Earlier this month, the Supreme Court heard the highly-anticipated oral argument in Hallburton Co. v. Erica P. John Fund, Inc. Prior to the argument, there was a growing consensus that the Court was likely going to overturn Basic Inc. v. Levinson (1988), the groundbreaking case that adopted the “fraud-on-the-market” doctrine and allowed plaintiffs to proceed without a showing that they had actually relied on any particular alleged misrepresentation (reliance having been a bedrock requirement in fraud cases, dating back to the Garden of Eden). But the tea leaves left over after the oral argument point to a different result—a compromise that would create additional significant hurdles for class plaintiffs but not eviscerate securities class actions.
Halliburton is the rare case where one of the parties has explicitly asked the Supreme Court to overrule one of its prior cases. (This is the second time in the case that an issue has made its way to the Court; the Court in 2011 reversed the Fifth Circuit’s holding that proof of loss causation was required at the class certification stage.) The argument was notable because of the prominent role that an amicus brief (written on behalf of a group of law professors) played and because of a key concession made by Deputy Solicitor General Malcolm Stewart, who argued on behalf of the SEC, ostensibly on the Respondent’s side.
Basic’s fraud-on-the-market doctrine has been a critical aspect of securities class actions for the past 25 years. In a nutshell, the fraud-on-the-market doctrine acts as a substitute for the reliance element of a securities fraud claim, and allows plaintiffs to get past the critical class certification stage without showing that any member of the class actually relied on any allegedly false statements. The fraud-on-the-market doctrine was considered an adequate proxy for reliance, in large part, because of the “efficient market hypothesis,” which was in vogue at the time that Basic was decided. The efficient market hypothesis, posits that financial markets rapidly take all publicly-available information into account, and the price of a security, therefore, has all material information baked into it. So, according to the fraud-on-the-market doctrine, the buyer of a security is presumed to have relied on a particular public misrepresentation because the import of that misrepresentation was already reflected in the stock price at the time of the purchase.
In the years since Basic was decided, a class could avail itself of the presumption of reliance by demonstrating that (1) the alleged misstatement was made publicly; and (2) the market in which the security traded was “efficient.” The key hurdle to invoking the fraud-on-the-market doctrine is the demonstration of market efficiency. This is critical at the class certification stage because the presumption of reliance takes an issue that traditionally was a quintessentially individual issue (did Jane Doe rely on the misrepresentation?) and turns it into a common issue for the entire class (does Doe, Inc.’s stock trade in an efficient market?). And, as it has turned out over the past quarter century, it is has not been particularly difficult for plaintiffs to demonstrate in most instances that the markets in which the subject securities traded (such as the New York Stock Exchange) were “efficient.” At the same time, it has been difficult for defendants to rebut the reliance presumption.
The petitioner in Halliburton seeks to have the Court do away completely with the presumption of reliance, which would then require plaintiffs to demonstrate reliance in some other fashion. Without the presumption, plaintiffs would, presumably, need to demonstrate reliance on an individual basis, which would then make it nearly impossible to certify a class. In the alternative, the petitioner asks the Court to require plaintiffs to show that a particular “misrepresentation actually distorted the market price” in order to invoke the presumption of reliance.
The oral argument offered significant insight into how the case may ultimately be decided. On several occasions, the more conservative justices, in particular Justice Kennedy, asked about the “middle ground” suggested by the Petitioner and more forcefully (and persuasively) argued in the amicus curiae brief submitted on behalf of the group of law professors who specialize in corporate and federal securities law.
The law professors argue that the fraud-on-the-market doctrine need not rely on the efficient market hypotheses, which has been both misunderstood and, to a large extent, discredited in the years since Basic was decided. And, since the fraud-on-the-market doctrine and the efficient market hypothesis are independent of each other, one can jettison the efficient market hypothesis without killing the fraud-on-the-market doctrine—keeping the baby but not the bathwater.
The alternative to the efficient market hypothesis that the law professors suggest is requiring a plaintiff at the class certification stage to show, with regard to each alleged misrepresentation, that the particular alleged misrepresentation in fact had an impact on the price of the security. Price impact can be demonstrated by using event studies, which are commonly-used analyses often used in the later stages of securities litigation by parties trying to prove or disprove materiality or loss causation. So, instead of requiring a plaintiff to show that a market is generally an efficient one, the professors argue that plaintiffs should be required to establish that the market was efficient in their particular case.
During the argument, Petitioner’s counsel, Aaron Streett, quickly recognized that none of the justices (at least the eight who asked questions) seemed particularly inclined to overrule Basic in its entirety and spent most of his time supporting the law professors’ position that the fraud-on-the-market doctrine was still viable, but that the presumption should arise only if an event study demonstrates price impact. And David Boies, who argued on behalf of the Respondent, also primarily answered questions about the law professors’ position.
The justices seemed interested in how great a burden these event studies would be, and, while both Streett and Boies acknowledged that event studies would be sufficient to invoke the presumption and that the same event studies would, in any event, be required later in the case to prove loss causation, they differed on the alleged burden that the event study would impose on plaintiffs at the class certification stage. Boies argued that requiring plaintiffs to demonstrate price impact can be a significant burden—especially in situations where there are multiple events and significant confounding effects affecting the security in question. Streett, on the other hand, argued that there was little, if any, added burden since plaintiffs would need event studies later in the litigation.
Perhaps the most significant moment of the oral argument was when Justice Kennedy asked Deputy Solicitor General Malcolm Stewart about the law professors’ position. Stewart, who argued on behalf of the SEC as amicus curiae on behalf of the respondent, said the following:
“I understand the professors … basically advocated a shift away from analyzing the general efficiency of the market and focusing only on the effect or lack of effect on the … particular stock. I don’t think that the consequences would be nearly so dramatic. In fact if anything that would be a net gain to plaintiffs because plaintiffs already have to prove price impact at the end of the day.”
With amici like that, who needs inimici?
At the end of the day, it appears likely that securities class actions will not go the way of the dodo bird. At the same time, the burdens on plaintiffs seeking class certification will likely rise. We will certainly get to see soon enough whether we have read these tea leaves correctly. And we will report on what happens when the decision comes down.