Here’s a riddle for you: What does the Supreme Court’s June 23, 2014 decision in Halliburton Co. v. Erica P. John Fund, Inc. (No. 13-317) have in common with Oakland, California? Answer: “There is no there there” (at least according to Gertrude Stein). Actually, there is considerably more “there” in Oakland than you will find in the opinion of Chief Justice Roberts in Halliburton v. Erica P. John Fund.
The Halliburton decision was the long-awaited opportunity for the Supreme Court to give serious and perhaps enlightened reconsideration to the 25-year reign of Basic Inc. v. Levinson, 485 U.S. 224 (1988), as the Creator of the Securities Class Action. Alas, the Court chose to avoid the crucial theoretical, practical, and policy issues introduced in Basic, and instead presented us with a lot of fluff, and unclear fluff at that. The analysis was scant; the reasoning evasive, illogical, and imprecise; the rationales internally inconsistent; and, as icing on the cake, the ultimate holding was unclear, leaving much guessing and costly clarification for the future. With the loss of this opportunity for clear-headed analysis of the foundation for securities class actions, we face many more years of a cottage industry that benefits only plaintiff and defense securities lawyers.
How Did the Supreme Court Get Us Here?
The Supreme Court’s patent unwillingness to take on these issues is most unfortunate because the Supreme Court is single-handedly responsible for the very existence of private securities litigation under section 10(b) of the Securities Act of 1934 and the SEC’s Rule 10b-5 promulgated thereunder. Congress never enacted this federal cause of action. The existence of a so-called “implied private right of action” under section 10(b) and Rule 10b-5 was announced by the Supreme Court in 1971, 37 years after enactment of the 1934 Act, in a footnote in Superintendent of Ins. of N. Y. v. Bankers Life & Casualty Co., 404 U. S. 6, 13 n.9 (1971), which said “it is now established” with absolutely no analysis or reasoning. The Court soon found that ad hoc legislation of a popular private cause of action can be hard and enduring work. From that point, the Court took responsibility for determining the parameters of the private action it created that would normally be enacted by statute, like what are the elements of a claim, who has standing to bring a claim, how do you prove damages, what is the statute of limitations, is there a right of contribution against jointly liable persons, etc. In 1995, in the Private Securities Litigation Reform Act (PSLRA), Congress sought to temper the harmful consequences of the judicially-created federal securities fraud class action, but in doing so explicitly stated that “Nothing in this Act … shall be deemed to create or ratify any implied right of action….”(Public Law 104-67, Section 203).
That brings us to the star of this show, Basic. By 1988, the Supreme Court had not yet determined fully the elements of the implied private action it created in Bankers Life. Among the elements never determined was whether that cause of action required proof of reliance by the plaintiff on alleged misrepresentations that caused stocks to be improperly priced in the securities markets. A reliance requirement created a problem for securities plaintiffs because shareholders engaging in stock transactions typically could not prove they knew about, and acted on the basis of, allegedly misleading statements by companies or their officers. And even if some could do so, they would have to present individualized evidence showing their reliance in order to prove their claims. Those individualized showings, which would not carry over from one shareholder to others, would make the claims not susceptible to treatment as a class action because class actions must involve predominantly issues for which common evidence can prove a case for all class members.
What the Court Did in Basic v. Levinson.
The Basic Court quickly resolved the reliance issue, holding that “reliance is an element of a Rule 10b-5 cause of action” because it “provides the requisite causal connection between a defendant’s misrepresentation and a plaintiff’s injury.” That was consistent with the underpinnings of section 10(b), which was understood to address fraudulent conduct. Fraud claims in the common law always required proof that the plaintiff was harmed by reasonable reliance on false representations by the defendant.
