In what circumstances should you be permitted to invest your retirement savings in your own employer’s stock? We have blogged before about an ERISA class action pending at the Supreme Court regarding when plan fiduciaries must prevent participants from investing in employer stock. After the Solicitor General filed an amicus brief (pdf) asking the Court to broaden its inquiry, the case was poised to challenge a bedrock of ERISA stock-drop actions—a presumption that fiduciaries act prudently when investing in employer stock.

On Friday, the Supreme Court granted certiorari in the case, Fifth Third Bancorp v. Dudenhoeffer, No. 12-751, but did not accept the Solicitor General’s request to have the parties brief the appropriateness of the presumption of prudence. Rather, the Court left intact the question presented by the petition, which concerns only the applicability of the presumption at the motion-to-dismiss stage.

A bit of background: As a general rule, the fiduciaries who administer ERISA-governed retirement plans owe a duty of prudence to plan participants. But although many investment advisors would warn investors not to invest substantial portions of their retirement savings in a single stock, Congress wanted to encourage employees to invest in their companies. So it waived the duty of prudence “to the extent that it requires diversification” for purchases of company stock. 29 U.S.C. § 1104(a)(2).

Of course, the risk of a non-diversified portfolio is that an individual stock will lose value. When that happens, securities-fraud class actions are commonplace, as are ERISA class actions that argue that retirement plan fiduciaries should have forced plan participants to sell their employer stock. Nearly 20 years ago, the Third Circuit recognized the tension between such claims and Congress’s goal of encouraging employee ownership. Under Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995), which has been adopted in varying forms by seven federal courts of appeals, when a plan sponsor requires or encourages plan fiduciaries to invest in employer stock, plan fiduciaries are not generally liable for permitting such investments—unless the employer was in such dire financial straits that the company’s viability as a going concern was in doubt.

Despite the general agreement among the courts of appeals, the Labor Department has long disagreed with the Moench presumption. But as the presumption has gained acceptance in the lower courts, the Supreme Court has exhibited no particular interest in adopting a different course. The Court’s order in Fifth Third signals, if anything, that the Justices are not particularly eager to enter the fray now. That’s a sensible outcome. The Supreme Court rarely will address an issue that the parties did not contest below. And there are good reasons—grounded in Congress’s special dispensation for employer stock—why the courts of appeals have been reluctant to saddle employers with liability for stock-market volatility.

At a minimum, this case will determine what a plaintiff must allege to survive a motion-to-dismiss and to obtain discovery. And the Court is not precluded from resolving the broader issue when the case is decided this spring. That would be a substantial undertaking, however, because the Moench presumption implicates big questions for ERISA class actions:

  • When plan fiduciaries are instructed by the plan sponsor to invest in employer stock, they face a potential conflict between the terms of the plan and the duty of prudence. When must a fiduciary disregard the terms of the plan? See 29 U.S.C. § 1104(a)(2)(D).
  • If the purpose of diversifying investments is to “minimize the risk of large losses,” how (if ever) does a plan fiduciary violate the duty of prudence by permitting plan participants to sustain large losses through an investment in employer stock? See id. § 1104(a)(1)(C), (a)(2).
  • Do fiduciaries face the same prudence obligations when they affirmatively invests plan participants’ retirement assets (as in a defined-benefit pension plan) as when they merely offer investment options among which plan participants will construct a portfolio (as in a 401(k) plan)?

To see whether the Court answers those questions, we will have to await the argument and decision.

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 Basic was 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 in BusinessWeek, “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.

Under the American Pipe rule, in federal court the filing of a class action tolls the statute of limitations for would-be class members. Otherwise, the Supreme Court reasoned in American Pipe, putative class members would have to intervene or file their own individual actions during the pendency of the class action in case class certification is denied to avoid having their claims become time-barred.

But does the American Pipe rule also apply to statutes of repose, which create an absolute right to be free from liability after a certain time frame? District courts had reached conflicting decisions on this issue with respect to the statute of repose for the Securities Act—Section 13.

The Second Circuit has now provided its answer. In Police & Fire Retirement System of City of Detroit v. IndyMac MBS, Inc. (pdf), — F.3d —-, 2013 WL 3214588 (2d Cir. June 27, 2013), the Second Circuit held that the filing of a class action does not toll Section 13’s statute of repose. Nor does intervention under Rule 24 or “relation back” under Rule 15(c) allow absent class members to avoid application of the statute of repose to claims dismissed for lack of jurisdiction.

The IndyMac case involved allegations by plaintiffs that offering documents for a host of IndyMac MBS mortgage pass-through certificates contained misstatements that violated the Securities Act. The district court dismissed the claims as to many of the certificates because the named plaintiff did not purchase those certificates and thus lacked standing to assert the claims. Several putative class members who purchased certificates beyond those purchased by the named plaintiff then moved to intervene in the suit and amend the complaint pursuant to the “relation back” doctrine of Rule 15(c). The district court denied the motion based on Section 13’s statute of repose, which had expired during the pendency of the case.

