Nearly three decades after the U.S. Supreme Court embraced the “fraud on the market” presumption of reliance in securities fraud class actions (Basic v. Levinson, 485 U.S. 224 (1988)), significant recalibrations have been made. In two recent decisions, In re Petrobras Sec. Litig., 862 F.3d 250 (2d Cir. 2017) and Waggoner v. Barclays PLC, No. 16-1912-cv, 2017 U.S. App. LEXIS 22115 (2d Cir. Nov. 6, 2017), en banc petition pending, the Second Circuit held:
• In cases involving large cap, actively traded and well followed stocks (such as most listed on the NYSE and NASDAQ), plaintiffs need not present an “event study” to demonstrate that the stock traded in an “efficient” market. Petrobras, 862 F.3d at 278.
• When considering the efficiency of smaller cap stocks, district courts should “holistically” consider indirect factors of efficiency (e.g., trading volume, analysts and bid/ask spreads) along with event studies, rather than elevate event studies to a sine qua non status. Id. at 277.
• Plaintiffs need not show price movements when the alleged misrepresentations were first made, but rather may proceed on a “price maintenance theory,” i.e., that the misstatements “merely maintained inflation already extant in a company’s stock price.” Barclays, 2017 U.S. App LEXIS 22115, at *48, quoting In re Vivendi, S.A. Sec. Litig., 838 F.3d 223, 256 (2d Cir. 2016).
• Courts indeed should be wary of excessive reliance on event studies, given that such studies were intended for analysis of massive amounts of data involving multiple stocks, not individual firms with few “events.” Petrobras, 862 F.3d at 278.
• While Halliburton II afforded defendants an opportunity to rebut the reliance presumption by demonstrating that the alleged fraud had no impact on the price of the stock, defendants must do so by a “preponderance of the evidence.” 2017 U.S. App. LEXIS 22115, at **41-42.
Presuming no further review by either the Second Circuit en banc or the U.S. Supreme Court, these two decisions mark a pivotal point where proof of market efficiency is no longer “wedded” to event studies in every federal securities fraud class action. This should simplify class certification motions. That said, event studies will still remain useful for measuring damages.
Moreover, as discussed herein, Petrobras and Barclays mark a return to basics for proof of reliance in securities fraud class actions, back to principles recognized long before event studies and dueling financial market experts became SOP. The decisions reaffirm the underlying principles, i.e., that on today’s highly liquid, rapid-response stock exchanges, information drives prices, and misinformation inflates prices paid by unsuspecting investors. After all, investors rely upon the integrity of companies, and the markets, when purchasing shares. As noted in Basic: “[I]t is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?” Basic, 485 U.S. at 246-47, quoting Schlanger v. Four-Phase Sys., 555 F. Supp. 535, 538 (S.D.N.Y. 1982) (J. Brieant).
Here we focus on the lead-up to these two decisions—how did we get here—and demonstrate that the linkage of event studies to class certification motions was, in fact, an after-thought to the court’s early embrace of a more general “fraud on the market” presumption of reliance. Our next installment will focus on the reasoning and future applications of these decisions.
Rule 23’s adoption in 1966 spurred the development of a wide range of class actions, including those based on the federal securities laws. In recognizing an implied private right of action for claims arising under the 1934 Exchange Act, courts incorporated certain elements of the common law tort of fraud or deceit (Blue Chip Stamps v. Manor Drug Stores, 421 U. S. 723, 744-745 (1975); Herman & MacLean v. Huddleston, 459 U.S. 375, 388-89 (1983)), including “reliance” upon the misstatement or omission (Halliburton Co. v. Erica P. John Fund (Halliburton II) 134 S. Ct. 2398, 2407 (2014)). To proceed on behalf of a class, plaintiffs had to show inter alia, that facts common to all class members’ decisions to purchase shares predominated over facts unique to individual class members. (Rule 23(b)(3) also requires a finding that “a class action is superior to other available methods for fairly and efficiently adjudicating the controversy.”) Since common law required proof of direct reliance, courts quickly recognized that if each investor had to demonstrate they read the misstatements, individual issues of proof would overwhelm the common issues, thereby precluding class certification. See Green v. Wolf, 406 F.2d 291, 301 (2d Cir. 1968) (“Carried to its logical end, it would negate any attempted class action under Rule 10b-5, since … reliance is an issue lurking in every 10b-5 action.”).
