The USSC Revisits the Fraud-on-the-Market Principle: Halliburton Co v Erica P John Fund
Last Wednesday, the United States Supreme Court heard oral arguments for Halliburton Co v Erica P. John Fund, thereby revisiting the contentious “fraud-on-the-market” principle adopted in the 1988 case of Basic Inc v Levinson, 485 US 224 (1988). The principle works as follows: open and developed securities markets are efficient and all relevant information about a particular security is reflected in its price; investors buy these securities relying on the integrity of this price; material misstatements made by the issuer distort this price; and therefore, investors can be deemed to have relied on the misstatement because they relied on the price.
Undoubtedly, this is something of a legal fiction, as markets do not always incorporate relevant information in real time and investors buy securities for any number of reasons—often precisely because they believe the market is not accurately valuing a security. However, fraud-on-the-market is an indispensable construct in certifying securities fraud classes in the United States and there are significant consequences to overruling it.
Section 10(b) of Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder, allows the government to prosecute securities fraud. While the Act does not explicitly provide for an analogous private right of action, courts have held that such a right is implicit (Superintendent of Ins v Bankers Life & Casualty Co, 404 US 6 (1971)).
Cases brought under Section 10(b) require: (1) a material misrepresentation or omission by the defendant; (2) that the misrepresentation was made knowingly; (3) a connection between the misrepresentation and the purchase or sale of the security; (4) reliance upon the misrepresentation; (5) economic loss; and (6) loss causation. Before Basic, securities fraud class actions were difficult to bring as each individual had to prove actual reliance on the material misstatement in question. This made certification under Rule 23 of the Federal Rules of Civil Procedure untenable because individual questions of investor reliance outweighed the common, class-wide issues.
In Basic, the Supreme Court held that a requirement of actual reliance placed too great an evidentiary burden on plaintiffs. The fraud-on-the-market doctrine, which is the analogue to our own recently enacted “deemed reliance provisions” for primary- and secondary-market misrepresentations under the Ontario Securities Act, allows plaintiffs to sidestep this hurdle. Accordingly, under the doctrine, investors need only show 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 when the truth was revealed (the class period). As set out in the jurisprudence since Basic, the second requirement will almost always be satisfied when the securities were traded on a major exchange like the NYSE. Defendants may rebut this presumption by showing that the misrepresentations did not in fact cause the distortion in price.
Prior to the enactment of the Ontario deemed reliance provisions, plaintiffs had tried unsuccessfully to import the principle north of the border. In Carom et al v Bre-X Minerals Ltd et al (1998), 41 OR (3d) 780, Justice Winkler flatly rejected the applicability of the fraud-on-the-market principle in Ontario on the basis that it was developed specifically for the Section 10(b) cause of action and because the predominance of common issues requirement under Rule 23 was never incorporated into the Ontario Class Proceedings Act. Ontario, having a functional legislature, therefore opted to address the matter by amending the Securities Act.
Halliburton & Amgen
The facts in Halliburton are unremarkable: Class plaintiffs brought an action against the company and its CEOs, alleging that it had misrepresented its liability in asbestos litigation, construction revenue projections, and benefits expected to flow from a merger. Shareholders who bought common stock during the class period suffered damage when Halliburton’s share price declined in light of these revelations. The significance of Halliburton only really became clear once the Court’s decision in Amgen Inc v Connecticut Retirement Plans & Trust Funds, 133 S Ct 1184 (2013), was released.
Writing for the majority in this case, Justice Ginsburg held that securities fraud class action plaintiffs do not need to prove the materiality of the alleged misstatements in order to be certified. However, a quartet of dissenters (Justices Scalia, Kennedy, Thomas, and Alito) noted that Amgen did not uphold the fraud-on-the-market theory and expressed their willingness to revisit the legal and economic foundations of the doctrine.
The Economic and Legal Foundations of Fraud-on-the-Market
On Wednesday, counsel for Halliburton asked the Court to overrule Basic on the basis that it substituted “economic theory for the bedrock common law requirement of actual reliance” and because the presumption “preserves an unjustified exemption from Rule 23 that benefits only securities plaintiffs” (6). In making this argument, counsel for Halliburton touched on the two main streams of criticism with respect to fraud-on-the-market: (1) the principle is based on questionable economic premises that ought not to form the foundation of a legal doctrine; and (2) as a legal doctrine, this presumption gives rise to an unfair and unjustified allocation of procedural rights.
