Yesterday’s Supreme Court ruling in the Halliburton case leaves the securities class action system pretty much unchanged. And that isn’t because the Supreme Court examined the system and concluded it is working well and makes sense. Instead, the Court simply didn’t address those questions.
That’s very good news for the lawyers who make their living representing plaintiffs and defendants in these cases. The gravy train will continue: $1.1 billion in fees and expenses awarded to plaintiffs’ counsel in 2013, with hourly rates up to $1370. Defense counsel likely took home a multiple of that amount, given that securities class actions routinely target multiple defendants with separate counsel, and that defense fees pile up in those cases that don’t reach the settlement stage.
But it’s very bad news for investors, who are forced to foot the bill for this economically-irrational litigation system that—in the words of Joseph Grundfest, former SEC Commissioner and current Stanford Law professor— “is broken” because it “fails to efficiently . . . deter fraud and fails [to] rationally compensate those harmed by fraud.” Professor Donald Langevoort of Georgetown has said: “Were this system sold as an insurance product, consumer-protection advocates might have it banned as abusive because the hidden costs are so large.” (More information about the dysfunctionality of the securities class action system is collected here.)
Indeed, the Court’s decision almost certainly will make this litigation even more expensive by increasing the scope of the class certification inquiry (while not changing the result in many cases). That means even more money out of the pockets of shareholders and into the pockets of lawyers and economic experts.
Why did the Court refuse to revisit the correctness of the fraud-on-the-market presumption recognized in Basic Inc. v. Levinson and decline even to consider the mountain of evidence that securities class actions hurt shareholders? And why is the Court’s tweak of the presumption unlikely to have any real-world effect?
The Punt to Congress
Stare decisis—respect for precedent—is the reason why this potential blockbuster case fizzled. Ordinarily, the Supreme Court is very reluctant to overrule a prior decision interpreting a federal statute. The Court’s view is that Congress has the power to correct errors in statutory construction.
But Basic is far from a conventional statutory interpretation case: courts, not Congress, created the private cause of action for securities fraud; courts, not Congress, specified the elements that a plaintiff must prove to recover damages; and courts, not Congress, formulated the fraud-on-the market presumption as a substitute for proof of reliance. For that reason, many observers (including me) thought that the Supreme Court would examine Basic under the different, more flexible stare decisis standard applicable to judge-made federal common law (and decisions under statutes like the antitrust laws that delegate common-law authority to courts). That standard permits the overruling of precedent in a broader range of circumstances, recognizing that Congress has allocated to the courts principal responsibility for supervising those areas of law.
Justice Thomas, writing for himself and Justices Scalia and Alito, applied that more expansive approach. As he explained, Basic “concerned a judge-made evidentiary presumption for a judge-made element of the implied 10b−5 private cause of action, itself ‘a judicial construct that Congress did not enact in the text of the relevant statutes.’” For that reason the high bar to overruling precedent that governs statutory construction cases should not apply:
[W]hen it comes to judge-made law like “implied” private causes of action, which we retain a duty to superintend[,] . . . . we ought to presume that Congress expects us to correct our own mistakes—not the other way around. That duty is especially clear in the Rule 10b–5 context, where we have said 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.”
Indeed, Justice Thomas pointed out that Congress in the Private Securities Litigation Reform Act had expressly declined to ratify the courts’ creation of a private cause of action, stating that “[n]othing in this Act . . . shall be deemed to create or ratify any implied private right of action.” That language makes clear that Congress intended that questions regarding the standards for establishing liability remain the province of the courts. In Justice Thomas’s words, “Basic’s presumption of reliance remains our mistake to correct.”
The majority in Halliburton did not even respond to these arguments, relying instead on the general rule that “[t]he principle of stare decisis has ‘“special force”’ ‘in respect to statutory interpretation,’” and citing a decision involving the interpretation of statutory language enacted by Congress, not a case relating to judge-made law.
Most importantly, the majority did not assess the merits of the arguments challenging Basic—instead dismissing them because they had been considered and rejected by the four-Justice majority in Basic or because they did not “so discredit Basic as to constitute ‘special justification’ for overruling the decision.” With respect to the harm to investors from the securities class action system, the Court also refused to engage, saying that “[t]hese concerns are more appropriately addressed to Congress.”
The three Justices concurring in the judgment did address these issues. They determined that the two assumptions underlying Basic’s presumption of class-wide reliance simply “do not provide the necessary support” for that presumption:
The first assumption—that public statements are “reflected” in the market price—was grounded in an economic theory that has garnered substantial criticism since Basic. The second assumption—that investors categorically rely on the integrity of the market price—is simply wrong.
Moreover, they recognized the reality that “in practice, the so-called ‘rebuttable presumption’ is largely irrebuttable”—“[o]ne search for rebuttals on individual-reliance grounds turned up only six cases out of the thousands of Rule 10b-5 actions brought since Basic,” likely because of the “substantial in terrorem settlement pressures brought to bear by [class] certification.” That is a critical failing, because “without a functional reliance requirement, the ‘essential element’ that ensures the plaintiff has actually been defrauded, Rule 10b–5 becomes the very ‘“scheme of investor’s insurance”’ [that] the rebuttable presumption was supposed to prevent.”
