Archives For securities litigation

I share Alden’s disappointment that the Supreme Court did not overrule Basic v. Levinson in Monday’s Halliburton decision.  I’m also surprised by the Court’s ruling.  As I explained in this lengthy post, I expected the Court to alter Basic to require Rule 10b-5 plaintiffs to prove that the complained of misrepresentation occasioned a price effect.  Instead, the Court maintained Basic’s rule that price impact is presumed if the plaintiff proves that the misinformation was public and material and that “the stock traded in an efficient market.”

An upshot of Monday’s decision is that courts adjudicating Rule 10b-5 class actions will continue to face at the outset not the fairly simple question of whether the misstatement at issue moved the relevant stock’s price but instead whether that stock was traded in an “efficient market.”  Focusing on market efficiency—rather than on price impact, ultimately the key question—raises practical difficulties and creates a bit of a paradox.

First, the practical difficulties.  How is a court to know whether the market in which a security is traded is “efficient” (or, given that market efficiency is not a binary matter, “efficient enough”)?  Chief Justice Roberts’ majority opinion suggested this is a simple inquiry, but it’s not.  Courts typically consider a number of factors to assess market efficiency.  According to one famous district court decision (Cammer), the relevant factors are: “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.”  In re Securities Litig., 430 F.3d 503 (2005).  Other courts have supplemented these Cammer factors with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation.  No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible?  How large may the bid-ask spread be?).  Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t.  It’s a crapshoot.

In addition, focusing at the outset on whether the market at issue is efficient creates a market definition paradox in Rule 10b-5 actions.  When courts assess whether the market for a company’s stock is efficient, they assume that “the market” consists of trades in that company’s stock.  This is apparent from the Cammer (and supplementary) factors, all of which are company-specific.  It’s also implicit in portions of the Halliburton majority opinion, such as the observation that the plaintiff “submitted an event study of vari­ous episodes that might have been expected to affect the price of Halliburton’s stock, in order to demonstrate that the market for that stock takes account of material, public information about the company.”  (Emphasis added.)

But the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), the economic theorem upon which Basic rests, rejects the notion that there is a “market” for a single company’s stock.  Both the semi-strong ECMH and Basic reason that public misinformation is quickly incorporated into the price of securities traded on public exchanges.  Private misinformation, by contrast, usually is not – even when such misinformation results in large trades that significantly alter the quantity demanded or quantity supplied of the relevant stock.  The reason private misinformation is not taken to affect a security’s price, even when it results in substantial changes in quantities demanded or supplied, is because the relevant market is not the stock of that particular company but is instead the universe of stocks offering a similar package of risk and reward.  Because a private misinformation-induced increase in demand for a single company’s stock – even if large relative to the  number of shares outstanding – is likely to be tiny compared to the number of available shares of close substitutes for that company’s stock, private misinformation about a company is unlikely to be reflected in the price of the company’s stock.  Public misinformation, by contrast, affects a stock’s price because it not only changes quantities demanded and supplied but also causes investors to adjust their willingness-to-pay or willingness-to-accept.  Accordingly, both the semi-strong ECMH and Basic assume that only public misinformation can be assured to affect stock prices.  That’s why, as the Halliburton majority observes, there is a presumption of price effect only if the plaintiff proves public misinformation, materiality, and an efficient market.  (For a nice explanation of this idea in the context of a real case, see Judge Easterbrook’s opinion in West v. Prudential Securities.)

The paradox, then, is that Basic and the semi-strong ECMH, in requiring public misinformation, assume that the relevant market is not company specific.  But for purposes of determining whether the “market” is efficient, the market is assumed to consist of trades of a single company’s stock.

The Supreme Court could have avoided both the practical difficulties in assessing market efficiency and the theoretical paradox identified herein had it altered Basic to require plaintiffs to establish not an efficient market but an actual price impact. Alas.

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.)

On Wednesday, the U.S. Supreme Court heard oral argument in Halliburton v. Erica P. John Fund, a case that could drastically alter the securities fraud landscape.  Here are a few thoughts on the issues at stake in the case and a cautious prediction about how the Court will rule.

