October 07, 2014 Top Story

Supreme Court Reaffirms Fraud-on-the-Market Theory of Reliance

Defendants may challenge market efficiency to defeat class certification

Douglas E. Motzenbecker

After agreeing to revisit its landmark ruling in Basic, Inc. v. Levinson, the U.S. Supreme Court has substantially reaffirmed the decision, which affords plaintiffs in federal securities litigation a rebuttable presumption of reliance when they can establish an open, developed, and efficient market for the stock in question. Halliburton Co. v. Erica P. John Fund, IncThe Court rejected arguments that its intervening decisions as well as empirical evidence had undermined Basic. Even so, it held that defendants may attempt to rebut the presumption at the class certification stage by offering direct evidence that the market was not efficient.

Basic Principles

Most federal securities fraud litigation is brought pursuant to Section 10(b) of the Securities Exchange Act of 1934 (the Act) and Rule 10b-5 thereunder. To recover damages in a Section 10(b) action, a plaintiff must show: (a) the defendant made a misrepresentation or omission of material fact; (b) scienter; (c) a connection between the misrepresentation or omission and the purchase or sale of a security; (d) reliance on the misstatement or omission; (e) economic loss; and (f) loss causation. Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds.

A great deal of attention has focused on the reliance element. In the traditional sense, a plaintiff will show that he relied directly on a statement made by the company in question , e.g., an annual report, SEC filing, or press release. Many plaintiffs, however, trade without actually obtaining or reading company documents, which, if individual reliance were necessary, would probably mean that individual reliance questions would predominate and, thus, preclude class certification. 

To solve the reliance dilemma, the Basic Court excused plaintiffs from proving direct reliance. Instead, it held that they may satisfy this element of a Section 10(b) claim by proceeding on a rebuttable presumption of reliance. The plaintiff must demonstrate that: (a) the misrepresentations were publicly known; (b) they were material; (c) the stock traded in an efficient market; and (d) the plaintiff traded the stock between the time the misrepresentations were made and when the truth was revealed. The defendant can then attempt to rebut the presumption by making any showing that severs the link between the alleged misrepresentation and either the price received or paid by the plaintiff, or his decision to trade at a fair market price.

The Issues in Halliburton

The plaintiffs in Halliburton alleged that the company and one of its executives violated Section 10(b) by making a series of public misrepresentations about its operations (e.g., minimizing its exposure to asbestos litigation and overstating both its revenue from certain construction contracts and the benefits of a merger with another company). These misstatements, the plaintiffs said, wrongfully inflated the price of Halliburton’s stock, which fell after the company made a series of corrective disclosures. In an earlier decision in same case, the Court excused the plaintiffs from establishing loss causation at the class certification stage. Erica P. Jong Fund, Inc. v. Halliburton Co..

On remand, Halliburton argued that the same evidence that belied loss causation also showed that the company’s misstatements had no net effect on the market price for its stock. After Halliburton appealed the district court’s order certifying a class, the U.S. Court of Appeals for the Fifth Circuit affirmed, holding that while the company could introduce price impact evidence at trial, it could not do so in opposing class certification (because, in its view, this data did not bear upon the Rule 23 predominance requirement).

The Court again granted certiorari, this time to resolve a circuit split over whether a defendant may resist class certification by showing the absence of price impact. And it agreed to decide whether to overrule or modify Basic’s fraud-on-the-market presumption of reliance.

The Court’s Decision

The Court reaffirmed Basic, rejecting each of Halliburton’s arguments that it should be overruled. Although the company insisted that plaintiffs should be required to show individual reliance, the majority saw insufficient grounds to disturb the presumption-of-reliance theory. It disagreed that the presumption was inconsistent with Congress’s statutory intent. The Court also found that while the fraud-on-the-market theory of reliance may be imperfect, Basic never suggested the contrary, explaining that this is why defendants may attempt to show that the market for the securities in question is not open, developed, or efficient.

The Court confirmed Basic’s premise that market prices will ordinarily adjust for newly disclosed information, and it did not find the economic theories that Halliburton advanced were sufficiently compelling to undo the presumption. The Court also concluded that its post-Basic jurisprudence in Section 10(b) cases or with respect to class actions in general did not warrant a new course.

The Court, however, unanimously held that a defendant may oppose class certification by introducing direct evidence that the alleged violations had no impact on the price of the company’s stock.

Reaction to the Decision

“Although the Court signaled a willingness to reconsider the presumption of reliance, it reaffirmed the decision and declined to return to the pre-Basic era,” says Robert W. Brownlie, San Diego, CA, cochair of the ABA Section of Litigation’s  Securities Litigation Committee. “Halliburton is most significant for what it did not do,” he notes. “First, it did not eliminate or limit the fraud-on-the-market theory even though the Court acknowledged that ‘the efficient capital markets hypothesis [on which it is based] may have garnered substantial criticism since Basic.’ Second, the Court did not overrule the practice of trial courts considering whether a defendant can rebut the fraud-on-the-market presumption at the class certification stage, a practice that has been accepted by most circuits.”

With respect to the Court’s holding allowing defendants to introduce rebuttal evidence at the class certification stage, “if a defendant successfully rebuts the presumption of price impact of its fraud with direct evidence (which may be ‘event studies’ that perform a regression analysis of events that show the misrepresentation event did not impact the price of defendant’s stock) at the class certification stage, then a plaintiff cannot satisfy the fraud-on-the-market test,” notes Matthew P. Allen, Troy, MI, a member of the Section of Litigation’s Securities Litigation Committee. “If a plaintiff cannot satisfy this test, then the plaintiff is not entitled to a presumption of reliance, which means each plaintiff will have to prove reliance individually,” says Allen.

“Most courts had already allowed defendants to test the fraud-on-the-market presumption of reliance,” says Brownlie, “but Halliburton removes all doubt that defendants may challenge alleged market efficiency at the class certification stage. Although defendants can overcome the presumption of reliance in a particularly compelling case, plaintiffs will ordinarily be able to show that there was an open, efficient, and developed market for the shares in question.”


Douglas E. Motzenbecker is an associate editor for Litigation News.

Keywords: reliance, fraud-on-the-market theory, securities litigation

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