The economic argument against the Basic presumption is that people buy and sell stocks for any number of reasons and few are naïve enough to believe that the price is “correct” or that it accurately reflects all relevant information. Counsel for Halliburton seized on this criticism in oral arguments, stating that this already-shaky presumption is all the more absurd in light of the rise of institutional value investors whose “investment strategies…do not rely on the integrity of the market price whatsoever” (7). The economic impact of the doctrine in practice was similarly attacked for hurting the very investors Section 10(b) was designed to protect. Because, the argument goes, large institutional frequency traders buy and sell shares so often, they tend to be overrepresented in the class, whereas small investors tend to hold onto their shares and, therefore, are left holding the damages bill in the aftermath (55).
Arguing as amicus curiae, counsel for the SEC conceded that while many investors “have devised a wide array of strategies in an effort to beat the market…it’s hard to imagine one that would render irrelevant evidence that the market price had been distorted by fraud” (42). In other words, even when an investor thinks they’ve outsmarted the market (and are therefore not relying on the integrity of the price), they suffer when the price is further distorted by unknown factors.
Justice Kagan was willing to defend the basic premise of the efficient market principle, stating that nobody “contested [the fact] that market prices generally respond to new material information” and counsel for Halliburton was forced to concede that, at a very general level, this rationale is sound. The Chief Justice positioned himself somewhere in the middle of this debate, pointing out that both parties acknowledge that the efficient market theory is generally sound and characterizing their dispute as being at the margins of its application.
Another common criticism of the fraud-on-the-market principle is that it grants a procedural right to securities class action plaintiffs that is unavailable to other class action claimants. Similarly, it allows groups of plaintiffs to benefit from procedural rights that they would otherwise not have had as individuals. In other words, if they were required to bring this case as individuals, they would have to prove individual reliance, but because they are a group they are subject to a much lower evidentiary threshold. It could be argued that harm of this nature only materializes when it is done within the context of a group (as the share price can only be distorted by a group of shareholders being materially misled) and that this justifies creating a separate legal doctrine to govern securities class actions. Nevertheless, it is hard to argue that, in practice, the fraud-on-the-market presumption does not stack the deck in the plaintiffs’ favour.
Justice Alito, for instance, pointed to the very low success rates of defendants in rebutting the presumption once established (8). Further, Justice Scalia asked pointedly what percentage of cases continue once the class has been certified shortly before answering his own query with: “Very few. Once you get the class certified, the case is over, right?” (23). Counsel for Halliburton similarly pointed to a joint Stanford/NERA study showing that 75 per cent of securities fraud class action claims are successfully certified.
Counsel for the Erica P John Fund countered by arguing that summary judgment acts as a filter for unmeritorious claims, even in a plaintiff-friendly certification regime. Nevertheless, counsel for Halliburton was quick to respond that only 7 per cent of claims reach the summary judgment stage “because once the case gets passed class certification, as this Court has recognized time and time again, there is an in terrorem effect that requires defendants to settle even meritless claims” (51).
A “midway” position, suggested by a group of law professors who submitted amicus briefs, was discussed as an alternative to overruling Basic in its entirety. Under this approach, plaintiffs seeking certification could still rely on the fraud-on-the-market presumption so long as they conduct an “event study” showing that the misrepresentations actually distorted the market price. Justice Sotomayor was critical of this proposal, arguing that it would turn “class certification into a full-blown merits hearing on whether loss causation has been proven” (19). However, the idea appeared to gain traction with Justice Kennedy. One possibility is that the Court, fearing the consequences of overruling Basic in its entirety, retreat to this middle position and marginally raise the hurdle for class plaintiffs seeking certification.
Since Basic, the Court has moved to curtail the growth of securities fraud class action suits and construe the Section 10(b) cause of action narrowly. For instance, the Court rejected attempts to expand the list of possible defendants to “aiders and abettors” in Central Bank of Denver v First Interstate Bank of Denver, 511 US 164 (1994), and recently held that US securities laws do not apply to purchases or sales of securities outside the US in Morrison v National Australia Bank Ltd., 130 S Ct 2869 (2010). However, there is a difference between curtailing the growth of securities fraud class actions and virtually eliminating it altogether.
Congress has had the opportunity to fix the issue legislatively but has repeatedly declined to do so. The Court cannot ignore the regulatory climate in Washington, and the justices should be cognizant of the fact that a statutory mechanism is unlikely to replace fraud-on-the-market any time soon. Further, Congress has legislated on the basis of this judicially created regime and it is unclear how statutes like the Private Securities Litigation Reform Act and the Securities Litigation Uniform Standards Act will function should Basic be overruled.
Critics of the doctrine point to the very high industry cost of securities class actions (one study pegs the annual cost to the industry at $39 billion) and argue that the real beneficiary is the legal profession. Nevertheless, it is inarguable that this type of private action acts as a very powerful regulatory lever, and it’s unclear what effect its sudden removal might have on capital markets. This uncertainty may be what keeps the Roberts Court from overruling Basic in its entirety, but until that decision is rendered, expect the white-knuckling to continue at major New York law firms.