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.”

I disagree.

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.

 

I recently had occasion to review a number of motion-to-dismiss rulings, including some in which denial of the motion seemed to be an easy call.  I’ve since been mulling over whether there are circumstances in which it would be strategically advantageous not to make a motion to dismiss in a Reform Act case, or a motion to dismiss for failure to make a demand on the board in a derivative case.  I have never foregone such a motion, even when it was relatively weak.  But is that the right strategic and economic approach?*

Routine motions to dismiss are certainly part of the predominant, formulaic approach to securities litigation defense.  As I noted in my recent Law360 Q&A, a formulaic approach can yield inefficiency and insufficient strategic thought.  Two obvious examples are class certification and document discovery:

  • Courts rarely deny class certification motions based on shortcomings in the proposed class representative – and often, even if they did, it would not be to the advantage of the defense.  Yet in virtually every case, defense attorneys travel around the country to take depositions of class representatives to support futile class certification oppositions.
  • The universe of important documents in a securities case usually distills to a relatively small number.  Yet in virtually every case, defense attorneys review every page of a vast number of documents collected as potentially responsive to overreaching document requests – ignoring the efficiency and other advantages of a more strategic approach.

I’ve vowed to take a more strategic and efficient approach in these and other areas.  A superior defense doesn’t require that we do everything, including tasks with little or no strategic value.  It means that we position the case for the best possible resolution.  That goal involves strategic and economic considerations.

So, then, what about motions to dismiss:  are there circumstances in which it would make sense to forego one?  It’s hard to imagine all conceivable circumstances under which this question may be posed, but I think the answer is probably “no.”  But in all cases, including those in which the motion to dismiss is weak, we need to think about how we use the motion to the defendants’ strategic advantage.

In my experience, there is a small group of cases – maybe 10% of those filed – that are bound to get past a motion to dismiss.  In those cases, neither the quality of the lawyers, on either side, nor the temperament or ability of the judge even matters.  Among these cases, some are meritorious and some aren’t.  Sometimes the initial allegations appear strong, although the plaintiffs’ ultimate case is not, and sometimes they involve high-profile situations or defendants, in which a judge is almost certain to allow the plaintiffs a chance to develop their case.  Regardless, these are all hard cases that are not going to be dismissed on a motion.

I can make a strong prima facie strategic case for not moving to dismiss this class of case, especially cases that are ultimately defensible.  The motion to dismiss is the judge’s first look at the case.  Judges are people, and they form first impressions.  The emphasis that a motion to dismiss can bring to the one-sided presentation of the “evidence” in the complaint can do harm to later rulings.  So, I could argue that a better strategy is to answer the complaint and wait for a chance to make a good first impression with the judge, at a time when the defendants can introduce favorable evidence.  This strategy also has the benefit of saving the client and/or carriers a substantial amount of money.

On balance, however, I think that other strategic considerations outweigh the advantages of foregoing motions to dismiss.  The vast majority of securities and derivative complaints are potentially dismiss-able.  Plaintiffs assume that a motion to dismiss will be made and – because of the high pleading standards required for complaints in Reform Act cases, and to excuse demand in derivative cases – they fear dismissal even in the strongest cases.  Thus, to not make a motion to dismiss would be significant, and would suggest to plaintiffs (and to the judge, too, if she or he is experienced in securities cases) that the plaintiffs’ case is extraordinarily strong.  It might even seem to be a concession of some kind.  Just as importantly, a motion to dismiss is the defendants’ only real leverage before summary judgment, and because of the discovery stay, the defendants have an informational advantage during the motion-to-dismiss process (setting aside the availability of a books and records inspection in the context of derivative litigation).

The combination of these factors strongly suggests that defendants make a motion to dismiss, even if they know it is very unlikely to succeed – but that they do so within a larger strategic framework geared toward the best ultimate resolution of the case.  In a great many cases, mediating while the motion to dismiss is still pending will be the right strategy, to take advantage of the leverage and the informational advantage that defendants have during this time.  This strategy requires the utmost strategic thought and risk analysis at the outset of the case, and then impeccable communication among the defendants, defense counsel, and the insurers and broker.  Even if this process leads these parties to the conclusion that it is better to continue to litigate the case, rather than attempt an early settlement, it will lend strategic shape and direction to the litigation process.

