On Wednesday, March 5, 2014 the Supreme Court will hear argument in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317. The case has the potential to rewrite the rules for how securities class actions are brought. This three part series will discuss the issues and arguments presented. Part I, set forth below, outlines the arguments presented by Petitioners. Part II, to be published on Wednesday, will outline the arguments being presented by Respondents. The concluding segment, to be published on Thursday, will outline the arguments presented, and key questions posed, by the Justices at oral argument.
Petitioners have presented two critical questions for resolution by the High Court. The first seeks to overrule Basic and its fraud-on-the-market presumption of reliance while the second would substantially modify the class certification process by permitting the introduction of evidence concerning price impact at the certification stage. Petitioners frame the issues this way: 1) “Whether the Court should overrule or substantially modify the holding of Basic Inc. v. Levinson, 485 U.S. 224 (1988), to the extent that it recognizes a presumption of classwide reliance derived from the fraud-on-the market theory. 2) Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of the stock.”
Basic is a key predicate for many securities class actions. It permits plaintiffs to establish the element of reliance through the use of a rebuttable presumption, the fraud-on-the-market theory. That theory holds, as the Court explained, “that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business . . . Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements . . .” In adopting the presumption the Court noted that its task was “not to assess the general validity of the theory, but to consider whether it was proper for the courts below to apply a rebuttable presumption of reliance, supported in part by the fraud-on-the-market theory.”
While the Petitioners and their amici in Basic argued that the “fraud-on-the-market theory effectively eliminates the requirement that a plaintiff . . .” prove reliance, the Court rejected the claim. In doing so the Court agreed that reliance is a key element of a claim, but noted that there is “more than one way to demonstrate the causal connection . . .” Not only is the presumption “supported by common sense and probability . . . .[but by] empirical studies . . [that] have tended to confirm Congress’ premise that the market price of shares traded on well-developed market reflects all publicly available information . . .” according to the Court. Finally, presumptions are typically used by courts where, as here “direct proof, for one reason or another, is rendered difficult.” And, presumptions can be rebutted, in this instance under Basic, by any proof that breaks the connection.
The underlying case: This is the second time the High Court has heard this case. In the first the Court reversed a denial of class certification by the District Court which had been affirmed by the Fifth Circuit Court of Appeals. The denial was predicated on then existing Fifth Circuit precedent which required that a securities law plaintiff prove loss causation to prevail on a certification motion. The Court predicated its decision on the Requirements of Federal Rule 23 which governs certification, concluding that the question of loss causation is not relevant to the issue of whether “reliance was capable of resolution on a common, classwide basis.”
The securities fraud complaint in this case was brought against Halliburton and one of its officers. Plaintiffs claimed that the defendants inflated the share price for Halliburton by downplaying the firm’s estimated asbestos liability and overstating revenue in certain business segments and the benefits of a merger. The complaint also claimed that after plaintiffs purchased shares the defendants made corrective disclosures that caused the share price to decline. Certification was sought on behalf of all persons who purchased shares within a specified time period.
Following remand from the Supreme Court the District Court certified the class. In granting the motion the Court rejected a defense contention that price impact must be demonstrated to obtain class certification. The Court of Appeals affirmed, relying on the Supreme Court’s decision in Amgen, Inc. v. Conn. Ret. Plans & Trust Funds, 133 S.Ct. 1184 (2013. There the Court held that in a fraud-on-the-market case the plaintiff need not establish materiality to obtain class certification. That element can be proven through evidence common to the class and thus failure to prove it will not present a situation in which individual questions of law or fact predominate over common ones which is the key Rule 23 question. Following this reasoning the Court of Appeals concluded that price impact is an objective inquiry that relies on evidence common to the class and therefore need not be established at certification.
Arguments: Petitioners have advanced five key arguments is support of either overruling or modifying Basic: 1) The reliance requirement of a Section 10(b) cause of action should have been modeled on Exchange Act Section 18(a), not the fraud-on-the-market theory; 2) Recent scholarship undermines the key premise of the decision; 3) Basic is out of step with the Court’s more recent class action case law; 4) Policy factors support overruling Basic; and 5) Alternatively, plaintiffs should be required to prove price impact to obtain certification. Threaded through these points is the notion that the cause of action is judge made and should therefore be constricted.
First, since the cause of action under Exchange Act Section 10(b) is judge made it should have been modeled on the most analogous express cause of action. That is Exchange Act Section 18(a) since it broadly authorizes damages for misrepresentations by a defendant who did not buy or sell from the plaintiff when the statements were made. That Section requires proof of actual reliance. Indeed, the legislative history demonstrates that Congress discarded an early version of the Section which lacked a reliance requirement. In adopting a presumption in place of actual reliance Basic was in error since “[o]nce Congress required an affirmative showing of actual reliance for causes of action that Congress felt were important enough to create, what could justify permitting a far lesser showing for causes of action that the judiciarycrafted? By disregarding the Act’s textual command in favor of a fictional presumption of reliance, Basic exceeded the Court’s proper judicial role.” (emphasis original).
