The Supreme Court will grapple with private securities class actions when it hears oral argument tomorrow in Halliburton v. Erica P. John Fund, Inc. The principal question in the case is the continuing validity of the fraud-on-the-market doctrine, endorsed by the Court twenty-five years ago in Basic Inc. v. Levinson, which relieves plaintiffs asserting claims under Section 10(b) of the Securities Exchange Act of the obligation to prove actual reliance, and permits the reliance element of a securities fraud claim to be satisfied presumptively by proof that the securities at issue traded on an efficient market.
A significant part of the debate in the Halliburton briefs addresses new scholarship contradicting the views of economists who developed the hypothesis underlying fraud-on-the-market. That is precisely what Justice White predicted in his Basic dissent: “[W]hile the economists’ theories which underpin the fraud-on-the-market presumption may have the appeal of mathematical exactitude and scientific certainty, they are—in the end—nothing more than theories which may or may not prove accurate upon further consideration. . . . I doubt we are in much of a position to assess which theories aptly describe the functioning of the securities industry.”
But the defenders of fraud-on-the-market, perhaps recognizing the doctrine’s tenuous status based on the economic learning over the past quarter-century, focus considerable attention on three arguments unrelated to the doctrine’s merits:
- Principles of stare decisis prevent the Court from overturning Basic;
- Congress ratified Basic’s endorsement of fraud-on-the-market when it enacted the Private Securities Litigation Reform Act; and
- Securities class actions benefit investors and, because they would be harder to bring if Basic were overturned, the Court should leave fraud-on-the-market in place.
To spare readers (and myself) an exegesis into economic analysis, this post focuses on these contentions, explaining why a fair appraisal of these arguments in fact demonstrates that the Court is obligated to assess Basic on the merits, and overrule the decision if the fraud-on-the-market presumption can no longer be justified.
The Supreme Court has frequently stated that the principle of stare decisis—respect for precedent—has special force in the context of statutory interpretation, because Congress has the power to alter the Court’s decisions through subsequent legislation.
But was Basic really a statutory interpretation case? No, it was not.
Section 10(b) does not create a private cause of action. The statute simply makes it “unlawful” to “use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange Commission] may prescribe as necessary or appropriate in the public interest or for the protection of investors.”
Not a word about lawsuits by private parties, where such lawsuits may be brought, the elements that a plaintiff must prove in order to prevail, the measure of damages—nothing. All of that has been “implied” by courts from this short congressional enactment. The private cause of action is, in the Supreme Court’s own words, “a judicial oak which has grown from little more than a legislative acorn.”
Given that courts have created the rules of 10(b) litigation—indeed, invented the entire area of litigation—should the precedents establishing those rules have the same status as more routine statutory interpretation decisions?
There is a clear line of Supreme Court decisions demonstrating that the answer is “no”—specifically, the cases in which the Court has overruled prior decisions under the antitrust laws.
Most types of antitrust liability rest on Sections 1 and 2 of the Sherman Act. Section 1 states in relevant part, “[e]very contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal.” Interpreting the phrase “restraint of trade,” the Supreme Court has prescribed a complex set of principles that govern antitrust liability.
Even though antitrust law is based on a statute, the Court has been much more willing to overrule antitrust precedents. In its most recent decision overturning a prior antitrust decision, Leegin Creative Leather Products, Inc. v. PSKS, Inc., the Court explained why:
Stare decisis is not as significant in this case, however, because the issue before us is the scope of the Sherman Act. [State Oil v. Khan, 522 U.S. 3, 20 (1997)] (“[T]he general presumption that legislative changes should be left to Congress has less force with respect to the Sherman Act”). From the beginning the Court has treated the Sherman Act as a common-law statute. . . . . Just as the common law adapts to modern understanding and greater experience, so too does the Sherman Act’s prohibition on “restraint[s] of trade” evolve to meet the dynamics of present economic conditions.
The Court has overturned a significant number of antitrust precedents under this standard, including two in just the last eight years.
Basic was much more an exercise of the Court’s common-law authority than any antitrust decision—the private cause of action under Section 10(b) is entirely a judicial creation without any authorization from Congress even to engage in that enterprise. Indeed, the Court has explained that “[t]he federal courts have accepted and exercised the principal responsibility for the continuing elaboration of the scope of the 10b–5 right and the definition of the duties it imposes.” The much more relaxed stare decisis standard that the Court employs in the antitrust context is therefore plainly applicable here.