That left the thorny issue of how these claims could proceed as class actions. Although private section 10(b) actions could still be brought, the lion’s share of those cases – and the cases that represented huge revenue opportunities for lawyers – were class actions. A ruling that debilitated securities class actions would make the section 10(b) private action largely underutilized and ineffectual. Indeed, the comparable cause of action that actually was included by Congress in the 1934 Act – the private action under Section 18 – was rarely used by plaintiffs because it included a requirement that the plaintiff prove a false statement and a purchase or sale “in reliance upon such statement.” The courts found that this mandated at least “eyeball reliance” by the plaintiff, that is, actual awareness of the statement.
Basic became the Creator of the Securities Class Action because it formulated a theory by which reliance could be proved en mass without the usual showing that each plaintiff actually relied on the alleged misrepresentation. It did this by accepting the viability of the “efficient capital markets hypothesis” (ECMH), an economic construct that open and developed securities markets are reasonably efficient marketplaces, which incorporate all publicly available information into stock price reasonably quickly. 485 U.S. at 243-45. On top of this, it concluded that investors assumed that the prices of stocks on these exchanges fairly reflected accurate publicly-available information about the issuers of those stocks, i.e., that they traded shares “in reliance on the integrity of the price set by the market.” Id. at 245. Using these assumptions, the Court created a “presumption” – founded on “considerations of fairness, public policy, and probability, as well as judicial economy” (id.) that allowed securities plaintiffs to prove reliance in private section 10(b) actions en mass: “An investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price. Because most publicly available information is reflected in market price, an investor’s reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action.” Id. at 247. However, that presumption can be rebutted: “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.” Id. at 248.
By creating the presumption of reliance on the so-called “integrity of the price set by the market,” which incorporated allegedly false public statements and therefore by transitive logic provided reliance on the statements themselves, the Basic court created the mechanism for securities class actions for decades to come. The decision was worth billions of dollars to future generations of lawyers, all of which was funded by public companies, their shareholders, and their customers.
What Was Wrong with the Basic Decision?
The Basic decision was flawed in both of the key assumptions it made. It relied on less-than-robust economic evidence about how stock markets function that have been substantially debunked in the last two decades, and it made assumptions about how investors function that lacked substantial evidence even at the time, and certainly are not valid based on what we know today.
The economic grounds are not strong for assuming that for a particular company over a specified period of time, its stock market price is driven by available information about that company, rather than by a variety of other factors, including factors that render the market less than “rationale,” at least for a time, e.g., forms of momentum investing leading to excessive exuberance or pessimism. Markets for different securities are driven by different considerations at different times, and markets for a particular security are driven by different considerations over time. As a result, even though the overall market for stocks on an exchange may be generally “reasonably efficient,” really important information about a particular company (accurate or false) may have no impact on market price in some circumstances, and really unimportant information can coincide with significant price movements founded in other factors. In short, economic studies now show that the efficient capital markets hypothesis relied on in Basic is flawed in many respects because markets often generate prices that are not consistent with available information. Justice White’s dissent in Basic founded in the inability of the courts to effectively judge the economics of securities markets (485 U.S. at 222-23) was spot on.
The assumption that investors inevitably rely on the market price of a stock fairly reflecting accurate public information about the stock is also seriously flawed, certainly now and almost surely then as well. Investors – particularly those large institutional investors whose investment decisions drive market prices – are fully aware of the fact that at any point in time public information about a company may be true, false, or somewhere in between. Not all important information about a company is required to be disclosed. Many sources of information are unreliable. There have been large enough and frequent enough examples of company information being unreliable that every knowledgeable investor knows there is always such a risk. In addition, many investors, including the largest investors in the marketplace, consider the public information about a company irrelevant to their investment decisions. Countless billions of investor dollars are invested in index funds or index ETFs that are required to purchase stocks without regard to considering company-specific information. Investors that do consider company information often bet that it is flawed, or that the market has not accurately taken it into account in determining market price.
As a result, both of the key assumptions underlying the fraud-on-the-market theory adopted in Basic are weakly, or at least not strongly, supported. The Halliburton Court was asked to, and agreed to, reconsider the Basic construct in light of the increasing evidence that the foundation on which that opinion was built is so unsteady that it badly needed to be reconstructed.
