Tag Archives: class certification

NY Court Flexes Muscles in Rejecting Bogus “Merger Tax” Settlement

We recently wrote two posts about abuses in bogus plaintiff’s actions challenging merger transactions — litigation designed to generate legal fees for plaintiff’s counsel and not benefits to the company or shareholders.  See Commentary on Abusive State Law Actions Following M&A Deals, and Hi-Crush Securities Class Action Settlement Benefits Lawyers and No One Else.  The first post described a New York state court judge’s willingness to reject a proffered collusive settlement designed to generate unearned benefits to plaintiff’s counsel in return for dismissal of the action and a broad set of releases for the defendants.  The second described a federal court judge’s unfortunate willingness to sign off on a settlement that lined the pockets of plaintiff’s lawyers but gave no real benefit to the purportedly defrauded shareholders.

Today we can report on another enlightened action by a New York state court judge in such a case: City Trading Fund v. Nye, No. 651668/2014 (NY Sup. Ct.).  The opinion includes a remarkable discussion of the nature of frivolous “merger tax” litigation, and includes an unusually frank discussion of why the filing of such cases renders to plaintiff, and the plaintiff’s law firm, unfit to serve as class representatives or class counsel.

The case involved alleged misleading disclosures in connection with an acquisition of Texas Industries, Inc. by Martin Marietta Materials, Inc.  Just before a scheduled hearing on a motion for a preliminary injunction to enjoin the shareholder vote on the proposed transaction, the parties entered into a settlement.  As the court describes, it was “disturbed by the settlement, which presents significant public policy concerns.”  It ordered defendants to file a memorandum addressing the settlement, which was needed because otherwise the defendants would stand mute, as implicitly required by the settlement.

Following a motion to approve the settlement, and the mandated filing by the defendants, Judge Shirley Kornreich of the New York Supreme Court wrote a scathing opinion describing in detail the cynical and abusive nature of the claims asserted and the practice of the plaintiff’s law firm, the Brualdi Law Firm, of filing such claims on behalf of a supposed investor which, in fact, held a portfolio of stocks for the purpose of being able to file what the judge calls “merger tax lawsuits.”  She wrote in detail about why the claims asserted were meritless, and then took the unusual step of describing the sordid practice of the plaintiff’s firm and its “client” as follows:

Plaintiffs allege that CTF is a general partnership and that Bass and Carullo are its partners.  CTF, however, is not a business, at least in the sense that it does not engage in commerce.  It does not sell or manufacture products nor does it provide services.  Rather, CTF is the name of an E*Trade brokerage account belonging to Bass and Carullo.  Before the merger, CTF owned 10 shares of MMM, which was worth approximately $1,200 in April 2014.

This is the modus operandi of Bass and the Brualdi Law Firm.  They purchase nominal amounts of shares in publicly traded companies.  Then, when one of the companies announces a merger, the partnership engages the Brualdi Law Firm to file a merger tax lawsuit.  Since 2010, the Brualdi Law Firm has filed at least 13 lawsuits in this court in the name of different partnerships.  Aside from this lawsuit, the Brualdi Law Firm has filed lawsuits on behalf of entities called RSD Capital (Index No. 651883/2010), Broadbased Equities (Index No. 652413/2011), Broadbased Fund (Index No. 653236/2011), Special Trading Fund (Index No. 653253/2012), Reliant Equities (Index No. 651230/2012), Sector Grid Trading Company (Index No. 650121/2013), Broadway Capital (Index No. 650143/2013), Gotham Investors (Index No. 651831/2013), Realistic Partners (Index No. 654468/2013), Rational Strategies Fund (Index Nos. 653566/2012 & 651625/2013), and Equity Trading (Index No. 650112/2014).  The Brualdi Law Firm resists disclosure of the relationship between these partnerships unless, in the face of an objection, such as GBL § 130, it must disclose who is really behind the curtain.

The Brualdi Law Firm’s recent wave of litigation in this court appears to be a continuation of a business strategy it previously carried out in the Delaware Court of Chancery, which went awry.  See In re SS & C Techs., Inc. S’holders Lit., 948 A2d 1140, 1150 (Del Ch 2008) (“those entities and that relationship raise very disturbing questions and may well disqualify those partnerships or the persons associated with them from serving in a representative capacity in the future”).  The SS & C court sanctioned the Brualdi Law Firm in a merger lawsuit based on immaterial disclosures, which led to the court rejecting the settlement.  See id. at 1142.  Vice Chancellor Lamb held that “the record did not support a finding that plaintiffs’ counsel adequately represented the interests of the class or that the settlement terms [were] fair and reasonable.'”  Id.  After the settlement was rejected, defendants discovered that the Brualdi Law Firm was filing lawsuits on behalf of “a web of small investment partnerships for the sole purpose of bringing stockholder lawsuits”, similar to the CTF-like entities in this court.  See id. at 1144.  Sanctions were imposed for a pattern of unethical conduct, including making false statements to the court, which were compounded by further false statements made to hide the original inaccuracies. See id. at 1145.

