By Peter A. Pease
Until recently, a court order certifying the class in a shareholder lawsuit was nearly a foregone conclusion, so long as the proposed class representatives and their counsel were properly attentive. No more.
Using an esoteric academic debate over whether or not the securities markets are “efficient,” defense attorneys have set their sights on defeating class certification. If they succeed, the ramifications will be enormous. Without a class, there is no class action – and the threat of liability for securities fraud is substantially diminished.
These new class certification challenges are framed as assaults on the underpinning of the fraud-on-the-market theory. That theory – adopted by the Supreme Court in Basic v. Levinson – allows investors to presume the reliance of all stock purchasers upon the integrity of its market price, so long as that market is “efficient.”
It is a critical presumption. Without it, it would no longer suffice for a plaintiff class representative to prove that a company made fraudulent public statements that affected its stock price. Every single class member alleging fraud would have to prove individually that he knew about the fraudulent statement and relied on it when he bought his shares.
Even if every class member could prove this separately, the case would not be allowed to go forward as a class action. Because of the individual proof required, the court would deny certification and require each stock purchaser to file his or her own separate case. Since economic factors preclude this, defendants would escape liability almost entirely.
Far from the Supreme Court, economists have been holding their own debate over whether the securities markets are efficient. The academics, covering terrain broader than the jurists, are arguing over whether the market price of a stock fully, rapidly and accurately reflects all publicly available information about the company.
Economists have been quarrelling over this so-called “efficient market hypothesis” for years, and the Internet bubble caused their long-simmering feud to boil over. Some economists argue that irrational investors in the heady days of Internet IPOs created an overvalued and therefore inefficient market for many dot-com and technology stocks.
Emboldened by the high stakes, defense lawyers have seized upon the academic dispute and dragged it into the courthouse, arguing that markets were inefficient during the class periods in question – particularly for companies issuing stock during the bull market that began in the late 1990s.
Take, for example, the recent securities case against PolyMedica Corp., in which defendants argued that the market for PolyMedica’s stock was not efficient during the first eight months of 2001.
Ultimately, U.S. District Judge Robert E. Keeton ruled for the plaintiffs, certifying the class in September 2004. “When legal precedent is available, I follow it, not economic or academic literature,” the judge wrote. But the fight added another hurdle for investors and slowed progression of the case.
In another securities case against Xcelera, an Internet holding company, defendants made a similar argument that the market was irrational and inefficient. Defendants tried to show that Xcelera stock was wildly overvalued in relation to earnings and no reasonable investor could rely on the integrity of the stock price. The defendants succeeded in raising the court’s interest to the point that an evidentiary hearing was scheduled and competing expert witnesses were examined for days.
However, on cross examination, defendants’ expert was forced to concede that the leading academic challengers to the efficient market hypothesis have gone on record stating that in their view efficient markets are extremely rare, if they exist at all. Indeed, the defendants’ expert opined that the market for all Internet stocks was not efficient.
The judge in Xcelera didn’t buy the defense’s claim. “The position of defendants’ expert suggests that market efficiency is a rare phenomenon. Whether or not that is true as a matter of pure economics, it does not function to shield defendants who mislead the public from the laws regulating securities,” wrote U.S. District Judge Rya W. Zobel in granting the motion for class certification in September.
The judge correctly noted the difference between an academic dispute among economists and the Supreme Court’s finding, in Basic v. Levinson, of market efficiency sufficient to support the uniformity of circumstance among stock purchasers needed to allow class certification.
But defense lawyers are having some successes in the class certification arena. For example, U.S. District Judge Jed Rakoff recently rejected class action status for three consolidated suits accusing Lehman Brothers of knowingly misrepresenting stock recommendations. Judge Rakoff said fraud-on-the-market theories of reliance do not apply to statements issued by analysts in the same way that they do for statements issued by a company itself.
“There is a qualitative difference between a statement of fact emanating from an issuer and a statement of opinion emanating from a research analyst,” the court said. “A well-developed efficient market can reasonably be presumed to translate the former into an effect on price, whereas no such presumption attaches to the latter.”
A January 20, 2005, decision of the 2nd Circuit Court of Appeals reached the same result for a different reason. In Lentell v. Merrill Lynch, the 2nd Circuit affirmed the dismissal of plaintiffs’ claims that Merrill’s knowingly false “buy” recommendations were actionable under the securities laws to allow investors in 24/7 Real Media and Interliant to recover their losses when the stock price collapsed.
The court’s concern was that the plaintiffs had not alleged that their losses were caused by Merrill’s phony buy recommendation, which could have been shown by a market reaction to a corrective statement by Merrill.
We think the analyst cases are a separate matter, and the fraud-on-the-market presumption will remain the law of the land in cases alleging fraudulent statements by corporate defendants. If this were not the case, it clearly would spell trouble for plaintiffs. Think of the magnitude of what’s at stake here: If the courts tell plaintiffs’ attorneys that we can’t litigate these cases as class actions, then defendants will only have to worry about how many investors can file individual claims against them.
Due to the forbidding economics of that litigation, which would dissuade all but the largest investors from pursuing their claims, the securities laws would be rendered toothless, a right without a remedy. Few would say today’s corporate leaders should not be answerable for their violations of securities laws. Beware of those who do, even if they are clothed in the gowns of academia.
Mr. Pease, a partner in the firm’s Boston office and the Monitor’s executive editor, is trial counsel in the Xcelera litigation.