United States: Rebutting The Fraud-On-The-Market Presumption Of Reliance

Last Updated: September 11 2013
Article by Robert L. Hickok, Gay Parks Rainville and Min Choi

Thanks to two recent U.S. Supreme Court decisions, Amgen v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), and Erica P. John Fund v. Halliburton, 131 S. Ct. 2179 (2011), plaintiffs in securities fraud class actions brought under Section 10(b) of the Securities Exchange Act of 1934 and U.S. Securities and Exchange Commission Rule 10b-5 do not need to prove two of the essential elements of their claim, loss causation and materiality, at the class certification stage. These two judicial alterations to the securities class-action playing field give plaintiffs a strategic advantage in obtaining class certification and, therefore, in increasing the potential settlement value of their claims. Yet, both decisions leave open the question of whether defendants can defeat class certification by rebutting the fraud-on-the-market presumption of reliance with evidence that defendants' alleged misrepresentations did not measurably impact the market price of the security at issue.

By way of background, to establish a Rule 10b-5 violation, a private plaintiff must prove that the defendant (a) made a misstatement or omission (b) of material fact (c) with scienter (fraudulent intent) (d) in connection with the purchase or sale of a security (e) upon which the plaintiff reasonably relied and (f) the plaintiff's reliance was the proximate cause of his or her injury (loss causation). If courts strictly applied the reliance requirement in the class action context, then common questions would not "predominate" for purposes of Federal Rule of Civil Procedure Rule 23(b)(3) because each prospective class member would have to prove that he or she individually relied on the misrepresentation or omission at issue, and no class would ever be certified. Instead, courts allow plaintiffs to establish a rebuttable presumption of classwide reliance under the fraud-on-the-market theory adopted by the Supreme Court in Basic v. Levinson, 485 U.S. 224 (1988). Under this theory, courts presume that all members of the putative class indirectly relied on the alleged misrepresentation or omission through their reliance on the stock's market price, so long as the lead plaintiff can show that the stock traded in an efficient market.

At first sight, the Supreme Court's decisions in Amgen and Halliburton appear to hinder the ability of a defendant to rebut the fraud-on-the-market presumption at the class certification stage. The issues presented in Amgen and Halliburton arose through a spectrum of circuit splits. At one end of the spectrum was the U.S. Court of Appeals for the Fifth Circuit, which required plaintiffs to prove both loss causation and materiality in order to certify a class under the fraud-on-the-market theory. (See Archdiocese of Milwaukee Supporting Fund v. Halliburton, 597 F.3d 330 (5th Cir. 2010); and Oscar Private Equity Investments v. Allegiance Telecom, 487 F.3d 261 (5th Cir. 2007).) The Second Circuit also required plaintiffs to prove materiality at the class certification stage. (See In re Salomon Analyst Metromedia Litigation, 544 F.3d 474 (2nd Cir. 2008).)

At the other end of the spectrum was the Ninth Circuit's ruling in Connecticut Retirement Plans and Trust Funds v. Amgen, 660 F.3d 1170 (9th Cir. 2011), that to invoke the fraud-in-the-market presumption at the class certification stage, a Rule 10b-5 plaintiff need not prove that the alleged misrepresentations were material, and the Seventh Circuit's decision in Schleicher v. Wendt, 618 F.3d 679 (7th Cir. 2010), that class certification did not require proof of either materiality or loss causation. The Supreme Court reversed the Fifth Circuit in Halliburton and affirmed the Ninth Circuit in Amgen, holding that a plaintiff need not prove either loss causation or materiality to certify a class.

In contrast to the Fifth and Seventh circuits, the Third Circuit applied a middle-ground approach to class certification, which the Supreme Court's decisions in Amgen and Halliburton arguably left unaddressed. While the Third Circuit did not require plaintiffs to prove either loss causation or materiality in order to invoke the fraud-on-the-market presumption of reliance at the class certification stage, it expressly permitted defendants to rebut the presumption and defeat certification by showing the absence of "price impact." (See In re DVI Securities Litigation, 639 F.3d 623, 637-38 (3d Cir. 2011).) In DVI, the court concluded that, whether a lack of price impact is due to market inefficiency or an absence of materiality, it nonetheless is inconsistent with the fraud-on-the-market theory. As the court explained:

"Evidence an allegedly corrective disclosure did not affect the market price undermines the fraud-on-the-market presumption of reliance for several reasons. 'An efficient market for good news is an efficient market for bad news.' A demonstration the market did not assimilate information about the security into the market price — either when the alleged misrepresentation occurred, or when an alleged corrective disclosure occurred — may undercut the general claim of market efficiency or demonstrate market inefficiency relating to the securities in issue.

"Even if a plaintiff could establish the market was efficient notwithstanding a lack of market impact, under our precedents the lack of market impact may indicate the misstatements were immaterial — a distinct basis for rebuttal."

When he served on the Third Circuit, Justice Samuel Alito authored the opinion in In re Burlington Coat Factory Securities Litigation, 114 F.3d 1410 (3d Cir. 1997), a precursor to the court's DVI decision. As Alito explained in Burlington, if a company's stock trades in an efficient market, and the alleged misrepresentations have no impact on the stock's price, then they are "immaterial as a matter of law." Consistent with Burlington, the Third Circuit in DVI determined that it was appropriate for courts to consider price impact at the class certification stage because, if the alleged misrepresentation is not material, then every putative class member's claim would fail on the merits and there would be no need to explore each plaintiff's individual reliance. Notably, in Amgen, Alito wrote a brief concurrence suggesting that it may be time to reconsider the fraud-on-the-market theory in light of research indicating that the theory may sometimes rest on a faulty premise. In support, Alito cited a law review article by Donald C. Langevoort, "Basic at Twenty: Rethinking Fraud on the Market," published in the Wisconsin Law Review in 2009, which discusses at length another Third Circuit price-impact case, In re Merck & Co. Securities Litigation, 432 F.3d 261 (3d Cir. 2005). Merck further cemented the Third Circuit's view that information is immaterial when the stock price does not react significantly to a corrective disclosure.

When the Supreme Court remanded Halliburton to the Fifth Circuit, the defendants, in Erica P. John Fund v. Halliburton, 718 F.3d 423 (5th Cir. 2013) ("Halliburton II"), attempted once again to defeat class certification, this time under the Third Circuit's price-impact approach. But the Fifth Circuit rejected the defendants' argument, explaining that, under the "analytical framework" of Amgen, determining at the class certification stage whether a misrepresentation had an impact on the stock price is essentially the same as deciding whether the misrepresentation was material. The decision in Halliburton II is not binding on other circuits, however, and, at the very least, creates some tension with the Third Circuit's decision in DVI.

In sum, challenges to class certification in securities fraud lawsuits may still be viable in the Third Circuit. Under DVI, district courts in this circuit may give defendants the opportunity at the class certification stage to rebut a presumption of fraud-on-the-market with lack of price-impact evidence. Plaintiffs will no doubt challenge this approach, all the way to the Supreme Court if necessary, citing Amgen, Halliburton and Halliburton II. Therefore, defense counsel should pursue a price-impact rebuttal at the appellate level only if the underlying evidence of lack of price impact is compelling enough to withstand scrutiny by the Supreme Court in a case of first impression.

Reprinted with permission from the September 3, 2013 issue of The Legal Intelligencer.

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Robert L. Hickok
Gay Parks Rainville
Min Choi
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