Justices Signal Interest In Middle-Ground Approach To Adjusting Fraud-On-The-Market Presumption

by Pepper Hamilton LLP

On March 5, 2014, the U.S. Supreme Court heard oral argument in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317. In this closely watched case, Halliburton has asked the Court to overrule the fraud-on-the-market presumption of reliance in securities class actions that the Court adopted in Basic v. Levinson, 485 U.S. 224 (1988). If the Court were to grant Halliburton’s request, federal courts would stop certifying classes in securities actions where reliance is an essential element of the claim.

As many commentators predicted, however, the justices’ questioning during oral argument signaled a possible reluctance to overturn Basic, especially in light of the hundreds of federal appeals court and district court cases that applied the presumption after the Court created the Basic standard 25 years ago. Instead, many of the justices’ questions focused on Halliburton’s alternative argument that, at the very least, the Court should adopt a “middle-ground” ruling that would allow defendants in securities class actions to rebut the fraud-on-the-market presumption at the class certification stage.

By way of background, to bring a securities fraud lawsuit under Section 10(b) of the Securities Exchange Act of 1934 and the U.S. Securities and Exchange Commission (SEC) Rule 10b-5, a private plaintiff must prove, among other things, that he or she individually relied on the misrepresentation or omission at issue. If courts strictly applied the reliance requirement in the class action context, then common questions would not “predominate” for purposes of Federal Rule of Civil Procedure Rule 23(b)(3) because each prospective class member would have to prove the element of reliance at the class certification stage, potentially through hundreds, if not thousands of depositions. Thus, as a practical matter, few, if any, classes would ever be certified.

In Basic, the Supreme Court resolved this problem by holding that plaintiffs could use a proxy for individual reliance by establishing a rebuttable presumption of class-wide reliance via the fraud-on-the-market theory. Under this theory, a court presumes that all members of the putative class indirectly relied on the alleged misrepresentation in deciding whether to buy the defendant’s stock through their reliance on the stock’s market price, so long as the lead plaintiff can show that the stock traded in an efficient market.

During the March 5 argument, Halliburton explained that, in the years since the Supreme Court adopted the Basic standard, academics have widely discredited the idea that information about a stock gets immediately incorporated into the stock’s price in an efficient market. Halliburton further argued that the fraud-on-the-market theory is inconsistent with the Court’s recent decisions in non-securities class actions – such as Wal-Mart v. Dukes, 131 S. Ct. 2541 (2011) – which disfavor presumptions at the class certification stage and require plaintiffs to make some showing of proof in order to obtain class action status.

In response, the Fund argued that an equal number of academics have concluded that the economic theory underpinning the fraud-on-the-market presumption remains valid. The Fund further pointed out that other evidentiary hurdles in place – such as the heightened pleading requirements for securities class actions under the Private Securities Litigation Reform Act of 1995 (PSLRA) – essentially impose evidentiary requirements that the Court emphasized in other class action contexts. Lastly, the Fund argued that, through the many years of briefing in this matter, Halliburton effectively had the opportunity to rebut the fraud-on-the-market presumption, but failed.

Most of the Court’s questioning focused on Halliburton’s alternative, or middle-ground argument. In particular, Justice Anthony Kennedy asked counsel numerous questions about an amicus brief written by two law professors, Adam Pritchard of the University of Michigan and Todd Henderson of the University of Chicago. In that brief, the professors urged the Court to allow defendants to rebut the presumption by using an event study to demonstrate that the defendant’s stock did not “move” in direct response to the alleged misrepresentation. According to these professors, this “lack of price impact” would demonstrate that, even if a company’s stock trades in an efficient market, the alleged misrepresentation was not material. As a result, every putative class member’s claim would fail on the merits, and there would be no need to explore each plaintiff’s individual reliance.

Halliburton’s counsel agreed that use of an event study would “remedy some of Basic’s underinclusiveness and overinclusiveness” by allowing courts to weigh actual – yet focused and limited – evidence about specific aspects of the merits of the case. Counsel for the Fund, however, countered that even event studies limited to price impact would increase costs for both plaintiffs and defendant companies and also raise complicated issues that would improperly blur the lines between class certification and summary judgment.

As an example, counsel for the Fund noted that, in this case, the trading price history of Halliburton’s stock indicated that it moved significantly after the alleged misrepresentations. Counsel for the Fund argued that the only way to demonstrate that the stock moved in response to “something else” would be to ask the court to weigh evidence and rule on the merits of the issue of loss causation, a result that the Supreme Court precluded at the class certification stage in Erica P. John Fund v. Halliburton, 131 S. Ct. 2179 (2011) (Halliburton I).

In any event, four justices have already shown a desire to reconsider Basic. In Amgen v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), and Halliburton I, Justices Kennedy, Samuel Alito, Antonin Scalia, and Clarence Thomas expressed doubts based, in part, on research showing that market prices are not always accurate, up-to-date indicators of a stock’s value. As the U.S. Chamber of Commerce noted in its amicus brief, many investors trade stock using an arbitrage strategy “precisely because they do not believe the market price accurately reflects the true value of the security.”

Several of the amicus briefs also emphasize the cost that securities class actions cause businesses whose shares trade on national exchanges. Specifically, despite Congress’ enactment of the PSLRA in 1995 to curb securities lawsuits, approximately 200 securities class action suits have been filed annually since, leading to an estimated $73 billion in settlements. More than 40 percent of corporations on major stock exchanges reportedly have been targeted.

The Solicitor General also participated in the oral argument and spoke on behalf of the SEC. Because the SEC can bring securities lawsuits without having to prove reliance, the Supreme Court’s decision in this case will not directly impact SEC cases. Nonetheless, the Solicitor General expressed the view that private lawsuits deter companies from misconduct. Thus, eliminating them altogether could increase the already-heavy workload of the SEC.

Moreover, the Solicitor General noted that even arbitrage traders rely on information conveyed by the stock’s price when developing their strategy, for example, to profit from making short sales – that is, from selling stock at what they believe to be an artificially high price, but then buying them back later at a much lower cost. In that way, he argued, a stock’s price is still a good proxy for reliance. Further, when asked by both Justices Kennedy and Elena Kagan what the consequences would be if the court adopted a middle-ground test, the Solicitor General said they would not be nearly as dramatic as a reversal of the Basic decision. He concluded, “In fact, if anything, that would be a net gain to plaintiffs, because plaintiffs already have to prove price impact at the end of the day.”

In sum, although it is difficult to predict the outcome of a case based on oral arguments, signs are that the Court is seriously considering modifying Basic’s fraud-on-the-market presumption. Further, it appears that such a modification might allow defendants to present evidence at the class certification stage about issues that at least touch on – if not directly decide – merits issues like materiality and loss causation. While these limited evidentiary hearings, as a practical matter, may already be taking place, the hope is that a decision in this case will provide future class certification hearings with more guidance and predictability. A decision may be issued as early as this summer.

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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