Distortion other than price distortion.

• Author: Velikonja, Urska
• Position: New Directions for Corporate and Securities Litigation

1. INTRODUCTION

   The fraud-on-the-market doctrine adopted in Basic Inc. v. Levinson ("Basic") allows the plaintiff suing under Rule 1 Ob-5 to satisfy the reliance requirement by showing that the market in which the security was traded was efficient and that she purchased the security at the market price during the period of the misrepresentation. (1) If she succeeds, the plaintiff is entitled to two presumptions: first, that the misrepresentation distorted the price of that security, and second, that she purchased the security in reliance on that misrepresentation. (2)

   In Halliburton Co. v. Erica P. John Fund, Inc. ("Halliburton II"), (3) the Court considered a direct attack on Basic's presumptions, and declined to do away with them. Judging by the volume of academic commentary to date, the most significant contribution of Halliburton II is a more pragmatic definition of market efficiency, which is the underlying mechanism that converts information about securities into their prices. (4) To invoke the presumption of reliance in a fraud-on-the-market suit, plaintiffs no longer need to show that the market for a public company security is hyper-efficient, in that it fully and quickly impounds into stock prices all publicly available information, as some courts have required. (5) Rather, the Court embraced the notion that market efficiency is a "matter of degree." (6)

   In a subsidiary challenge to the Basic presumptions individually, the Court declined to reject the first of the two presumptions--that a public misrepresentation distorts the price of a security traded in a reasonably efficient market--and to require plaintiffs to show, at the class certification stage, that the defendant's misrepresentation in fact distorted the price of a particular security. (7) The Court did throw defendants a bone and allowed them to prevent the class from being certified if defendants could show that the alleged misrepresentation did not impact the price of the publicly-traded security. (8) How exactly defendants are supposed to do that has been left for the lower courts to figure out. (9)

   In a majority of cases--the "confirmatory lie" cases where the defendant conceals the truth and thus prevents an immediate price reaction (10)--it is the absence of price movement at the time of the misrepresentation that is allegedly fraudulent. In such cases, neither plaintiffs nor defendants can demonstrate empirically what impact the misrepresentation had on the price of the security at the time it was uttered. Instead, various courts have used the price reaction at the moment of corrective disclosure as a proxy," but it is an imperfect proxy for the extent to which the original misrepresentation distorted the price at the time that it was made. The Court followed lower courts' approach by allowing defendants to show the lack of price distortion at the time of the misrepresentation by offering evidence that the corrective disclosure has no impact on the stock price, without acknowledging the limitations of the proxy. (13)

   In this Article, I propose that much of Halliburton II's second holding--that a defendant can prevent class certification by showing no statistically significant movement in the price of the security at the time of corrective disclosure--does nothing to improve the quality of securities class-action litigation, and could make it worse. (14)

   In an earlier article, I explained in considerable detail that disclosure fraud is economically harmful not because it hurts buyers and sellers of public company stock--though it certainly hurts some--but because it produces considerable economic consequences that are not fully captured by stock price movements. (15) Halliburton II, and the cases before it, focus exclusively on securities price distortion and price impact, consistent with the idea that Rule 10b-5 litigation is a cause of action available to purchasers and sellers of securities. (16) While the idea seems sound legally, it is less sound economically. Inaccurate stock prices and subsequent corrections do not harm shareholders as a class; they merely redistribute wealth between selling and buying shareholders. (17) This process, by itself, produces some welfare losses, including enhanced monitoring by investors, greater price volatility, and reduced liquidity as weary investors stay away from the market. As a result, issuers must pay a premium to account for the higher risk and cost, and thus cannot fund investments on the margin. (18)

   But a significant portion of welfare losses caused by financial manipulation is the product of the distortion in capital allocation, and resulting changes in investment, employment, and output, all of which are used to detect, avoid, exploit, or cover up the misrepresentation. (19) Fraud firms' disclosures are used by other firms in their own investment decisions, spreading welfare losses beyond the fraud firm like fruit rot. (20) These economic consequences are associated with securities frauds that are discovered as well as with those that are not. (21) If the truth ultimately catches up with the fraud firm, the firm can sometimes pass the cost on to non-shareholders. (22)