First, some quick background for the uninitiated.  The broadest anti-fraud provision of the securities laws, Section 10(b) of the 1934 Securities Exchange Act, forbids the use of “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe….”  The Commission’s Rule 10b-5, then, makes it illegal “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”

Although Section 10(b) doesn’t expressly entitle victims of securities fraud to sue for damages, the Supreme Court long ago inferred a private right of action to enforce the provision.  The elements of that judicially created private right of action are: (1) a material misrepresentation or omission by the defendant, (2) scienter (i.e., mental culpability worse than mere negligence) on the part of the defendant, (3) a connection between the misrepresentation or omission and the purchase or sale of a security, (4) the plaintiff’s reliance upon the misrepresentation or omission, (5) economic loss by the plaintiff, and (6) loss causation (i.e., the fraud, followed by revelation of the truth, was the proximate cause of the plaintiff’s investment loss).

For most individual investors, the economic loss resulting from any instance of securities fraud (and, thus, the potential recovery) is not enough to justify the costs of bringing a lawsuit.  Accordingly, 10b-5 suits seem like an appropriate context for class actions.  The elements of the judicially created cause of action, however, make class certification difficult.  That is because most securities fraud class actions would proceed under Federal Rule of Civil Procedure 23(b)(3), which requires that common issues of law or fact in all the plaintiffs’ cases predominate over plaintiff-specific issues.  Because the degree to which any individual investor relied upon a misrepresentation (element 4) requires proof of lots of investor-specific facts (How did you learn of the misrepresentation?, How did it influence your investment decision?, etc.), the reliance element would seem to preclude Rule 10b-5 class actions.

In Basic v. Levinson, a 1988 Supreme Court decision from which three justices were recused, a four-justice majority endorsed a doctrine that has permitted Rule 10b-5 class actions to proceed, despite the reliance element.  The so-called “fraud on the market” doctrine creates a rebuttable presumption that an investor who traded in an efficient stock market following a fraudulent disclosure (but before the truth was revealed) “relied” on that disclosure, even if she didn’t see or hear about it.  The theoretical basis for the fraud on the market doctrine is the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), which posits that securities prices almost instantly incorporate all publicly available information about the underlying company, making it impossible to earn above-normal returns by engaging in “fundamental analysis” (i.e., study of publicly available information about a listed company).  The logic of the fraud on the market doctrine is that publicly available misinformation affects a security’s price, upon which an investor normally relies when she makes her investment decision.  Thus, any investor who makes her investment decision on the basis of the stock’s price “relies” on the “ingredients” of that price, including the misinformation at issue.

In light of this logic, the Basic Court reasoned that a defendant could rebut the presumption of reliance by severing either the link between the misinformation and the stock’s price or the link between the stock’s price and the investor’s decision.  To sever the former link, the defendant would need to show that key market makers were privy to the truth, so that the complained of lie could not have affected the market price of the stock (in other words, there was “truth on the market”…great name for a blog, no?).  To sever the latter link, the defendant would need to show that the plaintiff investor made her investment decision for some reason unrelated to the stock’s price—say, because she needed to divest herself of the stock for political reasons.

Basic thus set up a scheme in which the class plaintiff bears the burden of establishing that the stock at issue traded in an efficient market.  If she does so, her (and similarly situated class members’) reliance on the misinformation at issue is presumed.  The defendant then bears the burden of rebutting the presumption by showing either that the misrepresentation did not give rise to a price distortion (probably because the truth was on the market) or that the individual investor would have traded even if she knew the statement was false (i.e., her decision was not based on the stock’s price).

The Halliburton appeal presents two questions.  First, should the Court overrule Basic and jettison the rebuttable presumption of reliance when the stock at issue is traded in an efficient market.  Second, at the class certification stage, should the defendant be permitted to prevent the reliance presumption from arising by presenting evidence that the alleged misrepresentation failed to distort the market price of the stock at issue.

With respect to the first question, the Court could go three ways.  First, it could maintain the status quo rule that 10b-5 plaintiffs, in order to obtain the reliance presumption, must establish only that the stock at issue was traded in an efficient market.  Second, it could overrule Basic wholesale and hold that a 10b-5 plaintiff must establish actual, individualized reliance (i.e., show that she knew of the misrepresentation and that it influenced her investment decision).  Third, the Court could tweak Basic by holding that plaintiffs may avail themselves of the presumption of reliance only if they establish, at the class certification stage, that the complained of
misrepresentation actually distorted the market price of the stock at issue.