In affirming, the Second Circuit first rejected the argument that Section 13 should be tolled by the filing of a class action. The court reasoned that, whether the American Pipe tolling rule is “equitable” or “legal” in nature, it cannot be applied to Section 13. The Supreme Court has expressly held that equitable tolling principles do not apply to the repose period in Section 13. And the Rules Enabling Act does not allow a court to use Rule 23—the source of any “legal” tolling—to “abridge, enlarge or modify any substantive right,” which by the Second Circuit’s reckoning includes the repose promised by Section 13.

The Second Circuit also rejected the argument that the would-be intervenors should be allowed to “relate back” their proposed amended complaint to the prior, timely complaint. The court explained that untimely intervention could not cure the jurisdictional defect that led to dismissal of the claims that the proposed intervenors wanted to assert.

As sensible and welcome as the Second Circuit’s tolling and intervention holdings are, their importance is diminished somewhat by the same court’s decision in NECA–IBEW Health & Welfare Fund v. Goldman Sachs & Co., 693 F.3d 145 (2d Cir. 2012), which (as we have noted) allows named plaintiffs to bring some class claims regarding certain securities that the named plaintiff did not purchase. Still, the IndyMac decision offers a valuable tool to prevent belated expansion of securities class actions. And it may even be of use in other areas of the law when plaintiffs’ lawyers try to either prop up expansive class actions after a repose period has expired or use tolling to shop successive class actions in different courts until a favorable forum appears.

In Section 10(b) securities-fraud cases based on affirmative misrepresentations, a class action cannot be certified unless investor reliance is presumed under the fraud-on-the-market theory of Basic, Inc. v. Levinson, 485 U.S. 224 (1988). In Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179 (2011), the Supreme Court ruled that a plaintiff does not need to establish loss causation at the class-certification stage in order to invoke the fraud-on-the-market presumption. On remand from that ruling, Halliburton argued that it should be permitted to rebut that presumption and defeat the request for class certification with evidence that the alleged misrepresentations had no impact on Halliburton’s stock price. Based largely on the Supreme Court’s intervening decision in Amgen Inc. v. Connecticut Retirement Plans & Trust Funds, 133 S. Ct. 1184 (2013), the Fifth Circuit rejected Halliburton’s argument, holding that price impact is not properly considered at the class-certification stage. Erica P. John Fund, Inc. v. Halliburton Co. (pdf), — F.3d —-, 2013 WL 1809760 (5th Cir. Apr. 30, 2013).

The Fifth Circuit acknowledged that when the Supreme Court adopted the fraud-on-the-market presumption of reliance in Basic, it made the presumption rebuttable. The Fifth Circuit likewise recognized that establishing that a misrepresentation had no price impact would rebut the presumption of reliance by severing the link between the alleged misrepresentation and the price paid by the plaintiffs. The Fifth Circuit further noted that, even though Halliburton offered its price-impact evidence only for rebuttal purposes, such evidence also could be probative on the market-efficiency, public-statement, and materiality elements of the fraud-on-the-market presumption.

Despite this settled law, the Fifth Circuit understood Amgen to make questions about price impact off limits at the class-certification stage. The Supreme Court held in Amgen that immateriality is not a proper ground for refusing to presume reliance at the class-certification stage because it turns on objective evidence common to the class and is an element of securities fraud. As a result, the Court reasoned, a lack of materiality would lead to judgment for the defendant rather than individual inquiries that would defeat class certification.

The Fifth Circuit concluded that price impact should be treated like materiality. Proof of price impact is common class-wide evidence, in the court’s view. And, even though price impact itself is not an element of a securities-fraud claim, the court ruled that proof that there was no price impact would mean that a plaintiff could not establish loss causation—which is an element of securities fraud. Thus, a victory for Halliburton on price impact, the court explained, “will not result in the possibility of individual claims continuing.” As the Fifth Circuit understood Amgen, those conclusions meant that “Halliburton’s price impact evidence does not bear on the question of common issue predominance, and is thus appropriately considered only on the merits after the class has been certified.”

The Fifth Circuit’s ruling represents an unfortunate misreading of the Supreme Court’s troubling Amgen decision. Under these decisions, the limited fraud-on-the-market inquiry at the class-certification stage is a slender reed on which to presume reliance for class certification purposes and thereby allow sprawling and coercive securities-fraud class actions. From my perspective, this is all the more reason to reconsider whether the economic and other premises of the fraud-on-the-market presumption of reliance are faulty, as four Justices suggested in Amgen.

We’ve been blogging about the Second Circuit’s decision in NECA-IBEW Health & Welfare Fund v. Goldman Sachs (pdf), which held that a named plaintiff in a securities fraud suit might have standing in some situations to assert class action claims regarding securities that he or she never purchased. Yesterday, the Supreme Court denied (pdf) Goldman’s petition for certiorari (pdf) in that case. We’ll continue reporting on the aftermath of the Second Circuit’s decision.

