How one N.Y. judge is quietly eroding securities class actions
Earlier this month I told you about a certiorari petition that has the potential to end securities class action litigation as we know it. Halliburton has asked the U.S. Supreme Court to dismantle the very foundation of modern shareholder fraud litigation: the court’s 1987 decision in Basic v. Levinson, which held that investors are presumed to have relied on public misrepresentations about stock trading in an efficient market. Basic preserved defendants’ opportunity to rebut that presumption of reliance, but as a group of eminent law professors and former officials of the Securities and Exchange Commission said in an Oct. 11 amicus brief supporting Halliburton’s petition, that’s more of a theoretical right than an actual one. “A quarter-century of experience with Basic has demonstrated that the fraud-on-the-market presumption is effectively not rebuttable, and that it essentially eradicates the element of reliance,” the brief said. “Time has borne out Justice (Byron) White’s concern that, ‘while, in theory, the court allows for rebuttal…such rebuttal is virtually impossible in all but the most extraordinary case.’ ” In fact, according to a working paper by Stanford law professor and former SEC Commissioner Joseph Grundfest, who signed on to the Halliburton amicus brief and is cited liberally within it, there have only been five – five! – cases in which securities fraud defendants actually succeeded in countering Basic’s presumption of reliance.
But a pair of recent rulings by U.S. District Judge Katherine Forrest of Manhattan – including her decision Tuesday to deny certification of a class of Deutsche Bank shareholders – shows that in some cases, defendants can altogether avoid Basic’s presumption of reliance by challenging the efficiency of the market in which their shares trade. In both the Deutsche Bank decision and Forrest’s opinion last July in George v. China Automotive Systems, the judge insisted on hearings to evaluate shareholders’ evidence of market efficiency – and ultimately concluded in both cases that shareholders hadn’t established the existence of an efficient market for the defendant’s stock. Basic’s fraud-on-the-market presumption, she ruled in both class actions, wasn’t even triggered because the China Automotive and Deutsche Bank shareholders hadn’t satisfied Basic’s condition that shares trade in an efficient market.
I should point out that Forrest had other big problems with the proposed China Automotive and Deutsche Bank classes. Lead plaintiffs in each of the class actions bought and sold shares during the class period, and the judge said that such in-and-out shareholders are inadequate class representatives because they’re subject to individual defenses. Forrest also ripped to shreds the expert witness for Deutsche Bank shareholders, whose main expertise, she said, was “being an expert in plaintiffs’ securities cases.” (Ouch.) Forrest disallowed his testimony on Daubert grounds, which made it impossible for shareholder lawyers from Robbins Geller Rudman & Dowd to establish market efficiency.
Nevertheless, there are lessons for other securities class action defendants in Forrest’s extensive discussion of the shortcomings of shareholders’ efficient-market proof in the China Automotive and Deutsche Bank cases. Securities fraud defendants often concede market efficiency; in the Halliburton case challenging Basic, for instance, Halliburton didn’t contest that its shares trade on an efficient market. Judge Forrest’s rulings suggest defendants should at least force shareholders to prove their right to invoke Basic’s fraud-on-the-market presumption.
That’s particularly true of cross-listed defendants like Deutsche Bank, whose lawyers at Cahill Gordon & Reindel clearly understood, based on their brief opposing class certification, that Judge Forrest sets a high bar for certification. Cahill brought in two professors, Paul Gompers of Harvard Business School and the aforementioned Joe Grundfest of Stanford, to counter shareholders’ efficient market expert, Mark Marek of Financial Market Analysis. Forrest was impressed by the analysis of both defense experts, but she was especially persuaded by Grundfest’s discussion of where Deutsche Bank’s share price is actually determined.
Grundfest compared the U.S. market for cross-listed Deutsche Bank shares to the much more robust German market. Only 7.6 percent of trading in Deutsche Bank stock takes place on U.S. exchanges, according to Grundfest; the remaining 92.4 percent almost all occurs on German exchanges, where Deutsche Bank trades are, on average, much larger and more frequent than U.S. trades in Deutsche Bank shares. The professor concluded that the German market for Deutsche Bank shares is the true mirror of publicly available information about the bank, which is typically disclosed in Germany before U.S. markets even open. Share prices on German exchanges respond to information, according to Grundfest. Share prices on U.S. exchanges, in turn, respond to German prices. So the real question, Grundfest said, isn’t whether U.S. exchanges are an efficient market for Deutsche Bank shares but whether the German market is efficient.
If Forrest had held that the U.S. market is inefficient by definition when it merely reacts to prices set elsewhere, that would have been a huge break for cross-listed securities defendants. She did not go that far. Instead, the judge said that shareholders must meet the burden of demonstrating the efficiency of the primary market for a defendant’s shares when that market is outside of the U.S. For Deutsche Bank, the primary market is Germany, she said. But shareholders in the class action hadn’t even offered evidence of the efficiency of the German market for the bank’s shares. Forrest said that failing was “fatal” to their reliance case.
Forrest’s market-efficiency analysis last summer in the China Automotive case considered whether the company’s share price (it’s listed on the Nasdaq) reflected market reaction to material disclosures, a necessary element of an efficient market. The judge found that China Automotive shares did not respond quickly to more than half of the significant disclosures plaintiffs had identified as triggering events. That was powerful evidence the China Automotive traded in an inefficient market, Forrest found, exactly the opposite of the efficient trading shareholders intended (and needed) to show.
Rulings that market inefficiency precludes the application of Basic, according to an email I received from Grundfest on Wednesday, are not nearly as rare as actual rebuttals of Basic’s fraud-on-the-market presumption. Forrest, in other words, is notable for two closely-spaced certification denials based on market efficiency, but she is not the only judge putting plaintiffs through their paces, which is all the more reason for defense lawyers to contest the fraud-on-the-market presumption if there’s any hope of prevailing.
Grundfest told me that although the implications of Forrest’s ruling for other cross-listed companies (or those with American Depository Shares trading on U.S. exchanges) will depend on individual facts, “as a general matter, if the primary market for a security is abroad, then a credible argument can often be made that it is impossible to assess the efficiency of the market in the United States without also analyzing price formation in the foreign market where most (or a significant portion) of the trading occurs,” Grundfest said. “The market might or might not be efficient, but you can’t make that determination by exclusively examining U.S. prices when a sufficient amount of the trading, information disclosure, and price formation occurs offshore.”
Judge Forrest’s ruling are yet another reminder that the securities class action business isn’t what it used to be, even if Basic isn’t toppled. On that note, keep your eye on the Supreme Court docket. Halliburton’s lawyers at Baker Botts filed their reply brief on Tuesday, so the cert petition is ready for the Supreme Court’s consideration. If four justices vote to grant cert, a lot of plaintiffs lawyers are going to be very, very worried.
(Reporting by Alison Frankel)