On June 6, 2011, the United States Supreme Court, in a unanimous opinion authored by Chief Justice John Roberts, narrowly held that plaintiffs need not show loss causation to certify a class in Section 10(b) securities fraud class actions. This decision endorses the majority position adopted by the Second, Third and Seventh Circuits and reverses the position previously held by the Fifth Circuit.
Circuit Split: Background
Basic v. Levinson: The Fraud-On-The-Market Doctrine
Class certification under Rule 23(b)(3) requires a showing that questions of law or fact common to the class predominate over individual questions. In Section 10(b) cases, this has meant that plaintiffs must prove that the elements of the claim — "(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation" — can be established by common proof.1
In Basic Inc. v. Levinson2, the Supreme Court recognized that there would be an "unnecessarily unrealistic evidentiary burden" placed on plaintiffs in Section 10(b) securities fraud class actions to satisfy the predominance requirement if each member of the proposed class had to prove reliance.3 The Supreme Court consequently allowed securities fraud plaintiffs to establish a rebuttable presumption of reliance under the "fraud-on-the-market" doctrine. The fraud-on-the-market (FOTM) doctrine presumes that public information is reflected in the price of a stock traded on a well-developed market, thereby enabling investors to rely on the integrity of the market price when determining whether to buy or sell a security. Accordingly, under the doctrine, investors need not show that they actually relied on the misstatements in order to recover damages. To invoke the FOTM doctrine and thereby establish a rebuttable presumption of reliance, plaintiffs need to demonstrate, for example, that: (1) the alleged misrepresentations were publicly known; (2) the stock traded in an efficient market and (3) the relevant transaction occurred between the time the misrepresentations were made and the time the truth was revealed.4
But the Supreme Court in Basic also held that defendants may rebut the FOTM presumption by "show[ing] that the misrepresentation in fact did not lead to a distortion of price[.]"5 The Court noted that "[a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price" will rebut the FOTM presumption.6
The Circuit Split: Need Plaintiffs Prove Loss Causation to Be Entitled to the FOTM Presumption?
While setting the above guidelines, the Supreme Court in Basic did not outline specific procedural and substantive rules for applying the FOTM doctrine. As a result, a circuit split developed as to whether securities fraud plaintiffs must also establish loss causation to benefit from this presumption at the class certification stage:
- Fifth Circuit: The Fifth Circuit, in Oscar Private Equity Investments v. Allegiance Telecom, Inc.,7 interpreted the FOTM doctrine as requiring plaintiffs to affirmatively establish loss causation at the class certification stage.8
- Seventh Circuit: The Seventh Circuit, in Schleicher v. Wendt,9 rejected the Fifth Circuit’s approach. The court held that, in an efficient market, "each investor’s loss usually can be established mechanically, common questions predominate and class certification is routine, if a suitable representative steps forward."10
- Second and Third Circuits: Both the Second and Third Circuits have adopted approaches that do not require plaintiffs to establish loss causation in order to invoke the presumption of reliance, but do allow defendants to rebut this presumption prior to class certification by, among other things, showing that the market price for the security was not affected by the alleged misrepresentation.11
Factual and Procedural Background
In Halliburton, a group of plaintiffs claimed that Halliburton violated Rule 10b-5 when it made various material misrepresentations concerning (1) the expense of asbestos litigation (2) changes to the accounting methodology used by Halliburton and the effect of those changes on earnings and (3) the benefits of Halliburton’s merger with Dresser Industries.12 Plaintiffs claimed that they suffered losses when the company corrected these misrepresentations, leading to a statistically significant decline in the price of the company’s stock.13
Plaintiffs survived a motion to dismiss, but the district court subsequently denied their motion for class certification on the basis that plaintiffs had failed to establish loss causation at the class certification stage, as required by the Fifth Circuit in Oscar.14
The Fifth Circuit upheld the district court’s denial of class certification, reaffirming Oscar’s requirement that securities fraud plaintiffs in the Fifth Circuit must establish loss causation in order to trigger the Basic FOTM presumption of reliance.15 The Supreme Court granted certiorari to resolve the circuit split.16
The Supreme Court unanimously reversed the Fifth Circuit by deciding that securities fraud plaintiffs need not establish loss causation at the class certification stage as a precondition for invoking the rebuttable FOTM presumption. In doing so, the Supreme Court noted that requiring plaintiffs to show that a public misrepresentation caused subsequent economic loss "contravenes Basic’s fundamental premise" and has "no logical connection" to whether an investor relied on such a misrepresentation when buying or selling a company’s stock.17
Notably, Halliburton conceded that securities fraud plaintiffs need not prove loss causation to apply Basic’s presumption of reliance or otherwise achieve class certification.18 Halliburton then argued that the Fifth Circuit had not actually required that plaintiffs show loss causation, but rather that they show "price impact" (i.e., whether the alleged misrepresentations affected the market price in the first place).19 The Court found this to be a "wishful interpretation" without merit, given that the Fifth Circuit had explicitly and repeatedly referred to the distinct concept of "loss causation," not "price impact."20
In vacating and remanding the Fifth Circuit’s judgment, the Supreme Court observed that because it had reversed the Fifth Circuit’s loss causation requirement for class certification, it need not address other issues raised regarding "Basic, its presumption, or how and when it may be rebutted."21 Halliburton thus remains free to pursue these other arguments against class certification when the Fifth Circuit hears the case on remand.
