Yesterday’s Supreme Court decision in Halliburton Co. v. Erica P. John Fund, Inc. (Halliburton II) may well have the lowest impact-to-fanfare ratio of any Supreme Court securities decision.  Despite the social-media-fueled frenzy within the securities bar leading up to the decision, the Court’s decision will effect little change in class certification law and practice in most securities class actions.

Most of the fanfare concerned whether the Court would overrule the fraud-on-the-market presumption of reliance established in its 1988 decision in Basic v. Levinson.  But the Court refused to overrule Basic.  Instead, the core of the Halliburton II decision focused on defendants’ fallback argument that plaintiffs must show that the alleged misrepresentations had impact on the market price of the stock, as prerequisite for the presumption of reliance.  The Court refused to place on plaintiffs the burden of proving price impact, but agreed that a defendant may rebut the presumption of reliance at the class certification stage, with evidence of lack of price impact.

The Court’s ruling, which in the lead-up to the decision has been called the “middle ground” between overruling Basic or affirming the Fifth Circuit, is a well-reasoned decision, and reaches a good practical result.  Overruling Basic would have led to a securities-litigation train wreck.  Affirming the Fifth Circuit would have been legally dubious.   But the legal middle ground of allowing a defendant to demonstrate a lack of price impact captures class-certification arguments that defendants have been making for many years, although they have often been framed as arguments about materiality or loss causation.   Thus, the Court’s ruling allows defense attorneys to contest the right issue on class certification, by demonstrating that the market just didn’t care about the challenged information.  Although I believe the ruling will not have an impact on the merits of most cases, it sets up an analytically sound framework for addressing arguments that did not fit well in other doctrinal buckets.

And, for those of us who litigate securities class actions full time, the Court’s decision to revisit Basic set up the Super Bowl of securities litigation.  The road to Halliburton II was long.  I trace it below, before discussing and analyzing Halliburton II.  (Kevin LaCroix’s post on Halliburton II in The D&O Diary contains a good discussion of the background and issues as well.)

The Fraud-on-the-Market Presumption: From Basic to Halliburton I to Amgen to Halliburton II

All of the Halliburton hubbub is about reliance, which is an essential element of a Section 10(b) claim.  Absent some way to harmonize individual issues of reliance, class treatment of a securities class action is not possible; individual issues would overwhelm common ones, precluding certification under Federal Rule of Civil Procedure 23(b)(3).  In Basic, the Supreme Court provided a solution: a rebuttable presumption of reliance based on the fraud-on-the-market theory, which provides that a security traded on an efficient market reflects all public material information. Purchasers (or sellers) rely on the integrity of the market price, and thus on a material misrepresentation.  Decisions following Basic have established three conditions to its application: market efficiency, a public misrepresentation, and a purchase (or sale) between the misrepresentation and the disclosure of the “truth.”

Over the years, defendants have argued that, absent a showing by plaintiffs that the challenged statements were material, or upon a showing by defendants that they were not, the presumption is not applicable or has been rebutted.  And, in a twist on such arguments, defendants sometimes argued that the absence of loss causation rebutted the presumption. In Erica P. John Fund, Inc. v. Halliburton Co. (Halliburton I), the Supreme Court unanimously rejected loss causation as a condition of the presumption of reliance.

In Halliburton I, the defendants did not dispute that proof of loss causation is not required for the fraud-on-the-market presumption to apply.  Instead, they argued to the Supreme Court that, although the Fifth Circuit ruled on loss-causation grounds, it really ruled that the absence of loss causation means that the challenged statements were not material because the challenged statements did not impact the price of Halliburton’s stock, and a lack of materiality defeats the application of the presumption.  The Supreme Court disagreed: “Whatever Halliburton thinks the Court of Appeals meant to say, what it said was loss causation: ‘[EPJ Fund] was required to prove loss causation, i.e., that the corrected truth of the former falsehoods actually caused the stock price to fall and resulted in the losses.’ . . . . We take the Court of Appeals at its word. Based on those words, the decision below cannot stand.”

