Could this be Armageddon for shareholder class actions?
FORTUNE — On Wednesday, the U.S. Supreme Court will hear arguments in a case that could decimate the class-action shareholder-suit industry, crippling a litigation juggernaut that extracted $73 billion in settlements from corporations between 1997 and 2012. Nearly $17 billion of that sum went to plaintiffs attorneys and a roughly equal sum — on top of the $73 billion — was paid to the corporate defense bar. Will the Court really pull the trigger?
Filed against Halliburton (HAL) almost 12 years ago, this lawsuit, which could boomerang so catastrophically against the lawyers who brought it, was fittingly once led by Bill Lerach, the greatest pioneer, architect, and impresario of the genre. Lerach went to prison in 2007 for conspiring to obstruct justice, but not before winning billion-dollar settlements from crime-ridden firms like Enron and WorldCom, while also bringing scores of more pedestrian suits against the likes of Apple (AAPL), Citigroup (C), Walt Disney Co. (DIS), Exxon (XOM), Goldman Sachs (GS), and — as we should disclose — Time Warner (TWX), the parent of Fortune‘s publisher.
The case today is known as Halliburton Co. v. Erica P. John Fund, though many lawyers call it Halliburton II because it already reached the Supreme Court once, in 2011, on a slightly different issue.
The subject this time is the so-called fraud-on-the-market doctrine, or “FOTM” to the initiated. FOTM is a judge-made doctrine without which the vast majority of garden-variety shareholder, class-action fraud suits simply could not be brought (more on the mechanics of FOTM in a minute). The Court is reassessing whether that linchpin theory — blessed by the Supreme Court in 1988 by an anemic 4-2 vote, with three justices (all conservative) not participating — ever made sense and should still be adhered to.
With such momentous stakes it’s no surprise that the case has attracted nearly two dozen amicus briefs, from the likes of the U.S. Chamber of Commerce, the Council of Institutional Investors, AARP, former SEC commissioners, former congressmen, economists (including Nobel laureate Eugene Fama), and loads and loads of law professors. (The Obama Administration, through Solicitor General Donald Verrilli, Jr., is urging adherence to the FOTM doctrine.)
Yet, the stakes of this case are so momentous that the single, most decisive factor will probably be one that can’t be openly broached in any of those briefs. In deciding a case like this one, Chief Justice John Roberts, Jr. — who is widely assumed to represent the swing vote — must engage in a lonely act of supreme judicial statesmanship. He must gauge how quickly his Court can continue to change American society without compromising its own legitimacy and reservoir of goodwill in the eyes of the public it serves. As someone who famously — many would say infamously — pledged at his confirmation hearings in 2005 to act as a neutral “umpire,” passively calling balls and strikes, and to be sensitive to the institutional demands of stare decisis — respect for precedent, basically — he will have to calibrate whether the country is ready for yet another 5-4 ruling, along ideological lines, that overturns decades of precedent and violently upends the existing legal and, in this instance, business landscape.
The fraud-on-the-market doctrine addresses the following difficulty. To prove a traditional fraud case, the plaintiff has to show not only that the defendant lied to him, but that he fell for that lie — i.e., “relied” on it — in a way that caused him injury. So in the securities fraud context, if a company’s CEO publicly understates what he really thinks his company’s asbestos liabilities are — one of the frauds Halliburton stands accused of — that lie might obviously lull an individual investor into purchasing the stock, believing it to be a safer bet than it really is. When the truth later emerges, and the stock falls precipitously — 42% in Halliburton’s case, after it got hit with a mammoth asbestos verdict in December 2001 — that investor can credibly claim to have been injured.
But if that investor wants not just to sue on his own behalf but to bring a class action, how can he prove that the entire class of investors who bought Halliburton stock during the same time period attached the same importance as he did to the CEO’s allegedly false statement — or that, indeed, they ever even knew that the statement had been uttered?
One answer might be: He can’t. In that case the investor couldn’t bring a class action and, if he was just an individual, with only a few thousand bucks worth of stock losses at stake, it probably wouldn’t make economic sense for him to bring suit of any kind.
The FOTM doctrine comes to that person’s rescue. It theorizes that when there is an efficient market, in which stock analysts routinely pore over 10Qs, 8Ks, media reports, and, indeed, every passing rumor implicating the companies they cover, any material statement by a company’s CEO quickly gets incorporated into the price of its shares. Every investor can then further be assumed to rely on the “integrity” of the share price — i.e., the assumption that that price isn’t being artificially depressed or inflated by fraudulent statements. With the benefit of the FOTM assumption, an investor can now bring a class action because the CEO’s allegedly false statement can be assumed to have been incorporated into the share price, and all investors can be further assumed to have relied on the integrity of that price, whether or not they actually ever knew the statement had been made and attached any significance to it.
