On March 5, 2014, the Supreme Court will hear oral argument in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317. This much-anticipated case will provide the Court with an opportunity to reexamine the “fraud on the market” doctrine – a central tool for securities fraud class action plaintiffs that the Court first accepted more than a quarter century ago, by a 4-2 vote, in Basic Inc. v. Levinson, 485 U.S. 224 (1988).
Basic And The “Fraud On The Market” Presumption
The “fraud on the market” doctrine posits that the price of a security trading in an efficient market reflects all publicly available information about that security, and gives rise to a rebuttable presumption that investors rely on misrepresentations that are reflected in the prices of such securities at the time they transact. Armed with the “fraud on the market” doctrine, plaintiffs in private actions under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 can establish their own reliance, and the reliance of proposed class members, on alleged misstatements they never saw and of which they may have been entirely unaware.
The importance to securities class action litigation of Basic and the “fraud on the market” doctrine cannot be overstated. The Supreme Court recently and cogently observed that proving each class member's “eyeball” reliance on an alleged misrepresentation would be difficult because “many, if not most, individuals who purchase stock from third parties on an impersonal exchange will be unaware of statements made by the issuer of those securities.” Amgen Inc. v. Connecticut Retirement Plans & Trust Funds, 133 S. Ct. 1184, 1208 (2013). Thus, without the “fraud on the market” presumption of reliance, plaintiffs purporting to assert class action securities fraud claims would have difficulty showing reliance on a classwide basis, and hence satisfying the prerequisite to class certification under Fed. R. Civ. P. 23(b)(3) that “questions of law or fact common to class members predominate over any questions affecting only individual members.” By dispensing with the need for proof of “eyeball” reliance by each class member, Basic effectively paved the way for modern-day securities litigation. After Basic, securities fraud class actions rose dramatically. Between 1997 and 2012, more than 3,050 private securities class action lawsuits were reportedly filed, and those cases generated aggregate settlements of more than $73 billion.[1]
Questioning Basic’s Presumption Of Reliance
Yet Basic has never been without its critics. In Basic itself, Justice White filed a dissenting opinion (joined by Justice O’Connor) that questioned the reasoning behind the “fraud on the market” doctrine endorsed by the majority:
[T]he fraud on the market theory is a mere babe. Yet today, the Court embraces this theory with the sweeping confidence usually reserved for more mature legal doctrines. In so doing, I fear that the Court’s decision may have many adverse, unintended effects as it is applied and interpreted in the years to come.
Basic, 485 U.S. at 250-51. Academic literature subsequent to Basic has questioned the economic theory that underpins the “fraud on the market” doctrine. And earlier this year, in Amgen, Justices Alito, Kennedy, Scalia and Thomas signaled their willingness to revisit Basic and the appropriate contours of the presumption it created.
