Any day now, the Supreme Court will decide Halliburton v. Erica P. John Fund, a case that could make it more difficult for investors to file class action lawsuits against large corporations who commit fraud. The Court looks poised to embrace a "compromise" position that would continue to allow these class actions, but with new burdens on plaintiffs before they can proceed to trial.
Halliburton Could End the Fraud-On-The-Market Theory, A Powerful Legal Tool For Defrauded Class Action Plaintiffs
Alliance For Justice: Ending The Fraud On-The-Market-Theory Would Pose "A Nearly Insurmountable Task For Investors" To Sue As A Class Action. In 1986, the Supreme Court ruled in Basic v. Levinson, which allowed plaintiffs in securities class actions who had been defrauded to rely on the fraud-on-the-market theory, rather than individually being forced to prove they relied on a specific incident of fraud. If the Supreme Court discards this doctrine in Halliburton, it could make it even easier for corporations to lie to investors:
Twenty-six years ago, in Basic Inc. v. Levinson, the Supreme Court made it possible for investors to form class actions to sue corporations for securities fraud. Typically, to succeed on a claim of securities fraud, plaintiffs must prove that they relied on a fraudulent misrepresentation when they invested in certain securities. However, the Supreme Court recognized in Basic that this poses a nearly insurmountable task for investors who buy securities on an open exchange, and is particularly unfair when applied to shareholder class actions. Using pragmatic logic, the Court explained that requiring each individual investor to prove actual reliance "would place an unnecessarily unrealistic evidentiary burden on the [securities fraud] plaintiff who has traded on an impersonal market," and would effectively serve as a "barrier to class certification, since each of the individual investors would have to prove reliance on the alleged misrepresentation."
To avoid this absurd result, the Court in Basic recognized a rebuttable presumption of reliance based on the "fraud-on-the-market" theory. This doctrine presumes that a stock's market price "reflects all publicly available information," including any "public material misrepresentations." Consequently, when an investor purchases stock at the market price, she presumptively relies on the integrity of that price as influenced by the alleged misrepresentation. Defendant corporations can rebut this presumption by showing either that the stock price never in fact incorporated the misrepresentation, or that the plaintiffs were aware of the misrepresentation when purchasing the stock. Importantly, the fraud-on-the-market presumption can be invoked collectively by putative class members to show reliance when seeking class certification.
The Court's decision in Basic set the "foundation for modern, private securities litigation," and the fraud-on-the-market doctrine has been a critical mechanism for allowing shareholders to sue big businesses for fraud through class action lawsuits. Moreover, Congress has since reformed securities litigation on multiple occasions without abandoning or modifying the presumption. [Alliance for Justice, 3/5/14]
During Oral Arguments, The Court Looked Ready To Embrace A "Compromise" That Would Allow Class Actions, But With New Burdens On Plaintiffs
The New York Times: The Supreme Court "Seemed Ready To Impose New Limits On Securities Fraud Suits." After oral arguments in Halliburton, the Times' Adam Liptak reported that some justices "seemed ready" to further restrict class actions, making it more difficult for plaintiffs to bring class actions for securities fraud. Justice Kennedy "seemed particularly taken" with a so-called compromise position that would allow class actions to continue, but would also force plaintiffs to undertake a complicated and expensive "event study" before the class was approved:
The Supreme Court on [March 5] seemed ready to impose new limits on securities fraud suits that would make it harder for investors to band together to pursue claims that they were misled when they bought or sold securities. But the justices did not seem inclined to issue a ruling that would put an end to most such suits.
The new limits would be in keeping with earlier decisions from the court led by Chief Justice John G. Roberts Jr., which has made it more difficult for workers and consumers to pursue class actions. The decision in the case argued Wednesday, expected by June, seems likely to do something similar in cases brought by investors.
Companies facing fraud class actions prefer to address as many issues as they can before judges decide whether to certify a class. Once a class is certified, they say, the damages sought are often so enormous that the only rational calculation is to settle even if the chances of losing at trial are small.
"Once you get the class certified, the case is over," Justice Antonin Scalia said on Wednesday.
Several justices suggested that this phenomenon could be partly addressed through a proposal in a supporting brief filed by two law professors, which argued that plaintiffs should be required to show at an early stage "whether the alleged fraud affected market price."
