Halliburton II

The Supreme Court’s decision in Halliburton affirms a legal doctrine that for several decades has set the United States apart from most other countries.  Lawyers who claim to represent enormous numbers of investors, most of whom have never met the lawyers, are allowed to sue public companies for alleged misrepresentations of material facts even if a substantial number, perhaps most, of the plaintiff investors never heard or read, much less relied upon, the alleged misrepresentations.  When these class actions settle (almost all of them do settle rather than go to trial) damages are paid by the company to the plaintiff class, with the lawyers taking their fees off the top.  The company’s current shareholders thus bear the cost of compensating the plaintiff investors and their lawyers.  To the extent the plaintiff class includes current shareholders, these shareholders are paying themselves damages, less of course the share that goes to the lawyers.

The purported purpose of all of this is to deter misrepresentations to begin with.  Corporate managers who know they will be sued for misrepresentations won’t make them, and this deterrence alone presumably is worth the cost of lawsuits in which one group of investors (current shareholders) compensates another group of investors (persons who bought during the class period) and their lawyers.  Never mind that the bulk of the cost of these lawsuits is absorbed by the company and its shareholders, and not by the managers who make the alleged misstatements.   Presumably these managers are deterred from making false statements because of the threat of lawsuits.

A few of the many questions that foreign and domestic critics of this litigation regime have are:

* If there is so much deterrence from these suits, how come there are so many of them responding to so many incidents of alleged fraud?

*Wouldn’t it be better for suits to be brought only against the individual managers who make or authorize misstatements to investors, so they can compensate investors, rather than holding the company liable so its current shareholders have to bear most of the costs?

*If this system of class action securities litigation is so effective, how come very few other countries in the world are using it to deter securities fraud?

* Why are investors who cannot prove that they relied upon a particular statement allowed to sue over that statement when common law fraud actions generally require proof of individual reliance?

There are some good responses to these questions.  Perhaps there would be even more misrepresentations to investors if there were no securities class actions to deter corporate managers from making misstatements.  Perhaps holding the company liable is important for creating a sufficient deterrent as well as a sufficient incentive for plaintiffs’ lawyers to bring the suits.  Perhaps other countries are behind the U.S. in carrying out the investor protection mandate, and indeed there is some evidence that a few other countries such as the Netherlands are allowing more class actions (I discuss this in a recent article coauthored with Wulf Kaal in the Minnesota Law Review).  Perhaps securities class actions should be different from common law fraud claims because small investors simply would not sue if they had to show individual reliance on the company’s misrepresentations.

There are good arguments, on both sides.  So who should decide?  Should courts decide or should Congress decide.   Congress is after all the legislative body that passed the 1933 and 1934 Acts, a host of amendments thereto, the Sarbanes-Oxley Act of 2002 and the almost one thousand page Dodd-Frank Act of 2010.  Congress presumably knows how to regulate securities markets, or thinks it does, and Congress certainly knows how to create private rights of action under the securities laws, including private rights of action such as sections 11 and 12 of the 1933 Act (neither of those express private rights of action for false statements made in the sale of securities requires a plaintiff to show individual reliance on the false statements, although the express private right of action in section 18 of the 1934 Act for open market purchasers relying upon false SEC filings, does require individual reliance).

So what did Congress decide with respect to lawsuits brought under the provision at issue in Halliburton, section 10b of the 1934 Act?  Congress did not address that issue because Congress did not, and has never, created an express private right of action under section 10b.   The courts made it up, and Congress did nothing to reverse it.  Our Constitution does not say that law should be made in that way – courts make up rules which become binding precedent unless Congress acts to legislatively overrule or “veto” the courts – but that is what has happened to section 10b.  With Basic, and now Halliburton, this judicial law creation includes not just a private right of action where there was none in the statute but a departure from the reliance requirement for fraud suits so plaintiffs lawyers can have an easier time assembling class actions.

The problem for this approach is that the Supreme Court has already recognized its limitations in a global securities market.  In Morrison v. National Australia Bank, the Court in 2010 held that section 10b, and presumably the rest of the US securities laws, only apply to securities transactions taking place inside the United States.  This means that public companies and investors who want to opt out of the “fraud on the market theory” endorsed by the Court in Halliburton can do so by issuing securities and trading securities outside the United States.  With the explosive growth of securities markets outside the United States, particularly in Asia, many companies and investors may do just that.  And the fact that the Supreme Court in Halliburton has embraced a “fraud on the market” doctrine that not a single national legislature, including the United States Congress, has adopted, does not necessarily bode well for the competitiveness of US markets on the global stage.  The age of American “exceptionalism” may be drawing to a close in the realm of investor protection and securities litigation.

Although Congress should not be in a position of having to “veto” laws made up by the courts, perhaps it needs to do just that and pass legislation rejecting the fraud on the market theory in securities class actions.  Congress could also consider stricter measures to hold corporate managers responsible for misleading statements to investors – for example requiring that a portion of SEC fines and civil judgments imposed against a company for securities law violations come out of executive compensation instead of being taken only out of the pocket of shareholders.  If Congress does nothing, many issuers and investors may find our obsession with class action litigation, and our unwillingness to make individuals instead of shareholders pay for fraud, to be an aberration that they no longer have to put up with in a global market.  They may simply take their business elsewhere.

Richard W. Painter is the S. Walter Richey Professor of Corporate Law at the University of Minnesota Law School.