On March 5, 2014, the United States Supreme Court will hear arguments for and against the continued vitality of a critical presumption that has since 1988 formed the basis for “fraud-on-the-market” securities class actions based on alleged false or misleading information publicly disseminated by companies in violation of antifraud provisions of the federal securities laws. The case before the Court -- Halliburton Co. v. Erica P. John Fund, Inc. -- challenges whether the presumption of investor reliance on materially false or misleading information disseminated into the marketplace based on the fraud-on-the-market theory should survive. The fraud-on-the market theory rests on the “Efficient Market Hypothesis,” which holds that an “efficient” market rapidly processes information in an unbiased manner, and that the market price of a stock impounds all publicly available information. Materially false or misleading information disseminated into a marketplace may thus artificially inflate the market price. When the truth becomes known to the market, the stock price resets downward to a correct value, and investors who purchased at the inflated price suffer losses measured by the extent of the decline in the market price. The assertion of such a market fraud claim for recovery on behalf of an entire class of investors rests on a presumption recognized by the Supreme Court in 1988 that investors rely on the integrity of a stock’s market price made artificial by misinformation, and each investor comprising that class need not show individual reliance on the false or misleading information itself in making the decision to purchase the stock. Because reliance is an essential element of claims under antifraud provisions of the federal securities laws, without the class-wide fraud-onthe-market presumption of reliance, a critical individual investor issue could predominate over issues common to the entire class and, as a matter of law and the rules governing class action, prevent the case from proceeding as a class action. The fraud-on-the market theory for establishing reliance on materially false or misleading information disseminated into a market has been a mainstay of class action securities litigation since its recognition, although finding that a market is “efficient,” and that actionable false or misleading information was in fact disseminated into that market, remain prelude considerations. Recently, however, the efficient market predicate for fraud-on-the market has become problematic. Skepticism regarding the economic theory underpinning fraud-on-the-market has emerged. In the Halliburton case, the Supreme Court will revisit the class-wide presumption of reliance it first recognized in 1988, deciding today whether that earlier determination based on the fraud-on-the-market theory should be overruled or substantially modified. The outcome in the case will be critical for the future of securities class action litigation. How it all began The fraud-on-the-market theory, as first applied in class action litigation arising under antifraud provisions of the federal securities laws, was recognized by the U.S. Supreme Court in 1988, in Basic, Inc. v. Levinson. In Basic the Supreme Court determined that class action plaintiffs may invoke the fraud-on-themarket theory in seeking to recover economic losses based on the market price of a security said to be artificially inflated by reason of materially false or misleading information disseminated into an “efficient” market. Public investors, said the Court, could rely on the integrity of the market price of a stock as reflecting all publicly disseminated information. That class-wide reliance would be presumed, thus supplanting any need for individual class members to prove their specific reliance on materially false or misleading information disseminated to the market. At the time, the Supreme Court put it this way: The presumption is... supported by common sense and probability. Recent empirical studies have tended to confirm Congress’ premises that the market price of shares traded on well-developed markets reflects all publicly available information, and hence, any material misrepresentations. It has been noted that it is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game? Importantly, the Supreme Court made the presumption of class-wide reliance rebuttable. Any showing, said the Court, that severs the link between alleged misrepresentations and either the price received (or paid) by the plaintiff, or the decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance. The fact that the critical presumption of reliance in market fraud cases was from the outset made rebuttable has not played significantly in securities class action litigation since. Its underpinning, however, is a critical point because courts, including more recently the Supreme Court itself, subsequently focused greater attention on the connection (or lack thereof) between allegedly false or misleading information disseminated into a market and an actual loss suffered by investors. That is to say, was the alleged fraud causally connected to the market loss that investors sought to recover? This connection -- loss causation -- is also an essential element of claims under the general antifraud provisions of the federal securities laws. Loss causation is not presumed. It may be defeated by evidence that alleged false or misleading information disseminated by a company did not distort the market price of its stock. Loss causation and the fraud-on-the-market presumption of reliance on false or misleading information are two different things. The fraud-on-the-market presumption of reliance permits class actions to proceed. Ultimately, recovery of damages by investors depends on proof that the loss was caused by the alleged fraud. That is not, however, a bar to the case proceeding as a class action. That said, one of the questions now before the Supreme Court in the Halliburton case is whether in a proposed class action, where the plaintiff invokes the presumption of reliance, the company may rebut the presumption, and thus prevent a class action from proceeding, by introducing evidence that the alleged fraud did not distort the market price of the stock. The challenge to fraud-on-the-market The challenge to fraud-on-the-market and the presumption of reliance in securities market fraud class actions it supports is, in practical terms, based on some 25 years of observations that the Efficient Markets Hypothesis is invalid. Significant pricing anomalies, perhaps best evidenced by the bubbles of recent history, and the seeming absence of rationality that leads to turbulent markets and stock prices disconnected from fundamental values, lend support to the notion that markets are driven by behavior considerations more than anything else. In this way, stock prices are said to be “noisy.” Over- or underreaction to new information in the marketplace, or reactions grounded in no news at all, occurs. Critics also persuasively argue that all “public” information does not in fact quickly make its way into the marketplace and does not impact the “price discovery” process. Critics point to the fact that security analysts and “value” investors