Of course, the economic burden of this “insurance” falls squarely on investors. One recent study found that investors’ “total wealth loss” from securities class actions “averages to about $39 billion per year, in order to collect an average of $6 billion in settlements per year ($5 billion per year after plaintiff attorneys’ fees). In other words, because of the filing of securities class actions, shareholders incrementally lost more than six times the settlement amount (or more than seven and half times the amount that shareholders would receive after plaintiffs’ attorneys’ fees).”
The majority’s decision to disclaim responsibility for addressing these very real—and very harmful—consequences of judge-made law “‘places on the shoulders of Congress the burden of the Court’s own error.’”
The Tweak With Little Real-World Impact
After declining to reconsider Basic, the Supreme Court majority addressed what has been labeled the “middle ground” argument in the case: whether the Court should modify the factual showing that a plaintiff must make at the class certification stage in order to gain the benefit of the fraud-on-the-market presumption.
Some news reports have called the Court’s decision on this point a “new burden” on securities class action plaintiffs or a “new hurdle” to obtaining class certification. But the consensus of informed observers is that the Court’s ruling means more litigation and cost with little ultimate difference in the results of class certification decisions. Perhaps in some cases class certification may become more difficult, but the big picture is bleak: The securities class action engine will roll along essentially unchanged, continuing to drain away billions of dollars in shareholder value each year.
To begin with, here’s a bit of background on the Basic presumption. The Court held in that case that, as an alternative to proving actual reliance on the defendant’s false material misstatement, a plaintiff may—as the Halliburton majority explained—“invok[e] a rebuttable presumption of reliance” by showing that the misrepresentations were publicly known and material, that the security purchased or sold by the plaintiff “traded in an efficient market” and that the plaintiff traded in the security “between the time the misrepresentations were made and when the truth was revealed.”
In that situation, the fraud-on-the-market theory holds that the market price “‘reflects all publicly available information, and, hence, any material misrepresentations’”; that “the typical ‘investor who buys or sells stock at the price set by the market does so in reliance on’ . . . the belief that it reflects all material public information”; and that the investor therefore may be presumed to rely on any misrepresentations. The presumption can be rebutted “if a defendant could show that the alleged misrepresentation did not, for whatever reason, actually affect the market price, or that a plaintiff would have bought or sold the stock even had he been aware that the stock’s price was tainted by fraud.”
Halliburton’s “middle ground” argument—strongly supported by an amicus brief filed by law professors Adam Pritchard and Todd Henderson—was that Basic’s focus on market efficiency was misplaced, and that plaintiffs should be required to prove “price impact”—meaning that the defendant’s alleged misrepresentation actually affected the stock price—in order to invoke the presumption of reliance. “In light of the [courts’] difficulties in evaluating efficiency,” the brief argued, “the Court should shift the focus of fraud on the market inquiries from a market’s overall efficiency to the question whether the alleged fraud affected market price.” (emphasis added) Pritchard and Henderson further urged the Court to “limit” the “out-of-pocket measure of damages . . . to cases in which the plaintiff can show actual reliance or that a material misstatement has distorted the market price for a security. If a plaintiff cannot make that showing, the remedy should be limited to disgorgement.”
The Supreme Court majority rejected these arguments and refused to alter the proof needed to invoke the presumption. It held only that a defendant may submit price impact evidence prior to class certification to demonstrate “that the alleged misrepresentation did not actually affect the stock’s market price and, consequently, that the Basic presumption does not apply.”
Most observers believe that this ruling—which places the burden on the defendant to introduce price impact evidence sufficient to rebut the presumption—will do little to change class certification results, but definitely will increase the cost and complexity of the fight over class certification as defendants submit expert analyses demonstrating the lack of price impact and plaintiffs commission their own studies to prove the opposite. (Economic consulting firms will do better than ever given the inevitable demand for competing price impact studies. Come to think of it, investing in one might be a good bet—particularly a firm that is not publicly traded, and therefore would not likely be subject to a class action lawsuit.)
As Professor Henderson, one of the two proponents of the price impact approach, explained:
The ruling will make these cases more expensive…without targeting the worst corporate actors….My prediction is that the average case will get longer and cost more, since defendant corporations will put on evidence that plaintiffs will have to respond to….So, all in all, I think this is very disappointing.
His co-author, Professor Pritchard, said (subscription): “We are adding to the expense. We are not getting rid of any weak lawsuits.”
The plaintiffs’ bar has been unable to disguise its glee. Salvatore Graziano (of the plaintiffs-side securities class action firm Bernstein Litowitz Berger & Grossmann) told one reporter: “I don’t see this decision having much impact at all.” “It’s a non-event.” David Boies, who represents the plaintiffs in Halliburton, said: “Defendants have always been permitted to try to prove the absence of price impact, and permitting them to do so at the class-certification stage will not significantly limit securities lawsuits in the future.”
In sum, plaintiff and defense-side lawyers can breathe a sigh of relief—there will be little or no change in the status quo for them.
But for investors, there is a change for the worse: these lawsuits will be more expensive and impose an even greater burden on innocent shareholders, who ultimately pay all of the costs of the securities class action system.