Securities class actions impose staggering costs on U.S. public corporations and their shareholders, driving potential IPOs from our shores and deterring private firms from going public. The Supreme Court missed an opportunity this week to correct what is considered by many to be the most unattractive feature of U.S. capital markets, and one the Court greatly helped to create.
In Halliburton v. Erica P. John Fund, the Court was asked to overturn a 25-year-old precedent establishing the so-called “fraud on the market” theory of reliance that threw wide the courthouse doors to prospective class action plaintiffs.
Class actions under U.S. law require a plaintiffs’ class to have “common questions” of law or fact that predominate over individualized questions, while securities fraud claims require a plaintiff to prove that he relied on a specific misrepresentation or omission in purchasing a security, a highly individualized inquiry. The challenge of reconciling these seemingly incongruent requirements was put before the Court in 1987.
Luckily for plaintiffs’ bar, a four-justice plurality held in Basic v. Levinson that where an investor purchases a security on an “efficient” market (e.g., the NYSE), he does so “in reliance on the integrity of [the market] price.” In an “efficient” market, all public information is known to the market and reflected in securities prices. Thus even if an investor did not subjectively know of the allegedly fraudulent misrepresentation or omission at the time of purchase, he still was deemed to rely upon it by virtue of its incorporation into the market price—even if the investor never knew or cared what the price was. The fraud is, therefore, “on the market,” and plaintiffs are entitled to a rebuttable presumption of reliance.
Unfortunately, while the costs of increased securities class actions are real, the benefits are illusory. In the last two decades plaintiffs’ lawyers have targeted over 40 percent of corporations listed on a major U.S. stock exchange, costing public companies approximately $5 billion a year. Litigation insurance costs are six times higher for a Fortune 500 company in the U.S. than in Europe, and only cover a small portion of the largest settlements.
The purported benefits—compensation and deterrence—are unsubstantiated. Long-term institutional investors effectively sue themselves, sometimes paying and sometimes receiving damages. Individuals often cannot be bothered to collect what amounts to a pittance. Subtract substantial legal fees and no one ends up better off except the lawyers.
Moreover, since people—not corporations or shareholders—commit fraud, any deterrent value resulting in corporate liability is minimal, particularly when compared to the increasing enforcement powers of the Justice Department and SEC. As detailed in the Committee on Capital Markets Regulation’s amicus brief on Halliburton, there is a solid policy case for doing away with Basic.
Yet Monday’s Halliburton decision did not overturn Basic. It only required that defendants be allowed to rebut the presumption at the class certification stage, rather than having to wait until trial.
This was already the rule solely in the Second Circuit, pursuant to In re Salomon Analyst Metromedia Litigation (2008). Once class actions are certified they almost always settle, since the risk to defendants of losing, even if small, could be catastrophic. In theory, allowing rebuttal at certification would reduce certifications and therefore the number of securities class actions brought in the first place.
However, NERA Economic Consulting data indicates that the Salomon decision has not reduced class actions. Forty securities class actions were filed in the Second Circuit in 2007 and 2009, the years before and after Salomon—rising to 50 in 2013. Nor does any data indicate that settlements are reached prior to certification in the Second Circuit more readily than in other Circuits. This stands to reason due to the daunting task of rebutting presumptions in the first place, and the marginal difference in doing so at certification rather than at trial.
The Court’s reluctance to reverse Basic stemmed from a notion that Congress should correct the Court’s prior misinterpretation, if the Court was in error. This rationale boggles the mind. If the Court now thought Basic a mistake, why shouldn’t it clean up its own mess rather than shuffling the problem over to Congress? And the Court’s opinion never clearly addresses whether it thinks it made a mistake! Although the economic theory was indeed wrong—as economists demonstrated—the idea that securities class actions are good for our capital markets is the more fundamental mistake.
It is time for the SEC to get back in the game. Consideration of other avenues of securities class action reform open to the SEC had been suspended pending Halliburton. Since the Supreme Court has failed to deal with the problem, these efforts need to be rekindled. Most importantly, the SEC needs to explain why they have blocked the efforts of shareholders—on a company-by-company basis—to opt out of exposure to securities class actions through by-law amendments requiring non-class arbitration, as suggested by the Committee on Capital Markets Regulation and set forth in detail in a law journal article I co-authored with Les Silverman.
Hal Scott is professor of international financial systems at Harvard Law School and director of the Committee on Capital Markets Regulation.
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