Fraud-on-the-market and Halliburton II
In a private securities fraud action investors can recover damages only if they prove that they relied on the defendant's misrepresentation in deciding to buy or sell a company's stock. In 1988, the Supreme Court ruled in Basic v. Levinson, 485 U.S. 224 (1988) thatsecurities class action plaintiffs could prove class-wide reliance by invoking the "fraud-on-the market" doctrine (FOM), which is the "rebuttable presumption of reliance on public, material misrepresentations regarding securities traded in an efficient market" in which a security's price quickly and correctly impounds material new public information.
Basic did not clarify how efficiency could be adequately proven for reliance purposes. Therefore, following Basic, lower courts have typically considered a list of ad hoc factors as intuitive indicators or proxies of market efficiency. For instance, a district court decision shortly after Basic first listed five such factors. See Cammer v. Bloom, 711 F. Supp. 1264 (D.N.J. 1989). However, many of these factors except for the fifth (price impact), have little probative value according to recent research, including a study I co-authored last year, and may indicate that a security traded in an efficient market, when in fact it did not. Moreover, market efficiency theory has been vigorously attacked since Basic. Indeed, the 2013 Nobel Prize in economics was shared by Eugene Fama, the founding father of the market efficiency theory, and Robert Shiller, one of its most influential critics.
In Halliburton Co. v. Erica P. John Fund, Inc. No. 13-317 (Halliburton II) the Supreme Court revisited the applicability of the FOM doctrine 26 years after Basic. Although Halliburton II did not overturn Basic, it permitted defendants to rebut the FOM presumption at the class certification stage by introducing evidence that the alleged misrepresentation did not impact the market price, noting that "the fact that a misrepresentation has price impact is 'Basic's fundamental premise.'"
Measuring Price Impact
In an efficient market, a stock's price can change due to news unrelated to the company, such as market or industry news, or even due to random fluctuations not related to any news per se. Therefore, to assess the price impact of a particular firm-specific news event, economists generally use a statistical method known as an "event study." In an event study, the stock's "excess return" (or price change net of the change attributable to contemporaneous changes in the market or industry indices) following an event is first calculated. This excess return is compared to its normal range of fluctuation. If it is outside its normal range, the excess return is said to be "statistically significant". If not, the evidence generally does not support the conclusion that the event had a price impact. The Halliburton II ruling is likely to result in a battle of economic experts to assess price impact early in the litigation process.
Implications of Halliburton II
Alleged misrepresentations are expected to inflate the stock price. So, following Halliburton II the defendants are likely to engage experts early to assess if the stock's price reaction following alleged misrepresentations was statistically significant. The defendants may attempt to exclude some alleged misrepresentations by proving they did not have any price impact. Even if a stock's price reaction following an alleged misrepresentation is found to be significantly positive, the defendants may chisel some of that price reaction away by arguing that it was attributable to other firm-specific news not at issue, rather than the alleged misrepresentation. The defendants may argue that the remaining insignificant price reaction proves that the misrepresentation per se did not have any price impact. By excluding some misrepresentations for lack of price impact, the defendants' bargaining power during negotiations could improve as fewer remaining misrepresentations could shorten the class period and hence lower potential damage exposure.
The plaintiffs' experts may criticize defendants' event study results on technical grounds. The plaintiffs may also argue that lack of a price increase following a misrepresentation does not prove that the stock traded in an inefficient market, by casting the misrepresentation as an "omission" that propped up the stock price at its prior inflated level rather than inflating it further. As a logical matter, while such an omissions argument may have merit, it must be proven. Absence of proof (or a price impact) does not constitute proof. Yet, if courts accept such arguments, then a debate on price impact issues may become irrelevant, making class certification a virtual certainty once again. Only time will tell the extent to which Halliburton II actually affects the manner in which 10b(5) securities class actions proceed in the future.
Sumon C. Mazumdar is lead director of the Securities and Finance Practice at Navigant Economics as well as a leadership member of the Securities Litigation and Class Actions committees of the American Bar Association's Section of Litigation.
Keywords: expert witnesses, litigation, Halliburton II, price impact, private securities fraud action, market efficiency theory, fraud-on-the-market