A recent petition to the Supreme Court of the United States could fundamentally change securities class action litigation in the US, and encourage practitioners to reflect on the way securities class actions are argued in Australia.

The Supreme Court of the United States (Supreme Court) has recently heard a petition in Halliburton Co. v. Erica P. John Fund, Inc that has fundamentally challenged the economic theory that has shaped securities class actions in the US for the last 30 years. The Supreme Court’s consideration of proving causation and reliance in class actions may provide crucial guidance on the application of statutory provisions on misleading and deceptive conduct to securities class actions in Australia.

The proceedings

The proceedings were commenced against Halliburton Company and its CEO, President and Chairman of its Board (Halliburton) by the Erica P. John Fund (Fund), a class of shareholders who alleged that they suffered material losses as a result of fraudulent misrepresentations made by Halliburton. The alleged misrepresentations related to Halliburton’s asbestos litigation liability, construction contract revenue and benefits from a merger.

Securities class actions in the US are based on a “securities fraud cause of action” derived from Rule 10b-5 of the Securities and Exchange Commission Rules and Regulations (SEC Rule 10b-5).  An essential element of this cause of action is proof that the applicants relied on the misrepresentation. 

Proof of reliance usually becomes an issue at the very start of the proceedings, when the class applicants must apply for a certification order (class certification) and prove that common questions of law or fact predominate in the class.[1]

In September 2007 the Fund sought to certify a class of all persons who purchased shares in the class period.  The Fund relied on the seminal US decision of Basic Inc. v Levinson [2] to prove that all members of the class relied on the misrepresentation. In Basic the Supreme Court adopted a rebuttable presumption of reliance based on “fraud on the market” theory which posits that an efficient market will incorporate all available information (including misleading information) into the price of stock. An investor who purchases stock does so in reliance on the market, so (assuming that the market is efficient) reliance on the misrepresentation is presumed. 

This theory assumes that the misrepresentation is public and material, and that the market in which the securities were traded is efficient. The presumption of reliance can be rebutted by disproving any of those elements, although the extent to which the presumption could be rebutted at class certification was contentious.

Halliburton sought to rebut this presumption on basis that the misrepresentation was not material enough to cause the decline in stock price. The Fund argued that Halliburton was not entitled to raise this issue at the class certification stage.  In 2011 the dispute reached the Supreme Court, where the Fund was successful.[3] 

When the matter returned to the District Court and then the Fifth Circuit, Halliburton unsuccessfully attempted to rebut the presumption of reliance again, this time by showing an absence of price impact.  In 2013 Halliburton appealed to the Supreme Court. In doing so it took advantage of growing scepticism of the economic theories underpinning fraud on the market theory to agitate for change.

The arguments

On 9 September 2013 Halliburton filed a writ of certiorari in the Supreme Court (Petition).  One of the two questions posed by the Petition was whether the Supreme Court should “overrule or substantially modify the holding of Basic Inc v Levinson...to the extent that it recognizes a presumption of class-wide reliance derived from fraud-on-the-market theory”. [4] 

Halliburton asked the Supreme Court to re-consider the Basic decision on the basis that the assumptions that underpin the fraud on the market theory had been “almost universally repudiated” and that scholars of economic theory had discredited the central economic premise of the fraud on the market theory, namely that: [5]

  1. an efficient market accurately reflects all public material misrepresentations; and
  2. an investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price.

In response, the Fund defended Basic on the basis that it was “common sense” and argued that it should be upheld on policy grounds.[6] 

Event studies as a compromise

Interestingly, amicus briefs filed by third parties argued that, rather than establishing overall market efficiency, the most effective way to prove reliance would be to demonstrate that the alleged misrepresentation had a statistically significant effect on stock price. [7] The Supreme Court took particular interest in a suggestion that it should prescribe the use of event studies to prove reliance.

An event study is a regression analysis that measures the effect of a specific event on a company’s stock price (controlling for other causes of stock price movements, such as the movement of the overall market). Event studies have been used in several Australian securities class actions to establish the materiality of the alleged misleading and deceptive conduct and to prove loss.[8]  

Watch this space

Crucial differences between SEC Rule 10b-5 and Australian misleading and deceptive conduct laws have prevented the adoption of fraud on the market theory in Australia. Other Commonwealth jurisdictions, such as Canada, have rejected fraud on the market theory.[9]

Notwithstanding, the decision in Basic was prompted, in part, by the logistical difficulty of proving individual reliance by each member of a class and the view that this would be an unrealistic evidentiary burden on class applicants. This concern is equally applicable to Australian class actions. Consequently, class action applicants have sought to avoid this difficulty by relying on some form of market based indirect causation theory to prove causation.[10] 

Like the fraud on the market theory, the indirect causation theory assumes that the market is efficient. However, unlike fraud on the market theory, the indirect causation theory adopted by some plaintiff lawyers holds that the inflated share price at the time of purchase alone is sufficient to prove causation.

The adoption of market based causation theory along with the use of event studies in Australian shareholder class actions suggests that Halliburton v EPJ Fund is potentially relevant to shareholder class actions, particularly if the Supreme Court:

  1. considers the effectiveness of market based causation theory generally;
  2. provides legal analysis and appraisal of recent economic theories (including event studies); and
  3. modifies the legal principles established by Basic Inc. v Levinson into a form that could be applied in Australian shareholder class actions.

A decision is expected in June or July 2014.