If the Court concludes that Basic erred in endorsing the fraud-on-the-market doctrine, therefore, stare decisis presents no barrier to overruling that determination.
If Congress “ratifies” or “acquiesces” in a judicial interpretation of a statute, courts lack the power to change it. In 1995, Congress enacted the Private Securities Litigation Reform Act (PSLRA), which imposed a variety of procedural requirements on securities class actions in an attempt to curb the filing of abusive lawsuits that harmed investors.
Did the PSLRA ratify Basic?
Again, the answer is “no,” for three reasons.
First, Congress considered a variety of approaches to fraud-on-the-market, but ended up adopting none of them. The bill introduced in the House of Representatives would have abolished the doctrine, but the bill ultimately passed by the House would have codified a modified version of the Basic rule. The Senate-passed bill did not mention fraud-on-the-market, and neither did the bill produced by the House-Senate conference committee that was enacted into law.
Does the failure to enact the House-passed codification of Basic mean that Congress rejected the Basic rule? Does the failure to enact the House-introduced bill mean that Congress endorsed Basic?
The only logical conclusion is that Congress intended to take no action with respect to fraud-on-the market one way or the other. That is especially true in light of the Supreme Court’s repeated injunction that courts should be reluctant to infer anything from congressional inaction—because all there is in the record with respect to fraud-on-the-market is congressional inaction.
Second, when Congress intended to codify a substantive liability rule in the PSLRA, it did so expressly. For example, Section 105 of the PSLRA specifically codifies the judicially-created requirement that a plaintiff prove loss causation. There is no such express ratification of fraud-on-the-market in the PSLRA, or even any mention of reliance.
Third, the PSLRA does not apply only to securities class actions under Section 10(b)—it governs all class actions under the Securities Act and the Securities Exchange Act. (In addition to the judicially-created Section 10(b) claim, there are numerous private causes of action expressly created by Congress in both statutes—many of which are invoked as the basis for class actions.) Given the broad scope of the legislation, there is no basis whatsoever to conclude that Congress focused specifically on the standards for liability under the Section 10(b) implied cause of action, let alone that Congress approved them.
The Claimed Benefits of Securities Class Actions
Even if fraud-on-the market is wrong as a matter of economics, should it stay in place because it facilitates securities class actions and eliminating the doctrine would deprive investors of the benefits of these lawsuits?
Again, the answer is a resounding “no.”
The simple fact is that the harm that today’s securities class actions inflict on investors far outweighs any potential benefit. That isn’t just my opinion—it’s the view of many academics and former government officials who have studied these cases. A comprehensive discussion of the issue is available here (pdf).
A recent study (pdf) released by the Institute for Legal Reform of the U.S. Chamber of Commerce confirms that conclusion, demonstrating that the filing of securities class action lawsuits decrease investors’ wealth by $39 billion each year—typically harming the very same investors who are included as plaintiff class members. Those losses far outweigh the $5 billion in settlement proceeds that are distributed to investors. (As the authors of the study note, I reviewed and offered comments on the study.)
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Even if the Court has the power to reconsider Basic, and even if the evidence tends to show that securities class actions do more harm than good, some may say that the Court still should refuse to act, because “this is an issue for Congress to address.”
But the Court imposed the fraud-on-the-market rule based on its own common-law authority, not as the result of any direction from Congress. If that rule doesn’t make sense, the Court has a responsibility to withdraw it.
More fundamentally, history teaches that Congress is highly unlikely to face up to these issues if Basic is left in place.
The PSLRA was a direct result of the Court’s 1991 decision in Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, which prescribed the statute of limitations applicable to Section 10(b) claims. Because Lampf altered the prevailing rule in the lower courts, the plaintiffs’ bar sought Congress’s intervention to overturn the Court’s decision. Congress did eliminate Lampf’s effect on pending cases, but the debate over the proper statute of limitations led Congress to hold hearings on the abuses of securities class actions, which in turn led to enactment of the PSLRA.
Leaving Basic intact provides no reason for Congress to revisit the status quo. Overturning Basic is the only effective means of focusing Congress’s attention on these important policy issues.