The Intersection of Law and Financial Theory

When lawyers and judges venture into the realm of financial theory, interesting things happen, often accompanied by unintended consequences. Take, for example the efficient market hypothesis. As anyone with a grounding in financial theory knows, the efficient market hypothesis (in the semi-strong version) holds that the market quickly incorporates all readily available information into stock prices. In 1988 the United States Supreme Court used this theory to create the legal doctrine of “fraud on the market”, which holds that shareholders do not have to directly prove that there is a connection between a shareholder’s losses and the fraud being alleged. Rather, the courts assume that the shareholders have been harmed by an alleged fraud because the market has incorporated the fraudulent information into the stock price, regardless of whether the aggrieved shareholder can show direct reliance on the fraudulent information.

The upshot (and unintended consequence) of this legal doctrine was a surge in the number of securities class actions filed beginning in 1988. In fact, it became so bad that Congress stepped into the fray and enacted the Private Securities Litigation Reform Act of 1995. This act made things tougher on plaintiffs, requiring them to plead the alleged securities fraud with a great deal more specificity than before and creating a “safe harbor” for forward looking statements made by a company. But the act did not specifically do away with the “fraud on the market” doctrine, and plaintiff’s lawyers, being a resilient and resourceful bunch, continued to file securities class action lawsuits. In fact, according to a paper written by Donald C. Langevoort at the Georgetown University Law Center, such lawsuits in the last 15 years have resulted in more than $70 billion in settlements (Judgment Day for Fraud on the Market? Reflections on Amgen and the Second Coming of Halliburton http://scholarship.law.georgetown.edu/facpub/1226 http://ssrn.com/abstract=2281910). This is because, even with the heightened filing requirements, with the fraud on the market doctrine, all shareholders are part of the class of damaged investors, not just those investors that can show they relied upon the alleged fraud. As a result, the class is so large and the potential damages can be so great that almost all securities fraud class actions that survive the pleadings stage wind up getting settled. Which, coincidentally, generates large fees for plaintiffs’ lawyers.

Now, however, the Supreme Court is taking a second look at the “fraud on the markets doctrine. Arguments in the case of Erica P. John Fund v. Halliburton Co. will be heard shortly and four of the Supreme Court justices are on record as opposing the fraud on the market doctrine. If the court reverses the doctrine, or even if they significantly curtail it, the upshot will be a lessening of class action securities lawsuits. For the first time since 1988, plaintiffs will have to actually prove that they were aware of, relied upon, and were damaged by the corporate statements they allege are fraudulent. Wouldn’t that be something? 

Know Thine Enemy

As a matter of self-defense, one should always try to understand their enemies. For those of us that are in the business of dealing with the equity markets, this would include trying to understand class action securities lawyers. These are the people who bring lawsuits against companies alleging fraud and seeking to recover the lost value of stock for shareholders following some event that has caused the stock price to go down, while simultaneously collecting large fees for their firms. If you want some insight into the mindset of these plaintiff’s lawyers, I suggest you get a copy of the book, “Circle of Greed” by Patrick Dillon and Carl M. Cannon.

The book tells the story of the rise and fall of Bill Lerach and his firm, Milberg Weiss Bershad Hynes & Lerach. In its day, the firm was perhaps the most feared and reviled securities class action law firm around, bringing cases against a veritable who’s who of corporate America, from Fortune 500 companies to Silicon Valley high tech pioneers. One of the key insights of the book is that the mindset of a plaintiff’s lawyer is to immediately assume fraud on the part of a corporation when something unusual happens and the stock price goes down. It doesn’t matter that the process of running a complex corporation in a highly competitive environment is fraught with difficulties that mean that things don’t always go as planned and that the markets are unforgiving in such a case. In the minds of lawyers like Bill Lerach, if a stock has been going up and suddenly declines, the company has clearly been hiding something and defrauding shareholders. If this was compounded by management making optimistic comments and selling stock, the company was clearly guilty and large settlements could be extracted. My own personal experience confirms this: Many years ago I was on a continuing legal education panel with a lawyer from the firm of Milberg Weiss and he told me that the best research tool for new lawsuits he had was that day’s edition of The Wall Street Journal. He would read it every day and look for stocks that had taken a large decline in the previous day’s trading and assume that company was ripe for a lawsuit.

After reading the book, I want to add securities class action lawsuits to the old saying that legislation and sausages are things you don’t want to watch being made. In the old days, before the Private Securities Litigation Reform Act of 1995, securities class action lawsuits were little more than a legalized form of corporate extortion. A company’s stock price would go down, a lawsuit would be filed and, faced with the prospect of producing boxcars full of documents, tying up management’s time and attention with depositions and trial strategy, and a hostile jury willing to vote for the small shareholder against big corporations, most companies made the economically rational decision to settle. All you needed to do was file a lawsuit and you had a gun pointed at the head of the company. The 1995 Act has changed things a bit in that plaintiffs have to actually allege specific acts of fraudulent behavior before they can get certified by the court to lead the class action suit. But importantly, it hasn’t changed their mindsets – they still believe corporations are guilty – they just have to work harder to prove it.

“Circle of Greed” tells a compelling story, the Greek drama of how one person rose to the peak of his chosen profession, but was ultimately undone by his own seeds of fraud sown early in his career. While Lerach was publicly taking a high moral tone, claiming to recover money for the little shareholder, he and his firm were engaged in an ongoing scheme to pay illegal kickbacks, covered up by perjury, to people who agreed to act as named plaintiffs in their cases. Having a ready stable of plaintiffs meant that Milberg Weiss could get to the courthouse first and capture the lion’s share of the attorney’s fees. In the end, disbarment, jail time and significant fines were the fruit reaped by their actions.

While engrossing, the book is not perfect. It’s probably about 100 pages too long, with so much detail that you start to think the authors are trying to prove how thorough they were. It’s really not necessary to tell the reader where every one of the many lawyers in the book went to law school. More disturbing to me is the fact that the authors can’t seem to make up their minds about who the bad actors are. At one point they seem to point at the plaintiff’s bar, at others they seem to think almost all of corporate America is corrupt and the securities law plaintiffs are serving a useful enforcement purpose. At the end of the book I came away with the feeling that the authors believe the whole system is corrupt, but their sympathies lie much more with people like Lerach than corporate America.

(Author’s note: I received a free copy of this book from the publisher. No promises were made about reviewing the book in return, but after reading the book I thought readers of this blog might be interested.)