On March 5, 2014, the U.S. Supreme Court heard oral arguments in the appeal of Halliburton Co. v. Erica P. John Fund, Inc.. The Court’s forthcoming opinion, expected by June 2014, will decide the continuing vitality of the fraud-on-the-market presumption, one of the legal underpinnings of modern securities-fraud class actions. The Court’s decision may have profound implications for securities fraud class action litigation in the United States, and thus for the millions of investors in U.S.-listed public companies who, since 1996, have recovered nearly $80 billion in settlements of such cases.
Some Background on Fraud-on-the-the-Market Presumption
Securities fraud class actions are generally brought under Section 10(b) of the Securities Exchange Act of 1934 and Rule 23 of the Federal Rules of Civil Procedure. One of the elements that a plaintiff must prove in an action under Section 10(b) is reliance upon the fraud. However, if each of a company’s thousands of individual investors were required to prove that he or she traded in the company’s stock in reliance on a defendant’s fraudulent statements, such individualized issues could preclude class certification under Rule 23.
To enable private enforcement of the federal securities laws on a class-wide basis, the Supreme Court, in the 1988 case of Basic v. Levinson, developed the “fraud-on-the-market” presumption. The presumption is based upon the “efficient-market hypothesis” that an efficient financial market will reflect all publicly available information about a company, and holds that a buyer of a security trading on an efficient market may be presumed to have relied on that information in purchasing the security. Unless defendants can successfully rebut the presumption, then the presumption permits plaintiffs to satisfy Rule 23, paving the way to class certification.
By eliminating the requirement of individualized proof of reliance in securities fraud class actions, the fraud-on-the-market presumption has allowed courts to certify classes consisting of thousands or millions of allegedly defrauded investors, often leading to significant recoveries. Not surprisingly, securities fraud defendants have made numerous attempts in the 25 years since Basic to abolish that presumption or expand the ways by which it can be rebutted. Halliburton is the latest such attempt.
In accepting Halliburton, the Supreme Court will answer two questions:
whether the Court should overrule or modify the presumption of class-wide reliance derived from the fraud-on-the-market theory, and
whether a defendant may rebut the fraud-on-the-market presumption (and prevent certification of a class of investors) by introducing evidence that the alleged misrepresentations did not distort the market price of its stock.
The Court could rule in a variety of ways, each having a different effect on the future of securities fraud class action litigation.
First, the Court May Reaffirm the Fraud-on-the-Market Presumption
The Court may simply reaffirm the fraud-on-the-market presumption under Basic, essentially maintaining the status quo. There is precedent for such a result. Last year, in Amgen v. Connecticut Retirement Plans, Chief Justice John Roberts joined the Court’s four more liberal justices in rejecting the defendants’ invitation to require plaintiffs to prove a misstatement’s “materiality” for the presumption of reliance to apply. In doing so, the majority reaffirmed Basic. If Justice Roberts again sides with the Court’s liberal wing, the Court may again reaffirm the fraud-on-the-market presumption in Halliburton.
Further, since 1988, the Court has repeatedly reaffirmed the vitality of its decision in Basic. A reaffirmance in 2014 would be consistent with the Court’s often-expressed hesitance to disturb long-settled precedents. Additionally, when Congress enacted the Private Securities Litigation Reform Act (PSLRA) of 1995, it reformed many aspects of private securities fraud litigation but did nothing to alter or eliminate the fraud-on-the-market presumption of reliance. During the recent oral argument, Justice Kagan acknowledged this when she noted that “Congress has had every opportunity and has declined every opportunity to change Basic itself.”
Or, the Court May Clarify How the Presumption of Reliance May Be Rebutted
Following the oral argument, many commentators predict that the Court will focus on the second certified question, thereby preserving a plaintiff’s ability to invoke presumption of reliance in securities fraud litigation, but specifying how defendants can rebut that presumption and prevent class certification.
In this regard, several justices expressed interest in requiring future plaintiffs to prove not merely that the market for a particular company’s stock was “efficient,” but that it was efficient with respect to the particular information at issue in the case. If the Court follows this path, future plaintiffs may be required to offer expert testimony, event studies, regression analyses, market reports, or other statistical proof to demonstrate that an alleged misrepresentation actually affected a security’s price. Justice Kennedy voiced interest in this “midway position that says there should be an event study” and noted that it seemed to be “a substantial answer to … the challenge … to the economic premises of the Basic decision.”
