Supreme Court Hears Challenge to Fraud-on-the-Market Presumption in Securities Fraud Litigation

Even if it stops short of reversing Basic, the Court could still issue an opinion that curtails securities fraud class actions, by giving defendants more ammunition to oppose class certification with evidence that alleged misrepresentations did not affect the stock price.

Many Interested Parties

The high stakes of the case are reflected in the amicus curiae briefs filed. In a brief in support of Halliburton's appeal, the Chamber of Commerce of the United States, National Association of Manufacturers and other business groups contend that under Basic, “securities fraud plaintiffs get a near free pass to class certification, and the easy certification of plaintiff classes has predictably led to excessive securities fraud litigation and the in terrorem settlement of insubstantial claims.”

By contrast, the United States, through the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC), filed a brief supporting the presumption, arguing that parties seeking reversal “identify no good reasons to overrule Basic's fraud-on-the market holding,” which it contends Congress could have undone through legislation but chose not to. Other amici opposing reversal include former SEC Chairmen William H. Donaldson and Arthur Levitt, Jr.

What's at Stake?

Basic is so important because it eased the burden plaintiffs' lawyers had to meet to obtain certification of a class. Among the elements of an investor's securities fraud misrepresentation claim under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 is reliance ' that is, showing that the investor, in purchasing a company's shares, relied on a false statement by the company, its directors or officers.

In seeking to certify a class under Rule 23 of the Federal Rules of Civil Procedure, plaintiffs' counsel would have to show that common, rather than individual, issues predominate in the case. Yet, in showing reliance, each class member arguably could have relied on a different statement by the company, creating a lack of commonality that could defeat class certification.

Thus, the Supreme Court in Basic found that “[r]equiring proof of individualized reliance from each member of the proposed plaintiff class effectively would” bar a class action. If proof of individualized reliance were required, individual issues would “overwhelm” common ones.

Basic solved this problem by creating a presumption of reliance ' reliance not on any particular statement by a company in its financial statements or SEC filings, but rather, reliance on the fact that all available public information was reflected in the company's stock price. Thus, all investors would be presumed to have relied on the same statement: the market's valuation of a company based on the market's knowledge of all available public information.

Hence, the theory was known as the “fraud-on-the-market” theory.

Fraud-on-the-Market

The underpinnings of this theory were taken from the field of economics, not law. At the time Basic was decided, economists were uniting behind the view that the U.S. securities markets were rational, meaning that they took into account all of the information released by a company ' its 10Ks and Qs, earnings releases, and the rest of its public statements. From this theory, the Court reasoned that investors were, in effect, making decisions based on the market's assessment of all available public information. Thus, if all investors were relying on the same thing ' the market ' then a “fraud on the market” was presumptively a fraud on all investors, and the reliance of a class of investors could be viewed as collective reliance, meaning that Rule 23's commonality requirement would be satisfied.

The Court did not apply this approach rigidly. Rather, it said that if the necessary pleadings were made about the efficiency of the market, then the plaintiff would be entitled to a presumption of reliance. The defense would still have the ability to rebut this presumption by showing, for example, that the market for a particular company's stock was not efficient. It did not specifically address at what procedural stage of a litigation this rebuttal could be demonstrated ' for example, whether at trial, or earlier, on a pretrial motion for class certification.

Basic's presumption, although rebuttable, provided major assistance to plaintiffs' lawyers in seeking class certification. It made certification, often a major challenge for plaintiffs in other types of class actions, easy to obtain in securities class actions.

Questions from the Outset

Basic had its doubters from the start. Justices White and O'Connor dissented from the part of Justice Blackmun's opinion adopting the fraud-on-the-market approach, contending, among other things, that the efficient-market economic theories upon which the presumption relied “are ' in the end ' nothing more than theories which may or may not prove accurate upon further consideration.”

