The U.S. District Court for the Central District of California recently issued an interesting decision (pdf) denying class certification in 15 consolidated consumer class actions against the maker of 5-hour ENERGY drinks.
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.
The securities class action industry was launched a quarter-century ago when the Supreme Court recognized the so-called “fraud-on-the-market” presumption of reliance in most putative securities class actions. The result has been that—despite Congressional efforts at securities litigation reform—most securities class actions that survive the pleadings stage are likely to achieve class certification, forcing defendants to settle. In the meantime, as explained in prior blog posts, the best economic thinking has shifted, calling the empirical assumptions underlying the fraud-on-the-market presumption into question.
In Halliburton Co. v. Erica P. John Fund, Inc. (pdf), decided today, the Supreme Court declined to abandon that presumption, instead largely maintaining the status quo. The Court did clarify one key aspect of how class certification works in the securities context, holding that defendants are now entitled to attempt to rebut the presumption by introducing evidence at the class certification stage that there was no “price impact”—i.e., that misrepresentation alleged in a particular lawsuit did not affect the stock’s price. This adjustment will make it possible for defendants to challenge class certification in a number of securities class actions, but is unlikely to alter the landscape of securities litigation significantly—a result that is troubling from a policy perspective because (for reasons we have previously stated) securities class actions generally benefit the lawyers who bring and defend them rather than the investors.
We provide more details about the decision below. Continue Reading Supreme Court Refuses To Overturn Fraud-On-The-Market Presumption, But Adjusts Presumption To Allow Evidence of Absence Of “Price Impact” At Class Certification Stage
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.
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.
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.
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