In sum, this litigation is “pernicious” for reasons best articulated by defendants’ counsel:

First, permitting Mr. Brualdi’s clients—fictitious entities with no purpose for existing and no economic interests apart from the generation of attorneys’ fees—to act on behalf of classes of other, real investors with actual money staked on the financial health of public companies poses a stark conflict of interest.  Second, that fundamental conflict causes the Brualdi Law Firm to adopt inequitable litigation tactics and to advance meritless claims directed not at vindicating the rights of real shareholders but at maximizing the chance Brualdi Brand litigation will settle, resulting in awards of attorneys’ fees that are wholly out of proportion to any real benefit conferred on shareholders. Making this conflict even worse is the fact that ultimately, the shareholders themselves are (through their ownership of the companies Mr. Brualdi sues) responsible for paying fees awarded to Mr. Brualdi.  Allowing the Brualdi Law Firm’s tactics to succeed wastes judicial resources, undermines the public’s faith and confidence in the courts of this State and impairs the State’s reputation as a fair, welcoming place for companies to do business.

Dkt. 87 at 7-8.  The court could not agree more.

Slip op. at 14-16 (footnotes omitted).

The court went on to discuss why the supposed “corrective disclosures” agreed to as part of the settlement were not at all meaningful to shareholders because they were “grossly immaterial.”  See id. at 16-21.  It then says: “Plaintiffs’ counsel wants $500,000 for bringing this lawsuit.  This lawsuit has already cost the shareholders tens of (or possibly hundreds of) thousands of dollars to defend.  This is a problem.”  Id. at 22 (footnote omitted).

The court then proceeds to bemoan “the current state of merger litigation,” and mentions “proposed reforms to corporate by laws” to address these concerns (presumably referring to the current discussion of “loser pays” derivative actions provisions in corporate bylaws), as follows:

It is no secret that when a public company announces a merger, lawsuits follow. There is nothing inherently wrong with this phenomenon.  If the merger price is woefully unjustifiable or if shareholders are not given adequate disclosure to cast an informed vote, a lawsuit is very much the proper way to redress these matters.  However, the ubiquity and multiplicity of merger lawsuits, colloquially known as a “merger tax”, has caused many to view such lawsuits with a certain degree of skepticism.  The lawsuits are filed only a relatively short time before the shareholder vote, and all it takes is a remote threat of injunction or delay to rationally incentivize settlement, even if defendants firmly and rightfully believe the lawsuit has no merit and would be disposed on a motion to dismiss or at the summary judgment stage.  Most commonly, the lawsuits are brought on behalf of the company being acquired, and the claim is that the shareholders are not being bought-out at a high enough price. This court is well acquainted with such lawsuits. . . .  Likewise, this court, and presumably all counsel in this action, are aware of the proposed reforms to corporate bylaws aimed at addressing the concerns many have with the way in which this litigation occurs.  The wisdom of these reforms and their legality are hotly contested issues. Compelling arguments have been made by a variety of stakeholders. Aside from what one thinks of the proposed reforms, that such reforms are such a hot topic suggests a growing frustration with the current realities of merger taxes.

No one, not even plaintiffs, disputes this reality.  The defendant corporation’s cost-benefit calculus almost always leads the company to settle.  Even a slight change of an adverse outcome will induce a company to rationally settle given the costs.  Here, defendants provide countless examples of such costs, none of which are contested by plaintiffs. See Dkt. 87 at 23-24 (discussing impact on information technology, human resources, sales and marketing, finance, accounting, tax, and regulatory matters); see also In re Delphi Fin. Group S’holder Lit., 2012 WL 729232, at *19 (Del Ch 2012) (“if the merger is enjoined, the deal may be lost forever”); In re CheckFree, 2007 WL 3262188, at *4 (“The theoretical harm to plaintiffs here is not particularly substantial” and “the public interest requires an especially strong showing where a plaintiff seeks to enjoin a premium transaction in the absence of a competing bid”).  The very nature of this lawsuit incentivizes settlement, regardless of its frivolity.

Slip op. at 22-24 (footnotes omitted).

The court finally determines that it “will not certify the class nor will it approve the settlement because it is not in the best interest of the class.”  Judge Kornreich refers to Judge Schweitzer’s “highly persuasive opinion in Gordon v Verizon Communications, Inc., which was the subject of the earlier post Commentary on Abusive State Law Actions Following M&A Deals.  A copy of that opinion is available here: Decision and Order in Gordon v. Verizon Communications.  She concludes: “Here, had plaintiffs alleged material omissions or settled for material supplemental disclosures, the court would have approved the settlement.  Even if the court did not think the supplemental disclosures were worth much, if they were legally material, the court would have withheld any criticism of plaintiffs’ counsel until the final approval stage, when the court, as guardian of the best interests of the class, would have limited the attorneys’ fees award to an amount commensurate with the value of the disclosures.  However, in this case, the supplemental disclosures are utterly immaterial for the reasons discussed earlier. The settlement, therefore, should not be approved. . . .  Approving the settlement in this case would both undermine the public interest and the interests of MMM’s shareholders.  It would incentivize plaintiffs to file frivolous disclosure lawsuits shortly before a merger, knowing they will always procure a settlement and attorneys’ fees under conditions of duress — that is, where it is rational to settle obviously frivolous claims.  Without the court serving as a gatekeeper, plaintiffs who file such ligation will continue to unjustifiably extract money from shareholders, who get no benefit from the litigation but nonetheless end up paying two sets of attorneys, both plaintiffs’ and defendants’.  This is a perverse result.”  Slip op. at 32-33 (footnotes omitted).

