On June 6, 2011, the United States Supreme Court unanimously reversed the Fifth Circuit's decision requiring securities fraud plaintiffs to prove loss causation to obtain class certification.
Petitioner, Erica P. John Fund, Inc. (EPJ Fund) is the lead plaintiff in a putative securities fraud class action filed against Halliburton and one of its executives. EPJ Fund alleged that Halliburton had made false statements that artificially inflated its stock price, in violation of Section 10(b) and Rule 10b-5. According to EPJ Fund, the corrective disclosures that Halliburton later released caused its stock price to drop and thereby resulted in losses to investors.
After the district court denied Halliburton's motion to dismiss, EPJ Fund sought class certification. The district court declined to certify the class because EPJ Fund had failed to establish loss causation. The Fifth Circuit affirmed the district court's denial of class certification, confirming that "[i]n order to obtain class certification on its claims, [EPJ Fund] was required to prove loss causation, i.e., that the corrected truth of the former falsehoods actually caused the stock price to fall and resulted in the losses."
The Fifth Circuit's requirement that securities fraud plaintiffs prove loss causation to obtain class certification had been in conflict with the law of the Second, Third and Seventh Circuits, none of which require such proof at the class certification stage. The Supreme Court granted certiorari to resolve this split.
Basic Inc. v. Levinson and the Fraud-on-the-Market Presumption
The Supreme Court overturned the Fifth Circuit's decision, holding that securities fraud plaintiffs need not prove loss causation to obtain class certification.
The Supreme Court noted that to obtain class certification under Federal Rule of Civil Procedure 23(b)(3), the plaintiff must demonstrate that, among other things, "questions of law or fact common to the class members predominate." The Court wrote that whether common questions of law or fact predominate begins with consideration of the elements of a private securities fraud claim pursuant to Section 10(b) and Rule 10b-5, but often turns on the element of reliance.
With reliance, the Supreme Court explained that its 1988 ruling in Basic Inc. v. Levinson permitted plaintiffs to invoke a rebuttable presumption of reliance based on the fraud-on-the-market theory, which proposes that: "the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations." Accordingly, it may be assumed that an investor relies on public misstatements whenever he "buys or sells stock at the price set by the market."
Typically, plaintiffs establish a rebuttable presumption of reliance by demonstrating that the alleged misrepresentations were publicly known; that the stock traded on an efficient market; and that the relevant transaction occurred between the time the misrepresentations were made and the truth was disclosed. The Fifth Circuit, however, required EPJ Fund to also prove loss causation at the class certification stage in order to trigger the fraud-on-the-market presumption of reliance. The Supreme Court disagreed, stating: "The Court of Appeals' requirement is not justified by Basic or its logic." The Supreme Court noted that it has "never before mentioned loss causation as a precondition for invoking Basic's rebuttable presumption of reliance."
Loss Causation is Logically Distinct from Reliance
The Supreme Court explained that the fundamental premise of Basic was that a plaintiff's reliance on a misrepresentation is presumed "so long as it was reflected in the market price at the time of his transaction." Loss causation is different. According to the Supreme Court, loss causation looks to whether an alleged misrepresentation caused a subsequent economic loss. Whether factors other than correction of a misrepresentation caused the drop in stock price "has nothing to do with whether an investor relied on the misrepresentation in the first place." Indeed, "[l]oss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory." Accordingly, while loss causation must be proved by securities fraud plaintiffs at trial, it need not be at the class certification stage of the case.