rely on market inefficiencies to identify mispriced securities based on information that is seen by them as not being fully reflected in market prices. As a practical matter, the Efficient Market Hypothesis depends on the fact that some market participants disbelieve it, and make investment decisions that in turn inform the market and impact market prices. At any moment, the generally efficient market that is the predicate for the fraud-on-themarket presumption of reliance may simply not exist. In the Halliburton case now before the Supreme Court the company argues that new evidence demonstrates the fundamental inefficiency of markets that the Supreme Court did not anticipate in 1988. Irrationality in markets is argued to be understandable, and as being on the rise. Market efficiency, it is argued, is not a simple yes or no question. Moreover, the company argues that that scholars who favored the theoretical basis for the fraud-on-the-market presumption of reliance before the Court in 1988, have since repudiated it, more or less. The lead-up to Halliburton As noted earlier, the fraud-on-the-market presumption of reliance in securities class actions has been thoroughly entrenched in the law since 1988. Lower federal courts, and the Supreme Court itself, have not questioned any of its theoretical premises. In 2013, for example, a majority of the Supreme Court justices said in another market fraud case: If a market is generally efficient in incorporating publicly available information into a security’s market price, it is reasonable to presume that a particular, public misrepresentation will be reflected in the security’s price. Furthermore, it is reasonable to presume that most investors -- knowing that they have little hope of outperforming the market in the long run based solely on their analysis of publicly available information -- will rely on the security’s market price as an unbiased assessment of the security’s value in light of all public information. That case did not involve a challenge to the fraud-on-the-market presumption of reliance, but rather whether proof of materiality of an alleged false or misleading statement should be a prerequisite to permitting a case to proceed as a class action under the general antifraud provisions of the federal securities laws. (The Court held that it was not necessary.) Although the validity of the fraud-on-themarket theory was not an issue, Justice Samuel Alito made the observation that it may be an appropriate time to revisit the Court’s 1988 decision in the Basic case. He said so because “more recent evidence suggests that the presumption may rest on a faulty economic premise.” Three other Justices, Clarence Thomas, Antonin Scalia and Anthony Kennedy, also expressed concerns. Other Justices, however, noted that the particular case before the Court was not the appropriate vehicle to explore whatever implications market efficiency research may have on the original fraud-on-the-market legal analysis. The vehicle, however, was shortly put before the Court in the Halliburton case, and the Court accepted the case for review. With argument set for March 5, 2014, a decision will come no later than June. The future of fraud-on-the-market class action litigation? In the Halliburton case, two questions have been put before the Supreme Court. The first is whether the Court should simply reverse the 1988 decision in Basic, Inc. v. Levinson to the extent that it recognizes a presumption of class-wide reliance on false or misleading information disseminated to a marketplace based on the fraud-on-the-market theory. The second, alternative, question presented is whether, in a case where a class action plaintiff invokes the presumption of reliance as the basis to proceed as a class action, the company may rebut the presumption by presenting evidence that the alleged fraud did not impact the market price of the subject stock. Outright rejection of the presumption of reliance in market fraud class actions would fundamentally alter the securities litigation landscape -- a result that is advocated by the company in the case on the argument that, among other things, securities class actions premised on the presumption of reliance hinder policy goals, poorly compensate investors, harm innocent shareholders, and minimally deter bad conduct by public companies and those who run them. As a practical matter, overruling the 1988 decision in Basic would make actual reliance on misrepresentations a prerequisite to proceeding with a claim, and sound the death knell for securities class actions in circumstances other than those in which a presumption of reliance may still be available. Those circumstances exist, but are limited. Modifying the Basic presumption of reliance in market fraud cases, or accepting the alternative proposition offered, by requiring that plaintiffs intending to proceed in a class action first demonstrate that the misrepresentations actually made the market price of a stock artificial is problematic. As noted earlier, loss causation, a separate element of market fraud cases, is premised on just that determination, and the Supreme Court has already held in a 2011 predecessor to the present Halliburton case that a showing of loss causation is not a prerequisite to proceeding with a market fraud class action. Several organizations and groups appearing in the current Halliburton case with friend-of-the-court arguments urge that “price impact” should be the fundamental prerequisite for application of the fraud-onthe-market presumption of reliance as originally established in Basic. These arguments offer that all that is necessary is evidence of a particular misstatement’s effect on a security’s market price. That is to say, in light of the difficulties today in evaluating the efficiency of markets, the Supreme Court should shift the focus of market fraud away from the overall question of efficiency to the question whether the alleged fraud on the market actually affected a market price. There is intuitive appeal in this, but the Supreme Court will necessarily wrestle with the position it has already taken much more recently that market price impact, although essential for ultimately framing a loss in market fraud cases, is not a prerequisite for a class action to proceed. Leaving things as they are is a very real possibility. In very recent decisions a majority of Justices of the Supreme Court have not expressed doubts over the theoretical underpinnings or operation of the fraud-on-the-market presumption of reliance. The 1988 decision establishing the fraud-on-the- market presumption is being criticized in the Halliburton case today because, among other things, the Supreme Court engaged in theoretical economic analysis. But to overrule the 1988 decision today would require no less of the current Court. Bob handles financial market regulatory and complex litigation matters for a wide range of market participants and financial intermediaries. He is a noted author and teacher on law, theory and practice in financial markets. Mitch is the co-chair of Calfee’s Litigation practice group and he litigates and tries complex disputes, with special emphasis on securities and derivative litigation and enforcement.