Earlier today, the U.S. Supreme Court granted review in Halliburton Co. v . Erica P. John Fund, No. 13-317, to address an important question affecting securities class actions: whether the “fraud-on-the market” presumption created by the Court in Basic, Inc. v. Levinson remains viable in light of new developments—both in economic thinking and in the marketplace—over the 25 years since Basicwas decided.
Where did the fraud on the market presumption come from? Here are the basics (pun intended). The vast majority of securities fraud class actions are brought under a private right of action that was not created by Congress but rather implied by the courts from Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, which the SEC promulgated under that provision. In these cases, the plaintiff must plead and prove (among other things) that the defendant misrepresented or omitted a material fact in connection with the purchase or sale of securities.
Typically—and certainly at common law—a plaintiff who alleges fraud must show that he or she relied on that misrepresentation or omission. And reliance is an element of a Section 10(b) fraud claim too.
But in 1988, the Supreme Court held in Basic, by a 4-2 vote (with three Justices not participating), that reliance may be presumed across an entire proposed class based upon the so-called efficient market “hypothesis”: “that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business,” and “[m]isleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.” Stated another way, the Basic majority assumed that transactions in an efficient market essentially take public statements (or misstatements) into account, regardless of whether the plaintiff or class members actually heard or acted upon the statements. The consequence—for 25 years—has been that in securities fraud class actions, plaintiffs need not prove actual reliance unless the defendant can rebut the fraud-on-the-market presumption, something that happens only rarely.
Today’s grant of review in Halliburton will allow the Court to take a second look at the presumption. The Court will analyze whether economic learning over the past 25 years has undermined Basic’s foundation based on economic theory, or whether the Basic dissent (written by Justice White on behalf of himself and Justice O’Connor) was correct in warning that the four Justices in the majority had “embark[ed] on a course that [they do] not genuinely understand, giving rise to consequences [they] cannot foresee.”
We’ll have more to say about the merits of the fraud-on-the-market presumption as the Halliburton case progresses. But we wanted to address a claim we are already hearing in the hours since the Court granted review: that rejection of the fraud-on-the-market doctrine would harm investors by depriving them of an essential remedy that provides protection against fraud.
To begin with, if plaintiffs must actually prove reliance—as is true of fraud-based class actions in other contexts—it certainly will not be as easy for the plaintiffs’ bar to bring securities class actions as it is now. That is because under current law the reliance element of a Section 10(b) action is essentially presumed out of existence in virtually all cases.
But the idea that these class actions actually benefit investors—as opposed to lawyers—is simply wrong. As many academics—law professors, economists, or both—have recognized, the securities class-action system is fundamentally broken. Perhaps most significant, because a corporation is owned by its shareholders, the effect of a settlement in a securities class action is to require the current set of shareholders to pay the settlement amounts to past shareholders, with a substantial portion of that settlement deducted for attorneys’ fees to the plaintiffs’ lawyers. And the current shareholders are also forced to pay the costs of defending that litigation, including very sizeable attorneys’ fees and e-discovery costs.
Adding to these concerns is the long history of abusive securities class actions. Nearly two decades ago, Congress reacted to the record of abusive shareholder litigation by enacting the Private Securities Litigation Reform Act. While the PSLRA made some welcome changes to the system, the abuses did not end; instead, they simply took on different forms.
Thus, as Professor Adam Pritchard has put it, “[s]ecurities fraud class actions are a ‘pocket shifting’ exercise for shareholders. . . . [T]he dollars paid in these suits come from the corporation, either directly in the settlement or indirectly in the form of premiums for insurance policies. . . . Shareholders effectively take a dollar from one pocket, pay about half of that dollar to lawyers on both sides, and then put the leftover change in their other pocket.” According to a commentary inBusinessWeek, “there is widespread agreement among legal scholars that [shareholder] class actions make little economic sense and are anemic deterrents to fraud.”
The plaintiffs’ bar seems set to argue that fraud-on-the-market must be maintained—whether it makes economic sense or not—to avoid what some claim would be “the end of securities class actions.” But that line of argument will force the plaintiffs’ bar to justify its assertion that these lawsuits actually provide a net benefit to investors. Given the large number of academic commentators who agree upon the fundamental irrationality of securities class actions—and the harm they inflict on investors—that is going to be a very high mountain for the plaintiffs’ bar to climb.