Whether the Fifth Circuit’s ruling contradicts Supreme Court precedent and violates Federal Rule of Civil Procedure 23 by requiring securities-fraud plaintiffs to show loss causation at the class certification stage rather than at trial.
Halliburton is accused of making misstatements about its financial position regarding asbestos litigation, a merger, and costs-overruns on fixed price contracts. As those misstatements came to light or were corrected, Halliburton’s stock price dropped. The Erica P. John Fund asserts that these misstatements defrauded Halliburton’s investors and seeks class certification to recover investors' losses from Halliburton. The Court of Appeals for the Fifth Circuit held that in order to be certified as a class, investors must not only demonstrate elements common to the class, but must also prove that the fraud actually caused the drop in stock value. Halliburton asserts that this is necessary because, unless the fraud actually caused the loss, no presumption of reliance on the misstatement can arise, and therefore the plaintiffs have failed to make the case for certification as a class. The Erica P. John Fund argues that the Fifth Circuit’s holding contradicts the Federal Rules of Civil Procedure and Supreme Court precedent, and that requiring proof of loss causation undermines the values and goals of the reliance presumption. The Supreme Court’s decision in this case will affect the ability of investors to pursue private securities actions against companies who misstate their financial positions.
Questions as Framed for the Court by the Parties
1. Whether the Fifth Circuit correctly held, in direct conflict with the Second Circuit and district courts in seven other circuits and in conflict with the principles of Basic v. Levinson, 485 U.S. 224 (1988), that plaintiffs in securities fraud actions must satisfy not only the requirements set forth in Basic to trigger a rebuttable presumption of fraud on the market, but must also establish loss causation at class certification by a preponderance of admissible evidence without merits discovery.
2. Whether the Fifth Circuit improperly considered the merits of the underlying litigation, in violation of both Eisen v. Carlisle & Jacquelin, 417 U.S. 156 (1974), and Federal Rule of Civil Procedure 23, when it held that a plaintiff must establish loss causation to invoke the fraud-on-the-market presumption even though reliance and loss causation are separate and distinct elements of security fraud actions and even though proof of loss causation is common to all class members.
In an action for securities fraud under Securities and Exchange Commission Rule 10b-5, a plaintiff must show (1) that he or she relied upon a defendant’s material misstatement or omission in buying or selling the security and (2) that the misstatement was a direct cause of the investor’s loss. These are known, respectively, as the reliance and loss causation requirements of a 10b-5 action. In Basic Inc. v. Levinson, the Supreme Court adopted the fraud-on-the-market theory in holding that, where a plaintiff demonstrates that there was a material misstatement, that plaintiff is presumed to have relied on the misstatement in buying or selling the security, thus satisfying the reliance requirement. This allowed for easier certifications of securities class actions; otherwise, each plaintiff would have to affirmatively demonstrate that he bought or sold the security based on the misstatement.
In this case, Respondent Halliburton is accused of misrepresenting financial information, which led to declines in the price of Halliburton stock and losses for investors. The Petitioner, Erica P. John Fund (“The Fund”), states that from June 3, 1999 to December 7, 2001 Halliburton made a series of misleading misstatements relating to its asbestos litigation liability and available resources to pay for possible damages. Halliburton’s asbestos liability stems from the activities of Harbison-Walker, a subsidiary of Dresser Industries; Halliburton had merged with Dresser Industries and thus assumed Harbison-Walker’s liabilities.
The Fund, relying partially on the fraud-on-the-market theory, filed a class action suit under Rule 10b-5 in the United States District Court for the Northern District of Texas. The district court denied class certification on the grounds that the Fund did not prove loss causation at this preliminary stage. The Fund appealed to the Fifth Circuit on two grounds: (1) the Fund did not need to prove loss causation for class certification because that was a question that dealt with the merits of the case, and (2) the Fund had proved loss causation regardless.
The Fifth Circuit rejected the first claim in footnote, stating that under its own precedent in Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F.3d 261, 269 (5th Cir. 2007), a fraud-on-the-market class action must prove loss causation at the certification stage. The Circuit Court also affirmed the lower court’s decision that the Fund had failed to prove loss causation in its claims relating to the Dresser merger.
The Fund appealed to the Supreme Court, arguing that the Fifth Circuit’s requirement of proving loss causation at the class certification stage was an impermissible reading of Basic and the Federal Rules of Civil Procedure. The Supreme Court granted the Fund’s appeal and agreed to hear the case on January 7, 2011.
