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The End of Securities Fraud Class Actions?

By James M. Beck and Mark Herrmann

This isn't a "drug and device law" story.

But it could be the bigget development in corporate securities law since Marty Lipton invented the "poison pill," and it appears to have been overlooked elsewhere, so we're spreading the word.

In the September 22, 2008, National Law Journal, Professor Adam Pritchard of Michigan Law School explained how corporations can unilaterally end securities fraud class actions. (Here's a link to the original article, titled "'Basic' Error is focus on loss.") A longer article, in the Cato Supreme Court Review, explains the thesis at greater length. Here's a link to "Stoneridge Investment Partners v. Scientific-Atlanta: The Political Economy of Securities Class Action Reform."

Twenty years ago, the Supreme Court held in Basic, Inc. v. Levinson, 485 U.S. 224 (1988), that a plaintiff alleging securiites fraud need not prove actual reliance on a misrepresentation so long as the plaintiff suffered harm trading in a market shown to be "efficient." By essentially eliminating the reliance requirement, the Court dramatically expanded the availability of securities fraud class actions.

In his recent article, Professor Pritchard explains how corporations can unilaterally undo the effect of Basic: "The U.S. Securities and Exchange Commission's proxy proposal rule allows shareholders to recommend amendments to a company's articles of incorporation. An amendment limiting damages in secondary market cases and requiring actual reliance for claims of compensation would undo the harm caused by the Supreme Court in Basic."

If that works -- and why shouldn't it? -- then essentially every company should be recommending amending its articles of incorporation to achieve this result. All future securities fraud claims could be brought only by plaintiffs who actually relied on misrepresentations. Since reliance is an inherently individualized issue, injecting reliance into these cases would reduce, or eliminate, the possibility of securities fraud cases being certified as class actions. Professor Pritchard's proposal would eliminate most 10b-5 class actions.

Although courts might not approve amendments to articles of incorporation that try to overrule statutes by eliminating causes of action, Pritchard's proposal doesn't suggest this. Pritchard suggests adjusting the measure of damages in securities class actions (for sensible reasons that Pritchard explains in the article) and thus tinkering with the notion of reliance. Although we haven't yet looked at the issue, we assume that courts would uphold the amendments that Pritchard proposes.

Adopting a "Pritchard amendment" would of course operate prospectively only. But even prospective protection will ultimately be worth billions of dollars to American corporations.

For a whole collection of reasons, we've never been big fans of Basic. One of us criticized the case over a decade ago in John M. Newman, Jr., Mark Herrmann, and Geoffrey J. Ritts, "Basic Truths: The Implications of the Fraud-on-the-Market Theory for Evaluating the 'Misleading' and 'Materiality' Elements of Securities Fraud Claims," 20 J. Corp. L. 571 (1996).

But, if we'd come up with Pritchard's idea way back then (instead of what we actually wrote -- though it was awfully clever, if we do say so ourselves), the
entire field of 10b-5 class actions would have been tranformed by now.

Pritchard's suggestion has been public for nearly two weeks now. It's time to act!

And, for us, it's time to go back to drug and device law.

Full post as published by Drug and Device Law on October 02, 2008 (boomark / email).