Securities class actions often follow close on the heels of major announcements by public companies. These class actions have been portrayed as a shareholder's weapon against corporate wrongdoing, but too often that weapon inflicts harm on the very shareholders it is intended to protect.
If a company makes a misstatement that affects the stock price and an investor relies on that statement in purchasing or selling shares, he can sue the company. Such suits are based on Rule 10b-5 under Securities Exchange Act Section 10(b), which prohibits "mak[ing] any untrue statement of a material fact . . . in connection with the purchase or sale of any security." Litigation costs may preclude a shareholder from suing on his own, and a class action cannot proceed absent a showing of common, class-wide reliance on the corporation's alleged misstatement.
The Supreme Court made class actions possible in Basic v. Levinson, 485 U.S. 224 (1988) by embracing the fraud-on-the-market theory. That theory, which assumes that public information is baked into stock prices, supports a judicial presumption that investors buy and sell in reliance on that baked-in public information, which includes alleged corporate misstatements. As a consequence, Basic eliminated the need to show investor-by-investor reliance on alleged corporate misstatements and facilitated the establishment of a powerful class action industry.
The U.S. Chamber of Commerce released a report on Friday that attempts to quantify shareholder harm from class actions. The report shows that when a class action is announced, the company's stock price drops. The drop reflects the fact that, regardless of whether the suit has merit, the company will incur substantial litigation costs and will likely seek to stem those costs by offering a hefty payment to settle the case. The settlement money, of course, comes out of company coffers, which are funded by shareholders. A sizable piece of this settlement goes to the plaintiffs' attorneys and another portion covers the cost of distributing the remainder to class members. According to the Chamber's study, the money distributed to shareholders pales in comparison to the shareholder losses resulting from the hit the company's stock price took when the class action was announced. There are winners among shareholders, namely those who both bought and sold shares when the stock price was inflated. They keep their profits from the sales and, as purchasers, receive a share of the class action settlement.
The Supreme Court has scheduled an oral argument on March 5th in Halliburton v. Erica P. John Fund, a case that allows the Court the opportunity to reconsider the Basic holding. Shareholders--who have footed the bill for past class actions--should be hoping that the Court rethinks Basic. If the Supreme Court instead blesses the status quo, the winners will not be shareholders, but the plaintiffs' lawyers, defense lawyers, consultants, expert witnesses, distribution agents, and other professionals that make such a lucrative business of class actions.