The FOTM doctrine appears to have been first accepted by an appeals court in 1975. Every appellate panel to consider the question afterward then followed suit. Finally, in March 1988, the U.S. Supreme Court, sitting with a bare quorum of six justices and splitting along ideological lines, approved the FOTM doctrine by a 4-2 margin in Basic v. Levinson. Writing for the plurality, Justice Harry Blackmun (joined by Justices William Brennan, Jr., Thurgood Marshall, and John Paul Stevens) based his decision on “common sense and probability,” since “market professionals generally consider most publicly announced material statements about companies” and “most publicly available information is reflected in [the] market price.” He alluded also to some of the then-recent economic scholarship advancing the so-called efficient capital markets hypothesis, a theory generally holding that share prices reflect all publicly available information. (The dissenters were Justices Byron White and Sandra Day O’Connor. Not participating were Chief Justice William Rehnquist and Justices Antonin Scalia and Anthony Kennedy.)
That’s where things stood until last February, when the Supreme Court decided Amgen [(AMGN)] v. Connecticut Retirement Plans and Trust Funds. Though that case was a victory for the class-action plaintiffs, four of the more conservative justices — Justice Antonin Scalia, Clarence Thomas, Anthony Kennedy, and Samuel Alito — suggested in separate opinions that Basic needed to be reconsidered. Seven months later Halliburton’s lawyers at Baker Botts, led at the Supreme Court level by Aaron M. Streett, gave the Court that opportunity, and here we are.
One nominal basis for reexamination was that, in the intervening years, economics scholars have become more skeptical of some of the claims of the “efficient capital markets hypothesis,” or “ECMH,” which Justice Blackmun had cited in his opinion in Basic. But Blackmun’s opinion was really based as much on common sense as on any nuanced, highfalutin economic theory. The lawyers for the plaintiff Erica P. John Fund, led by David Boies of Boies, Schiller & Flexner, are probably correct when they write: “Basic is built upon the obvious fact … — which even critics of the ECMH almost uniformly accept — that stock prices generally react reasonably promptly to material, public information by incorporating that information into the stock price.”
There are, however, better reasons to reexamine Basic than arcane schisms among ECMH scholars. One might be that it has “produced a litigation leviathan” that Congress and the Basic Court “could not possibly have conceived.” This argument is advanced by former U.S. Securities and Exchange Commissioner Joseph Grundfest, a professor at Stanford Law School, in an amicus brief he has co-written with lawyers at Wachtell, Lipton, Rosen & Katz. They dub FOTM “the most powerful engine of civil liability ever established in American law.”
Beyond citing statistics on the volume of litigation FOTM unleashed, Grundfest advances a textualist legal argument for why the original Basic court reached the wrong conclusion in 1988. Though the details of his logic would take us deep into the weeds, suffice it to say that it is the sort of argument to which Chief Justice Roberts would very likely be receptive if he were writing on a clean slate (i.e., not being asked to overturn long-standing precedent). It relies on an argument made more fully in one of Grundfest’s own articles, which appears to be — judging from my eyeballing of the parties’ and amici’s submissions in the case — roughly the second-most-referenced law review article in the totality of the briefing.
The most-referenced article, by the same crude methodology, is one that Columbia Law School professor John Coffee, Jr., published in the Columbia Law Review in November 2006. That is a thoroughgoing critique of FOTM securities fraud litigation itself, calling into question whether, all told, investors are net winners or losers as a result of its very existence. The article focuses on the central “circularity” of these cases, given that their costs — “both the settlement payments and the litigation expenses of both sides — fall largely on the defendant corporation,” meaning that they are ultimately borne by the company’s “innocent shareholders, not the responsible parties.” Writes Coffee: “To punish the corporation and its shareholders in such a case is much like seeking to deter burglary by imposing penalties on the victim for having suffered a burglary.”
For diversified investors, who will be receiving recoveries in some suits but dishing them out in others, the cases in aggregate are a wash at best, but more likely a “deadweight loss,” Coffee argues, after factoring in all the transaction costs — attorneys fees and insurance premiums — they are paying for.
For undiversified investors, he continues, the results are even more untoward, because unsophisticated, buy-and-hold investors usually won’t have bought or sold within the narrowly circumscribed time periods necessary for inclusion in the plaintiff class. “Ironically,” Coffee writes, “the clear winner under such a system is the more rapidly trading, undiversified investor — which is the profile of the contemporary hedge fund. The clearest loser is the small investor who buys and holds for retirement — exactly the profile of the American retail investor.”
