All eyes in the securities litigation bar are on the U.S. Supreme Court as it prepares to rule on the continued viability of the "fraud-on-the-market" theory in Halliburton v. Erica P. John Fund.
Since the Court's 1988 ruling in Basic, Inc. v. Levinson, plaintiffs have been able to use this theory to establish the "reliance" element of a securities fraud claim. In an efficient market, the theory goes, publicly available information about a corporation will be quickly factored into the market price for its stock. Where a company is alleged to have put out false or flawed information, that information will be reflected in the price of the company's stock. An investor who purchases stock after a misrepresentation was made has done so at a price distorted by the misrepresentation. Because of this efficient market theory, the Court in Basic v. Levinson spared investor-plaintiffs the burden of establishing one critical element of their securities fraud claims- that they specifically relied on the misrepresentation in purchasing the stock.
The ability to resolve the reliance question en masse using the "fraud-on-the-market" theory opened the door for securities fraud plaintiffs to pursue class action claims. Without the presumption of reliance that the theory authorizes, each of the thousands of shareholders within the class would have to prove knowledge of and reliance on the misrepresentation in making the decision to purchase the stock. Such individual inquiries about stockholders' individual states of mind would quickly overwhelm the common questions in the case, rendering the class action vehicle inappropriate for resolution of securities fraud claims.
In recent years, economic and legal scholars have increasingly questioned the efficient markets hypothesis underlying the "fraud-on-the-market" theory, and in last year's decision in Amgen v. Connecticut Retirement Plans four current Justices called for reconsideration of Basic v. Levinson.
Reports of the oral argument in Halliburton on March 5, 2014, suggest that the Justices are disinclined to jettison Basic's "fraud-on-the-market" theory entirely. But several justices, echoing the suggestion of an amicus brief filed by a group of law professors, asked whether the Court should modify Basic to allow evidence at the class certification stage on whether the market in the company's stock truly operates efficiently. Such evidence could take the form of event studies, which explore whether a statistically significant market reaction can be detected following the alleged misrepresentation. The "fraud-on-the-market" theory's presumption of reliance would become rebuttable prior to the class certification determination, under the outcome suggested by these questions.
However Halliburton is decided, the Supreme Court's ruling will have major implications for securities fraud litigation. Stay tuned.