But the Court explicitly left the door open for the argument that plaintiffs must prove materiality for the presumption of reliance to apply.  Later, the Court granted certiorari in Amgen Inc. v. Connecticut Retirement Plans to review the Ninth Circuit’s decision that plaintiffs are not required to prove materiality for the presumption to apply, and that the district court is not required to allow defendants to present evidence rebutting the applicability of the presumption before certifying a class.

In a majority opinion authored by Justice Ginsburg, and joined by Chief Justice John Roberts and Justices Breyer, Alito, Sotomayor, and Kagan, the Amgen Court concluded that proof of materiality was not necessary to demonstrate, as Rule 23(b)(3) requires, that questions of law or fact common to the class will “predominate over any questions affecting only individual members.”  The Court reasoned that this was because: 1) materiality was judged according to an objective standard that could be proven through evidence common to the class, and 2) a failure to prove materiality would not just defeat an attempt to certify a class, it would also defeat all of individual claims, because it is an essential element to a claim under Section 10(b).

The majority’s conclusion was dubious.  Its chief flaw was its avoidance of the central question through circular reasoning.  The materiality of a statement is an essential prerequisite for the application of the fraud-on-the market presumption that the Court developed in Basic, as a device to overcome the need to prove actual, individual reliance.  In Basic, the Court used then-emerging economic theory to create a rebuttable presumption of reliance, based on the assumption that a security traded in an efficient market reflects all public material information, and that traders in that market rely on the market price, and thus on any material misrepresentations that are reflected in the price.  The Amgen Court did not dispute that the materiality of a misrepresentation is necessary to create the fraud-on-the-market presumption, nor that the fraud-on-the-market presumption is essential to show under Rule 23 that common questions predominate for the class.

Instead, to avoid the logical conclusion that a showing of materiality was thus necessary to certify the class, the Court reasoned backwards: because plaintiffs must also show the materiality of the alleged misstatements in order to prove the underlying merits of a Section 10(b) claim, a finding that there was no materiality would defeat claims for all plaintiffs, whether brought as a class or individually.  Therefore, the Court concluded, materiality (or the lack of it) was a “common question,” that should not be decided until summary judgment, or theoretically, trial.

The holding was properly subject to wide criticism, but the criticism was quickly displaced by intrigue.  The Court’s opinions signaled a willingness to re-evaluate Basic, with four votes already supporting the view that the decision was “questionable,” and the other five failing to come to its defense.  In addition, as I wrote following the Amgen argument, the justices seemed intrigued by Amgen’s argument that market efficiency depends on the type of specific information at issue.

The Holding in Halliburton II

That leads us back to Halliburton II.  As Amgen was being litigated in the Supreme Court, the parties in Halliburton were briefing the plaintiffs’ class certification motion on remand.  The district court certified a class, prior to the Supreme Court’s decision in Amgen.  Halliburton sought and obtained Rule 23(f) certification from the Fifth Circuit, which affirmed, after the Supreme Court decided Amgen.

The Fifth Circuit held that a price-impact inquiry is more analogous to materiality than it is to the permissible prerequisites to the fraud-on-the-market presumption (market efficiency and a public misrepresentation).  Based upon that view, the Fifth Circuit reasoned that while price impact is not an element, as is materiality, “a plaintiff must nevertheless prevail on this fact in order to establish loss causation.”  Thus, “if Halliburton were to successfully rebut the fraud-on-the-market presumption by proving no price impact, the claims of all individual plaintiffs would fail because they could not establish an essential element of the action.”  Because the Fifth Circuit believed that the absence of price impact would doom all individual claims, it concluded that price impact is not relevant to common-issue predominance and is therefore not relevant at class certification.

