Securities Litigation

You know that listed corporations have extensive affirmative disclosure obligations under the securities acts (see the Securities Law Primer in Chapter 1). But what happens if the corporation does not disclose truthfully? One possibility is that the SEC will bring an enforcement action. Another possibility that we will look at here is that a specialized plaintiff law firm will file a “securities fraud” class action against the corporation (!). If the corporate disclosure was misleadingly positive, then the suit will attempt to recover damages for shareholders who bought at an inflated price — inflated because it was based on erroneously positive information. Inversely, sellers will sue if the disclosure was misleadingly negative and thus the price was deflated. Notice that those on the other side of these trades—sellers who sell at an inflated price, or buyers who buy at a deflated price—benefitted from the erroneous corporate disclosure, but they are not party to the litigation.

Most of the time, any individual trader’s losses from the fraud are too small to make an individual lawsuit worthwhile. The big question in securities litigation is therefore the availability of the class action. That is the main question addressed in Basic, besides defining the standard of materiality for securities fraud. By endorsing the fraud-on-the-market theory, Basic paved the way for an entire industry of specialized class action law firms. Congress and recently the Supreme Court have tried to reign in some of this litigation, which remains controversial. In 1995, Congress passed the Private Securities Litigation Reform Act, which, among other things, introduced very strict pleading requirements via Exchange Act §21D.

Doctrinally, the fraud-on-the-market theory is an interpretation of the reliance element of the private right of action under rule 10b-5. Notwithstanding the convoluted text of the rule, the elements of a 10b-5 claim appear to be exactly the same as those of common law fraud: (1) a false or misleading statement (2) of a material fact (3) made with scienter that (4) the plaintiff reasonably relied on, (5) causing injury to the plaintiff. As the Basic decision shows, however, these similarities are deceptive. These elements have a special meaning in the context of 10b-5.