Fraud on the Market Is Reaffirmed in Halliburton

Basic History
Plaintiffs in a securities-fraud case must show that they relied on the defendant’s alleged misrepresentations when deciding to purchase or sell the defendant’s stock. This can be a significant stumbling block for class-action plaintiffs, as most potential class members—investors—never read a defendant company’s statements or disclosures. The Supreme Court addressed this issue and the issue of a statement’s materiality in Basic, Inc. v. Levinson, 485 U.S. 224 (1988).

The Court defined the materiality of a statement in relation to a reasonable investor. If there is a “substantial likelihood” that the misstatement or omitted fact would have “significantly altered” the “total mix” of information for the reasonable investor, the misstatement or omitted fact is material. Put succinctly, “materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information.”

The Court next addressed if it is proper to apply a rebuttable presumption of reliance, an element of a Rule 10b-5 cause of action, supported by the fraud-on-the-market theory. The Court answered in the affirmative, viewing presumptions favorably as they support judicial economy and are useful in allocating burdens of proof.

As the Court explained, the fraud-on-the-market theory rests on another: the efficient capital markets theory. This theory posits that in efficient capital markets, security prices reflect all the information publicly available about the securities in that market. It is irrelevant whether an individual investor relied on a company’s statements when purchasing the stock because the stock’s price already reflected the company’s alleged misrepresentation. Further, the presumption of reliance created by the fraud-on-the-market theory is supported by the congressional policy underlying the Securities Exchange Act of 1934—an investor must be allowed to rely on the integrity of markets that are affected by publicly available information.

The presumption of reliance is rebuttable, as “[a]ny showing that severs the link between the alleged misrepresentations and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.”

In 2011, the Supreme Court confirmed Basic’s materiality requirement and the fraud-on-the-market theory. First, in a case involving a pharmaceutical company’s liability for failure to disclose adverse event reports, the Supreme Court reaffirmed that the materiality requirement is satisfied when there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011).

Pharmaceutical companies need not disclose every negative report; they only need to disclose reports or information that the reasonable investor would view “as having significantly altered the ‘total mix’ of information made available.” Id. at 1321–22. (In 2009, the FDA received 500,000 reports of adverse events.) The existence of a few adverse events reports will not alter the total mix of information. The Court validated Basic’s requirement that a court undergo a fact-intensive, case-by-case inquiry to answer thefollowing question: Will a reasonable investor view adverse statements, reports, or information as material? Almost six months later, the Court addressed Basic’s other significant holding—the presumption of reliance based on the fraud-on-the-market theory.

Halliburton
The Halliburton case is succinct and limited in scope. The Supreme Court unanimously held that private securities-fraud plaintiffs do not need to prove loss causation “as a precondition for invoking Basic’s rebuttable presumption of reliance.” Halliburton, 131 S. Ct. at 2186. Plaintiffs only need to show three elements to invoke the fraud-on-the-market presumption of reliance: The alleged misrepresentations must have been publicly known, that defendant’s security must have traded in an efficient market, and the plaintiff must have traded the defendant’s security between the time the defendant made the alleged misrepresentations and the time the defendant corrected its allegedly fraudulent statement. While the holding resolved a circuit split, overturning the Fifth Circuit’s line of cases requiring loss causation and upholding the Second, Third, and Seventh’s rejection of such a requirement, it did not provide direction on a number of issues, including when defendants may rebut the presumption of reliance. Some of these issues were answered, at least implicitly, in the later Wal-Mart decision.

Petitioner Erica P. John Fund, Inc. (EPJ), the lead securities-fraud, class-action plaintiff, sued Halliburton and David Lesar, its COO or CEO during the operative period, alleging that the defendants made false statements that artificially inflated Halliburton’s stock price in violation of section 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5. The alleged misrepresentations concerned Halliburton’s exposure in asbestos litigation, the revenue from construction contracts, and the benefits of a recent merger. Subsequent investors lost money when Halliburton’s later corrective disclosures caused its stock price to drop.

The plaintiffs defeated a motion to dismiss, but failed in their motion for class certification. The district court held that EPJ met the Rule 23(a) prerequisites for class actions, but that they failed to satisfy Rule 23(b)(3)’s requirement that “questions of law or fact common to class members predominate over any questions affecting only individual members.” The plaintiffs could not meet the Fifth Circuit’s requirement of “loss causation” necessary to invoke the presumption of reliance on the part of the entire class based on the fraud-on-the-market theory. Specifically, they failed to show, by a preponderance of the evidence, any connection between Halliburton’s material misrepresentations, the corrective disclosures, and the stock price’s decline. The Fifth Circuit affirmed the district court’s denial of class certification, holding that EPJ failed to show that certain disclosures had a “corrective effect linked” to a prior misrepresentation. Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 597 F.3d 330, 338 (5th Cir. 2010). For the Fifth Circuit court, requiring a securities plaintiff to show loss causation is crucial because “[l]oss causation is a direct causal link between the misstatement and the [plaintiff’s] economic loss.”

The Supreme Court, in an opinion authored by Chief Justice Roberts, reversed. Echoing the Fifth Circuit, the Court stressed that proof of reliance is critical because it ensures a link between the defendant’s misrepresentation and the plaintiff’s injury. However, the Supreme Court affirmed the continuing validity of Basic’s rebuttable presumption of reliance based on the fraud-on-the-market theory and held that plaintiffs need not prove loss causation to invoke the presumption.

