The U.S. Supreme Court this morning, in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317 (U.S. June 23, 2014), preserved (by a 6-3 vote in an opinion by Chief Justice Roberts)the “fraud on the market” theory adopted by the Court in Basic v. Levinson, but unanimously reversed the Fifth Circuit, holding that defendants can rebut the presumption at the class certification stage by showing that a misrepresentation had no impact on the price of the security. The decision thus stops short of any great innovations in Rule 10b-5 cases, but underscores the ability of defendants to contest the impact of an alleged fraud on the market price at the class certification stage. As the Court concluded:
Price impact is…an essential precondition for any Rule 10b–5 class action. While Basicallows plaintiffs to establish that precondition indirectly, it does not require courts to ignore a defendant’s direct, more salient evidence showing that the alleged misrepresentation did not actually affect the stock’s market priceand, consequently, that the Basic presumption does not apply.
Slip op. at 21 (emphasis added). Defendants will, however, apparently bear the burden of disproving price impact if plaintiffs have otherwise demonstrated an entitlement to the traditional Basic presumption.
The Court's decision said less than it might have about how courts define an “efficient market,” how litigants prove one, and how exactly the impact of public statements on stock prices is to be litigated and proven. It also left the impact on class certification of individual determinations of reliance unclear. Many of those questions will be left to be litigated in the lower courts.
I. Why Halliburton?
Some background on the facts and procedural history of Halliburton is in order to understand how the case came to the Supreme Court and why it presented the issues as it did. The case, filed in 2002, alleged a class period running from June 1999 through December 2001, and asserted misrepresentations in numerous Halliburton public filings covering most of the class period. The plaintiffs alleged misrepresentations on three topics: (1) understatement ofHalliburton’s exposure to asbestos liability, (2) overstatement of income by inclusion of billings whose collection was unlikely, and (3) exaggerated cost savings and efficiencies from a 1998 merger with Dresser industries.
In a misrepresentation case, there are – at least in theory – four possible ways in which a proposed class might try to show that misrepresentations affected the price at which every class member bought stock, at the time they bought the stock. First, and most directly, the plaintiffs could use an event study or similar market-price evidence to demonstrate that the price of the stock reacted positively to the alleged misrepresentations. The plaintiffs inHalliburton never tried to show that the market price of the stock reacted to the misrepresentations at the time they were made.
Second, in some cases, plaintiffs assert that misrepresentations are merely “confirmatory” – that they falsely confirm to the market something the market already believed, e.g., “the company remains solvent” – and thereby “maintain” the market price. This is a controversial approach, because it takes the very absence of a price reaction as proof that there was a price effect. But the Halliburton plaintiffs (in contrast to the approach taken by plaintiffs in some other Circuits) were unable to rely on this theory because a 2003 Fifth Circuit precedent, Greenberg v. Crossroads, held that confirmatory misrepresentations are not actionable, and the plaintiffs did not challenge Greenberg in the Supreme Court.
Third, particularly where there is no visible price reaction to an alleged misrepresentation, a plaintiff may try to prove that price impact at the time of purchase can be inferred from the price’s reaction to a corrective disclosure at the time the truth came out. However, under the Fifth Circuit’s Oscar Private Equity rule, a plaintiff could not do so if the plaintiff did not show that the corrective disclosures met the prevailing test for loss causation – that is, (1) the disclosure of new information (2) that disclosed the falsity of prior statements and (3) could be shown as the cause of a stock drop distinct from other intervening or confounding bad news released at the same time.
But the Fifth Circuit in 2010 held that the plaintiffs in Halliburton had failed the Oscar test. On the asbestos claims, the court reviewed the five alleged corrective disclosures between June 28, 2001 and December 7, 2001, and found that these did not correct any prior misrepresentation; one of the disclosures was not new but simply an elaboration on a prior disclosure; and the others were not related back to the original statements about asbestos litigation reserves but implicated new information – a new request by a spun-off subsidiary for financial assistance and new jury verdicts. One of the asbestos jury verdicts, announced on December 7, is the main corrective disclosure at issue in the case and was cited by plaintiffs’ counsel in the most recent Supreme Court argument.
