Selling Us Short

When corporate ethics have a run-in with the law, such as in securities fraud, the collateral damage isn’t restricted to the boardroom. 

Just the hint of an SEC investigation or civil lawsuit can send stocks into free fall. Some cases mean a death sentence for a corporation (see: Enron), and even low-level employees can face prison time. Annette Bongiorno, who says her only crime was being a good secretary and typing out what boss Bernie Madoff told her to, faces a possible maximum of 78 years behind bars for her part in his Ponzi scheme.

“Greed is a growth industry, and always has been,” says Max Berger of Bernstein Litowitz Berger & Grossman. “For all the honest financial people in the world, there’s many dishonest people looking for shortcuts to acquire wealth. I’ve been prosecuting security-fraud cases for 43 years, and every time I think I’ve seen the worst of it, a few years later something worse comes along.”

“Many of the matters we’ve been handling the past few years arose out of the financial crisis we just lived through,” says Daniel J. Kramer of Paul, Weiss, Rifkind, Wharton & Garrison. “These are challenging questions and complicated markets. It’s an exciting time.”

Technology makes it even more exciting. 

“Emails have brought about convictions that you wouldn’t have even been charged with before,” says Robert S. Fink of Kostelanetz & Fink.

“I worked with an individual in a fraud case a few years ago, and the one document the government was relying on was a joke from one of his supervisors, who forwarded an email about new regulations and a crackdown on violators,” says Barry H. Berke of Kramer Levin Naftalis & Frankel. “He said in the [subject line], ‘This means you!!!!!’—with five exclamation points—clearly intended as a joke. That is not a helpful email for clients.”

Securities fraud encompasses a spectrum of wrongdoing from embezzlement to Ponzi schemes, but one of its most basic forms involves corporate officers either willfully or recklessly giving investors faulty information that influences them to buy or sell shares. The government can pursue a criminal or civil case against the alleged offenders, while shareholders typically seek redress via a class-action lawsuit. 

A century ago, though, the phrase “securities fraud” didn’t mean much. There was no major federal law governing the trade of securities, which were covered by a variety of state laws of varying degrees of laxness. It took the 1929 stock market crash and the New Deal for the Securities Act of 1933 to set in stone the fundamental law of securities: complete and accurate disclosure. 

Today, interpretation of that law is dominated by court rulings from the 1970s and 1980s, including Basic v. Levinson Inc. (1988), which established the fraud-on-the-market theory. It asserts that investors count on the trustworthiness of the market as a whole, and in an efficient market, securities prices will rely on all publicly available information from a company. So if a company puts out misleading statements about itself, it will distort prices. Fraud-on-the-market creates a rebuttable presumption of reliance for investors because they trusted the integrity of the market when buying a company’s stock, and thus indirectly relied on the company’s misrepresentation of itself. The Basic v. Levinson decision paved the way for the modern model of the majority of securities class-action suits.

Since the mid-1990s, however, the Private Securities Litigation Reform Act of 1995, Tellabs Inc. v. Makor Issues & Rights (2007) and Morrison v. National Australia Bank (2010) have tightened the circumstances under which plaintiffs can pursue securities fraud lawsuits.

A recent Supreme Court case, Halliburton Co. v. Erica John Fund Inc., challenged the entire fraud-on-the-market theory; at issue was whether the court should overrule or substantially modify the decision made in Basic v. Levinson. 

On June 23, the court unanimously declined to overturn Basic v. Levinson, but agreed that securities defendants “must be afforded an opportunity to rebut the presumption of reliance before class certification with evidence of a lack of price impact,” Chief Justice Roberts wrote in the decision.  

Investors who think their stock prices have dropped suspiciously should seek the advice of an attorney who specializes in securities litigation. But they should be aware of the risks: Opposing counsel has the right to go through the plaintiffs’ email, phone and other records. Most cases are painstaking endeavors that take from two to five years. And there’s no guarantee of seeing a cent even if you win: if, for example, the company declares bankruptcy.

As for avoiding the other side of the courtroom in a securities-fraud trial? Much simpler.

“Don’t take the tip,” says Fink.