Opinion analysis: Son of Halliburton

The eagerly awaited decision in Halliburton Co. v. Erica P. John Fund – before the Court for the second time – was finally handed down by the Supreme Court.  As usual, there is a little something for everyone.  What is unusual is that there were no dissents.  Rather, the Justices divided into three camps of three.

The question before the Court this time around was whether a defendant can defeat class action status by showing that market price was unaffected by an alleged misrepresentation.  The question arises because under the fraud-on-the-market (FOTM) theory, adopted by the Court in Basic, Inc. v. Levinson, investors can be presumed to rely on a public material misrepresentation about a stock that is traded in an efficient market because it is presumed to affect market price and because investors are presumed to rely on the integrity of the market.

In a word, the answer to this question is YES – defendants may seek to rebut the presumption for purposes of defeating certification.

The question has really been before the court twice before, first in the earlier iteration of this case and then in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds.  Both times the Court ducked the issue of price impact by characterizing the question as one on the merits – whether loss causation or materiality (respectively) must be shown to gain certification – when the defendants wanted only the opportunity to show lack of price impact.  Finally, the Court – speaking through Chief Justice Roberts – said what it could have said in the first go-round.

As if considering the matter for the first time, the Court told us that Basic itself holds that the presumption can be rebutted.  And if plaintiffs can introduce evidence as to why the presumption applies, then defendants can certainly introduce evidence to the contrary.  So what is the big deal? Expanding a bit, the Court described FOTM as a method of proving reliance and not a substitute for reliance itself.  But the Court also insisted that FOTM is a substantive doctrine of law.

It is not clear how much change is wrought by the Court’s decision.  To be sure, it will permit defendants to avoid certification – the practical equivalent of dismissal – in cases in which they can show lack of price impact.  But it will not necessarily be easy to show lack of price impact. In some cases, the price impact of bad news may be offset by the price impact of good news that just happens to be disclosed at the same time (or vice versa).  The Court itself has recognized this possibility more than once.  So one nice question left open by yesterday’s decision is what is meant by price impact.  Is it enough that defendant can show that there was no significant price movement?  What if plaintiff responds by identifying new information that would have been expected to affect price in the opposite way?

Nevertheless, the Court’s decision will eliminate some frivolous cases. And how could anyone argue that a case that is doomed to fail should not be put to death sooner rather than later – let alone argue that it should survive to force the defendant into settlement?  Thus, Justice Ginsburg concurred (joined by Justices Breyer and Sotomayor) on the theory that the decision is not likely to matter much.

Incidentally, the Court’s decision is not likely to have any effect on omission cases, in which where there is no need to show reliance anyway.  And almost any misrepresentation case can be recast as an omission to issue a correction.

On the other hand, the decision may further encourage plaintiffs with large claims to opt out of any class action, thus avoiding the need for certification and other features of Federal Rule of Civil Procedure 23 such as the requirement of court approval for any settlement.

In addition to the argument that it should be permitted to rebut the FOTM presumption at the class certification stage, Halliburton also argued that the Court should overrule Basic because the FOTM theory is inconsistent with the statutory scheme of federal securities law – in that it dispenses with proof of reliance – and that the efficient market theory on which FOTM is based is so discredited that the presumption has lost its foundation.

The Court rejected both of these sweeping arguments.  As to the former, the Court simply declined to decide the issue on grounds that Congress has acquiesced in FOTM at least twice in enacting securities litigation reforms, effectively recognizing the validity of the theory.  As to the latter, the Court quite correctly observed that FOTM does not require the market to be infallible.  It requires only that the market react to new information (other than randomly).

It is one thing to claim that no one can beat the market (at least without inside information).  It is quite another to say that the market is always and everywhere correct.  No one really doubts that information affects the market – or thus that investors may sometimes trade at a prices that are wrong in the sense that they would be different if the market had the facts.

