Imagine that you bought 1000 shares of stock in Jimmy Co., a large publicly traded pharmaceutical company at $50 per share. Before you bought your stock, Jimmy Co.’s officers had been claiming that a new drug that was being developed would greatly enhance the ability to treat the plague. They predict that the drug will sail through the FDA testing because the drug is perfectly safe and the manufacturing process is up to code. They will get approval and be on the market in two years. Their stock price has been rising ever since that announcement and is now where you bought it, at $50.
Six months after you bought that stock it is revealed that Jimmy Co. did not get FDA approval for its new drug because they cut a corner in the manufacturing process which could make the drug unsafe. Jimmy Co.’s share price falls to $40. You’ve lost $10 per share because they weren’t as by the book as they said they were. When you need to sell the shares, the price has only recovered to $42 so you are still down $8.
So you want to sue them because their stock should not have been valued that high to begin with, its price was based on a cover-up of the corner cutting. How would you go about it? It won’t be worth it for any lawyer to take this case on contingency because unless you bought a significant percentage of shares, the recovery would not be enough to cover the cost. The same problem if they don’t work on contingency. But you weren’t the only one to buy and sell in that period of time, surely. There is a whole class of people out there who are all in the same boat as you. So you want to join a class action. In order to certify your class, however, you will need a way to bind all of the class members together under one, predominant theory.
Such a theory was provided in 1988. In Basic v. Levinson, the Supreme Court affirmed what is known as the “fraud-on-the-market theory”. This allows a plaintiff who traded the stock of a company to claim a rebuttable presumption that the plaintiff indirectly relied on the misleading statements whether the plaintiff was actually aware of those statements or not. This presumption carries the same weight as direct reliance. The reasoning is that in an efficient market, the stock price is determined by an amalgamation of all of the available and material information about the company. If a company or its executives make a misleading statement, that statement will be factored into the price, distorting it in one direction or another and thus defraud anyone who purchases the stock at that price. The presumption may be rebutted by showing that the misstatement and the price that was paid by the plaintiff were not linked.
A couple of weeks ago, the Supreme Court heard arguments in Halliburton Co. v. Erica P. John Fund Inc. You can listen to the oral arguments here. This case is testing the merits of the fraud-on-the-market theory and the Supreme Court will have an opportunity to reverse itself and eliminate it. The problem with it is that people buy stocks for all sorts of reasons that may be completely unrelated to the alleged fraud. As Daniel Fisher at Forbes points out:
“Value investors buy stocks because they believe the price is wrong, too low relative to the value of a company’s assets. Momentum investors buy stocks because the price is going up. Quants buy stocks because the price is cheap relative to some other variable such as interest rates or grain futures in Mongolia. Index investors buy because the issuing company is in the index.”
Not all of these investors directly relied on the statements when making their stock purchasing decision. Without reliance, are these investors really entitled to damages? Currently, the fraud-on-the-market theory would step in for the reliance requirement because it assumes the stock price reflects the market’s knowledge of the state of the company.
This theory is used in the class certification stage of the class action case where the plaintiffs have to get the court’s approval to represent the entire class of potential plaintiffs. In order to get a class approved in a class action, two of the several requirements that plaintiffs must show are commonality (that there are questions of law or fact that are common to the class) and predominance (that the common questions of law or fact predominate over questions affecting only the individual members). The fraud-on-the-market theory provides a platform to show common reliance on the alleged misstatements by the company by all of the purchasers thus satisfying the commonality and predominance requirements. Essentially, because it assumes that everyone who buys a stock relies in someway on the information about the company, everyone in the class has that in common and it will be the most prominent of any of the individual factors.
The complete elimination of this rebuttable presumption could severely limit the ability of plaintiffs to bring these cases by killing them at the class certification stage. Individual proof of reliance, as would be required without the fraud-on-the-market theory, would likely cause individual issues to predominate. If the potential plaintiffs don’t all have the ability to use fraud-on-the-market to provide the commonality and predominance elements then plaintiff attorneys would need to provide another common question that linked the plaintiffs together and show that the new question predominates over all of the other individual claims. As of now no one has developed a proposal for how this can be done and therefore the ability to certify the class collapses.
Without the ability to sue as a class, the small plaintiffs would all drop out as their claims would not be large enough to warrant the cost of pursuing the case. This would leave the large, institutional investors, who are generally the lead plaintiffs in these cases. Their losses would be large enough to warrant a lawsuit but they would then run into a reliance problem themselves. In order to preserve the link between their purchase and the fraud, they would need to trade stock in such a way that clearly showed that their method took into account the available and material information about a company.
At this point it may seem like, due to practical reasons, it is an obvious thing to keep. It is one of the only ways that aggrieved shareholders can claw back any of their fraudulently lost money. This is not the whole picture, however because there are practical and procedural concerns as well. One criticism of this theory and these suits in general is that the group that tends to fair best in this arena is the plaintiff’s attorneys. A case that settles for tens or hundreds of millions of dollars will rack up quite the legal bill when it comes to paying the contingent fees. Defendants have come to the Halliburton fight armed with claims like the suits have cost shareholders $700 billion since the PSLRA (Private Securities Litigation Reform Act). There are certainly lawyers who have done plenty well for themselves doing solely this type of work. What defendants are arguing then is that it is a greater harm to the securities market for securities class actions to continue to rack up large bills at the expense of companies than to continue with one of the current safe-guards against corporate fraud.
Another issue that defendants have against the implementation of the fraud-on-the-market theory is that they do not get a rebuttal to the plaintiff’s presumption of reliance. Those familiar with Basic will say “Doesn’t Basic require that defendants had an opportunity to rebut the reliance presumption?” The technical answer is yes, defendants technically have the ability to rebut. The practical answer is that the rebuttal would come so late in the case that the case would not last long enough to get to that point. This is “because once the case gets passed class certification, as this Court has recognized time and again, there is an in terrorem effect that requires defendants to settle even meritless claims.” (Halliburton Oral Arguments Pg. 51, line 5-9) Because of the stay on discovery that is placed on plaintiffs through the PSLRA, summary judgment at the class certification stage would be premature as plaintiffs would not have had the opportunity to review all of the evidence. Currently, only 7% of securities class actions make it to summary judgement and only 1/3% make it to a verdict.
So what should the answer be? Eliminating the fraud-on-the-market theory will greatly reduce the amount of money that shareholders of companies will pay to plaintiff’s lawyers to settle securities suits but it will also eliminate one of the few ways that investors have of recuperating losses for fraud. In addition, it will eliminate a big deterrent for companies issuing misinformation and decrease the incentive of those companies to provide more transparency to the marketplace. By keeping it, investors are compensated but the large plaintiff law firms will still be big winners and a lot of money will be wasted in legal fees for both sides.
*As a side note for those unfamiliar with securities class actions, look no further than this for an example of how long and complicated these cases can get. Halliburton was filed back in 2002 for events that happened between 1999 and 2001 and this is the second time that the Supreme Court has been asked to rule on an issue. All of that and it still isn’t in trial, they are still trying to certify the class.
**Also an interesting behind-the-scenes look at the history behind Halliburton.
***Update: There will be another entry discussing the “Law Professor’s Brief” soon.