The worst strategy – although it unfortunately seems to be a prevalent one – is to simply litigate the case full tilt, without serious evaluation of whether an early settlement is strategically or economically wise, and without adequate communication with the client or the carriers about the risks of the case.

 

* I don’t include merger cases in this analysis, because they present special considerations – principally quick settlements and multi-jurisdictional issues – that often make a motion to dismiss impractical.

 

On April 16, 2013, Law360 featured me in its Q&A series.

In the article, I address two critical economic issues in securities litigation defense: containing escalating defense costs, and managing electronic document review.  I also discuss the Supreme Court’s Amgen decision, a securities litigation defense lawyer who impressed me, a case that helped launch my career as a securities litigator, and a mistake that I made.

I hope you will take a moment to read the article.

 

In our post in the immediate wake of the Supreme Court’s decision in Amgen Inc. v. Connecticut Retirement Plans, we concluded that rather than being a new threat to the defense of securities class actions, Amgen basically endorsed the status quo: In holding that plaintiffs do not need to establish that allegedly false statements were material to the market before they can gain class certification, the Amgen Court reinforced the rule that is already followed in most courts.  At the same time, we promised to dive deeper in a future post, to discuss the effect of Amgen in those circuits that had previously entertained disputes over materiality in determining whether to certify a class.

This was a weighty task.  In the absence of clear guidance from the Supreme Court, the law on class certification has developed in myriad, complex, and contradictory ways across the circuit courts. The precise legal effect of the Amgen decision will therefore vary from one circuit to the next, as the law in many circuits has not been fully developed, and other circuits have developed distinct doctrines in their effort to find a principled way to implement the fraud-on-the-market presumption from Basic v. Levinson.  Yet a survey of these circuit court decisions, and the way that they have been interpreted in the district courts, merely reinforces our conclusion that Amgen will have relatively little negative practical impact on defendants – in any jurisdiction.  Far from being a “crushing blow” to the defense bar that will “make it easier” for plaintiffs to maintain securities class actions, as many commentators have claimed, the Amgen decision seems to close very few strategic doors to the defense, no matter where a case is litigated.

This is true for three primary reasons.  First, most of the arguments that defendants have made to dispute materiality at class certification are the same as arguments that can be made – and often are, with greater success – on a motion to dismiss, because they challenge fundamental flaws in the complaint that point to plaintiffs’ inability to make sufficient allegations of falsity and loss causation.  Second, the only circuit that required plaintiffs to “prove” materiality before a class would be certified was the Fifth Circuit, whose holdings in this regard had already been largely neutralized by the Supreme Court’s 2011 ruling in Erica P. John Fund, Inc. v. Halliburton.  Finally, in those circuits that had allowed defendants a chance to rebut materiality and thus defeat class certification – in particular, the Second and Third Circuits – the bar was already set so high that this opportunity seemed to be largely illusory.

As an initial matter, it is necessary to identify those circuits that have holdings which are incompatible with the Amgen opinion.  While many circuit courts have yet to grapple explicitly with the issue, the Amgen ruling is in line with the approach articulated by the Ninth Circuit (see that court’s decision in Amgen, 660 F.3d 1170 (9th Cir. 2011)) and the Seventh Circuit (see Schleicher v. Wendt, 618 F.3d 679, 687 (2010)), and the emerging doctrine of the First Circuit (see, e.g., In re Boston Scientific Corp., 604 F. Supp.2d 275 (D. Mass. 2009)) and the Fourth Circuit (see, e.g., In re Red Hat, Inc., Sec. Litig., 261 F.R.D. 83 (E.D. N.C. 2009)).  On the other hand, as discussed below, Amgen raises questions when examined in connection with the extreme approach formerly taken by the Fifth Circuit (see Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F.3d 261, 267 (5th Cir. 2007)) as well as the more moderate doctrines articulated by the Second Circuit (see In re Salomon Analyst Metromedia Litigation, 544 F.3d 474, 484 (2d Cir. 2008)) and the Third Circuit (see In re DVI, Inc. Securities Litigation, 639 F. 3d 623, 631 (3d Cir. 2011)).