Judge Kornreich’s coda is an attack on The Brualdi Firm and the plaintiff “and why they are ill suited to be class counsel and class representative”:

[T]he court does believe they filed this class action because they had a genuine concern for the Company’s corporate governance.  Rather, they are simply trying to make money from litigation.  They and their counsel have accurately identified a massive inefficiency in the way in which courts adjudicate merger litigation, and have capitalized accordingly.  They are, in a word, shrewd investors. Their investment, unfortunately, is in litigation. . . . 

In merger litigation — unlike other class action litigation (e.g., securities fraud) where, if the case is frivolous, the court can dispose of it on a motion to dismiss — the time crunch incentivizes a payout to plaintiffs to settle all cases, even frivolous ones.  Thus, extra scrutiny is warranted when it appears that the incentives of the purported class representatives diverge from those of the shareholders.  Such a divergence of incentives may exist, as is the case here, where it appears that the original plaintiff, CTF — essentially a fictitious entity — seeks to obfuscate what it really is.  When a proposed class representative appears to be a fiction, there is the concern that it has no accountability, either to the class or to the court. . . .

Simply put, the secretive nature in which plaintiffs and their counsel choose to litigate, both here and in Delaware, along with the frivolity of their claims, is a strong indication that they are ill suited to represent the class. . . .

Slip op. at 34-37 (footnote omitted).

Bravo Judge Kornreich.  May the seeds strewn by you and Judge Schweitzer bear fruit in other judicial orchards.

The full opinion can be found here.

Straight Arrow

December 9, 2015

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Judicial Competence in Statistics Will Govern the Future of Securities Class Actions

In today’s post we dig into the weeds of one aspect of what it takes to pursue a class action for alleged fraudulently misleading disclosures by public companies in violation of the federal securities laws.  The recent Supreme Court decision in Erica P. John Fund Inc. v. Halliburton Co., 134 S. Ct. 2398 (2014) (often referred to as Halliburton II because it was the second Supreme Court decision addressing the class action issues in that case), reemphasizes the importance of expert evidence that must be presented by a plaintiff to prove that a class action is appropriate.  That places great weight on the evaluation of such evidence.  There is a small body of case law addressing how to go about doing that, and on August 4, 2014, another case was decided that adds a little to that body of law: Brown v. China Integrated Energy Inc., No. CV 11-02559 (C.D. Cal.).  (Click here to see a copy of Brown v. China Integrated Energy).

First, some background.  A securities fraud action for alleged violations of section 10(b) of the Securities Exchange Act of 1934 requires, among other elements, proof that the plaintiff suffered losses by acting in reliance on the defendants’ alleged fraudulent communications.  In order to proceed as a class action – that is, an action in which a representative plaintiff pursues a case on behalf of many other similarly-situated persons – the plaintiff must show that the key evidence used to prove a case will apply equally to the cases of the “absent class members,” the other plaintiffs who would win or lose based on the representative plaintiff’s case.  Because “reliance” is a subjective concept, to proceed as a class action, a putative class representative must somehow show that its theory of “reliance” would apply equally to show reliance by the absent class members.

As we discussed in our previous post on the Halliburton II decision, in Basic Inc. v. Levinson, 485 U.S. 224 (1988), the Supreme Court decided that private federal securities fraud damage actions for violations of section 10(b) could proceed as class actions if the evidence showed that the security in question traded on an “efficient market” for those securities.  The Court accepted that for such markets, the price of the security necessarily would reflect all material public information about the security, and as a result, both the representative plaintiff and those who engaged in market transactions in the same time-frame would, by completing the transaction, be effectively “relying” on all material information in the marketplace at that time, which would have been incorporated into the price of the security.

As we described in the earlier post:

Basic became the Creator of the Securities Class Action because it formulated a theory by which reliance could be proved en mass without the usual showing that each plaintiff actually relied on the alleged misrepresentation.  It did this by accepting the viability of the “efficient capital markets hypothesis” (ECMH), an economic construct that open and developed securities markets are reasonably efficient marketplaces, which incorporate all publicly available information into stock price reasonably quickly.  485 U.S. at 243-45.  On top of this, it concluded that investors assumed that the prices of stocks on these exchanges fairly reflected accurate publicly-available information about the issuers of those stocks, i.e., that they traded shares “in reliance on the integrity of the price set by the market.”  Id. at 245.  Using these assumptions, the Court created a “presumption” – founded on “considerations of fairness, public policy, and probability, as well as judicial economy” (id.) that allowed securities plaintiffs to prove reliance in private section 10(b) actions en mass: “An investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price.  Because most publicly available information is reflected in market price, an investor’s reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action.”  Id. at 247.  However, that presumption can be rebutted: “Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.”  Id. at 248.

