At long last, the United States Supreme Court is going to address the viability and/or prerequisites of the fraud-on-the-market presumption of reliance established by the Court in 1988 in Basic v. Levinson. Securities litigators, on both sides of the aisle, are understandably anxious, because our entire industry is about to change – either a little or a lot.
I say “change,” and not something more ominous like “be obliterated,” because the Supreme Court’s ruling in Halliburton cannot and will not do away with securities litigation. If the Court’s ruling were to undermine class actions, the plaintiffs’ securities bar would adjust – likely through burdensome large individual and non-class collective actions, and class actions that attempt to work around whatever ruling the Court makes – and the government would act to facilitate some type of securities class action and/or expand government enforcement of the securities laws. Worse outcomes for companies in a new no-Basic era are far easier for me to imagine than better ones. I’ll explain why, after a quick review of how we got here.
The Fraud-on-the-Market Presumption: From Basic to Halliburton to Amgen to Halliburton
Reliance is an essential element of a Section 10(b) claim. Absent some way to harmonize individual issues of reliance, however, 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., the Supreme Court unanimously rejected loss causation as a condition of the presumption of reliance.
In Halliburton, 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 Supreme Court explicitly left the door open for the argument that plaintiffs must prove materiality for the presumption of reliance to apply. The Supreme 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 based on the presumption.
In a majority opinion authored by Justice Ginsburg, and joined by Chief Justice John Roberts and Justices Breyer, Alito, Sotomayor, and Kagan, the 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 on a false or misleading statement – which made securities class actions all but impossible to bring. 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.
As Justice Thomas wrote in his dissent (joined by Justice Scalia (in part) and Justice Kennedy), the majority essentially “reverse[d]” the inquiry. Although class certification is supposed to be decided early in the litigation, and depends upon a showing of materiality to invoke the fraud-on-the-market presumption, the majority effectively said that that portion of the class certification inquiry can be skipped, merely because it is also a question that will be asked at the merits stage. Justice Thomas wrote: “A plaintiff who cannot prove materiality does not simply have a claim that is ‘dead on arrival’ at the merits. . .he has a class that never should have arrived at the merits at all because it failed in Rule 23(b)(3) certification from the outset.”
Perhaps the most striking part of the Amgen decision was Justice Alito’s one paragraph concurrence, which baldly called for a reconsideration of the fraud-on-the-market presumption. Alito concurred with the majority, but only with the understanding that Amgen had not asked for Basic to be revisited. Alito thus signaled that he agreed with Thomas’s contention in footnote 4 of the dissent that the Basic decision was “questionable.” The majority, in turn, did not come to the defense of Basic, but simply noted with apparent relief (in footnote 2) that even Justice Thomas had acknowledged that the Court had not been asked to revisit that issue. Considered together, these three opinions put out a welcome mat for the right case challenging Basic’s fraud-on-the-market presumption, with four votes already supporting the view that the decision was “questionable,” and the other five failing to come to its defense.
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 the inquiry of the challenged statements’ lack of impact on the price of Halliburton’s stock was more analogous to materiality than it is to the permissible prerequisites to the fraud-on-the-market presumption (market efficiency and a public misrepresentation). 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.
Halliburton filed a petition for a writ of certiorari, and the Court granted the petition on Friday November 15, 2013. That day, many plaintiffs’ and defense lawyers predicted the demise of securities litigation as we know it. One defense lawyer put it in blunt terms: “If the Supreme Court rejects the ‘fraud-on-the-market presumption of reliance altogether, then it would effectively end securities class action litigation in the United States.”
What’s Next? How Will the Supreme Court Rule? If the Court Overrules Basic, What Will Happen?
There are three primary possible outcomes in the Supreme Court:
1. The Court will affirm the Fifth Circuit without overruling or adjusting Basic. This seems unlikely.
2. The Court will adjust Basic.
One adjustment might be to require that a putative class plaintiff show that the market for the issuer’s stock be efficient as to the specific information that the defendants allegedly misrepresented – which is Halliburton’s alternative grounds for relief, and a proposition that Amgen included in a footnote in its Supreme Court briefs. I predict that this will be what the Supreme Court decides. Such a decision would address the primary economic criticism of the fraud-on-the-market presumption – that market efficiency is not a binary “yes” or “no” question, and instead depends on the specific information at issue – and would preserve salutary features of private securities litigation, which long has been an important means of securities regulation.
