Capital Flows Contributor

Guest commentary curated by Forbes Opinion. Avik Roy, Opinion Editor.

For the past 25 years, securities class actions have been a source of excessive and sometimes abusive litigation, reallocating billions of dollars from shareholders to lawyers.  The Supreme Court will soon hear a case, Halliburton v. Erica P. John Fund, with the potential to correct the anomaly in the law that has produced this peculiar result.

The plaintiff in Halliburton alleges that the company misstated its financial position and that Halliburton shares purchased by the plaintiff later declined in value.  The plaintiff does not claim that it relied on the alleged misstatements by the company, but wants the court to require the company to spend millions of dollars on attorneys, accountants, and consultants to indulge the plaintiff’s attorneys’ fishing expedition searching for evidence to prove a case.  The plaintiff’s attorneys hope that the threat of all of this expense, distraction, and media hoopla will lead the company to settle the case rather than engage in a paper chase, an unfair tactic that almost always works to make a weak or non-existent case pay off, at least for the attorneys.

This type of case was made possible by a 1988 Supreme Court decision, Basic v. Levinson, that represents undisguised judicial rulemaking.  Following Basic, courts require plaintiffs to show only that the company’s stock declined and that there was an alleged inaccuracy or omission in the company’s public disclosures.  Investors do not have to show that they actually relied on the alleged misstatement when buying stock, or were even aware of the statement at all, because Basic allows the court simply to presume it—even though, since the 1930s, the securities laws have emphasized the importance of “reliance” as a fundamental and legally required element of securities fraud.

American businesses know all too well that the Basic decision led to an explosion of costly nuisance litigation and attempts to shake down corporations.  Even the Supreme Court noted, 20 years later, that plaintiffs with weak claims may “extort” settlements from innocent companies.  Permitting fabricated claims to survive in the courts long enough to pressure companies and their shareholders into paying off the plaintiff certainly does not deter future fraudsters.

Because these cases are so attractive to lawyers who often receive contingency fees as large as lottery jackpots from friendly judges, opportunistic plaintiffs’ firms started donating large sums of money to politicians so they would be hired to represent state pension funds in multi-million dollar class action suits.  This pay-to-play game illustrates the corrupt, cynical nature of these suits.

The lawyers who bring these suits say “investors recover billions” in settlements.  But those billions come out of the pockets of investors.  The costs of defending and settling these suits are borne by the company’s shareholders, leading to an absurd situation in which money is merely shifted from one group of innocent investors to another, with plaintiff and defense attorneys siphoning off billions of dollars in the process.  In 2013 alone, attorneys’ fees and expense awards in the litigation bonanza surrounding securities class action suits amounted to $1.1 billion.

Some commenters worry that securities fraud will go unpunished if the presumption in Basic is eliminated.  That will not be the case.  Plaintiffs will still be able to litigate on a class-wide basis and then recover damages by showing that a specific material misstatement, on which they relied, caused their loss.  This would be little different than other class-action contexts in which members of the class must show that they were deceived and that the deception caused their harm. The securities context should not be any different.  In addition, the Securities and Exchange Commission has broad enforcement authority.  Many private class-action cases are actually born from SEC actions—the SEC has already done the legwork, private attorneys find a plaintiff to file suit based on what the SEC alleges, and the lawyers then lay claim to one-third or more of the monetary settlement.  Well-paid “work,” if the courts allow you to get away with it.

The Supreme Court should clear the judicial underbrush surrounding securities class action suits so American businesses can focus their time and resources on their real business operations—for the benefit of all shareholders.

Paul Atkins, CEO of Patomak Global Partners, is a former SEC commissioner.