The Supreme Court of the United States is set to hear Halliburton v. Erica P. John Fund, Inc. this spring with a ruling expected late summer or fall. If defendants win, federal securities class actions could be eliminated in most circumstances. This would materially reduce the exposure to directors and officers and insurance carriers providing D&O coverage.
The Halliburton case revisits a short cut that plaintiffs’ lawyers use to band together shareholders as a class, alleging corporations have defrauded investors. The “fraud-on-the-market” theory was created by the high court itself in its 1987 in its Basic Inc. v. Levinson ruling. It determined that investors in securities fraud cases may be presumed to rely on public misrepresentations about stock trading in an efficient market. This made it possible for shareholders to win class certification without proving that each and every class member made investment decisions in actual reliance on the defendant corporation’s alleged misstatements and those of its directors and officers.
The class structure and the plaintiffs’ fees associated with them have driven much of the securities litigation in Silicon Valley. The Basic case created a momentum-shifting uptick in the number of securities class suits, 3,050 suits in a 16 year span accounting for $73 billion in judgments and settlements, and another $17 billion in plaintiff fees as measured by NERA Consulting. An important beginning to those suits was the Basic case, having been cited almost 17,000 times as counted by Westlaw.
Without the presumption of reliance provided by Basic, individual questions of reliance may predominate over class-wide questions, making class certification difficult and class actions for Section 10(b)5 fraud claims almost impossible.
There is a good chance the Halliburton case may modify or overturn Basic. Basic was decided by an unusual four-justice majority in 1987, with three justices recusing themselves from the case. Now, four justices of the Supreme Court have expressed their reservations over Basic while writing their opinions in the Amgen case decided last term. Only one of the five remaining justices is needed to get to a majority. Briefs filed to support the overturn of Basic try to disprove the efficient market theory, show the Court that the presumption has been essentially irrefutable, and go as far as to undo the private right to sue under Section 10(b)5 created by the Court.
While an overturn of Basic would be surprising as the Supreme Court rarely reverses itself, many pundits and legal experts are predicting the Court will make major changes. Those opposed to overturning Basic and retaining the current method of certifying disgruntled shareholders as a class, argue Congress endorsed the Basic precedent by not overturning it through various legislative initiatives, such as Private Securities Litigation Reform Act of 1995, and Sarbanes-Oxley Act.
The Court could also chicken out of any decision on Basic as there is an alternate question in Halliburton (whether price distortion has to be proven prior to class certification) that the Court could decide in isolation and not rule on Basic’s issue of class certification.
If the Court overturns or significantly alters Basic’s presumption of efficient market, it could have a material impact on exposure and insurance. For example:
- We would anticipate an immediate drop in Section 10(b)5 class actions as the plaintiff bar regroups
- Plaintiffs would likely focus on class actions against companies for IPOs, mergers and tender offers
- Public companies could rethink D&O limit levels, particularly companies purchasing large towers in excess of $50M
- Some insurance carriers are already considering modified underwriting strategies that would attempt to gain market share given the perception of reduced risk
- What are now referred to as “opt-out” lawsuits, we may see more institutional investors bringing independent lawsuits
- Plaintiffs may move to state courts to bring class actions in jurisdictions that are plaintiff friendly (this would likely increase defense costs in the early stages of litigation)
- Search by shareholder lawyers for the most plaintiff-friendly state to pursue securities fraud claims
- To offset , the SEC may feel pressured to pursue more Section 10(b)5 investigations
- Congress may act to reinstate the right to bring private actions, although Republican control of the House of Representatives may make such legislation difficult to pass
The Court’s ruling in Halliburton could have favorable short term effects for publicly traded companies. The plaintiff bar does not give up easily, particularly with so much money at stake, so look for them to regroup and reinvent themselves in the longer term.
We will continue to cover this pivotal case, and keep looking ahead for our clients and partners.