Halliburton II reaffirmed the approach adopted in Basic, leaving in place the basic elements of a class action for alleged violations of section 10(b).  In particular, it left in place the concept that there could be classwide proof of reliance by showing that a security traded on an “efficient market.”  The Halliburton II opinion added to this that a defendant could still avoid class certification in such cases by proving there was, in fact, no price impact from the misleading disclosures alleged in the complaint (and therefore the stock price did not implicitly convey those disclosures).  Both the proof that the security traded on an efficient market and any proof that the security price nevertheless was unaffected by the alleged misrepresentations require expert evidence.  So Halliburton II doubled down on the importance of this type of expert evidence as predicate for securities class action cases.

Experts are notoriously flexible in their ability to perform a supposedly rigorous analysis and yet reach contrary conclusions.  Plaintiffs can be expected to present “experts” whose studies will show the market for the securities at issue was efficient.  Defendants will likewise be expected to present experts who will either use studies to show the opposite, or will poke holes in plaintiff’s expert analysis to show it is unreliable, and therefore the plaintiff failed to satisfy its burden of proving an efficient market.  This places a lot of weight on how courts evaluate and rule on this battle of experts.

The experts in this area rely on statistical or “econometric” analysis to support an opinion.  The statistical analysis involved is called an “event study.”  It involves looking at how the price of the security at issue typically moves in relation to a set of factors in a period during which no fraud is alleged or known.  Usually the experts use a statistical tool called a “regression analysis,” which is a method of estimating the impact on a “dependent variable” (here, changes in the security price) of a range of “independent variables.”  The expert would then look to see how much, if any, the security price departed from the price “predicted” by this formula on days when company-specific information was released.  If the departures from the predicted price are large enough, they would be found “statistically significant” and the expert would opine that the market had characteristics showing efficiency and/or that released information had a specified impact on the price of the security.  

The key word here is “estimate,” because this type of analysis proceeds with a high degree of uncertainty.  The regression analysis looks at a lot of data points and tries to map out a formula (or “model”) of how the dependent variable is affected by the independent variables that comes close to matching the data points.  (Often that model tries to map a straight line through the data points which minimizes how far the data points are from the line, but the same analysis can be used with other possible models such as logarithmic or parabolic relationships between the independent and dependent variables).  One interesting measure, called the “coefficient of determination” or “r-squared,” shows how well the data actually fit the model.  It provides a measure of how well observed outcomes are replicated by the model, i.e., what proportion of total variation of outcomes is, or is not, “explained” by the formula.  Strikingly, many of these analyses in securities cases result in a r-squared in the range of 0.2 to 0.3, which means that the model relied on by the expert for his or her conclusions only explains 20% to 30% of stock price changes, leaving 70% to 80% of the stock price movement unexplained by the analysis.

Not only is there a high degree of uncertainty because of unexplained price movement, but there are many judgmental decisions about how to go about building this “model.”  These would include what time period to use as the “control” period; what independent variables to use; what to do about dates during the control period when there were company-specific disclosures that could impact security price; what period of time after a disclosure to use to determine whether or not there was a price impact (i.e., does the price impact have to occur within one minute of a disclosure, one month of the disclosure, or somewhere in between?); how to attempt to differentiate between the impact of the tested disclosure and other simultaneous events (e.g., disclosures not alleged to be inaccurate) that could be the cause of price movement, etc.  Different choices will often yield different expert opinions.  The courts are just beginning to develop standards by which to judge the efficacy of these kinds of expert opinions.  They will have to become much more proficient at this in the post-Halliburton II era.

It is in this context that Judge Beverly Reid O’Connell waded into the competing expert reports addressing plaintiffs’  motion to certify a class in Brown v. China Integrated Energy.  Plaintiffs presented experts to support their contention that the company’s stock traded on an efficient market.  The court rejected one of the two plaintiff experts for lack of expertise – it turned out that he had nearly zero prior experience addressing the market efficiency issue.  The court permitted expert evidence from plaintiff’s other expert but found his methodology so flawed that his expert opinion on the issue was essentially worthless.  The flaw in his methodology was in how he conducted his event study.  The defense (through its own expert) convinced the judge that key decisions in constructing the event study model were totally subjective, unsupported by any governing standards, and thus “unreliable.”  He used an “entirely subjective approach to selecting events to include” in the event study.  Even though he testified that the conclusions would not have been altered  by changes in the events used, the court found that he “did not follow commonly accepted methods in performing his event study” and therefore “his declaration and testimony are unreliable and should be excluded.”  Without that evidence, plaintiffs could not sustain their burden under Basic and Halliburton II of showing the stock traded on an efficient market, thereby triggering the “fraud on the market” presumption of reliance that would make the claims certifiable as a class action.

Securities lawyers out there had better brush off their college statistics books and learn more about regression analysis.  Especially following the decision in Halliburton II, these will be the front lines in securities class action litigation for some time to come, and federal judges will need a lot of help to determine when putative experts give reliable evidence in this arcane area.

