On June 23, 2014, the Supreme Court held that defendants in a Rule 10b-5 securities fraud suit can defeat Basic Inc. v. Levinson’s fraud-on-the-market presumption of reliance prior to class certification by proving that the misrepresentations at issue did not affect the price of the underlying securities. The 9-0 decision, Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317, resolved a circuit split and held that defendants do not have to wait until after a class is certified to challenge the “price impact” of alleged misrepresentations. In so holding, the Supreme Court rejected the argument that Basic should be overruled, a result which could have, as a practical matter, eliminated class action suits in cases based on securities fraud. While deciding not to overrule Basic, the Court’s decision in Halliburton will make it easier for defendants to defeat securities fraud claims at an early stage and may deter some fraud claims from being brought because defendants now have the green light to make price impact challenges prior to class certification.
To recover damages for securities fraud, plaintiffs must prove, inter alia, a material misrepresentation or omission by the defendant and reliance upon the misrepresentation or omission. These two elements are linked by the “fraud-on-the-market” presumption that the Supreme Court endorsed 25 years ago in Basic Inc. v. Levinson, 485 U.S. 224 (1988). In Basic, the Court held that if the market for securities is efficient, then courts can presume that purchasers of the securities relied on any public misrepresentations that were material because the market would incorporate the information contained in those statements into the price of the securities. To gain the benefit of the Basic presumption, plaintiffs must prove (1) that the alleged misrepresentations were publicly known; (2) that they were material; (3) that the stock traded in an efficient market; and (4) that the plaintiff traded the stock between the time the misrepresentations were made and when the truth was revealed.
Basic’s rule is critical to class certification. Absent the fraud-on-the-market presumption, plaintiffs would have to prove individual reliance on the alleged misstatements by each class member—and in so doing create individual questions of proof that would predominate over common questions—fatally undermining class certification.
Here lead plaintiff Erica P. John Fund, Inc. (“EPJ”) sought to certify a Rule 10b-5 securities fraud class action based on a series of misrepresentations that Halliburton allegedly made between 1999 and 2001. EPJ alleged that Halliburton’s stock price dropped and investors lost money after Halliburton made corrective disclosures.
The litigation first reached the Supreme Court in 2011. There the Court reversed the Fifth Circuit’s holding that EPJ was required to prove loss causation—i.e., that the plaintiffs’ economic losses were caused by the defendants’ alleged misrepresentations and not by market or other factors unrelated thereto—prior to class certification in order to invoke Basic’s presumption of reliance. A unanimous Supreme Court rejected the Fifth Circuit’s reasoning and held securities fraud plaintiffs need not prove loss causation at the class certification stage. See Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179, 2187 (2011).
On remand, Halliburton sought to use evidence that its alleged misstatements did not impact the price of its stock in order to rebut Basic’s presumption that these misstatements were incorporated into the price of the stock (and therefore plaintiffs relied on the misstatements when purchasing the stock at that given price). The district court declined to consider Halliburton’s argument and certified a class; the Fifth Circuit affirmed and held Halliburton could not use price impact evidence to refute the presumption of reliance at the class certification stage.
The Supreme Court granted certiorari to resolve a circuit split over whether defendants could use price impact evidence to rebut the Basic presumption at the class certification stage or instead had to make such a challenge on the merits. The Court also reconsidered the underlying Basic presumption of reliance. Commentators had expected the Court to reexamine the fraud-on-the-market doctrine for some time; Justice Alito had recently questioned the theory’s continued viability in his concurrence in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184, 1204 (2013), and a footnote in the Amgen majority opinion recognized that more recent research suggested differences in efficiency can exist within a single market, raising issues as to the viability of the doctrine. Id. at 1197 n.6. Three dissenters in Amgen also suggested that the presumption had been extended far beyond what Basic originally intended.
The Supreme Court’s Ruling
Chief Justice Roberts, joined by Justices Kennedy, Ginsburg, Breyer, Sotomayor and Kagan, wrote the opinion of the Court holding that defendants may use price impact evidence to rebut Basic’s presumption of reliance at the class certification stage by proving that the alleged misrepresentations did not impact the price of the stock. The majority reasoned that defendants could already use price impact evidence at the class certification stage to prove a stock did not trade in an efficient market in order to challenge whether plaintiffs could obtain the benefit of the Basic presumption in the first instance. According to Chief Justice Roberts, restricting defendants to using price impact evidence to show whether a stock traded in an efficient market—and barring defendants from using the same price impact evidence as direct proof that a given misrepresentation did not affect the price of a stock—“makes no sense, and can readily lead to bizarre results.”
Chief Justice Roberts rejected several arguments made by Halliburton which sought to overrule or modify Basic, opining that (1) Halliburton failed to show the “special justification” the Court requires to overturn “long-settled precedent”; (2) the efficient capital markets hypothesis that the market price of a stock reflects all material public information is still valid at least to some extent; (3) persons who purchase stock because they believe the price does not reflect the true value, e.g., value investors who believe a stock is undervalued, still rely on the fact that the market price will reflect public material information within a reasonable time period; (4) the Basic presumption is consistent with the Supreme Court’s recent decisions requiring plaintiffs to prove at the class certification stage that common issues will predominate over individual issues; and (5) Halliburton’s concerns that the Basic presumption facilitates certification of non-meritorious claims to extort settlements and harm shareholders are best reserved for Congress.
Justice Ginsburg, joined by Justices Breyer and Sotomayor, wrote a short concurrence stating that although “[a]dvancing price impact consideration from the merits stage to the certification stage may broaden the scope of discovery available at certification,” because “it is incumbent upon the defendant to show the absence of price impact” the new approach “should impose no heavy toll on securities-fraud plaintiffs with tenable claims.”
Justice Thomas, joined by Justices Scalia and Alito, wrote a concurring opinion in which he argued that Basic’s fraud-on-the-market presumption should be overruled. Justice Thomas reasoned that the economic underpinnings of the fraud-on-the-market presumption—that public statements are reflected in the market price—has attracted substantial criticism since Basic and that investors do not categorically rely on the integrity of market price when purchasing securities. Justice Thomas also opined that Basic’s presumption of reliance allowed securities fraud plaintiffs to bypass the Court’s more recent class certification decisions that require plaintiffs to prove each of Rule 23’s prerequisites to class certification. Justice Thomas further concluded that as a practical matter the Basic presumption of reliance “is largely irrebuttable” because, among other reasons, “[a]fter class certification, courts have refused to allow defendants to challenge any plaintiff’s reliance on the integrity of the market price prior to a determination on classwide liability.”
Twenty-five years after Basic was decided, the Court’s decision to reaffirm the fraud-on-the-market presumption means securities fraud class actions will not be relegated to the dustbin of history. However, because defendants can now challenge price impact at class certification, defendants will have the opportunity to defeat cases prior to full-blown “merits” proceedings. Providing defendants with this opportunity may limit the ability of plaintiffs to extract unjustified settlements from defendants merely because of the expense and litigation risk that arises for defendants once a class is certified. In addition, potential fights over price impact at the class certification stage—regardless of the outcome—in and of itself may deter plaintiffs’ counsel from bringing claims that should not be brought.