Critics of Basic’s economic premise question the efficient capital markets hypothesis upon which the fraud on the market presumption relies. In particular, economic scholars call into question the notion of “binary” market efficiency, and the assumption that the “market” – including its market professionals – acts rationally. Among other things, critics of the efficient market theory point to the Internet bubble and the economic crisis of 2008 as prime examples of markets acting irrationally, with stock prices trading far from fundamental values. Academics also have observed that information that is public, but complex or difficult to understand, may take weeks or months to be fully incorporated into the market price of a security, if at all. And the market for a given security may efficiently incorporate information into prices at some times but not others.[2] Stated differently, critics of the “fraud on the market doctrine” contend that efficiency is rarely uniform, even for a single security in a well-developed market. As the Halliburton petitioners argue, even if a stock trades in a market that is generally efficient, that “mere fact says nothing about whether it was efficient with respect to a particular misrepresentation.”[3]
Halliburton
The Court’s grant of certiorari on November 15, 2013 in Halliburton is the latest chapter in a multi-year battle over class certification, and marks the case’s second trip to the Supreme Court. Two years ago, reversing a Fifth Circuit decision, the Court held that, at the class certification stage, the plaintiff in a private securities fraud action need not show loss causation. However, the Court did not address the defendants’ argument that, at that stage, they could defeat application of the “fraud on the market” presumption of reliance by demonstrating that the alleged misrepresentations on which the plaintiff based its claims had no impact on the market price of Halliburton common stock. Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179 (2011). On remand, defendants raised that argument unsuccessfully. Affirming a district court’s certification of a plaintiff class, the Fifth Circuit reasoned, in light of Amgen, that “the fraud-on-the-market elements that should be addressed at class certification are limited to those matters which bear on common question predominance and the propriety of class resolution: trade timing, market efficiency, and publicity (but not materiality). . . . The Amgen Court’s analysis leads to the conclusion that price impact fraud-on-the-market rebuttal evidence should not be considered at class certification.” Erica P. John Fund, Inc. v. Halliburton Co., 718 F.3d 423, 432, 435 (5th Cir. 2013). Notably, contrary to the Fifth Circuit’s decision, the Second and Third Circuits have held that defendants may defeat application of the “fraud on the market” doctrine by making a sufficient showing that an alleged misstatement had no impact on the market price of the relevant security. See In re Solomon Analyst Metromedia Litig., 544 F.3d 474, 484 (2d Cir. 2008); In re DVI, Inc. Sec. Litig., 639 F.3d 623, 638 (3d Cir. 2011).
Potential Implications
Defendants in Halliburton have asked the Supreme Court to address two questions: (1) whether the holding in Basic should be overruled or substantially modified to the extent it recognizes a presumption of classwide reliance derived from the “fraud on the market” theory; and (2) whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut that presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of the security at issue. Depending on how the Court answers those questions, its decision could have a profound impact on the ability of investors to bring securities fraud class actions, the ability of class action plaintiffs to obtain monetary settlements, and the strategies by which public companies and their directors, officers and outside professionals defend such cases.
Should the Court overrule Basic entirely, or substantially limit the “fraud-on-the-market” presumption it endorsed, the Halliburton decision would represent a seismic shift in the landscape of securities litigation. In most proposed securities fraud class actions, requiring individualized proof of investor reliance would – at a minimum – greatly complicate class certification, since it would become very difficult to establish that common classwide issues predominate over individual issues. However, as some commentators have observed, investors could look to Securities and Exchange Commission enforcement actions for financial and other recourse.[4] Moreover, because regulatory actions are not dependent on the fate of the “fraud on the market” doctrine, such actions could see a marked increase due to pressure by investors and legislators alike. Of course, eliminating or substantially curtailing the “fraud on the market” doctrine might have only limited impact on private securities fraud claims by large institutional investors, who have ample economic incentive to pursue individual claims and are more likely able to establish that they had actual awareness of, and actually relied on, alleged false statements.
Alternatively, the Court could take a more limited approach in Halliburton and address only the more narrow question of a defendant’s ability to present defenses to class certification. The Court may decide to adopt the Second and Third Circuit approach, which allows defendants to rebut the “fraud on the market” presumption of reliance, at the class certification stage, with evidence that the alleged misrepresentations did not distort the market price of the security in question. Or, the Court might require class action plaintiffs to make an affirmative showing of price impact as a prerequisite to invoking a presumption of classwide reliance.
The Supreme Court's Halliburton decision promises to be another in its series of momentous decisions over the past decade concerning the private right of action under Section 10(b) and Rule 10b-5. Whatever the outcome, the decision should add clarity to an area of the law in which there has been a diversity of views in the Courts of Appeals. The decision is expected by mid-2014.
[1] See Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317, Brief for Former SEC Commissioners and Officials and Law Professors as Amici Curiae, at 3.
[2] See Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317, Petition for a Writ of Certiorari, at 16.
[3] Id. at 17 (citation omitted).
[4] See, e.g., Alison Frankel, "What if SCOTUS does away with securities fraud class actions?," Reuters, Nov. 15, 2013.
Published December 18, 2013.
