On June 23, the Supreme Court made a minor tweak to securities class action litigation rules but let stand a 26-year-old decision that undergirds the federal shareholder shakedown apparatus.
The court's decision in Halliburton v. Erica P. John Fund will offer limited relief to corporations and their shareholders but otherwise leaves untouched the lawsuits that continue to tax stock market investors.
The federal securities laws, enacted during the Depression in the wake of the 1929 stock market crash, are designed to ensure investors' decisions are informed by mandating disclosure of corporate information and prohibiting fraud or deceit in the connection with the purchase or sale of any security. On their face, the laws only empower the federal Securities and Exchange Commission to enforce the anti-fraud provisions, but the courts have long read an “implied private right of action” into the securities laws that enables investors who bought or sold a security in reliance on management's fraud to sue the company for damages.
In its 1988 decision in Basic v. Levinson, the Supreme Court held that investors need not show that they directly relied on a company's alleged fraudulent misstatement. Instead, the court ruled that because the stock market incorporates all publicly available information into share prices, the investors buying or selling subsequent to stock price investors were presumably harmed by any adverse stock price movement flowing from the fraud.
Under Basic’s presumption of reliance, because every plaintiff buying a security following an alleged fraud was commonly affected, they could be combined into an aggregate “class” seeking damages. The modern securities class action lawsuit was born.
In short order, plaintiffs’ law firms developed securities class action practices in which they monitored stocks for sharp price movements — which would quickly trigger a lawsuit alleging some fraud had caused the stock to move. Because defending against these types of lawsuits would involve expensive document production — and risk of verdicts in the millions or even billions of dollars — the suits almost inevitably settle.
The problem with the securities class action lawsuits created under Basic is that they serve mainly as a tax on the average investor. A subset of shareholders receives payment from the company — essentially all other shareholders — and the typical diversified investor is equally likely to be a payor as a payee in any securities claim. The principal beneficiaries are the lawyers involved, who take a hefty piece of the action.
Defenders of Basic’s securities litigation regime argue that such suits are important in deterring fraud. But given that there is little relationship between the filing of a lawsuit and fraud — as opposed to a stock-price swing — the instrument would seem blunt indeed. And were class action suits not permitted, nothing would stop a large investor like a hedge fund or pension fund that lost money after actually relying on a fraud from filing suit to recover damages — which would deter management misstatements at lower costs to all shareholders.
Although many court-watchers hoped that the justices might reverse course in Halliburton, a divided majority instead decided not to overturn the Basic precedent. The court did permit corporate defendants to challenge the claim that a price movement was in fact caused by a fraud before a class action claim could proceed; but because most such lawsuits are predicated upon a price movement in the first place, the practical effect of this rule is likely to be limited.
Given the Supreme Court's failure to make major changes to the securities class action lawsuit game, shareholders who want to pare back this wealth transfer to attorneys are left with two recourses. First, they can persuade Congress to pass legislation firming up the reforms passed nineteen years ago, not long after Basic launched the shareholder-litigation revolution. Second, they can encourage boards of directors to pass “loser pays” bylaws for shareholder suits -- recently upheld by the courts in Delaware, where most large companies are incorporated -- which would deter shakedown lawsuits while preserving genuine claims for fraud.
Absent those changes, securities-shakedown suits seem here to stay.James R. Copland is the director of the Center for Legal Policy at the Manhattan Institute.