Another adjustment might be to allow the fraud-on-the-market presumption for purposes of satisfying the element of reliance, but require proof of actual reliance on the challenged statements for purposes of recovering money damages. This is the position taken in an amicus brief in support of cert filed by a group of prominent law professors and former SEC commissioners, primarily relying on the elements of the Exchange Act’s only express private right of action, set forth in Section 18.
3. The Court will overrule Basic and leave nothing in its place – thus negating the primary support for securities class actions.
What would happen then?
The plaintiffs’ securities bar would adjust.
The plaintiffs’ bar would seek to work around Halliburton in some fashion. That would result in much uncertainty and expensive litigation of the scope of Halliburton in the district courts, circuit courts, and likely the Supreme Court.
Worse, the largest firms with large institutional investor clients – clients the Private Securities Litigation Reform Act encouraged them to court, and with which they now work closely to identify and pursue securities claims – would file large individual and non-class collective actions. Smaller plaintiffs’ firms would also file individual and non-class collective actions. The damages in cases filed by smaller firms would tend to be smaller, but the litigation burdens would be similar.
Non-class securities actions would be no less expensive to defend than today’s class actions, since they would involve litigation of the same core merits issues. Non-class litigation would be even more expensive in certain respects – e.g. multiple damages analyses and vastly more complex case management. And if securities class action opt-out litigation experience is indicative of the settlement value of such cases, they would tend to settle for a larger percentage of damages than today’s securities class actions.
In a new non-class era of securities litigation, the settlement logistics would be vastly more difficult – it’s hard enough to mediate with one plaintiffs’ firm and one lead plaintiff. Imagine mediation with a dozen or more plaintiffs’ firms and even more plaintiffs. One reason we sometimes oppose lead-plaintiff groups is the difficulty of dealing with a group of plaintiffs instead of just one.
Even when settlement could be achieved, it wouldn’t preclude suits by other purchasers during the period of inflation, because there would be no due process procedure to bind them, as there is when there’s a certified class with notice and an opportunity to object or opt out. Indeed, there likely would develop a trend of random follow-up suits by even smaller plaintiffs’ firms after the larger cases have settled. There would be no peace absent the expiration of the statute of limitations.
The government would act.
The government would not allow the securities markets to be profoundly less regulated. So it would do something. It might legislatively enable securities class actions. If it did so, would it also make other adjustments, such as lessen the Reform Act’s protections? Who knows, but I wouldn’t bet on an improvement for companies. I strongly believe that the biggest securities-litigation threat to companies is erosion of the Reform Act’s protections.
The government might also, or instead, enhance public enforcement of the securities laws. This would be a negative development. Companies have much greater ability to predict the cost and outcome of today’s securities class action than they do the outcome of a government enforcement action. Experienced defense counsel can predict how plaintiffs’ firms will litigate and resolve a case. Defense counsel have much less ability to predict how an enforcement person with whom he or she may have never dealt will approach a case.
Finally, I must say that I am not one who thinks that the fraud-on-the-market presumption results in much injustice, especially given the protections of the Reform Act. The Reform Act weeds out a lot of cases. To be sure, some cases incorrectly survive motions to dismiss. The only real policy problem with class actions regarding Basic is with the subset of these cases that also are certified as class actions at the class-certification stage but are destined to be decertified at summary judgment or trial – defendants in those cases are unjustly subjected to burdensome class action litigation. The combination of these errors, however, isn’t frequent. And even when it does occur, experienced plaintiffs’ and defense counsel are able to handicap the merits on both counts, i.e. the lack of merit to the claims and to the case temporarily surviving as a class action, and adjust the settlement value of the case accordingly.
This is just a start on our analysis. We’ll certainly write more during the long wait for the Court’s ruling.