Or, the Court May Abolish the Fraud-on-the-Market Presumption Altogether
At the oral argument, the majority of the justices appeared unwilling to take this approach. However, if Basic were overruled, investors likely would be unable to pursue securities fraud claims based upon affirmative misrepresentations under Section 10(b) through class actions. If that happened, a major deterrent to securities fraud would be lost. However, such a development would not put an end to securities fraud litigation altogether. To the contrary, even if the Court abolishes the fraud-on-the-market presumption, securities fraud litigation will continue in several different forms. What is important to remember is that institutional investors would no longer be able to merely remain passive (absent) class members when faced with losses caused by securities fraud. Rather, they would need to consider and adopt more active loss-recoupment strategies.
Even without the fraud-on-the-market presumption, investors or groups of investors with substantial losses would still be able to bring individual or collective actions under Section 10(b). Such actions would resemble the opt-out actions that have been frequently brought by large institutional investors seeking to obtain better results than they would receive by remaining passive class members. In fact, experience over the past 15 years with opt-out litigation suggests that investors filing individual actions can obtain even better results as individual plaintiffs than as passive class members, and on average have done so.
Investors pursuing individual actions without the benefit of the fraud-on-the-market presumption could use several legal strategies to maximize their chance of success. First, institutional plaintiffs may be able to avoid pleading (and ultimately proving) reliance on a particular statement by characterizing their cases not as frauds of misrepresentation, but of omission. The Supreme Court acknowledged this distinction in Affiliated Ute Citizens of Utah v. United States, in which the Court concluded that securities fraud plaintiffs do not have to prove reliance to sustain claims based on a defendant’s failure to disclose material information.
Second, an individual case can seek to take advantage of Section 18 of the Exchange Act, which provides an express right of action for any person who purchases or sells a security in reliance on a false or misleading statement or omission made in a document filed with the Securities and Exchange Commission. Unlike Section 10(b), which requires a plaintiff to plead, with particularity, a “strong inference” of the defendant’s guilty state of mind, a plaintiff suing under Section 18 need not prove that the defendant acted with any particular mental state.
Third, Section 11 of the Securities Act of 1933 provides investors who purchase securities pursuant to an initial public offering with a statutory right of action against, among others, the issuers of those securities and each individual who signed the registration statement. Because issuers are strictly liable for misrepresentations under Section 11, investors bringing suit are not required to show reliance. Actions under Section 11 will remain viable regardless of how Halliburton is decided.
Finally, investors in individual or collective actions will have the opportunity to assert state common-law claims such as fraud, negligent misrepresentation and unjust enrichment. State law often is advantageous to defrauded investors as it may provide for broader liability (such as liability for investment bankers, accountants, and other “secondary actors” who often aid and abet the fraudulent conduct) and enhanced damages (such as punitive damages) against defendants.
Justice Kennedy’s “Midway Position” May Prevail
While some believe that the Supreme Court absolutely will abolish the fraud-on-the-market presumption, the March 5 oral argument suggests that the Court is more likely to take a middle road by clarifying the ways in which the parties can establish and rebut the stock-price impact of an alleged misrepresentation. Deputy Solicitor General Malcolm Stewart described this result as “a shift away from analyzing the general efficiency of the market and focusing only on the effect or lack of effect on the -- particular stock.” As Stewart noted during the hearing, such a decision would not “be nearly so dramatic” as overruling Basic since “plaintiffs already have to prove price impact at the end of the day.”
That said, even if the fraud-on-the-market presumption is entirely overruled, securities litigation will certainly continue. But, investors will no longer have the luxury to sit on the sidelines while class action litigation proceeds on their behalf. Rather, investors suffering losses will need to participate in securities fraud litigation directly through individual actions and collective “opt-in” actions, using more diverse causes of action. Large institutional investors with substantial losses will inevitably lead these actions. As with the “opt-out” actions of the past 15 years, the large institutions that actively assert their legal rights though such individual actions may be able to achieve even better settlements than would otherwise be achieved in class actions. As such, for vigilant investors, even Halliburton’s worst-case scenario will not mean an end to securities fraud litigation, but a new beginning.