My guess, which I held before oral argument and seems consistent with the justices’ questioning on Wednesday, is that the Court will take the third route.  There are serious problems with the status quo.  First, it rests squarely upon the semi-strong version of the ECMH, which has come under fire in recent years.  While no one doubts that securities prices generally incorporate publicly available information, and very quickly, a number of studies purporting to document the existence of arbitrage opportunities have challenged the empirical claim that every bit of publicly available information is immediately incorporated into the price of every security traded in an efficient market.  Indeed, the winners of this year’s Nobel Prize in Economics split on this very question.   I doubt this Supreme Court will want to be perceived as endorsing a controversial economic theory, especially when doing so isn’t necessary to maintain some sort of reliance presumption (given the third possible holding discussed above).

A second problem with the status quo is that it places an unreasonable burden on courts deciding whether to certify a class.  The threshold question for the fraud on the market presumption—is the security traded in an efficient market?—is just too difficult for non-specialist courts.  How does one identify an “efficient market”?  One court said the relevant factors are:  “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.”  Others have supplemented these so-called “Cammer factors” with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation.  No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible?  How large may the bid-ask spread be?).  Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t.  It’s a crapshoot.

The status quo approach of presuming investor reliance if the plaintiff establishes an efficient market for the company’s stock is also troubling because the notion of a “market” for any single company’s stock is theoretically unsound.  An economic market consist of all products that are, from a buyer’s perspective, reasonably interchangeable.  For example, Evian bottled water (spring water from the Alps) is a very close substitute for Fiji water (spring water from the Fiji Islands) and is probably in the same product market.  From an investor’s perspective, there are scores of close substitutes for the stock of any particular company.  Such substitutes would include all other stocks that offer the same package of financial attributes (risk, expected return, etc.).  It makes little sense, then, to speak of a “market” consisting of a single company’s stock, and basing the presumption of reliance on establishment of an “efficient market” in one company’s stock is somewhat nonsensical.

With respect to the second possible route for the Halliburton Court—overturning Basic in its entirety and requiring individualized proof of actual reliance—proponents emphasize that the private right of action to enforce Section 10(b) and Rule 10b-5 is judicially created.  The Supreme Court now disfavors implied rights of action and, to avoid stepping on Congress’s turf, requires that they stick close to the statute at issue.  In particular, the Court has said that determining the elements of a private right of action requires “historical reconstruction.”  With respect to the Rule 10b-5 action, the Court tries “to infer how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision of the 1934 Act,” and to do that, it consults “the express causes of action” in the Act and borrows from the “most analogous” one.  In this case, that provision is Section 18(a), which is the only provision in the Exchange Act authorizing damages actions for misrepresentations affecting secondary, aftermarket trading (i.e., trading after a public offering of the stock at issue).  Section 18(a) requires a plaintiff to establish actual “eyeball” reliance—i.e., that she bought the security with knowledge of the false statement and relied upon it in making her investment decision.  There is thus a powerful legal argument in favor of a full-scale overturning of Basic.

As much as I’d like for the Court to take that route (because I believe Rule 10b-5 class actions create far greater social cost than benefit), I don’t think the Court will go there.  Overruling Basic to require eyeball reliance in Rule 10b-5 actions would be perceived as an activist, “pro-business” decision:  activist because Congress has enacted significant legislation addressing Rule 10b-5 actions and has left the fraud on the market doctrine untouched, and pro-business because it would insulate corporate managers from 10b-5 class actions.

Now, both of those characterizations are wrong.  The chief post-Basic legislation involving Rule 10b-5, the 1995 Private Securities Litigation Reform Act, specifically stated (in Section 203) that “[n]othing in this Act shall be deemed to … ratify any implied private right of action.”  As Justices Alito and Scalia emphasized at oral argument, the PSLRA expressly declined to put a congressional imprimatur on the judicially created Rule 10b-5 cause of action, so a Court decision modifying Rule 10b-5’s elements would hardly be “activist.” Nor would the decision be “pro-business” and “anti-investor.”  The fact is, the vast majority of Rule 10b-5 class actions are settled on terms where the corporation pays the bulk of the settlement, which largely goes to class counsel.  The corporation, of course, is spending investors’ money.  All told, then, investors as a class pay a lot for, and get very little from, Rule 10b-5 class actions.  A ruling eviscerating such actions would better be characterized as pro-investor.