Under the fraud-on-the-market theory of reliance adopted in Basic Inc. v. Levinson, there is a rebuttable presumption that investors relied on the market price of the security in choosing to buy or sell. Therefore, if a company makes a material misstatement, each plaintiff presumably relied on a material misstatement, allowing for class-wide reliance. In addition to reliance, a successful plaintiff must show loss causation—meaning that the material misstatement actually caused the loss by affecting the market price.
The parties dispute the proper role of loss causation at the class certification stage. Respondent Halliburton maintains that because reliance on price is effectively a substitute for reliance on information, if the defendant is able to show that the misstatements did not affect the price of the security, then the defendant has effectively rebutted the reliance presumption. In essence, Halliburton claims that a defendant can prove a lack of reliance by demonstrating that there was no loss causation. The Fifth Circuit agreed with this position, but went further to hold that unless the plaintiff can demonstrate that the defendant’s misstatements affected the market price, no presumption of reliance will exist to aid the plaintiff in meeting the requirements for certification as a class. Petitioner Erica P. John Fund urges that these theories regarding the presumption conflate the two core elements of fraud-on-the-market—loss causation and reliance—in a manner not permitted by Federal Rule of Civil Procedure 23 (“Rule 23”) during class certification. In this case, the Supreme Court must resolve what plaintiffs must establish during the certification stage to take advantage of a rebuttable presumption of reliance.
What must a plaintiff demonstrate at the class certification?
The Fund notes that in Basic Inc. v. Levinson, the Supreme Court recognized a growing effort among the circuit courts to create a rebuttable presumption that market investors rely on the listed market prices as a reflection of all publicly available information about the products. The Fund asserts that, to meet the class certification requirements of Rule 23, plaintiffs do not have to prove that they will prevail on the merits. Therefore, the Fund argues that at class certification plaintiffs must demonstrate that their reliance claim is based on shared evidence, but they do not need to prove that they will eventually succeed at trial In addition, for the loss causation prong, the Fund maintains that plaintiffs need only show that common issues predominate, not that they will be successful on the merits. Loss causation, according to the Fund, only asks whether the defendant company’s misstatements affected the value of the company’s stock. The mere fact that a plaintiff held the stock is enough to establish a shared harm across the class for certification purposes; to actually inquire whether the disclosure caused the loss would be an impermissible examination of the merits of the case.
Halliburton argues that courts routinely inquire into all relevant issues during class certification, even if doing so means the court has to consider issues that overlap with the merits of the case. Moreover, Halliburton asserts that plaintiffs have the burden of persuading the court that the rebuttable presumption is well-established, as part of plaintiffs’ burden of showing that the case is appropriate for class certification. Halliburton argues that this inquiry into loss causation is permissible at the class certification stage because it relies on publicly available information, namely the market prices of a security and the company’s statements. Therefore, Halliburton dismisses concerns that the loss causation inquiry will be too complex. Halliburton also notes that securities-fraud plaintiffs often use studies and expert testimony at the certification stage to establish that there was an efficient market.
The Fund maintains that the Fifth Circuit’s requirement of proof of loss causation places an improperly high burden on plaintiffs at the certification stage, consuming time and resources. The Fund maintains that certification would permit more extensive discovery, allowing the Fund “to establish what Halliburton knew and when it knew it.”
Can a defendant use a lack of loss causation to prove a lack of reliance?
While the Fifth Circuit held that the plaintiff must prove loss causation for class certification, Halliburton primarily argues on appeal that the defendant can prove a lack of loss causation to rebut the presumption of reliance. Halliburton argues that neither Basic nor the Federal Rules of Evidence require the defendant to restrict its attacks to the evidence that invokes a presumption. Halliburton reasons that as long as a reasonable fact-finder could believe that a defendant company’s misstatements did not cause the plaintiffs’ stock losses, the presumption is effectively rebutted.
Although there may be a presumption of reliance, Halliburton asserts that evidence against loss causation directly attacks that presumption by showing that the market itself did not use the defendant’s misstatements to determine the stock’s market value. In this case, the Fund’s argument depends on a showing that the correction of misstatements by Halliburton caused a drop in stock prices. Therefore, Halliburton concludes that its presentation of evidence to rebut the presumption, demonstrating that the alleged losses were not linked to any of Halliburton’s corrections, was sufficient to defeat the Fund’s request for class certification. In closing, Halliburton argues that, whether or not the burden is on the plaintiff or the defendant regarding the existence of loss causation, the Supreme Court should affirm the Fifth Circuit’s opinion.