Straight Arrow

August 5, 2014

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Supreme Court Chooses Avoidance and Confusion in Halliburton v. Erica P. John Fund

Here’s a riddle for you: What does the Supreme Court’s June 23, 2014 decision in Halliburton Co. v. Erica P. John Fund, Inc. (No. 13-317) have in common with Oakland, California?  Answer: “There is no there there” (at least according to Gertrude Stein).  Actually, there is considerably more “there” in Oakland than you will find in the opinion of Chief Justice Roberts in Halliburton v. Erica P. John Fund.

The Halliburton decision was the long-awaited opportunity for the Supreme Court to give serious and perhaps enlightened reconsideration to the 25-year reign of Basic Inc. v. Levinson, 485 U.S. 224 (1988), as the Creator of the Securities Class Action.  Alas, the Court chose to avoid the crucial theoretical, practical, and policy issues introduced in Basic, and instead presented us with a lot of fluff, and unclear fluff at that.  The analysis was scant; the reasoning evasive, illogical, and imprecise; the rationales internally inconsistent; and, as icing on the cake, the ultimate holding was unclear, leaving much guessing and costly clarification for the future.  With the loss of this opportunity for clear-headed analysis of the foundation for securities class actions, we face many more years of a cottage industry that benefits only plaintiff and defense securities lawyers.

How Did the Supreme Court Get Us Here?

The Supreme Court’s patent unwillingness to take on these issues is most unfortunate because the Supreme Court is single-handedly responsible for the very existence of private securities litigation under section 10(b) of the Securities Act of 1934 and the SEC’s Rule 10b-5 promulgated thereunder.  Congress never enacted this federal cause of action.  The existence of a so-called “implied private right of action” under section 10(b) and Rule 10b-5 was announced by the Supreme Court in 1971, 37 years after enactment of the 1934 Act, in a footnote in Superintendent of Ins. of N. Y. v. Bankers Life & Casualty Co., 404 U. S. 6, 13 n.9 (1971), which said “it is now established” with absolutely no analysis or reasoning.  The Court soon found that ad hoc legislation of a popular private cause of action can be hard and enduring work.  From that point, the Court took responsibility for determining the parameters of the private action it created that would normally be enacted by statute, like what are the elements of a claim, who has standing to bring a claim, how do you prove damages, what is the statute of limitations, is there a right of contribution against jointly liable persons, etc.  In 1995, in the Private Securities Litigation Reform Act (PSLRA), Congress sought to temper the harmful consequences of the judicially-created federal securities fraud class action, but in doing so explicitly stated that “Nothing in this Act … shall be deemed to create or ratify any implied right of action….”(Public Law 104-67, Section 203).

That brings us to the star of this show, Basic.  By 1988, the Supreme Court had not yet determined fully the elements of the implied private action it created in Bankers Life.  Among the elements never determined was whether that cause of action required proof of reliance by the plaintiff on alleged misrepresentations that caused stocks to be improperly priced in the securities markets.  A reliance requirement created a problem for securities plaintiffs because shareholders engaging in stock transactions typically could not prove they knew about, and acted on the basis of, allegedly misleading statements by companies or their officers.  And even if some could do so, they would have to present individualized evidence showing their reliance in order to prove their claims.  Those individualized showings, which would not carry over from one shareholder to others, would make the claims not susceptible to treatment as a class action because class actions must involve predominantly issues for which common evidence can prove a case for all class members.

What the Court Did in Basic v. Levinson.

The Basic Court quickly resolved the reliance issue, holding that “reliance is an element of a Rule 10b-5 cause of action” because it “provides the requisite causal connection between a defendant’s misrepresentation and a plaintiff’s injury.”  That was consistent with the underpinnings of section 10(b), which was understood to address fraudulent conduct.  Fraud claims in the common law always required proof that the plaintiff was harmed by reasonable reliance on false representations by the defendant.

That left the thorny issue of how these claims could proceed as class actions.  Although private section 10(b) actions could still be brought, the lion’s share of those cases – and the cases that represented huge revenue opportunities for lawyers – were class actions.  A ruling that debilitated securities class actions would make the section 10(b) private action largely underutilized and ineffectual.  Indeed, the comparable cause of action that actually was included by Congress in the 1934 Act – the private action under Section 18 – was rarely used by plaintiffs because it included a requirement that the plaintiff prove a false statement and a purchase or sale “in reliance upon such statement.”  The courts found that this mandated at least “eyeball reliance” by the plaintiff, that is, actual awareness of the statement.

Basic became the Creator of the Securities Class Action because it formulated a theory by which reliance could be proved en mass without the usual showing that each plaintiff actually relied on the alleged misrepresentation.  It did this by accepting the viability of the “efficient capital markets hypothesis” (ECMH), an economic construct that open and developed securities markets are reasonably efficient marketplaces, which incorporate all publicly available information into stock price reasonably quickly.  485 U.S. at 243-45.  On top of this, it concluded that investors assumed that the prices of stocks on these exchanges fairly reflected accurate publicly-available information about the issuers of those stocks, i.e., that they traded shares “in reliance on the integrity of the price set by the market.”  Id. at 245.  Using these assumptions, the Court created a “presumption” – founded on “considerations of fairness, public policy, and probability, as well as judicial economy” (id.) that allowed securities plaintiffs to prove reliance in private section 10(b) actions en mass: “An investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price.  Because most publicly available information is reflected in market price, an investor’s reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action.”  Id. at 247.  However, that presumption can be rebutted: “Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.”  Id. at 248.