   All of this is a long way of saying that financial misreporting by public companies distorts more than just the price of the firms' securities, and that distortion other than that affecting the prices of public securities can in some circumstances be more significant and economically wasteful than stock price distortion. This Article develops an analytical matrix that identifies possible combinations of distortions in the stock price and economic dislocation to suggest when fraud-on-the-market litigation is likely to insufficiently deter disclosure fraud. (23) Based on empirical studies, this Article identifies the circumstances in which large economic distortions caused by false disclosures are likely to be particularly large. In light of these observations, the Article suggests that fraud-on-the-market litigation should not be understood primarily as a remedy for victimized shareholders, who can often eliminate the cost of fraud ex ante, but as a quasi qui tarn cause of action available to purchasers and sellers of (usually equity) securities to police economically-harmful false disclosures by public companies. (24) Even in cases where buyers and sellers of stock are not the class most significantly harmed by disclosure fraud, they nearly always suffer some identifiable losses, thus avoiding difficult evidentiary questions about standing. When viewed through this lens, many of the objections to securities litigation become moot and its virtues are revealed. In that this Article is sympathetic and consistent with ideas of "publicness" discussed in the article by Professors Sale and Thompson that is part of this symposium. (25)

2. WHAT PURPOSE DOES SECURITIES LITIGATION SERVE?

   In recent decades, countless articles have denounced securities litigation, many suggesting that it is a nothing more than a costly pocket-shifting transfer of wealth without many corresponding benefits. (26) The critiques usually observe that attorneys file securities class actions on behalf of shareholder plaintiffs--usually purchasers of overpriced stock--seeking compensation for losses caused by fraudulent misrepresentations from the issuer and its top management. (27) In a large majority of cases, the issuer did not trade in the affected security during the period of misrepresentation, and thus did not benefit from its fraudulently distorted price. (28) The lucky sellers of overpriced securities are the ones who benefit, and they are allowed to keep their gain. Instead, the issuer, who rarely trades in its own securities, and its top management are listed as defendants. In all but a handful of cases, only the issuer, directly or indirectly though its D&O insurer, pays damages to settle a securities class action. (29) The money comes from the issuer's current shareholders, who are ostensibly the victims of the fraud. Damages in securities class actions, thus, add insult to injury and victimize the shareholders for the second time--this has been described as circularity at the firm level. (30)

   In addition, critiques of securities litigation note that damages in securities class actions also suffer from circularity at the investor level. (31) Investors can eliminate firm-specific risk of fraud by self-insuring through diversification and trading. Diversification cannot eliminate systematic risk of fraud, but all securities are sold at a discount that reflects the market risk of fraud. At least ex ante, securities purchasers should be indifferent to disclosure fraud if its prevalence and impact on the prices of securities remain stable over time. (32) Fraud consistently harms only those shareholders who cannot diversify and trade. (33)

   Since compensation can provide only a limited rationale for securities class action litigation, most commentators today agree that perhaps such litigation could be justified as a deterrent of fraudulent misrepresentations by public companies. (34) Class actions supplement public enforcement efforts and can "vindicate the public interest through private litigation." (35)

   But, as critics have often argued, class actions fall short on the deterrence front for two reasons. First, individual managers who are responsible for securities fraud rarely pay out of pocket to settle securities class action claims. (36) Nevertheless, because managers apparently dislike the hassle of litigation, there is evidence that public firms that operate in capital markets where the threat of fraud-on-the-market litigation is real are less likely to commit disclosure fraud than those that are immune from such threat. (37)

   Second, and a bigger problem with the deterrence justification for securities litigation--one that this Article takes on--is that the potential liability exposure in a fraud-on-the-market suit has little to...