Sadly, our financially illiterate news media cannot be expected to understand all this and would, if Basic were overturned, fill the newsstands and airwaves with familiar stories of how the Roberts Court continues on its activist, pro-business rampage.  And even more sadly, at least one key justice whose vote would be needed for a Basic overruling, has proven himself to be exceedingly concerned with avoiding the appearance of “activism.”  A wholesale overruling of Basic, then, is unlikely.

That leaves the third route, modifying Basic to require that class plaintiffs first establish a price distortion resulting from the complained of misrepresentation.  I have long suspected that this is where the Court will go, and the justices’ questioning on Wednesday suggests this is how many (especially Chief Justice Roberts and Justice Kennedy) are leaning.  From the Court’s perspective, there are several benefits to this approach.

First, it would allow the Court to avoid passing judgment on the semi-strong ECMH.  The status quo approach—prove an efficient market and we’ll presume reliance because of an inevitable price effect—really seems to endorse the semi-strong ECMH.  An approach requiring proof of price distortion, by contrast, doesn’t.  It may implicitly assume that most pieces of public information are instantly incorporated into securities prices, but no one really doubts that.

Second, the third route would substitute a fairly manageable inquiry (Did the misrepresentation occasion a price effect?) for one that is both difficult and theoretically problematic (Is the market for the company’s stock efficient?).

Third, the approach would allow the Court to eliminate a number of the most meritless securities fraud class actions without appearing overly “activist” and “pro-business.”  If class plaintiffs can’t show a price effect from a complained of misrepresentation or omission, then their claim is really frivolous and ought to go away immediately.  The status quo would permit certification of the class, despite the absence of a price effect, as long as class counsel could demonstrate an efficient market using the amorphous and unreliable factors set forth above.  And once the class is certified, the plaintiffs have tons of settlement leverage, even when they don’t have much of a claim.  In short, the price distortion criterion is a far better screen than the market efficiency screen courts currently utilize.  For all these reasons, I suspect the Court will decide not to overrule Basic but to tweak it to require a threshold showing of price distortion.

If it does so, then the second question at issue in Halliburton—may the defendant, at the class certification stage, present evidence of an absence of price distortion?—goes away.  If the plaintiff must establish price distortion to attain class certification, then due process would require that the defendant be allowed to poke holes in the plaintiff’s certification case.

So that’s my prediction on Halliburton.  We shall see.  Whatever the outcome, we’ll have lots to discuss in June.

Barbara Black has suggested that the time may have come to reconsider arbitration of federal securities claims against issuers (and not just brokers).  And that’s only the beginning.  Here’s the abstract:

Ever since the U.S. Supreme Court held that arbitration provisions contained in brokerage customers’ agreements were enforceable with respect to federal securities claims, proposals have been floated to include in an issuer’s governance documents a provision that would require arbitration of investors’ claims against the issuer. To date, however, publicly traded domestic issuers and their counsel have not seriously pursued these proposals, probably because of several legal obstacles to implementation. In addition to these legal obstacles, publicly traded issuers may not have perceived significant advantages to arbitration. Recent legal developments, however, make inclusion of an arbitration provision in a publicly traded issuer’s governance documents a proposal worthy of serious consideration. In particular, because of the Supreme Court’s recent opinion in AT&T Mobility LLC v. Concepcion, issuers may be able to achieve an advantage through adoption of an arbitration provision in their governance documents that they were not able to achieve through PSLRA and the Securities Litigation Uniform Standards Act. They could finally achieve the demise of securities class claims.

And from the conclusion (footnotes omitted):

The overarching policy issue is the future of the securities class actions. Respected academics have previously called for the SEC to take an active role in assessing the strengths and weaknesses of the federal securities class action.  There have been similar calls for reform of state securities class actions. Currently there are numerous securities class actions working their way through the judicial system in the wake of the 2008 financial crisis. In short, the time is right for a re-examination of the costs and benefits of securities class actions.

