Are plaintiffs in securities fraud class actions required to prove materiality at the class certification stage? In cases where plaintiffs rely on the “fraud on the market” theory to plead reliance, the Second, Third, and Fifth Circuits have all suggested that the answer may be yes, creating a major potential obstacle for class action plaintiffs. The Seventh and Ninth Circuits, however, have held that class action plaintiffs need not prove materiality at the class certification stage. The Supreme Court recently granted certiorari to the latest circuit court decision to address this question in an apparent effort to resolve this split among the circuits. Amgen Inc. v. Connecticut Retirement Plans & Trust Funds, 660 F.3d 1170 (9th Cir. 2011), cert. granted, 80 U.S.L.W. 3519 (U.S. Jun. 11, 2012) (No. 11-1085). In addition to resolving this split of authority, the Supreme Court’s impending decision could help further define the contours of the fraud on the market theory for the first time in nearly twenty-five years and affect the number of securities fraud class actions filed in the future.
In 2011, the Supreme Court handed down two decisions that sent mixed signals to courts addressing class certification in securities class actions, Erica P. John Fund Inc. v. Halliburton Co., 131 S. Ct. 2179 (2011) and Wal-Mart Stores v. Dukes, 131 S. Ct. 2541 (2011). In Dukes, the Court reaffirmed a position expressed in General Telephone Co. of the Southwest v. Falcon, 457 U.S. 147 (1982), that courts must engage in a “rigorous analysis” to determine if Rule 23(b)(3)’s threshold issues like numerosity and commonality have been satisfied. The Court explained that such analysis may likely “overlap with the merits of the plaintiff’s underlying claim,” and that this overlap simply “cannot be helped” since the class certification inquiry “generally involves considerations that are enmeshed in the factual and legal issues comprising the plaintiff’s cause of action.” Dukes, 131 S. Ct. at 2551-52. In contrast, just weeks before Dukes, the Halliburton Court ruled that class action plaintiffs do not need to prove up the merits of loss causation in order to obtain class certification. As a result, courts applying Rule 23(b)(3) in the wake of Halliburton and Dukes have grappled with the questions of which elements must be subjected to merits-based scrutiny to determine class certification, and what level of scrutiny should be applied.
Further complicating this issue is application of the “fraud on the market” theory in securities class actions. Nearly twenty-five years ago, the Supreme Court in Basic v. Levinson, 485 U.S. 224 (1988), endorsed the “fraud on the market” theory, making it easier for plaintiffs in securities fraud class actions to establish commonality on the issue of reliance. The fraud on the market theory creates a rebuttable presumption of reliance on false statements once they become public. According to the theory, when a party “makes a false [or true] statement that adds to the supply of available information, that news passes to each investor through the price of the stock.” Schleicher v. Wendt, 618 F.3d 679, 682 (7th Cir. 2010). The presumption can be invoked even if the investor never saw the misstatements at issue because the theory’s premise is that the misstatements are built into the market price itself. To obtain class certification, virtually all courts since Basic have agreed that class action plaintiffs may be required to do more than plead the conditions necessary for a fraud on the market—such as an efficient market—they may be required to show some proof of it.
Materiality, like an efficiently operating market, could be viewed as a necessary precondition for establishing a case of fraud on the market. This seems to be the basis for the approach taken by the Second, Third, and Fifth Circuits. In support of their position, those courts cite a footnote from the Supreme Court’s Basic decision, which appears to include materiality as one of the elements required for the fraud on the market presumption:
The Court of Appeals held that in order to invoke the presumption, a plaintiff must allege and prove: (1) that the defendant made public misrepresentations; (2) that the misrepresentations were material; (3) that the shares were traded on an efficient market; (4) that the misrepresentations would induce a reasonable, relying investor to misjudge the value of the shares; and (5) that the plaintiff traded the shares between the time the misrepresentations were made and the time the truth was revealed. 485 U.S. at 248 n.27 (emphasis added).
Based on this language, the Second Circuit requires plaintiffs to make “some showing”—beyond the allegations of the complaint—of the elements triggering the Basic presumption, including materiality. In re Salomon Analyst Metromedia Litigation, 544 F.3d 474, 484 (2d Cir. 2008). The Fifth Circuit’s requirement is even more rigorous: “[T]he plaintiff may recover under the fraud on the market theory if he can prove that the defendant’s [alleged fraud] materially affected the market price of the security.” Oscar Private Equity Investments v. Allegiance Telecom Inc., 487 F.3d 261, 265 (5th Cir. 2007). The Third Circuit’s rule permits defendants to rebut the fraud on the market presumption during class certification by affirmatively showing that alleged misrepresentations were immaterial. In re DVI, Inc. Sec. Litig., 639 F.3d 623 (3d Cir. 2011).
The Seventh and Ninth Circuits, however, hold that materiality need not be proven for class certification. Instead, materiality, like loss causation, must only be plausibly alleged at the class certification stage, and its adjudication on the merits must await trial. In defense of this approach, the Seventh Circuit has explained that “certification is largely independent of the merits, and a certified class can go down in flames.” Schleicher, 618 F.3d at 685. In a similar vein, the Ninth Circuit has held that materiality “is a merits issue that abides the trial or motion for summary judgment.” Amgen, 660 F.3d at 1172. The Seventh and Ninth Circuits contend that Basic’s footnote 27 demonstrates only that the decision under review in Basic deemed materiality an essential precondition, not that the Supreme Court adopted that precondition. The Ninth Circuit also notes that more recent formulations of the fraud on the market presumption contained in Halliburton and Dukes do not mention materiality as a precondition. Amgen, 660 F.3d at 1176.
Amgen presents the Court with its first chance in almost a quarter of a century to revisit and refine the fraud on the market theory and to indicate, more specifically, whether materiality is a precondition that must be proven to obtain class certification. If the Court does hold that materiality is an element that must be proven to sustain the presumption of reliance under a fraud on the market theory, the number and viability of class action securities fraud cases would certainly be diminished, as this would be difficult for many class plaintiffs to establish. Either way, Amgen is a decision that should be carefully watched.