As to the other two categories of statements, the Fifth Circuit found that subsequent restructuring charges did not mention or otherwise disclose to the market the accounting practices alleged to be improper, and faulted the plaintiffs’ expert, Jane Nettesheim, for relying entirely on analyst report characterizations of the merger statements rather than “perform[ing] any statistical or econometrical analyses” of the various items of unrelated information contained in the disclosures about the Dresser merger. The Fifth Circuit also found that statements of general optimism about the Dresser merger were not actionable, and thus did not separately analyze price reactions to them.
The procedural problem, for the defendants, was that the Oscar rule was framed as a loss causation rule and used precisely the same analysis that would be used for a loss causation summary judgment motion, with the difference that it was applying the procedural standards of Rule 23 (under which the plaintiffs bear the burden of proof by a preponderance of the evidence). The Supreme Court took the case (Halliburton I), and in 2011 it held that plaintiffs do not have to show loss causation to certify a class, because a failure of loss causation will affect all class members’ claims on the merits equally. The Court in Halliburton I refused to consider the question (argued then by the defendants) of whether the same evidence would also support a finding that the misrepresentations had not affected the price of the stock; the Court remanded for consideration of that issue. But the Fifth Circuit, on remand, concluded that a lack of price impact would similarly be a class-wide problem – and thus not an obstacle to class certification, or even to be considered at the class certification stage. The briefing at the Supreme Court in Halliburton II contained little discussion of the parties’ arguments over whether the disclosures were corrective; the plaintiffs argued, primarily, that the Fifth Circuit’s conclusion was nullified when the opinion was vacated. But they have offered little in the way of rebuttal of its conclusions.
Fourth, rather than produce any evidence related to actual market price reactions, class action plaintiffs may simply try to rest on the syllogism that Basic allows them to presumeprice impact by alleging that the market was efficient (which the defendant in Halliburton, with 848 million shares outstanding on the NYSE during the class period, did not contest) and alleging that the misrepresentation was material (which under Amgen, need not be proven at the class certification stage) and publicly disseminated. But if there is no evidence of price movement at the time of the misrepresentation, no legally actionable confirmatory misrepresentation, and no price reaction tied to a proper corrective disclosure, has the defendant rebutted the presumption – and is it the defendant’s burden to show all those things, or the plaintiff’s? Those are the questions the Court was potentially faced with when it granted certiorari.
II. Basic and Market Efficiency
The Court upheld Basic primarily on stare decisis grounds, and declined to revisit whether it comported with Congressional intent. Slip op. at 8-16. As the Court summarized a plaintiff’s burden at class certification:
[A] plaintiff must make the following showings to demonstrate that the presumption of reliance applies in a given case: (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 in the stock between the time the misrepresentations were made and when the truth was revealed.
. . .
The burden of proving those prerequisites still rests with plaintiffs and (with the exception of materiality) must be satisfied before class certification.
Id. at 6–7, 14. As to publicity, a sometimes overlooked element of this burden, the Court noted that “[i]f the misrepresentation was not publicly known, then it could not have distorted the stock’s market price.” Id. at 16. On the operation of efficient markets, the Court described, seemingly without explicitly endorsing, the view that
[t]he markets for some securities are more efficient than the markets for others, and even a single market can process different kinds of information more or less efficiently, depending on how widely the information is disseminated and how easily it is understood.
Id. at 9. The Court went on:
[I]n making the presumption rebuttable, Basic recognized that market efficiency is a matter of degree and accordingly made it a matter of proof. The academic debates discussed by Halliburton have not refuted the modest premise underlying the presumption of reliance. Even the foremost critics of the efficient-capital-markets hypothesis acknowledge that public information generally affects stock prices. . . . Debates about the precise degree to which stock prices accurately reflect public information are thus largely beside the point.
Id. at 10–11 (emphasis in original). The Court also observed that Basic “never denied the existence” of value investors who try to beat the market. Id. at 11.
