Supreme Court Reaffirms "Fraud-on-the-Market" Presumption in Securities Fraud Class Actions
On June 23, 2014, the US Supreme Court decided Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. ____ (2014), reaffirming one of the critical underpinnings for prosecuting a private securities fraud lawsuit on a class-wide basis. Most notably, in an opinion written by Chief Justice Roberts and joined by five other Justices, the Court declined to overrule the "fraud-on-the-market" presumption, first recognized in Basic Inc. v. Levinson, 485 U.S. 224 (1988), to establish that there are sufficiently common issues of reliance for a securities fraud claim to proceed as a class action. The Court concluded, however, that "defendants must be afforded an opportunity before class certification to defeat the presumption through evidence that an alleged misrepresentation did not actually affect the market price of the stock." The Halliburton decision reemphasizes the importance, in defending securities fraud cases, of scrutinizing proposed classes and challenging them where appropriate.
Background and Procedural History
The Halliburton case has a long history, which includes one prior trip to the Supreme Court in 2011.1 The case was filed in June 2002 and alleged that Halliburton made material misstatements relating to (1) exposure to asbestos liability and the reserves associated with that liability, (2) accounting of revenue associated with cost over-runs on fixed-price construction and engineering contracts, and (3) the benefit from a merger. The district court initially declined to certify a proposed class, holding that the plaintiffs had failed to establish loss causation – i.e., that the stock losses were related to any of Halliburton's alleged misstatements – and the Fifth Circuit affirmed.2 In its 2011 decision, the Supreme Court unanimously reversed, holding that proof of loss causation was a merits determination, not a requirement for class certification.3
On remand, Halliburton argued that the class should not be certified for another reason: that so called "price impact" evidence demonstrated that the purported misrepresentations had not actually affected the stock price, and, therefore, the plaintiffs could not have relied on the purported misrepresentations in deciding to purchase the stock. In other words, Halliburton contended that its "price impact" evidence rebutted the Basic fraud-on-the-market presumption.
In Basic, the Supreme Court held that if the securities trade in an efficient market, plaintiffs are entitled to a rebuttable presumption to establish reliance, obviating the need for each shareholder to demonstrate that it actually relied on an alleged misrepresentation in purchasing securities. The Basic court assumed that in an efficient securities market, all public information about a company (including alleged misrepresentations) is incorporated into and reflected in the price of the securities traded in the market, and that an investor who buys or sells securities at market price relied on the price as an indication of a company's value. Accordingly, under Basic, in order to obtain certification of a class in an action alleging fraud on the market, plaintiffs need only show that (1) the stock at issue was traded in an efficient market, (2) the defendant's misrepresentations were made to the public, (3) the misrepresentations were material, and (4) plaintiffs bought or sold the stock in between when the material misrepresentations were made and when they were corrected.
Relying on Basic, the district court certified the class. The Fifth Circuit affirmed on interlocutory appeal of the district court's order granting class action certification pursuant to Federal Rule of Civil Procedure 23(f), citing Basic and concluding that Halliburton's "price impact" evidence should not be considered until trial. Halliburton sought certiorari contending that Basic was wrongly decided and should be overturned and that, in any event, the district court should have considered the "price impact" evidence in deciding whether to certify the class. In seeking review, Halliburton noted that in the Supreme Court's 2013 decision in Amgen Inc. v. Connecticut Retirement Plans & Trust Funds, four Justices opined that Basic should be reconsidered.4
The Court Reaffirms the Fraud-On-The-Market Presumption
The Court declined Halliburton's invitation to overrule Basic, rejecting arguments that (1) "the Basic presumption is inconsistent with Congress's intent in passing the 1934 Exchange Act" and (2) the presumption "has been undermined by subsequent developments in economic theory." The Court quickly dispensed with Halliburton's congressional intent argument, finding that the dissenting Justices in Basic made the "same argument" to no avail and concluding that "Halliburton has given us no new reason to endorse it now."
As for Halliburton's arguments regarding developments in economic theory, the Court concluded that there has not been a "fundamental shift in economic theory," noting that the Basic decision recognized there was a "debate" among economists regarding the "efficient capital markets hypothesis" and "declined to enter the fray." According to the Court, Basic "based the presumption on the fairly modest premise that 'market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices'" – and the Court noted that both critics of the hypothesis and Halliburton itself concede that "public information generally affects stock prices."5
In rejecting Halliburton's arguments, the Court cited the principle of stare decisis, which the Court noted would require "special justification" to overturn a "long-settled precedent" like Basic. The Court also concluded that, although the fraud-on-the-market presumption was judicially created, the "special force" by which stare decisis applies to cases involving statutory interpretation should also apply to the presumption because Congress is able to "overturn or modify" it.
