Halliburton: Nothing if not efficient. Photographer: Simon Dawson/Bloomberg
Halliburton: Nothing if not efficient. Photographer: Simon Dawson/Bloomberg

Every once in a while a company will announce bad news and its stock price will go down. When this happens, enterprising lawyers will sue the company, saying that it should have announced the bad news earlier and that innocent shareholders were tricked into buying stock because they didn't know about the bad news. These lawsuits are informally called "stock-drop lawsuits," and a lot of people think they're Bad, because they mostly are.1 So those people have tried, with mixed success, to get Congress or the Supreme Court to eliminate them.2

Today the U.S. Supreme Court issued an important decision in a stock-drop lawsuit called Halliburton Co. v. Erica P. John Fund Inc. in which it ruled that there can still be stock-drop cases, but only if the stock actually drops. This seems sensible enough, but it comes wrapped in a hard candy shell of efficient-markets flummery, and I don't know what to tell you.

The story is this. If you're an enterprising lawyer and you want to bring a stock-drop case, the first important hurdle is to get "class certification," in which the court agrees that you can represent all the investors who bought the stock during the period leading up to the announcement of bad news.3 Once you get a class certified, you get to throw around giant damages numbers, and so you have a lot of leverage to get the company to settle.4 On the other hand, if you can't get a class certified, then it's not going to be worth your time to represent just one shareholder suing over its losses. So plaintiffs' lawyers really want to get a class certified, and defense lawyers really want to prevent that.

Now, to win a securities-fraud lawsuit -- and stock-drop cases are securities-fraud cases -- you need to prove a bunch of things, including, in particular, 1) that the company made false statements, 2) that those false statements were material and 3) that you relied on them.5 The reliance element presents a problem for class actions, because you can't really prove that every shareholder who bought during the class period relied on the company's statements. You can't even prove that every shareholder read the company's statements. Most of them probably didn't.

The solution to this problem is a 1988 U.S. Supreme Court decision called Basic Inc. v. Levinson, in which the court ruled that you don't actually have to show reliance to get a class certified. Instead, you can rely on the normal way people buy stocks: They see the price, assume that it reflects the market's judgment of all disclosed and required-to-be-disclosed information, and decide whether they like the stock. So plaintiffs can get a "rebuttable presumption of reliance" by showing:

(1) that the alleged misrepresentations were publicly known, (2) that they were material, (3) that the stock traded in an efficient market, and (4) that the plaintiff traded the stock between the time the misrepresentations were made and when the truth was revealed.6

This is called the "fraud on the market" theory, and it has been controversial ever since it was announced. First, because it allows for lots of stock-drop lawsuits, which people think are Bad, and second, because some people get all worked up about "well, actually, markets aren't totally efficient." The first objection is plausible enough, if you think stock-drop lawsuits are Bad; the second is really dumb and I consign it forever to the footnotes.7 One reason that the Halliburton case is important is that Halliburton explicitly asked the Supreme Court to overrule Basic, for these two reasons. The court said no.

But it gave Halliburton a bit of what it wanted. Halliburton wanted the court to

allow defendants to rebut the presumption of reliance with evidence of a lack of price impact, not only at the merits stage -- which all agree defendants may already do -- but also before class certification.

And the court agreed.

What this means is:

  • If a company announces bad news and its stock goes down, and
  • You sue the company saying that it defrauded innocent investors, and
  • The company proves, no, the stock didn't go down, then
  • Your lawsuit gets thrown out before the class is ever certified.

O ... kay? This seems straightforward enough, and yet. For one thing, if the stock didn't go down, why would anyone sue? For another thing, how much of a dispute can there really be over whether the stock went down? (The answer is "probably a lot": You can debate whether the stock went down because of the bad news or because of some other, unrelated thing in the company's news release, or market conditions, or whatever, so the company could introduce evidence that the concealed-and-then-disclosed bad news isn't what actually caused the stock drop.)

Here's another weird bit, though. Obviously, as the court says, Halliburton would have a chance to argue that its failure to disclose bad news didn't prop up the stock price, and that revealing that news didn't cause the price to drop. The question is just whether it can argue that before class certification -- as part of this fraud-on-the-market inquiry -- or afterward. After the class certification, Halliburton can make all sorts of arguments, including that its omissions weren't material: that there was not "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."8

But Halliburton can't argue materiality before class certification, because it has nothing to do with whether a court should certify a class.9 Price impact, on the other hand ... well, what?

EPJ Fund argues that much of the foregoing could be said of price impact as well. Fair enough. But price impact differs from materiality in a crucial respect. Given that the other Basic prerequisites must still be proved at the class certification stage, the common issue of materiality can be left to the merits stage without risking the certification of classes in which individual issues will end up overwhelming common ones. And because materiality is a discrete issue that can be resolved in isolation from the other prerequisites, it can be wholly confined to the merits stage.

Price impact is different. The fact that a misrepresentation "was reflected in the market price at the time of [the] transaction" -- that it had a price impact -- is "Basic's fundamental premise." It thus has everything to do with the issue of predominance at the class certification stage.

The Supreme Court is saying here that whether a misrepresentation "was reflected in the market price" is a totally different question from whether it "would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."

Now: This may be true.10 But if you believe in efficient markets -- as the Supreme Court professes to -- this is hard to square. It suggests that reasonable investors should care about news that doesn't affect the stock price or should not care about news that does. Whether information is important, and whether it affects prices, are two separate questions.