Until 2011, the Fifth Circuit took the most aggressive approach toward class certification, requiring not only proof that an alleged misstatement “actually moved” the market in order to invoke the fraud-on-the-market presumption, but also requiring plaintiffs to prove loss causation.  This doctrine was summarily rejected by a unanimous Supreme Court in Halliburton, which found that the requirement that plaintiffs prove loss causation to gain class certification was “not justified by Basic or its logic.”  (See 131 S.Ct. 2179 (2011)). It is not clear what, if anything, remained of the Fifth Circuit’s doctrine after Halliburton.  Arguably, a requirement survived that plaintiffs make a showing prior to class certification that either the misrepresentation or the corrective disclosure had an impact on stock price, but that is unclear, because the Fifth Circuit’s justification for this requirement was closely tied to its demand that plaintiffs prove loss causation – and neither the Fifth Circuit nor its district courts have made rulings on this basis since the Halliburton decision.

By contrast, the rule in the Second Circuit survived Halliburton, but was overturned by Amgen. According to the Second Circuit, plaintiffs were required to make “some showing” of materiality in order to trigger the fraud-on-the-market presumption, either through showing an impact of information on the stock price, or simply by arguing that there was a “substantial likelihood” that the misrepresented or omitted information “would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.” (See Salomon, 544 F.3d at 485).  At that point, the burden shifted to the defendants to rebut the presumption of reliance, with evidence that “severs the link” between the alleged misrepresentation and the price of the stock.

Similarly, the Third Circuit ruled in 2011 that district courts may consider evidence to rebut the presumption of reliance, and thereby defeat class certification.  The court reasoned that evidence that a corrective disclosure did not affect the market price could defeat class certification in one of two ways.  If the statement was material, it could show that the market was not efficient in absorbing information (an acknowledged prerequisite to the Basic presumption).  On the other hand, if the market was efficient but the corrective disclosure did not affect the stock price, the Third Circuit held that it could demonstrate that the challenged statement was immaterial as a matter of law. (See In re DVI, 639 F. 3d at 638).

Before Halliburton, the Fifth Circuit’s standard undoubtedly made it difficult for plaintiffs to gain class certification – not only because loss causation was explicitly incorporated into the class certification inquiry, but because plaintiffs bore the burden of proving loss causation before certification was granted.  As noted above, much or all of this hurdle was removed by Halliburton, leaving little or nothing for Amgen to resolve.  By contrast, the standard used by in the Second and Third Circuits placed the burden on the defendants to rebut the presumption of materiality.  Although this gave defendants the opportunity to present evidence about materiality, including expert testimony, the courts implementing this standard generally found that the defendants had failed to meet their burden, and granted class certification despite this evidence.  In ruling that defendants could not present evidence to rebut materiality until summary judgment or trial, the Amgen Court eliminated the possibility that this materiality evidence will be considered at the class certification stage – but this ruling will likely have little practical effect in the Second and Third Circuits, where that opportunity did not seem to give defendants any real advantage.

What is most striking in the pre-Amgen cases that considered materiality on class certification was that nearly all of the arguments that defendants advanced could have been advanced – and often, already had been advanced – at the motion-to-dismiss stage.  If the courts had already accepted these arguments on a motion to dismiss, in most cases the issue would not have reached class certification.  On the other hand, if the courts had already rejected these contentions once at the motion-to-dismiss stage, they did not seem to be any more willing to accept them when they were reframed on class certification.  For example, defendants in these cases sought to defeat materiality by contending that the defendant company had disclosed the truth to the market, rendering the allegedly false statement material.  This argument is easily recast, especially in the case of alleged omissions, to contend that plaintiffs failed to adequately allege of the existence of a false or misleading statement in the first place. Similarly, at class certification, defendants advanced arguments that the plaintiffs had failed to connect the alleged misstatements with any corrective disclosure that revealed the truth to the market, or that they were unable to point to a drop in the stock price following the corrective disclosure – failures that the courts already routinely recognize as fatal to adequate pleading of loss causation, which can be adjudicated on motions to dismiss.