And since the Basic Court's adoption of the presumption, a number of academics have disputed the efficient-market theory, contending that it fails to capture the behavior of all or even most investors, some of whom are searching for undervalued stocks, or stocks that the market has not correctly valued based upon available information ' which would suggest that the market is inefficient, not efficient.

Thus, the defendants in Halliburton and their supporters who have filed amicus briefs contend that the theoretical premise of Basic no longer applies. Indeed, the defendants in Halliburton were likely encouraged to pursue a direct attack on Basic by the statements of four justices ' Justices Alito, Kennedy Scalia and Thomas ' in dissenting or concurring opinions in Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), who in varying ways signaled, at the very least, an openness to hearing a challenge to Basic.

Ironically, Amgen itself was decided favorably to class action plaintiffs on a separate, though not unrelated, securities fraud issue: whether plaintiffs had to demonstrate the materiality of alleged misrepresentations or omissions in obtaining class certification under the fraud-on-the-market presumption of reliance. Justice Alito agreed that this was not required under Basic, and thus did not dissent from the Court's decision, but in his concurrence wrote that “recent evidence suggests that the [fraud-on-the market] presumption may rest on a faulty economic premise.”

Also ironic is that the underlying litigation in Halliburton has already generated a Supreme Court decision, in 2011, and that that decision too was decided favorably to the plaintiffs on the issue of whether loss causation had to be proven by plaintiffs on a class certification motion. Erica P. John Fund, Inc. v. Halliburton Co., 131 S.ct. 2179 (2011) (“Halliburton I “).

Halliburton I

The underlying complaint alleges claims against Halliburton and its CEO concerning alleged misstatements as to the company's revenues, asbestos liability and the benefits of a 1998 merger between Halliburton and Dresser Industries.

The chain of events leading to Halliburton I began with the district court's denying class certification, based on the plaintiff's failure to satisfy the loss causation element of a securities fraud claim. The Fifth Circuit affirmed. In Halliburton I, however, the Supreme Court held unanimously that proof of loss causation was not required at the class certification stage.

When the case returned to the district court to decide the issue of class certification in light of the Supreme Court's decision, Halliburton continued to argue against certification, now on the basis that its evidence demonstrated that the alleged misrepresentations did not affect the price of Halliburton stock.

But the district court refused to consider this evidence, on the basis that Haliburton could not rebut the fraud-on-the market presumption on a class certification motion by proving an absence of price impact. The Fifth Circuit affirmed.

By this time, Amgen had been decided. And the Fifth Circuit portrayed the issue of price impact as analogous to the issue of materiality dealt with in Amgen ' that is, a merits issue as to which the plaintiff would have to prevail at trial to win the case (although “price impact” itself is not a separate element of a 10b-5 claim, it is something a plaintiff would have to demonstrate to establish loss causation, which is an element). If Haliburton succeeded at trial in proving lack of price impact, all plaintiff's claims would fail, which to the Fifth Circuit meant that price impact is not relevant to whether common issues predominate, the issue for class certification.

Thus, the Fifth Circuit stated, under the reasoning of Amgen, the district court was correct in declining to consider price impact evidence.

The Case on Appeal

In its appeal to the Supreme Court, Hlaliburton raises this narrower issue upon which the Fifth Circuit decided the case: whether a defendant may rebut the Basic presumption of reliance at the class certification stage by “introducing evidence that the alleged misrepresentation did not distort the market price of its stock.”

But it further raises the broader question of whether the Court “should overrule or substantially modify” Basic's recognition of “a presumption of class wide reliance derived from the fraud-on-the-market theory.”

Although the Supreme Court's grant of certiorari has provoked speculation that Basic will be reversed, the outcome of the case is by no means clear. Defendants are heartened by the fact that the four justices critical of the fraud-on-the-market theory said what they did in Amgen. Many believe those four are inclined to overrule Basic . But plaintiffs' lawyers believe that at least four of the other five justices ' Justices Ginsburg, Kagan, Breyer and Sotomayor ' are leaning the other way. Many believe the key question is how Chief Justice Roberts, who joined the plaintiff-favorable decisions in Halliburton I and in Amgen but is more often aligned with the four justices critical of Basic, will view the case.