Justice Anthony M. Kennedy seemed particularly taken with the brief, referring to it several times. "I call it the midway position," he said.
Aaron M. Streett, a lawyer for the Halliburton Company who had argued for broader limits, said he welcomed that approach as a fallback position. But David Boies, a lawyer for the plaintiffs, resisted it.
"That's very complicated," Mr. Boies said. "It takes a lot of time. It's very expensive. It's a lot of expert testimony." [The New York Times, 3/5/14]
Reuters: Event Studies Are "A New And Different Burden For The Securities Class Action Bar." As Reuters' Alison Frankel reported, the "midway" compromise still manages to place serious obstacles between plaintiffs and the chance to prove their case. According to Frankel, "plaintiffs would have to hire experts to conduct event studies analyzing the market effect of particular misrepresentations" before class certification, and not all of the justices were on board with deciding a merits question pre-trial:
From the questions posed to Halliburton counsel Aaron Streett of Baker Botts and EPJ Fund lawyer David Boies of Boies, Schiller & Flexner, the Supreme Court seems to be searching for a way to require investors to demonstrate the price impact of alleged corporate misrepresentations in order to win class certification. That would be a new and different burden for the securities class action bar, which, under Basic's fraud-on-the-market theory, simply had to show that shares traded in an efficient market in order to invoke the presumption that investors relied on corporate misstatements. To establish price impact, plaintiffs would have to hire experts to conduct event studies analyzing the market effect of particular misrepresentations.
Justice Sotomayor was particularly uncomfortable with Kennedy's suggested "midway" compromise. "I don't see how this is a midpoint," she said to Streett. "If you're going to require proof of price impact, why not do away with market efficiency?" Requiring proof of price impact at the class certification stage, Sotomayor said, would turn class certification into "a full-blown merits hearing." Sotomayor later posed the same question to Boies: "If we believe price impact is necessary, why keep Basic if we're going to put it in a class certification (hearing)?" Boies said price impact is a merits question, not a class certification question, which prompted Justice Kennedy to ask why price impact couldn't be considered a class certification issue. "Even if Basic did not rely on economic theory, and there is a dispute on that ... if later economic theories show that the market doesn't react the way Basic assumed it automatically did, then certainly Congress would not wish to foreclose the court from considering that new evidence," Kennedy said, in a question that implicitly noted that the certification process for securities fraud cases rests on Basic's fraud-on-the-market theory. [Reuters, 3/5/14]
The "Midway" Position Requires The Plaintiffs To Complete A Burdensome Event Study Before They Can Bring Suit Against Corporate Fraudsters
Duke Law Professor Ann Lipton: Event Studies Are "Useless" In The Typical Securities Fraud Class Action Lawsuit. Not only are event studies expensive, often "there's simply no market movement to detect," according to Professor Lipton. This is because in "most fraud cases, the defendant's lies are not designed to move the stock price up, but to keep prices level -- or to slow a stock price descent":
The first thing to note is that the fraud on the market doctrine is actually two separate, but related, presumptions in favor of the plaintiffs. First, that in an open and well-developed market, security prices reflect publicly available material information (the "objective" presumption); and second, that investors "rely" in some sense on market prices when they transact in such a market (the "subjective" presumption). From a doctrinal perspective, both presumptions are necessary for plaintiffs to satisfy the element of reliance in a Section 10(b) [of the Securities Exchange Act] action.
In practice, lower courts have demanded that the plaintiffs demonstrate that markets are "efficient," in an informational sense, before they will allow plaintiffs to proceed using the fraud on the market presumptions. This is a relatively demanding test for efficiency -- it requires that plaintiffs show that the stock price is heavily traded, followed by multiple analysts, and that new public information is rapidly -- often within hours -- incorporated in security prices. Though the test has been severely (and justly) criticized, it does ultimately require that the plaintiffs show that the market is very well developed, and the security heavily traded and widely followed.
The position of Halliburton and some of its amici is that even these kinds of markets are not perfectly efficient, and therefore the first presumption -- the objective presumption -- is improper. Courts should not assume that all public information is incorporated into stock prices. Instead, they argue that plaintiffs should prove, statement by statement, that the defendant's falsehoods impacted market prices. They argue that tools like event studies, to detect abnormal price movement, are an appropriate way of making such determinations. And it is this position that the Supreme Court seemed willing to consider.
