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| M. Todd Henderson |
The court made it clear that it expected Congress to make any substantive reform to securities class actions, despite the fact that the court created the current securities class action regime out of whole cloth. What are the implications of the court’s Halliburton decision, and what would real reform look like?
The Halliburton decision reaffirmed the Supreme Court’s 1988 decision, Basic Inc. v. Levinson, that underlies most securities class actions. The question in Basic, revisited in Halliburton, is what plaintiffs need to show to certify a class of investors. Class certification has enormous consequences in these cases; virtually all companies will settle if a class is certified rather than face the enormous costs of discovery and the risk of trial.
Under Basic, plaintiffs can certify a class if they show that the stock of the defendant company trades in an “efficient” market, that is, one in which securities prices reflect all public information. That showing allows plaintiffs to invoke the so-called “fraud-on-the-market” presumption, excusing them from showing that the investors in the class read the misstatement alleged to have distorted the market.
Under the Basic rule, plaintiffs lawyers can certify a class against the largest public companies (those listed on the New York Stock Exchange or the Nasdaq Global Market) almost automatically, since these markets are deemed “efficient.” Companies whose securities trade in “inefficient” markets — e.g., smaller companies trading in the over-the-counter market and debt issuers — are essentially immune to securities class actions, even though these issuers are more likely to commit fraud because they generally lack the elaborate internal controls and Big Four auditors employed by the largest companies.
The Halliburton decision does nothing to discourage plaintiffs lawyers from going after the deepest pockets. The decision does, however, add a new battle of the experts that will further increase the already enormous cost of litigating these cases.
Halliburton gives defendants an opportunity to defeat class certification if they can show that the alleged misstatements did not have “price impact.” In other words, defendants need to show that the fraud did not actually affect the market.
Markets vary in the speed with which they incorporate information, and the significance of the information matters as well, so it can be a challenging task to establish whether a statement affected the market price. That challenge can be particularly daunting if a company releases multiple pieces of information at the same time.
Under Halliburton, defendants put on economists to testify that the alleged misstatements did not affect the market price; plaintiffs will respond with their own economists who will testify that they did. With the burden of proof on defendants, many trial judges, faced with conflicting economic evidence that they are scarcely equipped to evaluate, will opt to certify a class.
Consequently, the watered-down role for price impact evidence adopted by the court in Halliburton is not likely to have much of a real-world effect. Despite the limited prospects for success and the added litigation expense, it will be the rare defendant that does not take advantage of the opportunity afforded by the Halliburton decision. It’s worth a shot.
Note that these disputes over market efficiency and price impact have nothing to do with whether the company or its officers actually lied. That question is never resolved in securities class actions, which are always settled if they are not dismissed.
What reforms would actually push these lawsuits toward resolving that question? The answer lies with understanding that the incentive to settle these cases has little to do with the merits of the particular case: even a small prospect of losing at trial puts a big thumb on the scale toward settlement, even if the company has done nothing wrong.
Looming in the background is a potentially bankrupting judgment. The math is simple: a 5 percent chance of losing a $2 billion judgment means it is economically rational to cut a check for $100 million, even ignoring the massive costs of mounting a defense. Such settlements are wasteful; investors do not benefit when companies pay settlements that have little to do with the merits of the case. Securities class actions are a costly form of insurance against fraud, and investors are the ones ultimately footing the bill. Only the lawyers, and now, the economists, are enriched.
Fixing securities class actions requires fixing the damages measure, something not mentioned in Basic or Halliburton. The damages measure used in these cases is out of step with economic reality. Every loss to a buyer-victim of securities fraud is matched by a windfall to a seller who dumped his shares at an inflated price. Investors can (and should) diversify their portfolios to protect themselves against these losses, instead of a costly litigation system that promises, but rarely delivers, full compensation.
Intertwined with the question of damages is the question of who pays. Real reform of securities class actions would shift the focus of those suits from corporations, which typically get no benefit from fraudulent misstatements, to corporate officers, who collect bonuses or cash out stock options based on stock prices inflated by fraud.
Corporations do not defraud people; corporate officers do. But under current law, corporations and their insurers pay, while managers typically get a free pass. Requiring fraudulent officers to give up their gains from fraud — a remedy called “disgorgement” — would be a critical step toward genuine reform. Disgorgement would simultaneously reduce the extortion value of these suits, while at the same time shifting the target of them to the individuals who are the most culpable.
The Supreme Court created the securities class action industrial complex in Basic, but refused to undo its mistake in Halliburton. The Halliburton court has preserved the status quo, which focuses suits on the wrong defendants and amounts to a full-employment provision for lawyers and economists. It appears that it is up to Congress to correct the fundamental flaw of securities class actions.
—By M. Todd Henderson, University of Chicago Law School, and Adam C. Pritchard, University of Michigan Law School
M. Todd Henderson is a professor of law and a teaching scholar at the University of Chicago Law School. Adam Pritchard is a professor of law at the University of Michigan Law School, where he teaches corporate and securities law. Pritchard and Henderson filed an amicus brief in the Halliburton case.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.