I argued when it was decided that the AT&T case “could end up being one of the most important pro-business cases of the last several years.”  That may be an understatment.

Janus Investment Fund’s (JIF) prospectus included a misstatement about market timing.  Its investment adviser and administrator is Janus Capital Management (JCM).  Plaintiff shareholders in the parent company, Janus Capital Group (JCG) argue in the Supreme Court that JCM should be liable as JIF’s manager for “mak[ing] an[] untrue statement of a material fact” in violation of Rule 10b-5 (and also that JCG should be liable as a control person).

The conservative five-member majority, in an opinion by Justice Thomas, rejected the argument that an investment advisor is the “maker” of the statement by its mutual fund, whose formal legal independence everybody including the SEC recognized.

The dissenters insist this ignores the reality of JCM’s control of JIF, and was not compelled by the word “make” in 10b-5. Moreover, they worried the majority’s approach could leave nobody responsible in some situations — not the managers who actually drafted a false statement nor the innocent board that made the statement.  Even the SEC couldn’t go after the managers for aiding and abetting without a primary violator.    

What’s really happening here is that the Court is facing the consequences of its 2008 Stoneridge aiding and abetting opinion and Central Bank which preceded it, as well as of the mess of mutual fund regulation left unresolved by last term’s Jones v. Harris.

The Court said its decision followed from Stoneridge’s holding denying liability of the defendant customers and suppliers because their acts didn’t make it “necessary and inevitable” that the transactions would be falsely accounted for.  In other words, the final decision was made by the company that actually made the decision to issue the disclosure documents.  Same in Janus.

The Court also noted its decision was made necessary by the decision Stoneridge elaborated on, the Court’s 1994 ruling in Central Bank to deny a private right of action against aiders and abetters:

A broader reading of “make,” including persons or entities without ultimate control over the content of a statement, would substantially undermine Central Bank. If persons or entities without control over the content of a statement could be considered primary violators who “made” the statement, then aiders and abettors would be almost nonexistent.6

6 The dissent correctly notes that Central Bank involved secondary, not primary, liability. Post, at 4 (opinion of BREYER, J.). But for Central Bank to have any meaning, there must be some   distinction between those who are primarily liable (and thus may be pursued in private suits) and those who are secondarily liable (and thus may not be pursued in private suits).

We draw a clean line between the two—the maker is the person or entity with ultimate authority over a statement and others are not. In contrast, the dissent’s only limit on primary liability is not much of a limit at all. It would allow for primary liability whenever “[t]he specific relationships alleged . . . warrant [that] conclusion”—whatever that may mean. Post, at 11.

Indeed, as I commented at the time Stoneridge was decided (and as Justice Thomas acknowledged in n. 7 of yesterday’s opinion), that case’s unsatisfactory resolution made Janus necessary.  I noted that, instead of focusing on the reliance requirement, the Court should have considered “precisely what conduct gives rise to a 10b-5 cause of action, and how that conduct must be connected to the deception of investors. * * * It’s not clear how th[e] “necessary or inevitable” standard will be applied in subsequent cases.”

Unfortunately, even after Janus, we still don’t know.   William Birdthistle decries the victory of “nice legal formalities” and worries that this will “tend to encourage highly strategic behavior in future.”  More likely, the Court will now find it necessary where to draw the line on strategic legal separation as a device for avoiding 10b-5 liability.

Janus actually didn’t squarely present that problem, because the formal separation the Court relied on was baked into the law of mutual funds.  This law decrees that mutual funds should have a corporate-type legal structure, complete with a board that does little of importance, despite the fact that such a structure is inconsistent with the nature of an open-end mutual fund. As I have written, this problem gave rise to Jones v. Harris, and only Congress and not the Supreme Court can solve it.

Nor can the Court solve the Central Bank-Stoneridge-Janus aiding and abetting problem.  This comes from trying to trim the judicial oak that has grown out of the little acorn in Section 10(b) of the 1934 Act.  For years the Court let the tree grow, and then for years after a different Court has visited it every several years and tried to prune it.  The Court now essentially must choose between letting it grow wild, as Justice Breyer’s dissent in Janus would do, or rely on artificial over-formal distinctions like the one in Justice Thomas’s opinion. 

