The U.S. Supreme Court issued a pair of decisions this month on securities class-action lawsuits—one that could help companies defend against such suits, the other a victory for shareholders.
The cases are the latest in a string of securities class actions that the high court has decided recently, a shift from past Supreme Courts that hesitated to rule on securities cases. “Over the past few years, the court has taken and decided significantly more securities-related cases,” says Dan Gold, a lawyer in the securities and shareholder litigation practice at law firm Haynes and Boone.
With the most recent ruling, Janus Capital Group v. First Derivative Traders, the court raised the hurdles for shareholders to hold a company responsible for the actions of financial intermediaries. The decision could have a huge effect on future cases related to securitized mortgages at the center of the financial crisis of 2008.
The case stemmed from a lawsuit filed by Janus Capital Group shareholders against Janus Capital Management, the fund's investment adviser, over allegations that Janus entered into several rapid-trading deals with hedge funds from 2000 to 2003 that resulted in financial losses for long-term fund holders.
The shareholders claimed Janus Capital Management, an affiliate of Janus Capital Group, was at fault for issuing prospectuses containing misstatements that Janus had adopted measures to curb such market-timing trades. A U.S. District Court in Maryland dismissed the case on the grounds that the defendant was not the entity that had prepared the prospectuses, but the Fourth Circuit Court of Appeals reversed, holding that Janus Capital Management made the alleged misstatements “by participating in the writing and dissemination of the prospectuses.”
In a 5-4 decision handed down on June 13, the U.S. Supreme Court held that a mutual fund's investment adviser cannot be liable for securities fraud due to misstatements made in a fund's prospectus, because the fund itself—a separate entity from the investment adviser—ultimately controls the statements.
Rule 10b-5 of the Securities Exchange Act states that it is unlawful for “any person, directly or indirectly … [to] make any untrue statement of a material fact” in connection with the sale or purchase of securities. The question in Janus focused on who actually “makes” the statement. In Janus, the court defined the maker of a statement as “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not ‘make' a statement in its own right.”
Not all the justices agreed. In a dissenting opinion, Justice Stephen Breyer—joined by Justices Ruth Bader Ginsburg, Sonia Sotomayor, and Elena Kagan—worried that the decision immunizes “guilty management” from liability under Rule 10b-5. “Every day, hosts of corporate officials make statements with content that more senior officials or the board of directors have ‘ultimate authority' to control,” Breyer wrote.
“The Court's clarification of the scope of primary liability under the securities laws is important not just for the parties to this case, but for all participants in the securities markets, including bankers, lawyers, accountants, and investment advisers,” says Mark Perry, Gibson Dunn partner and lead counsel for Janus.
“The Court's clarification of the scope of primary liability under the securities laws is important not just for the parties to this case, but for all participants in the securities markets.”
—Mark Perry,
Partner,
Gibson Dunn
The decision could also, however, affect claims against corporate officers and directors. As a legal bulletin from the law firm Paul Weiss noted, private plaintiffs frequently sue corporate officers, directors, or employees for statements made on behalf of a corporate issuer. In these types of lawsuits, individual corporate officers or directors will likely argue that they can't be held liable because they didn't have ultimate authority over the statement.
“The strength of that argument will differ based on the individual officer's level of responsibility with the company and the type of corporate statement at issue,” Gold says.
Examples of corporate statements include a corporate officer who signs a Securities and Exchange Commission filing for the purpose of Sarbanes-Oxley certification, or who makes oral statements on behalf of a company during a news conference.
“In situations where there is no filing obligation, however, the Janus ‘clean line' test may not be so straight forward to apply,” says Tom Gorman of law firm Dorsey & Whitney. “Just who has ‘control' under those circumstances may become a facts-and-circumstances test, which is difficult to resolve.”
The ruling could provide a shield for investment banks from shareholder securities suits over massive losses due collateralized debt obligations, since many of them set up separate entities to act as investment vehicles, apart from the entities that managed and sold them.
Halliburton
In a second case on shareholder suits, Erica P. John Fund v. Halliburton, the Supreme Court decided in favor of the shareholders. The court ruled that plaintiffs in a securities class-action suit do not need to show loss causation as a condition of obtaining class certification.
The Halliburton case stems from a securities class-action lawsuit filed in 2002 over allegations that the oilfield services company understated its asbestos litigation liabilities while overstating the financial benefits of its merger with Dresser Industries, as well as revenues from its construction contracts.
According to the plaintiffs, the misstatements artificially inflated Halliburton's stock price, and then caused prices to fall when the company eventually made corrective disclosures. The lawsuit was filed on behalf of investors who purchased Halliburton stock between June 1999 and December 2001.