Second, recent scholarship has discredited the predicate of Basic. That decision relied on then recent empirical studies to incorporate into federal law the notionthat when shares are traded on well developed markets they reflect all publicly available information. While this theory was supported at the time, a “new ‘consensus,’ that Basic’s efficient-markets theory ‘simply did not work in practice,’ emerged quickly . . . Shortly after Basic, a leading professor explained that ‘theopposite’ of Basic’s presumption ‘appears to be true’ . . . That is partly because many investors’ ‘strategies’ involve ‘attempt[ing] to locate undervalued stocks in an effort to ‘beat the market,’ meaning that they ‘are in essence betting that the market for securities they are buying is in fact inefficient.’” (emphasis original).
More importantly, according to Petitioners, “overwhelming empirical evidence” suggests that the capital markets are not fundamentally efficient, a point reflected in numerous papers. Even in well-developed markets public information is often not incorporated immediately into market prices. While this does not mean that markets are never efficient, the “binary” view of “yes” they are or “no” they are not is simply an incorrect view which, of necessity, is either under or over inclusive and, in the end lacks meaning. This means, according to Petitioners, that “[t]he bottom line is that ‘[t]he fraud-on-the-market . . . cause of action just doesn’t work. At least that is the consensus view among academics respecting the primary class action vehicle under federal securities laws.’”
Third, Basic is out of step with the Court’s recent decisions regarding class actions. The Court has insisted on actual, not presumed conformance with the requirements of Rule 23. “Basic flouts this principle by presuming common reliance in the face of near-certain falsity.” Indeed, in its recent Wal-Mart decision [Wal-Mart Stores, Inc v. Dukes, 131 S.Ct. 2541 (2011) the “Court required a punitive class to ‘affirmatively demonstrate . . . compliance’ with Rule 23, and thereby ‘prove’ . . . in fact” that the issues were common.” Comcast [Comcast Corp. v. Behrend, 133 S.Ct. 1426 (2013)] reinforced this point. YetBasic reduces “predominance ‘to a nullity’” with its presumption.
Fourth a series of policy points supports overruling Basic. Those include the fact that securities class actions force settlement without regard to the merits; those actions poorly compensate investors; they do not deter culpable parties; they consume excessive judicial resources; and DOJ and SEC enforcement actions provide superior deterrence and compensation. Collectively these points, when coupled with the text of Section 18(a), scholar ship on markets and the Court’s recent class action jurisprudence, compel the conclusion that Basic is an accidental anachronism of the ‘ancient regime,’ in which the Court created and expanded causes of actions ‘to provide such remedies as are necessary to make effective the congressional purpose.’” [citations omitted]. That “regime” has passed according to Petitioners. Basic should be overruled.
Alternatively, if the presumption is to be retained, it should be modified to require plaintiffs to prove that the alleged misrepresentations impacted price. The predicate of Basic and its presumption is the claim that investors rely on the market price which reflects the misrepresentation. In view of that premise plaintiffs should be required to establish price impact to rely on the presumption.
Amicus briefs: A number of amicus briefs were filed in support of Petitioners. One was filed by Former SEC Commissioners and Officials and Law Professors. The former Commissioners included Paul Atkins, Edward Fleishman, Laura Unger and Joseph Grundfest. The professors included Stephen Bainbridge, Richard Painter and Jonathan Macey. This brief argued that the Court that it “need not wade into the complex and highly technical debate over the efficient markets hypothesis to answer the question here.” Rather, following its traditional approach for crafting elements to an implied cause of action it should look to Exchange Act Section 18(a), the most analogous provision. This is because it is the “only express right of action in existence in 1934 that authorizes damages actions for misrepresentations or omissions that affect secondary, aftermarket trading. It is the only express right that provides a cause of action for damages in favor of open-market purchasers and sellers against those . . . who allegedly made false or misleading statements, but did not transaction with the plaintiffs – the quintessential Section 10(b) class claim today.” In that Section Congress expressly required that reliance be established. Indeed, during the legislative debates a draft bill that did not require reliance was rejected.
The Securities Industry and Financial Markets Association also filed an amicus brief supporting Petitioners. Those organizations argued that Basic should be overruled, eschewing the alternative position advocated by Petitioners. SinceBasic was decided a parade of horribles has resulted. Those include the fact that the economic theories on which the decision is based have been “debunked;” the expansion of securities fraud class actions has resulted in large judgments which, in the end, are paid by shareholders; and there is confusion in the courts as to how, if at all, the presumption can be rebutted.
“Defendants, faced with massive potential exposures and the distraction of lengthy and costly litigation, frequently are constrained to submit to in terrorem settlements. Moreover, there is little evidence that providing securities plaintiffs with a virtual free pass to certify a class has had a deterrent effect on misconduct by publicly traded companies, improved the quality of corporate disclosure, or resulted in meaningful recoveries that actually benefit investors in the aggregate, as opposed to their lawyers.” To resolve these issues Basic should be overruled. While the alternative suggested by Petitioners would be preferable to the status quo, “it lacks a sound economic basis,” the two organizations told the Court.