The villain in the fight against securities class actions is the fraud-on-the-market presumption of reliance established by the U.S. Supreme Court in 1988 in Basic Inc. v. Levinson, 485 U.S. 224 (1988). Without Basic, the thinking goes, a plaintiff could not maintain a securities class action, and without securities class actions, executives could speak their minds without worrying so much about securities law liability. In the current environment, the risk of further attacks on Basic seems high. (A general class action reform bill, the “Fairness in Class Action Litigation Act of 2017,” has already been introduced in the House—analyzed by Alison Frankel here, and by Kevin LaCroix here.)
But Basic ballasts the system of securities-law enforcement by protecting investors, while providing companies with predictable procedures and finality upon settlement. We have a lead plaintiff and class representative who prosecutes a claim that defendants can settle with a broad class-wide release. Because the private plaintiffs’ bar is doing its job, the SEC stays away in most cases. Honest executives have nothing to fear with the current system—they routinely get through securities litigation without any real reputational or personal financial risk.
On the other hand, without Basic, plaintiffs’ lawyers would still file securities litigation. In place of class actions, each plaintiffs’ firm would file an individual or multi-plaintiff collective action, resulting in multiple separate actions in courts around the country. These would be difficult to manage, expensive to defend, and impossible to settle with finality until the statute of limitations expires. SEC enforcement would become more frequent. Companies and their D&O insurers and brokers would be unable to predict and properly insure against the risk of a disclosure problem.
Moreover, I have never understood the supposed benefits of abolishing Basic. Although it is possible that the frequency of securities litigation would decline, I doubt it would. A disclosure problem that would trigger a securities class action today would result in at least several non-class securities actions in a post-Basic system.
And any decrease in frequency would come at a high cost—in addition to the increased cost of defending and resolving those cases that are filed, investors and the economy would suffer from more securities fraud resulting from the diminished deterrence that class actions provide. Even an executive who detests securities class actions pictures prominent plaintiffs’ lawyers when he or she decides whether to omit an important fact.
So, to those who bash Basic, be careful what you wish for.
A Brief History of the Fraud-on-the-Market Doctrine
The fraud-on-the-market doctrine concerns the reliance element of a Section 10(b) claim. Absent some way to harmonize individual issues of reliance, class treatment of a securities class action is not possible; individual issues overwhelm common ones, precluding certification under Federal Rule of Civil Procedure 23(b)(3). In Basic, the Supreme Court provided a solution: a rebuttable presumption of reliance based on the fraud-on-the-market theory, which provides that a security traded on an efficient market reflects all public material information. Purchasers (or sellers) rely on the integrity of the market price, and thus on a material misrepresentation. Decisions following Basic have established three conditions to its application: market efficiency, a public misrepresentation, and a purchase (or sale) between the misrepresentation and the disclosure of the “truth.”
Over the years, defendants have argued that, absent a showing by plaintiffs that the challenged statements were material, or upon a showing by defendants that they were not, the presumption is not applicable or has been rebutted. And, in a twist on such arguments, defendants sometimes argued that the absence of loss causation rebutted the presumption. In Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011), the Supreme Court unanimously rejected the latter argument, finding that loss causation is not a condition of the presumption of reliance. But the Court explicitly left the door open for the argument that plaintiffs must prove materiality for the presumption of reliance to apply.
Later, the Court granted certiorari in Amgen Inc. v. Conn. Ret. Plans and Trust Funds, 133 S. Ct. 1184 (2013), to review the Ninth Circuit’s decision that plaintiffs are not required to prove materiality for the presumption to apply, and that the district court is not required to allow defendants to present evidence rebutting the applicability of the presumption before certifying a class. In a majority opinion authored by Justice Ginsburg, and joined by Chief Justice John Roberts and Justices Breyer, Alito, Sotomayor, and Kagan, the Amgen Court concluded that proof of materiality was not necessary to demonstrate, as Rule 23(b)(3) requires, that questions of law or fact common to the class will “predominate over any questions affecting only individual members.”
As Amgen was being litigated in the Supreme Court, the parties in Halliburton were briefing the plaintiffs’ class certification motion on remand. The district court certified a class, prior to the Supreme Court’s decision in Amgen. Halliburton sought and obtained Rule 23(f) certification from the Fifth Circuit, which affirmed, after the Supreme Court decided Amgen. The Halliburton case ended up before the Supreme Court once again, this time with the viability of Basic squarely presented. The Court rejected Halliburton’s argument that Basic is inconsistent with modern economic theory, under which market efficiency is not a binary “yes or no” issue. Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014). Thus, Basic survived the Halliburton battle.
What Would Securities Litigation Look Like without Basic?