In the meantime, defendants facing these sorts of claims should remember that the Second Circuit’s novel standing test requires that the claims regarding the unpurchased securities raise the same set of concerns as the claims regarding the securities that the named plaintiff actually bought. That limitation should help trim the sails of expansive securities fraud class actions.

In addition, defendants should emphasize that the fact that a named plaintiff may have standing to sue does not mean that he or she can represent a class of purchasers of securities that the named plaintiff never bought. At class certification, the defendant may be able to mount challenges to commonality, typicality, adequacy, and predominance based on the fact that the named plaintiff never bought some of the securities at issue.

With all of the attention on last week’s Amgen decision, another interesting decision addressing the fraud-on-the-market presumption of reliance in securities fraud actions may have escaped notice. In GAMCO Investors, Inc. v. Vivendi, S.A. (S.D.N.Y. Feb. 28, 2013), Judge Scheindlin found that the defendant had rebutted the presumption of reliance as to a group of related investment advisers and mutual funds by showing that the plaintiffs’ investment decisions did not rely on the prices of the defendant’s securities as an accurate assessment of the value of those securities. As one of the few decisions to address this issue following a bench trial, GAMCO provides a valuable example of how the presumption of reliance can be rebutted. The decision also illustrates why individualized questions as to reliance should make class certification impossible in some fraud-on-the-market class actions. Continue Reading Securities Fraud Defendant Rebuts Fraud-on-the-Market Presumption of Reliance

Today, in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, No. 11-1085, the Supreme Court held that proof of materiality is not a prerequisite for class certification in a securities fraud class action under Section 10(b), even though materiality is a predicate of the fraud-on-the-market presumption of reliance.  The opinion for the majority of the Court was authored by Justice Ginsburg.  Justices Scalia, Thomas, and Kennedy dissented.  Justice Alito wrote a concurring opinion indicating that, in an appropriate case, he (like the three dissenting justices) would be open to reconsidering the fraud-on-the-market presumption.  For more, see our report on the decision.  (See also our report and article on the argument.)

I previously blogged about the Second Circuit’s troubling decision in NECA-IBEW Health & Welfare Fund v. Goldman Sachs & Co. (pdf), 693 F.3d 145 (2d Cir. 2012), which invented a “class standing” doctrine allowing a named plaintiff in a class action to assert Securities Act claims regarding securities that he or she never purchased. In the wake of that decision, plaintiffs have filed a flurry of motions to reconsider district court decisions that had dismissed claims like these for lack of standing.

So far, a few courts have granted those motions and revived some or all of the previously dismissed claims. E.g., New Jersey Carpenters Health Fund v. DLJ Mortg. Capital, Inc. (pdf), 2013 WL 357615 (S.D.N.Y. Jan. 23, 2013). But other courts have declined to do so, preferring to wait for a decision on the pending certiorari petition in NECA.

Defendants facing such reconsideration motions should consider asking for a similar delay and preserve the argument that NECA is wrongly decided. There is little point litigating those claims in earnest until we know whether NECA’s novel class-standing rule will be reviewed by the Supreme Court.

Alternatively, defendants could oppose reconsideration on the ground that the claims regarding the unpurchased securities don’t truly raise the same set of concerns as the claims regarding the purchased securities, as required by the Second Circuit’s new standing test. Indeed, in the New Jersey Carpenters case, the defendant was able to limit the reinstated claims by pointing to differences among the mortgage originators whose underwriting standards were allegedly misstated in the offering materials at issue.

Finally, if litigation of these revived claims re-commences, defendants should emphasize that NECA announced a mere standing rule—it did not decide that a named plaintiff who has bought security X can represent a class of purchasers of securities Y and Z. There likely will be ample fodder for challenging commonality, typicality, adequacy, and predominance at the class-certification stage.

According to a recent report authored by Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse, Securities Class Action Filings—2012 Year in Review (pdf), 19 percent fewer securities fraud class actions were filed in federal court in 2012 than in 2011. The 152 new class actions filed in 2012 is the second-lowest such number in the last 16 years. Continue Reading Cornerstone and Stanford Law School Issue Report On Securities Class Actions

A number of courts recently have weighed in on a question we’ve blogged before—whether lawsuits by state attorneys general seeking restitution on behalf of private citizens are subject to removal under the Class Action Fairness Act of 2005 (pdf) (“CAFA”). These rulings have broad implications for the litigation of these quasi-class actions.  They also are of substantial importance to determining whether securities fraud actions filed by state attorneys general are precluded by the federal Securities Litigation Uniform Standards Act of 1998 (pdf) (“SLUSA”). Continue Reading Are Quasi-Class Action Suits By State AGs Removable Under CAFA (Or, For Securities Fraud Cases, Barred By SLUSA)?