Fraud-on-the-Market Lives On: Halliburton Co. v. Erica P. John Fund, Inc.

by Orrick, Herrington & Sutcliffe LLP

On June 23, 2014, the U.S. Supreme Court issued its second decision in Halliburton Co. v. Erica P. John Fund, Inc., __U.S. __(2014), 2014 WL__ (U.S. June 23, 2014) ("Halliburton II"). In this widely anticipated decision, the Court reaffirmed its earlier embrace of the so-called fraud-on-the-market doctrine in Basic, Inc. v. Levinson, but held that defendants may rebut the presumption of reliance that undergirds certification of Rule 10b-5 securities class actions by showing that alleged misrepresentations did not have a material impact on the price of the stock.

This alert discusses Halliburton II’s possible impact on class action suits brought under federal securities laws.

Case Background

Plaintiff-Respondent Erica P. John Fund, Inc. (the "Fund") is a not-for-profit group that supports the outreach work of the Archdiocese of Milwaukee. The Fund purchased stock in Halliburton Company and lost money when Halliburton’s stock price dropped following the release of negative news regarding Halliburton’s (1) potential liability in asbestos litigation, (2) revenue accounting on fixed-price construction contracts, and (3) merger with Dresser Industries. The Fund filed a lawsuit 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," known as "predominance."

Since the parties did not dispute that the market for Halliburton common 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 decision in Basic sought to address the difficulties plaintiffs in securities class actions face in establishing predominance under Rule 23(b)(3) concerning alleged misrepresentations in connection with the sale of securities – that if each class member were required to establish actual reliance on defendants’ alleged misrepresentations in deciding to purchase a security, the individual issues of reliance would always overwhelm issues common to all class members, defeating predominance and preventing class certification.

The Basic Court recognized a rebuttable presumption of class-wide reliance under the "fraud-on-the-market" theory. That theory was based, in part, on the efficient capital markets hypothesis, which in its simplest form, broadly assumes that in an efficient market all material information concerning a company is known to the market and incorporated immediately in the company’s stock price. Thus, when an investor buys or sells stock in an efficient market, the investor presumably does so in reliance upon the integrity of the efficient market’s price. Basic instructed federal courts to presume that class members relied on the public, material misrepresentations efficiently incorporated into the company-defendant’s stock price, eliminating the need to prove reliance individually, and thereby permitting certification of 10b-5 class actions.

In opposing class certification, the Halliburton Defendants did not challenge the Basic presumption of reliance based on market efficiency. Instead, Halliburton argued that the Fund did not establish loss causation under the Fifth Circuit’s requirement that a plaintiff prove a misstatement actually moved the market. The District Court agreed and denied class certification because the Fund did not show any stock price increase resulting from the alleged misrepresentations. On appeal, the Fifth Circuit affirmed the District Court. 

In what would be its first pass at this case, the Supreme Court reversed the Fifth Circuit. Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179 (2011) ("Halliburton I"). As the Court in Halliburton I explained, the question of loss causation—i.e., whether an alleged misrepresentation actually caused investors to lose money on their securities purchases—is different from the question of reliance under Basic—i.e., whether the investor-class members can be presumed to have relied on the alleged misrepresentation in making the decision to purchase the securities. The Court held that plaintiffs are not required to prove loss causation to obtain class certification, and remanded the case to address other arguments against class certification.

On remand, the District Court certified the class and held, without analysis, that "[t]he fraud-on-the-market theory applies to this case, so proof of each individual class member’s reliance is not required." Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 2012 WL 565997, at *2 (N.D. Tex. Jan. 27, 2012). The Fifth Circuit affirmed class certification and, significantly, rejected Halliburton’s contention that the absence of "price impact"—an effect of a misrepresentation on stock price—could rebut the fraud-on-the-market presumption. The court relied on the Supreme Court’s decision in Amgen Inc. v. Connecticut Retirement Plans & Trust Funds, 133 S. Ct. 1184 (2013), which held that since the element of materiality was established by evidence common to all plaintiffs and failure to prove materiality would cause all individual claims to succeed or fail on evidence common to the class, materiality was unnecessary to consider at the class certification stage. The Fifth Circuit similarly found that price impact was an objective inquiry that applied to everyone in the class. If Halliburton could prove the absence of price impact, all individual claims would fail because plaintiffs would be unable to establish loss causation. "[T]he focus of the 23(b)(3) class certification inquiry—predominance—is not whether the plaintiffs will fail or succeed, but whether they will fail or succeed together." Erica P. John Fund, Inc. v. Halliburton Co., 718 F.3d 423, 431 (5th Cir. 2013). Since price impact evidence did not bear on the question of whether common questions predominated, the Fifth Circuit affirmed class certification.

On appeal to the Supreme Court for the second time, Halliburton asked the Court two questions: (1) should the Court overrule Basic to the extent that Basic recognized a presumption of class-wide reliance derived from the fraud-on-the-market theory?; and (2) where a plaintiff invokes the Basic presumption, should a defendant be allowed to rebut the presumption and prevent class certification by introducing evidence that any alleged misrepresentations did not actually distort the stock price? The Court answered no to the first question and yes to the second.

