothing, but the plaintiffs? attorneys? fees were still paid by the corporation.[6] Mills thus created a powerful economic incentive for lawyers to sue even in cases where it was clear that no injury had been caused by the violation.
The sweeping mandate in Mills to plaintiff?s attorneys to go forth and uncover proxy rule violations was somewhat pared back by later Supreme Court decisions.[7] Today, the case law requires that the plaintiff?s cause of action must create either a common fund from recovered damages or some substantial nonmonetary benefit in order for fees to be awarded.[8] Because injunctive relief likely satisfies the ?substantial benefit? standard, however, there is still an incentive to sue even where it seems unlikely that monetary damages ultimately will be forthcoming.
[1] 377 U.S. 426 (1964).
[2] For analyses with application to securities law, see Joseph A. Grundfest, Disimplying Private Rights of Action Under the Federal Securities Laws: The Commission?s Authority, 107 Harv. L. Rev. 963 (1994); Michael J. Kaufman, A Little ?Right? Musick: The Unconstitutional Judicial Creation of Private Rights of Action Under Section 10(b) of the Securities Exchange Act, 72 Wash. U. L.Q. 287 (1994); Marc I. Steinberg and William A. Reece, The Supreme Court, Implied Rights of Action, and Proxy Regulation, 54 Ohio St. L.J. 67 (1993). Noting that the Supreme Court?s standards for creating implied private rights of action have stiffened in recent years, some lower courts have questioned whether Borak would be decided the same way today and even whether its reasoning remains valid. See, e.g., Reschini v. First Fed. Sav. & Loan Ass?n of Ind., 46 F.3d 246, 255 (3d Cir. 1995) (opining that Borak ?is still good law as a construction of the 1934 Act and Rule 14a-9. However, it is not clear that Borak, if it arose for the first time today, would be decided the same way.?).
[3] Richard A. Posner, Economic Analysis of Law 223-224 (4th ed. 1992).
[4] Put more precisely, deterrence seeks to minimize the social loss associated with crime, which can be viewed as a function of the loss created by the activity itself (activity loss), the cost of enforcing a prohibition against the activity (enforcement loss), and the cost of imposing sanctions against the activity (penalty loss). Activity loss is a function of the number of offenses and of the loss resulting from each offense. Enforcement and penalty losses are distinguished primarily by the stage of the deterrence process where they occur. Enforcement loss is the cost to society of detecting and convicting wrongdoers. Penalty loss is the cost of subsequent punishment. The sum of the costs to society and to the individual resulting from the imposition of the sanction and from any externalities created is the net penalty loss to society. Any attempt to minimize social loss must attempt to minimize the sum of all three factors, and not merely activity losses. If activity losses were the only factor in determining social loss, the social loss could be minimized simply by increasing the nominal sanction or the probability of conviction until the expected sanctions far outweigh the expected benefits. An increase in enforcement activity, however, requires increased enforcement expenditures and increases the enforcement loss to society. Similarly, an increase in nominal sanctions increases the externalities associated with imposing the sanction?such as deterrence of beneficial activities?thereby increasing the penalty loss to society. See generally Gary S. Becker, Crime and Punishment: An Economic Approach, 76 J. Pol. Econ. 169 (1968).
[5] 396 U.S. 375 (1970).
[6] Mills v. Eltra Corp., 663 F.2d (7th Cir. 1981); Mills v. Electric Auto-Lite Co., 552 F.2d 1239 (7th Cir. 1977).
[7] See, e.g., Alyeska Pipeline Service Co. v. Wilderness Society, 421 U.S. 240, (1975) (holding that absent statutory authorization, courts should not award attorneys fees to a plaintiff simply because plaintiff he served as a private attorney general).
[8] See, e.g., Goldberger v. Integrated Resources, Inc., 209 F.3d 43 (2d Cir. 2000); Amalgamated Clothing and Textile Workers Union v. Wal-Mart Stores, Inc., 54 F.3d 69 (2d Cir. 1995); Smillie v. Park Chemical Co., 710 F.2d 271 (6th Cir. 1983).