The Supreme Court vacated the Fifth Circuit’s decision and remanded with the decision issued yesterday.  The Court’s opinion is remarkably straightforward.  First, the Court refused to overrule Basic.  The Court rejected Halliburton’s argument that Basic is inconsistent with modern economic theory, under which market efficiency is not a binary “yes or no” issue, finding that “Halliburton’s criticisms fail to take Basic on its own terms.”  Halliburton II at 9.    According to the Halliburton II Court, the Basic Court expressly refused to enter into such economic debate and instead “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.”  Basic “thus does not rest on a “binary’ view of market efficiency.”  Indeed, in “making the presumption rebuttable, Basic recognized that market efficiency is a matter of degree and accordingly made it a matter of proof.”  Id. at 10.

Second, the Court rejected Halliburton’s argument that trading that is based on factors other than price undermines Basic’s premise that purchasers and sellers invest in reliance on the integrity of the market price.  The Court held that “Basic never denied the existence” of investors that believe that the market price does not fully reflect public information, and,  in any event, surmised that such investors do indeed “implicitly” rely on the integrity of the market price.

Third, the Court found that the presumption of reliance does not conflict with Rule 23 or the Court’s recent decisions ratcheting up the degree of proof at class certification:  “Basic does not, in other words, allow plaintiffs simply to plead that common questions of reliance predominate over individual ones, but rather sets forth what they must prove to demonstrate such predominance.”  Id. at 14.

Finally, the Court found that Halliburton’s concerns about the “serious and harmful consequences” that the Basic presumption produces are more appropriately addressed by Congress, which has already addressed them in part through the Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998.

Having refused to overrule Basic, the Court turned to Halliburton’s alternative arguments that (1) plaintiffs should be required to prove that a misrepresentation impacted the stock price as a condition to invoking the presumption of reliance; and (2) if plaintiffs do not bear the burden of proving price impact, defendants should be allowed to introduce evidence of lack of price impact to rebut the presumption.  The Court refused to place the burden of proof on the plaintiffs:  “By requiring plaintiffs to prove price impact directly, Halliburton’s proposal would take away the first constituent presumption,” i.e., that the misrepresentation was public and material and that the stock traded in a generally efficient market.  In response to Halliburton’s concern that a misrepresentation might not impact the price of a stock even in an efficient market, the Court held that “Basic never suggested otherwise; that is why it affords defendants an opportunity to rebut the presumption by showing, among other things, that the particular misrepresentation at issue did not affect the stock’s market price.”  Id. at 18.

But the Court did hold that defendants could rebut the presumption by proving at the class-certification stage that the misrepresentations did not impact the market price of the stock.  The Court based its holding in part on the fact that price impact evidence is part of the market-efficiency determination.  Given this, it found that plaintiffs’ argument that defendants may not introduce such evidence at class certification “makes no sense, and can readily lead to bizarre results.”  The presumption is an “indirect proxy” of showing price impact, and “an indirect proxy should not preclude direct evidence when such evidence is available.”  Id. at 20.  In so holding, the Court distinguished Amgen:  price impact “is ‘Basic’s fundamental premise.’  It thus has everything to do with the issue of predominance at the class certification stage.”  Id. at 22 (quoting Halliburton I).   In contrast, “materiality is a discrete issue that can be resolved in isolation from the other prerequisites.”  Id.

The Court summarized its price-impact holding as follows:

Our choice in this case, then, is not between allowing price impact evidence at the class certification stage or relegating it to the merits.  Evidence of price impact will be before the court at the certification stage in any event.  The choice, rather, is between limiting the price impact inquiry before class certification to indirect evidence, or allowing consideration of direct evidence as well.  As explained, we see no reason to artificially limit the inquiry at the certification stage to indirect evidence of price impact.  Defendants may seek to defeat the Basic pre­sumption at that stage through direct as well as indirect price impact evidence.