By creating the presumption of reliance on the so-called “integrity of the price set by the market,” which incorporated allegedly false public statements and therefore by transitive logic provided reliance on the statements themselves, the Basic court created the mechanism for securities class actions for decades to come.  The decision was worth billions of dollars to future generations of lawyers, all of which was funded by public companies, their shareholders, and their customers.

What Was Wrong with the Basic Decision?

The Basic decision was flawed in both of the key assumptions it made.  It relied on less-than-robust economic evidence about how stock markets function that have been substantially debunked in the last two decades, and it made assumptions about how investors function that lacked substantial evidence even at the time, and certainly are not valid based on what we know today.

The economic grounds are not strong for assuming that for a particular company over a specified period of time, its stock market price is driven by available information about that company, rather than by a variety of other factors, including factors that render the market less than “rationale,” at least for a time, e.g., forms of momentum investing leading to excessive exuberance or pessimism.  Markets for different securities are driven by different considerations at different times, and markets for a particular security are driven by different considerations over time.  As a result, even though the overall market for stocks on an exchange may be generally “reasonably efficient,” really important information about a particular company (accurate or false) may have no impact on market price in some circumstances, and really unimportant information can coincide with significant price movements founded in other factors.  In short, economic studies now show that the efficient capital markets hypothesis relied on in Basic is flawed in many respects because markets often generate prices that are not consistent with available information.  Justice White’s dissent in Basic founded in the inability of the courts to effectively judge the economics of securities markets (485 U.S. at 222-23) was spot on.

The assumption that investors inevitably rely on the market price of a stock fairly reflecting accurate public information about the stock is also seriously flawed, certainly now and almost surely then as well.  Investors – particularly those large institutional investors whose investment decisions drive market prices – are fully aware of the fact that at any point in time public information about a company may be true, false, or somewhere in between.  Not all important information about a company is required to be disclosed.  Many sources of information are unreliable.  There have been large enough and frequent enough examples of company information being unreliable that every knowledgeable investor knows there is always such a risk.  In addition, many investors, including the largest investors in the marketplace, consider the public information about a company irrelevant to their investment decisions.  Countless billions of investor dollars are invested in index funds or index ETFs that are required to purchase stocks without regard to considering company-specific information.  Investors that do consider company information often bet that it is flawed, or that the market has not accurately taken it into account in determining market price.

As a result, both of the key assumptions underlying the fraud-on-the-market theory adopted in Basic are weakly, or at least not strongly, supported.  The Halliburton Court was asked to, and agreed to, reconsider the Basic construct in light of the increasing evidence that the foundation on which that opinion was built is so unsteady that it badly needed to be reconstructed.

The Halliburton Court Whiffed.

The Halliburton Court was squarely presented with three issues: (1) whether to retain Basic’s presumption of reliance on public information based on the two crumbling pillars of the efficient capital markets hypothesis and investors’ assumed reliance on the integrity of market prices; (2) if that presumption is retained, whether in order to invoke that presumption a plaintiff must first show an actual stock price impact of the alleged misleading information; and (3) if plaintiff has no such burden, whether a court was required to consider before certifying a class action evidence proffered by defendants that no such price impact could be shown.

The Court Chose Not To Step to the Plate on the Key Basic Issues.

The Court’s decision on the first issue left much to be desired.  In essence, the Court held that because the Basic Court did not base its decision on the uniform applicability of either efficient markets or reliance on price integrity in all circumstances, there was insufficient evidence of changed circumstances since then to overturn the earlier decision under the principle of stare decisis.  What amount of evidence would have been sufficient to cause reconsideration was unstated and remains unknown.  And whether this Court, based on the enormous amount of additional research and evidence accumulated since 1988, believes the Basic  presumption remains warranted, was simply not addressed.  In essence, the Court wrote that because the Basic Court was content to rely on rough assumptions about efficient markets and investor motivations, and those rough assumptions could not be proved generally wrong wrong in all, or even most, cases, it would not reexamine that Court’s analysis and conclusions.

The Court phrased this by saying that the defendant did not succeed at presenting a “special justification” for overturning Basic, rather than simply showing it was “wrongly decided.”  (Slip. Op. at 4.)  It acknowledged the numerous studies since 1988 addressing the ECMH, but noted that even the defendant did not argue that capital markets are always inefficient.  Since Basic never said that all markets were efficient at all times, its decision could not be deemed flawed on that basis.  And because even today it is acknowledged by ECMH critics “that public information generally affects stock prices,” the point should not dwelled upon because “Debates about the precise degree to which stock prices accurately reflect public information are thus largely beside the point.”  (Id. at 10-11.)  Yet, without determining the “degree” to which Basic’s key presumption was really valid, the Court went on to opine that defendant “has not identified the kind of fundamental shift in economic theory that could justify overruling” Basic (id. at 11).