Indeed, the only arguments advanced by defendants in these cases that were unique to the class certification procedure were those that used expert testimony to assert that a price drop was not due to an alleged corrective disclosure, but rather to other negative information that was released simultaneously, or general adverse market conditions.  These contentions involved difficult factual distinctions that the district courts were reluctant to make, particularly in the Second Circuit, where the defendants carried the burden of disproving materiality.

In sum, the Amgen decision seems to foreclose very little in terms of defense strategy.  It may eliminate the use of expert testimony regarding materiality on class certification motions – although such testimony can still be relevant regarding the “efficiency” of the market for the company’s stock.  And it will likely foreclose defendants’ efforts to contend, based largely on expert testimony, that a stock price drop was not the result of a corrective disclosure, but of other factors present at the same time – although defendants should still be able to offer evidence and expert testimony to define the proper contours of the class period based on market events and the timing of corrective disclosures.  But most of the defense arguments that have been used to oppose class certification – whether they are phrased in terms of materiality, falsity, or loss causation – will continue to be available, and effective, through motions to dismiss.

More significantly, the Amgen decision suggests room for doubt on the larger question of reliance – the most fundamental and problematic issue for plaintiffs in obtaining certification of a securities class action.  The decision all but invites the defense bar to use its creativity to find the right argument to advance in the right case, to engage district and circuit courts that are already struggling with the fraud-on-the-market doctrine, and in turn, to tempt the Supreme Court into reconsidering the wisdom of Basic (which it has shown a clear inclination to do).  While Amgen may have closed the door on a few defense strategies – which were rarely successful, in any case, in defeating class certification – it has simultaneously opened the window for defense counsel to find new ways to illustrate the shortcomings of the Basic presumption, and thus to mount a much more serious challenge to ability of the plaintiffs’ bar to bring securities class actions.

The Supreme Court released its anxiously awaited decision in Amgen Inc. v. Connecticut Retirement Plans yesterday. On the face of the decision, it was a loss for defendants in that case, and for companies everywhere that are forced to defend themselves against securities class action lawsuits – as the Court found that plaintiffs do not need to establish that allegedly false statements were material to the market before they can gain class certification.

As I have written before (see here and here), the Court had an opportunity in Amgen to make class certification a more meaningful stage in securities class actions, providing defendants with a new tool for stopping unmeritorious cases early in the process.  On the surface of the Amgen decision, the Court declined to take that step.  For this reason, many of the early reports indicate that the defense bar is concerned about the impact of Amgen.  I’m not concerned.  At worst, Amgen leaves defendants in most circuits in the same position they were before.  (Look for our upcoming post analyzing the effect that Amgen will have in the minority of circuits, such as the Second Circuit, which have previously ruled that materiality can be considered on class certification.)  The decision leaves open several arguments that will allow defendants to continue to challenge lack of materiality in the early stages of litigation.  And, perhaps most significantly, the decision seems to tee up the Court’s re-consideration of the legitimacy and scope of the fraud-on-the-market presumption of reliance that it adopted in Basic v. Levinson.

I explore Amgen’s impact after discussing its majority, concurring, and dissenting opinions.

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).

Much can be said, and doubtless will be said, in criticism of the majority’s decision.  Its chief flaw is 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 v. Levinson, 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 does 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 reasons 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 writes in his dissent (joined by Justice Scalia (in part) and Justice Kennedy), the majority essentially “reverses” 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 says 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.  Writes Thomas:  “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.”

