Plaintiffs in a securities class action are not required to prove loss causation as part of the class certification process, the Supreme Court held in a unanimous decision handed down on Monday. Erica P. Hon Fund, Inc. v. Halliburton Co., No. 09-1403 (Decided June 6, 2011). The ruling reversed a decision by the Fifth Circuit Court of Appeals. This is the second ruling favorable to securities class action plaintiffs this term. Earlier the Court handed down a ruling favorable to plaintiffs on the question of materiality (here). Matrixx Initiatives v. v. Siracusano, 563 U.S. __ (2011).
The Court’s Decision
The Court’s opinion, authored by Chief Justice Roberts, is brief, narrow and to the point. After reciting the background to the case it notes that “the sole dispute here is whether EPJ Fund satisfied he prerequisites of Rule 23(b)(3).” Slip at 3. That subsection of Rule 23, which governs class certification, requires that common questions of law or fact predominate over individual question for the class to be certified. Since the district and circuit courts had agreed that the requirements of Rule 23 were met, by posing the question in this manner the case was immediately resolved.
The Court went on however to explain the predicate for its ruling, explaining the erroneous premise on which the lower court’s ruling turned. The question under Rule 23(b)(3) the Chief Justice wrote, centers on the question of reliance. Proof that the plaintiffs relied on the deceptive actions of the defendants is an essential element of an Exchange Act Section 10(b) private cause of action for damages. Citing Basic Inc. v. Levinsion, 485 U.S. 224, 243 (1988), the Court went on to note that reliance assures there is a proper connection between the defendant’s misrepresentation and a plaintiff’s injury.
Traditionally reliance is established by a plaintiff through proof that he or she was aware of the misrepresentation and purchased or sold the securities based on it. When the securities are purchased in the open market this is not feasible. Accordingly, Basic permits the plaintiff to invoke a rebuttable presumption of reliance called the “fraud-on-the-market theory.” Under this theory the price of a security traded on an efficient market reflects all of the publically available information, including any material misrepresentation. Investors who purchase securities in such a market are presumed to rely on its integrity.
The Court of Appeals confused loss causation and reliance. The Circuit Court held that to invoke the Basic presumption plaintiff is required to prove at the class certification stage that the decline in the price of the shares resulted because of a correction to the prior misleading statement and that the subsequent loss could not be explained by other factors revealed in the market at the time. This is loss causation as required by Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (3005) the High Court noted.
Dura loss causation is distinct from Basic and the question of reliance. Reliance typically focuses on the facts regarding an investor’s decision to engage in a transaction. Loss causation requires the plaintiff to show that the misrepresentation affected the integrity of the price and caused the subsequent economic loss. “According to the Court of Appeals, however, an inability to prove loss causation would prevent a plaintiff from invoking the rebuttable presumption of reliance. Such a rule contravenes Basic’s fundamental premise – that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction. The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively through the fraud-on-the-market theory. Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.” Slip at 8.
The Lower Courts
The case arose from a decision of the Fifth Circuit Court of Appeals in The Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 597 F. 3d 330 (5th Cir. Feb. 12, 2010). The complaint is based on three categories of claimed misstatements. First, plaintiffs alleged that statements concerning Halliburton’s exposure to liability in asbestos litigation, and its stated reserves for that litigation, are false and misleading. That liability derived from Halliburton’s merger with Dresser Industries. Supposedly corrective statements were made in press releases and SEC filings on four dates in 2001.
The second and third groups of alleged misrepresentations focus on the benefits to Halliburton of its merger with Dresser and its accounting for revenue from cost-overruns on fixed-price construction and engineering contracts. Corrective disclosures were supposedly made on four dates in 1999 and 2000.
The Fifth Circuit affirmed the district court’s denial of class certification, concluding that plaintiffs had failed to establish loss causation as required by the Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005). The Circuit Court began its analysis by noting that a securities law plaintiff basing a claim on Exchange Act Section 10(b) must establish six elements: 1) a material misrepresentation or omission; 2) scienter; 3) a connection with the purchase or sale of a security; 4) reliance; 5) economic loss; and 6) loss causation.
