On June 23 the Supreme Court regrettably declined the chance to stem the abuses of private fraud-based class action securities litigation. In Halliburton v. EPJ Fund (June 23, 2014), a six-Justice Supreme Court majority (Chief Justice Roberts writing for the Court, joined by Kennedy, Ginsburg, Breyer, Sotomayor, and Kagan) reversed the Fifth Circuit and held that a class action certification in a securities fraud case should be denied if the defendants produce evidence rebutting the presumption that defendants’ misrepresentations had a price impact. EPJ Fund filed a class action against Halliburton and one of its executives, alleging that they made misrepresentations designed to inflate Halliburton’s stock price, in violation of Section 10(b)(5) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5. In Basic v. Levinson (1988), the Supreme Court held that: (1) investors could satisfy the requirement that plaintiffs relied on defendants’ misrepresentations in buying stock by invoking a presumption that the price of stock traded reflects all public, material information, including material misrepresentations; but that (2) defendants could rebut this presumption by showing that the misrepresentations had no price impact. Halliburton argued that class certification was inappropriate because the evidence it introduced to disprove loss causation also showed that its alleged misrepresentations had not affected its stock price, thereby rebutting the presumption. The district court rejected Halliburton’s argument and certified the class, and the Fifth Circuit affirmed, concluding that Halliburton could use its evidence only at trial. Although the Court rejected Halliburton’s arguments for overturning Basic, it agreed with Halliburton that defendants must be afforded an opportunity to rebut the presumption of reliance before class certification, because the fact that a misrepresentation has a price impact is “Basic’s fundamental premise.”
Justice Thomas, joined by Scalia and Alito, concurred in the judgment, but argued that the “fraud on the market” (FOTM) theory embodied in Basic should be overruled, based on logic, economic realities (“market efficiency has . . . lost its luster”), and subsequent jurisprudence clarifying class certification requirements. Significantly, the Thomas dissent points to a variety of well-recognized motives for the purchase of securities that have nothing to do with a presumption (key to the FOTM theory) that the market accurately reflects the value of a stock in light of all public information: “Many investors in fact trade for the opposite reason—that is, because they think the market has under- or overvalued the stock, and they believe they can profit from that mispricing. . . . Other investors trade for reasons entirely unrelated to price—for instance, to address changing liquidity needs, tax concerns, or portfolio balancing requirements. . . . In short, Basic’s assumption that all investors rely in common on price integrity is simply wrong.” [citation omitted]
Thomas, Scalia, and Alito are right – the Court’s majority missed a major opportunity to rein in class action opportunism by failing to consign Basic to the graveyard of economically flawed Supreme Court precedents, where it belongs. Given the costs and difficulties inherent in rebutting the presumption of reliance at the class action stage, Halliburton at best appears likely to impose only a minor constraint on securities fraud class actions.
The FOTM presumption that has enabled a substantial rise in securities class action litigation over the last quarter century makes no economic sense, according to the scholarly consensus. What’s more, it imposes a variety of social harms on the very groups that were supposed to benefit from this doctrine, as described in a recent study of the political economy of FOTM. Specifically, longer-term shareholders end up bearing the cost of class action settlements that benefit plaintiffs’ trial lawyers, and to the extent paying and receiving shareholders are fully diversified, FOTM is a wash in terms of compensation that turns into a net loss when costs including attorneys’ fees are included. Moreover, FOTM’s utility as a fraud deterrent is “much muted” because payments are made by the corporation and its insurer, not the individual culpable agents. In short, “[w]hen the dust settles, FOTM not only fails to meet its stated goals, it does not even try.”
Not included in this litany of FOTM’s shortcomings is the serious issue of error costs, and in particular the harmful avoidance of novel but efficient behavior by corporate officials that fear it will incorrectly be deemed “fraudulent.” This largely stems from the fact that “fraud” is not precisely defined in the securities law context, which has led to “at least three costs: public and private actions are not brought on behalf of clearly specified regulatory objectives; the line between civil and criminal liability has become unacceptably blurred; and the law has come to provide at best a weak means of resolving vital public questions about wrongdoing in financial markets.”
In light of these problems, Congress should eliminate the eligibility of private securities fraud suits for class action certification. Moreover, Congress should require a showing of specific reliance on fraudulent information as a prerequisite to any finding of liability in a private individual action. What’s more, Congress ideally should require that the SEC define with greater specificity what categories of conduct it will deem actionable fraud, based on economic analysis, as a prerequisite for bringing enforcement actions in this area.
Public choice insights suggest this wish list will be difficult to obtain, of course (but not impossible, as passage of the Class Action Fairness Act of 2005 demonstrates). Public support for reform might be sparked by drawing greater attention to the fact that class action securities litigation has actually tended to harm, rather than help, small investors.
What about even more far-reaching securities law reforms? Asking Congress to consider decriminalizing insider trading undoubtedly is unrealistic at this juncture, but it is interesting to note that even mainstream journalists are starting to question the social utility of the SEC’s current crackdown on insider trading. This focus may lead to a serious case of misplaced priorities. Notably, as leading Federal District Court Judge (SDNY) and former Assistant U.S. Attorney (AUSA) Jed Rakoff has stressed, AUSAs avoid pursuing far more serious frauds arising out of the 2008 Financial Crisis in favor of bringing insider trading cases because the latter are easier to investigate and prosecute in a few years’ time, and, thus, best enhance the AUSAs’ marketability to law firms. (Hat tip to my Heritage colleague Paul Larkin for the Rakoff reference.)