Supreme Court wrestles with 'fraud-on-the-market' future

While the oral arguments on 5 March brought clarity to where the four solidly liberal justices on the US Supreme Court stand in a case that could decide how class-action securities fraud lawsuits are handled in the future, it was foggier trying to deduce on which side the other five may align, although there was a lot of discussion about a "midway" solution.

The justices are tangling with whether they should overrule or substantially modify the Supreme Court's 1988 decision in Basic Inc v Levinson, which established the so-called fraud-on-the-market theory – the principle that the market price of a security traded in an efficient market reflects all public information, and therefore, a buyer of the security is presumed to have relied on the truthfulness of that information in purchasing the security.

In an amicus brief filed with the Supreme Court, the Pharmaceutical Research and Manufacturers of America (PhRMA), joined by the US Chamber of Commerce, the National Association of Manufacturers and the Business Roundtable, argued the application of the Basic ruling "has imposed substantial costs on public companies and their shareholders without producing corresponding benefits to investors."

They insisted Basic opened the floodgates for class-action securities lawsuits, putting a "significant economic drain on US public companies and their investors, both through the direct costs of litigation and settlements and indirectly through higher insurance costs."

"These deadweight costs impose a burden on capital markets and increase the costs of capital and insurance for businesses of all sizes and for the US economy generally," PhRMA and the other groups asserted.

They contended that Basic's presumption of reliance is "grounded in an outdated and overly simplistic understanding of market efficiency," and that the "functioning of markets and the manner in which they assimilate information into prices are more complex and more nuanced" than the majority of the court recognized when it came to its decision in 1988.

But the Council of Institutional Investors (CII), a nonprofit association of pension and other employee benefit funds, endowments and foundations – which have combined assets exceeding $3tn – said if the Supreme Court overturns the fraud-on-the-market presumption, institutional investors "will face serious impediments to pursuing securities-fraud lawsuits, whether class actions or individual suits."

"A robust private remedy for securities fraud is critical to achieving Congress's aims of deterring fraud and recouping investor losses," said CII Executive Director Ann Yerger.

In the case before the Supreme Court, the investors – the Erica P John Fund – alleged that energy mammoth Halliburton attempted to inflate its stock price by downplaying the company's estimated asbestos liabilities, overstating the revenue in its engineering and construction business and exaggerating the benefits of a merger.

The investors asserted that after they had purchased Halliburton shares, the company made corrective disclosures, which caused its stock price to tumble.

A district court initially denied the investors' class certification motion, explaining the fund had failed to prove loss causation, which the court insisted was required to prove before the fraud-on-the-market presumption could be invoked.

An appeals court affirmed the district court's ruling.

But the Supreme Court initially reversed that decision, declaring that a class-action plaintiff who invokes the fraud-on-the-market presumption need not prove loss causation to obtain class certification because that element is not relevant to whether reliance was capable of resolution on common classwide basis.

On remand, the district court certified the class, rejecting Halliburton's argument the investors must show price impact to obtain class certification in a fraud-on-the-market case.

Halliburton's appeal was pending when the Supreme Court last year ruled against Amgen in a class-action suit that a plaintiff relying on the fraud-on-the-market presumption need not prove materiality to obtain class certification (scripintelligence.com, 27 February 2013).

But in arguing before the Supreme Court on 5 March, Halliburton's lawyer, Aaron Streett, a partner at Houston, Texas law firm Baker Botts, charged that Basic v Levinson should be overruled "because it was wrong when it was decided and it is even more clearly erroneous today."

"Basic substituted economic theory for the bedrock common law requirement of actual reliance that Congress embraced in the most analogous express cause of action," Mr Streett insisted.

He said the high court in 1988 "judicially created presumption preserves an unjustified exemption" from Securities and Exchange Commission (SEC) Rule 23, resulting in only securities plaintiffs benefitting.

"Basic has proven unworkable, has been undermined by later developments, and has proven to have harmful consequences for investors and companies alike," Mr Streett declared. "The most direct course is to overrule Basic altogether and require a showing of actual reliance."

