D&O INSURANCE WATCH: Erica P. John Fund v. Halliburton -- A 'Basic' question: Is this the End of "Fraud on the Market" doctrine?
In 1988, the U.S. Supreme Court decided in Basic v. Levinson, 485 U.S. 224 (1988): a plaintiff in a securities fraud case need not prove actual reliance on statements made by a company before buying or selling its shares. Instead, the Court held that in an efficient market, all publicly available information is reflected in the company's share price. Because public fraudulent statements on behalf of the company would affect that price, a shareholder would not need to show actual reliance on the statements, because the share price would be based on the false statements. But now Halliburton - supported by legal theorists, law professors, former-SEC heavy hitters, and the securities defense bar - is arguing that the Court should reconsider the Basic decision and overrule it.
The case against Halliburton was filed in 2002 by the Erica P. John Fund, (f/k/a the Archdiocese of Milwaukee Supporting Fund), alleging that Halliburton made false and misleading statements about its business, specifically its asbestos liabilities, between 1999 and 2001. The complaint also claims that the company's officers and directors overstated revenue and misled investors in connection with Halliburton's' 1998 merger with rival Dresser Industries. In 2011, the Supreme Court reversed a decision that the Plaintiff had to show that the allegedly false statements had led to a loss for shareholders before the class could be certified. The case was sent back to the District Court and the class has since been certified.
Drawing heavily on an article by Professor Joseph A. Grundfest of Stanford Law School (here), Halliburton is arguing that the doctrine never should have been adopted and that it improperly strips the "actual" reliance requirement out of '34 Act. Accordingly to Professor Grundfest, a textual analysis of the '34 Act with other federal securities statutes shows that Congress intended the '34 Act to mean "actual" reliance.
It is hard to overstate the importance of the Basic decision to shareholders, corporations, their officers and directors, and D&O insurers: In an article in The New York Times this week, discussing the Halliburton petition (here), the author noted, "The Basic decision expanded the universe of possible plaintiffs. By discarding a person-by-person test for reliance, class actions were now easier to bring. And once a class action can be brought, the potential for damages rises exponentially. Companies often have no choice but to settle. … [T]he Basic case has made possible modern-day securities litigation. Without the presumption held in the Basic case, most ordinary investors would be out of luck. It wouldn’t just be the common investor. Index funds, for example, would never be able to prove reliance, because they buy and sell shares simply to reflect an index."
According to Cornerstone Research, between 1997 and 2002, over 3.050 securities litigations were filed, totaling settlements and judgments of a staggering $73.1B. (Almost one quarter of that - $17B - accounted for legal fees paid to Plaintiffs' counsel.)
Most of the $73B was covered by directors and officers insurance. So, obviously, a drop in securities class action cases would mean a drop in D&O payouts; it would also mean a drop in D&O premium. The Times article observes that it appears that at least four justices of the Court favor overruling Basic. While it only takes four justices to consider a case, however, it takes at least five to form a majority. But before Haliburton's argument becomes the law - and not just legal theory - the Court needs to agree next month to take up the Halliburton case, and more to the point, overrule Basic. These are two major hurdles, and ones that will not be reached anytime soon. For now, it is status quo, but as the Times piece suggests, the question of the Court revisiting the "fraud on the market" doctrine may be a case of "when" not "if".