This is not exactly new to this case. But it's an increasingly important question, as prosecutors pursue more insider-trading cases (which also turn on materiality) and as regulators try to extend the law of insider trading to computer-driven activities that they label "Insider Trading 2.0." In modern, electronic, liquid, efficient markets, it would be reasonable and convenient for courts, and helpfully clarifying for investors, to have a simple rule of materiality: If it affects the price,11 it's material; if not, not.

But that's not the rule. For the Supreme Court, whether market prices reflect material public information remains a mystery, to be considered on a case-by-case basis. That's not much of an endorsement of efficient markets at all.

1 The Supreme Court sums up the arguments:

Such class actions, they say, allow plaintiffs to extort large settlements from defendants for meritless claims; punish innocent shareholders, who end up having to pay settlements and judgments; impose excessive costs on businesses; and consume a disproportionately large share of judicial resources.

The second point is the most important one. When a stock drops, lawyers sue on behalf of a class consisting of "everyone who bought the stock before it dropped" or whatever, and then settle for $X. The way the settlement works is that the company -- that is, its current shareholders -- pay $X, the lawyers take a chunk of it, and they pass on the rest to the class. So current shareholders pay the settlement, and former (and also some current!) shareholders receive the settlement (minus lawyers' fees), and on net diversified shareholders of public companies are worse off by the amount of the lawyers' fees.

The counterargument is, essentially, that the threat of these lawsuits deters misconduct and makes companies more likely to be honest with shareholders. There is probably something to that. But each actual lawsuit feels like sort of a loss for society.

2 The main efforts in Congress are the Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998, both of which were partially successful efforts to cut down on these lawsuits.

3 I'm being a little tendentious about how I describe some of these things. Here's how the court describes the class in Halliburton:

According to EPJ Fund, between June 3, 1999, and December 7, 2001, Halliburton made a series of misrepresentations regarding its potential liability in asbestos litigation, its expected revenue from certain construction contracts, and the anticipated benefits of its merger with another company -- all in an attempt to inflate the price of its stock. Halliburton subsequently made a number of corrective disclosures, which, EPJ Fund contends, caused the company's stock price to drop and investors to lose money.

EPJ Fund moved to certify a class comprising all investors who purchased Halliburton common stock during the class period.

This is a little different in emphasis, though not in substance, from my characterization of "a company will announce bad news and its stock price will go down." Incidentally: Supreme Court opinions, the final bastion of the correct usage of "comprising."

4 Or that's the claim. The plaintiffs' lawyers in Halliburton disagree, and they make some decent points (citations omitted):

Halliburton points to the aggregate $73 billion in class settlements since the PSLRA, and implies that companies are paying billions to settle meritless litigation. That is wrong. First, most cases settle only after surviving a motion to dismiss, including the PSLRA’s heightened pleading requirement for scienter, which screens out many meritless cases. Second, the ten largest cases alone count for $29.7 billion in settlements, and there can be no serious question that executives at most if not all of those companies, which include Enron, WorldCom, and Tyco, committed significant securities fraud. Third, given the evidence that defendants in securities-fraud cases have prevailed in summary judgment, at trial, and on appeal, it is implausible that sophisticated defense counsel advised their clients to pay tens or hundreds of millions of dollars to settle meritless cases. Tellingly, Halliburton does not provide a single example of such a case.

5 The full list, again from the Halliburton opinion:

To recover damages for violations of section 10(b) and Rule 10b-5, a plaintiff must prove "(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation."

6 Quoting the Halliburton opinion's summary of Basic.

7 Actually, I wrote about it when the case was argued, so just read that. Everyone wants to determine if markets are "really" efficient, without putting any intellectual rigor around what that might mean, but the question of "do stocks tend to drop when fraud is revealed?" is of course a separate and simpler question from "do stock markets seamlessly and instantly incorporate all public information?" These three sentences from the Halliburton opinion (citations omitted) are perfectly sensible:

To recognize the presumption of reliance, the Court explained [in Basic], was not "conclusively to adopt any particular theory of how quickly and completely publicly available information is reflected in market price." The Court instead based the presumption on the fairly modest premise that "market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices." Basic's presumption of reliance thus does not rest on a "binary" view of market efficiency.

Particularly goofy is Justice Clarence Thomas's concurrence in the judgment, which has more amateur criticism of the efficient-markets hypothesis than I can handle. Don't take investment advice from Justice Thomas is my advice!

8 That's the Supreme Court's materiality standard, from Basic v. Levinson.

9 The theory is that the materiality of Halliburton's statements is an objective-ish fact that is only about those statements, not the shareholders, while reliance is a fact about the shareholders. So to certify a class you need to not exactly prove reliance, but demonstrate that all of the shareholders will probably have the same reliance theory (that is, fraud on the market). If you can show that, then it makes sense to treat all the shareholders as one big class; if not, not. Materiality, on the other hand, will be the same question no matter who's in the class, so there's no need to decide it before certifying a class.

10 We've talked about the difference, in the amusing context of insider trading in the wrong stocks: News about Nest can affect the price of Nestor stock, whose only relationship to Nest is that they have similar names.

11 "... by more than (X) percent," you'd probably want to add, though that gets complicated fast. If you're a high-frequency trader, a 0.01 percent edge, repeated frequently, might be material.

To contact the writer of this article: Matt Levine at mlevine51@bloomberg.net.

To contact the editor responsible for this article: Brooke Sample at bsample1@bloomberg.net.