On Wednesday, the U.S. Supreme Court heard oral argument in Halliburton v. Erica P. John Fund, a case that could drastically alter the securities fraud landscape. Here are a few thoughts on the issues at stake in the case and a cautious prediction about how the Court will rule.
First, some quick background for the uninitiated. The broadest anti-fraud provision of the securities laws, Section 10(b) of the 1934 Securities Exchange Act, forbids the use of “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe….” The Commission’s Rule 10b-5, then, makes it illegal “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”
Although Section 10(b) doesn’t expressly entitle victims of securities fraud to sue for damages, the Supreme Court long ago inferred a private right of action to enforce the provision. The elements of that judicially created private right of action are: (1) a material misrepresentation or omission by the defendant, (2) scienter (i.e., mental culpability worse than mere negligence) on the part of the defendant, (3) a connection between the misrepresentation or omission and the purchase or sale of a security, (4) the plaintiff’s reliance upon the misrepresentation or omission, (5) economic loss by the plaintiff, and (6) loss causation (i.e., the fraud, followed by revelation of the truth, was the proximate cause of the plaintiff’s investment loss).
For most individual investors, the economic loss resulting from any instance of securities fraud (and, thus, the potential recovery) is not enough to justify the costs of bringing a lawsuit. Accordingly, 10b-5 suits seem like an appropriate context for class actions. The elements of the judicially created cause of action, however, make class certification difficult. That is because most securities fraud class actions would proceed under Federal Rule of Civil Procedure 23(b)(3), which requires that common issues of law or fact in all the plaintiffs’ cases predominate over plaintiff-specific issues. Because the degree to which any individual investor relied upon a misrepresentation (element 4) requires proof of lots of investor-specific facts (How did you learn of the misrepresentation?, How did it influence your investment decision?, etc.), the reliance element would seem to preclude Rule 10b-5 class actions.
In Basic v. Levinson, a 1988 Supreme Court decision from which three justices were recused, a four-justice majority endorsed a doctrine that has permitted Rule 10b-5 class actions to proceed, despite the reliance element. The so-called “fraud on the market” doctrine creates a rebuttable presumption that an investor who traded in an efficient stock market following a fraudulent disclosure (but before the truth was revealed) “relied” on that disclosure, even if she didn’t see or hear about it. The theoretical basis for the fraud on the market doctrine is the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), which posits that securities prices almost instantly incorporate all publicly available information about the underlying company, making it impossible to earn above-normal returns by engaging in “fundamental analysis” (i.e., study of publicly available information about a listed company). The logic of the fraud on the market doctrine is that publicly available misinformation affects a security’s price, upon which an investor normally relies when she makes her investment decision. Thus, any investor who makes her investment decision on the basis of the stock’s price “relies” on the “ingredients” of that price, including the misinformation at issue.
In light of this logic, the Basic Court reasoned that a defendant could rebut the presumption of reliance by severing either the link between the misinformation and the stock’s price or the link between the stock’s price and the investor’s decision. To sever the former link, the defendant would need to show that key market makers were privy to the truth, so that the complained of lie could not have affected the market price of the stock (in other words, there was “truth on the market”…great name for a blog, no?). To sever the latter link, the defendant would need to show that the plaintiff investor made her investment decision for some reason unrelated to the stock’s price—say, because she needed to divest herself of the stock for political reasons.
Basic thus set up a scheme in which the class plaintiff bears the burden of establishing that the stock at issue traded in an efficient market. If she does so, her (and similarly situated class members’) reliance on the misinformation at issue is presumed. The defendant then bears the burden of rebutting the presumption by showing either that the misrepresentation did not give rise to a price distortion (probably because the truth was on the market) or that the individual investor would have traded even if she knew the statement was false (i.e., her decision was not based on the stock’s price).
The Halliburton appeal presents two questions. First, should the Court overrule Basic and jettison the rebuttable presumption of reliance when the stock at issue is traded in an efficient market. Second, at the class certification stage, should the defendant be permitted to prevent the reliance presumption from arising by presenting evidence that the alleged misrepresentation failed to distort the market price of the stock at issue.
With respect to the first question, the Court could go three ways. First, it could maintain the status quo rule that 10b-5 plaintiffs, in order to obtain the reliance presumption, must establish only that the stock at issue was traded in an efficient market. Second, it could overrule Basic wholesale and hold that a 10b-5 plaintiff must establish actual, individualized reliance (i.e., show that she knew of the misrepresentation and that it influenced her investment decision). Third, the Court could tweak Basic by holding that plaintiffs may avail themselves of the presumption of reliance only if they establish, at the class certification stage, that the complained of
misrepresentation actually distorted the market price of the stock at issue.
My guess, which I held before oral argument and seems consistent with the justices’ questioning on Wednesday, is that the Court will take the third route. There are serious problems with the status quo. First, it rests squarely upon the semi-strong version of the ECMH, which has come under fire in recent years. While no one doubts that securities prices generally incorporate publicly available information, and very quickly, a number of studies purporting to document the existence of arbitrage opportunities have challenged the empirical claim that every bit of publicly available information is immediately incorporated into the price of every security traded in an efficient market. Indeed, the winners of this year’s Nobel Prize in Economics split on this very question. I doubt this Supreme Court will want to be perceived as endorsing a controversial economic theory, especially when doing so isn’t necessary to maintain some sort of reliance presumption (given the third possible holding discussed above).
A second problem with the status quo is that it places an unreasonable burden on courts deciding whether to certify a class. The threshold question for the fraud on the market presumption—is the security traded in an efficient market?—is just too difficult for non-specialist courts. How does one identify an “efficient market”? One court said the relevant factors are: “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.” Others have supplemented these so-called “Cammer factors” with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation. No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible? How large may the bid-ask spread be?). Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t. It’s a crapshoot.
