A group of pro-corporate forces has begun a behind-the-scenes fight at the Supreme Court. You may not have heard about it, but it could just end shareholders’ ability to sue companies for securities fraud.
Securities fraud litigation â€" suits against companies for disclosure violations of the federal securities laws â€" has been a big business over the years. From 1997 to 2012, more than 3,050 securities litigation cases were brought, according to Cornerstone Research, a financial and economic consulting firm. Companies and their insurers paid $73.1 billion in judgments and settlements, and plaintiffs’ lawyers alone collected almost $17 billion in fees, Cornerstone’s research shows.
Not surprisingly, corporate America has spent decades criticizing this type of litigation as little more than costly nuisance suits. Not only that, since the chief executives and other officers who are accused of having made fraudulent statements never have to pay out of their own pockets, the companies end up paying their own shareholders. In other words, shareholders are really paying this money to themselves â€" with a nice tip for the lawyers, of course.
Shareholders and their advocates argue that fraud is fraud, and that shareholder litigation is merely punishing companies for their wrong conduct. They point to the more than $7.3 billion recovered in the case of Enron or the $6.1 billion from WorldCom.
Now, a loosely organized coalition is seeking to end such litigation, and it is pushing a case at the Supreme Court to do exactly that.
The case is Erica P. John Fund v. Halliburton, the oil-services company. The Erica P. John Fund exists to support the Catholic Archdiocese of Milwaukee.
The fund’s lawsuit was initially brought in 2002, and it accused Halliburton and its chief executive then of lying to the market about Halliburton’s asbestos liabilities. The company and chief executive were also accused of overstating revenue and hyping up claims about the companies’ merger with Dresser Industries.
As Dickens memorably portrayed in “Bleak House,†litigation can be interminable, and this case is no exception. The parties have spent a decade fighting over whether the case can be brought as a class action, meaning whether it can be brought on behalf of all shareholders.
The Supreme Court considered a related issue in the case in 2011, unanimously reversing a decision that the Erica P. John Fund had to show that the allegedly false statements had led to a loss for shareholders before the class could be certified.
The case was sent back to a lower court, which has now certified the class action, but Halliburton is still fighting. The oil company is again asking the Supreme Court to reconsider the case in a petition filed last month.
In its argument, Halliburton is asking the Supreme Court to confront one of the fundamental tenets of securities fraud litigation: a doctrine known as “fraud on the market.â€
The doctrine has its origins in the 1986 Supreme Court case Basic v. Levinson. To state a claim for securities fraud, a shareholder must show “reliance,†meaning that the shareholder acted in some way based on the fraudulent conduct of the company.
In the Basic case, the Supreme Court held that “eyeball†reliance â€" a requirement that a shareholder read the actual documents and relied on those statements before buying or selling shares â€" wasn’t necessary. Instead, the court adopted a presumption, based on the efficient market hypothesis, that all publicly available information about a company is incorporated into its stock price.
Applying this doctrine, the Supreme Court reasoned that any fraud would affect a company’s price. The court held that therefore a shareholder need not prove reliance because the shareholder’s purchase or sale was based on an inaccurate share price, a price that changed as a result of false information.
Most investors, at least the average small investors and even many mutual funds, usually don’t read the information released by the company and probably could not prove reliance. The Basic decision expanded the universe of possible plaintiffs. By discarding a person-by-person test for reliance, class actions were now easier to bring. And once a class action can be brought, the potential for damages rises exponentially. Companies often have no choice but to settle.
The Supreme Court’s reliance on the efficient market hypothesis was also aggressive. Since 1986, the dot-com and credit market bubbles have led many to question the truth of that hypothesis. Reflecting this uncertainty, the Nobel in economic science was awarded this week to Eugene F. Fama, one of the main proponents of the efficient market hypothesis, and Robert J. Shiller, one of its main detractors.
Nonetheless, the Basic case has made possible modern-day securities litigation. Without the presumption held in the Basic case, most ordinary investors would be out of luck. It wouldn’t just be the common investor. Index funds, for example, would never be able to prove reliance, because they buy and sell shares simply to reflect an index.
For those who believe that much of this litigation is frivolous, the ruling in the Basic case is becoming the center of attack.
It’s here that we come to the Halliburton case.
The company has petitioned the Supreme Court to overturn the decision in the Basic case, arguing that its standard should never have been adopted. A group of former commissioners at the Securities and Exchange Commission and law professors represented by the New York law firm Wachtell, Lipton, Rosen & Katz have also taken up the cause. In an amicus brief, the group argues that, in practice, the Basic case has effectively ended the reliance requirement intended by the statute, something that is not justified.
They rely on a forthcoming law review article by an influential professor, Joseph A. Grundfest of Stanford Law School. Professor Grundfest argues that the statute on which most securities fraud is based â€" Section 10(b) of the Exchange Act â€" was intended by Congress to mean actual reliance because the statute is similar to another one in the Exchange Act that does specifically state such reliance is required.
Professor Grundfest’s argument is a novel one and is likely to be disputed by the pro-securities litigation forces, but the question probably comes down to whether there are five justices who want to put a stake through the heart of securities fraud cases.
The opponents of the Basic decision are getting closer. In a case involving the biotechnology company Amgen in 2012, four dissenting justices appeared to support overruling the Basic ruling. The majority, which included Chief Justice John Roberts, supported the ruling, noting that Congress had considered the issue when it reformed securities litigation in 1995 and adopted the Private Securities Litigation Reform Act, the statute that was meant to cut back on securities laws. Congress didn’t discard the Basic decision when it could have.
Still, the foundation of the Basic decision on a financial theory has always been shaky. And the Supreme Court has not been in a pro-litigation mood of late. In the Morrison case decided in 2007, the justices ran a steamroller through foreign cases involving securities fraud, basically ending these cases.
It takes only four justices for the Supreme Court to decide to consider a case. The question now is really whether four justices think the time is right to go after the Basic ruling. The justices are expected to decide whether to do so next month.
Momentum may favor Halliburton, but its time may not have come: the Supreme Court could reject its petition. If so, the company will be looking at a 2014 trial.
Whatever happens to Halliburton, the bigger fight over the ruling in the Basic case will not end for corporate America. For good or bad â€" like so many other issues before the Supreme Court these days â€" the opponents need only one more vote to change everything.
