Should the fraud-on-the-market theory of reliance be overruled or substantially modified to allow defendants to challenge a class certification by introducing evidence that the alleged fraud did not impact the price of its stock?
In 2002, the Erica P. John Fund, which supports the Archdiocese of Milwaukee, sued Halliburton, an oil-services company, for securities fraud. The lawsuit accused Halliburton of lying about its asbestos liabilities, overstating its revenues, and building up hype about the company’s merger with Dresser Industries. The lawsuit was brought on behalf of a class consisting of all shareholders of Halliburton. Contesting this class action, Halliburton argues that the lawsuit could not be brought by all shareholders unless individual shareholders actually relied on Halliburton’s alleged fraudulent acts to make their investment decisions. However, the Fund contends that reliance by the individual shareholders is presumed due to the fraud-on-the market theory established by Basic v. Levinson. The theory assumes that all public information provided by a company is incorporated into its stock price. Thus, Halliburton’s fraudulent information harmed all of its shareholders even if not every one of them personally read and relied on the information. The Supreme Court’s decision in this case will determine whether the fraud-on-the-market theory remains valid. If the Court rejects the theory, then plaintiffs would have a harder time initiating lawsuits for securities fraud, and companies that allegedly commit the fraud would likely pay less in damages.
Questions as Framed for the Court by the Parties
- Whether this Court should overrule or substantially modify the holding of Basic Inc. v. Levinson, 485 U.S. 224 (1988), to the extent that it recognizes a presumption of classwide reliance derived from the fraud-on-the-market theory.
- Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock.
The Erica P. John Fund, Inc. (“The Fund”) alleges that between June 3, 1999, and December 7, 2001, the Halliburton Company (“Halliburton”) and its top executives misrepresented significant aspects of its operations. According to the Fund, Halliburton fraudulently misrepresented three key issues: underestimating costs for an asbestos liability claim, overestimating revenues, and inflating benefits derived from a merger with Dresser Industries. These misrepresentations artificially inflated Halliburton’s stock price and, when the misrepresentations were revealed, the stock plummeted, damaging purchasers of stock during the period in question.
The Fund moved in September 2007 to certify as a class all those who purchased Halliburton stock between June 1999 and December 2001. The district court concluded that the Fund had satisfied the threshold requirement of Federal Rules of Civil Procedure (“FRCP”) 23(a) for class actions. The district court, however, denied class certification under FRCP 23(b)(3). Fifth Circuit precedent placed a substantial burden on plaintiffs in securities fraud cases to show loss causation before receiving class certification. The Fund appealed the decision, and the Fifth Circuit affirmed the lower court’s decision.
The Supreme Court granted certiorari, ultimately reversing the Fifth Circuit’s decision and holding that the court erred in requiring proof of loss causation for certification. The Court remanded the case to the Fifth Circuit, which in turn remanded the case to the district court. The court rejected Halliburton’s proffered evidence that the alleged misrepresentation did not cause the inflation or distortion of the company’s stock and certified the class. Halliburton appealed this decision, filing a writ of certiorari on September 9, 2013, which the Supreme Court granted on November 15, 2013.
This case presents the Supreme Court with an opportunity to reaffirm or reject the validity of the fraud-on-the-market theory from Basic v. Levinson. Petitioner Halliburton and its supporters believe that the theory is invalid and should be overruled because it leads to high volumes of securities fraud litigation, which deters companies from doing business or accessing capital markets in the United States. Respondent Erica P. John Fund and its supporters assert that the theory preserves shareholders’ ability to bring lawsuits against companies, to hold them accountable for their fraudulent actions, and to deter future bad behavior.
COSTS OF SECURITIES CLASS ACTION
The Committee on Capital Markets Regulation (“CCMR”) argues that securities class actions impose significant costs to the United States economy and its capital markets. Indeed, according to the CCMR, in 2012, almost 150 securities class action suits were filed and the aggregate cost of settlements added up to $3.3 billion. CCMR also reports that more than 40% of the corporations that are traded on major U.S. stock exchanges are targets of securities class action suits. CCMR further alleges that the mere threat of litigation to companies leads to deteriorating profitability and higher risk of bankruptcy. According to the Securities Industry and Financial Markets Association (“SIFMA”), the perception of such litigation costs is cited as one reason among foreign companies why they stay away from U.S. capital markets. SIFMA contends that U.S. markets must remain attractive to foreign companies as a place to list their securities; however, there is a wide perception that the U.S. legal system imposes higher costs on business than do other legal systems in major capital markets. On a similar note, Applied Molecular Genetics (“AMGEN”) contends that the economic costs of securities fraud cases are highly damaging to pharmaceutical and biotechnology companies because such litigation and settlement costs drain the resources available for investment in research and development. AMGEN argues that the public depends on such companies to develop cures for serious illnesses, but that numerous securities class actions further delay the innovative remedies that normally take 10-15 years to develop.
