Corporate Lies Are Increasingly Immune to Investor Complaints

Corporate Lies Are Increasingly Immune to Investor Complaints
MARCH 20, 2014
High & Low Finance
By FLOYD NORRIS
Companies do not have a right to lie to their shareholders, a German judge ruled this week. But sometimes, she added, lies are necessary.

And with that Carola Wittig, a judge in the state court in Stuttgart, dismissed a suit filed by a group of hedge funds that lost a lot of money when Porsche Holding, then the owner of the Porsche automaker, lied about its intentions regarding Volkswagen.
“It was hardly possible to react to public speculation about a takeover of VW except with a denial,” the court explained in a news release, adding that the statements cited in the litigation were not about Porsche’s own stock, but about another company’s, for which standards are evidently not as strict.
The actual court ruling has not been released, so I may be missing some nuances. But the result is the same. Those who believed the lies and invested on that belief lost a lot of money — and have no recourse.
It is not just Germany where lies may be immune to investor complaint. The United States Supreme Court is considering whether to reverse a decision it made a quarter-century ago and — in effect — make it impossible for most investors to ever recover if they fall victim to corporate lies. A decision is expected by June.
The 2008 takeover battle involving Porsche and VW was among the most colorful ever. It was known that Porsche had been accumulating VW shares, but it denied that it planned a takeover. As the VW share price rose — at one point it was the most valuable company in the world, based on market prices — some hedge funds shorted VW shares on the belief they were ridiculously overvalued.
They were right about that, but it did not matter.
Porsche had been buying not only the Volkswagen shares but also had accumulated a huge position in call options on the stock. It had cornered the stock. Porsche revealed that it owned 42.6 percent of the stock and had acquired options for another 31.5 percent. It said it wanted to go to 75 percent — and expected to require those who had written the options to deliver the shares. With a German state owning a 20 percent stake, there were few shares available for the short sellers to buy to cover their positions, or for those who had written the options Porsche bought.
The shorts ended up taking huge losses. In order to close out their positions, they had to pay whatever Porsche demanded.
Once the short-squeeze was over, the VW price fell, and it ended up acquiring Porsche. Hedge funds filed suits in both Germany and the United States, but so far have nothing to show for them.
The United States case before the Supreme Court, Halliburton v. Erica P. John Fund, in some ways reflects the state of securities class action cases in this country. Because of a 1995 law that was passed over President Bill Clinton’s veto, it can be excruciatingly difficult to even get a court to hear such a case. Plaintiffs need a lot of evidence before they can even file a case, and many cases are dismissed at an early stage.
No court has yet heard evidence as to whether Halliburton, the large oil services company, defrauded investors between 1991 and 2001 by understating its exposure to asbestos litigation, overstating revenues by including billings that were unlikely to be collected and exaggerating the benefits from a merger.
But that has not kept the case from reaching the Supreme Court twice. Halliburton originally got a district court judge to refuse to certify the class of investors, and the United States Court of Appeals for the Fifth Circuit upheld that ruling. In 2011, the Supreme Court unanimously overruled that decision,saying the appeals court was wrong to require proof that the investors’ losses were caused by the alleged misstatements before the class was certified.
So the district court certified a class, which would have meant that a trial could take place on the merits. But Halliburton appealed, arguing that it should have been allowed to try to prove it had not caused the losses before a class was certified. And it argued that the 1988 decision in the case of Basic v. Levinson should be overturned.
The Basic case established the “fraud on the market” principle, which had previously been accepted by some but not all circuit courts. In the case of widely traded securities, investors were entitled to assume that the market price reflected the known information. If someone could prove that false information had inflated a stock price, those who disseminated the false information could be sued even if the investor could not prove that he had relied on that specific false statement.
That is critical for securities class actions. To establish a class, a judge must be persuaded that the relevant facts are the same for all members of the class. That would not be the case if each one had to prove that he or she knew of and relied on the false information.
Without the “fraud on the market” principle, investors could still sue, one by one. But few could afford to do so, given that the possible recovery would not be enough to pay a lawyer. In the current German case, that would not be a problem; there is no doubt that the hedge funds relied on the Porsche statements, and they lost more than 1 billion euros.
Those who attack the Basic decision argue that it was based on the dubious economic theory of efficient markets, a theory they say is no longer believed by many economists. And they add that companies routinely settle most cases for which a class is certified, so that class certification effectively concludes the case. “Settlement is the only reasonable option for many securities fraud defendants,” stated a brief filed by the U.S. Chamber of Commerce and other corporate groups.
Supporters of the Basic decision say that it relied on common sense. You don’t have to believe that the market is completely efficient to believe that a company’s statements about its business will influence the price.
There is some thought that the court might adopt a middle course — one of allowing defendants such as Halliburton the opportunity, before a class is certified, to contest whether their statements affected the stock price. If that is the course chosen, the result may be that defendants get two trials. The first, with competing experts testifying, would be a preliminary one. If the defendants lost that one, they could still settle before the real trial on the merits.
The Securities and Exchange Commission, in a brief filed with the court, and two former S.E.C. chairmen, Arthur Levitt and William Donaldson, in their own brief, argue that regulators need the help of private cases in enforcing the law. But a group that includes four former members of the S.E.C., including Joseph A. Grundfest, who is now a Stanford law professor, says the Basic decision should be overturned. The Basic ruling, that group argues, “accounts for the lion’s share” of the “breathtaking” total of $73 billion in settlements stemming from class action cases filed between 1997 and 2012.
Opponents of the Basic ruling dismiss it as bad law made by ill-informed judges just 26 years ago. The Solicitor General’s office, representing the S.E.C. in the case, says the principle at stake goes back at least two centuries.
“In an early fraud case involving market traded securities,” states the brief filed on behalf of the commission, “an English court held that false rumors of Napoleon’s death — circulated by those seeking to raise the prices of securities issued by the British government — constituted ‘a fraud leveled against all the public’ because the rumors affected market prices, harming those who purchased at a distorted price.”
A return to a requirement that investors prove reliance on specific statements would in some ways fly in the face of the normal advice now given to many investors, which is to buy stock index funds. Those funds have low costs precisely because they do no independent research and cannot claim to have relied on any particular statement by a company. A repudiation of “fraud on the market” conceivably could render those investors — who could not be more unlike the hedge funds that lost in the German case — unable to ever recover damages due to fraud.