The US Supreme Court has affirmed the "fraud on the market" presumption in the context of US securities class actions, making it easier for claimants to establish causation in US securities litigation.
Significantly for US defendants though, the Supreme Court ruled that they may adduce evidence at class certification stage to rebut the presumption. The implications for Australian securities claims remain to be seen, but the US decision will no doubt spark further debate over causation principles.
Plaintiff investors in US securities class actions will continue to be able to invoke a presumption of reliance based on the "fraud on the market" theory after the US Supreme Court failed to be moved by criticisms of the theory in the judgment delivered in Halliburton Co v Erica P. John Fund this week. [See previous e-Bulletin 26 November 2013 and our 2014 edition of Year in Preview]
The majority of the US Supreme Court was not persuaded to overturn the presumption which has underpinned securities class actions since being established twenty-five years ago in Basic Inc v Levinson.1
What is the "fraud on the market" theory?
In securities class actions, plaintiff investors can only recover damages if they prove reliance on the defendant's misrepresentation in deciding whether to trade in a company's securities.
Based on the "efficient market hypothesis", the "fraud on the market" theory holds that the price at which investors buy and sell shares in an efficient market reflects all publicly available information, including misstatements by a company. The fact that a misstatement by a company is presumed to have been factored into the price of the security means shareholders do not need to show individual reliance on misleading information.
The presumption of reliance is therefore an alternative means of satisfying the reliance element of the cause of action. It is rebuttable if, for example, a defendant can show that the alleged misrepresentation had no impact on the price of its securities.
The arguments before the Court
Relevantly (and among other things), Halliburton invited the Court to reconsider the presumption of reliance and instead to require every plaintiff to prove actual reliance on the defendant's misrepresentation in deciding to buy or sell securities. Halliburton relied on various criticisms of the "fraud on the market" theory including:
- that capital markets are not fundamentally efficient - a contention it argued was backed up by empirical evidence; and
- the existence of various classes of investors who do not invest in reliance on the integrity of the market price. For example, "value investors" who invest in certain securities on the basis that they are undervalued or overvalued in an attempt to beat the market.
The majority found that Halliburton had misconstrued Basic in that:
- the Basic presumption was based on the "fairly modest" premise that "market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices". Market efficiency is a matter of degree and subject to proof (noting that the presumption is rebuttable); and
- Basic had acknowledged the existence of investors who do not rely on the integrity of the share price in noting only that most investors will rely on the market price. In addition, "value investors" will implicitly rely on the fact that a share price will eventually reflect all material information if they hope to make a profit.
The Court was not persuaded in the circumstances that there was "special justification" to overturn the presumption.
It is interesting to note the dissenting judgment, which concluded that Basic should be overruled and commented that "logic, economic realities, and our subsequent jurisprudence have undermined the foundations of the Basic presumption…".
The minority emphasised that reliance by the plaintiff on the defendant's deceptive acts is an essential element of the cause of action which requires "transaction causation", that is, a proper connection between the misrepresentation and the loss. The minority considered that without that connection, a securities class action (based on the relevant US statute) is reduced to a "scheme of investor's insurance", because a plaintiff could recover whenever a misrepresentation caused a share price to be distorted, regardless of whether the plaintiff was actually deceived into buying or selling the shares.
In short, the minority described the Basic presumption as a mistake, based on "a questionable understanding of disputed economic theory and flawed intuition about investor behaviour".
While the decision potentially has consequences for the certification process that applies in US securities class actions,2 its implications for shareholder class actions in Australia are unlikely to be profound.
To date, no Australian court has awarded damages to a plaintiff shareholder who has not proven actual reliance on a defendant's misrepresentation. Of course, generally, most shareholder class actions in Australia are commenced on the basis that it is sufficient to show reliance by proving that the defendant's conduct caused the market price for its securities to be higher than they otherwise would have been. All of those actions have settled without a court considering whether the "fraud on the market" theory should be adopted here.
The decision in Halliburton will see plaintiffs in securities class actions in this country continue to rely on the theory as sound, despite its many critics.