In an opinion concurring in the judgment, three Justices (Justice Thomas, writing for himself and Justices Scalia and Alito) concluded that Basic should be overturned and that plaintiffs should be required to prove "actual reliance." Much of Justice Thomas' opinion was devoted to attacking the economic theory on which the fraud-on-the-market presumption was based, and the opinion contended that "Basic's muddled logic and armchair economics" should not be saved by the principle of stare decisis.
Defendants May Rebut Presumption of Reliance at Class Certification Stage
While the Court declined to overrule the Basic fraud-on-the-market presumption, the Court nonetheless vacated the Fifth Circuit's order in light of the lower court's decision to exclude the "price impact" evidence. In this regard, the Court held that "defendants must be afforded an opportunity before class certification to defeat the presumption through evidence that an alleged misrepresentation did not actually affect the market price of the stock."
The Court noted that allowing such evidence was consistent with Basic itself, which made clear that the fraud-on-the-market presumption could be rebutted. As the Court explained, the fraud-on-the-market presumption provides an "indirect way of showing price impact" – but, Basic "does not require courts to ignore a defendant's direct, more salient evidence showing that the alleged misrepresentation did not actually affect the stock's market price and, consequently, that the Basic presumption does not apply." The Court also noted that defendants already are permitted to submit "price impact" evidence in conjunction with a motion for class certification in order to rebut a plaintiff's showing that the market in which the security trades is efficient, concluding that it "makes no sense" to limit this evidence only to market efficiency rather than allow the evidence also to be presented to rebut the presumption of reliance. The Court rejected Halliburton's argument, however, that plaintiffs must prove price impact directly at the class certification stage, noting it was sufficient for "plaintiffs to demonstrate the general efficiency of the market in which the stock is traded."
Both concurring opinions suggested that this portion of the decision would have little practical impact. In his opinion, Justice Thomas noted that the rebuttable presumption has proven "largely irrebuttable" in practice at the merits stage and questioned the efficacy of permitting rebuttal at the class certification stage (which traditionally has focused on the qualifications of class representatives). Conversely, in a short concurring opinion, Justice Ginsburg (writing for herself and for Justices Breyer and Sotomayor) wrote that they joined the main opinion on the understanding that it would be defendants' burden to "show the absence of price impact" and, accordingly, this would not impose a "heavy toll on securities-fraud plaintiffs with tenable claims."
A six-Justice majority preserved the Basic fraud-on-the-market presumption in the face of strong arguments against the economic foundations for the presumption. Accordingly, in the absence of congressional action to the contrary, the Basic presumption and securities fraud class action cases are here to stay for the foreseeable future.
Nonetheless, the Court's clarification that defendants may present "price impact" evidence at class certification reaffirms that defendants have another tool to consider in opposing securities fraud class action claims in the future. It remains to be seen what effect this will have, including to what extent it will increase the needs and expenses associated with expert work and certification-related discovery prior to class certification. In appropriate cases (such as those where defendants can demonstrate that purported misrepresentations did not affect the stock price), the decision should result in denials of class certification motions.
See The Supreme Court Rejects Fifth Circuit's Loss Causation Test as a Prerequisite to Obtaining Class Certification in Section10(b) Cases, Arnold & Porter LLP Advisory (June 2011).
See Supreme Court Holds Proof of Materiality is Not Necessary to Win Class Certification, Arnold & Porter LLP Advisory (Mar. 2013). For additional background and procedural history on the Halliburton case, see Supreme Court To Reconsider "Fraud-on-the-Market" Presumption in Securities Fraud Class Actions, Arnold & Porter LLP Advisory (Mar. 2014).
The Court also rejected Halliburton's argument that, contrary to one of the premises underlying the Basic presumption, many types of investors do not rely on the integrity of the market price of securities. According to the Court, although some investors (such as "value investors" that seek to buy undervalued securities and sell overvalued securities) are indifferent to the market prices of securities, Basic concluded only that "most" investors rely on the integrity of market prices and, in any event, value investors rely on the integrity of market prices to some extent because they believe the stock market price will increase as the price "will eventually reflect material information."