Today the Supreme Court of the United States released its much-anticipated decision in Halliburton Co. v. Erica P. John Fund, Inc., in which it revisited the "fraud-on-the-market" theory. This theory underlies a rebuttable presumption that investors rely on a defendant's misrepresentation in deciding to buy or sell a company's securities, and has been a major contributor to the boom in U.S. securities class actions since it was first endorsed by the U.S. Supreme Court in the Basic Inc. v. Levinson decision in 1988.
In Halliburton, the court upheld the fraud-on-the-market presumption, noting that the high threshold for overturning one of its own precedents had not been met. However, securities class action defendants have several reasons to celebrate the decision. For one thing, the court confirmed that Basic was not to be construed as a monolithic endorsement of the efficient markets theory – market efficiency being "a matter of degree and accordingly . . . a matter of proof." For another, the court held that defendants may, at the certification stage, rebut the presumption of reliance on the basis that the alleged misrepresentations did not affect the share price.
BACKGROUND: FRAUD-ON-THE-MARKET AND THE BASIC DECISION
The "fraud-on-the-market" theory posits that an investor, in buying or selling securities at the market price, relies on the integrity of that price in the belief that it reflects all public, material information about the issuer. This is because the market price of shares traded on well-developed markets reflects all publicly available information, including any material misrepresentations.
By endorsing this theory, the Basic decision has facilitated the certification of securities class actions in the U.S. by allowing plaintiffs advancing misrepresentation claims premised on section 10(b) of the Securities Exchange Act of 1934 and the U.S. Securities and Exchange Commission's Rule 10b-5 to avoid the common law requirement that each individual investor demonstrate direct reliance on a defendant's misrepresentation. As the Supreme Court observed in Basic, such a requirement would make certification "inappropriate" because the significant individual issue of investor reliance would "overwhelm" the common issues.
The two key takeaways from the Halliburton decision are that the fraud-on-the-market theory has been preserved and that defendants are entitled to tender evidence at the certification stage to show that alleged misrepresentations did not affect the market price of the securities at issue.
Fraud-on-the-Market Theory Preserved
Chief Justice John G. Roberts, Jr., in delivering the opinion of the court, rejected Halliburton's argument that the Basic decision should be overruled and that every securities fraud plaintiff should be required to prove that he or she actually relied on the defendant's misrepresentations in deciding to buy or sell a company's securities.
He considered, and rejected, the following two principal arguments that Halliburton had advanced:
- The court in Basic had erred in taking a "robust view" of market efficiency that is no longer tenable in light of "overwhelming empirical evidence that 'suggests that capital markets are not fundamentally efficient'"
- The court in Basic had erred in presuming that plaintiffs make investment decisions in reliance on the integrity of the market price of a security.
With respect to the first argument, Chief Justice Roberts stated that the Basic decision had not been founded on a robust view of market efficiency but rather on the "fairly modest premise" that "market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices." He concluded that by making the presumption of reliance rebuttable, the court had recognized that market efficiency was a matter of degree, and therefore appropriately a matter of proof. Ultimately, "the kind of fundamental shift in economic theory that could justify overruling a precedent on the ground that it misunderstood, or has since been overtaken by economic realities" had not been established.
With respect to the second argument, Halliburton pointed to classes of investors for whom the integrity of the market price of a security is "marginal or irrelevant," such as "value investors" who believe stocks are undervalued or overvalued and attempt to "beat the market" by buying the undervalued securities and selling overvalued ones. Chief Justice Roberts affirmed that the Basic decision did not deny the existence of such investors, and noted that even value investors, by anticipating eventual market corrections, implicitly place some reliance on the notion that market prices will incorporate public information about the issuer within a reasonable period.
Price Impact May Be Refuted at Certification Stage
Halliburton was successful in its alternate line of argument that defendants should be entitled to rebut the presumption of reliance at the certification stage by demonstrating that the alleged misrepresentation did not have an impact on the price of the securities. Chief Justice Roberts accepted the fact that it was "Basic's fundamental premise" that the impact of a misrepresentation is reflected in the market price at the time of an investment transaction. Accordingly, he concluded there was no reason to artificially limit, as lower courts had done, the ability of defendants to defeat certification by showing that the alleged misrepresentations did not affect the price of the securities and, therefore, that class-wide reliance could not be presumed.
RESULT AND ITS IMPLICATIONS
The decision of the U.S. Court of Appeals for the Fifth Circuit, which had upheld the certification of Halliburton, was vacated and the case was remanded for further proceedings. Justice Ruth Bader Ginsburg, joined by Justice Stephen G. Breyer and Justice Sonia Sotomayor, wrote a brief concurring opinion. Justice Clarence Thomas, joined by Justice Antonin Scalia and Justice Samuel Alito, Jr., concurred in the result but indicated that he would have overturned Basic because its "reimagined reliance requirement was a mistake, and the passage of time has compounded its failings."
Halliburton is one of several recent decisions which may have a dampening effect on securities class action activity south of the border. Canadian courts have traditionally rejected the fraud-on-the-market theory. However, starting in 2005, legislatures in various Canadian provinces and territories have enacted "deemed reliance" provisions as part of the secondary market liability provisions of their securities acts. Given the differences between Canadian and U.S. securities and class action laws, Halliburton is unlikely to directly affect Canadian jurisprudence. However, the decision is one more indication that the securities class action regimes in the two countries are at different stages of development. While the pendulum in the U.S. may be swinging towards a more restrictive approach to the certification of such cases, Canadian courts appear to be moving in the opposite direction.
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