Supreme Court Should Scale Back Securities Class Actions

3/4/14Follow @BradLoncar

Class-action lawsuits against publicly traded companies, which ironically are meant to protect investors like me, have officially jumped the shark.  That was the only conclusion I could come to after learning last week that one firm alone, Levi & Korsinsky, is suing not one, but three companies I invest in—Aegerion Pharmaceuticals (NASDAQ: AEGR), Sarepta Therapeutics (NASDAQ: SRPT), and Zale (NYSE: ZLC). The firm is also investigating numerous others.  While I would normally be flattered to have an army of high-priced lawyers working on my behalf, these have been some of the best stocks I own, and I want them to do even better in the future.  So what is the point of all those lawyers distracting these companies, and suing, supposedly, on my own behalf?  While I have witnessed truly fraudulent behavior from companies I’ve invested in before, many recent cases have swung so far towards frivolity that investors and companies surely would be better off if the process was reinvented.

The Legal Issue and the Supreme Court

Interestingly enough, the U.S. Supreme Court is examining that very topic on Wednesday, March 5th, in a case (Halliburton Co. v. Erica P. John Fund) that will have broad implications if the justices reverse the way these lawsuits have been practiced.  Given how widespread the problem is, I’m surprised more people aren’t talking about it.  At issue here is a previous ruling from the 1980s that established what is known as the “fraud-on-the-market” theory.  I’m not a lawyer, but will try to summarize my understanding of it in layman’s terms.

Fraud-on-the-market assumes current stock prices are always efficient, or essentially always an accurate reflection of the real value of the business (a laughable concept).  This means executives who mislead the market by withholding info, or even outright lying, have inherently manipulated their stock price and therefore affected everybody who buys it at a so-called wrong price.  This is an important theory because without it, shareholders wouldn’t so obviously share the same harm and therefore would have difficulty forming a class.  In fact, they would otherwise likely be burdened with having to prove how they were individually deceived.  The result is that if the justices strike down fraud-on-the-market, many class actions as we currently know them will be hard, or perhaps impossible, to put together.

While I can understand how this theory was originally meant to benefit shareholders with the best of intentions, the problem is that it is a very low bar that can be taken advantage of.  I see how lawyers practically pounce on any stock that goes down, earning a surefire settlement and fees for them, yet this typically results in less than peanuts for shareholders.  In fact, shareholders rarely come out with anything meaningful, even in the legitimate cases of fraud against shareholders.  I’m overgeneralizing of course, but have seen this happen time and again.  It is a big deal because frivolous lawsuits can actually be harmful to the very capital markets they are meant to protect.  I think it is important to show you just how counterintuitive these lawsuits can sometimes be through an example.

Intercept Pharmaceuticals and the 48-Hour Buyers

Levi & Korsinsky, the same firm who is suing my three stocks, is also suing Intercept Pharmaceuticals (NASDAQ: ICPT) (I have no ownership position).  You might have heard of Intercept because it is arguably the best stock of any kind this year, up 501 percent.  Given that, the obvious question you might be asking is:  why would any shareholder in their right mind want to sue a company after such success?  The answer lies in the details of the law firm’s press release.  The lawsuit only applies to investors who bought Intercept stock on January 9 or 10, just two days!  They are presumably using fraud-on-the-market to argue the stock was mispriced over that time because the National Institutes of Health, which is conducting a clinical trial using Intercept’s drug, announced an early halt to the study on Jan. 9 (good news), but then mentioned possible side effects in a statement to the Wall Street Journal on Jan. 10 (general consensus amongst investors and experts is still unclear on how important this is, if at all).  You heard correctly, btw, it is not even Intercept’s study.

In my opinion, this case perfectly illustrates the absurd, and harmful level these lawsuits have stooped to lately.  Though it is often forgotten in this day and age, investing is supposed to be about the long-term.  I’d like to ask: who is this lawsuit protecting here, day traders?  If we are going to assume every breath a company takes revolves around Wall Street traders, our capital markets are in big trouble.  Intercept stock was up over 500% during those two days.  Common sense would suggest the people who were buying it should have … Next Page »

Brad Loncar is an individual investor. Follow @BradLoncar

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  • micro kid

    Very good article! Hopefully sanity will prevail over the current insanity. I really wonder, if some of these lawsuits and threats of lawsuits are designed to disrupt the price. Most of these companies have E&O insurance, so the law suits will have minimal effect to operation. When companies have to search for a lead plantiff, there is something wrong with the system.

  • Ramsis423

    Unfortunately the cases continue.. I’m tired of seeing articles in my news feed about Levi and Korsinsky attempting class actions against good companies.. especially pharmas trying to develope life saving drugs (Vertex being the most recent I believe).

  • binthere222

    It is greenmail plain and simple, but even worse if the lawfirm holds, or represents a person who holds, a short position in the stock.
    In any case simply re-publicizing that they are LAUNCHING an investigation is a misrepresentation. Unless of course they have closed a previous investigation.
    Beside any complaints to the NY Bar ethics committee, A referendum is in order for the ballot in NY state. Simply stated and vetted for if it would stand up to appeal. Change it to an opt out form of class action and go back to “you sue, you lose, you pay”.

  • binthere222