The U.S. Supreme Court gave companies new ammunition to defeat securities fraud class actions. In Halliburton v. Erica P. John Fund, the Court held that defendants can, at the preliminary class certification stage, rebut the plaintiffs’ presumption of reliance on an efficient market by demonstrating that the alleged misrepresentation did not actually affect the stock price. This decision is likely to lead to an increase in expert economic analysis at the class certification stage, and may prevent plaintiffs from obtaining class certification where they might have been able to in the past.
In Halliburton¸ as we previously described in more detail earlier this year, the Court considered whether to overturn its 1988 decision in Basic v. Levinson, which adopted the “fraud on the market” theory. Under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, a private investor may not bring a securities fraud action unless he can allege that he relied upon specific false statements by the defendant. This reliance requirement caused difficulties in securities fraud class actions—individual investors may rely upon various factors in purchasing securities, and as a result, an abundance of unique factual issues could preclude class certification under Rule 23 of the Federal Rules of Civil Procedure.
The fraud on the market theory addressed this issue. The theory holds that because well-developed markets generally are efficient, the trading price for a stock in those markets reflects all material information known to investors, including any material misrepresentations. Therefore, because any purchase made after a misrepresentation will be at a price affected by that misrepresentation, it may be presumed that plaintiffs in a securities fraud action relied upon the misrepresentation when they purchased the stock at the post-misrepresentation price. Thus, after Basic, plaintiffs seeking to certify a class action need not demonstrate that each investor relied upon the alleged misrepresentation, only that each purchased shares after the misrepresentation was made.
In support of its argument to overturn Basic, Halliburton argued that the fraud on the market theory could not be reconciled with the Court’s more recent decisions in class certification cases. These decisions all make it clear that plaintiffs wishing to proceed through a class action must actually prove that their proposed class satisfies the requirements of Rule 23 of the Federal Rules of Civil Procedure. Halliburton also asserted that the loss of academic confidence in the economic theory at the center of Basic’s reasoning justified reconsideration and rejection of the theory.
The Court, in an opinion[1] authored by Chief Justice Roberts and joined by Justices Kennedy, Ginsburg, Breyer, Sotomayor, and Kagan, rejected Halliburton’s arguments, holding that Halliburton had not demonstrated a “special justification” for overruling Basic’s presumption of reliance. Nevertheless, the Court placed an important limit on Basic and the fraud on the market theory—defendants now may defeat Basic’s presumption at the class certification stage by presenting evidence that the alleged misrepresentation did not, in fact, affect the stock price. Prior to this ruling, defendants were prohibited from introducing evidence to rebut Basic’s presumption until the merits stage, a restriction that the Court noted was inconsistent with Basic’s own logic and could “readily lead to bizarre results.”
Had the Court overturned Basic, it would have dramatically altered the securities litigation landscape. Although it declined to do so, the decision nevertheless will have a significant effect going forward. We are likely to see a dramatic increase in expert economic analysis (and corresponding litigation costs) at the class certification stage as parties dispute whether the alleged misrepresentation had an impact on the stock price. This may result in fewer certified securities class actions, enabling companies to contest allegations of securities fraud without the prospect of a large class action verdict or settlement.
[1] Although the Court’s judgment was unanimous, Justice Thomas, joined by Justices Scalia and Alito, authored a concurring opinion concluding that Basic should be overruled because economic realities have undermined the foundation of its premise.
