On June 25, 2014, the U.S. Supreme Court decided Halliburton Co. v. Erica P. John Fund, No. 13-317, __ U.S. __ (2014), slip op. (U.S. June 23, 2014) (Halliburton II), holding that defendants in a class action securities lawsuit must be allowed to defeat the fraud-on-the-market presumption of reliance at the class certification stage through evidence that the alleged misrepresentation did not have an impact on the defendant company's stock price. While the decision may not prevent investors from filing class action securities lawsuits, as some had hoped, Halliburton II does provide companies with a meaningful opportunity to defeat class certification.
Background
To bring a securities fraud lawsuit under Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and the U.S. Securities and Exchange Commission (SEC) Rule 10b-5, an investor plaintiff must prove, among other things, that he or she individually relied on the alleged misrepresentation. If courts strictly applied this requirement in the class action context, then common questions would not "predominate" for purposes of satisfying Federal Rule of Civil Procedure Rule 23(b)(3). Instead, each investor would have to testify that he or she was aware of the alleged misrepresentation and made an investment decision based on that representation.
In Basic Inc. v. Levinson, 485 U.S. 224 (1988), the Supreme Court resolved this problem by holding that prospective investor classes could use a proxy for individual reliance by establishing a rebuttable presumption of class-wide reliance via the fraud-on-the-market theory. Under this theory, as long as a company's stock trades in an efficient market, all public information about that stock is viewed as being incorporated in the stock's price – including the alleged misrepresentation. Thus, a court may presume that all members of the putative class indirectly relied on the alleged misrepresentation through reliance on the stock's market price, so long as plaintiffs can prove an efficient market.
Over the years, federal district courts have applied the presumption to certify classes of investor plaintiffs. Proof of efficient markets has been based on such factors as whether the average weekly trading volume of the defendant company's stock was robust, whether there was a high number of analysts and professional investors following and trading in the stock, whether the company had a history of making available detailed SEC filings, and whether a so-called "event study" demonstrated that the stock had previously reacted to material news and other information about the company.
However, last year, in Amgen v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), three dissenting justices – Clarence Thomas, Antonin Scalia and Anthony Kennedy – expressly criticized the Court's decision in Basic. In his concurring opinion in Amgen, Justice Samuel Alito cited academic research questioning whether the Basic presumption "rest[s] on a faulty economic premise" and suggested that "reconsideration" of the Basic presumption "may be appropriate."
The Opinion
Creating an opportunity for the Court to reconsider the fraud-on-the-market presumption, the Halliburton defendants asked the Court in this appeal to consider whether to "overturn or significantly modify" the Basic presumption. Halliburton also requested, in the alternative, that the Court adopt a "middle-ground" approach that would allow defendant companies to "rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock."
In an opinion written by Chief Justice John Roberts, the Court declined the broader challenge to Basic. The Court explained that, before overturning long-settled precedent, it must be convinced of a "special justification," not simply that a "precedent was wrongly decided." Thus, the Court rejected Halliburton's first argument that Basic is inconsistent with a strict reading of the federal securities laws requiring that each plaintiff demonstrate individual reliance. According to the Court's opinion, if Congress is dissatisfied with its interpretation of the law, it can address the matter with new legislation.
The Court also rejected Halliburton's argument that Basic should be overturned in light of economic research over the past decades that has undermined the presumption. As the Court explained, the "foremost critics of the efficient-capital-markets hypothesis" acknowledge that "public information generally affects stock prices." As an example, the Court noted that even so-called "value investors" – or those who look to only buy stocks in undervalued companies – "implicitly" rely on all public information when they purchase stock. Specifically, while such investors may disagree with conventional thinking about public information, they are nevertheless betting on assumptions about that information.
When addressing Halliburton's alternative request that it consider a middle-ground approach, the Court acknowledged the real concerns driving Halliburton's appeal – that companies caught in the crosshairs of a securities class action lawsuit prefer to address as many issues as they can before the lower court decides whether to certify a class. The Court also recognized that, once a class is certified, the damages sought are often so enormous that the defendants' only rational option is to settle even if the chances of losing at trial are small. As the Court pointed out, class actions "allow plaintiffs to extort large settlements from defendants for meritless claims; punish innocent shareholders, who end up having to pay settlements and judgments; impose excessive costs on businesses; and consume a disproportionately large share of judicial resources."