Coffee himself has not signed onto any of the amicus briefs in Halliburton II. In a
in January he predicted a compromise outcome, which stems from yet another possible objection to Basic, and reason for reconsidering it.
The Basic plurality thought they were setting up a “rebuttable” presumption of reliance, which the defendant would have an opportunity to disprove. In practice, however, lower courts have permitted defendants to rebut FOTC only in very limited ways — by arguing, for instance, that the market for the securities in question was not “efficient.” But such an argument is methodologically hard to prove — no one’s sure exactly how to do it — and, many people feel, beside the point. The more pertinent rebuttal argument from the defense perspective — and one defendants often feel they could prove if they were only given the chance — is that the alleged false statement never had any impact on the price of the securities in question in the first place. That genre of rebuttal has generally been precluded by courts, at least at the all-important class-certification stage of the proceedings, on the theory that it should be postponed for consideration by a jury at trial. In practice, though, postponement means never, because once a class gets certified, defendants almost always settle rather than risk a multibillion-dollar jury verdict. (From 1995 through 2012, plaintiffs filed 3,988 securities class-actions, of which only 14 — about one-third of 1% — went to a jury verdict, according to a NERA Economic Consulting report cited in Halliburton’s brief.)
For this reason, Halliburton is urging as a backup argument, in case the Court refuses to abandon Basic altogether, that it at least afford defendants a meaningful opportunity to challenge at the class-certification stage whether the alleged false statements had any impact on share price. This outcome has also been urged as the most appropriate result by two securities law professors, Adam C. Pritchard of the University of Michigan, and M. Todd Henderson, of the University of Chicago, in an brief written by John P. Elwood of Vinson & Elkins. (It is also the result predicted by professor Coffee in his blog post as well.)
Counterbalancing all these weighty arguments for reconsidering or modifying Basic, the Erica P. John Fund contends not only that the case was correctly decided in 1988 but that, even if it wasn’t, principles of stare decisis would weigh heavily against overturning it now, a quarter century after the fact. A number of academic securities law experts have supported these positions — many more than joined Grundfest’s brief — including Jill E. Fisch of the University of Pennsylvania, the brief’s principal author. Five more academics, stare decisis experts, have filed an additional brief urging adherence to Basic.
A key point they all make is that subsequent to the Court’s ruling in Basic Congress has twice — in 1995 and 1998 — passed major amendments to the securities laws, choosing on neither occasion to overturn or even fine-tune Basic, which it could have done. They argue that such inaction should be understood as “ratification” by Congress of the Court’s ruling. Professor Donald Langevoort of Georgetown University Law Center has argued, in an article also cited frequently in the briefing, that the 1995 legislation in particular “makes no sense except when read as a political compromise that preserves the foundation of the fraud-on-the-market class action while making it harder for plaintiffs to bring, plead, and prove a successful claim through a variety of reforms.” For the Court to eliminate FOTM now would be to pull the rug out from under the delicately balanced framework Congress has crafted.
What, then, will Chief Justice Roberts do? My SWAG (scientific wild-ass guess) is that he’ll split the difference. He’ll reaffirm Basic, allowing him to honor the principle of stare decisis. But he’ll go on to say that Basic contemplated a rebuttable presumption of reliance, which many lower courts have, in practice, allowed to wither away into irrebuttability. Accordingly, to truly honor stare decisis, he’ll argue, the Court must give defendants a meaningful opportunity to challenge at the class-certification stage whether the alleged false statements had any impact on share price — the result favored by professors Pritchard and Henderson, and predicted by Coffee.
A challenge to reaching this compromise is that it would come quite close to overruling two very recent Supreme Court rulings — last February’s ruling in Amgen and the 2011 ruling in this very lawsuit, Halliburton I. In each of those decisions the Court rebuffed requests by defense lawyers for a chance to present evidence at the class-certification stage very similar to what the Court would now be permitting — a showing by defendants that the allegedly false statements had no impact on share price. Though the legal rubrics at issue in the earlier cases were different — those cases were about what lawyers call “loss causation” and “materiality” rather than about “reliance” — the upshot for practitioners would be nearly indistinguishable.
So the compromise would require some fancy footwork. But Chief Justice Roberts is up to the task, and I think he will take it on rather than face either unpalatable alternative: (a) leaving Basic completely intact — a result at war with every fiber of his conservative being — or (b) blasting it to smithereens and fueling perceptions of a politicized, agenda-driven, pro-corporate Court.