While the critics of Basic focus on academic literature challenging the efficient-market hypothesis, both the plaintiffs' and the United States' briefs maintain that the presumption does not depend on the proposition that markets are always efficient, and that the academic debate about whether markets “correctly” value securities is irrelevant. The Basic supporters' key argument, however, may be that Congress has “acquiesced” in the presumption. Since Basic, Congress enacted the Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998, modifying the scope of the private right of action under section 10(b) but not modifying the fraud-on-the-market presumption.

Conclusion

Even if the fraud-on-the-market presumption survives, the case could still result in a change of the status quo in securities litigation if the Court's decision permits defendants to rebut the presumption of reliance at the class certification stage, by introducing evidence that any misrepresentations did not distort the market price. Defendants can do that now at trial, but many defendants find it too risky to go to trial where a plaintiff class has been certified, causing companies to settle cases before trial. The ability to wage that fight at class certification could enable defendants to fight class certification more effectively, and thus develop greater leverage in negotiating settlements before certification is decided.

Eric Rieder is a partner in the New York office of Bryan Cave LLP. A member of this newsletter's Board of Editors, Rieder has broad experience as a litigator in securities and other commercial cases and as an adviser on the duties of directors and officers of both public and private companies. He can be reached at [email protected].

When the U.S. Supreme Court 25 years ago decided Basic, Inc. v. Levinson , 485 U.S. 224 (1988), it adopted a legal theory that commentators would describe as revolutionizing securities law in the United States. By accepting the “fraud-on-the-market” theory, the Basic Court made it much easier for plaintiffs to get their cases certified as class actions, increasing the potential exposure of corporations and their officers and directors.

This month, the Court will hear argument in a case that seeks to overthrow Basic's revolutionary regime. The Court last year agreed to hear the appeal of the corporate defendants in Halliburton v. Erica P. John Fund; they directly put to the Court the question of whether Basic and the fraud-on-the-market theory it adopted should be overruled.

If the Court ultimately decides to overturn Basic , it will likely have a significant impact on securities fraud class actions, depriving plaintiffs' lawyers of a critical doctrinal weapon and giving corporate defendants far greater leverage in settlement negotiations.

Even if it stops short of reversing Basic, the Court could still issue an opinion that curtails securities fraud class actions, by giving defendants more ammunition to oppose class certification with evidence that alleged misrepresentations did not affect the stock price.

Many Interested Parties

The high stakes of the case are reflected in the amicus curiae briefs filed. In a brief in support of Halliburton's appeal, the Chamber of Commerce of the United States, National Association of Manufacturers and other business groups contend that under Basic, “securities fraud plaintiffs get a near free pass to class certification, and the easy certification of plaintiff classes has predictably led to excessive securities fraud litigation and the in terrorem settlement of insubstantial claims.”

By contrast, the United States, through the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC), filed a brief supporting the presumption, arguing that parties seeking reversal “identify no good reasons to overrule Basic's fraud-on-the market holding,” which it contends Congress could have undone through legislation but chose not to. Other amici opposing reversal include former SEC Chairmen William H. Donaldson and Arthur Levitt, Jr.

What's at Stake?

Basic is so important because it eased the burden plaintiffs' lawyers had to meet to obtain certification of a class. Among the elements of an investor's securities fraud misrepresentation claim under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 is reliance ' that is, showing that the investor, in purchasing a company's shares, relied on a false statement by the company, its directors or officers.

In seeking to certify a class under Rule 23 of the Federal Rules of Civil Procedure, plaintiffs' counsel would have to show that common, rather than individual, issues predominate in the case. Yet, in showing reliance, each class member arguably could have relied on a different statement by the company, creating a lack of commonality that could defeat class certification.

