United States: Fraud-On-The-Market Presumption Of Reliance May Be Overruled

Last Updated: December 6 2013
Article by Robert L. Hickok, Gay Parks Rainville and Min Choi

On Nov. 15, the U.S. Supreme Court granted Halliburton Co.'s second petition for writ of certiorari in the Erica P. John Fund v. Halliburton, No. 13-317, securities litigation, this time to consider whether to "overrule or substantially modify the holding of Basic v. Levinson, 485 U.S. 224 (1988), to the extent it allows a presumption of classwide reliance under the fraud-on-the-market theory," and, if the court does not overrule Basic, to decide whether a defendant "may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock." The petition is available at http://goo.gl/ZWkXlW. If the court eliminates Basic's fraud-on-the-market presumption altogether, then each member of a proposed class will be required to prove that he or she actually relied on a defendant's alleged misrepresentations and common issues will no longer predominate. In short, courts will stop certifying classes in securities actions where reliance is an essential element of the claim.

Fraud-on-the-Market Presumption of Reliance

To establish securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and the U.S. Securities and Exchange Commission's Rule 10b-5, 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). In order for a private plaintiff to prosecute a Rule 10b-5 claim as a class action under Federal Rule of Civil Procedure Rule 23(b)(3), common questions must "predominate" over questions affecting individual class members.

Prior to Basic, lower courts wrestled with how to certify a class where the essential element of reliance was individual, not common. To avoid this problem, some courts went so far as to hold that questions of individual reliance could be litigated separately, after other common liability issues had been tried. (See, e.g., Hurwitz v. R. B. Jones, 76 F.R.D. 149, 168-70 (W.D. Mo. 1977) (citing supporting cases and commentary).)

In Basic, the Supreme Court resolved this problem by holding that plaintiffs could establish a rebuttable presumption of classwide reliance under the fraud-on-the-market theory. Under this theory, courts presume that all members of the putative class indirectly relied on the alleged misrepresentation in deciding whether to buy or sell the defendant's stock 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.

In his dissenting opinion, the late Justice Byron White argued that—in practice—most defendants would feel pressured to settle in the face of class certification and, therefore, would not have the opportunity to rebut a presumption of reliance. In response to this argument, the majority held that a defendant could rebut the presumption of reliance with "any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price."

In recent years, defendants have attempted to avoid class certification by arguing that a plaintiff must prove loss causation and materiality for the Basic presumption to apply. Although the Supreme Court rejected these arguments in Erica P. John Fund v. Halliburton, 131 S. Ct. 2179 (2011) (Halliburton I), and Amgen v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), the dissenting justices in Amgen (Clarence Thomas, Antonin Scalia and Anthony Kennedy) expressly criticized the court's decision in Basic, and Justice Samuel Alito's brief concurrence suggested that it may be time to reconsider the fraud-on-the-market theory.

Halliburton's Petition for Writ of Certiorari

Halliburton's petition asks the Supreme Court to overrule the fraud-on-the-market presumption on grounds that the court in Basic incorrectly based the presumption on a flawed economic theory, as opposed to legal principle. In their supporting amicus brief, a group of law professors and former SEC commissioners and officials argue further that, based on a holistic reading of the plain text of the exchange act, the court should require individual reliance from each and every plaintiff, either before a class is certified or before damages are rewarded. In the alternative, Halliburton asks the court to allow defendants to rebut the fraud-on-the-market presumption—at the class certification stage—with evidence that the alleged misrepresentations did not actually impact the price of the stock.

In its opposition brief, the Erica P. John Fund, the lead plaintiff, argues, inter alia, that eliminating the fraud-on-the-market presumption would be too drastic a measure since it would overturn several other Supreme Court decisions affirming Basic, as well as numerous lower court decisions adopting the presumption. In addition, the lead plaintiff argues that the economic theory supporting Basic has evolved and become more nuanced, and that lower courts considering whether to apply the fraud-on-the-market presumption have found ways to incorporate that nuance in reaching sound decisions.

With respect to Halliburton's alternative argument, the Erica P. John Fund argues that the decision in Amgen foreclosed defendants from rebutting the presumption through evidence of lack of price impact, since such a determination would require deciding questions about the materiality of a lead plaintiff's claim. In its reply, Halliburton points out that the Supreme Court specifically reserved judgment on the "lack of price impact" defense in Halliburton I, and that the issue is ripe for a decision now.

Analysis of Possible Outcome

If the Supreme Court were to eliminate Basic's fraud-on-the-market presumption, then securities class action plaintiffs would almost certainly be unable to obtain class certification going forward. At first glance, such an outcome would seem groundbreaking, especially given the hundreds of federal appeals court and district court cases that have applied the presumption during the last 25 years since Basic was decided. Practically speaking, however, securities plaintiffs and the securities plaintiffs bar would likely adjust. Importantly, securities class action lawsuits are increasingly brought by large institutional investors, which may simply bring individual cases.

In addition, prior to Basic, as referenced above, some courts permitted separate phases of litigation—after liability had been established—that allowed individuals to prove reliance in order to obtain damages. If the court were to overrule Basic's fraud-on-the-market presumption, such pre-Basic cases would still be good law, and large consolidated plaintiffs and multiphase litigation could become the norm in securities fraud lawsuits.

Alternatively, the court may take a less severe approach and adopt a test for determining whether a defendant's stock trades in an efficient market, such as the five-factor test applied by the court in Cammer v. Bloom, 711 F.Supp. 1264, 1276 (D.N.J. 1989). Under the Cammer test, a court examines the following factors: (1) the average weekly trading volume of the stock; (2) the number of securities analysts following the stock; (3) the extent to which market makers and arbitrageurs traded in the stock; (4) the issuer's eligibility to file an SEC registration Form S-3; and (5) the demonstration of a cause-and-effect relationship between unexpected, material disclosures and changes to the stock's prices. The court may also decide to adopt the U.S. Court of Appeals for the Third Circuit's approach of allowing a defendant to rebut the fraud-on-the-market presumption of reliance, at the class certification stage, with evidence that the alleged misrepresentations did not distort the market price of its stock.

When the Supreme Court hears argument in this case March 4, 2014, we can count on securities litigators on both sides of the issue to scrutinize the justices' questions and comments for any signal that the majority is leaning toward overruling Basic's fraud-on-the-market presumption. Whatever the outcome, the court's decision in Halliburton will significantly impact the future of securities class actions.

Reprinted with permission from the December 3, 2013 issue of The Legal Intelligencer. © 2013 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

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Robert L. Hickok
Gay Parks Rainville
Min Choi
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