The only real solution is for Congress to cut the damn thing down and disimply a private remedy under 10(b).  Since that won’t happen either, I suppose we should just sit back and enjoy the spectacle.

I’ve previously written about the increasingly unruly market for corporate law, in which many cases involving the governance Delaware corporations are being brought outside of Delaware.  Now Jennifer Johnson writes about Securities Class Actions in State Court.  Here’s the abstract:

Over the past two decades, Congress has gradually usurped the power of state regulators to enforce state securities laws and the power of state courts to adjudicate securities disputes. This Paper evaluates the impact of Congressional preemption and preclusion upon state court securities class actions. Utilizing a proprietary database, the Paper presents and analyzes a comprehensive dataset of 1500 class actions filed in state courts from 1996-2010. The Paper first examines the permissible space for state securities class actions in light of Congressional preclusion and preemption embodied in the 1998 Securities Litigation Uniform Standards Act (SLUSA) and Class Action Fairness Act of 2005 (CAFA). The Paper then presents the state class action filing data detailing the numbers, classifications, and jurisdictions of state class action cases that now occupy the state forums. First, as expected, the data indicates that there are few traditional stock-drop securities class actions litigated in state court today. Second, in spite of the debate over the impact of SLUSA and CAFA on 1933 Act claims, very few plaintiffs attempt to litigate these matters in state court. Finally, the number of state court class actions involving merger and acquisition (M&A) transactions is skyrocketing and now surpasses such claims filed in federal court. Moreover, various class counsel file their M & A complaints in multiple jurisdictions. The increasingly large number of multi-forum M&A class action suits burden the defendants and their counsel, the judiciary and even plaintiffs’ lawyers themselves. The paper concludes that absent effective state co-ordination, further Congressional preemption is possible, if not likely.

The basic problem is that SLUSA’s “Delaware carve-out” exempting Delaware corporate cases from preemption under SLUSA doesn’t clearly require the cases to be heard in Delaware, despite the legislative history indicating that Congress’s respect for Delaware courts was a justification for the carve out. 

As Jennifer indicates, this is, indeed, a regulatory coordination problem.  As Erin O’Hara O’Connor and are explaining in a forthcoming paper, this may justify giving SLUSA broad preemptive effect — i.e., a narrow reading of Delaware carve-out exemption from preemption.  The catch is that it’s not clear preemption would be justified on regulatory coordination grounds for forum choice, as distinguished from law choice.  The coordination problem involves parties’ ability to anticipate what law will be applied.  On the other hand, the nature of the legal rules depends to some extent on which court is applying them.

Congress has the last word on this.  As Jennifer suggests, Congress might respond by repealing the Delaware carve-out or by requiring actions within the carve-out to be filed in Delaware.

In any event, this situation shows that regulatory coordination is a dynamic problem, aka whack-a-mole.  The PSLRA tightens requirements for federal securities class actions, the actions pop up in state courts, Congress enacts SLUSA to stop these, plaintiffs start filing “holder” actions in state courts, the Supreme Court stops those in Dabit (see my paper on this case), but state court M & A cases still manage to sneak in through the Delaware carve-out.

Fortunately this will never end so I’ll keep having stuff to write about.

In Erica P. John Fund vs. Halliburton the Court held that the Fifth Circuit erred when it required loss causation for class certification.  The Court taught the lower courts the distinction among various elements of securities cases.  In order to get Basic’s presumption of reliance you have to prove, e.g.,

that the alleged misrepresentations were publicly known (else how would the market take them into account?), that the stock traded in an efficient market, and that the relevant transaction took place “between the time the misrepresentations were made and the time the truth was revealed.” Basic, 485 U. S., at 248, n. 27; id., at 241–247; see also Stoneridge, supra, at 159.

But the Court said that you don’t have to prove, as the Fifth Circuit put it

that the decline in Halliburton’s stock was “because of the correction to a prior misleading statement” and “that the subsequent loss could not otherwise be explained by some additional factors revealed then to the market.” Id., at 336 (emphasis deleted).

This is “loss causation,” an element of the plaintiff’s case, often dealt with on motion for summary judgment.

For an analysis of loss causation in the context of the other elements of a 10b-5 case, see my Fraud on a Noisy Market.

