U.S. Supreme Court Reaffirms Vitality of Fraud-on-the-Market Theory Used by Securities Class Action Plaintiffs

6/23/2014 - The United States Supreme Court issued its much-anticipated ruling in the Halliburton Co. v. Erica P. John Fund, Inc. securities class action.  In a victory for investors, the Court rejected a direct challenge to the “fraud-on-the-market” theory, which has been a lynchpin of securities fraud class action litigation for almost 30 years.  In 1988, the Supreme Court held in Basic v. Levinson that, under certain circumstances, an investor’s reliance on an alleged misrepresentation could be presumed, relieving the investor of the burden of having to prove direct reliance on the misrepresentation.  The basis for this presumption is the fraud-on-the-market theory, which holds that the market price of shares traded in a well-developed market reflects all publicly-available information about the company, including any material misrepresentations.  Basic’s fraud-on-the-market theory has been particularly important because it allows the reliance issue to be resolved on a class-wide basis with proof that market price of the stock was affected by a defendant’s misrepresentation.  Without the presumption created by the fraud-on-the-market theory, each investor would need to prove direct reliance on the alleged misrepresentation.  Requiring individual proof of reliance would cause individual issues to overwhelm issues common to the class, thus preventing the case from proceeding as a class action.        

In the Halliburton case, the district court certified the case as a class action and, after the appellate court affirmed the certification, the company sought review by the Supreme Court, which agreed to hear the case. The company argued that the Supreme Court should overturn the Basic presumption of reliance.  The company also raised questions about what evidence can be presented in a motion for class certification and how the evidentiary burden is allocated at the class certification stage.  The Supreme Court’s Halliburton decision reflects three core holdings.  First, the Court reaffirmed the fraud-on-the-market presumption created in Basic.  Second, the Court declined to modify the prerequisites for invoking the fraud-on-the-market presumption of reliance by injecting a new element that would have required a plaintiff to show the “price impact” of the alleged misrepresentations at the class certification stage.  Finally, the Supreme Court held that on a motion for class certification a defendant should be afforded an opportunity to rebut the presumption of reliance if the defendant can show that an alleged misrepresentation did not actually affect the stock’s price.  Defendants had always been allowed to make such a showing when presenting evidence on the merits of the case.  But the Halliburton ruling resolves a conflict that had existed among several circuit courts of appeal by making clear that defendants may also do so in the context of a motion for class certification. 

Barrack, Rodos & Bacine participated in the Supreme Court case by submitting an amicus (friend of the court) brief on behalf of a group of financial economists, including Nobel Prize winner, Eugene Fama.  The amicus brief (available here) was cited by the Supreme Court in support of its decision.  Commenting on the Supreme Court’s ruling, Robert Hoffman, a partner of Barrack, Rodos & Bacine, stated, “The Halliburton decision means that class actions will remain an important tool for vindicating the rights of investors who are injured by securities fraud.  The ruling acknowledges the reality that, in modern, impersonal securities markets, stock prices reflect material information about a company and that investors may be harmed when false information is incorporated into the stock price.”

Basic’s Fraud-on-the-Market Presumption Upheld

The defendants in Halliburton directly challenged Basic’s fraud-on-the-market presumption.  The company argued that the presumption rests on an economic theory – the efficient capital markets hypothesis – that is no longer tenable.  Specifically, Halliburton claimed that empirical evidence suggests that capital markets are not fundamentally efficient.  The Supreme Court noted that Halliburton’s argument focused on the debate among economists “about the degree to which the market price of a company’s stock reflects public information about the company – and thus the degree to which an investor can earn an abnormal, above-market return by trading on such information.”  The Court observed, however, that even critics of the efficient capital markets hypothesis acknowledge that public information generally affects stock prices.  The Court noted that academic debates about the degree to which stock prices accurately reflect information are “largely beside the point” because the fact that a stock price may be inaccurate “does not detract from the fact that false statements affect it, and cause loss.”

Halliburton also attacked another premise of Basic – that investors typically rely on the integrity of the market price of a stock in making investment decisions.  Halliburton referred, for example, to so-called “value” investors, who believe that certain stocks are undervalued or overvalued and who attempt to “beat the market” by buying undervalued stocks or selling overvalued ones.  The Court rejected this argument as well, noting that even value investors trade stocks based on the belief that the market price will incorporate public information within a reasonable period.  The Court noted that value investors also seek to determine how undervalued or overvalued a particular stock is “and such estimates can be skewed by a market price tainted by fraud.” 

Halliburton also argued that Basic conflicted with more recent Supreme Court securities law precedent.  The Court rejected this argument, noting that the earlier cases cited by the company had refused to extend securities fraud claims to new categories of defendants, but did implicate the means by which the reliance element of a claim could be satisfied, which was the subject of Halliburton’s appeal.   Halliburton also argued that the Basic presumption imposes excessive costs on businesses.  The Court rejected this argument as well, observing that it was the responsibility of Congress to address issues relating to the economic costs of securities class actions and that Congress had, in fact, done so through the enactment of the Private Securities Litigation Reform Act and other laws.

The Supreme Court concluded that the defendants had failed to provide any “special justification” for overturning Basic and, accordingly, affirmed the continued viability of the fraud-on-the-market theory in securities fraud class actions.

No Change to Plaintiff’s Burden for Invoking the Fraud-on-the-Market Presumption

Halliburton also argued that the plaintiff should have the burden of showing price impact at the class certification stage.  To invoke the Basic presumption, a plaintiff must prove that:  (1) the alleged misrepresentations were publicly known; (2) they were material; (3) the stock traded in an efficient market; and (4) the plaintiff traded the stock between when the misrepresentations were made and when the truth was revealed.  In practice, the principal battleground on a motion for class certification has involved the third of these elements; i.e., showing that the market for a defendant company’s stock was efficient.  To make that showing, plaintiffs frequently retain expert economists to perform “event studies” that are designed to assess whether the company’s stock reacted in a statistically significant manner to new, material information.    

A plaintiff has been required to show only that the market for the stock was generally efficient; Halliburton argued that a plaintiff should be required to show that the alleged misrepresentation actually affected the price of the stock. The Court declined to impose such a requirement stating that it “would radically alter the required showing for the reliance element of the Rule 10b-5 action.”

A Defendant May Now Offer Evidence at the Class Certification Stage That an Alleged Misrepresentation Did Not Have an Impact on the Stock Price

Halliburton also argued that a defendant should be allowed to defeat the presumption of reliance at the class certification stage through evidence that the alleged misrepresentation did not affect the price of the stock.  The Supreme Court agreed.  The Court reasoned that “price impact is … an essential precondition for any Rule 10b-5 class action” and that “[w]hile Basic allows plaintiffs to establish that precondition indirectly, it does not require courts to ignore a defendant’s direct, more salient evidence showing that the alleged misrepresentation did not actually affect the stock’s market price and, consequently, that the Basic presumption does not apply.”  In a one paragraph concurrence, Justice Ginsburg, joined by Justices Breyer and Sotomayor, emphasized that the “Court recognizes that it is incumbent upon the defendant to show the absence of price impact” and that the Court’s decision in this regard “should impose no heavy toll on securities-fraud plaintiffs with tenable claims.”

Thus, the Halliburton decision leaves largely unchanged the legal framework for determining whether a class should be certified in a securities fraud case.  Defendants now have the opportunity to present price impact evidence at the class certification stage.  However, price impact issues have always been a facet of securities litigation and, as a result, the decision merely affects the timing for presenting evidence relating to that issue.