By:
Daniel Dunne, David Keenan and Steven Hong
On June 23, 2014, the U.S. Supreme Court issued its second decision in Halliburton Co. v. Erica P. John Fund, Inc.,
__U.S. __(2014), 2014 WL__ (U.S. June 23, 2014) ("Halliburton II"). In this widely
anticipated decision, the Court reaffirmed its earlier embrace of the
so-called fraud-on-the-market doctrine in Basic,
Inc. v. Levinson, but held that defendants may rebut the
presumption of reliance that undergirds certification of Rule 10b-5
securities class actions by showing that alleged misrepresentations did not have a material impact on the
price of the stock.
This alert discusses Halliburton II’s possible
impact on class action suits brought under federal securities laws.
Case Background
Plaintiff-Respondent
Erica P. John Fund, Inc. (the "Fund") is a not-for-profit group
that supports the outreach work of the Archdiocese of Milwaukee. The Fund
purchased stock in Halliburton Company and lost money when Halliburton’s
stock price dropped following the release of negative news regarding
Halliburton’s (1) potential liability in
asbestos litigation, (2) revenue accounting on fixed-price construction
contracts, and (3) merger with Dresser
Industries. The Fund filed a lawsuit against Halliburton and its CEO David
Lesar (collectively, "Halliburton") alleging that Halliburton had
made knowing or severely reckless misrepresentations concerning those
topics, in violation of Sections 10(b)
and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The
Fund sought to certify a class of plaintiffs under Federal Rule of Civil
Procedure 23(b)(3), which requires that "the questions of law or fact
common to class members predominate over any questions affecting only
individual members," known as "predominance."
Since the parties did
not dispute that the market for Halliburton common stock was
"efficient," the Fund invoked the Supreme Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988)
("Basic") to
establish class-wide reliance. The decision in Basic sought to address the difficulties plaintiffs in
securities class actions face in establishing predominance under Rule
23(b)(3) concerning alleged misrepresentations in connection with the sale
of securities – that if each class member were required to establish actual
reliance on defendants’ alleged misrepresentations in deciding to purchase
a security, the individual issues of reliance would always overwhelm issues
common to all class members, defeating predominance and preventing class
certification.
The Basic Court recognized a rebuttable
presumption of class-wide reliance under the
"fraud-on-the-market" theory. That theory was based, in part, on
the efficient capital markets hypothesis, which in its simplest form,
broadly assumes that in an efficient market all material information
concerning a company is known to the market and incorporated immediately in
the company’s stock price. Thus, when an investor buys or sells stock in an
efficient market, the investor presumably does so in reliance upon the
integrity of the efficient market’s price. Basic
instructed federal courts to presume that class members relied
on the public, material misrepresentations efficiently incorporated into
the company-defendant’s stock price, eliminating the need to prove reliance
individually, and thereby permitting certification of 10b-5 class actions.
In opposing class
certification, the Halliburton Defendants did not challenge the Basic presumption of reliance based on
market efficiency. Instead, Halliburton argued that the Fund did not
establish loss causation under the Fifth Circuit’s requirement that a
plaintiff prove a misstatement actually moved the market. The District
Court agreed and denied class certification because the Fund did not show
any stock price increase resulting from the alleged misrepresentations. On
appeal, the Fifth Circuit affirmed the District Court.
In what would be its
first pass at this case, the Supreme Court reversed the Fifth Circuit. Erica P. John Fund, Inc. v. Halliburton Co.,
131 S. Ct. 2179 (2011) ("Halliburton
I"). As the Court in Halliburton
I explained, the question of loss causation—i.e., whether an
alleged misrepresentation actually caused investors to lose money on their
securities purchases—is different from the question of reliance under Basic—i.e., whether the investor-class
members can be presumed to have relied on the alleged misrepresentation in
making the decision to purchase the securities. The Court held that
plaintiffs are not required to prove loss causation to obtain class
certification, and remanded the case to address other arguments against
class certification.
On remand, the District
Court certified the class and held, without analysis, that "[t]he
fraud-on-the-market theory applies to this case, so proof of each
individual class member’s reliance is not required." Archdiocese of Milwaukee Supporting Fund, Inc. v.