Justice Elena Kagan asked whether Halliburton was arguing whether Basic was flat-out wrong or if something has changed since the 1988 ruling.

"Because usually that's what we look for when we decide whether to reverse a case, something that makes the question fundamentally different now than when we decided it. And that's especially so in a case like this one where Congress has had every opportunity, and has declined every opportunity, to change Basic itself," Justice Kagan said.

Mr Streett said both circumstances applied – Basic was "wrong when decide and certain things have changed."

He contended the Supreme Court fundamentally changed its approach in interpreting the SEC's Section 10(b) cause of action.

"It's consistently construed it narrowly, and Basic stands out like a sore thumb among that jurisprudence," he asserted.

Mr Streett also argued the high court had consistently held in other cases, specifically Comcast v Behrend and Wal-Mart v Dukes, that there cannot be presumptions of classified issues and they must instead be proved in fact.

He also insisted the economics have changed since Basic was decided in 1988.

Many investors, like hedge funds, rapid-fire traders, index fund investors and sophisticated value investors, have investment strategies that do not rely on the integrity of the market price whatsoever, Mr Streett argued.

But the investors' lawyer, Davie Boies, chairman of New York-based Boies, Schiller & Flexner, argued that even though modern times have created a whole new genre of investors, in which the market is "massively more efficient" than it was in 1988 – when people had to rely on Barron's or the Wall Street Journal for their information – they still depend on the integrity of the market.

Chief Justice John Roberts pointed out that Mr Streett had acknowledged in his brief to the court the efficient market theory is accurate, to some extent, while the investors' lawyer had admitted it was not a perfect theory and there are situations in which events are not reflected in market price.

In other words, one side is saying most of the time the theory is sufficient, while the other is arguing much too often it's not.

"How am I supposed to review the economic literature and decide which of you is right on that?" Chief Justice Roberts demanded.

But Justice Anthony Kennedy said he was interested in the "midway position" raised by a group of law school professors, who said there should be an "event study" at the class certification stage.

Event studies, which are regression analyses that measure the effect of an event, such as a firm's earnings announcement, on a firm's stock price, are the "best available tool to examine market distortion and show reliance," the law professors said in an amicus brief filed with the court.

An event study could determine whether the alleged misrepresentations caused any statistically significant stock price movements when made or when a supposedly corrective disclosure was made, controlling for other possible causes of stock price movements, such as movements of the overall market and random fluctuations, they said.

If an event study shows that a misrepresentation or a corrective disclosure had a statistically significant effect on the price of a stock, then the market may be said to have relied" on the misrepresentation.

And, by the fraud-on-the-market theory, all of the investors who bought or sold the stock also relied by buying or selling at a market price that included a component reflecting the falsity, the law professors said.

Conversely, if an event study shows that a misrepresentation or corrective disclosure9 had no statistically significant effect on the stock price, then the market cannot be said to have relied on the misrepresentation, they said.

But Mr Boies argued that imposing event studies at the class certification stage would "enormously" increase the cost and time for investors in filing such suits.

Justice Antonin Scalia, who last year said the ruling in the Amgen case expanded the consequences of Basic from the "arguably regrettable to the unquestionably disastrous," surprisingly expressed some hesitancy at the 5 March Halliburton v Erica P John Fund oral arguments in overturning the high court's 1988 decision.

At the 5 March oral arguments, he noted that if Basic were entirely overruled, the Private Securities Litigation Reform Act (PSLRA) of 1995, which was enacted to curb abusive securities fraud lawsuits, would be "sort of useless."

But if the court adopts the law professors' proposal of imposing events studies, resulting in what Justice Scalia called a "Basic writ small," he wondered whether such a move would lessen the effectiveness of the PSLRA – showing he, too, was perhaps leaning to a midway solution rather than nixing the 1988 ruling.

A decision in Halliburton v Erica P John Fund is expected by 30 June, when the court’s current term is due to end.