Moreover, all investors rely on the integrity of the market in this sense.  Still, the parties and the Court seem to obsess about value-investors who buy because they think a stock is undervalued (or sell because it is overvalued).  But such an investor relies on the market price just like a swimmer who relies on wall of a pool not to move when she makes a turn.  If I buy a stock at $20 because I think it is worth $30 and then the stock falls to $10 when new information arrives, I may still think it is a good buy, but I would rather have bought at $10.  The same goes for portfolio investors and arbitrageurs.

The biggest problem with Basic is that it used vague phrases – like market integrity – and bad examples – like a stockholder who must sell because of antitrust concerns or political pressure.  But that does not make FOTM wrong.

Yesterday’s decision does reveal some interesting features of the Court’s thinking about FOTM that were not necessarily clear before.  For example, the Court notes that defendants may occasionally pick off individual class members without necessarily undermining the predominance of common questions for purposes of Rule 23(b)(3).  The key is to choose a representative plaintiff who is bulletproof – which, Justice Clarence Thomas noted, requires only one representative plaintiff who can resist such sniping.  Moreover, the Court seemed to emphasize that defendants should remain free to take aim at individual class members at some point in the litigation – contrary to some courts that have ruled them off-limits once the class is certified.  Again, if the presumption is rebuttable, there must be a way to rebut it – though apparently defendants have recorded only six such kills. In short, individual class members are fair game. And that may involve some questions of individual proof but (probably) not so many as to predominate over common questions.

Predictably, Justice Thomas took issue with this aspect of the decision in his concurrence (joined by Justices Scalia and Alito).  Regrettably, he focuses on predominance – the same problem that flummoxed Justice White in Basic.  But predominance is not the real problem.  Again, everyone relies on market prices.

Rather, the ultimate problem is that no one can fairly and adequately represent the class as required by Rule 23(a) because the recovery is paid by the corporation (or by its insurer).  As a result, some of the members of the plaintiff class lose more as holders than they recover as buyers.  And all stockholders – buyers as well as holders – are effectively deprived of any recovery by the corporation from the individual wrongdoers.  In short, the plaintiff class is riddled with conflicts.

The Court hinted at this issue in acknowledging Halliburton’s argument that securities fraud class actions “allow plaintiffs to extort large settlements from defendants for meritless claims; punish innocent shareholders, who end up having to pay settlements and judgments; impose excessive costs on businesses; and consume a disproportionately large share of judicial resources.”  Indeed, this is the twelfth case involving securities fraud class actions to reach the Court since 2007.

The root problem is the measure of damages.  In a successful class action, buyers may recover the difference between the price they paid and the market price following corrective disclosure.  But this measure of damages includes some amounts that ought not be recovered by individual investors, including losses from company-specific increases in cost of capital and from expenses of defense as well as fines and indeed damages.  These losses are suffered by the company itself – by all of the stockholders and not just buyers – and should be recovered by the company from the individuals responsible for misleading the market by means of a stockholder derivative action (if the company itself fails to sue). To be clear, the market reacts immediately – which explains why stock price seems to crash when the truth comes out.  In other words, the market does not wait to see if a class action will be filed.  The market knows the law and assesses all of the damage up front.

As things currently stand, investors who happen to buy during the fraud period have a claim for all of their loss – including portions that should belong to the corporation.  And to add insult to injury their fellow stockholders pick up the tab.  Admittedly, stockholders seldom recover all of their losses. Defendant companies almost always settle.  But bargaining happens in the shadow of the law.  If the rule is that a buyer may recover the total loss, that is what the class will claim and that is where negotiations will start.

Fortunately, the courts can deal with the problem if they have the will to do so.  As the late Judge Robert Bork observed, to permit individual recovery on a corporate claim is to divert an asset of the corporation to the plaintiff stockholder to the exclusion of other stockholders.  In other words, the fact that the plaintiff wants to assert a direct class claim for damages does not make it so.  If the claim belongs to the corporation, it should be the subject of a derivative action – not a class action.  Moreover, since class action rules require that a class claim for damages be superior to other means of resolving the dispute, it follows that if a claim can be so handled, it must be so handled.  Thus, the courts have the power – and the duty – to recast a class action as a derivative action.

Needless to say, this would be a big change in the law. And it is not likely to happen quickly. In the meantime, defendant companies will get some relief under this decision.