Even if Fraud on the Market is Dumped, Don’t Cut Back on D&O Insurance

 It is hard to prognosticate the outcome of the Halliburton case now before the U.S. Supreme Court. But while we can’t be sure what the outcome will be, we can start to think about what will happen if the Supreme Court overturns Basic. In an interesting February 7, 2014 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Halliburton: The Morning After” (here), Boris Feldman of the Wilson Sonsini  law firm take a look at how the plaintiffs’ bar may respond if the Supreme Court dumps the fraud on the market theory.

As Feldman put it, “those who think plaintiffs’ lawyers will go quietly into the night are, in my opinion, ignoring the lessons of history.”  Because of the many possible responses from a plaintiffs’ bar that has over the years proven to be resilient and adaptive, it could be years before the ramifications of a reversal of Basic is fully understood, and therefore “individual companies would be making a serious mistake if, in the face of a reversal of Basic, they cut back on their D&O insurance protection.”

Referring to the way that the plaintiffs bar overcame the hurdles Congress imposed in the PSLRA, Feldman contends that the plaintiffs’ bar has shown “persistence and resilience” as well as “creativity and entrepreneurialism.” Despite the PSLRA’s heightened pleading standards and other procedural impediments for the plaintiffs, securities litigation has continued. Feldman emphasizes that he is not saying that the PSLRA and other legislative reforms have had no impact. But, he says, the legislative reforms “did not put the plaintiffs’ bar out of business.”

Feldman suggests that “if recent history is a guide, then, even a strong decision in Halliburton is unlikely to make the plaintiffs’ bar give up.” The plaintiffs’ lawyers, Feldman contends, will “wage a multifront-war to survive even in the face of judicial abolition of the fraud-on-the-market presumption.”

The plaintiffs’ lawyers’ first line of attack, Feldman suggests, if the Court overturns Basic, is that the plaintiffs’ lawyers could seek to have Congress overturn Halliburton. Given the recent track record in Congress, that could be an uphill battle. But even if it could involve tough prospects, “there is no doubt the plaintiffs’ bar would give it a try.”

The second way plaintiffs might try to fight Halliburton is to try to “undermine it in the lower courts.” Securities plaintiffs’ lawyers, Feldman suggests, are “masters of the disingenuous pleading doctrine. They are skilled at using bad facts to influence judges’ application of precedents unfavorable on their face.” Feldman speculates that if Halliburton is overturned but Affiliated Ute stands, “one can confidently predict that all cases will be pleaded as omissions cases” (a possibility that is discussed at length here). Short of a broad ruling explicitly holding that class action securities class actions are not permitted because questions of individual reliance will always predominate, “plaintiffs will find ways to plead within the decision and persuade some courts not to throw the suit out at the threshold.”

Plaintiffs’ lawyers could also seek to engage the SEC, for example, by trying to get the SEC to amend Rule 10(b)-5 to include the fraud on the market presumption as an explicit way to establish reliance. The plaintiffs could also focus in on disclosure requirements or exchange-listing requirements (for example requiring companies to include in the periodic filings statements whether the company’s shares trade in an efficient market).

The bottom line is that the plaintiffs’ bar is not simply going to throw in the towel even if Basic is overturned. The business community, Feldman says “needs to prepare for the plaintiffs’ responses to the decision.”

Given the likelihood that the plaintiffs’ lawyers will adapt, “individual companies would be making a serious mistake if, in the face of a reversal of Basic, they cut back on their D&O insurance protection.” The fact that it will be some time before the implications are sorted out presents the possibility that for a time “shareholder suits are likely to be even more expensive to litigate than now.” And of course, conservative disclosure practices “should not be eased or abandoned until the promise of Halliburton becomes a reality.”

Feldman is correct when he refers to the plaintiffs’ bar’s adaptability. The plaintiffs’ bar has adapted to the PSLRA and to the adverse Supreme Court cases that have followed. Along those same lines, since the moment that the Supreme Court granted cert in the Halliburton case, there has been extensive commentary on the Internet and elsewhere about the ways the plaintiffs’ bar might be able to persist even if the fraud on the market theory is thrown out. Once the Court has ruled, this process will accelerate.

Feldman is also spot on in his contention that companies should not cut back on their D&O insurance even if Basic is overturned, at least until all of the decision’s  ramifications are fully understood. I would liken the situation (that is, if Basic is overturned) to the circumstances back in 1995 and 1996 after the PSLRA passed. There were those in the D&O insurance industry then who presumed that the PSLRA’s passage meant that the risks associated with class action securities litigation had been substantially diminished. There were even some insurers who jumped into the D&O insurance market with very aggressive pricing based on the ssumptions about the diminished risk of securities litigation. The rest of the D&O insurance market got sucked into a downward pricing spiral. Of course, securities litigation didn’t go away, and the D&O insurance industry pretty much got crushed during the underwriting years 1997 through 2001.  

The lesson from that era – both for insurance buyers and for the D&O insurers — is not to make insurance decisions based on assumptions about what might happen. The key point here is that everyone involved in the insurance process should proceed cautiously even if Basic is overturned. At a minimum, as Feldman states, until the ramifications are understood, it would be unwise for companies to start cutting back on their D&O insurance.

There Are Those Who Still Love the Fraud on the Market Theory: There is of course the possibility that the fraud on the market theory will survive. That is certainly the hope of a wide variety of groups and commentators who have filed amicus briefs urging the court to affirm Basic and uphold the fraud on the market theory. In an interesting February 6, 2014 post in her On the Case blog (here) , Alison Frankel reviewed the amicus briefs that have been filed with the Supreme Court arguing that the fraud on the market theory in securities class action litigation should be preserved. 

Frankel notes that the fraud on the market theory has  “received powerful support in amicus briefs from (among many others) the Justice Department; two former chairmen of the Securities and Exchange Commission (one Republican, one Democrat); 11 current and former members of Congress; and scholars of the doctrine of stare decisis, whose filing was authored by Harvard Law professor Charles Fried – the onetime U.S. solicitor general who wrote the Justice Department brief supporting investors in the original Basic case at the Supreme Court.” 

Frankel says that as a group “these briefs provide compelling legal and policy justifications for leaving Basic alone, arguing, in essence, that this Supreme Court would be overstepping its judicial bounds if it reversed its own precedent, defied Congress, and undermined the regulation and enforcement of the securities laws.”

The brief filed by the former members of Congress argues that, as the Court itself has acknowledged numerous times, including as recently as the Court’s 2013 decision in the Amgen case, that despite revising the securities laws on several occasions since the Supreme Court’s decision in Basic, Congress has left the fraud on the market theory unchanged, which, the former congressmen argue, is evidence that Congress wants Basic to remain good precedent.

The brief filed by Professor Fried argues that under principles of statutory stare decisis, it is not for the Court itself to alter its interpretations of statutes; rather, “the task of modifying decisions like Basic is best left to the branch that is best situated to evaluate the often complicated factual claims underlying the call of its repeal and the unavoidable political judgments those requests entail.” 

 Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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