Photo by: Jamie Rector/Getty Images.
Do you want less paperwork in your life? If so, the Supreme Court and Delaware state legislature might make your life easier! In a coincidence of rather uncanny timing, both bodies are weighing whether to make securities class action lawsuits radically more difficult to pursue—something with big potential implications for investors and the companies they own.
Securities class actions, for those not familiar, are lawsuits brought by a company’s shareholders against the company itself for issuing fraudulent or misleading information—whether an outright lie or a willful omission of an ugly truth. These lawsuits have become a regular occurrence over the past several years, averaging 191 annually from 1997-2013, and they tend to spike during big downturns. But they weren’t always so common. Before 1988, it was exceedingly difficult for a company’s shareholders to claim damages if they were defrauded—they had to prove their investing decision relied on that misleading information. Not exactly an easy thing to show beyond a doubt.
This changed with the landmark Supreme Court case Basic v. Levinson, which established the “fraud on the market” (FOTM) presumption—that if you owned the stock at any time between the misinformation’s issuance and when the company fessed up, you were de facto misled. Even if you weren’t aware of the information in question. This might sound bizarre, but it has a reasonable theoretical underpinning: The Efficient Markets Hypothesis. FOTM assumes a relatively strong interpretation of this theory: Markets price in all public information near-instantly, including all misleading statements, so as soon as the lie is out there, the stock’s price reflects it. Thus, if you based your investment decision on the price, you were as good as misled. This, of course, makes claiming damages much simpler—hence the soaring number of securities class actions.
FOTM has its critics, with some arguing that interpretation of the Efficient Markets Hypothesis is too extreme—it ignores the ample evidence of the market’s short-term inefficiencies. This issue is at the heart of the Supreme Court case Halliburton Co. v. Erica P. John Fund, Inc., which was heard in March and should get a ruling any day. Justices are weighing whether to overturn or modify FOTM and whether to allow defendants to rebut lawsuits simply by proving the misleading information didn’t distort its stock price—a sort of middle ground between FOTM and the pre-1988 system. Legal analysts suspect this will be the Court’s preference, based on the Justices’ comments during the hearing, though we’d note Supreme Court decisions aren’t a gameable market function.
If Basic goes bye bye, it will become significantly more difficult for securities class action plaintiffs to prove their claims. And if Delaware’s legislature upholds a recent state court decision, it could become significantly more expensive if they lose: Plaintiffs could end up paying the company’s legal fees.
In most states, each party in a corporate lawsuit covers its own legal expenses regardless of the outcome. But in May, the Delaware Supreme Court ruled corporate bylaws can include clauses requiring investors who sue and lose to pay the company’s legal fees—an obvious deterrent, considering the astronomical fees companies can rack up in the name of self-defense. Now, Delaware is just one state, but it happens to be the one where most publicly traded US companies are incorporated, so Delaware practice could set a national standard and the ruling a precedent. If it sticks, that is. Lawyers, predictably, weren’t amused by the court’s ruling—“loser-pays” is a huge incentive against suing, which probably puts a bunch of them out of business. So they backed (wink wink) legislation to outright ban loser-pays. The vote is still pending, but observers note measures backed by the state bar have an uncanny knack for passing.
There are a few potential outcomes here—the status quo of the last 26 years, if FOTM stays while the Delaware legislature bans loser-pays; a class action clampdown if FOTM goes and loser-pays stays; and some form of middle ground if FOTM is scrapped or watered down and loser-pays goes. Any of these will create winners and losers. Class action proponents argue legal recourse offers investors a way to keep corporations accountable—important even if the financial rewards of a legal victory or settlement usually amount to pennies per share for most folks. Others argue the low bar for class actions forces companies to spend too much on in-house legal and compliance—capital that could go to better use (and perhaps better benefit shareholders) in more growth-oriented undertakings like research and development.
Our hunch is this isn’t a huge market driver either way—and there isn’t a counterfactual to weigh on either side. One thing does seem clear, though: Investors will always have to deal with the possibility of companies issuing misleading information. Yes, it’s illegal, but it’s a sad fact in this world that people will break the law occasionally—some execs just don’t have good values. Class actions or no, looking beyond a company’s official statements—scouring footnotes, disclosures and all available resources—will remain key to making fully informed stock decisions.