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Since 1988, when the U.S. Supreme Court issued its decision in Basic Inc. v. Levinson, 485 U.S. 108 (1988), courts have struggled with the showing required to trigger the presumption of reliance in fraud-on-the-market cases. When it established the presumption, the Supreme Court invoked the efficient market hypothesis (EMH), which holds that in an open and efficient market all available information, including any material misrepresentation, is reflected in a stock’s price. The premise of Basic is that shareholders’ reliance on the integrity of a stock price, presumably assured by an efficient market for the stock, is an adequate substitute for reliance on an alleged misrepresentation. All plaintiffs need to do to obtain the presumption of reliance is show that the market is efficient. Courts and commentators have noted, however, that Basic “offers little guidance for determining whether a market is efficient.” Gariety v. Thornton LLP, 368 F.3d 356, 368 (4th Cir. 2004). Troubling the waters even more is the fact that Basic launched the EMH at more or less the same time economists began to question it. From its beginnings, the presumption of reliance has thus lacked broad theoretical grounding and clear judicial guidance. The 5th U.S. Circuit Court of Appeals’ recent excursion into these murky waters is its most aggressive attempt yet to set the matter right. In Oscar Private Equity Investment v. Allegiance Telecom Inc., 487 F.3d 261, reh’g en banc denied (5th Cir. 2007), the 5th Circuit held that plaintiffs seeking the presumption of reliance must do more than establish indicia of efficiency in the market for the defendant’s stock. They must demonstrate that the alleged fraud actually moved the stock price. Specifically, they must prove loss causation. Inasmuch as it is nearly impossible to meet the predominance requirement for class certification without the presumption of reliance, this holding places a substantial obstacle in the way of plaintiffs in fraud-on-the-market cases. 5th Circuit was asked to rule on class certification The putative class in Oscar consisted of investors who purchased shares of Allegiance Telecom from April 24, 2001, to Feb. 19, 2002. The plaintiffs alleged that the company misstated its line-installation count in its first three quarterly announcements in 2001, and its stock price dropped when the misstatements were disclosed. The case came to the 5th Circuit on an interlocutory appeal of the trial court’s certification of the class, addressing whether the district court properly applied the fraud-on-the-market theory when it granted the presumption of reliance. The 5th Circuit vacated the certification order on the ground that the plaintiffs had not proven that the line-count misstatements, as opposed to other negative information, moved the market price of Allegiance Telecom’s stock. The 5th Circuit acknowledged that its purpose was to “tighten the requirements for plaintiffs seeking a presumption of reliance.” Id. at 265. Like an increasing number of circuit courts, the 5th Circuit rejected the contention that the Supreme Court in Eisen v. Carlisle & Jacquelin, 417 U.S. 156 (1974), prohibited it from addressing the merits of the case when making a class certification determination. It stated instead that courts are required to make findings sufficient to show that all of the Fed. R. Civ. P. 23 requirements have been met, and it concluded that in fraud-on-the-market cases this means courts must determine whether the alleged fraud caused investor losses. The 5th Circuit reasoned that the market can be defrauded only insofar as a misrepresentation affects a stock’s price. Proof of a causal relationship between the alleged fraud and investor losses is necessary to show that a misrepresentation actually is reflected in the stock’s price. Loss causation is thus a “fraud-on-the-market prerequisite” that must be assessed under Rule 23. One principal effect of the Oscar decision is to relieve defendants of the burden of rebutting market efficiency, which the Supreme Court placed on defendants in Basic. By identifying loss causation as a “fraud-on-the-market prerequisite,” Oscar shifts the burden to plaintiffs to prove loss causation. Moreover, the decision requires plaintiffs to come forward with proof of loss causation on a motion for class certification, earlier than has been typical in fraud-on-the-market cases. Critics have attacked both of these consequences of the holding. But both consequences have the advantage of being consistent with Congress’ goals in the Private Securities Litigation Reform Act (PSLRA), as well as with the Supreme Court’s reasoning in Dura Pharmaceuticals Inc. v. Broudo, 544 U.S. 336 (2005). Congress passed the PSLRA to curtail frivolous securities fraud lawsuits and avoid the in terrorem effect of meritless securities class actions. Toward that end, it raised the pleading standard under � 10(b) of the Securities Exchange Act of 1934, forcing plaintiffs to demonstrate at the beginning of the litigation that their claims have substantial basis. In addition, it codified the loss causation element of a � 10(b) claim to assure that plaintiffs recover only