The United States Supreme Court recently issued its opinion in Amgen Inc. v. Connecticut Retirement Plans & Trust Funds, No. 11-1085, regarding the use of the fraud-on-the-market theory to prove reliance and its impact on class certification. Grounding its ruling in Rule 23, the Court refused to require proof of materiality (akin to the proof required at summary judgment or trial) at the class-certification stage. Some reports have the defense bar “reeling” after the Court’s decision; such a suggestion goes too far. While the decision may be unfavorable to defendants, it does not make defending class-action securities fraud lawsuits more difficult than before Amgen. After all, the majority of federal circuits were already in line with the Court’s ruling. Rather, Amgen underscores the need for strong Rule 12 and Rule 23 motions, and foreshadows a future challenge to the fraud-on-the-market theory.
Section 10(b), Rule 10b-5, and “Fraud on the Market”
At issue in Amgen was the intersection of the procedural requirements of Rule 23 and the substantive element of “materiality,” which is encompassed in the fraud-on-the-market theory and is an essential element of securities-fraud claims under Section 10(b) of the 1934 Act and Rule 10b-5. Securities fraud claims have six elements:
- a material misstatement or omission;
- the misrepresentation or omission is connected to the purchase or sale of a security;
- reliance on the misrepresentation or omission, i.e., that a stock transaction was caused by the alleged misstatement or omission;
- economic loss; and
- loss causation.
The fraud-on-the-market theory, established in Basic Inc. v. Levinson in 1988, hypothesizes that, in an efficient market, the price of a security reflects all material, publicly available information. After Basic, class-action plaintiffs use the fraud-on-the-market theory to satisfy the substantive element of reliance in Section 10(b) and Rule 10b-5 claims.
To employ the fraud-on-the-market theory a plaintiff must show that the following elements are present:
- an efficient market;
- a public statement;
- the stock was traded after the statement or omission was made, but before the truth came to light; and
- the statement was material, such that the market price of the stock would respond to the revealed truth.
Securities-fraud claims and the fraud-on-the-market theory overlap: both require that the defendant make a material misrepresentation or omission. This overlap caused considerable tension in the Court’s decision.
Background of the Amgen Lawsuit
The Connecticut Retirement Plan and Trust Funds (Plan) sued Amgen and several of its officers for violations of Section 10(b) and Rule 10b-5. The Plan alleged that Amgen made misrepresentations or omissions about two of its “flagship drugs,” which inflated the stock price. When the truth came to light, the stock price fell. The Plan relied on the fraud-on-the-market theory to establish investors’ reliance. When the Plan moved to certify the class, Amgen argued that the Plan’s motion should be denied. Specifically, Amgen contended that the Plan could not prove that the fraud-on-the-market theory applied to this case to establish reliance. Further, Amgen argued that individual issues of reliance would predominate over common questions and a class action was inappropriate.
The District Court rejected Amgen’s argument and certified the class, ruling that the Plan was not required to prove materiality to prevail on its motion for class certification. Instead, the Plan had to show that reliance was a common question that predominated over other individual questions. The Ninth Circuit affirmed, siding with several other circuits on the issue. The Supreme Court resolved the circuit split by affirming the Ninth Circuit. Although the Court acknowledged that the merits of the Plan’s securities-fraud claim was marginally relevant to class certification, it was only relevant to the extent it informed class certification questions. The dissenters argued that proof of materiality should be mandatory for class certification.
The Supreme Court’s Ruling and Dissents
The Court analyzed the interaction of Rule 23, fraud on the market, and the Section 10(b) or Rule 10b-5 claims. It held that Amgen’s argument was untenable because it reached too far into the merits analysis of the securities-fraud claims and could have the “unwanted” effect of terminating all litigation arising out of the alleged misstatements. This, the Court held, was not the purpose of Rule 23, which was to decide the proper vehicle for the litigation, not to pass upon the merits of the underlying claims.
First, the Court addressed the element of materiality. Materiality is an objective inquiry: would the misstatement or omission have a significant effect on a “reasonable investor”? If yes, the misstatement or omission is material, and the case moves forward to the next stage.
Second, the Court acknowledged that materiality is a factor that overlaps the fraud-on-the-market theory and securities-fraud claims. In fact, for both doctrines, proof of materiality is essential. To establish fraud on the market (and, ultimately, reliance), the plaintiff must show that a material statement or omission influenced the market price of a security. If the plaintiff cannot show a statement was material, she cannot establish the fraud on the market; without fraud on the market, the plaintiff cannot establish reliance as part of her securities-fraud claim. Similarly, if the plaintiff fails to show that a misrepresentation or omission is material, his securities-fraud claim fails for lack of proof on the materiality element. This overlap concerned the Court when it turned to Rule 23.
Based on these premises, the Court addressed Rule 23—the crux of this case. If a purported class representative was required to prove fraud-on-the-market theory, and specifically that a misstatement or omission was material at the class-certification stage and failed, then the entire case—class claims and individual claims—could be defeated. The Court reasoned that this result, promoted by Amgen, would permit defendants to obtain a ruling on the merits at class certification. The Court concluded that the focus of a Rule 23 motion is not the merits of claim, although they will be touched upon; Rule 23 motions are only used to determine whether “questions of law or fact common to class members predominate over any questions affecting only individual members...”; i.e., whether a class action is an appropriate vehicle for the case.
The dissenters feared that the Court’s opinion would let defective cases slip through the cracks. Justice Thomas, penning the principal dissent, wrote, “to prove that reliance is a common question, [the plaintiff] must establish the entire presumption” of the fraud-on-the-market theory, including materiality. Essentially, fraud-on-the-market theory is a “condition precedent” to establishing that reliance is a common question among class members. As such, the dissenters saw no problem if claims were terminated on their merits, even at class certification.
What Amgen Means for the Fraud-on-the-Market Theory
For many practitioners, Amgen will mean very little, since the Court resolved a circuit split in favor of an already existing rule. For other practitioners, and the rest of the defense bar, the importance of a strong Rule 12 motion cannot be understated. It is the first line of defense in attacking a putative class action on the plausability of the allegations, especially on materiality. Given the Court’s analysis and the overlap of the materiality requirement, proof that an alleged misrepresentation or omission is material serves a dual purpose for cases where the fraud-on-the-market theory is in play: it is an opportunity to "knock out" both the materiality and reliance elements of the securities-fraud claims.
Even if Amgen is a defeat on the narrow issue presented, it contains hints of an opening for the defense of securities class action. The Court hinted that the fraud-on-the-market theory may be more vulnerable on its first prong: market efficiency. Footnotes in the majority and dissenting opinions acknowledge that recent economic research suggests that market efficiency is not a simple “yes or no” question. The market does not necessarily treat all information the same, nor do all sectors of a given market process information equally. Research tends to show that the market efficiency question is up for debate and that future plaintiffs relying on the fraud-on-the-market theory may be vulnerable on that element.
A thorough response to a securities fraud class-action suit should exploit this crack in Basic’s façade. The Court may have taken away one weapon to defeat Section 10(b) and Rule 10b-5 class-action suits, but it appears to have left the door to the armory open.