In other words, even if, based on the scholarly work done in the past 25 years, today’s Court could not accept the assumptions made in the Basic opinion about the ECMH, it would not reconsider Basic on that basis.  The Court made no effort to describe what amount  or “degree” of contrary economic evidence or scholarly work would be sufficient to evidence the required “fundamental shift.”  When is enough enough?  The Court did not even attempt to let us know.

The same theme applied to the Basic assumption of investor reliance on the “integrity of market price,” which was not based on any theory or analysis when first made.  Despite numerous examples showing that the assumption simply was not correct, and was not correct in large respects (e.g., seven of the top 10 mutual funds are index funds), the Court said “Basic never denied the existence of such investors,” and blithely accepted as reasonable Basic’s “presumption” that investors will rely on a security’s market price “as an unbiased assessment of the security’s value in light of all public information” (id. at 11-12).  Without any apparent analysis of the evidence underlying that assumption – which is critical to the reliance-on-the-market theory – the Court speculated about ways that investors might rely on prices as indications of value, thereby simply recapitulating the errors of the Basic court.  See id. at 12.

The Court justified this massive failure to subject Basic’s reliance-on-the-market presumption to rigorous analysis on the principle of stare decisis, and gallingly did so in supposed deference to Congress.  But, as we have seen, Congress had essentially nothing to do with the adoption and development of the private right of action under section 10(b), the elaboration of the elements of the claim, or the formulation of the Basic presumption.  The section 10(b) private action, and especially the section 10(b) class action, are purely judicially-created creatures.  To shy away from reconsidering the quasi-legislative decision of the Basic Court in the purported name of deference to Congress smacks of a cynical effort to avoid either recognizing or cleaning up your own mess.

The Ruling on the Role of Price Impact Evidence Is Vague, Confusing, and Inconsistent.

Having decided to take a pass on the core Basic issues, the Court turned to the more mundane question of what evidence should be considered to determine a motion for class certification in a fraud-on-the-market securities class action.  Even in this respect, the analysis is muddled and the result difficult to justify (or even understand).

In the court below, the defendant presented evidence that certification should be denied because plaintiff did not present evidence supporting loss causation – that its alleged loss was caused by the allegedly misleading disclosures.  The district court agreed and denied certification, and the court of appeals affirmed.  On appeal, the Supreme Court decided in an earlier Halliburton decision that proof of loss causation, while an element of the claim, was not a prerequisite for class certification because loss causation was not crucial to the application of the fraud-on-the-market doctrine (and therefore the mere lack of loss causation does not implicate predominant individualized issues that would preclude certification), and that it could be proved through evidence applicable to the entire class after certification.  See Erica P. John Fund, Inc. v. Halliburton Co., 131 S.Ct. 2179 (2011) (Halliburton I).  The case was remanded for further consideration of certification.

On remand, the defendant argued that the economic analysis it presented showed that the alleged misleading disclosures did not have any impact on Halliburton’s stock price, and therefore certification was improper because the key aspect of Basic’s fraud-on-the-market doctrine could not be satisfied: that plaintiffs purchased stock at a price distorted by the allegedly false disclosures, and therefore plaintiff’s reliance on the “integrity of market price” produced a transitive form of reliance on the underlying allegedly false disclosures.  In other words, if the price was not affected by the disclosures, plaintiff’s reliance on the price did not show reliance on the disclosures.  The district court rejected that argument and certified the class, believing that the earlier decision in Halliburton I precluded it, and that decision was affirmed by the court of appeals.

So the Supreme Court was faced with deciding what impact, if any, the lack of evidence of price impact of allegedly false disclosures should have on certifying a class.  The Court effectively split the baby on that issue.  It acknowledged that a plaintiff has the burden of proving all elements required to support class certification, including the predominance of class issues.  It also acknowledged that in a fraud-on-the-market case, that required a classwide form of proof of reliance on the alleged misrepresentations.  But it never expressly imposed on plaintiffs the burden of presenting such proof.  Instead, it held that under the still-breathing Basic presumption of reliance, once an efficient market for the security is shown (which is plaintiff’s burden), that is all a plaintiff must do on this issue to support certification.  If, however, the defendant proves there was no price impact from the alleged misrepresentations, the class could not be certified because the principle underpinning of Basic – reliance on the integrity of market price – would not yield an inference of general investor reliance on the allegedly false statements.

The critical issue is one of burden: who has the burden of showing price impact?  The Court acknowledged, indeed, emphasized, that price impact was essential to support a Basic presumption of reliance.  See slip op. at 21 (“Price impact is thus an essential precondition for any Rule 10b-5 class action.”).  Yet, the Court never once states with clarity that it is plaintiff’s burden to prove this “essential precondition.”  Instead, it holds that plaintiffs may “establish that precondition indirectly” (id.) by means of showing the misrepresentation was public, “the stock traded in a generally efficient market,” and they “purchased the stock at the market price during the relevant period.”  Id. at 17-18.  The Court instructs that plaintiffs “need not directly prove price impact” (id. at 18).