Dan Fisher correctly notes that “the U.S. Supreme Court once again confounded critics who accuse it of a pro-business bias.”

But I don’t necessarily agree with him that “[t]he decision reaffirms the entire court’s approval of securities class actions as a method of compensating investors for stock-market losses.”  Nothing fundamental has changed since the Court tightened the loss causation requirement in Dura Pharmaceuticals or limited the foreign reach of the securities laws in Morrison vs. National Australia Bank.  All the Court did is discipline a misapplication of doctrine.  Any more basic fix here will have to be up to Congress.

Today’s WSJ reports on the US’s slide in stock listings, which explains the NYSE/Deutsche Borse move.  It notes that

  • U.S. stock listings are down by 43%, or by 3800, since 1997.
  • Listings outside the U.S. have doubled.  
  • U.S. IPOs since 2000 are down 71% from the 1990s. 
  • IPOs by VC-backed startups are down from 90% in the 1980s to 15%.

Some reasons:  firms have lower compliance costs, fewer shareholder suits, lower d & o insurance costs, and lower listing fees, no SOX (or Dodd-Frank).

Nasdaq is seeking to compete with London’s AIM by opening an exchange for small companies that don’t meet its general listing requirements.

But this won’t solve the problem.  In the long run, the US securities laws compete in a global market.  Although other factors, including the growth of foreign markets, help explain the above shifts, these other factors increase the competitive pressure on US law.  Congress and the SEC are going to have to stop acting like they’re alone in the world.

Steve Davidoff discusses materiality issues in the GS Abacus transaction, Gupta/Galleon, Apple and Jobs’ health and Sokol. He questions “quirky” American securities laws that don’t require continuous disclosure of material information, and a materiality standard which “allows lawyers and others to argue that something is not material because they didn’t think it was certain or important enough to affect the stock price of the company significantly.” 

Davidoff also says that “efforts to find distinctions between material and nonmaterial can seem baffling” to non-lawyers, and that “the current disclosure scheme and its definition of materiality* * * is increasingly disconnected from the desires of investors and the marketplace.” He adds that “a failure to act here may lead to increasing distrust of the markets by an already wary public.”

Davidoff may be right that investors want more information, but fails to identify a key reason why the legal standard can’t and shouldn’t be tighter:  litigation.  A looser materiality standard could expose every statement or non-statement to judicial second-guessing. 

This also answers Davidoff’s question of why companies don’t just disclose on their own “what investors will find important,” and why companies don’t seem to “understand that information disclosure is not just a legal game.”:  Every disclosure is a potential securities fraud claim.

More disclosure may be a good idea.  But the way to get it is to fix securities litigation.

Peter Henning discusses “the SEC under fire”, specifically Beckergate, which I’ve already discussed, and Guptagate, which I’ve been mulling since Sorkin’s Dealbook column last Monday. Henning observes that “the questions being asked could undermine the agency’s credibility as an effective regulator of the securities markets.”

As for Beckergate, Henning notes (in addition to the issues discussed in my post earlier today) that ethics approval came 25 minutes after the request from an ethics officer who was supervised by Becker, and “did not consider whether there would be any appearance of impropriety even though work on the matter came within the letter of the conflict of interest rules.” 

Becker was involved in the SEC’s decision whether to clawback money from from a $1.54 million account in which he had an interest.  Does this seem like there might be an appearance of impropriety worth more than 25 minutes deliberation?  

Moreover, even if this is ok with the government, it might not be ok with the DC bar.  Henning points out that Becker’s judgment might well be “adversely affected by the lawyer’s * * * own financial, business, property, or personal interests,” and thus raising a question under DC attorney ethics rules.  

Guptagate is the SEC’s decision on March 1, the eve of its big Rajaratnam case, to file an administrative order against Rajat K. Gupta, former Goldman Sachs and P & G director, for tipping Rajaratnam about nonpublic information at the two companies.  Gupta had responded to a Wells notice only four days earlier, and the SEC made the decision after an unusually short weekend review.