Despite acknowledging that the “degree” to which stock prices accurately reflect public information may vary, the Court embraced the notion that evidence of price impact may be considered for purposes of determining market efficiency – without clarifying the boundaries of the “degree” necessary for purposes of finding an efficient market:
Nor is there any dispute that defendants may introduce price impact evidence at the class certification stage, so long as it is for the purpose of countering a plaintiff’s showing of market efficiency, rather than directly rebutting the presumption. . . . After all, plaintiffs themselves can and do introduce evidence of the existence of price impact in connection with “event studies”—regression analyses that seek to show that the market price of the defendant’s stock tends to respond to pertinent publicly reported events. . . . In this case, for example, EPJ Fund submitted an event study of various episodes that might have been expected to affect the price of Halliburton’s stock, in order to demonstrate that the market for that stock takes account of material, public information about the company. . . . The episodes examined by EPJ Fund’s event study included one of the alleged misrepresentations that form the basis of the Fund’s suit. See id., at 230, 343–344. See also In re Xcelera.com Securities Litigation, 430 F. 3d 503, 513 (CA1 2005) (event study included effect of misrepresentation challenged in the case).
Id. at 18–19 (emphasis in bold added, emphasis in italics in original).
Suppose a defendant at the certification stage submits an event study looking at the impact on the price of its stock from six discrete events, in an effort to refute the plaintiffs’ claim of general market efficiency. All agree the defendant may do this.Suppose one of the six events is the specific misrepresentation asserted by the plaintiffs. All agree that this too is perfectly acceptable.
Id. at 19–20 (emphasis added). Ultimately, the Court’s discussion of market efficiency is less than clear for lower courts or litigants looking for guidance as to what must be proven in order to show that a market is efficient, other than knocking down the straw man of requiring plaintiffs to show that market prices were correct in addition to reacting swiftly.
III. Price Impact
The Court stressed the centrality of price impact, but declined to require plaintiffs to show its existence directly:
Such a result is inconsistent with Basic’s own logic. Under Basic’s fraud-on-the-market theory, market efficiency and the other prerequisites for invoking the presumption constitute an indirect way of showing price impact. As explained, it is appropriate to allow plaintiffs to rely on this indirect proxy for price impact, rather than requiring them to prove price impact directly, given Basic’s rationales for recognizing a presumption of reliance in the first place. See supra, at 6–7, 16–17.
. . .
Halliburton’s argument for doing so [i.e., requiring the plaintiff to bear the burden of proving price impact] is the same as its primary argument for overruling the Basicpresumption altogether: Because market efficiency is not a yes-or-no proposition, a public, material misrepresentation might not affect a stock’s price even in a generally efficient market. But as explained, Basic never suggested otherwise; that is why it affords defendants an opportunity to rebut the presumption by showing, among other things, that the particular misrepresentation at issue did not affect the stock’s market price.
Id. at 18, 20 (emphasis added).
Instead, the Court concluded that the burden is on the defendant to rebut price impact:
But an indirect proxy should not preclude direct evidence [of lack of price impact] when such evidence is available. . . .And without the presumption of reliance, a Rule 10b-5 suit cannot proceed as a class action.
. . .
In the absence of price impact, Basic’s fraud-on-the-market theory and presumption of reliance collapse. The “fundamental premise” underlying the presumption is “that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction.”
Id. at 20, 17. But the Court avoided many of the other questions inherent in this inquiry, such as the timing of price impact and how it is to be examined.
Finally, the Court noted that
Basic does afford defendants an opportunity to rebut the presumption of reliance with respect to an individual plaintiff by showing that he did not rely on the integrity of the market price in trading stock. . . . That the defendant might attempt to pick off the occasional class member here or there through individualized rebuttal does not cause individual questions to predominate.
Id. at 14–15. The Court went on to say that “there is no reason to think that theses questions [of individual reliance] will overwhelm common ones and render class certification inappropriate under [Fed. R. Civ. P.] 23(b)(3).” Id. at 15.
Three Justices (Thomas, Scalia and Alito) would have voted to overturn Basic. Justices Ginsburg, Breyer and Sotomayor concurred to emphasize their views that “[a]dvancing price impact consideration from the merits stage to the certification stage may broaden the scope of discovery available at certification” and that the Court’s opinion “should impose no heavy toll on securities-fraud plaintiffs with tenable claims.” Slip op. 1 (Ginsburg, concurring).
Please click here to view the Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317 case online.