U.S. Supreme Court Upholds Fraud on the Market Theory in Securities Class Actions

Written By Robert W. Staley, Kenneth T. Lenz, Q.C., Barry J. Reiter and Jonathan G. Bell

A much-anticipated decision of the U.S. Supreme Court, Halliburton Co. v. Erica P. John Fund, Inc. was released on June 23, 2014. While the Supreme Court upheld the "fraud on the market" presumption of reliance which has made the U.S. a plaintiff-friendly jurisdiction for securities class actions, it provided defendants with a potentially powerful new tool for challenging the presumption at the certification stage.

History of the Fraud on the Market Presumption

In the United States, Rule 10b-5, enacted under section 10(b) of the Securities Exchange Act, prohibits misrepresentations or omissions in connection with the purchase or sale of securities. One of the elements of a 10b-5 claim is the plaintiff's individual reliance upon the alleged misrepresentation or omission.

In order to certify a class action in the United States, class plaintiffs must demonstrate, among other things, that the questions of law or fact common to class members predominate over any questions only affecting individual members. The "fraud on the market" presumption essentially allows plaintiffs to side-step the need to establish individual reliance with respect to a 10b-5 claim, allowing plaintiffs to demonstrate the common questions of law or fact necessary for certification. The presumption was first recognized by the U.S. Supreme Court in Basic v. Levinson, 485 U.S. 224 (1988) and is based upon the hypothesis that, in an open market, the price of a corporation's securities is determined by all available material information; therefore, misleading statements will defraud investors even if they do not directly rely on the misleading statements. On this basis, an investor's reliance may be presumed for purposes of Rule 10b-5.

Basic v. Levinson provided a framework for plaintiffs to avoid proving that each investor relied on the alleged misstatement, allowing for what has sometimes been called "rubber stamp" certification. Basic allowed plaintiffs to overcome an otherwise significant certification hurdle. As the vast majority of securities class actions in the United States settle proximate to or shortly after certification, Basic has become an important weapon in the hands of plaintiff law firms, making certification easier and ultimately affecting the settlement dynamic.

Basic has been questioned by lower courts, and has attracted unfavourable commentary, but was not expressly revisited by the Supreme Court prior to Halliburton.

Relevant Facts of Halliburton Co. v. Erica P. John Fund, Inc.

The lead plaintiff, Erica P. John Fund, Inc., commenced a proposed class action against Halliburton Company and its CEO alleging that misstatements were made between 1999 and 2011 with respect to Halliburton's asbestos-related legal liability, Halliburton's revenues, and the cost savings from a 1998 merger. Halliburton opposed class certification, arguing that the alleged misstatements did not impact the market price of the stock, which Halliburton argued rebutted the "fraud on the market" presumption. The district court rejected Halliburton's arguments and certified the class. This was affirmed on appeal. In 2013, the Supreme Court agreed to hear Halliburton's appeal.

The Supreme Court heard oral arguments in March 2014. Halliburton argued that the holding in Basic v. Levinson should be overruled given that it is based upon a simplistic understanding of market efficiency that does not accord with economic realities, also noting that it massively expands Rule 10b-5 liability. The lead plaintiff argued, among other things, that Basic v. Levinson is well-settled good law, and that Congress could have overturned the decision through legislation at any point in time but has chosen not to, leaving the framework from Basic v. Levinson in place.

In finding middle ground between these two positions, the Supreme Court upheld the "fraud on the market" presumption, but held that defendants are entitled to lead evidence prior to certification to rebut the presumption, and to demonstrate that the alleged misrepresentations did not affect the market price of the securities at issue. Once price impact is demonstrated through the application of the fraud on the market presumption or through direct evidence, or both, the materiality of that impact is a matter for the later merits determination.

Impact of Halliburton

Halliburton represents a deliberate but incremental shift of the pendulum in favour of defendants, adding another weapon to their arsenal in an effort to defeat certification. In the United States, the importance of class certification event studies will almost certainly increase, and they will become important prior to certification. Although Halliburton will increase the cost of opposing certification, Halliburton also increases the likelihood of defeating certification, which necessarily impacts the settlement dynamic in favour of defendants.

Canadian courts have rejected the "fraud on the market theory". In its place, provincial securities laws provide for deemed reliance in initial offerings and secondary market purchases of securities. In recent years Canadian courts appear to be consciously lowering the bar to certification and to granting leave under secondary market regimes. It remains to be determined if higher thresholds to certification in the U.S. will have any impact on Canadian courts. In the meantime, especially for dual-listed securities, we may see more U.S. plaintiff firms active in Canada, taking interlocutory steps that can provide evidence to support corresponding U.S. claims.

Protections for public companies and their directors and officers will be impacted by Halliburton. Shortly before Halliburton was released, and in anticipation of its outcome, AIG provided all publicly traded AIG primary D&O policyholders with a new event study endorsement, which provides that the policy's retention will not apply to class certification event study expenses. This endorsement provides additional protection to insureds, and encourages insureds to take steps now available to them, following Halliburton, to defeat certification.