What if SCOTUS does away with securities fraud class actions?
On Friday, as you’ve surely heard, the U.S. Supreme Court agreed to hear Halliburton v. Erica P. John Fund, which challenges an essential building block of securities fraud class actions. Halliburton’s cert petition presented the question of whether the Supreme Court should overrule its own 1988 decision in Basic v. Levinson, which held that investors in broadly traded stock presumptively relied on public misstatements. Basic’s fraud-on-the-market theory freed securities class action lawyers from having to show that individual shareholders made investment decisions based on fraudulent misrepresentations, permitting the certification of enormous classes of investors. If the justices decide to chuck Basic’s presumption of reliance, it’s hard to imagine how plaintiffs’ lawyers will be able to win certification of securities fraud class actions. As Max Berger of Bernstein Litowitz Berger & Grossmann said at a securities litigation conference on Tuesday, “I seldom lose sleep at night, but one of the things that keeps me up is what the Supreme Court is going to do in Halliburton. It’s a game changer.”
Let’s stipulate that shareholder lawyers aren’t the only folks who will be affected if the Supreme Court makes it impossible to certify securities fraud class actions. Their counterparts on the defense side will lose millions of dollars of billings in a very lucrative practice area. All of the economists and law professors who serve as experts on class certification and settlement approval motions will also be out millions of dollars in fees. Settlement administration firms that handle the back-end of class actions, sending notices to class members and distributing recovery, will have less work. Even the D&O industry will feel the impact, according to Kevin LaCroix of the D&O Diary, if the Supreme Court eliminates fraud class actions. Corporate risk simply won’t be as severe if investors can’t sue as a group over alleged misrepresentations. Law professors like to talk about the transaction costs of securities fraud class actions, in which an awful lot of lawyers and other professionals take a cut of the money that’s transferred from one group of shareholders to another via class action settlements. Those transaction costs amount to hundreds of millions, if not billions, of dollars a year – and they’re imperiled if the Supreme Court undoes Basic v. Levinson.
But undoing Basic won’t end shareholder litigation, or even shareholder class litigation. In fact, defendants who have hoped fervently for an end to fraud class actions that generated more than $73 billion in settlements between 1997 and 2012, including six of the 10 biggest settlements in class action history, may end up ruing that they got what they wished for, according to Stanford Law School professor Joseph Grundfest, the securities litigation guru whose working paper, Damages and Reliance Under Section 10(b) of the Exchange Act, supplied me with the statistics I just quoted.
Grundfest is no fan of Basic’s fraud-on-the-market theory. His paper, which documents the de facto impossibility of rebutting Basic’s presumption of reliance, was the foundation of an amicus brief by a group of law professors and former SEC officials who urged the Supreme Court to use the Halliburton appeal as a vehicle to wipe out its 1988 precedent. In a phone interview Friday, after the justices granted cert, Grundfest pointed out that even if the court eliminates the presumption of classwide reliance, investors in some cases will still be able to bring class actions under Section 11 of the Securities Act of 1933, which does not require a showing of reliance but holds defendants strictly liable for material misstatements in offering materials. Individual investors with sizeable losses may also still sue for fraud under both state and federal law, as long as they can show that they relied on alleged misrepresentations, Grundfest said.
Litigation over mortgage-backed securities has taught plaintiffs’ lawyers how to leverage information by filing similar complaints for multiple investors with claims for individual losses. MBS litigation has also encouraged relationships between top-tier shareholder firms and large institutional investor clients. Individual fraud suits don’t pose the enormous threat of class actions, but Grundfest said that if the Supreme Court reverses Basic, defendants might wind up facing big institutional investor claims in state courts across the country. That’s an inconvenient and expensive proposition, as companies have discovered in multiforum shareholder M&A litigation. “There may be companies that would say, ‘We prefer the old regime,’” Grundfest said. “You’re not going to find the partners of Bernstein Litowitz out on the street if the court undoes Basic.”
And even if the Supreme Court eliminates its fraud-on-the-market precedent, shareholders can still bring Exchange Act class actions based on allegedly fraudulent omissions, rather than misrepresentations, according to Paul Vizcarrondo of Wachtell, Lipton, Rosen & Katz, who filed the law professors’ amicus brief in the Halliburton case. Because the Supreme Court has previously held that shareholders do not have to establish that they relied on such omissions, Vizcarrondo predicted in an interview Friday, plaintiffs’ lawyers will likely try to reframe cases to claim that defendants deliberately failed to disclose material information. So, for instance, instead of arguing that JPMorgan Chase CEO Jamie Dimon misstated the bank’s risk when he called losses from trades by the so-called London Whale “a tempest in a teapot,” shareholder lawyers might argue that JPMorgan officials fraudulently avoided revealing the magnitude of losses by its chief investment office. Plaintiffs’ lawyers, as we all know, are nothing if not resourceful.
It’s also possible, of course, that the Supreme Court will leave the presumption of reliance intact when it decides the Halliburton case. Last term, in Amgen v. Connecticut Retirement Plans, four justices seemed prepared to confront Basic’s fraud-on-the-market theory, but Chief Justice John Roberts sided with the court’s liberal wing and instead held, in a narrower ruling, that shareholders need not prove the materiality of alleged misstatements in order to win class certification. The challenge for shareholders in the Halliburton case, represented by Boies, Schiller & Flexner, will be crafting an argument that keeps the chief justice on their side.
Grundfest told me that their smartest course will be to argue that Congress has left Basic’s fraud-on-the-market presumption intact, despite imposing new restrictions on shareholder fraud class actions in the Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998. (Boies Schiller does indeed make that argument in its brief opposing Halliburton’s cert petition.) On the other hand, Grundfest said, there’s significant Supreme Court precedent holding that congressional silence doesn’t prove congressional intent.
That leads me to one final point (for now) about the fallout from overturning Basic. If small investors are precluded from recovering losses attributable to fraud through class actions, their only recourse will be SEC fair funds, which the agency can establish to compensate investors when it settles enforcement actions. But as you know, the SEC can’t recover through restitution and penalties anything approaching what shareholders can obtain through private fraud class actions. If private cases are made extinct, Grundfest told me, the SEC will be under pressure to bring more cases – and Congress will be under pressure to boost the recovery available to the SEC or else to figure out a new regime for shareholder recovery.
(Reporting by Alison Frankel)