Halliburton Co., 2012 WL 565997, at *2 (N.D. Tex. Jan. 27,
2012). The Fifth Circuit affirmed class certification and, significantly,
rejected Halliburton’s contention that the absence of "price
impact"—an effect of a misrepresentation on stock price—could rebut
the fraud-on-the-market presumption. The court relied on the Supreme
Court’s decision in Amgen Inc. v.
Connecticut Retirement Plans & Trust Funds, 133 S. Ct. 1184
(2013), which held that since the element of materiality was established by
evidence common to all plaintiffs and failure to prove materiality would
cause all individual claims to succeed or fail on evidence common to the
class, materiality was unnecessary to consider at the class certification
stage. The Fifth Circuit similarly found that price impact was an objective
inquiry that applied to everyone in the class. If Halliburton could prove
the absence of price impact, all individual claims would fail because
plaintiffs would be unable to establish loss causation. "[T]he focus
of the 23(b)(3) class certification inquiry—predominance—is not whether the
plaintiffs will fail or succeed, but whether they will fail or succeed together." Erica P. John Fund, Inc. v. Halliburton Co.,
718 F.3d 423, 431 (5th Cir. 2013). Since price impact evidence did not bear
on the question of whether common questions predominated, the Fifth Circuit
affirmed class certification.
On appeal to the Supreme
Court for the second time, Halliburton asked the Court two questions: (1)
should the Court overrule Basic
to the extent that Basic
recognized a presumption of class-wide reliance derived from the
fraud-on-the-market theory?; and (2) where a plaintiff invokes the Basic presumption, should a defendant
be allowed to rebut the presumption and prevent class certification by
introducing evidence that any alleged misrepresentations did not actually
distort the stock price? The Court answered no to the first question and
yes to the second.
The Decision
On the first question,
the Court declined to overrule its prior holding in Basic. As to Halliburton’s argument
that the Basic presumption
was inconsistent with Congress’s intent in passing the 1934 Exchange Act,
the Court noted that Justice White made "the same argument" in
his dissent in Basic; the
majority found it unpersuasive then, "and Halliburton has given us no
new reason to endorse it now."
Turning to the substance
of Halliburton’s argument to
overturn Basic, the Court
first rejected Halliburton’s argument that the efficient capital markets
hypothesis supporting the Basic
presumption was erroneous at adoption and had fallen out of favor with the
economic and finance experts cited throughout its brief. Noting that the
academic "debate is not new," the Court held that Halliburton’s
argument did not fundamentally address Basic
"on its own terms." The Court explained that Halliburton's
contentions about the invalidity of the efficient capital markets
hypothesis were beside the point, because the Court in Basic did not "adopt any
particular theory of how quickly and completely publicly available
information is reflected in market price." Instead, the Court said, Basic stood for the more
"modest" proposition that "professionals generally consider
most publicly announced material statements about companies, thereby
affecting stock market prices." The majority concluded that
"[t]he academic debates discussed by Halliburton have not refuted the
modest premise underlying the presumption of reliance."
Halliburton also argued
that it was a fallacy that all investors relied on the integrity of the
market, pointing out many examples of investors who purchased or sold
securities for other goals or purposes. For example, a "value
investor" purchases stocks on the belief that the price of the
securities does not
accurately reflect all public information available at the time of the purchase. But the
majority retorted that Basic
never denied the existence of such investors, who in any event, rely at
least on the fact that market prices will incorporate public information
within a reasonable period,
and that market prices, however inaccurate, are not distorted by fraud. Thus, the Court appears to have
adopted a "weak" version of the presumption of reliance, in which
investors are not presumed to
have relied on the efficiency of the market in instantaneously setting an
accurate price, but on some effect from market efficiency that is less
precise, determinable and measurable.
The Court also cast
aside Halliburton’s last argument—that stare
decisis was of less import here because Basic could no longer be reconciled
with the Court’s more recent jurisprudence concerning securities class
actions. For example, Halliburton argued that Basic expanded the Rule 10b-5 cause of action, while the
Court’s holding in Central Bank of
Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S.
164 (1994) called for the rule to be more narrowly applied. The Court
distinguished Halliburton from Central
Bank and Stoneridge
as cases that rejected attempts to broaden Rule 10b-5 liability to
defendants who were not alleged to have made misstatements. "While the
presumption makes it easier for plaintiffs to prove reliance, it does not
alter the elements of the Rule 10b-5 cause of action and thus maintains the
action’s original legal scope."