To overcome this hurdle, the pioneer of shareholder litigation, Abraham L. Pomerantz, argued that defendants’ public misrepresentations created a “fraud on the market” (FOM) which impacted all investors alike:
The relevant impact of the misrepresentations was on the market. It was the artificially heightened market price, pure and simple, which operated on plaintiffs and other members of the class to induce conversion.” (Brief, p. 6). If plaintiffs can prevail in their “fraud on the market” theory, this may be sufficient to sustain a recovery under Section 10(b) of the Securities Exchange Act.
Herbst v. Able, 47 F.R.D. 11, 16 (S.D.N.Y. 1969) (emphasis in original). Origination of “fraud on the market” in this case, which was briefed by Pomerantz, was confirmed by Prof. Jill Fisch in “The Trouble With Basic: Price Distortion after Halliburton,” 90 Wash. U. L. Rev. 895, 906-07 (2013).
The FOM concept was thereafter embraced by courts seeking to fashion a tool for class-wide proof of reliance:
[P]roof of subjective reliance on particular misrepresentations is unnecessary to establish a 10b-5 claim for a deception inflating the price of stock traded in the open market…. Proof of reliance is adduced to demonstrate the causal connection between the defendant’s wrongdoing and the plaintiff’s loss. We think causation is adequately established in the impersonal stock exchange context by proof of purchase and of the materiality of misrepresentations, without direct proof of reliance. Materiality circumstantially establishes the reliance of some market traders and hence the inflation in the stock price—when the purchase is made the causational chain between defendant’s conduct and plaintiff’s loss is sufficiently established to make out a prima facie case.
Blackie v. Barrack, 524 F.2d 891, 906 (9th Cir. 1975).
Thereafter, clever academics linked FOM to the Efficient Market Hypothesis (EMH) posited by Eugene Fama of the Chicago School of Economics, a disciple of Milton Friedman. Eugene F. Fama, “Efficient Capital Markets: A Review of Theory & Empirical Work,” 25 J. Fin. 383 (May 1970). A marriage of FOM and EMH was first proposed by Fama’s colleague Prof. Daniel Fischel in “Use of Modern Finance Theory in Securities Fraud Cases Involving Actively Traded Securities,” 38 Bus. Law. 1, 3 (November 1982):
In an efficient capital market, such as American stock markets, … the market price of a firm’s stock will reflect all available information about the firm’s prospects. Because the market price itself transmits all available information, investors have no incentive to study other available data.
In 1988, the Supreme Court formally adopted a presumption of reliance for securities fraud class actions in Basic. The court reasoned that so long as plaintiffs demonstrated that the stock traded in a “well-developed market,” the stock “reflects all publicly available information, and, hence, any material misrepresentations.” 485 U.S. 224, 246 (1988) (Fischel’s article was cited in support of this observation at 485 U.S. 224 n.24). The court explained that the departure from the common law requirement of proof of direct reliance was warranted given that:
[M]odern securities markets, literally involving millions of shares changing hands daily, differ from the face-to-face transactions contemplated by early fraud cases, and our understanding of Rule 10b-5’s reliance requirement must encompass these differences.
Basic, 485 U.S. at 243-44, 245; see also Halliburton II, 131 S. Ct. at 2185; Stoneridge Inv. Partners, v. Scientific-Atlanta, 552 U.S. 148, 159 (2008) (“[U]nder the fraud-on-the-market doctrine, reliance is presumed when the statements at issue become public. The public information is reflected in the market price of the security. Then it can be assumed that an investor who buys or sells stock at the market price relies upon the statement.”).
Justice Blackman listed several reasons why such a presumption made sense, including (1) “common sense and probability;” (2) “market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices;” and (3) Professor Fischel’s article on EMH. Basic, 485 U.S. at 246 and n.24. (Critical to understanding the latest developments, though, is that the Basic court did not cite EMH to the exclusion of other factors.) Basic also rendered the presumption of reliance rebuttable if defendants produced evidence that “sever[ed] the link” between the market’s efficiency and individual investor’s reliance thereon. 485 U.S. at 248 (“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, will be sufficient to rebut the presumption of reliance.”).
The Advent of Event Studies
Academics viewed Basic as consecrating a marriage of EMH and FOM, and thereafter advocated borrowing tools developed by econometricians to measure the precise “efficiency” of markets for particular stocks, especially complex “event studies.” [see note 1]. A cottage industry of financial market experts for securities fraud cases was thereby spawned (including Lexicon, founded by none other than Professor Fischel).
