In its recent ruling Halliburton v. Erica P. John Fund, No. 13-317 (S. Ct. June 23, 2014) (Slip Op.) the Supreme Court declined an invitation from business groups and the defense bar to overturn 25 years of precedent by eliminating the judicially-created “fraud-on-the-market” presumption of reliance applicable to certain securities fraud class action suits. The fraud-on-the-market presumption frees plaintiffs in securities fraud suits from the requirement to prove that they relied on a purportedly false or misleading statement or omission when investing. The Court did, however, make it incrementally easier for defendants to have such suits dismissed at the earliest stages of litigation if they can demonstrate that the purportedly false or misleading statements or omissions did not affect the stock price at issue, and therefore could not have caused the damages alleged by plaintiffs.
The fraud-on-the-market theory was embraced by the Supreme Court in its 1988 decision in Basic v. Levinson, 485 U.S. 224 (1988). It rests on the notion that stock prices reflect all publicly available information about the company and its business, and that in an efficient market, stock prices adjust quickly as new information becomes available to investors. According to the theory, in efficient markets materially false or misleading information about a stock is almost immediately incorporated into the market and can artificially affect its price, thereby defrauding not only the recipient of the misleading information, but perpetrating a fraud against everyone in the market who bought or sold shares at the artificial price created by the misrepresentation. By granting investors a rebuttable presumption that they relied on the integrity of the marketplace in purchasing stocks, the fraud-on-the-market theory makes it easier for plaintiffs to succeed on fraud claims, and easier for plaintiffs’ attorneys to succeed in having shareholder class actions certified in order to bring claims on behalf of large numbers of investors at once.
Halliburton, joined by a number of business groups and academics, asked the Supreme Court to reconsider Basic, and do away with the fraud-on-the-market presumption. They argued, among other things, that this judicially-created presumption has unduly multiplied the number, magnitude and associated expenses of frivolous or ‘strike’ suits without creating any meaningful protection for investors or deterrents to fraud. They also argued that Congress never intended the securities laws to be so broad, and that the fraud-on-the-market presumption is based on questionable economic theories that do not comport with contemporary securities trading realities.
Chief Justice Roberts, writing for the five-justice majority, was not persuaded. The Court found Halliburton’s academic evidence too thin to justify overturning a 25 year-old precedent, particularly where Congress has had ample opportunity to amend the law but has declined to do so. Instead, the Court’s ruling now allows defendants to argue at the class certification stage of litigation that the alleged fraud didn’t cause stock prices to move, and therefore cannot have injured shareholders. If successful, this type of argument will shut down a class action at its early stages.
This decision is significant and may allow defendants to dispose of meritless suits more quickly, reducing overall litigation and settlement costs (even if marginally increasing discovery and litigation costs at the earlier class certification stage of the proceedings). And, as Justice Ginsburg noted in a concurring opinion, it “should impose no heavy toll on securities-fraud plaintiffs with tenable claims.” The effect that a misrepresentation had on stock price, which is usually shown through a statistical method known as an event study, is an issue litigated in nearly every securities suit. Therefore, allowing defendants the option to wage this “battle of the experts” at the outset of litigations that typically last several years may also save courts from expending limited judicial resources on meritless cases. Although the decision did not overturn the decades-old fraud-on-the-market presumption of reliance, which could have radically curtailed the ability to bring securities class action lawsuits, it marks a further step in a series of recent Supreme Court jurisprudence designed to limit the burdens and expenses of defending weaker cases by requiring more proof at the early stages of a case that the allegations of a complaint are sufficiently strong to justify further proceedings.
The author would like to thank John Vazquez, an associate in Cadwalader, Wickersham & Taft’s Commercial, Corporate & Securities Litigation group, for his contribution to this piece.