On the other hand, Respondent argues that the litigation and settlement costs spent by companies are exaggerated. Respondent claims that more cases have been dismissed than settled or continued beyond the pleading stage. Indeed, Respondent reports that a total of 73% of cases were resolved through dismissal or settlement even before a motion for class certification was filed, and that 12% were resolved before any ruling on the class certification motion. Therefore, according to the Respondent, 85% of the cases were resolved even before the court granted a class certification. Moreover, although ten cases accounted for almost $30 billion in settlement claims, there was no question that executives in those companies committed significant securities fraud. More importantly, Respondent contends that although securities class action filings rose in 2013, such filings were at their lowest levels in 2012 ever since 2007 and that during 2010 to 2012, attorneys’ fees have declined dramatically compared to 1996 to 2009. Furthermore, Respondent argues that the settlement claims are largely derived from external sources such as insurance companies and accounting firms. According to Respondent, more than half of all settlement claims are borne by the insurers and contributed by accounting firms.
DETERRENT EFFECT OF SECURITIES CLASS ACTION
According to the United States Chamber of Commerce, the threat of class action of securities fraud does not deter corporate fraud among companies. The U.S. Chamber of Commerce argues that the SEC has power to bring statutory causes of action against companies that commit securities fraud and can redress securities fraud through enforcement actions by imposing monetary penalties. Indeed, the U.S. Chamber of Commerce contends that both the SEC and the Department of Justice have pursued restitution for investors harmed by fraud. The CCMR further supports this by noting that since 2009, the SEC has devoted greater staff resources to securities enforcement efforts and that it successfully obtained roughly $2 billion in penalties and disgorgements. Given such robust securities fraud enforcement regimes, the CCMR argues that private class actions are not necessary to protect investors. In fact, according to the American Institute of Certified Public Accountants (“AICPA”), rather than deterring securities fraud, the threat of numerous class actions will deter accountants from providing audit services to companies critically in need of audits. The AICPA contends that the full disclosure that securities laws seek to achieve depends on robust auditing provided by accountants and accounting firms. Moreover, the AICPA claims that the risk of litigation will increase the cost of audit services and will ultimately be borne by the investors of companies, the group that the SEC intends to protect through its securities laws.
Conversely, Respondent argues that without the availability of class certification based on the fraud-on-the-market theory, defrauded investors will lack sufficient legal recourse. Indeed, according to Respondent, this Court has held that private securities litigation is an “essential supplement ” to criminal prosecutions and civil enforcement actions brought by the SEC and the Department of Justice. Respondent emphasizes that even the SEC has noted the importance of private actions. Furthermore, Respondent alleges that numerous empirical studies have confirmed the deterrent effect that private actions have on corporate fraud. According to Respondent, one study found that “private plaintiffs’ attorneys, . . . [provide] greater deterrence against more serious securities law violations compared with the SEC.” In fact, Respondent notes that managers are deterred from committing securities fraud due to the “fear of dismissal, fear of reputational harm, and fear of personal, financial consequences.” Respondent argues that private actions act as a vehicle for compensating defrauded investors when deterrence fails. Moreover, Respondent contends that government enforcement is only a partial solution. According to Respondent, notwithstanding the increase in the SEC’s budget and resources, the SEC is continuously overworked and underfunded. As such, Respondent notes that the government is limited to only prioritizing the most significant securities fraud—only those that rise to a criminal level. However, Respondent argues that private actions protect the seriously defrauded investors who lack sufficient evidence to support the prosecution of the companies that have committed harmful corporate fraud.
This case presents the Court with the opportunity to determine whether to maintain the fraud-on-the-market reliance presumption in securities fraud class action cases. The Court will decide whether to overrule the Basic precedent or substantially modify its standard. The Court will also determine whether a defendant may rebut the presumption through a showing that stock prices were not impacted by an alleged misrepresentation at class certification.
OVERRULING OR MODIFYING BASIC V. LEVINSON
Halliburton argues that the Court should overturn, or at least substantially modify, Basic’s reliance presumption based on the fraud-on-the-market theory. Halliburton contends that Basic was incorrectly decided and should therefore be overruled. According to Halliburton, the Basic majority incorrectly adopted the reliance presumption and violated Congressional intent, thus exceeding proper judicial discretion. Halliburton further posits that Basic was based in now-discredited economic theories, and that the Court should therefore update its precedents to reflect reality. Halliburton maintains that the Basic Court relied on an oversimplified “efficient-markets” hypothesis that scholars have subsequently rejected. Because the presumption of reliance standard was rooted in incorrect economic theory instead of in law, Halliburton argues that the Court should not extend stare decisis to the Basic precedent. Finally, Halliburton argues that the Court should overrule or modify the Basic precedent because lower courts either inconsistently apply the reliance presumption or refuse to follow the precedent altogether. Halliburton maintains that the Basic standard has created confusion among lower courts, leading to widely disparate applications. Halliburton further argues that state courts, which are not bound by the precedent, refuse to follow the fraud-on-the-market theoretical approach to securities fraud cases. Because of the ambiguous, inconsistent, and unreasonable application of Basic’s reliance presumption in lower courts, Halliburton urges the Court to overrule this decision.