In determining whether EPJ satisfied Rule 23(b)(3), the Court turned to the elements of the underlying cause of action, a violation of section 10(b) and Rule 10b-5: a material misrepresentation by the defendant, scienter, a connection between the defendant’s misrepresentation or omission and the purchase or sale of a security, the plaintiff’s reliance on the misrepresentation, economic loss, and loss causation. The strength of a securities-fraud action often depends on the fourth element, reliance, and, as explained in Basic, if courts required plaintiffs show their individual reliance on defendants’ misstatements, securities-fraud plaintiffs would rarely succeed on a motion for class certification. The fraud-on-the-market theory of reliance allows plaintiffs to overcome this burden, though only after plaintiffs have proven “certain things.” These things include, for example, that the stock traded in an efficient market and that the defendant’s misstatements were publicly known. Nowhere, in either Basic’s opinion or its logic, did the Court find “loss causation” as a prerequisite for invoking the rebuttable presumption of reliance.

The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively through the “fraud-on-the-market” theory. As noted by EPJ in its brief, because the effect of the defendant’s misstatements and the subsequent corrections are necessarily questions common to all proposed class members, the answer to those questions should not defeat certification.

The opinion does not address any other “question about Basic, its presumption, or how and when it may be rebutted.” Halliburton, on remand, may challenge class certification on grounds other than EPJ’s failure to prove loss causation at this stage in the litigation. The Court also failed to address the merits of Halliburton’s price-impact theory, which states that “if a misrepresentation does not affect market price, an investor cannot be said to have relied on the misrepresentation merely because he purchased stock at that price.” Halliburton argued that the Fifth Circuit’s “loss causation” analysis was really a price-impact analysis, but the Court rejected that argument without passing on the validity of the price-impact theory.

The Halliburton Court did not address the plaintiff’s burden of proof at the class-certification stage, even though both parties raised the issue. The Fifth Circuit’s opinion held that Rule 23 factors must be established by a preponderance of the evidence and the U.S. Solicitor General seemingly admitted this point in its brief, but the Court remanded the case without providing any guidance to the Fifth Circuit or any other lower court.

Halliburton after Wal-Mart
Before Wal-Mart Stores, Inc. v. Dukes, 131 S.Ct. 2541 (2011), courts generally did not consider the merits of a plaintiff’s claims when deciding a motion for class certification. Instead, courts focused on whether a plaintiff’s claims applied to the entire class, not whether a plaintiff would likely prevail on his or her claims at trial. After Wal-Mart, courts will be more willing or may be required to make a finding on a merits issue when that issue overlaps with a class-certification requirement. While this may seem beneficial to defense attorneys, the Supreme Court warned in Eisen v. Carlisle & Jacquelin, 417 U.S. 156 (1974), that if merits are considered at the class-certification stage, defendants could later be prejudiced by that ruling.

A court may not certify a class unless class counsel has met each Rule 23 factor, regardless of whether resolving those requirements entails some analysis of the merits of the case. “Rule 23 does not set forth a mere pleading standard,” and in the securities-class-action context, the Court’s opinion strongly suggests that district courts not only may, but must engage in fact-finding on any issue relevant to the Rule 23 factors. In support of considering merits issues at the Rule 23 stage, the Court cited Halliburton and noted that, in securities class actions, it is common for merits questions to affect Rule 23 factors, specifically the requirement that plaintiffs must prove the defendant’s stock traded on an efficient market to rely on the fraud-on-the-market theory. Even if plaintiffs must prove the existence of an efficient market at trial again, they still bear the burden of showing the same issue on a motion for class certification.

Unlike Halliburton, Wal-Mart addressed the question of burden of proof at the class-certification stage. The Court stressed that district courts must engage in a “rigorous analysis” of the Rule 23 factors, and they should “probe behind the pleadings.” The Court examined the anecdotal, statistical, and sociological evidence offered by plaintiffs. And, in at least the employment-discrimination context, the Court may require plaintiffs to provide “significant proof” of Rule 23 factors. If plaintiffs provide expert testimony to withstand a court’s rigorous analysis, the Court suggested that the witness providing such testimony must first qualify as an expert under the standards in Daubert v. Merrill Dow Pharmaceuticals, Inc. 509 U.S. 579 (1993). Id. at 2553–54. This suggestion—the Court merely “doubted” the district court’s conclusion that Daubert did not apply at the class-certification stage—is especially relevant in securities cases because the existence of an efficient market will often depend entirely on expert witness testimony.

Conclusion
In its last term, the Supreme Court offered up a mixed bag for securities-class-action practitioners. Halliburton established the continuing vitality of the fraud-on-the-market theory and plaintiffs’ ability to presume that the class relied on the defendants’ alleged misstatements. To invoke that theory, securities’ plaintiffs must show three elements: that the alleged misrepresentations were publicly known, that the defendant’s security traded in an efficient market, and that the plaintiffs traded the defendant’s security between the time the defendant made the alleged misrepresentations and the time the defendant corrected its allegedly fraudulent statement. After Wal-Mart, proving the existence of each element has become more daunting. Plaintiffs’ proffers of evidence will be subject to a “rigorous analysis,” and their expert witnesses must meet Daubert standards. Even if the trial court invokes the presumption of reliance and certifies the class, the basis for the presumption may be relitigated at trial. Defendants may challenge the trial court’s previous finding that their securities traded in an efficient market, and if successful, defendants will have eliminated the basis for the certification of the class. Considering Halliburton’s limited holding, specifically its decision not to decide the burden-of-proof issue, and Wal-Mart’s requirement of a rigorous analysis at the class-certification stage, a second Halliburton decision may not be too far off.

Keywords: litigation, class actions, derivative suits, fraud on the market, class certification

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