Last month, the Supreme Court agreed to reconsider the “fraud-on-the-market” presumption, an underpinning of class-action securities litigation for the last 25 years. The Court’s decision to grant certiorari in Halliburton Co. et al v. Erica P. John Fund, Inc., could significantly alter the landscape of private securities litigation in the United States.
The fraud-on-the-market theory, which has its roots in the Supreme Court’s 1988 decision in Basic v. Levinson, allows investors who claim to have lost money as a result of misstatements regarding a Company to recover damages without having to show that they actually relied on the misstatements in making their investment decision. Basic provided that plaintiffs could be presumed to have relied on distorted information and placed the burden on the defendant to prove that the plaintiffs did not in fact rely on that information. The Court’s decision in Basic was rooted in the then novel efficient-market hypothesis, which theorized that a public company’s stock’s price reflects all publicly available information regarding the company. The efficient-market hypothesis has come under increased scrutiny of late, with many investors and scholars citing the financial crisis that began in 2007 and related asset bubbles as an indication of how investor irrationality distorts market “efficiency.”
Basic was a four-to-two decision, with three Justices recusing themselves. Of the current nine Justices, the only two who were on the Court at the time of the Basic decision, Justices Kennedy and Scalia, were among the group who recused themselves. In a case decided last term, Amgen v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), Justices Scalia, Kennedy, Thomas and Alito indicated it might be appropriate to revisit the fraud-on-the-market theory because of increasing skepticism of the efficient-market hypothesis. In Amgen, the Court held that plaintiffs need not establish the materiality of alleged misrepresentations or omission at the class certification stage of a class action securities lawsuit.
The fraud-on-the-market theory is a powerful tool for the plaintiffs bar, as it enables certification of large classes in actions brought under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. If the Court overturns its holding in Basic, plaintiffs lawyers will likely face greater challenges when seeking to obtain class certification in securities fraud litigation. The magnitude of that increased burden, however, is currently the subject of much debate among commentators. Many believe that plaintiffs lawyers will turn to greater reliance on pursuing claims under Section 11 of the Securities Act, which statute does not require a showing of reliance but which instead holds issuers, officers, underwriters and experts virtually strictly liable for making a material misstatement or omission in a registration statement. While Section 11 claims do not require scienter or even negligence, they do require plaintiffs to trace the shares purchased back to the shares issued in the offering in regards to which the suit is filed, a key factor that will likely foreclose the possibility of a suit by many plaintiffs who could have otherwise maintained an action under Rule 10b-5. Other commentators predict plaintiffs’ attorneys also may revise the way they allege claims under Section 10. This is because the fraud-on-the-market theory’s presumption of reliance only applies to claims based upon misstatements. Based on other Supreme Court jurisprudence, a different presumption applies when the investor’s claim is based on allegedly omitted material information. In Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972), the Supreme Court similarly adopted a presumption of reliance, but not one that depended on a fraud-on-the-market theory. Since the line between alleged misstatements and omissions can be murky, plaintiffs could plead future 10b-5 claims based on alleged material omissions and not on material misstatements.
Oral arguments in the Haliburton case are scheduled for March, with the decision expected by mid-summer.