While the Fund is primarily concerned with the Fifth Circuit’s requirement that the plaintiff prove loss causation, it additionally argues that a defendant cannot rebut the presumption of reliance through a lack of loss causation. This is because loss causation focuses on whether corrective disclosure caused the plaintiff’s loss, rather than whether there was a price distortion when the plaintiff bought or sold the security. According to the Fund, because fraud-on-the-market focuses on the time of the purchase or sale, and not the corrective disclosure, loss causation is not relevant to the reliance inquiry.
The Erica P. John Fund argues that the Fifth Circuit’s decision—requiring a plaintiff in a fraud-on-the-market suit to prove loss causation at the class certification stage—necessitates an evaluation of the merits of the Fund’s claim, which conflicts with Basic v. Levinson and Rule 23 of the Federal Rule of Civil Procedure. Halliburton argues that a court should not certify a class when the defendant can show that the misstatements did not in fact alter the market price. The Supreme Court’s decision could significantly impact the availability of class actions for securities fraud.
Access to Judicial Remedy
The Fund argues that the rule applied by the Fifth Circuit will deny plaintiffs the right to a jury trial and dissuade shareholders from pursuing legitimate private securities actions. The Fund argues that the Fifth Circuit’s decision created a new requirement for class action certification, which will require lower courts to rule on the merits of the plaintiff’s case. The Fund argues that this higher standard will lead the to the denial of the right to a jury since the judge’s ruling on loss causation will essentially determine the outcome of the entire case.
The Fund also states that the Fifth Circuit’s ruling marks the end of the private enforcement function of securities law. The Fund argues that plaintiffs will consequently no longer use securities law to address their claims due to the high burden of proof. The Fund argues that the Fifth Circuit functionally eliminated the fraud-on-the-market theory, which is used by plaintiffs in class actions because it is impractical to demonstrate that each plaintiff relied upon the material misstatement when purchasing or selling a security. The Fund claims that certain securities claims are too small to pursue individually, thereby reducing the effective private enforcement of securities fraud.
The AARP argues that Rule 10b-5, in addition to compensating plaintiffs for their losses, is an “essential means of enforcing the securities laws and protecting the integrity of the securities markets for investors and maintaining investor confidence in the markets.” Therefore, the AARP asserts that the Fifth Circuit’s ruling restricts meaningful remedies for private investors. The Fund agrees, arguing that the increased difficulty in enforcing securities claims and the reduced enforcement of securities law will reduce confidence in the financial markets and further harm an economy already weakened by the financial crisis.
In contrast, Halliburton argues that the Fifth Circuit’s decision supports judicial economy by rejecting meritless claims at the class certification level. Halliburton contends that a defendant’s right to rebut plaintiffs’ claim at the class certification level should not be minimized because a defendant must bear major legal costs even before a viable claim has been proven. Furthermore, Halliburton argues that the harm to defendants can only be undone much later in the trial process when defendants are able to show that there was no loss causation. Halliburton notes that delaying an examination of the strength of the Fund’s claims allows plaintiffs to extort settlements from companies.
The Pharmaceutical Researchers and Manufacturers of America (“PhRMA”) agrees with Halliburton that courts should determine “potentially dispositive issues” as early as possible in class actions. . PhRMA cites one study’s conclusion that “the vast majority of certified class actions settle, most soon after certification.” PhRMA argues that a ruling in favor of the Fund would harm the pharmaceutical industry; because plaintiffs’ attorneys can often certify class actions by showing a misstatement without proving loss causation, companies are willing to settle rather than deal with burdensome litigation.
The Supreme Court will determine the role of loss causation at the certification stage of a fraud-on-the-market securities class action. The Fifth Circuit held that in order to show reliance, the plaintiff must show that the stock price actually decreased because the disclosure of a misstatement or omission. Halliburton argues that the Fifth Circuit’s decision must be upheld because the Fund failed to show that the alleged misrepresentation affected the market price of company stock. Additionally, Halliburton alleges that the defendant may prove a lack of loss causation in order to rebut the presumption of reliance. On the other hand, the Fund argues that the Fifth Circuit’s decision requiring proof of loss causation at certification conflicts with Supreme Court precedent. The Court’s decision in this case will determine the standard necessary to meet the reliance element for a private securities class action, and thus could impact the number of securities fraud class actions that go to trial or settle.
· Wex: Class Action
· Securities Docket: Second Circuit Reverses Class Certification in In re Salomon Credit Analyst Metromedia Litigation (Oct. 2, 2008)
· New York Law Journal, David M. Brodsky and Jeff G. Hammel: The Fraud on the Market Theory and Securities Fraud Claims (Oct. 24, 2003)
· New York Law Journal, Samuel H. Rudman: Oscar: Misinterpretation of Fraud-on-the-Market Theory (Jul. 17, 2009)