The Decision

On the first question, the Court declined to overrule its prior holding in Basic. As to Halliburton’s argument that the Basic presumption was inconsistent with Congress’s intent in passing the 1934 Exchange Act, the Court noted that Justice White made "the same argument" in his dissent in Basic; the majority found it unpersuasive then, "and Halliburton has given us no new reason to endorse it now."

Turning to the substance of Halliburton’s argument to overturn Basic, the Court first rejected Halliburton’s argument that the efficient capital markets hypothesis supporting the Basic presumption was erroneous at adoption and had fallen out of favor with the economic and finance experts cited throughout its brief. Noting that the academic "debate is not new," the Court held that Halliburton’s argument did not fundamentally address Basic "on its own terms." The Court explained that Halliburton's contentions about the invalidity of the efficient capital markets hypothesis were beside the point, because the Court in Basic did not "adopt any particular theory of how quickly and completely publicly available information is reflected in market price." Instead, the Court said, Basic stood for the more "modest" proposition that "professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices." The majority concluded that "[t]he academic debates discussed by Halliburton have not refuted the modest premise underlying the presumption of reliance."

Halliburton also argued that it was a fallacy that all investors relied on the integrity of the market, pointing out many examples of investors who purchased or sold securities for other goals or purposes. For example, a "value investor" purchases stocks on the belief that the price of the securities does not accurately reflect all public information available at the time of the purchase. But the majority retorted that Basic never denied the existence of such investors, who 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. Thus, the Court appears to have adopted a "weak" version of the presumption of reliance, in which investors are not presumed to have relied on the efficiency of the market in instantaneously setting an accurate price, but on some effect from market efficiency that is less precise, determinable and measurable.

The Court also cast aside Halliburton’s last argument—that stare decisis was of less import here because Basic could no longer be reconciled with the Court’s more recent jurisprudence concerning securities class actions. For example, Halliburton argued that Basic expanded the Rule 10b-5 cause of action, while the Court’s holding in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) called for the rule to be more narrowly applied. The Court distinguished Halliburton from Central Bank and Stoneridge as cases that rejected attempts to broaden Rule 10b-5 liability to defendants who were not alleged to have made misstatements. "While the presumption makes it easier for plaintiffs to prove reliance, it does not alter the elements of the Rule 10b-5 cause of action and thus maintains the action’s original legal scope."

The Court similarly declined to accept Halliburton’s argument that the Court’s holdings in Wal-Mart Stores, Inc. v. Dukes, 131 S. Ct. 2541, 2551 (2011), and Comcast Corp. v. Behrend, 133 S. Ct. 1426, 1432 (2013), which required plaintiffs to "actually prove—not simply plead—that their proposed class satisfies each requirement of Rule 23," could not be squared with Basic, which, as Halliburton argued, "relieves Rule 10b-5 plaintiffs of that burden." "That is not the effect of the Basic presumption," the Court retorted, observing that the Basic presumption puts the burden on plaintiffs to establish the prerequisites for invoking the presumption — "namely, publicity, materiality, market efficiency, and market timing."

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. Accepting Halliburton’s position that plaintiffs should be required to show price impact affirmatively would "take away the first constituent presumption."

On the other hand, the Court did agree with Halliburton that defendants must be given the opportunity prior to certification of a class to show evidence of a lack of price impact. What the Fund argued, and the Fifth Circuit held, was that defendants could not rely on this price-impact evidence "prior to class certification for the particular purpose of rebutting the presumption altogether." This restriction, the Court held, "makes no sense, and can readily lead to bizarre results." 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."

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 a lack of price impact at the certification stage. Like other developments in securities law over the last twenty years, today’s decision in Halliburton can be expected to reduce the percentage of securities fraud cases that survive motion practice. Halliburton should also dampen the enthusiasm that plaintiff’s lawyers might have for filing otherwise weak claims where there is no significant price effect at the time that alleged false statements are made.

As with the numerous other limitations on securities class actions that have accrued since Justice Thomas’s seminal decision in Central Bank of Denver in 1994, in the near term, corporations may expect to see a marginal decrease in the number of filings, a marginal decrease in the number of classes certified, and although probably not capable of measurement, a marginal decrease in the settlement value of 10b-5 class actions generally. These effects might become more pronounced over time if defendants achieve significant success in disproving price impacts from alleged misrepresentations and developing case law is friendly to such proof. Finally, Halliburton II would seem to be most influential in cases where plaintiffs allege that defendants’ misrepresentations effectively reassured investors that business was continuing on trend while concealing significant changes from market expectations; because the expected effect of such misrepresentations would be to prevent the market price from declining in response to new public material information, such cases would seem more susceptible to rebuttal by showing a lack of price impact.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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