What the Court did not seem to appreciate is that in most fraud cases, the defendant's lies are not designed to move the stock price up, but to keep prices level -- or to slow a stock price descent. Typically, the defendant makes statements about company performance that are true at the time. The market develops certain expectations for future performance, and coalesces around a stock price. Later, problems develop, and the defendant lies to cover them up, or to minimize them. The defendant commits accounting fraud to meet analyst expectations, or claims that a product in development is proceeding precisely as expected, while concealing the fact that the product does not function properly.
Because market prices only respond to unexpected information, for these frauds, the stock price does not move up in response to the false statement; it remains steady. Or it even falls, but it falls less than it would have had the truth been told.
Event studies are useless in these situations; there's simply no market movement to detect. But that doesn't mean the fraud didn't have an effect; it just means that the fraud's effect was to keep stock prices from falling to their natural levels. [Business Law Prof Blog, 3/8/14]
Georgetown Law Professor Donald Langevoort: "The Typical Fraud On The Market Case Does Not Involve A Single Dramatic Lie." Not only are event studies expensive and burdensome for plaintiffs, according to Professor Langevoort, they also may not accurately show fraud. As Langevoort explained, "finding measurable distortion is often hard" because "lies are often coupled with lots of other information about the issuer, some of which was presumably accurate":
[T]he typical fraud-on-the-market case does not involve a single dramatic lie. Rather, it involves a story that begins when the issuer is doing reasonably well. Gradually, however, things start turning bad and eventually the issuer is forced to reveal its troubles, at which point the stock price is much lower than it was during the good times. Plaintiffs will work to show that management knowingly or recklessly concealed those troubles. But concealment is not necessarily unlawful (another one of Basic's fundamental lessons), and so there will have to be a showing that particular misstatements or actionable omissions, usually half-truths, distorted the stock price. For a variety of reasons, finding measurable distortion is often hard. First, the alleged lies come out in dribs and drabs, and allegedly have the effect to preventing a decline in the stock price, not actually pumping it up. Second, these alleged lies are often coupled with lots of other information about the issuer, some of which was presumably accurate. There is simply no way of measuring distortion with precision in settings like these. Often there is no visible change in stock price at all, on which defendants seize for their truth-on-the-market defense. Well before Basic, plaintiffs responded to this difficulty by turning attention not to the date(s) of the alleged lie(s) but rather the event of corrective disclosure -- when the truth was later on brought home to the market. When there was a big stock price drop after such disclosure, plaintiffs would argue by backwards induction that this was the drop was a good measure of the cumulative extent of the original distortion (and the right measure of damages as well). But once the inquiry extends to a potentially lengthy period of time between the original lie and the corrective disclosure, it is likely that there will be many intervening or supervening events that also make their way into the correction, making it hard -- if not impossible -- to disentangle all the effects with any econometric rigor.
Courts vary considerably in how much they demand of plaintiffs, but many cases are insistent that if plaintiffs cannot show with rigorous evidence that there was either a price distortion at the time of the fraud or a deflation in price later on due to the revelation of the truth (not some separate causal event), they lose. Of course, if this burden is imposed only at the trial on the merits, it may be largely illusory for the reasons discussed earlier -- the case will be settled before then. In response, more aggressive courts began finding ways to accelerate this inquiry, taking us to the present controversies. As an effort to weed out these cases, class certification was appealing because it would permit an early evidentiary hearing, going well beyond the pleadings. The Supreme Court [previously] shut the door on using class certification to do this, first holding that loss causation is not an appropriate certification inquiry...then holding the same with respect to materiality[.] [Donald Langevoort, 11/16/13]
The Supreme Court Ultimately Accepted A Compromise Of The "Compromise," Allowing The Defendants To Argue Price Impact On Class Certification
Supreme Court of the United States: Prior To Trial, Burden Is On Corporate Defendants To Prove Fraudulent Statements Didn't Affect Stock Price. There were concerns that the Court might impose new costly burdens on the injured party to prove price impact at the class certification stage, or before the commencement of their suit. However, a unanimous Court shifted that burden and held corporate defendants -- not the harmed investors -- are responsible for proving price impact if that issue is argued before trial, an evidentiary study that shows that the "alleged misrepresentation did not actually affect the market price of the stock":
Investors can recover damages in a private securities fraud action only if they prove that they relied on the defendant's misrepresentation in deciding to buy or sell a company's stock. In Basic Inc. v. Levinson, we held that investors could satisfy this reliance requirement by invoking a presumption that the price of stock traded in an efficient market reflects all public, material information -- including material misstatements. In such a case, we concluded, anyone who buys or sells the stock at the market price may be considered to have relied on those misstatements. We also held, however, that a defendant could rebut this presumption in a number of ways, including by showing that the alleged misrepresentation did not actually affect the stock's price -- that is, that the misrepresentation had no "price impact."
