On June 6, 2011, the Supreme Court issued its decision in Erica P. John Fund, Inc. v. Halliburton Co., No. 09-1403, resolving a circuit split and unanimously holding that in proposed class actions under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5, proof of loss causation is not a prerequisite to class certification.
Plaintiff in Halliburton, purporting to sue on behalf of itself and a proposed class of investors who purchased Halliburton common stock, asserted claims under Section 10(b) and Rule 10b-5 based on alleged public misstatements concerning the company’s business. After the district court denied a motion to dismiss, plaintiff moved for class certification under Rule 23 of the Federal Rules of Civil Procedure. A disputed issue at class certification was whether, with respect to the reliance element of its claims, plaintiff could carry its burden under Rule 23(b)(3) to show that “questions of law or fact common to class members predominate over any questions affecting only individual members.” As is frequently the case in federal securities fraud actions, plaintiff sought to invoke the “fraud on the market” theory of reliance that the Supreme Court recognized in Basic Inc. v. Levinson, 485 U.S. 224 (1988). With respect to securities that trade in efficient markets, the “fraud on the market” theory posits that market prices reflect publicly-available information and, as the Halliburton Court recognized, creates a rebuttable presumption that investors “relie[d] on a misrepresentation so long as it was reflected in the market price at the time of [their] transaction[s].” The district court and Fifth Circuit both held that plaintiffs must demonstrate loss causation — that is, a causal relationship between the alleged misrepresentations and economic losses that the purported class had suffered — in order to trigger the “fraud on the market” presumption and, absent a showing of loss causation, declined to certify a plaintiff class.
The lower court decisions in Halliburton — relying on the prior Fifth Circuit decision in Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F.3d 261 (5th Cir. 2007) — conflicted with decisions by the Second and Seventh Circuits, both of which held that a plaintiff need not show loss causation in order to invoke the “fraud on the market” reliance theory. See Schleicher v. Wendt, 618 F.3d 679 (7th Cir. 2010); In re Salomon Analyst Metromedia Litig., 544 F.3d 474 (2d Cir. 2008). After the Supreme Court granted certiorari in Halliburton, the Third Circuit likewise held that plaintiffs need not show loss causation at the class certification stage. See In re DVI, Inc. Sec. Litig., 2011 WL 1125926 (3d Cir. Mar.
On review in Halliburton, the Supreme Court rejected the view of the Fifth Circuit. The Court’s opinion focused on the distinction between reliance and loss causation as separate elements of the private cause of action under Section 10(b) and Rule 10b-5. The Court noted that the reliance element is “typically focused on facts surrounding the investor’s decision to engage in the transaction.” By contrast, the Court pointed out that the loss causation element “requires a plaintiff to show that a misrepresentation that affected the integrity of the market price also caused a subsequent economic loss” — a matter that “has nothing to do with whether an investor relied on the misrepresentation in the first place” and “has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.” As a result, the Court held that the Fifth Circuit “erred by requiring [plaintiff] to show loss causation as a condition of obtaining class certification,” vacated the Fifth Circuit’s ruling, and remanded so that the lower courts could consider any further arguments Halliburton might have in opposition to class certification.
The holding in Halliburton — that application of the “fraud on the market” theory does not require a showing of loss causation — was narrow, and the Court carefully noted that it was not “address[ing] any other question about Basic, its presumption, or how and when it may be rebutted.” Importantly, the Court did not hold that evidence concerning the price impact of a given misrepresentation or omission is irrelevant at the class certification stage. The Court left open the possibility (also noted by the Second Circuit in Salomon) that the “fraud on the market” theory would not apply to a misrepresentation that had no effect on the market price of a security because, in that situation, “the price does not reflect the fraud” and “an investor cannot be said to have relied on the misrepresentation merely because he purchased stock at that price.” Relatedly, because the Court noted as Basic’s “fundamental premise” that reliance may be presumed so long as the misrepresentation “was reflected in the market price at the time of [plaintiff’s] transaction,” Halliburton supports the logical relevance of materiality considerations to application of the “fraud on the market” theory. After Halliburton, a plaintiff’s failure to demonstrate market efficiency, or to show that it transacted in reliance on market prices, also remain valid grounds to oppose application of the “fraud on the market” theory. Defendants will continue to raise these arguments and others in response to class certification motions in securities fraud cases.