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Ending the Shareholder Lawsuit Gravy Train

Geplaatst op feb 28, 2014 in News

The Supreme Court is going to host a debate next week on the efficient market hypothesis. The battle lines may not be exactly what you’d expect: the U.S. Chamber of Commerce and Justice Samuel Alito have already argued that the EMH is, as Alito put it, “a faulty economic premise,” while Justice Ruth Bader Ginsburg and the Obama administration have backed the idea that, as a sextet of Justice Department lawyers put it, “markets process publicly available information about a company into the company’s stock price.”

This debate is happening because in Halliburton Co. v. Erica P. John Fund, Inc., a case scheduled to go to oral arguments on March 5, the Supremes are reconsidering the “fraud on the market” doctrine at the heart of most securities-class-action lawsuits. These are the big-dollar shareholder suits frequently accused of endangering American economic competitiveness. They get less attention than they did in the 1990s and early 2000s (remember Bill Lerach, the “king of the shareholder class-action suit”?) but are still, as is clear from the chart below, costing companies a lot of money.


These lawsuits have been enabled in part by the efficient-market teaching that “in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business.” That’s from an appeals court decision approvingly quoted by Justice Harry Blackmun in his 1988 majority opinion in Basic, Inc., v. Levinson, the case that took the fraud-on-the-market standards that had been evolving in the appeals courts and consolidated them into the law of the land. Because prices reflect available information, that appeals decision went on, “misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.” That made it relatively easy to assemble a big group of plaintiffs, since all you had to do was find those who had bought or sold a company’s stock over a particular time period — whether or not they’d been paying any attention to the misleading statements of its executives. It also opened up the possibility of huge damage verdicts, as the stock drop after bad news finally came out could be seen as a first approximation of the loss to the defrauded shareholders.

How huge? Here are the ten biggest shareholder class-action settlements of all time, as tallied by National Economic Research Associates Inc. in its annual report on shareholder suits:


It’s worth dwelling for a moment on who gets that money and who pays it out. In most cases it’s the current shareholders of a company paying current and former shareholders. The corporate executives who made the misleading statements generally don’t pay anything at all because they’re covered by directors & officers liability insurance. In the two biggest settlements, the offending companies — Enron and WorldCom — went belly up, leaving their banks stuck with most of the tab, a somewhat more logical outcome but not the standard one. Then there are the lawyers. In the Enron case the plaintiffs’ attorneys got $798 million in fees and expenses; with WorldCom $530 million. The percentage take tends to go up as the settlement amounts get smaller — overall, NERA reports that plaintiff’s attorneys pocketed $1.13 billion, or 17% of settlements, in 2012. Defense attorney costs are harder to get at, but indications are that they add up to another 10% or more of settlements. In short, then, shareholder lawsuits amount to a weirdly circular process in which presumably blameless outside investors hand over money to other outside investors (and sometimes to themselves), with the executives accused of wrongdoing left untouched and the lawyers for both sides taking a big cut.

As a result, University of Pennsylvania law professors William W. Bratton and Michael L. Wachter wrote in 2011, a consensus has developed among academics that fraud on the market is “not just flawed, second-best, misdirected, or in need of improvement, but flat-out senseless, mindless, and reasonless.”

Just because most law professors think something is a bad idea, though, doesn’t make it go away. Fraud on the market now has decades of legal precedent on its side, plus a 1995 law passed by Congress that was intended to rein in shareholder suits but didn’t address fraud on the market (more on that in a moment). The one obvious thing that has changed since the Basic decision in 1988 is that the strong academic consensus around the efficient market hypothesis that prevailed then has weakened considerably — as evidenced by last year’s Nobel prize in economics, which was shared by the author of the efficient market hypothesis, its leading critic, and a third scholar who developed statistical tools for testing market efficiency.

For a business-friendly Supreme Court that has been nibbling around the edges of shareholder suits but had until now avoided taking on fraud on the market directly, this debate seems to have provided a window of opportunity. But if the economists on the Nobel committee can’t decide whether financial markets are efficient, we probably shouldn’t expect America’s highest court to. “The Supreme Court is not really the body that’s best situated to referee that kind of dispute,” says Stanford Law School professor Joseph Grundfest, who as founder and principal investigator of Stanford’s Securities Class Action Clearinghouse follows this stuff as closely as anybody. “I don’t think we want Supreme Court justices reading back issues of Econometrica and deciding which coefficients are asymptotically efficient.” What’s more, as Harvard Law School’s Lucien Bebchuk and Allen Ferrell recently wrote, none of the many academic criticisms of the efficient market hypothesis actually refute the basic idea (or Basic idea) that misleading statements can distort a company’s stock price.

