Worldwide Widget looks like a hot stock. The company makes a cutting-edge product in a growing market. All the best-known analysts are saying “buy.” So you buy a big chunk of WW stock for your portfolio.
Two days later, however, Worldwide admits that the company’s books have been cooked for years: revenues grossly exaggerated and known risks of liability concealed. The stock price dives; a rebound seems unlikely. You sell as fast as you can and take a big loss.
Worldwide’s “material misrepresentations” amount to securities fraud, and federal law allows you to sue the company for your stock losses. But there’s a catch: fraud cases require plaintiffs to show that they relied on the misstatements at issue. You never read Worldwide’s deceptive 10-K filings. You just put your faith in the market: the rising stock price and recommendations from experts who were reading the 10-K filings.
Strictly applied, the requirement to prove reliance would leave you and most other investors out of luck. But 25 years ago the Supreme Court adopted a solution for the innocently duped investors: the fraud-on-the-market theory. Under this theory, accepted by economists and courts in the 1980s, all investors can be presumed to have relied on fraudulent misrepresentations when they purchase stock at a price distorted by the misrepresentations.
The Supreme Court’s precedent-setting decision in Basic Inc. v. Levinson (1988) ushered in the modern securities fraud class action. Business interests criticized it at the time and have kept up the attacks ever since. Now, the Supreme Court’s conservative bloc has set the stage for possibly erasing it from the law books.
The justices agreed last week [Nov. 15] to hear a case, Halliburton Co. v. EPJ Fund, Inc., 13-317, in which a securities-fraud defendant, backed by the U.S. Chamber of Commerce, is urging the court to overrule or substantially modify the Basic decision. The ruling, lawyers for the Chamber argue in a friend-of-the-court brief, leads to “frivolous strike suits” that “bring more harm than benefits to shareholders.”
Four of the Roberts Court conservatives — Scalia, Kennedy, Thomas, and Alito — signaled their disquiet with the ruling in separate opinions in an unrelated securities case earlier this year, Amgen, Inc. v. Connecticut Retirement Plans. Troublingly for supporters of the 4-2 decision in Basic, the justices in the majority — Brennan, Marshall, Blackmun, and Stevens — are no longer on the court. (White and O’Connor dissented; Rehnquist, Scalia, and Kennedy did not participate.)
To be sure, securities-fraud class actions provide only rough justice, if that, for the victims of accounting shenanigans and outright deceptions engaged in by too many stock-issuing companies. A big chunk of any awards or settlements typically go to the lawyers who put the lawsuits together. For various reasons, some shareholders who deserve compensation do not get it, and others are compensated even though they might not deserve it.
In addition, as Georgetown law professor and securities law expert Donald Langevort has written, the defendant companies foot the bill for about 30 percent of the payouts in such cases — to the detriment of existing shareholders, who have done nothing wrong. Insurance picks up about two-thirds of the costs, while individual defendants — the company officials who actually did something wrong — escape virtually scot-free.
Realistically, however, private class actions are needed to help police the securities markets. The Securities and Exchange Commission (SEC) lacks the resources to pursue all the securities fraud cases that come to light, and business interests that criticize private securities fraud suits are not leading a campaign to increase the agency’s budget. It is also ironic that the kind of people who advocate privatizing such core government functions as education, prisons, and transportation fail to see the benefits of private enforcement of securities laws.
Writing for the majority in Basic, Justice Harry A. Blackmun explained that modern securities markets, with “millions of shares changing hands daily,” differ from the kind of face-to-face transactions contemplated in typical fraud cases. “An investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price,” Blackmun wrote. That presumption, he explained, is based on “considerations of fairness, public policy, and probability.”
The critics see instead, as the Chamber’s lawyers put it, an “unrealistic” economic theory and an “unworkable” legal standard. It is curious to hear business groups and political conservative that glorify the market in other settings argue that stock exchanges are not the “efficient marketplace” that the fraud-on-the-market theory presumes them to be. And the “unworkable” standard under Basic would be even harder to manage if individual investors had to prove specifically that they relied on the allegedly fraudulent misrepresentations in their stock transactions.
In the new case, the investment fund for the Archdiocese of Milwaukee is accusing Halliburton, the big oilfield services company, of misleading the stock market by minimizing its potential liability in asbestos cases, overstating revenue from construction contracts, and exaggerating the potential benefits of a pending merger. The company says those alleged misstatements did not actually affect the price — a defense that would still be available if the suit is allowed to proceed. But a decision to overrule Basic would gut this case and many others. Business interests would benefit, but individual investors in many cases would be left holding an empty bag.
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