June 12, 2013 Top Story

Fraud-on-the-Market Theory Questioned

Securities fraud plaintiffs win, but is the victory pyrrhic?

Sean T. Carnathan

Securities fraud plaintiffs must ultimately prove that the misstatements they challenge as being fraudulent were “material,” but the Supreme Court held that this threshold showing is unnecessary to certify a class. In a 6–3 decision in Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds [PDF], the Supreme Court resolved a circuit split, siding with the Seventh and Ninth Circuits and rejecting the positions of the Second, Third, and Fifth Circuits in so holding.

The Court also raised serious doubts about the continuing viability of the plaintiffs’ common use of the “fraud-on-the-market” theory to establish their claims. Thus, although the Amgen decision was technically a “win” for the plaintiffs’ bar, it opened the door for a future attack on the fraud-on-the-market theory, which would work a sea change for securities litigation.

Materiality as an Element of Fraud on the Market

To recover damages in a securities fraud action, a plaintiff must prove, among other things, reliance on a material misrepresentation or omission made by the de­fendant that affected the security at issue. In broad strokes, a material misstatement is one to which a reasonable investor would likely attach importance.

Plaintiffs typically rely on the so-called “fraud-on-the-market theory” to satisfy the reliance element of a fraud claim. The theory provides a rebuttable presumption—that in an efficient securities market, the price of the security reflects all public information, and so a buyer or seller of the security may be presumed to have relied on material misinformation.

Predominance and Fraud on the Market

In Amgen, the defendants alleged that the plaintiffs could not certify a class without first proving “materiality.” They said this proof was necessary because without it, plaintiffs would never be able to prove that “questions of law or fact common to class members predominate over any questions affecting only individual members,” as is required by Rule 23. Because the fraud-on-the-market theory is premised on material information only, if the challenged misstatements were not material, the fraud-on-the-market presumption should not apply.

If the fraud-on-the-market theory does not apply, individual reliance issues would predominate over questions common to the class and potentially eliminate the class action remedy for securities fraud plaintiffs. For securities plaintiffs, the continued viability of the fraud-on-the-market theory is a big deal.

Majority Opinion

The Supreme Court majority held that proof of materiality is not part of the predominance analysis at class certification. According to the majority, because the court assesses materiality objectively, plaintiffs prove materiality through evidence common to all class members. Accordingly, materiality supports a determination that common issues predominate over individual issues and proof of materiality is not required for class certification.

Furthermore, because materiality is an essential element of a fraud claim, the Court concluded that “there is no risk that a failure of proof on the common question of materiality will result in individual questions predominating.” The class rises and falls together on materiality. If they fail to prove materiality, all their claims fail.

Some Dissenting Snarkiness along the Way

Justice Thomas, along with Justices Scalia and Kennedy, dissented, positing that where the fraud-on-the-market theory is a judge-made rule, it is not unfair to require plaintiffs to prove its elements to rely upon it at the class certification stage. More specifically, the dissent noted, “[w]ithout materiality, there is no fraud-on-the-market presumption, questions of reliance remain individualized, and Rule 23(b)(3) certification is impossible.” Justice Thomas said he felt the only reason the majority had found materiality was not necessary at the certification stage was “because it will be proved later on the merits”—an assessment he felt was improper.

The majority responded, accusing Justice Thomas of “totally misapprehending [the majority’s] essential point.” It also poked at Justice Thomas’s assessment that a plaintiff must prove the elements of the fraud-on-the-market theory for class certification as having no basis, and, thus, was purely “his invention.”

Future of the Theory Is Questionable

In Justice Alito's concurrence, however, the future of the fraud-on-the-market becomes dicey. He notes that recent scholarship shows that the fraud-on-the-market theory may rest on a faulty economic premise. In fact, some scholars are concerned that he has openly invited reconsideration of the theory in a future case. Similarly, in the dissent, Justice Thomas called the entire theory “questionable,” and the majority opinion also alludes to the debate in a footnote. No doubt, the defense bar will accept this apparent invitation to challenge the theory.

Some legal scholars confirm that there have been serious doubts about the fraud-on-the-market theory for years and believe doing away with it might be a good thing. “The fraud-on-the-market presumption is predicated on the efficient market hypothesis”—a hypothesis which has its own share of doubters, says Koji F. Fukumura, San Diego, cochair of the ABA Section of Litigation’s Securities Litigation Committee “Indeed, there is evidence that stock prices do not always incorporate material information, often over- or under-react to news, and stray from intrinsic value,” he explains.

He believes it is about time that this theory is revisited: “Plaintiffs have, for too long, had their cake and been able to eat it too. They have sought refuge in the presumption (and market efficiency) despite empirical evidence undermining materiality and loss causation.”

Plaintiffs’ Perspective

Others believe the fraud-on-the-market-theory might need tweaking but has served a valuable purpose. “The presumption of reliance has served valuable interests in promoting investor rights and allowing for recoveries by smaller investors,” notes Ralph M. Stone, New York City, a leading lawyer in the securities litigation and investor rights fields. He believes if the Supreme Court does away with the fraud-on-the-market presumption of reliance, “it will disenfranchise smaller investors.” Thus, he believes such a change might partially “cut back on lawsuits relating to smaller frauds” but “won’t meaningfully reduce litigation, given the tremendous rise in individual litigation in the securities fraud arena.”

Ultimately, however, as Stone looks to the future, he hypothesizes a slightly different approach to the question might be helpful. “It would save everybody a lot of time to adopt a presumption of reliance founded on common sense rather than the latest economic fad or better yet just do away with reliance as an element of the claim and make non-reliance an affirmative defense.”

Sean T. Carnathan is an associate editor for Litigation News.

Keywords: securities fraud, class certification, fraud-on-the-market theory

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