The Erica P. John Fund (“The Fund”) urgers the Court to uphold Basic’s reliance presumption. The Fund argues the Basic was correctly decided and contends that the Court has reaffirmed the twenty-five-year-old precedent five times in the past ten years. The Fund further maintains that Basic follows Congressional intent, positing that Congress has had multiple opportunities to overrule Basic’s reliance presumption and has declined to do so. The Fund also rejects Halliburton’s argument that the reliance presumption is based on erroneous economic theory. The Fund contends that the Basic precedent was based on simple, but universally accepted, economic principles. The Fund thus rejects Halliburton’s contention that Basic rests on shaky economic foundations, instead arguing that the reliance presumption is based on modest – not controversial – economic grounds. Finally, the Fund counters Halliburton’s position that lower courts inconsistently, if at all, apply Basic’s standard. According to the Fund, any confusion surrounding the Basic precedent has been appropriately resolved. The Fund further maintains that, directly contradicting Halliburton’s claim, state courts do not refuse to follow the Basic reliance presumption. The Fund thus asks the Court to follow stare decisis and uphold Basic’s precedent.
REBUTTAL OF PRESUMPTION
Halliburton argues that even if the Court maintains Basic’s presumption of reliance standard, the Fifth Circuit erred in not allowing Halliburton to rebut the presumption of reliance. According to Halliburton, Basic’s rebuttal right is essentially useless. Halliburton instead argues that the Court should adopt a direct price-impact rebuttal, instead of the prevailing indirect price-impact rebuttal. Halliburton also maintains that Basic allows for rebuttal of presumption at class certification if defendants can show the absence of price impact. Halliburton argues that the Fifth Circuit misapplied precedent when it precluded Halliburton from making a price-impact rebuttal at the class certification stage. Halliburton thus asks the Court to allow rebuttal at certification stage.
The Fund contends that the fraud-on-the-market presumption is genuinely rebuttal through an early motion for summary judgment and the Court therefore does not need to allow rebuttal at the class certification stage. According to the Fund, the “truth-on-the-market” defense (the argument that an alleged misrepresentation cannot impact the market if the market is already aware of the truth) is well-established and readily available for defendants. The Fund further argues that successful rebuttals are evident in analogous cases brought under Section 11. The Fund also maintains that courts frequently grant motions to dismiss for plaintiffs that fail to plead price impact on the face of the complaint. The Fund argues that the willingness of the courts to grant a motion to dismiss based on the weakness of a plaintiff’s complaint decreases the need for rebuttal at class certification. Finally, the Fund contends that under Basic’s framework, rebuttal should properly occur at trial. The Fund therefore asks the Court to uphold the Fifth Circuit’s denial of rebuttal for Halliburton.
In this case, the Court will determine whether to maintain, overrule, or change the prevailing presumption of reliance for securities fraud cases. The Court will also decide whether a rebuttal of this presumption should be allowed at the class certification stage of proceedings. Petitioner Halliburton argues that the fraud-on-the-market theory should be overruled because it is based on a mistaken understanding of the principles of economics, and the theory goes against the congressional purpose of federal securities statutes. Furthermore, the theory creates a litigious environment that deters companies from engaging in business in the United States. Respondent Erica P. John Fund asserts that the fraud-on-the-market theory is a legitimate presumption of reliance on the shareholders’ part and does not harm companies because the theory is rebuttable. Moreover, if the theory were overruled or modified, shareholders would lose their protection against securities fraud. The Court’s decision will impact the costs of securities class action lawsuits and the ease with which plaintiffs can bring such suits.
- BakerHostetler, Emily Myers, Securities Class Action Filings Up In 2013, But Could The Supreme Court Burst Their Bubble In 2014? (Jan. 30, 2014).
- Legal Newsline, Jessica M. Karmasek, U.S. SC agrees to hear securities class action litigation (Nov. 19, 2013).
- Bloomberg, Greg Stohr, Investor Suits Challenged as Court Takes Halliburton Case (Nov. 15, 2013)
- Mayer Brown, Andrew J. Pincus & Archis A. Parasharami, Supreme Court Will Address “Fraud-On-The-Market” Presumption in Securities Class Actions (Nov. 15, 2013)