The End of Securities Class Actions: Four Blunt PointsPaul M. Barrett
Securities class-action lawsuits—the topic sounds both daunting and dull. Don’t be intimidated. We can break this down.
On March 5, the Supreme Court will hear arguments in a case that could doom securities class actions. Would that matter? In a word, yes. It would be a very big deal.
According to the U.S. Chamber of Commerce and its constituent corporations, killing securities class actions would be fine and dandy. Personally, I’m ambivalent. While it’s difficult to prove, the threat of class actions has got to make some executives think twice about lying—and that’s a good thing (unless you’re a dishonest corporate honcho). On the other hand, I’ve always thought there is something intrinsically illogical about privately filed securities class actions, a point I’ll return to in a moment.
Even though I ultimately favor curbing some quick-draw class actions, I have hesitations about the Supreme Court’s using its pending case, Halliburton v. Erica P. John Fund, to do the job. Instead, the justices ought to step aside and allow Congress to set clear national policy on the issue. And yes, I refer to our partisan-drunk barrel-of-monkeys Congress. For the sake of analysis, let’s pretend we have a functional legislative branch and proceed with our blunt points on securities litigation.
1. Halliburton concerns a “rebuttable presumption” about the concept of “fraud on the market.” Oy vey. On the surface the case seems impossibly wonky and procedural. Lurking beneath the jargon, however, is the potential for a major shift in courtroom power. The Houston oil field services company has asked the justices to overturn a 1988 precedent that made it much easier for shareholders to band together and allege that a corporation’s management defrauded them by failing to disclose financial weakness. In Halliburton’s case, shareholders claimed that from 1999 to 2001—this dispute has been bouncing around the courts forever—the front office distorted earnings reports and minimized asbestos liability.
The 1988 precedent, Basic v. Levinson, established that a shareholder class doesn’t have to show that its members relied on management misdirection when they made investment decisions. Levinson did that by importing into federal law a concept known as fraud on the market. That concept assumes misleading management utterances are seamlessly incorporated into stock prices investors depend on when they buy shares.
Allowing shareholders to allege fraud on the market, rather than having to prove they were individually deceived, helped turn a cottage industry into our current securities fraud industrial complex. NERA Economic Consulting reports that more than 4,000 class actions have been filed since 1996, producing almost $80 billion in settlements. Without the Basic presumption, a big portion of the litigation factory shuts down, says Daniel Sommers, a partner with Cohen Milstein Sellers & Toll in Washington, D.C., a prominent plaintiffs’ law firm. On that point there’s little serious debate.
2. In jurisprudential terms, Basic resembles a dead duck. Almost as soon as it became enshrined in federal law, the fraud-on-the-market theory began to look shaky (judges don’t necessarily make cutting-edge economists). A lot of recent economic research and ample practical experience have undermined the notion that the stock market hums with pristine efficiency. Under the heading of practical experience, recall Black Monday in October 1987, which preceded Basic and might have suggested to the then-justices that if shares could plunge 23 percent in a single day, the market ain’t exactly rational. For additional and more recent examples of stock market nuttiness, consider the bubbles and busts that accompanied the dot-com frenzy circa 1999-2000 and the real estate boom of 2006-07.
Four conservative, business-friendly justices—Samuel Alito, Anthony Kennedy, Antonin Scalia, and Clarence Thomas—have already suggested in a ruling last year that they’d entertain overturning Basic, despite the appearance of the Supreme Court flip-flopping on the issue. That means Chief Justice John Roberts likely holds the controlling vote. Savvy court watchers are betting Roberts will contradict his professed dedication to institutional continuity and join his ideological comrades to give Basic the ol’ heave-ho. (My Bloomberg News cousin Greg Stohr, who covers the Supreme Court like a blanket, makes the additional point that Basic itself came on an unusual and fragile 4-2 vote, with three of the nine justices recusing themselves. None of the members of the Basic plurality still sits on the high court; only one of them, John Paul Stevens, is even alive.)
3. There’s always been something weird about some class actions. The illogical thing about a lot of these suits is that they transfer money from one group of innocent investors to another group, with lawyers extracting beaucoup fees along the way. Think about it: The settlements that almost always resolve these cases are paid by the company or its insurance carrier. In effect, then, the innocent shareholders who happen to hold stock at the time of the settlement pay another batch of innocent shareholders—the ones bringing the class action. Since the pension funds and endowments that are often plaintiffs in these cases are generally buy-and-hold investors, the money moves from one collection of shareholders to—wait for it—the very same group of shareholders. That’s gotta make your brain hurt. “At best,” writes Richard Booth, a professor at Villanova University School of Law, “recovery via class action is an expensive rearrangement of wealth from one pocket to another—minus a cut for the lawyers.”
4. And yet … Private and public pension funds with assets approaching $2 trillion have filed friend-of-the-court briefs begging the justices to preserve Basic and, along with it, securities class actions as we know them. If these institutional investors were merely shuffling their own money from one pocket to the other—while paying off their attorneys for the privilege—why would they be along for the ride?
Management advocates would say that plaintiffs’ firms make influential campaign contributions to the politicians who influence public pension funds. “Pay to play” schemes exist, but that doesn’t explain everything. There are plenty of honest pension managers—public and private—who are concerned about their beneficiaries.
Salvatore Graziano, a partner with New York plaintiffs’ firm Bernstein Litowitz Berger & Grossmann, argues that his clients believe that, on balance, class actions keep management honest. Without the threat of private litigation supplementing enforcement by an underfunded and overmatched Securities and Exchange Commission, fraud would rise and faith in markets would decline, Graziano contends. He’s got a lot in the way of fees riding on Halliburton, but the point still seems valid.
Here’s another reason to pause and reflect: A lot of securities class actions seem marginal or worse in that they’re filed only days or weeks after a stock decline that may or may not stem from management funny business. The company settles to save itself court expenses and distraction. Lawyers on both sides—remember that the defense lawyers get paid, too, and handsomely—make out like bandits, and the beat goes on. But what about company-crushing frauds where shareholders get wiped out? Settlements in the private litigation concerning only two such fiascoes—Enron and WorldCom—totaled $13 billion. Those cases weren’t frivolous. The plaintiffs’ lawyers may have received windfalls, but that’s something federal judges already have the authority to police.
The last time Congress addressed these questions—in legislation enacted in 1995 that tried to stamp out phony rent-a-plaintiff scams and encouraged trial judges to rely on institutional investors as lead plaintiffs—lawmakers explicitly endorsed securities class actions as good for investors. At least in the abstract, “we the people” speak through our lawmakers. Or, as Graziano put it in a Supreme Court amicus brief, Halliburton and its many corporate allies are asking the justices to create “a radical new policy that is at odds with the central role that Congress has assigned to institutional investors.” The place “to pursue that kind of profound policy shift,” the brief added, “is not before this court but in the legislative branch of government.”
That sounds right to me. God help us, it’s ideally up to Congress to craft a rational set of legislative incentives favoring legitimate securities litigation that deters the next Enron or WorldCom.