The U.S. Supreme Court heard oral argument on November 5, 2012, to determine the issue of whether a court should decide the issue of materiality in an SEC Rule 10b-5 misrepresentation case, before certifying a plaintiff class based on the fraud-on-the-market theory — and if so, whether the court should then allow the defendant to present evidence rebutting the presumption of the theory before certifying the class. At oral argument, the petitioner stressed the importance of gate-keeping the materiality issue at the class-certification stage and was pressed by the court to distinguish it from the merits-based analysis conducted at the trial and summary judgment stage. Although the petitioner maintained that a finding at the class-certification stage was not determinative upon the later stages of the trial, many of the justices seemed unconvinced.
The case before the Court came from the Ninth Circuit Court of Appeals, which affirmed the lower district court’s ruling. That ruling held that “materiality was a factual issue" and “not necessary to ensure that the question of reliance is common among all prospective class members’ securities fraud claims . . . plaintiffs need not prove materiality to avail themselves of the fraud-on-the-market presumption of reliance at the class certification stage.” 660 F.3d 1170, 1177 (9th Cir. 2011).
The fraud-on-the-market presumption was first established by the Supreme Court in Basic, Inc. v. Levinson, 485 U.S. 224, 248 (1988), as a way to prove reliance, the requisite causal link between the defendant’s misrepresentation and the plaintiffs’ loss. According to the theory, anyone who buys stock at the prevailing market price is presumed (though the presumption is rebuttable) to have relied on that price, which is a reflection of available information in the marketplace, and thus the theory establishes the causal link to establish reliance on the defendant’s misrepresentation. To invoke the theory at trial, plaintiffs must prove that the defendant public made a material misrepresentation about stock traded in an efficient market. If the misrepresentation is immaterial, the fraud-on-the-market theory does not apply, because the misrepresentation would not have affected the stock price. The Court entertained argument as to whether the issue of materiality should be decided at the class certification stage.
At oral argument, Justice Antonin Scalia stressed the potential importance of a dismissal for lack of materiality at the class-certification stage, noting “the enormous pressure to settle once the class is certified,” which in many instances is effectively “the end of the lawsuit.” The government, arguing in support of the respondent, emphasized that the purpose of Rule 23 was to determine whether common issues predominated over individual ones — and as such the issue of materiality, which both sides seem to concede was indeed a “common issue” — need not be determined at the class certification stage. Justices Elena Kagan, Stephen Breyer and Ruth Bader Ginsberg further questioned whether a rational fact-finder or judge could, employing the same test, decide the issue of materiality different than the prior finding at the class certification stage. Justices Anthony Kennedy and Scalia, moreover, questioned whether Basic should be overruled in light of its endorsement of the fraud-on-the-market theory, which, if applied at the class certification stage, would either result in circular reasoning or an over-generalization of economic theory.
Requiring plaintiffs to prove materiality to allege reliance through the fraud-on-the-market theory would certainly further Congress’ intent in passing the PSLRA by creating a heightened bar to gain class status when alleging fraud claims. And it would not, as the petitioner argued, prevent plaintiffs from later individually proving some other form of reliance absent the fraud-on-the-market theory. All in all, it appears the Court might give weight to the respondent; also, to the government’s argument that materiality is an issue that should be assumed at the class certification stage and wait to be tried at the summary judgment or trial stage, thus affirming the Ninth Circuit’s prior holding.