Today the Supreme Court rejected calls from lawyers, economists and corporate associations to overrule the “fraud-on-the-market” theory that makes it possible to litigate federal securities fraud claims as class actions, instead handing defendants a modest procedural victory. In Halliburton Co. v. Erica P. John Fund, Inc., the Court declined to overrule a decision that for more than twenty-five years has been used by securities plaintiffs to certify thousands of federal class actions, but also recognized that defendants can rebut class certification by showing that allegedly misleading statements did not affect the price of a company’s securities. Halliburton kills what had been a growing movement to eliminate federal securities fraud class actions for all intents and purposes.
Plaintiff-respondent Erica P. John Fund, Inc. (the “Fund”) purchased stock in Halliburton and lost money when Halliburton’s stock price dropped upon the release of certain negative news regarding the company. The Fund filed suit against Halliburton and its CEO David Lesar (collectively, “Halliburton”), alleging that Halliburton had made knowing or severely reckless misrepresentations concerning those topics, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5.
The Fund sought to certify a class of plaintiffs under Federal Rule of Civil Procedure 23(b)(3), which requires that “the questions of law or fact common to class members predominate over any questions affecting only individual members.” Since the parties did not dispute that the market for Halliburton stock was efficient, the Fund invoked the Supreme Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988) (“Basic”) to establish class-wide reliance. The Court in Basic created a rebuttable presumption of class-wide reliance under the “fraud-on-the-market” theory. The theory assumes that in an efficient market, all public information concerning a company is known to the market and incorporated in the company’s stock price in that market. Further, the theory holds that when an investor buys or sells stock in this efficient market, that investor does so in reliance upon the integrity of the efficient market’s price. Thus, if the market is shown to be efficient, courts may presume that investors relied on the public, material misrepresentations efficiently incorporated into the company-defendant’s stock price. That presumption is essential to certifying a class of investors, because without it, individual issues of investor reliance would predominate over issues common to all class members.
In Halliburton’s second trip to the Supreme Court in this case, the company and numerous amici urged the Court to overrule Basic. Halliburton argued, among other things, that Basic was premised on an Efficient Capital Markets Hypothesis that has been substantially undermined and rejected by many economists, and that the Court’s more recent holdings requiring strict scrutiny at the class certification stage left Basic as an outlier. In addition, Halliburton argued that, even if the Court was not inclined to overrule Basic, at a minimum, the Court should resolve a circuit-split and allow evidence of price impact at the class certification stage—i.e., that the price of the security at issue actually moved (or did not) following the alleged material misstatement.
In today’s opinion, Halliburton went one-for-two, losing in its bid to have Basic overruled, but prevailing in its argument that defendants must be permitted to rebut the presumption of reliance by showing that defendants’ statements did not impact price. First, as to calls to overrule Basic itself, the Court held that no “special justification” existed for the Court to abandon established jurisprudence. In particular, the Court rejected Halliburton’s argument that developments in economic theory in the last twenty-five years had undermined the relaxed Efficient Capital Markets Hypothesis on which Basic rested. Noting that the Basic Court had not endorsed “any particular theory,” and that the Basic court itself had recognized weaknesses and anomalies in theories of market efficiency, the Court held that Halliburton had not actually identified any fundamental shift in the discipline of economics that would justify overruling its prior decision. The Court was nonplussed by extensive research and evidence showing that many investors do not, in fact, rely on the integrity of market prices, explaining that even these investors will “in any event rely at least on the fact[ ] that market prices will incorporate public information within a reasonable period and that market prices, however inaccurate, are not distorted by fraud.”
Having rejected calls to overrule Basic’s fundamental presumption of reliance, the Court also declined to accept Halliburton’s invitation to modify the prerequisites for invoking the presumption by requiring class-action plaintiffs to prove “price impact” directly at the class certification stage. The Basic presumption itself includes two “constituent presumptions”: (1) if the plaintiff can show a public, material misrepresentation concerning a defendant company whose stock trades in an efficient market, the court presumes that the misrepresentation affected the stock price; and (2) if the plaintiff purchased the stock during the relevant period, the court presumes that the plaintiff made that purchase in reliance on the misrepresentation. Yet, as the Court explained, accepting Halliburton’s position that plaintiffs should be required to show price impact affirmatively would “take away the first constituent presumption.”
Nonetheless, the Court held that defendants must be given the opportunity prior to certification of a class to show evidence of a lack of price impact. As the Court explained, Basic allows plaintiffs to establish price impact “indirectly” by showing that a defendant’s public, material misrepresentations were made in an efficient market. “But an indirect proxy should not preclude consideration of a defendant’s direct, more salient evidence showing that an alleged misrepresentation did not actually affect the stock’s price and, consequently, that the Basic presumption does not apply,” and “there is no reason to artificially limit the inquiry at that stage by excluding direct evidence of price impact.”
Though the immediate impact of the opinion was to vacate the Fifth Circuit’s holding and remand the case against Halliburton, the long-term effect on securities class actions is unclear. As the Court noted, the type of price-impact evidence Halliburton sought to introduce was already allowed to varying degrees at the class certification and merits stages in securities class actions. In consequence, this means that defense expert event studies could come in earlier in the proceedings, before plaintiffs have the settlement leverage that comes with class certification. Thus, while Basic remains good law, as a policy matter, the in terrorem value of a securities class action might have just swung slightly in favor of defendant companies trading in so-called efficient markets.
Justice Clarence Thomas wrote an opinion concurring in the judgment, in which he was joined by Justices Scalia and Alito. These justices called for Basic to be overruled because “economic realities . . . [had] undermined the foundations of the Basic presumption, and stare decisis cannot prop up the façade that remains.”
Façade or not, after today’s decision, the fraud-on-the-market theory remains alive and well, the growing chorus of voices to overrule it have been squelched, and securities fraud class actions will continue largely as they have for more than twenty-five years. Defense attorneys have acquired another procedural tool in their arsenal to defeat such cases – by showing that a lack of price impact at the certification stage. Halliburton turns out to be another in a series of seminal decisions and statutes that have trimmed securities fraud class actions incrementally, beginning with the Supreme Court’s rejection of aiding and abetting liability in 1994’s Central Bank of Denver case. Like many of those developments over the last twenty years, today’s decision in Halliburton can be expected to reduce the percentage of securities fraud cases that survive class certification. Halliburton should also dampen the enthusiasm that plaintiff’s lawyers might otherwise have for filing marginal claims where there is no significant price effect at the time that alleged false statements are made.