The Court permits the defendant to come forward with evidence of no price impact, but what happens then is not clear.  Here is what the Court says: “While Basic allows plaintiffs to establish that precondition [price impact] indirectly [via proof of a “generally” efficient market], it does not require courts to ignore a defendant’s direct, more salient evidence showing that the alleged misrepresentation did not actually affect the stock’s market price and, consequently, that the Basic presumption does not apply.”  Id. at 21 (emphasis added).  Elsewhere, the Court says that defendants “may seek to defeat the Basic presumption … through direct as well as indirect price impact evidence.”  Id. at 22-23.

If price impact is a “precondition” for the Basic  presumption of reliance, why didn’t the Court simply say that it is plaintiff’s burden to prove price impact in its motion for class certification?  That burden could be satisfied by the Basic presumption if there is no contrary evidence, but if the defendant introduces credible contrary evidence, it would remain plaintiff’s burden to prove price impact, giving due consideration to the strength of the supporting indirect evidence (of market efficiency) and the strength of the contrary direct evidence on price impact.  One might say that should be obvious, but the Court’s language suggests otherwise – it suggests that once the presumption is in place, the defendant has the burden of disproving the presumption though “more salient evidence.”  As a result, the Court, without any stated justification, and despite recognizing that plaintiff has the burden of supporting class certification, appears to shift the burden to defendants to prove there was no price impact.

You may say it doesn’t matter that the Court never expressly recognizes the burden of proving price impact is on plaintiff – that it is implicit and obvious that this would be required.  My reaction is that the language chosen by the Court strangely leaves that issue open, especially when Justice Ginsburg’s concurring opinion plainly identified that issue by saying that the concurring justices believe the majority opinion places the burden of proof on defendants (“the Court recognizes that it is incumbent upon the defendant to show the absence of price impact….  The Court’s judgment, therefore, should impose no heavy toll on securities-fraud plaintiffs with tenable claims.”).  Id. (Ginsburg, J., concurring), at 1.

The reason the burden issue is critical relates to the nature of evidence that can realistically be generated on the issue of price impact.  The question of whether specific disclosures had an impact on stock price is addressed by econometricians with an event study.  That event study uses a regression analysis to predict expect market price based on historic price movement over time, and tests whether in the period following particular disclosures the stock price departed significantly (from a statistical standpoint) from the expected price.  Critically, this type of analysis can show that stock price was not statistically different from expectations at the time of a disclosure, but often cannot show whether a specific disclosure had “no price impact.”  That is because often such disclosures occur together with conflating information that make it difficult (or impossible) to determine the specific impact of different pieces of information disclosed at the same time.  For example, the announcement of a past quarter’s earnings, future earnings expectations, and other business operational information in one press release or conference call makes it very difficult to test the stock price impact of each of those disclosures on its own.  That is why the burden of proof is so  critical.  If the plaintiff has the burden of showing that an allegedly false disclosure impacted stock price, it will often have difficulty sustaining that burden.  But if the burden is shifted to the defense to show that information had no stock price impact, it likewise will often have difficulty satisfying that burden.  The presence of conflating information impedes either side from satisfying the burden, so where the burden is placed is critical.

So what happens now when the securities plaintiff sues by identifying one out of several disclosure as false and alleges that disclosure to be responsible for a stock price decline?  As I read Halliburton, the plaintiff can rely on the Basic presumption, and even though it cannot sustain the burden of showing that this particular allegedly false disclosure had a price impact (and therefore cannot prove a “prerequisite” for applying the Basic presumption), the claim will proceed as a class action even if the defendant shows that plaintiff cannot support its allegation of price impact, if the defendant cannot go further by presenting “more salient evidence showing that the alleged misrepresentation did not actually affect the stock’s market price.”

Perhaps this won’t be what happens.  Perhaps district courts and courts of appeals will see the fundamental inconsistency between placing the burden on plaintiffs to show certification is warranted but requiring the defendant to disprove a key prerequisite for that certification.  Perhaps proof by defendants that plaintiff cannot show price impact will be treated by lower courts as shifting the burden back to plaintiffs to show they can.  But if past history is prologue, by using language that creates ambiguity on this fundamental point, the Supreme Court will leave the lower courts in disarray and the issue will remain in doubt for years.

One thing is virtually certain.  Given the amount of money at stake, each inch of ground will be hard fought by both sides, and millions upon millions of dollars will flow to the plaintiffs’ and defendants’ lawyers who man the trenches.  That is apparent already from lawyer commentary here, and here.

In the end, the Supreme Court squandered an opportunity decades in the making to scrutinize seriously and with precision the highly flawed, quasi-legislative fraud-on-the-market theory pronounced in Basic.  The Court chose not to take the hard path and ended up with a result that is unlikely to alter fundamentally the securities class action industry.  Unless lower courts put a more restrictive gloss on the price impact requirement for class certification, future bear markets will bring investment losses to shareholders, lucrative class action plaintiff and defense work for lawyers, and large settlements for companies.

Straight Arrow

June 26, 2014

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