The Halliburton Court Whiffed.
The Halliburton Court was squarely presented with three issues: (1) whether to retain Basic’s presumption of reliance on public information based on the two crumbling pillars of the efficient capital markets hypothesis and investors’ assumed reliance on the integrity of market prices; (2) if that presumption is retained, whether in order to invoke that presumption a plaintiff must first show an actual stock price impact of the alleged misleading information; and (3) if plaintiff has no such burden, whether a court was required to consider before certifying a class action evidence proffered by defendants that no such price impact could be shown.
The Court Chose Not To Step to the Plate on the Key Basic Issues.
The Court’s decision on the first issue left much to be desired. In essence, the Court held that because the Basic Court did not base its decision on the uniform applicability of either efficient markets or reliance on price integrity in all circumstances, there was insufficient evidence of changed circumstances since then to overturn the earlier decision under the principle of stare decisis. What amount of evidence would have been sufficient to cause reconsideration was unstated and remains unknown. And whether this Court, based on the enormous amount of additional research and evidence accumulated since 1988, believes the Basic presumption remains warranted, was simply not addressed. In essence, the Court wrote that because the Basic Court was content to rely on rough assumptions about efficient markets and investor motivations, and those rough assumptions could not be proved generally wrong wrong in all, or even most, cases, it would not reexamine that Court’s analysis and conclusions.
The Court phrased this by saying that the defendant did not succeed at presenting a “special justification” for overturning Basic, rather than simply showing it was “wrongly decided.” (Slip. Op. at 4.) It acknowledged the numerous studies since 1988 addressing the ECMH, but noted that even the defendant did not argue that capital markets are always inefficient. Since Basic never said that all markets were efficient at all times, its decision could not be deemed flawed on that basis. And because even today it is acknowledged by ECMH critics “that public information generally affects stock prices,” the point should not dwelled upon because “Debates about the precise degree to which stock prices accurately reflect public information are thus largely beside the point.” (Id. at 10-11.) Yet, without determining the “degree” to which Basic’s key presumption was really valid, the Court went on to opine that defendant “has not identified the kind of fundamental shift in economic theory that could justify overruling” Basic (id. at 11).
In other words, even if, based on the scholarly work done in the past 25 years, today’s Court could not accept the assumptions made in the Basic opinion about the ECMH, it would not reconsider Basic on that basis. The Court made no effort to describe what amount or “degree” of contrary economic evidence or scholarly work would be sufficient to evidence the required “fundamental shift.” When is enough enough? The Court did not even attempt to let us know.
The same theme applied to the Basic assumption of investor reliance on the “integrity of market price,” which was not based on any theory or analysis when first made. Despite numerous examples showing that the assumption simply was not correct, and was not correct in large respects (e.g., seven of the top 10 mutual funds are index funds), the Court said “Basic never denied the existence of such investors,” and blithely accepted as reasonable Basic’s “presumption” that investors will rely on a security’s market price “as an unbiased assessment of the security’s value in light of all public information” (id. at 11-12). Without any apparent analysis of the evidence underlying that assumption – which is critical to the reliance-on-the-market theory – the Court speculated about ways that investors might rely on prices as indications of value, thereby simply recapitulating the errors of the Basic court. See id. at 12.
The Court justified this massive failure to subject Basic’s reliance-on-the-market presumption to rigorous analysis on the principle of stare decisis, and gallingly did so in supposed deference to Congress. But, as we have seen, Congress had essentially nothing to do with the adoption and development of the private right of action under section 10(b), the elaboration of the elements of the claim, or the formulation of the Basic presumption. The section 10(b) private action, and especially the section 10(b) class action, are purely judicially-created creatures. To shy away from reconsidering the quasi-legislative decision of the Basic Court in the purported name of deference to Congress smacks of a cynical effort to avoid either recognizing or cleaning up your own mess.