In Basic, ... we recognized that requiring such direct proof of reliance "would place an unnecessarily unrealistic evidentiary burden on the ... plaintiff who has traded on an impersonal market." That is because, even assuming an investor could prove that he was aware of the misrepresentation, he would still have to "show a speculative state of facts, i.e., how he would have acted ... if the misrepresentation had not been made."
More than 25 years ago, we held that plaintiffs could satisfy the reliance element ... by invoking a presumption that a public, material misrepresentation will distort the price of stock traded in an efficient market, and that anyone who purchases the stock at the market price may be considered to have done so in reliance on the misrepresentation. We adhere to that decision and decline to modify the prerequisites for invoking the presumption of reliance. But to maintain the consistency of the presumption with the class certification requirements of Federal Rule of Civil Procedure 23, defendants must be afforded an opportunity before class certification to defeat the presumption through evidence that an alleged misrepresentation did not actually affect the market price of the stock. [Halliburton v. Erica P. John Fund, 6/23/14]
Supreme Court Justice Ruth Bader Ginsburg: Price Impact "Should Impose No Heavy Toll On Securities-Fraud Plaintiffs." In her concurrence, Justice Ginsburg warned that at the class certification stage, the burden is on the corporations accused of fraud to shoulder the costs of rebutting the presumption that their misleading statements had an impact on the company's stock price. Writing for liberal Justices Stephen Breyer and Sonia Sotomayor, Ginsburg warned that this new compromise should not be abused to unneccesarily hinder "tenable claims":
Advancing price impact consideration from the merits stage to the certification stage may broaden the scope of discovery available at certification. But the Court recognizes that it is incumbent upon the defendant to show the absence of price impact. The Court's judgment, therefore, should impose no heavy toll on securities-fraud plaintiffs with tenable claims. On that understanding, I join the Court's opinion. [Halliburton v. Erica P. John Fund, 6/23/14]
Public Justice: Although Investor Class Actions Were Reaffirmed, "Investor Plaintiffs Will Now Have To Win The Central Evidentiary Issues Twice." Speaking for the public interest law firm and consumer advocacy group Public Justice, Executive Director Bland warned that although it is "great news" when the pro-business Roberts Court declines to overrule class action precedent, the new hurdle imposed upon defrauded shareholders is worrisome. By shifting the analysis of a price impact from the trial to the earlier certification stage, the Court unnecessarily takes a merits question away from the jury:
It's great news that the Supreme Court didn't overturn Basic, wipe away securities class actions. By moving the evidentiary battle over whether markets actually operate efficiently and whether information was publicly shared, however, the Court has made it more expensive and time consuming to pursue a securities fraud class action. Investor plaintiffs will now have to win the central evidentiary issues twice -- once before the judge on class certification, and a second time before the jury at trial. [Paul Bland in a statement to Media Matters, 6/23/14]
Alliance For Justice: Courts Must "Heed Justice Ginsburg's Warning." Alliance for Justice President Nan Aron also acknowledged that the conservative justices were unable to convince their colleagues to radically overturn class action precedent. However, on behalf of Alliance for Justice and shareholders "stand[ing] up for their rights in court against corporations that have defrauded them out of their hard-earned money," Aron expressed "fear" that the "new barrier" of a price impact study before trial will cause more harm that it should:
While not expressly overturning precedent, the Supreme Court has placed new barriers in front of shareholders that could make it far more difficult for them to stand up for their rights in court against corporations that have defrauded them out of their hard-earned money. We hope the courts heed Justice Ginsburg's warning that this decision "should impose no heavy toll on securities-fraud plaintiffs with tenable claims," but we fear that it will. [Alliance for Justice, 6/23/14]