The US is widely acknowledged as the home of securities class actions. In recent months, however, there has been debate about how the upcoming Supreme Court decision in Erica John Fund v Halliburton and the fraud-on-the-market presumption might affect securities litigation.
The US is widely acknowledged as the home of securities class actions. In recent months, however, there has been debate about how the upcoming Supreme Court decision in Erica John Fund v Halliburton and the fraud-on-the-market presumption might affect securities litigation.
The US Supreme Court created modern securities class actions in 1987, when in the Basic v Levinson case, an unusual four-justice majority held that investors in securities fraud cases may be presumed to rely on public misrepresentations about stock trading in an efficient market.
Basic’s fraud-on-the-market theory made it possible for shareholders to win class certification without proving that class members made investment decisions based on the defendants’ alleged misstatements—a momentum-shifting boon to shareholders. The ruling has become such an essential building block of securities fraud litigation that since 1987, according to legal research service Westlaw, Basic has been cited almost 17,000 times.
On 15 November 2013, the Supreme Court granted Halliburton Co’s second petition for writ of certiorari in the Erica John Fund v Halliburton class action securities litigation. The aim of the second petition was to consider whether to “overrule or substantially modify the holding of Basic, to the extent it allows a presumption of class wide 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”.
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 class actions where reliance is an essential element of the claim.
What is fraud-on-the-market
presumption of reliance?
To establish securities fraud under Section 10(b) of the Securities Exchange Act of 1934, and the US Securities and Exchange Commission’s (SEC) Rule 10b-5, a private plaintiff must prove that the defendant (i) made a misstatement or omission (ii) of material fact (iii) with scienter (fraudulent intent) (iv) in connection with the purchase or sale of a security (v) upon which the plaintiff reasonably relied and (vi) 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.
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 John Fund v Halliburton (2011) and Amgen v Connecticut Retirement Plans and Trust Funds (2013), the dissenting justices in Amgen (Clarence Thomas, Antonin Scalia and Anthony Kennedy) expressly criticised 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 Securities 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 affect the price of the stock.
In its opposition brief, lead plaintiff Erica John Fund 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.
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.
Litigation over mortgage-backed securities (MBS) has taught plaintiffs’ lawyers how to leverage information by filing similar complaints for multiple investors with claims for individual losses. MBS litigation has also encouraged relationships between top-tier shareholder firms and large institutional investor clients. Individual fraud suits don’t necessarily pose the enormous threat of class actions, but if the Supreme Court reverses Basic, defendants might wind up facing big institutional investor claims in state courts across the country; an inconvenient and expensive proposition.
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 (DNJ 1989).
Under the Cammer test, a court examines the following factors: (i) the average weekly trading volume of the stock; (ii) the number of securities analysts following the stock; (iii) the extent to which market makers and arbitrageurs traded in the stock; (iv) the issuer’s eligibility to file an SEC registration Form S-3; and (v) 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 US 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.
Even if the US Supreme Court eliminates its fraud-on-the-market precedent, shareholders can still bring Securities Exchange Act class actions based on allegedly fraudulent omissions, rather than misrepresentations. Because the court has previously held that shareholders do not have to establish that they relied on such omissions, resourceful plaintiffs’ lawyers will likely try to reframe cases to claim that defendants deliberately failed to disclose material information.
So, for instance, instead of arguing that J.P. Morgan Chase CEO Jamie Dimon misstated the bank’s risk when he called losses from trades by the so-called London Whale “a tempest in a teapot”, shareholder lawyers might argue that J.P. Morgan officials fraudulently avoided revealing the magnitude of losses by its chief investment office.
Additionally, should the court do away with the presumption of class-wide reliance, investors in some cases will still be able to bring class actions under Section 11 of the Securities Exchange Act of 1933, which does not require a showing of reliance but holds defendants strictly liable for material misstatements in offering materials.
This summer, the Supreme Court will decide whether the fraud-on-the-market presumption should be overruled or modified. Whatever the outcome, the court’s decision in Halliburton will significantly impact the future of securities class actions, however it is unlikely, in my opinion, to wipe them out entirely.
