The Court of Appeals for the Third Circuit issued an opinion this week, In re DVI, Inc. Securities Litigation, that deepens the circuit split on issues related to the operation of the fraud-on-the-market theory at the class certification stage of a securities fraud case. The Supreme Court granted certiorari in the Halliburton case to address that circuit split, and is scheduled to hear oral argument on April 25. The Third Circuit joins the Second Circuit in adopting a middle-ground approach – permitting defendants to rebut the fraud-on-the-market presumption and defeat class certification by showing that the allegedly false statements did not impact the company’s stock price – that may be approved by the Supreme Court.
The Fraud-on-the Market Theory and the Circuit Split
One of the essential elements of a securities fraud claim is plaintiffs’ reliance on the defendants’ allegedly false statements. Plaintiffs may prove reliance directly by showing that they purchased stock based on the defendants’ statements. But direct proof of reliance requires individualized determinations, preventing the case from being brought as a class action. As an alternative means of proving reliance, courts have permitted plaintiffs to use the fraud-on-the-market theory. Under this theory, plaintiffs need not show that they actually read or were aware of the defendants’ allegedly false statements. Instead, all purchasing shareholders can be presumed to have relied on the integrity of the company’s stock price, which plaintiffs argue was artificially inflated by the allegedly false statements. Defendants may rebut this presumption by any showing that severs the link between the alleged misrepresentation and either the price paid by the plaintiff or the purchase decision.
Over the past few years, a circuit split has developed on how the fraud-on-the-market theory operates at the class certification stage, a key battleground in securities cases. At one end of the spectrum is the Fifth Circuit, which requires plaintiffs to prove that the defendants’ statements impacted the stock price in order to invoke the fraud-on-the-market presumption. This stock price impact is typically proven by showing that the stock price declined in response to the “truth” being revealed to the market, a requirement referred to as “loss causation.” In the middle is the Second Circuit, which does not require plaintiffs to prove stock price impact to invoke the presumption, but expressly permits defendants to rebut the presumption at the class certification stage by showing the absence of price impact. At the other end of the spectrum is the Seventh Circuit, which while not expressly rejecting or adopting the Second Circuit’s approach, has issued a decision that could be read as suggesting that defendants may not attempt to defeat class certification by showing the absence of price impact.
The Supreme Court is set to address these issues in Erica P. John Fund, Inc. v. Halliburton Co., an appeal from a Fifth Circuit decision affirming the denial of class certification based on the plaintiffs’ failure to prove price impact/loss causation. In that case, the plaintiffs/petitioners argue that requiring plaintiffs to prove price impact conflicts with Supreme Court precedent on the fraud-on-the-market theory. In addition, they argue that defendants should not be permitted to rebut the fraud-on-the-market presumption until trial, meaning that defendants would not be able to defeat class certification by showing that their allegedly false statements had no impact on the stock price.
DVI: The Third Circuit Adopts the Middle Ground Approach
In DVI, the Third Circuit delved into the circuit split in the context of an appeal by Deloitte & Touche, which plaintiffs claim wrongfully issued clean audit opinions. Deloitte argued that the district court erred by not requiring plaintiffs to prove stock price impact/loss causation, or alternatively that it had successfully rebutted the presumption of reliance.
While the Third Circuit did “not think plaintiffs must establish loss causation as a prerequisite to invoking the presumption of reliance in the first instance,” it agreed that “[e]vidence an allegedly corrective disclosure did not affect the market price undermines the fraud-on-the-market presumption of reliance for several reasons.” For example, such proof may undercut the claim of market efficiency or show that the alleged misstatement was immaterial. The court accordingly adopted the Second Circuit’s middle-ground approach on the relevance of price impact to the class certification inquiry: “we believe rebuttal of the presumption of reliance falls within the ambit of issues that, if relevant, should be addressed by district courts at the class certification stage. . . Moreover, we agree with the Second Circuit that a defendant’s successful rebuttal demonstrating that misleading material statements or corrective disclosures did not affect the market price of the security defeats the presumption of reliance for the entire class, thereby defeating the Rule 23(b) predominance requirement.”
It remains to be seen how the Supreme Court will resolve this issue in the pending Halliburton case, but it would not be surprising if the Court agrees with the middle-ground approach adopted by the Second and Third Circuits.