Thus, the Supreme Court in Basic found that “[r]equiring proof of individualized reliance from each member of the proposed plaintiff class effectively would” bar a class action. If proof of individualized reliance were required, individual issues would “overwhelm” common ones.

Basic solved this problem by creating a presumption of reliance ' reliance not on any particular statement by a company in its financial statements or SEC filings, but rather, reliance on the fact that all available public information was reflected in the company's stock price. Thus, all investors would be presumed to have relied on the same statement: the market's valuation of a company based on the market's knowledge of all available public information.

Hence, the theory was known as the “fraud-on-the-market” theory.

Fraud-on-the-Market

The underpinnings of this theory were taken from the field of economics, not law. At the time Basic was decided, economists were uniting behind the view that the U.S. securities markets were rational, meaning that they took into account all of the information released by a company ' its 10Ks and Qs, earnings releases, and the rest of its public statements. From this theory, the Court reasoned that investors were, in effect, making decisions based on the market's assessment of all available public information. Thus, if all investors were relying on the same thing ' the market ' then a “fraud on the market” was presumptively a fraud on all investors, and the reliance of a class of investors could be viewed as collective reliance, meaning that Rule 23's commonality requirement would be satisfied.

The Court did not apply this approach rigidly. Rather, it said that if the necessary pleadings were made about the efficiency of the market, then the plaintiff would be entitled to a presumption of reliance. The defense would still have the ability to rebut this presumption by showing, for example, that the market for a particular company's stock was not efficient. It did not specifically address at what procedural stage of a litigation this rebuttal could be demonstrated ' for example, whether at trial, or earlier, on a pretrial motion for class certification.

Basic's presumption, although rebuttable, provided major assistance to plaintiffs' lawyers in seeking class certification. It made certification, often a major challenge for plaintiffs in other types of class actions, easy to obtain in securities class actions.

Questions from the Outset

Basic had its doubters from the start. Justices White and O'Connor dissented from the part of Justice Blackmun's opinion adopting the fraud-on-the-market approach, contending, among other things, that the efficient-market economic theories upon which the presumption relied “are ' in the end ' nothing more than theories which may or may not prove accurate upon further consideration.”

And since the Basic Court's adoption of the presumption, a number of academics have disputed the efficient-market theory, contending that it fails to capture the behavior of all or even most investors, some of whom are searching for undervalued stocks, or stocks that the market has not correctly valued based upon available information ' which would suggest that the market is inefficient, not efficient.

Thus, the defendants in Halliburton and their supporters who have filed amicus briefs contend that the theoretical premise of Basic no longer applies. Indeed, the defendants in Halliburton were likely encouraged to pursue a direct attack on Basic by the statements of four justices ' Justices Alito, Kennedy Scalia and Thomas ' in dissenting or concurring opinions in Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds , 133 S. Ct. 1184 (2013), who in varying ways signaled, at the very least, an openness to hearing a challenge to Basic .

Ironically, Amgen itself was decided favorably to class action plaintiffs on a separate, though not unrelated, securities fraud issue: whether plaintiffs had to demonstrate the materiality of alleged misrepresentations or omissions in obtaining class certification under the fraud-on-the-market presumption of reliance. Justice Alito agreed that this was not required under Basic, and thus did not dissent from the Court's decision, but in his concurrence wrote that “recent evidence suggests that the [fraud-on-the market] presumption may rest on a faulty economic premise.”

Also ironic is that the underlying litigation in Halliburton has already generated a Supreme Court decision, in 2011, and that that decision too was decided favorably to the plaintiffs on the issue of whether loss causation had to be proven by plaintiffs on a class certification motion. Erica P. John Fund, Inc. v. Halliburton Co ., 131 S.ct. 2179 (2011) (“ Halliburton I “).

