In a much-anticipated case that slightly modified one of the most important doctrines in American securities law, the United States (U.S.) Supreme Court has determined to keep the “fraud on the market” theory of reliance in U.S. securities misrepresentation cases.
The U.S. has a private right of action for so-called “securities fraud,” contained in s. 10(b) of the 1934 Securities Exchange Act, which prohibits “deception” in the sale of securities. Rules of the SEC define such deception as fraud, untrue statements of material fact or deceptive practices. Over time a number of factors have developed that have to be proven in support of a private securities claim, including that a plaintiff relied on the alleged deception.
It was established in 1988 in Basic Inc. v. Levinson that a plaintiff can prove reliance inferentially, by use of the “efficient market hypothesis”. The efficient market theory stipulates that the public market for securities will reflect all relevant, material and publicly available information about a company in the price of its security. If the public market is “lied to” about a company, that misinformation will cause the price of the security to improperly rise, fall or hold; the reliance of an anonymous investor on that misinformation can be presumed by the fact that he or she bought or sold at the market-determined price. A “fraud on the market” causes investors to make misinformed investment decisions. Notably, however, Basic stands only for the proposition that the fraud on the market theory is a presumption, which can be disproven. That is, a defendant can always argue that a plaintiff should have to prove actual reliance because the various assumptions underlying the economic theory do not apply to the particular security at issue.
Halliburton v. Erica P. John Fund is actually this case’s second trip to the U.S. Supreme Court. There has been a remarkable run of recent securities class actions heard by the U.S.’s highest court, all about evaluating how tests for certification are to be applied in securities class actions. The first time Halliburton was heard by the Supreme Court, it was on the issue of whether a plaintiff has to prove at certification some nexus between the alleged misrepresentation and the damages suffered by the class. The Supreme Court determined that this is an issue for trial, and directed that the remaining issues on certification be resolved.
The case came back to the Supreme Court, this time on the issue of whether a defendant can attempt to rebut the presumption of reliance at the certification stage. That issue was significant because the defendant wanted to rely on an event study from an economic expert that the defendant argued demonstrated that there was no price impact as a result of alleged public misstatements. The defendant wanted show that study to the judge at certification, rather wait to show it to a jury at trial. The Supreme Court decided that it would consider whether it should overrule the fraud on the market theory altogether, which has been criticized by certain academics and some modern economic research suggesting that securities markets are not as “efficient” as the efficient market hypothesis suggests.
The Supreme Court affirmed Basic and the fraud on the market presumption, and also rejected the defendant’s invitation to make the theory more difficult for a plaintiff to invoke. The Court reiterated that the theory only supports a presumption that can be rebutted, so it allowed the defendant to raise at certification its challenge to the efficient market hypothesis.
Notably for securities litigation in Canada, the U.S. experience is largely an affirmation of the good sense in having codified the requirements to bring secondary market securities misrepresentation cases under legislation such as Part XXIII.1 of Ontario’s Securities Act. That legislation’s key feature is to presume reliance by investors on public misstatements made by issuers and certain insiders. With reliance presumed in cases where the court has granted leave to a plaintiff to bring a secondary market misrepresentation claim, there is no requirement to prove the validity or veracity of the fraud on the market theory, either for individual plaintiffs or for a class.