Likely Impact of Halliburton
Circuit Split Resolved
The Halliburton decision resolves the circuit split regarding the issue of whether Section 10(b) plaintiffs must prove loss causation at the class certification stage. The immediate impact of the opinion is limited to the Fifth Circuit — the only court to have held that plaintiffs must affirmatively prove loss causation to be entitled to Basic’s FOTM presumption. Beyond the Fifth Circuit, it is difficult to predict how great an impact this decision will have, particularly given that the Fifth Circuit does not decide a great number of securities class action lawsuits. Moreover, as noted above, the Second, Third and Seventh Circuits — which historically have been popular destinations for securities cases — have already rejected the Fifth Circuit’s loss causation requirement.
Defendants May Still Attempt to Rebut the FOTM Presumption at the Class Certification Stage With Price-Impact Evidence
The impact of the Halliburton decision is further limited because the Court only decided the narrow issue of whether plaintiffs must prove loss causation to, in turn, prove class certification. The opinion does not address what showings by defendants may rebut the FOTM presumption at the class certification stage.
Halliburton argued that if it was not the plaintiffs’ burden to establish price impact, evidence of a lack of price impact was sufficient to rebut the Basic presumption of reliance.22 In this case, Halliburton argued both that "Halliburton’s stock price did not react to any of the alleged misrepresentations when made," and that "none of the price declines on which the [Plaintiff] relies were attributable to disclosures that corrected the truth of any previous misrepresentation."23 Halliburton argued that, without either of these price movements, it would be impossible for Plaintiffs to claim that the misrepresentation was reflected in the stock’s price, undermining the entire foundation of the FOTM theory.
Although the Supreme Court did not directly address this argument in Halliburton, there is language from the opinion at least suggesting that "front-end" price impact — i.e., a material price increase when the misstatement is made — is required for the FOTM presumption to apply.24
Notably, Halliburton’s position on rebutting the FOTM presumption is consistent with the view adopted by both the Second and Third Circuits, which recognize that evidence showing an absence of price impact can rebut the FOTM presumption.25
And while the Seventh Circuit suggested in Schleicher that showing the absence of price impact was more of a merits inquiry that should be considered after class certification, it has not expressly specified a standard for rebuttal of the Basic presumption of reliance.26
Thus, while the Halliburton opinion confirms the prevailing view that securities fraud plaintiffs are not required to affirmatively establish loss causation at the class certification stage, it does not foreclose defendants from attempting to rebut the FOTM presumption of reliance by presenting evidence that the purported misrepresentations did not affect the price of the stock.
Unclear Whether Lack of "Back-End" Price Movement Will Rebut FOTM Presumption
The court in Halliburton was clear that loss causation is a "distinct concept" from reliance, and that loss causation need not be established by plaintiffs at the class certification stage.27 However, the court expressly did not decide whether price-impact evidence similar to that used in a loss causation analysis could be used to rebut the FOTM presumption.28 In other words, the Supreme Court did not discuss whether a showing by defendants at the class certification stage of an absence of "back-end" movement — i.e., no stock-price decline caused by the revelation of "truth" — could rebut the FOTM presumption.
Notably, the Third Circuit and district courts in the Second Circuit have held that lack of "back-end" price movement may rebut the presumption of reliance.29 The argument simply is that, if there is no "back-end" drop in stock price caused by the revelation of the truth, any "front-end" price increase at the time of the misstatement must have been caused by something other than the alleged misstatement.30
While the Supreme Court unequivocally rejected the Fifth Circuit’s rule that Section 10(b) plaintiffs must prove loss causation at the class certification stage, it left open a number of other issues relevant to the FOTM analysis, including how defendants may rebut the FOTM presumption. By leaving open these issues, and consistent with precedent from a number of other courts, defendants may continue to argue that the absence of price impact rebuts the presumption.