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 assumed there was a lot of risk in doing so. Furthermore, it is also ridiculous to assume that something up that much over such a short period of time is priced efficiently. This law firm is doing a disservice because it is wasting the company’s time and money, and putting the interests of short-term traders ahead of long-term investors.
Why These Lawsuits Can be Bad for the Capital Markets
Frivolous lawsuits like this are a big deal because they can hurt not just the individual companies involved, but also the capital markets as a whole because they make them less appealing. A sign of that is the paucity of public companies we have in this country these days. While you might be marveling at the red hot IPO market lately, recent statistics from WSJ tell a different story and show how we are still barely playing catch up. Believe it or not, we started last year with the smallest number of publicly traded companies going back to 1991. In fact, the problem is so bad that there are now only 3,667 companies in the Russell 5000 index because there are no longer 5,000 relevant companies to be found. This is not a good thing for our economy.
In short, when you make it so burdensome to be a public company, few people want to go that route anymore. Furthermore, many of the ones that do go public usually wait until they have matured, and arrive on the public markets at the last minute possible so that none of this nonsense disrupts their growth in the important early years. Biotech is a little different, because it is so capital intensive and leans on public markets heavily, but this is a big problem especially in other industries. While I don’t blame the lawsuits for all of it, they are definitely a contributing factor. We are way too focused as a financial community on the short-term and playing gotcha, which is not a good thing for fostering long-term growth and innovation.
So What Happens if the Supreme Court Strikes Down Fraud-On-The Market?
The question now is how can we move forward in a better way? You can bet that if the Supreme Court rules decisively against fraud-on-the-market, it is unlikely that this story, and the lawsuits, will just go away forever (more on that later). However, I’d argue that such a scenario wouldn’t even necessarily be all that bad.
First of all, I’m not sure investors need these lawsuits to do our bidding for us. As far as I’m concerned, we are more than capable of standing up for ourselves through shareholder activism, which is at an all-time high in effectiveness. These days if there is a problem with management, shareholders (and journalists) are able to sniff it out fast, mobilize quickly, and act as a bigger check and balance than we historically could have ever dreamed of. There are various reasons for this, but you can thank technology and social media for some of it. Even Carl Icahn, the billionaire investor who has been challenging management teams since the ‘80s, has made social media a big component of his activism campaigns lately.
Second, I’d argue that these lawsuits don’t act as a deterrent, so what is the point of all the time and money put into them? It would be different if they were more directly helping investors, but most executives tell me they simply view this as the cost of doing business, and investors rarely end up gaining anything meaningful when the lawsuits are settled. Furthermore, in major cases, the ones that should set an example and serve as a deterrent to other bad actors, the SEC and Department of Justice can and do get involved. Comparatively speaking, private class-action lawsuits are meaningless, so I wouldn’t be concerned as an investor if they were scrapped altogether.
What is more likely in this case if the Supreme Court does rule against fraud-on-the-market completely is that Congress will probably step in afterwards and write something directly into law. I would be all for that because the process needs to be reinvented, and it is a topic that deserves much more thought and open debate. I would recommend at a minimum that any such law include provisions that give added deference to long-term investing. I’d also like to see some kind of additional deterrents to filing frivolous cases, such as a rule that requires plaintiff law firms to pay the opponent’s fees if their case is dismissed. Judges and mediators could also be given much more leniency to decide which cases might actually be in the overall market’s best interest. Any of those things could allow the legitimate cases to still go forward while cutting down on the frivolous ones.
It is technically possible that the Supreme Court will find some middle ground too, such as requiring future cases to prove early on how management actions did specifically cause a stock move, but I would strongly recommend starting over from scratch. The system is clearly broken, let’s build it again from the ground up for the benefit of companies and investors.
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