Professor Explores Plaintiffs’ Practice of Taking a Financial Stake in the Company They Are Suing

Plaintiffs financially betting for or against companies they are suing sounds like insider trading.

It isn’t, says University of Virginia School of Law professor Albert Choi, and investing in the defendant can be a strategy to offset potential losses from litigation. But the practice raises a host of legal and ethical concerns that Choi explores in a new paper.

“Taking a Financial Position in Your Opponent in Litigation,” co-authored with Harvard law professor Kathryn E. Spier and forthcoming in the American Economic Review, explores the phenomenon and eyes a model for when a plaintiff may ethically trade the stock of a defendant firm.

Choi, who holds a Ph.D. in economics, previously served as a director on the American Law and Economics Association’s board. He is co-editor at the American Law and Economics Review, and associate editor of the International Review of Law and Economics.

What inspired you to write this paper?

The idea of writing this paper came when my co-author and I heard about a fairly well-known hedge fund, managed by Kyle Bass, taking “short” positions [betting that the stock price would fall] on pharmaceutical companies before bringing patent invalidity challenges against them. The pharmaceutical companies argued that this was an abuse of process and they even inspired legislation in Congress to substantially limit the ability to bring patent invalidity challenges by plaintiffs with a financial stake in the defendant. The episode raised interesting questions about what effect such a financial position will have on litigation and, more broadly, whether such a strategy should or should not be allowed.

What’s the difference between long and short positions?

When an investor holds a “long” position on a stock, for instance, the investor is betting or expecting that the stock price will go up. Most ordinary financial investments we can think of consist of taking a “long” position. However, when an investor is very pessimistic about the stock or expects the stock price to go down, she can take a “short” position on the stock. She does this, basically, by borrowing the stock from someone else and selling the stock on the market with a promise to return the stock to the person who lent her the stock at a later date.

How often do plaintiffs have financial stakes in defendants in civil lawsuits? Can you give an example of such a lawsuit?

We cite several examples, where plaintiffs have taken short positions on defendants, in the paper. One difficulty is determining how prevalent such a strategy is. Because short sellers are often not compelled to disclose their positions, we suspect that even when plaintiffs have such a financial position, they may hide such positions, or at least not be compelled to disclose the position. We also talk about plaintiffs having a long position on defendants. The most common kind is when shareholders bring suit against the company.

What are the main findings of the paper?

One thing we show in the paper is that, even if the plaintiff were to make no gain (or loss) on their financial position, having a short position grants them bargaining leverage and allows them to extract a larger settlement. A short position can also turn a lawsuit that would be expected to lose money into one that makes money for the plaintiff. If we think about Kyle Bass’ lawsuits, without additional incentives, he likely would have lost money because the hedge fund did not own any competing patents, the successful challenge will merely render the pharmaceutical companies’ patents invalid, and the litigation process is costly. With a short financial position, however, the hedge fund will now have a claim that can generate, in expectation, a positive return.

Is this more of a legal or ethical issue? How does it contrast with insider trading?

We suspect that this raises both legal and ethical issues. While some scholars have examined this problem with consideration to the laws on insider trading, unless some special relationship is present, it seems unlikely that a third-party plaintiff having a financial position on a defendant will make the plaintiff liable under the federal insider trading laws. This is because when the plaintiff is unrelated to the defendant (e.g., not an employee or have any special interest with the defendant) and is using its own information (that she is about to file a lawsuit), the plaintiff is not an insider and is not using any proprietary information of the defendant-company.

Are these lawsuits harmful to the litigation or the legal system? What are the policy implications?

The difficult policy question is whether we should allow or disallow plaintiffs taking short or long positions on defendants. The answer to this question depends, in part, on whether we should encourage or discourage certain types of lawsuits. For instance, if we think that more entities should bring patent invalidity challenges — which presumably was the rationale behind the America Invents Act, which allows virtually anyone to bring such challenges — allowing a prospective plaintiff to reap financial return through a short position can be a good thing, given that there is no direct return from successful prosecution. At the same time, because a substantial short position can encourage frivolous lawsuits, we suggest, in an extension to be published online, that the fee-shifting (i.e., loser pays all costs) regime can function as a mechanism to screen meritorious lawsuits from frivolous ones.

With respect to the federal securities class actions, there has been some controversy over institutional shareholders, who have a large long position on stock, settling the claims on behalf of the entire shareholder class as the lead plaintiff. [A securities class action is a lawsuit filed by investors who bought or sold a company’s securities within a specific period of time and suffered economic injury as a result of the company’s violations of securities laws.]

Given that a large long position can substantially weaken the institutional shareholder’s bargaining position, if we think that we should encourage more vigorous prosecution of certain securities class actions, then not allowing such an institutional shareholder be the lead plaintiff of the shareholder class — or even creating separate sub-classes of shareholder-plaintiffs — can be a good thing.