The Court
similarly declined to accept Halliburton’s argument that the Court’s holdings
in Wal-Mart Stores, Inc. v. Dukes,
131 S. Ct. 2541, 2551 (2011), and Comcast
Corp. v. Behrend, 133 S. Ct. 1426, 1432 (2013), which required
plaintiffs to "actually prove—not simply plead—that their proposed
class satisfies each requirement of Rule 23," could not be squared
with Basic, which, as
Halliburton argued, "relieves Rule 10b-5 plaintiffs of that
burden." "That is not the effect of the Basic presumption," the Court
retorted, observing that the Basic
presumption puts the burden on plaintiffs to establish the prerequisites
for invoking the presumption — "namely, publicity, materiality, market
efficiency, and market timing."
The Court also declined
to accept Halliburton’s invitation to modify the prerequisites for invoking
the presumption by requiring class-action plaintiffs to prove "price
impact" directly at the class certification stage. The Basic presumption itself includes two
"constituent presumptions": (1) if the plaintiff can show a
public, material misrepresentation concerning a defendant company whose
stock trades in an efficient market, the court presumes that the misrepresentation affected the stock
price; and (2) if the plaintiff purchased the stock during the relevant
period, the court presumes that the plaintiff made that purchase in
reliance on the misrepresentation. Accepting Halliburton’s position that
plaintiffs should be required to show price impact affirmatively would
"take away the first constituent presumption."
On the other hand, the
Court did agree with Halliburton that defendants must be given the
opportunity prior to certification
of a class to show evidence of a lack
of price impact. What the Fund argued, and the Fifth Circuit held, was that
defendants could not rely on this price-impact evidence "prior to
class certification for the particular purpose of rebutting the presumption
altogether." This restriction, the Court held, "makes no sense,
and can readily lead to bizarre results." As the Court explained, Basic allows plaintiffs to establish
price impact "indirectly"
by showing that a defendant’s public, material misrepresentations were made
in an efficient market. "But an indirect proxy should not preclude
consideration of a defendant’s direct,
more salient evidence showing that an alleged misrepresentation did not actually
affect the stock’s price and, consequently, that the Basic presumption does not
apply," and "there is no reason to artificially limit the inquiry
at that stage by excluding direct evidence of price impact."
Justice Clarence Thomas
wrote an opinion concurring in the judgment, in which he was joined by
Justices Scalia and Alito. These justices called for Basic to be overruled because
"economic realities . . . [had] undermined the foundations of the Basic presumption, and stare decisis cannot prop up the
façade that remains." Façade or not, after today’s decision, the
fraud-on-the-market theory remains alive and well, the growing chorus of
voices to overrule it have been squelched, and securities fraud class
actions will continue largely as they have for more than twenty-five years.
Defense attorneys have acquired another procedural tool in their arsenal to
defeat such cases by showing a lack of
price impact at the certification stage. Like other developments in
securities law over the last twenty years, today’s decision in Halliburton can be expected to reduce
the percentage of securities fraud cases that survive motion practice. Halliburton should also dampen the
enthusiasm that plaintiff’s lawyers might have for filing otherwise weak
claims where there is no significant price effect at the time that alleged
false statements are made.
As with the numerous
other limitations on securities class actions that have accrued since
Justice Thomas’s seminal decision in Central
Bank of Denver in 1994, in the near term, corporations may
expect to see a marginal decrease in the number of filings, a marginal
decrease in the number of classes certified, and although probably not
capable of measurement, a marginal decrease in the settlement value of
10b-5 class actions generally. These effects might become more pronounced
over time if defendants achieve significant success in disproving price
impacts from alleged misrepresentations and developing case law is friendly
to such proof. Finally, Halliburton II would
seem to be most influential in cases where plaintiffs allege that
defendants’ misrepresentations effectively reassured investors that
business was continuing on trend while concealing significant changes from
market expectations; because the expected effect of such misrepresentations
would be to prevent the
market price from declining in response to new public material information,
such cases would seem more susceptible to rebuttal by showing a lack of
price impact.
|