The U.S. Supreme Court held yesterday that defendants in securities fraud class actions can defeat the Basic fraud-on-the-market presumption of reliance at the class certification stage “through evidence that the misrepresentation did not in fact affect the stock price.” Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317, 573 U.S. ___, 2014 WL 2807181 (June 23, 2014) (Roberts, C.J.).
The fraud-on-the-market presumption of reliance, first articulated in Basic Inc. v. Levinson, 485 U.S. 224 (1988), posits that publicly available information is reflected in the market price of stocks traded on efficient, well-developed markets; that the typical investor buys and sells in reliance on the integrity of the stock price; and that therefore an investor who purchased a stock during the period when the stock price was affected by a misrepresentation may be presumed to have relied on the misrepresentation. Since its inception, the Basic presumption has been a driving force of securities class actions.
Halliburton asked the Supreme Court to overrule Basic or to modify it to require plaintiffs to prove that a misrepresentation affected a company’s stock price before gaining the benefit of the presumption. Alternatively, Halliburton asked that Basic’s fraud-on-the-market presumption be pared down to give defendants an opportunity to rebut the presumption at the class certification stage by demonstrating a lack of price impact.
The Court held that none of Halliburton’s arguments for overruling Basic or for modifying Basic to require plaintiffs to demonstrate price impact constituted a “special justification” for overturning the long-established precedent. Halliburton, 2014 WL 2807181, at *6 (quoting Dickerson v. U.S., 530 U.S. 428, 443 (2000)). Halliburton had pointed to recent academic studies purporting to debunk the economic theory upon which the fraud-on-the-market presumption rests. In rejecting Halliburton’s argument, the Court stated that “Halliburton’s criticisms fail to take Basic on its own terms.” Id. at *9. Basic did not adopt a particular theory of market efficiency, the Court continued, but instead “based the presumption on the fairly modest premise that ‘market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.’” Id. (quoting Basic, 485 U.S. at 247, n.24). The Court therefore declined to require plaintiffs to prove price impact directly.
The Court agreed, however, with Halliburton’s argument that defendants should be allowed to defeat the presumption at the class certification stage through evidence that the misrepresentation did not have an effect on a company’s stock price. Id. at *18. The U.S. Court of Appeals for the Fifth Circuit had held that defendants could not use price impact studies at the class certification stage to rebut the presumption altogether. Erica P. John Fund, Inc. v. Halliburton Co., 718 F.3d 423, 435 (5th Cir. 2013).
In reversing the Fifth Circuit, the Court noted that defendants may already introduce such evidence at the merits stage to rebut the Basic presumption, as well as at the class certification stage to counter a plaintiff’s showing of market efficiency. Prohibiting defendants from rebutting the Basic presumption altogether at the class certification stage “makes no sense, and can readily lead to bizarre results” that are inconsistent with Basic’s own logic. Halliburton, 2014 WL 2807181, at *16. Because the fraud-on-the-market theory is an “indirect proxy” for price impact, it “should not preclude direct evidence when such evidence is available,” and “‘[a]ny showing that severs the link between the alleged misrepresentation and … the price received (or paid) by the plaintiff … will be sufficient to rebut the presumption of reliance’ because ‘the basis for finding that fraud had been transmitted through market price would be gone.’” Id. at 20 (quoting Basic, 485 U.S. at 248).
What does the Court’s holding mean for securities class actions? Even though Halliburton did not persuade the Court to overrule Basic or to require plaintiffs to prove price impact to take advantage of the Basic presumption, Halliburton scored an important win for securities class action defendants by giving them an opportunity to rebut the Basic presumption at the class certification stage by demonstrating a lack of price impact. In a concurring opinion, Justice Ruth Bader Ginsburg, joined by Justices Stephen Breyer and Sonia Sotomayor, wrote that the Court’s holding “may broaden the scope of discovery available at certification,” but that the “Court recognizes that it is incumbent upon the defendant to show the absence of price impact,” so the “Court’s judgment, therefore, should impose no heavy toll on securities-fraud plaintiffs with tenable claims.” Halliburton, 2014 WL 2807181, at *18 (Ginsburg, J., concurring).
What lies ahead? In a scathing opinion, Justice Clarence Thomas, joined by Justices Antonin Scalia and Samuel Alito, concurred in the judgment, saying that “Basic should be overruled” and that “Basic’s presumption of reliance remains [the Supreme Court’s] mistake to correct.” Id. at *18, *26 (Thomas, J., concurring in judgment). According to Justice Thomas, both of the assumptions underlying Basic – that in a well-developed market public statements are generally reflected in the market price of securities and that investors in well-developed markets transact in reliance on the integrity of that price – are invalid. Id. at *21. Justice Thomas also expressed his view that Basic is inconsistent with recent cases clarifying Federal Rule of Civil Procedure 23’s class certification requirements because it provides plaintiffs with an end-run around the requirement to demonstrate through evidentiary proof that common questions of law or fact predominate over questions affecting only individual members. Id. at *24-*25. In Justice Thomas’ view, “Basic should be overruled in favor of the straightforward rule that … actual reliance, not the fictional ‘fraud-on-the-market version” is an essential element of a securities fraud class action. Id. at *26.
That three justices hold this view may invite defendants in securities class actions to challenge the Basic presumption in the future, even though Halliburton’s efforts fell short in this salvo.