The investors filed a motion to obtain class certification, but the Fifth Circuit Court of Appeals ruled in February 2010 that the class-action lawsuit couldn't proceed because the investors did not show “loss causation”—the requirement that plaintiffs in securities class actions show that the company's subsequent corrective disclosures caused investors' financial losses.
COURT OPINION
What follows is an excerpt from the decision rendered in Erica P. John Fund vs. Halliburton:
Halliburton concedes that securities fraud plaintiffs should not be required to prove loss causation in order to invoke Basic's presumption of reliance or otherwise achieve class certification. Halliburton nonetheless defends the judgment below on the ground that the Court of Appeals did not actually require plaintiffs to prove “loss causation” as we have used that term. According to Halliburton, “loss causation” was merely “shorthand” for a different analysis. The lower court's actual inquiry, Halliburton insists, was whether EPJ Fund had demonstrated “price impact”—that is, whether the alleged misrepresentations affected the market price in the first place.
“Price impact” simply refers to the effect of a misrepresentation on a stock price. Halliburton's theory is that if a misrepresentation does not affect market price, an investor cannot be said to have relied on the misrepresentation merely because he purchased stock at that price. If the price is unaffected by the fraud, the price does not reflect the fraud.
We do not accept Halliburton's wishful interpretation of the Court of Appeals' opinion. As we have explained, loss causation is a familiar and distinct concept in securities law; it is not price impact. While the opinion below may include some language consistent with a “price impact” approach ... we simply cannot ignore the Court of Appeals' repeated and explicit references to “loss causation.”
Whatever Halliburton thinks the Court of Appeals meant to say, what it said was loss causation: “[EPJ Fund] was required to prove loss causation, i.e., that the corrected truth of the former falsehoods actually caused the stock price to fall and resulted in the losses.” We take the Court of Appeals at its word. Based on those words, the decision below cannot stand.
Because we conclude the Court of Appeals erred by requiring EPJ Fund to prove loss causation at the certification stage, we need not, and do not, address any other question about Basic, its presumption, or how and when it may be rebutted. To the extent Halliburton has preserved any further arguments against class certification, they may be addressed in the first instance by the Court of Appeals on remand.
The judgment of the Court of Appeals is vacated, and the case is remanded for further proceedings consistent with this opinion.
Source: Erica P. John Fund vs. Halliburton.
In a unanimous decision handed down June 6, the Supreme Court disagreed and reinstated the lawsuit. The court essentially said that investors do not have to show loss causation at such an early stage in the litigation. “The question presented in this case is whether securities fraud plaintiffs must also prove loss causation in order to obtain class certification. We hold that they need not,” Chief Justice John Roberts wrote for the majority in a brief, 10-page opinion.
“It is important to weed out weak or abusive securities class actions, but it is equally important that valid class actions be permitted to proceed,” stated David Boies of law firm Boies, Schiller & Flexner, who represented the investors in the case.
In Halliburton, the Supreme Court said that the Fifth Circuit's reasoning was “not justified,” and that the Fifth Circuit had confused loss causation with presumption of reliance. Unlike the fraud-on-the-market theory, loss causation “requires a plaintiff to show that a misrepresentation that affected the integrity of the market price also caused a subsequent economic loss,” the court said.
Securities experts say that overall, the ruling is not surprising. “I think the Fifth Circuit decision, which required plaintiffs to show loss causation to get a class certified, was incorrect and the Supreme Court recognized that,” Singer says.
“The Fifth Circuit was out on its own ledge teetering, and the Supreme Court just kicked them off,” agrees Sarah Gold, a partner of law firm Proskauer Rose and co-head of its securities litigation and enforcement group. The decision now brings the Fifth Circuit in line with the Second, Third, and Seventh circuit appeals courts.
If anything, the decision is far too narrow, and “leaves open some key questions that the lower courts will continue to grapple with,” says Dan Gold of Haynes and Boone.
Even after Halliburton, the lower courts, including the Fifth Circuit on remand, will need to decide some pressing questions. Two of them, from Dan Gold: “Do plaintiffs, to take advantage of the fraud-on-the-market theory, need to show that the misstatement actually impacted the stock price? Alternatively, can the defendants rebut the presumption of reliance under the fraud-on-the-market theory by proving the statements did not cause that price impact?”
Sarah Gold of Proskauer Rose agrees. “We're still waiting for any kind of guidance we're going to get from the Court, because it gave exactly zero guidance to practitioners,” she says.
In a statement, Halliburton said that it “looks forward to presenting its arguments before the Court of Appeals.” The company plans to argue that the shareholder class shouldn't be certified because shareholders can't prove the corrective disclosures caused the company's stock price to fall. The company added that it hasn't set aside any money to cover potential damages “because it does not believe that loss is probable.”
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