In short, there are probably some things wrong with the Basic decision’s reliance on the efficient market hypothesis, and there are almost certainly some things wrong with the ways lower courts have interpreted it, such as the much-used Cammer test of market efficiency devised by a U.S. District Court judge in New Jersey in 1989. But that’s not the main thing wrong with fraud-on-the-market lawsuits, and it may not be central to what the Supreme Court decides.

Grundfest figures the Court will instead focus on the areas where it has comparative advantage — judicial precedent, textual analysis, legislative intent, that kind of stuff. Not that this necessarily simplifies anything. Legal scholars have churned out a staggering volume of work on shareholder lawsuits in recent years, and the small percentage of it that I’ve read (it took me several days) doesn’t lend itself to easy conclusions. It does, however, paint a fascinating picture of how we’ve landed in this predicament. So I’ll conclude with seven fun facts for you to recite at your next fraud-on-the-market-themed cocktail party, culled mostly from Georgetown University Law Center Professor’s Donald Langevoort’s “Basic at Twenty: Rethinking Fraud on the Market” and William & Mary Law School Professor Jayne Barnard’s “Basic, Inc. v. Levinson in Context”:

  1. In 1942, the Securities and Exchange Commission, fleshing out a section of the Securities Exchange Act of 1934, adopted Rule 10b-5, which spelled out that it was unlawful “to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”
  2. In 1964, the Supreme Court unanimously ruled that (I’m quoting Barnard here) “in order to effectively supplement the often-overwhelmed enforcement efforts of the Securities and Exchange Commission, it would recognize an implied right of action, enabling private investors to seek damages and other relief under … the Securities Exchange Act of 1934.” In 1970 it provided for the award of plaintiff’s attorney fees in such cases, and in 1971 it upheld a Rule 10b-5 case. So the whole securities class-action thing was basically a creation of the Supreme Court, with Congress and the SEC playing supporting roles.
  3. These decisions led to a doubling in the number of securities lawsuits filed in federal courts from 1970 to 1975, after which the Supreme Court, now with a majority of Nixon and Ford appointees, began making it harder to file shareholder lawsuits in federal courts. For time the lawsuit tide ebbed, then the frenzied Wall Street activity of the 1980s and the rise of fraud-on-the-market theory in the lower courts sent the numbers back up.
  4. Then came Basic, Inc. v. Levinson. For reasons that nobody seems to know, conservative Justices William Rehnquist and Antonin Scalia sat the case out. Also, Justice Lewis Powell had retired and his replacement, Anthony Kennedy, wasn’t confirmed in time to take part. As a result, the Court’s four-man liberal minority of Blackmun, William Brennan, Thurgood Marshall, and John Paul Stevens found itself in the majority — and provided the votes for the decision.
  5. Basic, Inc., a “maker of chemical refractories for the steel industry” (Harry Blackmun’s words), got a raw deal. The plaintiffs’ complaint was that Basic executives misled investors in 1977 and 1978 by repeatingly denying that they were involved in merger negotiations with Combustion Engineering, Inc., “a company producing mostly alumina-based refractories,” then announcing in December 1978 that they had agreed to a merger. It was the reverse of the usual shareholder class-action complaint — in this case it was the people who sold early, and missed out on the merger premium, who claimed to have been defrauded. But Basic’s executives argued, and the District Court judge agreed, that they hadn’t misled anybody at all. They had gotten occasional nibbles from Combustion Engineering over the years, but never took them seriously until receiving an offer in December 1978 at a far higher price than anything that Combustion had previously mentioned. The appeals court opted to ignore this defense, and so did the Supremes.
  6. Fraud on the market got crucial backing early on from conservative University of Chicago Law School scholars Frank Easterbrook (now a federal appeals court judge) and Daniel Fischel, both big believers in the efficiency of markets and the need to defend it. “The law should protect markets; markets will then protect investors,” is how Langevoort summarizes their thinking.
  7. In 1995, a Republican Congress passed — over President Clinton’s veto — the Private Securities Litigation Reform Act, which was intended put a damper on the securities class-action party. As it turned out, the PSLRA didn’t reduce the number or severity of such suits, but there are some indications that it cut back on nuisance filings and led to a better (that is, more serious) sort of shareholder suit. It did not directly address fraud on the market. In a brief filed in January, several then-members of Congress and staffers (all Republicans) explained that the House had considered constraining fraud on the market but gave up in order to assemble a veto-proof majority, while the Senate didn’t formally address the issue at all.

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