Despite the flaws of the decision, the Court has spoken, and there is limited usefulness to arguing about whether or not its decision is correct.  But lurking under the surface of the opinion are a number of issues that leave ample room for continued litigation over “materiality” issues:

1) The Court affirmed the district court in rejecting Amgen’s effort to offer rebuttal evidence upon class certification that would demonstrate that the misstatement was not material because the truth of the matter had already been disclosed to the market.  If this argument is framed as a “truth on the market” defense, alleging that truthful information had already entered the market by other means, then it is traditionally a question that is entertained at the summary judgment stage.  On the other hand, in its narrow focus on “materiality,” the Court overlooked that this may also be a question properly raised on a motion to dismiss:  if plaintiffs challenge a statement as misleading because it fails to disclose certain information, then the fact that the same information was actually disclosed (in that statement or other statement by the company), negates the existence of a false or misleading statement in the first place.  The Amgen decision will not affect defendants’ ability to make this challenge on a motion to dismiss, as an argument not against materiality, but rather against the sufficiency of plaintiffs’ allegations of falsity.

2) Because Amgen conceded that the market for its stock was “efficient,” the Court avoided more searching examination of what this term means, and how the efficiency of a market – an undisputed prerequisite to the application of the fraud-on-the-market presumption at the class certification stage – can be challenged.  In footnote 6, the Court noted that Amgen had advanced an argument founded on modern economic research tending to show that market efficiency was not a “binary, yes or no question.”  Rather, the efficiency of a market in absorbing information depends upon the type of information – a market might be able to readily process easily digestible information like public merger announcements, while the same market could be slow to respond to potentially important technical or scientific disclosures in an SEC filing. The Court sidestepped the issues raised by this argument, by saying that it did not impact the “materiality” question.

But the argument does raise the question of how efficiency should be defined, and whether the efficiency of a market may depend on the type of statement in question and/or its price impact.  The Court thus left the door open to question on class certification whether a statement was “efficiently” absorbed into, and thus reflected by, the market price.  This argument is a close cousin to materiality, with one important distinction:  I can imagine a circumstance in which a court could find that a public statement was not absorbed into, or reflected by the market price, and that the fraud-on-the-market presumption should not apply – but that, regardless, the statement was still “material,” in that a reasonable investor would find it significant.  In such an instance, the certification of a class would properly be defeated, but the ultimate question of materiality would be left open for an independent determination on the merits should an individual investor bring suit.  Such a circumstance would break the circle upon which the Court based its holding in Amgen.

3) Perhaps the most striking part of the decision was Justice Alito’s one paragraph concurrence, which baldly called for a reconsideration of the fraud-on-the-market presumption created in Basic.  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.  When, and if, Basic is reconsidered, the result could have a much larger impact on the future of class actions than would have been felt by any decision on the “materiality” questions raised in Amgen.

In summary, my first take on the Amgen decision is that far from settling the question of what plaintiffs must prove to gain class certification, it has merely opened the doors wider for continued litigation on the matter.  I predict that these issues are going to continue to be challenged, and that another case on class certification will be before the Court within the next few years.  After considering class-certification issues in Halliburton in 2011, and now in Amgen, the Court seems destined at long last to reach the ultimate question – the legitimacy and scope of the fraud-on-the-market presumption.

That doesn’t mean that Amgen will be forgotten – in addition to leaving behind a number of crumbs to feed continued litigation of “materiality” questions, the majority seemed to signal a shift away from its historic narrow construction of the securities laws based on the Court’s observation in Blue Chip Stamps v. Manor Drug Stores that “litigation under Rule 10b-5 presents a danger of vexatiousness different in degree and in kind from that which accompanies litigation in general.”  421 U.S. 723, 739 (1975).  Here, the Court flatly rejected Amgen’s argument based upon the public policy interest of containing that “vexatiousness.”  Amgen argued that if materiality was not addressed in class certification, it was likely not to be ever addressed at all, because after class certification, plaintiffs are able to bring substantial pressure to bear on defendants to get them to settle before the merits phase – even on frivolous claims.  But the Court contended that Congress had already taken steps, through the Reform Act, to curb the “‘extraction’ of ‘extortionate settlements’” of frivolous claims,” and, in doing so, had consciously decided not to challenge the fraud-on-the-market presumption. And while continuing to recognize the potential for abuse, the Court nonetheless chose to emphasize the possibility that securities class actions also serve an important public policy purpose, by supplementing the criminal prosecutions and civil enforcement actions brought by the DOJ and the SEC.  As the debate over the “materiality” question continues to play out, this passage may prove to be the most enduring takeaway from Amgen – and the one most likely to haunt us in plaintiffs’ briefs in the coming years.