The status quo approach of presuming investor reliance if the plaintiff establishes an efficient market for the company’s stock is also troubling because the notion of a “market” for any single company’s stock is theoretically unsound. An economic market consist of all products that are, from a buyer’s perspective, reasonably interchangeable. For example, Evian bottled water (spring water from the Alps) is a very close substitute for Fiji water (spring water from the Fiji Islands) and is probably in the same product market. From an investor’s perspective, there are scores of close substitutes for the stock of any particular company. Such substitutes would include all other stocks that offer the same package of financial attributes (risk, expected return, etc.). It makes little sense, then, to speak of a “market” consisting of a single company’s stock, and basing the presumption of reliance on establishment of an “efficient market” in one company’s stock is somewhat nonsensical.
With respect to the second possible route for the Halliburton Court—overturning Basic in its entirety and requiring individualized proof of actual reliance—proponents emphasize that the private right of action to enforce Section 10(b) and Rule 10b-5 is judicially created. The Supreme Court now disfavors implied rights of action and, to avoid stepping on Congress’s turf, requires that they stick close to the statute at issue. In particular, the Court has said that determining the elements of a private right of action requires “historical reconstruction.” With respect to the Rule 10b-5 action, the Court tries “to infer how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision of the 1934 Act,” and to do that, it consults “the express causes of action” in the Act and borrows from the “most analogous” one. In this case, that provision is Section 18(a), which is the only provision in the Exchange Act authorizing damages actions for misrepresentations affecting secondary, aftermarket trading (i.e., trading after a public offering of the stock at issue). Section 18(a) requires a plaintiff to establish actual “eyeball” reliance—i.e., that she bought the security with knowledge of the false statement and relied upon it in making her investment decision. There is thus a powerful legal argument in favor of a full-scale overturning of Basic.
As much as I’d like for the Court to take that route (because I believe Rule 10b-5 class actions create far greater social cost than benefit), I don’t think the Court will go there. Overruling Basic to require eyeball reliance in Rule 10b-5 actions would be perceived as an activist, “pro-business” decision: activist because Congress has enacted significant legislation addressing Rule 10b-5 actions and has left the fraud on the market doctrine untouched, and pro-business because it would insulate corporate managers from 10b-5 class actions.
Now, both of those characterizations are wrong. The chief post-Basic legislation involving Rule 10b-5, the 1995 Private Securities Litigation Reform Act, specifically stated (in Section 203) that “[n]othing in this Act shall be deemed to … ratify any implied private right of action.” As Justices Alito and Scalia emphasized at oral argument, the PSLRA expressly declined to put a congressional imprimatur on the judicially created Rule 10b-5 cause of action, so a Court decision modifying Rule 10b-5’s elements would hardly be “activist.” Nor would the decision be “pro-business” and “anti-investor.” The fact is, the vast majority of Rule 10b-5 class actions are settled on terms where the corporation pays the bulk of the settlement, which largely goes to class counsel. The corporation, of course, is spending investors’ money. All told, then, investors as a class pay a lot for, and get very little from, Rule 10b-5 class actions. A ruling eviscerating such actions would better be characterized as pro-investor.
Sadly, our financially illiterate news media cannot be expected to understand all this and would, if Basic were overturned, fill the newsstands and airwaves with familiar stories of how the Roberts Court continues on its activist, pro-business rampage. And even more sadly, at least one key justice whose vote would be needed for a Basic overruling, has proven himself to be exceedingly concerned with avoiding the appearance of “activism.” A wholesale overruling of Basic, then, is unlikely.
That leaves the third route, modifying Basic to require that class plaintiffs first establish a price distortion resulting from the complained of misrepresentation. I have long suspected that this is where the Court will go, and the justices’ questioning on Wednesday suggests this is how many (especially Chief Justice Roberts and Justice Kennedy) are leaning. From the Court’s perspective, there are several benefits to this approach.
First, it would allow the Court to avoid passing judgment on the semi-strong ECMH. The status quo approach—prove an efficient market and we’ll presume reliance because of an inevitable price effect—really seems to endorse the semi-strong ECMH. An approach requiring proof of price distortion, by contrast, doesn’t. It may implicitly assume that most pieces of public information are instantly incorporated into securities prices, but no one really doubts that.
Second, the third route would substitute a fairly manageable inquiry (Did the misrepresentation occasion a price effect?) for one that is both difficult and theoretically problematic (Is the market for the company’s stock efficient?).
Third, the approach would allow the Court to eliminate a number of the most meritless securities fraud class actions without appearing overly “activist” and “pro-business.” If class plaintiffs can’t show a price effect from a complained of misrepresentation or omission, then their claim is really frivolous and ought to go away immediately. The status quo would permit certification of the class, despite the absence of a price effect, as long as class counsel could demonstrate an efficient market using the amorphous and unreliable factors set forth above. And once the class is certified, the plaintiffs have tons of settlement leverage, even when they don’t have much of a claim. In short, the price distortion criterion is a far better screen than the market efficiency screen courts currently utilize. For all these reasons, I suspect the Court will decide not to overrule Basic but to tweak it to require a threshold showing of price distortion.
If it does so, then the second question at issue in Halliburton—may the defendant, at the class certification stage, present evidence of an absence of price distortion?—goes away. If the plaintiff must establish price distortion to attain class certification, then due process would require that the defendant be allowed to poke holes in the plaintiff’s certification case.
So that’s my prediction on Halliburton. We shall see. Whatever the outcome, we’ll have lots to discuss in June.