Institutional investors are holding their collective breath as the Supreme Court considers making it harder to bring class-action securities lawsuits.
On March 5, the justices will hear arguments in Halliburton Co. vs. Erica P. John Fund Inc., a case challenging a 25-year-old legal precedent that allows class actions to go forward on the presumption that stock prices can be negatively affected by corporate actions or misrepresentations.
“This is a fundamental right that investors can pursue, and most public pension systems have been very active (in class-action suits),” said Michael McCauley, senior officer for investment programs and governance with the Florida State Board of Administration, Tallahassee. “I think it will be a very significant ruling.”
The Supreme Court's decision is expected in June. Its ramifications will go far beyond the parties themselves, as numerous groups have taken sides in the case.
On one side are institutional investors from groups like AARP and the Council of Institutional Investors in Washington. The council's friend-of-the-court brief argues to preserve the status quo. That amicus brief was signed by 20 pension fund members, including the $282.5 billion California Public Employees' Retirement System, Sacramento; the $176.2 billion California State Teachers' Retirement System, West Sacramento; the $173.2 billion New York State Common Retirement Fund, Albany; the $42.3 billion Colorado Public Employees' Retirement Association, Denver; and the Florida SBA, which oversees $171.7 billion in assets.
The Department of Justice and the Securities and Exchange Commission also are supporting that side of the case, which has attracted a total of 23 friend-of-the-court briefs altogether.
Arguing the opposite are business groups like the U.S. Chamber of Commerce and some legal scholars, who complain the underlying legal premise Halliburton is challenging makes securities class-action lawsuits too easy to start, while the cost of litigating often leads to settlements regardless of a case's merits. An analysis by economic and financial consulting firm Cornerstone Research found that of securities fraud cases filed between 1996 and 2011, 67% were dismissed or settled before the merits of the case were argued.
Recruiting public funds
In statements, Chamber of Commerce officials said public pension funds in particular have been recruited by class-action law firms to be “frequent filers” of such cases since 1995, when securities litigation reforms tightened the standards for individual investors to serve in that role.
A new study conducted for the U.S. Chamber Institute for Legal Reform by Navigant Consulting, a management consulting firm, found that in the 1,456 cases settled between 1995 and January 2014, the cost to investors was $39 billion. while the recoveries were $5 billion. Navigant found that filing a lawsuit erased a median 4.4% of shareholder value.
The legal precedent at the heart of the case is Basic vs. Levinson, a 1988 decision that established the fraud-on-the-market theory, a presumption of reliance on market prices, which has since become a bedrock principle of securities litigation. “The issue front and center for the court is whether to retain this presumption,” said CII General Counsel Jeff Mahoney. Deciding to change it “would be a pretty big deal.“
Whether pension funds actively or passively participate in lawsuits, “congressional intent (in the 1995 reforms) explicitly encouraged these cases,” and the Securities and Exchange Commission also supports the right to private action as a complement to the agency's enforcement efforts, he said.
“We certainly agree with the SEC that private rights of action are necessary to help deter fraud, which helps with confidence in the markets,” said Mr. Mahoney.
Gregory W. Smith, executive director of Colorado PERA, said in an e-mailed response to questions. “The viability of private rights of action for securities fraud is critically important to an environment of accountability. The Halliburton case threatens that avenue and weakens the deterrence.”
That is particularly true for large institutional investors that rely heavily on passive investments, most notably in equities. They might not have the resources to initiate fraud cases, but “as part of their fiduciary obligations, they do monitor the cases. If there's a settlement or a judgment, that's something they have to pursue,” said Mr. Mahoney. Some public pension funds' policies even dictate that officials consider serving as lead plaintiff in securities class-action cases.
According to data from NERA Economic Consulting, an economic and financial impact consulting firm, institutional investors were lead plaintiffs in 62% of securities class actions settled in 2011. Public pension funds were lead plaintiffs in 37% of all cases in 2011; cases where a public pension fund was the lead plaintiff resulted in higher awards that year. The median settlement in 2011 was $22.75 million for actions led by other institutional investors, but $96.3 million when led by public pension funds.
The Halliburton case started a decade ago, when investors sued over losses from shares purchased between 1999 and 2001, arguing that company executives withheld or misrepresented information about asbestos claims against the company, construction revenue and a merger, among other things.
After several rounds of appeals, the case first went before the Supreme Court in 2011. Justices unanimously agreed to let stand the lower court ruling that such class actions could proceed on the theory that the market reflected true prices, and therefore such cases should be presumed valid enough to proceed to trial, before losses have to be proven.
By allowing that, “the Supreme Court unilaterally created a multibillion-dollar litigation industry that has significantly transformed our capital markets,” said Sheldon Gilbert, senior counsel for the U.S. Chamber of Commerce's litigation center in Washington. “It's time to revisit that transformative decision.”
Four Supreme Court justices seem to agree. In a 2013 class-action case led by the $24.3 billion Connecticut Retirement Plans & Trust Funds, Hartford, against Amgen Inc., the court's majority rebuffed efforts to make stock-loss class-action lawsuits more difficult to start. But several justices raised the idea of revisiting the legal presumption by Basic (plaintiff in the 1988 decision) that the investors relied on misstatements or other actions by the company, and whether it truly affected the share price. That interest became a reality Nov. 15 when the court accepted Halliburton's petition to address the underlying question head on. “Some justices may be open to eliminating the presumption,” said the CII's Mr. Mahoney.
Removing the presumption would fundamentally change the standards for starting a class-action lawsuit by requiring each investor to prove they experienced direct harm, which requires significant tracking and investigation of each company.
That would be unworkable, pension fund officials say, given the breadth of their holdings. “We are a very big passive investor, with about 85% indexed. If it's a large company, we're going to own it,”” said Mr. McCauley of Florida.
“If Halliburton prevails (in having the Supreme Court change the precedent), it would make it that much more difficult,” said Hank Kim, executive director and counsel of the National Conference on Public Employee Retirement Systems, Washington. “If our participants have been harmed, we want to be able to find recourse. The practical implication is that a lot more class actions would not be brought.” n
This article originally appeared in the March 3, 2014 print issue as, "Class actions at risk in Supreme Court challenge".