 

This promises to be an eventful  year in securities and corporate governance litigation.  A number of looming developments have the potential to change the landscape for many years to come. This is the first of two posts – or three, if I get carried away – discussing some of these developments.

The Delaware Supreme Court’s decision in Louisiana Municipal Police Employees’ Ret. Sys. v. Pyott (the Allergan derivative case)

In Allergan, the Delaware Supreme Court will decide whether the dismissal of a hastily filed shareholder derivative action precludes a subsequently filed action that was based on information obtained under a request to inspect books and records under Section 220 of the Delaware General Corporation Law.  Section 220 allows a stockholder to inspect a corporation’s “books and records” for a “proper purpose.”   On February 5, 2013, the Delaware Supreme Court heard oral argument.

In the Court of Chancery, Vice Chancellor Travis Laster ruled that the plaintiffs in the previously dismissed litigation, filed in California, provided “inadequate representation” to the corporation because, unlike the plaintiffs in the Delaware action, they did not utilize Section 220 to attempt to determine whether their claims were well-founded.  46 A.3d 313, 335-51 (Del. Ch. 2012).  The failure to provide adequate representation deprived the dismissal of preclusive effect.  In South v. Baker (the Hecla Mining derivative case), Vice Chancellor Laster similarly ruled that derivative plaintiffs who filed without the benefit of 220 provided inadequate representation.  2012 WL 4372538, at *20 (Del. Ch. Sept. 25, 2012).

Delaware courts have long urged shareholders to use Section 220 before filing derivative litigation.  A ruling that a derivative action filed without the benefit of 220 constitutes inadequate representation would be tantamount to a requirement that stockholders use Section 220 before filing a derivative complaint in many types of derivative cases.

Many defense counsel believe that a pre-filing 220 requirement would be a positive development, because they believe that in many cases, plaintiffs’ lawyers do not want to go to the time and expense of a 220 demand, and would therefore file fewer derivative cases.

I say be careful what you wish for: 220 demands impose compliance costs, risk interference with the discovery stay in related securities litigation, and can create more virulent derivative cases, because they facilitate pleading with factual support, which the defendants sometimes can’t combat effectively on a motion to dismiss.  In contrast, although they are a nuisance, fast-filed derivative cases are routinely dismissed.  And a dismissal can be achieved without great cost – if the defense firm defends the case strategically and efficiently.

The Supreme Court’s decision in Amgen

Amgen Inc. v. Connecticut Retirement Plans, pending before the Supreme Court, could bring significant change to securities litigation.  At issue is whether plaintiffs need to establish that the allegedly false statements were material to the market, before a court can certify a securities lawsuit as a class action.  If the answer is “yes,” class certification will become a more meaningful stage in securities class actions, providing defendants with a new tool for stopping unmeritorious cases relatively early on.

If the answer is “no,” class certification will remain mostly inconsequential, with the arguments centering around whether the class representative is adequate and typical, which in the vast majority of cases has little impact on the case as a whole – even if successful, these efforts often just mean a new class representative.  The discovery and motion practice associated with such efforts costs hundreds of thousands of dollars.  I’ve found the cost/benefit calculation isn’t worth it in most cases, and have become more conservative about opposing class certification absent compelling circumstances. But the ruling in Amgen could change this analysis, and breathe new life into the class certification process.

Federal courts’ application of the scienter decision in Matrixx

After the Supreme Court issued its ruling in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), it initially seemed to be an innocuous ruling that would have very little impact.  At issue was whether a drug manufacturer had a duty to disclose statistically insignificant adverse health impacts.  The issue was narrow, and the plaintiffs had the better legal argument.  So I was puzzled about why the parties litigated the issue to the Supreme Court and why the Supreme Court took the case.

