The U.S. Supreme Court is set to decide a case this term that could significantly affect the viability of securities fraud class actions against public companies. The case, Halliburton Co. v. Erica P. John Fund, Inc., will challenge the core Supreme Court doctrine underlying most securities class action cases—the presumption that investors relied on all public information released by a defendant corporation as embodied in the price of its publicly traded stock. Without this presumption, announced by the Supreme Court in the 1988 case Basic v. Levinson and known as the “fraud-on-the-market” presumption, class action plaintiffs would have to prove individualized reliance on defendants’ alleged misstatements. This would make it very difficult to obtain class action certification, which requires the plaintiff to show that common questions predominate over individual issues.
Basic revolutionized securities-fraud class actions. In their Halliburton amicus brief, a handful of former SEC commissioners and prominent law professors have described the Basic presumption as “the most powerful engine of civil liability ever established in American law.” In Basic, by a 4-2 vote (three justices did not participate), the Supreme Court essentially negated the previous requirement that plaintiffs prove they actually relied on defendants’ allegedly misleading statements and instead held that such reliance is presumed. The Court based the presumption on the “efficient market” hypothesis, which postulates that the price of a stock traded in an efficient securities market reflects all material available information about the company’s performance. Thus, when an investor buys or sells at a certain price, she presumptively relies on the integrity of the information embodied in that price, regardless of whether she heard or knows the information personally. Although the presumption is rebuttable, it is an enormous advantage to plaintiffs, as it greatly advances their ability to state viable claims and obtain class certification. At that point, the risk of a judgment for a potentially ruinous amount of damages pressures most defendants to settle. According to the Halliburton petitioners, for 25 years, plaintiffs’ lawyers have relied on Basic to bring over 3,050 securities-fraud class actions, generating over $73.1 billion in settlements.
The fraud-on-the-market presumption has been criticized. Economic commentators pilloried the decision immediately, focusing on the “efficient market” hypothesis underlying the presumption. As the petitioners in Halliburton note, some have argued that the market is simply not that efficient. When a company issues a press release, who is to say everyone participating in the market will know about it among the thousands of press releases issued every week? Professor Barbara Black pointed out, for example, that “the market did not react to publicly available information about the impact of a breakthrough in cancer research on a corporation until The New York Times wrote about it more than five months after the original release.” In another case, as finance professors Saeyoung Chang and David Y. Suk discovered, Wall Street Journal articles on insider trading appear to affect stock prices even in instances when the SEC released the same information days earlier. Courts have also struggled to apply the presumption. The 5th Circuit decision in the Halliburton case now accepted for review by the Supreme Court deepened an existing circuit split over whether defendants can overcome the Basic presumption and defeat class certification by showing that the alleged misrepresentations never actually affected the stock price.
Although it is difficult to predict what the Supreme Court will ultimately decide in the Halliburton case, Justice Alito previously indicated, in Amgen v. Connecticut Retirement Plans, that change may be in order. He stated: “More recent evidence suggests that the presumption may rest on a faulty economic premise. In light of this development, reconsideration of the Basic presumption may be appropriate.” George Conway, the attorney for the defendants in Halliburton, observed, “It’s simply unlikely that the Supreme Court took this case with an eye to leaving Basic in place.” This may prove to be an overstatement, as it takes only four of nine justices to accept review of a case. As a recent BusinessWeek commentary put it, “This could be the big one.” This conservative-leaning Supreme Court may well decide to pare back Basic, thereby altering a core principle that has driven securities class action litigation for the past 25 years. Whatever the outcome in Halliburton, the risk of high stakes securities litigation will not go away, even if the volume of cases is reduced. Institutional investors have become increasingly active and, depending on the facts of a given case, they may be well-positioned to pursue their claims independently, even without the benefit of the presumption or suing on behalf of a class.