The Supreme Court is taking up the contested legal theory that underpins most big securities class-action lawsuits in a case that could reshape the balance of power between companies and the lawyers who sue them.
The suits can take many forms: a claim against a drug maker for tricking investors about the chances of bringing a new pill to market, for instance, or an allegation against a tech firm for lying about its sales figures. But they almost always rely on a single legal doctrine called “fraud on the market.”
In essence, the doctrine lets aggrieved investors join forces in court without ever having to show a direct connection between each shareholder’s losses and the alleged fraud. Instead, the courts generally assume that shareholders suffer harm whenever they buy stock in a company that is cooking its books.
The fraud-on-the-market theory led to a surge in securities lawsuits after a divided Supreme Court enshrined it in 1988.
If a majority of the high court’s justices agree to strike it down in its entirety—an outcome that many legal experts think possible—it “would be a potentially devastating hit to securities class actions,” said Blair Nicholas, a plaintiffs’ securities lawyer at Bernstein Litowitz Berger & Grossmann LLP.
Between 1997 and 2013, more than 3,200 securities class actions were filed, yielding over $75 billion in settlements and billions in fees for plaintiffs’ and defense lawyers, according to Cornerstone Research, a litigation-consulting firm.
The case, which will be heard next Wednesday, comes as the Supreme Court’s conservative wing is showing an increasing willingness to rein in large lawsuits against companies such as Comcast Corp. and Wal-Mart Stores Inc.
The Supreme Court cleared the way for class actions to take off with its 4-2 ruling in a 1988 case called Basic v. Levinson, which first embraced the fraud-on-the-market concept.
The doctrine is based on an economic theory that at any given moment, a company’s stock price reflects all available relevant information. If some of that information is fraudulent, the court reasoned, it can safely be assumed that it has been baked into the price as well.
Thus, investors can be injured by simply buying a fraudulently inflated stock even if they weren’t paying attention to the company’s news releases or securities filings.
The ruling was controversial from the start. The late Justice Byron White, one of the 1988 dissenters, said the court had made an ill-advised foray into “economic theorization” that would sow confusion in the courts.
Four justices on the current bench have publicly expressed reservations about it, including Justice Samuel Alito, who wrote that the doctrine may rest “on a faulty economic premise.”
Business interests and some academic legal experts worry the theory has spawned excessive and expensive litigation. They also argue that such suits are fundamentally unfair because the system makes it so easy for plaintiffs to form a class and acquire negotiating leverage.
Plaintiffs’ lawyers view private securities class actions as instrumental in deterring corporate deception and promoting market confidence. They contend that private suits do a better job of compensating duped investors than government regulators, who they say can’t police the markets alone.
The plaintiffs accuse the oil-field services company of misleading investors about its accounting of cost overruns, exaggerating the benefits of its 1998 merger with Dresser Industries, and concealing its exposure to asbestos liabilities. They allege that when the real information was disclosed, Halliburton’s stock price took a dive. Halliburton, which denies it made any misrepresentations, disputes that there was any price impact.
Lawyers for Halliburton told the justices in a filing that the Basic ruling betrayed a “simplistic understanding of market efficiency” that is “at war with economic reality.”
In their own brief, lawyers for the lead plaintiff said Halliburton is asking the court “to do something it has not done in decades: reverse a settled statutory precedent in a field that Congress has closely superintended.”
The suit was spearheaded at one point by a pioneer of the securities class-action suit, William Lerach, who was expelled as co-lead plaintiffs’ counsel in 2007 after he became embroiled in a kickback scandal. The lead plaintiff in the Supreme Court case is a charitable fund that makes grants to programs of the Archdiocese of Milwaukee and to social-service groups.
Plaintiffs’ lawyers and shareholder groups warn that scrapping the theory could make it impractical for all but the largest institutional investors to pursue claims on their own. Mr. Nicholas said the litigation expenses alone—such as filing and discovery costs—would overwhelm the damages that a typical “retail” investor might stand to recover, draining any incentive to go to court.
In a friend-of-the-court filing, U.S. attorneys representing the Securities and Exchange Commission and the Justice Department said that discarding the fraud-on-the-market doctrine would “diminish the compensatory and deterrent effect of the private remedy.”
The court has the option to preserve the doctrine, but in a more limited form. One way would be to give an accused company the chance early on to knock down claims that an alleged fraud had anything to do with swings in a stock price. The Fifth U.S. Circuit Court of Appeals ruled last year that Halliburton isn’t owed that opportunity.
If the Supreme Court reverses its 1988 ruling, plaintiffs’ lawyers say they expect that Congress would consider restoring the “fraud-on-the-market” doctrine by passing a new law, said Nicholas Porritt, a partner at Levi & Korsinsky LLP who represents plaintiffs in securities class-action litigation.
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