In a putative class action, plaintiffs can establish a rebuttable presumption of reliance using the fraud-on-the-market theory under Basic Inc. v. Levinson, 486 U.S. 224 (1988). Citing its earlier decision in Greenberg v. Crossroads Sys., Inc., 364 F. 3d 657 (5th Cir. 2004), the Court noted that plaintiffs can make the required showing by demonstrating that the defendant company made a material misrepresentation at a time when its shares were traded in an efficient market and that they traded between the time those statements were made and the truth was revealed. The defendant can rebut the presumption by any showing that severs the link between the claimed misrepresentation and either the price received or paid by the plaintiff or the decision to trade at fair market price.
The critical question here, the Court noted, is the misrepresentations. The parties did not dispute the efficiency of the market or the trading. Under these circumstances to use the Basic fraud-on-the-market presumption of reliance plaintiffs must establish loss causation the Court held: “Plaintiff must prove that the complained-of-misrepresentation or omission materially affected the market price of the security . . .. In other words, Plaintiff must show that an alleged misstatement ‘actually moved the market.’ Thus, we require plaintiffs to establish loss causation in order to trigger . . . “ the presumption (internal citations and quotations omitted). That proof must be by a preponderance of the evidence. After a detailed analysis of the proof, including expert testimony, the Circuit Court concluded that plaintiffs failed to adequately establish loss causation.
This decision is in accord with and follows the Fifth Circuit’s earlier ruling in Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F. 3d 261 (5th Cir. 2007) which the district court applied in dismissing the complaint. The Halliburton panel stated at the outset that it was bound by Oscar.
Circuit courts had split over the application of the Basic presumption in the wake of Dura. The Fifth Circuit however is the only one which require proof of loss causation at the class certification stage and imposes the burden on the plaintiff. The Seventh Circuit, in contrast, expressly repudiated Oscar in Schleicher v. Wendt, 618 F. 3d 679 (7th Cir. 2010). Under this decision the question of class certification should be governed solely by the dictates of Federal Civil Rule 23. The merits should only be considered to the extent necessary to comply with that Rule.
The Second Circuit has taken an intermediate view. In In re Salomon Analyst Metromedia Litig., 544 F. 3d 474 (2nd Cir. 2008) the court concluded that some consideration of the merits is allowed at the class certification stage. Salomon declined to consider loss causation at the certification stage however. The Third Circuit has also declined to require proof of loss causation at the class certification stage. In re DVI, Inc. Securities Litigation, No. 08-8033, 2011 WL 1125926, *7 (CA 3, Mar. 29, 2011).
The Supreme Court agreed to hear the case to resolve the split in the circuits.
This is the second victory for plaintiffs this Term from a Court considered to be pro-business. It is interesting to note that while the first came in an opinion authored by Justice Sotomayor from the liberal wing, the second was authored by the Chief Justice who supposedly has helped guide the Court on its pro-business path.
While two victories have undoubtedly bolstered the spirits of the plaintiff’s bar, potentially the most important decision for class actions is yet to be decided, Janus Capital v. First Derivative Traders (here). That case may decide the scope of primary liability in a Section 10(b) case, a question which has been litigated since the High Court concluded that there is no aiding and abetting liability under the Section in its decision in Central Bank of Denver v. First Interstate, 511 U.S. 161 (1994).
Furthermore, Matrixx and Halliburton represent, in many ways, little more than a continuation of existing precedent which may explain the victories for the plaintiffs. The former essentially reiterates the long standing test for materiality, although its application by the Court does appear to somewhat dilute it. The latter is a narrowly drawn decision which focuses on the requirements of Rule 23 and the underlying theory of Basic.
Finally, in penning the opinion Chief Justice Roberts took care to note that that “we need not, and do not, address any other question about Basic, its presumption, or how and when it may be rebutted. To the extent Halliburton has preserved any further arguments against class certification, they may be addressed in the first instance by the Court of Appeals on remand.” The Court thus sidestepped many of the issues presented at the oral argument in which the parties debated Basic and how it should be applied. At the same time it emphasized the narrow focus of the decision. In emphasizing this point the Court also knew that Halliburton had reserved significant issues about Dura causation for the dispositive motion stage of the case.