Supreme Court decisions can have unintended consequences, and Matrixx may well end up altering courts’ scienter analysis for reasons that the Supreme Court almost certainly didn’t intend.  After deciding that Matrixx had a duty to disclose the adverse events, because they made its statements misleading, the Court found that the plaintiffs had pleaded scienter adequately under Tellabs.  Given that scienter was not the central issue before the Court, the Court’s scienter analysis was not elaborate, and it fairly easily found that the plaintiffs’ allegations sufficed to plead scienter.  The Court applied Tellabs, and in no way indicated that it was fashioning a new type of scienter analysis.

Yet some courts have read the Matrixx Court’s short scienter analysis as a signal that scienter analysis no longer should review scienter allegations individually as well as “holistically.”  For example, in Frank v. Dana Corp., 646 F.3d 954, 961 (6th Cir. 2011), the Sixth Circuit said (citations omitted):

In the past, we have conducted our scienter analysis in section 10(b) cases by sorting through each allegation individually before concluding with a collective approach. However, we decline to follow that approach in light of the Supreme Court’s recent decision in [Matrixx]. There, the Court provided for us a post-Tellabs example of how to consider scienter pleadings “holistically” in section 10(b) cases. Writing for the Court, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis. This is the only appropriate approach following Tellabs’s mandate to review scienter pleadings based on the collective view of the facts, not the facts individually. Our former method of reviewing each allegation individually before reviewing them holistically risks losing the forest for the trees. Furthermore, after Tellabs, conducting an individual review of myriad allegations is an unnecessary inefficiency. Consequently, we will address the Plaintiffs’ claims holistically.

The Tenth Circuit took a similar view in In re Level 3 Communications, Inc. Securities Litigation, 667 F.3d 1331, 1344 (10th Cir. 2012).

On the other hand, more recently, the Ninth Circuit in In re VeriFone Holdings, Inc. Securities Litigation, 2012 WL 6634351, *5-*6, ___ F.3d ___ (9th Cir. Dec. 21, 2012), affirmed the permissibility of a two-step analysis – first, a review of the individual scienter allegations and then a holistic review – and correctly ruled that the Supreme Court in Matrixx did not prescribe a particular analysis that a court must undertake, nor did it purport to alter the scienter analysis articulated in Tellabs:

Matrixx on its face does not preclude this approach and we have consistently characterized this two-step or dual inquiry as following from the Court’s directive in Tellabs. In cases where an individual allegation meets the scienter pleading requirement, whether we employ a dual analysis is most likely surplusage because the individual and the holistic analyses yield the same conclusion. Also, as a practical matter, some grouping and discussion of individualized allegations may be appropriate during a holistic analysis.

In its own analysis, the Ninth Circuit skipped analysis of the individual allegations and instead went right to a holistic review, to avoid the “potential pitfalls” of a “focus on the weakness of individual allegations to the exclusion of the whole picture.  The risk, of course, is that a piecemeal analysis will obscure a holistic view.”  The court emphasized, however, that it was not ignoring the individual allegations or the inferences drawn from them.

A solely holistic review risks expanding judicial discretion in applying a rule of law that already allows for significant judicial discretion.  Standards governing individual scienter allegations – for example, that stock sales of a certain percentage generally are not suspicious – impose some objectivity on an otherwise subjective analysis.  And discussion of the allegations individually invites a certain measure of thoughtfulness and skepticism.  A rule that eschews analysis of individual scienter allegations is unfriendly to defendants because it invites judges to engage in a less rigorous analysis that ignores the shortcomings of the individual allegations – and the easy decision in securities cases is usually to deny the motion to dismiss.  Regardless, a cursory analysis of scienter allegations is not fair to defendants, who at least deserve judicial scrutiny of the fraud allegations against them, and is contrary to Congress’ intent that courts play a gatekeeper function in this particularly vexatious type of litigation.

I attended the Supreme Court argument in Amgen yesterday.  Law360 and the 10b-5 Daily, written by my former Wilson Sonsini partner Lyle Roberts (now at Cooley), have posted good summaries of the argument.