their actual losses. The Oscar decision reflects both of these changes. By requiring proof of loss causation to obtain certification, the 5th Circuit makes it more likely that plaintiffs will recover only their actual losses, as Congress intended, and it encourages early dismissal of unsubstantiated claims. It was not lost on the 5th Circuit that virtually all fraud-on-the-market cases settle before a determination of the merits. Certification of a class is often dispositive of such a case. Under these circumstances, allowing a class to be certified without proof of loss causation threatens to defeat Congress’ intentions when it codified the loss causation element of the claim. The Oscar opinion also carries out the implications of the Supreme Court’s decision in Dura. The 5th Circuit barely mentions Dura, but its opinion follows logically from the Supreme Court’s reasoning. In Dura, the Supreme Court reversed the 9th Circuit’s pleading standard, which required plaintiffs only to allege that a fraud artificially inflated the defendant’s stock price. The Supreme Court held that to pass muster on a motion to dismiss, a complaint must include allegations showing a causal connection between the fraud and investor losses. Echoing Congress, the court expressed concern that the “Ninth Circuit’s approach would allow recovery where a misrepresentation leads to an inflated purchase price but nonetheless does not proximately cause an economic loss.” Id. at 346. The Oscar decision shares the Supreme Court’s unwillingness to presume the element of loss causation, even at the pleading stage of a case. In addition, Dura evinces considerable skepticism about the EMH, stating that the sale of a fraudulently inflated stock after a corrective disclosure only “ might mean a later loss,” but “that is far from inevitably so.” Id. at 342. The EMH, at least as courts have typically applied it under Basic, should assure that disclosure of a fraudulent, inflationary statement is reflected in a drop in the stock’s price. Yet the Supreme Court concluded that “[w]hen the purchaser subsequently resells such shares, even at a lower price, that lower price may reflect, not the earlier misrepresentation, but changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions or other events.” Id. at 343. The 5th Circuit noted, along the same lines, that “[t]he assumption that every material misrepresentation will move a stock in an efficient market is unfounded.” Oscar, 487 F.3d at 269. Proof of the indicia of general market efficiency is insufficient to trigger the presumption of reliance because ” ‘the market price of a security will not be uniformly efficient as to all types of information.’ ” Id. Hence, the 5th Circuit concluded, at least in cases of multiple negative disclosures, proof of loss causation is required to assure the relevant integrity of the defendant’s stock price and, hence, the plaintiffs’ right to the presumption of reliance. Dissent saw a radical departure from ‘Basic’ Plaintiffs’ attorneys have been quick to agree with the dissent’s contention that Oscar represents a “breathtaking revision of securities class action procedure” that “eviscerates Basic‘s fraud-on-the-market presumption.” Id. at 272. But if Oscar unsettles class certification procedure in fraud-on-the-market cases, it is because it probes the strained-at-birth relationship between the Supreme Court’s holding in Basic and the EMH. Those readers who interpret Basic the way the dissent does believe that the Supreme Court granted not one, but two presumptions in Basic. The presumption of reliance, to be sure. But before that, they contend that Basic grants the presumption that an efficient market impounds all available information, including misrepresentations, in a stock’s price. The dissent said just this: “Under Basic, the court is to presume that the defendant’s material misstatement distorted the market price of the stock at issue.” Id. at 274. The problem with this interpretation, however common it may be, is that it overtakes the core rationale of Basic: The presumption of reliance is warranted if the alleged fraud is reflected in the stock price. The 5th Circuit is faithful to this premise. Rather than offending Basic, the 5th Circuit poses a timely question to Basic: Did the Supreme Court ground the presumption of reliance on a demonstrable fraud on the market? Or on an overstatement of the EMH? The 5th Circuit opts for the former, concluding that Basic allows circuit courts to adopt an information-specific view of efficiency, which requires proof that the price of a stock actually does incorporate the alleged fraud before plaintiffs are granted the presumption of reliance. Along with raising the evidentiary standard for class certification, the Oscar decision thus solicits a fundamental reconsideration of the relation between market efficiency and the presumption of reliance. David Jacobson is a Seattle-based Dorsey & Whitney partner in the firm’s trial, regulatory and technology group. He focuses on complex commercial litigation, including securities, intellectual property, telecommunications and tax litigation, and general appellate practice.

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