Halliburton I

The underlying complaint alleges claims against Halliburton and its CEO concerning alleged misstatements as to the company's revenues, asbestos liability and the benefits of a 1998 merger between Halliburton and Dresser Industries.

The chain of events leading to Halliburton I began with the district court's denying class certification, based on the plaintiff's failure to satisfy the loss causation element of a securities fraud claim. The Fifth Circuit affirmed. In Halliburton I, however, the Supreme Court held unanimously that proof of loss causation was not required at the class certification stage.

When the case returned to the district court to decide the issue of class certification in light of the Supreme Court's decision, Halliburton continued to argue against certification, now on the basis that its evidence demonstrated that the alleged misrepresentations did not affect the price of Halliburton stock.

But the district court refused to consider this evidence, on the basis that Haliburton could not rebut the fraud-on-the market presumption on a class certification motion by proving an absence of price impact. The Fifth Circuit affirmed.

By this time, Amgen had been decided. And the Fifth Circuit portrayed the issue of price impact as analogous to the issue of materiality dealt with in Amgen ' that is, a merits issue as to which the plaintiff would have to prevail at trial to win the case (although “price impact” itself is not a separate element of a 10b-5 claim, it is something a plaintiff would have to demonstrate to establish loss causation, which is an element). If Haliburton succeeded at trial in proving lack of price impact, all plaintiff's claims would fail, which to the Fifth Circuit meant that price impact is not relevant to whether common issues predominate, the issue for class certification.

Thus, the Fifth Circuit stated, under the reasoning of Amgen, the district court was correct in declining to consider price impact evidence.

The Case on Appeal

In its appeal to the Supreme Court, Hlaliburton raises this narrower issue upon which the Fifth Circuit decided the case: whether a defendant may rebut the Basic presumption of reliance at the class certification stage by “introducing evidence that the alleged misrepresentation did not distort the market price of its stock.”

But it further raises the broader question of whether the Court “should overrule or substantially modify” Basic's recognition of “a presumption of class wide reliance derived from the fraud-on-the-market theory.”

Although the Supreme Court's grant of certiorari has provoked speculation that Basic will be reversed, the outcome of the case is by no means clear. Defendants are heartened by the fact that the four justices critical of the fraud-on-the-market theory said what they did in Amgen. Many believe those four are inclined to overrule Basic . But plaintiffs' lawyers believe that at least four of the other five justices ' Justices Ginsburg, Kagan, Breyer and Sotomayor ' are leaning the other way. Many believe the key question is how Chief Justice Roberts, who joined the plaintiff-favorable decisions in Halliburton I and in Amgen but is more often aligned with the four justices critical of Basic, will view the case.

While the critics of Basic focus on academic literature challenging the efficient-market hypothesis, both the plaintiffs' and the United States' briefs maintain that the presumption does not depend on the proposition that markets are always efficient, and that the academic debate about whether markets “correctly” value securities is irrelevant. The Basic supporters' key argument, however, may be that Congress has “acquiesced” in the presumption. Since Basic, Congress enacted the Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998, modifying the scope of the private right of action under section 10(b) but not modifying the fraud-on-the-market presumption.

Conclusion

Even if the fraud-on-the-market presumption survives, the case could still result in a change of the status quo in securities litigation if the Court's decision permits defendants to rebut the presumption of reliance at the class certification stage, by introducing evidence that any misrepresentations did not distort the market price. Defendants can do that now at trial, but many defendants find it too risky to go to trial where a plaintiff class has been certified, causing companies to settle cases before trial. The ability to wage that fight at class certification could enable defendants to fight class certification more effectively, and thus develop greater leverage in negotiating settlements before certification is decided.

Eric Rieder is a partner in the New York office of Bryan Cave LLP. A member of this newsletter's Board of Editors, Rieder has broad experience as a litigator in securities and other commercial cases and as an adviser on the duties of directors and officers of both public and private companies. He can be reached at [email protected].