Moreover, the SEC chose this as the first insider trading case (and the first of the 26 Galleon related cases) to be brought under a new Dodd-Frank provision that gives the SEC the benefit of a “home court,” a lower evidentiary standard, and the opportunity to avoid judicial review.  (Betcha didn’t know this was what Dodd-Frank was for).  Yet just a few days later the SEC filed an insider trading case against a lawyer in federal court that involved only $27,400, much less than R supposedly made off Gupta’s information.

Sorkin notes that despite its extensive phone-tapping, the Gupta calls evidently weren’t recorded.  Also, “you have to imagine that if the evidence was truly overwhelming against him, Mr. Gupta might have sought to become a government witness to save himself.”

So is the SEC in league with Justice to patch a gaping hole in its case against R by tainting a key witness?  If so, it wouldn’t be the first time the government has used its power to threaten and taint potential defense witnesses to smooth its path to victory.  Indeed, as I’ve written, such abuse is a foreseeable result of giving great power to lightly supervised government agents. 

If we’re going to keep passing financial laws that beef up the SEC’s power, we need to watch carefully how that power is exercised.

Update:  Carney reports the SEC was actually at odds with Justice over the Gupta charges and that they were actually a power play by the SEC. So less bad for Justice, but arguably even worse for the SEC.

We usually think about jurisdictional choice for corporate law as applying to state business association laws, not the federal securities laws.  But this distinction has never been clear given global securities markets, and it’s less true now than it used to be.

The WSJ discusses the securities bar’s and regulators’ lamentations over last summer’s Morrison v. National Australia Bank holding that that foreign plaintiffs who transacted in foreign shares on a foreign exchange (i.e., “f cubed”) could not bring a 10b-5 action.  The article notes that the ruling seems to be helping foreign-based companies like BP and Toyota that are facing investor suits over non-disclosure of risks that turned into big liabilities. It says  judges have been barring U.S. suits even by U.S. investors who bought shares on foreign exchanges (i.e., “f squared”).

Plaintiffs’ securities lawyers and some state officials are trying to get Congress to reverse the decision because, according to the article, “in a global marketplace in which U.S. capital increasingly flows into foreign stock exchanges, it is unfair to deprive U.S. investors of the protection of domestic law because they purchased stock overseas.”

But as I pointed out when the Morrison decision came down, the ruling “promotes globalized securities markets . . . by adopting a test that enables investors to choose the applicable regulation by deciding where to trade.”  In other words, investors may not want to be “protected” by U.S. law because it’s better for plaintiffs’ securities lawyers than for investors.   The exchange-based test gives investors clear notice of when they’re protected and when not.

At the same time, foreign firms can more easily choose, just by deciding which exchange to trade on, whether the extra credibility they get from the application of U.S. law is worth the extra costs.  As I’ve written, this may be less likely the case after federal laws like SOX (and now Dodd-Frank), which try to impose U.S. governance norms on foreign firms.

In other words, a true “global marketplace” depends at least in part on jurisdictional choice, and not necessarily on the application of the same law everywhere.

Per the WSJ, the SEC’s internal watchdog told the Senate Banking Committee that the SEC’s suit against Goldman was a “suspicious” attempt to “to distract attention from a report criticizing the SEC for failing to detect an alleged Ponzi scheme.”

It’s not like I’m surprised.  Here’s my criticism of the suit and the settlement

The only surprise (though perhaps it shouldn’t be) is the reaction reported in the WSJ article:  that we should have more litigation.  The SEC’s suit was intended not just to cover up its own negligence, but as a misguided response to satisfy the public craving for “accountability.”  Yet the pressure for more such suits continues according to the article:

Senator Kaufman (Del.):  “[We have seen very little in the way of senior officer or boardroom-level prosecutions of the people on Wall Street who brought this country to the brink of financial ruin. Why is that?”

Fred Gibson, FDIC deputy inspector general:  “There hasn’t been a prosecution that’s put a face on this crisis.”

Former SEC enforcement chief McLucas puts his finger on the problem:

“One of the challenges in this environment is there were such broad systemic failures that identifying the one or two people or the six enterprises that are quote responsible, which is what we see a broader appetite for, I don’t think that’s doable. There may be cases where the rules were broken. Are they all cases where you can or should put people in jail? Probably not, but that doesn’t satisfy the lust for accountability.”

So it looks like, despite the criticism of the SEC Goldman suit, we’re in for more of the same.