Thus, the Court agreed with Halliburton that, if the Basic presumption is established, defendants "should at least be allowed to defeat the presumption at the class certification stage through evidence that the misrepresentation did not in fact affect the stock price." In many cases, the Court explained, plaintiffs' counsel themselves introduce event studies at the class certification stage to show that the market price of a company's stock responds to information about the company, as part of plaintiffs' efforts to establish that the market for the company's shares is efficient. The Court reasoned that if plaintiffs are allowed to present price impact evidence to satisfy the efficient market requirement, then it made no sense to preclude defense counsel from introducing evidence to demonstrate that the alleged misrepresentation did not impact the price.
Concurring Opinions
Although all nine justices unanimously supported the result in this case – which was to vacate the trial court's class certification decision – three justices did not join the chief justice's opinion. A concurrence by Justice Thomas, joined by Justices Scalia and Alito, opined that the Court should overturn the fraud-on-the-market presumption, stating that "[l]ogic, economic realities, and our subsequent jurisprudence have undermined the foundations of the Basic presumption, and stare decisis cannot prop up the façade that remains."
In a separate, brief concurrence, Justice Ruth Bader Ginsburg, joined by Justices Stephen Breyer and Elena Kagan, explained that she decided to join the chief justice's opinion because it is still "incumbent upon the defendant to show the absence of price impact" and that permitting defendants to do so "should impose no heavy toll on securities-fraud plaintiffs with tenable claims."
Analysis
The Supreme Court's decision in Halliburton II requires that companies be given a chance to end a securities fraud lawsuit at the class-certification stage by showing that that the alleged misrepresentation or its correction did not actually result in a decline or rise in the company's stock price. Consequently, Halliburton II allows trial courts to deny certain class certification motions that they would have granted in the past. For example, in a Third Circuit case, In re Merck & Co. Securities Litigation, 432 F.3d 261 (3d Cir. 2005), Merck allegedly misstated revenues associated with a subsidiary, but eventually corrected those miscalculations in a later SEC filing. Because there was no demonstrable market impact around the time of that filing, the Third Circuit ruled on summary judgment that the market's lack of reaction established that there was no securities fraud as a matter of law. Cases like Merck may now be resolved at the class certification stage.
Halliburton II leaves a number of issues for the lower courts to determine at the class certification stage. Lower courts will undoubtedly confront mini-expert discovery battles about how to interpret event studies and what types of economic opinions the parties may use. The Court's Halliburton II opinion, however, provides no guidance regarding the sufficiency of evidence defendants must provide in order to rebut the Basic presumption. Such logistical issues will likely vary depending on the lower courts' local rules and the standard practices of the judges hearing these cases, which, of course, will be subject to interpretation by the courts of appeals.
Another consequence of the Court's Halliburton II decision is that it may affect the way these cases are pleaded. Securities fraud cases brought under Section 10(b) of the Exchange Act and Rule 10b-5(b) are based on affirmative misrepresentations, omissions, or some combination of the two. Whether the Basic presumption applies to a fraud theory based on omissions is an unsettled question, since a plaintiff arguably cannot be aware of information that he alleges the defendant company unlawfully withheld. To avoid the procedural hurdles presented by Halliburton II, plaintiff attorneys may try to disguise affirmative misrepresentation cases as omissions cases. Such pleading tactics likely will be hotly contested at both the motion-to-dismiss and class-certification stages.
It remains to be seen whether these new pre-merits battles will outweigh their costs, result in victories for defendant companies, impact settlement amounts, or provide a disincentive to securities plaintiffs and their attorneys in bringing these suits. In the meantime, Halliburton II should be viewed as a compromise: It preserves the ability of investors to bring these cases, but it also provides defendants with a new, meaningful opportunity to defeat them before incurring the significant costs of summary judgment briefing and trial.
Footnotes
1 Pepper Hamilton LLP has detailed issues in the case in progress in a previous article, "Fraud-on-the-Market Presumption of Reliance May Be Overruled" (on December 5, 2013, available at http://www.pepperlaw.com/publications_article.aspx?ArticleKey=2805) and our Client Alert, "Justices Signal Interest in Middle-Ground Approach to Adjusting Fraud-on-the-Market Presumption" (on March 10, 2014, available at http://www.pepperlaw.com/publications_update.aspx?ArticleKey=2874).
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