Here are links to (1) my October 15 blog post about Amgen and its significance and (2) the Amgen argument transcript.

After a reminder about the legal issue, I offer some thoughts about the argument, including Justice Scalia’s statement, “So maybe we should overrule Basic ….”

The Legal Issue

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 v. Levinson, 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 in 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.”

At issue in Amgen is whether the materiality of an alleged misrepresentation is also a condition to the presumption’s application for purposes of Rule 23(b)(3).

The Core of the Dispute

Most of the Amgen argument centered on the following debate:  Materiality is a substantive element of a Section 10(b) claim.  Amgen and the plaintiffs agree that materiality, as a substantive element, is a legal question common to the class.  The United States (and I suspect the plaintiffs too, if they had been asked) agreed that materiality is a condition to the application of the fraud-on-the-market doctrine for purposes of the merits, but not for purposes of Rule 23.

So the dispute boils down to this: if courts were to determine materiality at class certification, they would be deciding a “common question” (i.e. materiality as a substantive element), albeit for purposes of determining whether reliance is a common question; but if courts do not determine materiality at class certification, they are either prematurely or improperly certifying a class, because materiality is necessary to make reliance a common question.  Justice Scalia amplified the latter point as follows:

Materiality is a common issue.  Reliance is only a common issue if you accept the fraud-on-the-market theory.  That’s the problem.  And you are using the one, which is a common issue, to leapfrog into the second, to make the efficiency of the market reasoning something that it isn’t.

There was a lot of fairly technical discussion about the considerations bearing on these issues, including (a) the legal and practical effect of an immateriality ruling at class certification on a class member’s individual claim, (b) the difference between adjudication of materiality at class certification and summary judgment, and (c) the fact that market efficiency and a public statement – both undisputed conditions to the presumption’s application – also are common to all class members.

I’m not a Supreme Court observer and thus will leave the oral argument tea-leaf reading to others.    But it seems to me that, in resolving the technical legal question, the Court will be influenced by precedent proscribing the limits of securities class actions because of the “danger of vexatiousness” they present and the extraordinary pressure a certified class places on defendants to settle.  Justice Scalia emphasized the settlement-pressure point.  In response to a question from Justice Breyer, Seth Waxman of Wilmer Hale, on Amgen’s behalf, synthesized the technical legal point and policy point nicely:

the point of Rule 23 is to say, you get to use this very useful and powerful device if you have the key to the gate, and the key to the gate is showing that the answer to the question, will reliance be proven commonly – not lost commonly, but proven commonly – is in fact yes.

Continue Reading Supreme Court Argument in Amgen

The Supreme Court’s decision in the Amgen securities case will have a profound impact on the future of securities class action litigation.  If the Court affirms the Ninth Circuit’s decision, it will eliminate an important event: a determination of whether the alleged false or misleading statements materially impacted the price of the company’s stock sufficient to invoke the “fraud-on-the-market” presumption of reliance.  That would mean, absent settlement, that the vast majority of all securities class actions that survive a motion to dismiss will remain alive until at least summary judgment, even those that are doomed to fail because the challenged statements were not, in fact, material.  If the Court reverses the Ninth Circuit, many future securities class actions will involve a meaningful class certification process.  That would yield several important strategic and economic consequences.   Argument is scheduled for November 5, 2012.

Before getting to my prediction and a discussion of the consequences of the Court’s ruling, following is a brief overview of the law and practice surrounding the issue the Court will decide.

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 v. Levinson, 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.”  At issue in Amgen is whether the materiality of an alleged misrepresentation is also a condition to the presumption’s application.

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.  This argument was accepted by the Fifth Circuit in Oscar Private Equity Investments v. Allegiance Telecom, Inc.  But  Oscar rested on shaky analytic grounds, and indeed the Supreme Court in Halliburton unanimously rejected loss causation as a condition of the presumption of reliance.

Continue Reading “Materiality” of Class Certification Procedure in Securities Class Actions at Issue in Amgen