‘Basic’ Redux—‘Halliburton II’
In 2014, the Supreme Court revisited the interplay between reliance, FOM and EMH in Halliburton II, 134 S. Ct. 2398 (2014). Because Basic was a 4-2 plurality, the court reconsidered Basic’s foundation, but re-endorsed the rebuttable presumption of reliance for efficient markets. Id. at 2410. Noting the raging debate among economists [see note 2], the court rejected the view that markets must be perfectly efficient in order to find that they reflect all public information (including defendants’ misrepresentations):
The academic debates discussed by Halliburton have not refuted the modest premise underlying the presumption of reliance. Even the foremost critics of the efficient-capital-markets hypothesis acknowledge that public information generally affects stock prices … . Debates about the precise degree to which stock prices accurately reflect public information are thus largely beside the point. “That the … price [of a stock] may be inaccurate does not detract from the fact that false statements affect it, and cause loss,” which is “all that Basic requires.” Schleicher v. Wendt, 618 F. 3d 679, 685 (7th Cir. 2010) (Easterbrook, C. J.).
134 S. Ct. at 2410 (emphasis in original). “[T]o invoke the Basic presumption, a plaintiff must prove that: (1) the alleged misrepresentations were publicly known, (2) they were material, (3) the stock traded in an efficient market, and (4) the plaintiff traded the stock between when the misrepresentations were made and when the truth was revealed.” Id. at 2413
The Supreme Court expressly rejected the “robust view of market efficiency” espoused by petitioners (id. at 2409), endorsing instead the view that the presumption of reliance could be triggered by a showing that the stock traded in a “generally” efficient manner. The court also observed that plaintiff’s burden of proof should impose “no heavy toll on securities-fraud plaintiffs with tenable claims.” Id. at 2417 (Ginsburg, J., concurring). (This standard for plaintiffs’ burden was echoed in Petrobras, 862 F.3d at 277 and Barclays, 2017 U.S. App. LEXIS 22115 at *40 n.31.) As Chief Justice Roberts observed, the question of a market’s efficiency was not a yes/no “binary” question, but rather more an analysis along a continuum:
The markets for some securities are more efficient than the markets for others, and even a single market can process different kinds of information more or less efficiently, depending on how widely the information is disseminated and how easily it is understood.
Basic recognized that market efficiency is a matter of degree … .
Id. at 2409-10.
As such, Halliburton II adopted a Goldilocks-like formula; the presumption of reliance was appropriate so long as plaintiffs showed that the market was “generally efficient.” [see note 3]. At the same time, the court explicitly expanded defendants’ right to rebut the presumption of reliance by demonstrating that the alleged misinformation did not “impact” the price of a stock. 134 S. Ct. at 2414.
 See Macey, Miller, Mitchell, & Netter, “Lessons from Financial Economics: Materiality, Reliance & Extending the Reach of Basic v. Levinson,” 77 Va. L. Rev. 1017 (Aug. 1991). Event studies are “regression analyses that seek to show that the market price of the defendant’s stock tends to respond to pertinent publicly reported events.” Halliburton II, 134 S. Ct. at 2415. Such studies consider several factors, including contemporaneous general market and industry specific price movements, as well as the historic volatility of the company’s stock price, in order to measure the probability that the company’s stock price routinely responded rapidly to new, company-specific information.
 By this time, Eugene Fama had received a Nobel Prize for his work on market efficiency—but so too had Robert Shiller, for his work regarding irrational inefficiencies of markets. Professor Shiller is a leader in the “Behavioral Economics” field, see Robert J. Shiller, Irrational Exuberance (3d ed. 2015). Nobel Laureate Daniel Kahneman, author of the bestselling book Thinking, Fast & Slow (2011), is credited with developing this field with his colleague Amos Twersky; see also Michael Lewis, The Undoing Project (2016).
 Id. at 2414; see also Amgen v. Conn. Ret. Plans & Tr. Funds, 568 U.S. 455, 462 (2013). (“If a market is generally efficient in incorporating publicly available information into a security’s market price, it is reasonable to presume that a particular public, material misrepresentation will be reflected in the security’s price.”)
Marc I. Gross and Jeremy A. Lieberman are partners at Pomerantz LLP, plaintiffs’ lead counsel in ‘Petrobras’ and ‘Barclays’. Mr. Lieberman argued both appeals.