Our current securities class action system is straightforward and predictable. Like any other action, a securities class action starts with the filing of a complaint by a plaintiff. But after that, the procedure for these actions is unique. The Reform Act mandates that the first plaintiff to file a securities class action publish a press release giving notice of the lawsuit and advising class members that they can attempt to be the “lead plaintiff” by filing a motion with the court within 60 days of the press release. Additional plaintiffs will often file their own complaints in advance of the deadline, or they may simply file a motion to become lead plaintiff at the deadline.
The Reform Act provides that the “presumptively most adequate lead plaintiff” is the one who “has the largest financial interest in the relief sought by the class” and otherwise meets the requirements of Rule 23 of the Federal Rules of Civil Procedure, which governs class actions. The Reform Act’s standards for lead plaintiff selection have caused plaintiffs’ firms to pursue institutional investors and pension funds as plaintiffs, since they are more likely to be able to show the financial interest necessary to be designated as lead plaintiffs. But as I have chronicled, in recent years, smaller plaintiffs’ firms have won lead-plaintiff contests with retail investors as lead plaintiffs, primarily in securities class actions against smaller companies. About half of all securities class actions are filed against smaller companies by these smaller plaintiffs’ firms.
This deeper and more diverse new roster of plaintiffs’ firms means that securities litigation won’t just go away if they can’t file securities class actions. The larger plaintiffs’ firms have strong client relationships with the institutional investors the Reform Act incentivized them to develop. Claims by the retail investors that the Reform Act sought to replace have made a resurgence through relationships with smaller plaintiffs’ firms. Together, these plaintiffs and plaintiffs’ firms fully cover the securities litigation landscape. These firms are competitive with one another. One will rush to file a case, and if one files, others will too. They are specialized securities lawyers, and they aren’t going to become baristas or bartenders if Basic is abolished. They will seek out cases to file.
So the plaintiffs’ bar would adjust, just as they have adjusted to limited federal-court jurisdiction under Morrison v. National Australia Bank, 561 U.S. 247 (2010). And if the post-Morrison framework is any indication of what we would face post-Basic, look out—Morrison has caused the proliferation of unbelievably expensive litigation around the world, without the ability to effectively coordinate or settle it for a reasonable amount with certain releases.
In a post-Basic world, the plaintiffs’ firms with institutional investor clients would likely file large individual and non-class collective actions. Smaller plaintiffs’ firms would also file individual and non-class collective actions. The damages in cases filed by smaller firms would tend to be smaller, but the litigation burdens would be similar.
Non-class securities actions would be no less expensive to defend than today’s class actions, since they would involve litigation of the same core merits issues. In fact, non-class litigation would be even more expensive in certain respects because, for example, there would be multiple damages analyses and vastly more complex case management. And if securities class action opt-out litigation experience is indicative of the settlement value of such cases, they would tend to settle for a larger percentage of damages than today’s securities class actions.
In a new non-class era of securities litigation, the settlement logistics would be vastly more difficult. It’s hard enough to mediate with one plaintiffs’ firm and one lead plaintiff. Imagine mediation with a dozen or more plaintiffs’ firms and even more plaintiffs. We often object to lead-plaintiff groups because of the difficulty of dealing with a group of plaintiffs instead of just one. In a world without securities class actions, the adversary would be far, far worse—a collection of plaintiffs and plaintiffs’ firms with no set of rules for getting along.
Even when settlement could be achieved, it wouldn’t preclude suits by other purchasers during the period of inflation, because there would be no due process procedure to bind them, as there is when there’s a certified class with notice and an opportunity to object or opt out. Indeed, there likely would develop a trend of random follow-up suits by even smaller plaintiffs’ firms after the larger cases have settled. There would be no peace absent the expiration of the statute of limitations.
These unmanageable and unpredictable economics would disrupt D&O insurance purchasing decisions and cost. Under the current system, D&O insurers and brokers can reliably predict the risk a particular company faces based on its size and other characteristics. A company can thus purchase a D&O insurance program that fits its risk profile.
Compounding the uncertainty of all of this would be the role of SEC and other government enforcement. Even with the current U.S. administration’s relatively hands-off regulatory approach, the job of the human beings who work at the SEC is to investigate and enforce the securities laws. They aren’t going to not do their jobs just because government regulation has been eased in the bigger picture. And they will step in to fill the void left by the inability of plaintiffs to bring securities class actions. Experienced defense counsel can predict how plaintiffs’ firms will litigate and resolve a case, but they have much less ability to predict how an enforcement person with whom he or she may never have dealt will approach a case.
Executives who do their best to tell the truth really have nothing to fear under the securities laws. The law gives them plenty of protection, and the predictability of the current system allows them to understand their risk and resolve litigation with certainty. It would be a mistake to try to abolish securities class actions. Abandoning Basic would backfire—badly.