On June 23, 2014, the U.S. Supreme Court rejected a legal challenge to the validity of the basis upon which securities market fraud class actions have proceeded in federal courts for more than 25 years. In Halliburton Co. v. Erica P. John Fund, Inc., the Supreme Court refused to overturn the “Fraud-On-The-Market” theory (FOM) in class action litigation brought on behalf of investors seeking to recover market losses under the antifraud provisions of the federal securities laws. FOM was first recognized by the Supreme Court 1988, and has since been the mainstay for investor class actions against companies and senior management over the dissemination of allegedly false or misleading information into the marketplace which causes the company’s stock price to be, in the most common setting, artificially inflated. Using FOM, investor class actions are brought in the wake of a later disclosure event said to reveal the truth, at which time the stock price resets to a lower, correct, level and investor losses can be measured by the decline. With the decision in Halliburton, those cases will continue to be brought as class actions largely unabated.
As a practical matter, most investor class actions based on company public disclosures could not exist without FOM. Normally, investors can recover losses in private securities fraud actions only if they prove that they relied on a defendant’s materially false or misleading representations in deciding to buy or sell a company’s stock. Class actions proceed on the basis that no individual issue among the proposed class members predominates over issues common to the class. Requiring proof of individual reliance on company disclosures would be such a predominate issue, and thus preclude class action status for the case. In 1988, however, in Basic, Inc. v. Levinson, the Supreme Court recognized FOM as establishing a rebuttable presumption of reliance by investors on information disseminated into an “efficient” market, in which the stock price reflects all public information, including that which is materially false or misleading. By relying on the market price or, as some would say, the integrity of the market price, of a stock, investors indirectly rely on any material misinformation that is reflected in the price. Acceptance of FOM eliminated any requirement for proof of direct individual reliance on the information itself, and thus eliminated a fundamental barrier to cases proceeding as class actions on behalf of all investors who purchased at market prices impacted by the alleged false or misleading information.
That said, the Supreme Court also made clear in the Basic case that the FOM presumption of reliance is rebuttable rather than conclusive, and stated that any showing that severs the link between alleged misrepresentations and the price paid (or in some cases received) by a plaintiff, or her decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance. Few cases ever involved such a showing, however, as the issue was seen as going to the ultimate merits of claims rather than as bearing on the procedural device of class action status under which a case proceeds.
In Halliburton, the company challenged FOM and the Supreme Court’s 1988 acceptance of it, principally urging two things: First, that the time had come to reject, outright, the economic theory on which FOM is based. It is the “Efficient Capital Market Hypothesis” (ECMH) that holds that all publicly available information disseminated into an efficient securities market is rapidly processed in an unbiased manner, and is impounded into the market price of a stock at any point in time. The company argued that developments in economic theory, and financial market events, since the Court’s 1988 decision in Basic entirely undermined the essential premise for FOM that investors invest in reliance on the integrity of market prices and invalidated assumptions about investor behavior. Second, the company argued, as an alternative to the Supreme Court overruling its 1988 decision in Basic, and eliminating FOM as a basis for class action litigation, that class action plaintiffs should be required to prove that alleged misrepresentations actually affected the stock price – had actual price impact – as a condition to invoking the presumption of reliance that is the essential element of FOM, or at least that defendant companies should be permitted to defeat the presumption by offering evidence of the absence of price impact at the class certification stage of the case.
Halliburton lost outright on the first proposition. A majority of Justices, led by Chief Justice John Roberts, found that nothing in the years since Basic, and nothing in the ongoing academic debates over ECMH, presented any justification for overturning the fairly modest premise for the Basic decision that stock prices in efficient markets are generally affected by information disseminated into those markets. The academic debates, he said, have not refuted this premise, and that even the foremost critics of ECMH acknowledge that public information generally affects stock prices. In sum, Halliburton identified no fundamental shift in economic theory that could justify overruling the precedent for FOM established inBasic. In all of this, however, it is important to keep in mind that whether a particular market is efficient has been, and will continue to be, open to challenge as part of relying on FOM and the presumption of reliance.
As for its second proposition, Halliburton fared better with the Supreme Court. Although the Court rejected the call to impose the burden on class action plaintiffs to prove the market impact of alleged false or misleading information as a condition to invoking FOM and the presumption of reliance, the Justices agreed with Halliburton that companies should be allowed to rebut the presumption with evidence of a lack of market impact, and that this opportunity be afforded at the class certification stage. How meaningful this opportunity is, and to what extent it will impact the class certification process is unclear. Justice Ruth Bader Ginsburg, joining the majority of Justices, observed that advancing price impact consideration to the class certification stage may broaden the scope of discovery available to defendants at that stage. (The “event study” already ubiquitous in FOM cases in dealing with certain elements of FOM claims on their merits, would no doubt be advanced to the class certification stage by defendants who mount a serious price impact challenge). Justice Ginsburg went on to say, however, that since it is clear that the burden is on defendants to show the absence of price impact, the Court’s decision to allow it “should impose no heavy toll on securities fraud plaintiffs with tenable claims.”
Whether FOM claims by class action plaintiffs are tenable on their face is today early and robustly tested by defendants, with challenges as a matter of law and the significant requirements established by courts for sufficiently pleading those claims and, surviving that, adducing sufficient evidence to defeat summary dispositions on the merits of claims. The public dissemination of information, its materiality, the efficiency of the market into which it was disseminated, the fact that investors purchased the stock between the time when alleged misrepresentations were made and when the truth was revealed, and loss causation, are all addressed in connection with pleading requirements as establishing the tenability of claims.
It may be the rare case in which, having survived challenges to the sufficiency of presenting these essential elements in making claims, a further “price impact” challenge will be made to class certification rather than an attack on the merits of claims themselves. Defendants will carefully weigh the opportunity now accorded to them in FOM cases by the Supreme Court in Halliburton, but whether it changes the securities class action landscape in any significant way is an open question.