Id. at 22-23

Halliburton II is Important, but Will Not Impact the Merits of Many Cases

Halliburton II presented two very important issues: the viability of Basic, and the need to prove price impact.  After the Court granted cert in Halliburton II, most defense lawyers seemed to actively hope that the Court would put an end to securities class actions.  But after some time, most defense lawyers seemed to come around to the view that the end of Basic would result in a securities litigation train wreck, with plaintiffs’ firms filing individual and large collective actions that would be quite difficult and expensive to manage, while the government would also step up enforcement, since the federal and state governments wouldn’t allow under-regulation of the securities markets, at least for long.  And those who still hoped for the end of Basic had their hopes dashed by the Halliburton II oral argument, in which the justices did not seem interested in overruling Basic, and instead seemed focused on the price-impact argument.  Since that argument, most of the discussion has been about the potential price-impact ruling.

What impact will the price-impact ruling have?  For starters, it’s important to remember that the ruling will only affect securities class actions that have survived a motion to dismiss – class certification is premature before then.  It wouldn’t be economical to adjudicate class certification while parties moved to dismiss under Rule 12(b)(6) and the Reform Act, and adjudicating class certification before rulings on motions to dismiss could result in defendants waiving their right to a discovery stay under the Reform Act.

It’s also important to remember that most securities class actions challenge many statements during the class period.  Although there could be strategic benefit to a ruling that a subset of the challenged statements did not impact the stock price – for example, shortening the class period or dismissing especially awkward statements – a finding that some statements had an impact would support certification of some class, and thus would allow the case to proceed.

It is impossible to say what percentage of the cases that survive motions to dismiss would be good candidates for price-impact disputes at class certification.  To be sure, defendants will make price-impact arguments in most cases in which there is some basis to make the argument.  But the number of cases in which there is a real issue, much less a knock-out blow, is likely relatively small.  Some types of cases, such as biotech cases and cases involving companies with a low volume of public statements, tend to present fewer economic problems.  More generally, the experience in the Second and Third Circuits before Amgen is cause for some skepticism.  Despite standards for class certification that allowed defendants to contest materiality and price impact, defendants seldom defeated class certification.

It also is debatable whether a price-impact rule will weed out many more bad cases on a net basis.  For example, cases that suffer from a price-impact problem typically also suffer from some other fatal flaw, such as the absence of loss causation or materiality.  Indeed, the price-impact issue in Halliburton was based on evidence about the absence of loss causation.  (Nevertheless, it may be helpful to have a cleaner legal argument to make about the underlying lack of logic to the claims.)

Defendants will lose an important feature of the pre-Halliburton II world: the ability to make no-price-impact arguments in settlement discussions in the absence of a ruling about them.  Now, defendants will make and obtain rulings on class certification arguments that they previously could have asserted would be resolved in their favor at summary judgment or trial, if necessary. Plaintiffs will press harder for higher settlements in cases with certified classes.  Prominent plaintiffs’ lawyers make this point in Alison Frankel’s blog about Halliburton II.  The more sophisticated firms already think through price impact and related issues as they evaluate which cases to pursue, and I expect plaintiffs’ lawyers to make that point in the wake of Halliburton II as well.

Yet plaintiffs certainly would have preferred to have the Court eliminate any fight over price impact at class certification.  They will face another hurdle and greater costs, and will have to adapt.  Plaintiffs’ lawyers likely will attempt to bring more Section 11 claims, where reliance is not an element.  However, Section 11 claims aren’t possible without a registered offering, and the damages are limited.  Plaintiffs’ lawyers also will try to re-cast their misrepresentations as omissions claims, and thus invoke Affiliated Ute’s presumption of reliance for claims of omission.  But plaintiffs face an uphill legal battle on this issue, as we wrote last winter.  And they likely will not file cases in which it is clear that they face a difficult and expensive class-certification battle – or they will try to settle them before class certification.

One thing that is certain is that Halliburton II will increase defense costs.  Whether the increased defense costs will be worth it will be the subject of much debate in individual cases, and in the big picture over time.  In the coming months, I will write about post-Halliburton II issues, including the shape of the price-impact dispute, and the cost-benefit of the new world of class-certification.