The Ruling on the Role of Price Impact Evidence Is Vague, Confusing, and Inconsistent.
Having decided to take a pass on the core Basic issues, the Court turned to the more mundane question of what evidence should be considered to determine a motion for class certification in a fraud-on-the-market securities class action. Even in this respect, the analysis is muddled and the result difficult to justify (or even understand).
In the court below, the defendant presented evidence that certification should be denied because plaintiff did not present evidence supporting loss causation – that its alleged loss was caused by the allegedly misleading disclosures. The district court agreed and denied certification, and the court of appeals affirmed. On appeal, the Supreme Court decided in an earlier Halliburton decision that proof of loss causation, while an element of the claim, was not a prerequisite for class certification because loss causation was not crucial to the application of the fraud-on-the-market doctrine (and therefore the mere lack of loss causation does not implicate predominant individualized issues that would preclude certification), and that it could be proved through evidence applicable to the entire class after certification. See Erica P. John Fund, Inc. v. Halliburton Co., 131 S.Ct. 2179 (2011) (Halliburton I). The case was remanded for further consideration of certification.
On remand, the defendant argued that the economic analysis it presented showed that the alleged misleading disclosures did not have any impact on Halliburton’s stock price, and therefore certification was improper because the key aspect of Basic’s fraud-on-the-market doctrine could not be satisfied: that plaintiffs purchased stock at a price distorted by the allegedly false disclosures, and therefore plaintiff’s reliance on the “integrity of market price” produced a transitive form of reliance on the underlying allegedly false disclosures. In other words, if the price was not affected by the disclosures, plaintiff’s reliance on the price did not show reliance on the disclosures. The district court rejected that argument and certified the class, believing that the earlier decision in Halliburton I precluded it, and that decision was affirmed by the court of appeals.
So the Supreme Court was faced with deciding what impact, if any, the lack of evidence of price impact of allegedly false disclosures should have on certifying a class. The Court effectively split the baby on that issue. It acknowledged that a plaintiff has the burden of proving all elements required to support class certification, including the predominance of class issues. It also acknowledged that in a fraud-on-the-market case, that required a classwide form of proof of reliance on the alleged misrepresentations. But it never expressly imposed on plaintiffs the burden of presenting such proof. Instead, it held that under the still-breathing Basic presumption of reliance, once an efficient market for the security is shown (which is plaintiff’s burden), that is all a plaintiff must do on this issue to support certification. If, however, the defendant proves there was no price impact from the alleged misrepresentations, the class could not be certified because the principle underpinning of Basic – reliance on the integrity of market price – would not yield an inference of general investor reliance on the allegedly false statements.
The critical issue is one of burden: who has the burden of showing price impact? The Court acknowledged, indeed, emphasized, that price impact was essential to support a Basic presumption of reliance. See slip op. at 21 (“Price impact is thus an essential precondition for any Rule 10b-5 class action.”). Yet, the Court never once states with clarity that it is plaintiff’s burden to prove this “essential precondition.” Instead, it holds that plaintiffs may “establish that precondition indirectly” (id.) by means of showing the misrepresentation was public, “the stock traded in a generally efficient market,” and they “purchased the stock at the market price during the relevant period.” Id. at 17-18. The Court instructs that plaintiffs “need not directly prove price impact” (id. at 18).
The Court permits the defendant to come forward with evidence of no price impact, but what happens then is not clear. Here is what the Court says: “While Basic allows plaintiffs to establish that precondition [price impact] indirectly [via proof of a “generally” efficient market], it does not require courts to ignore a defendant’s direct, more salient evidence showing that the alleged misrepresentation did not actually affect the stock’s market price and, consequently, that the Basic presumption does not apply.” Id. at 21 (emphasis added). Elsewhere, the Court says that defendants “may seek to defeat the Basic presumption … through direct as well as indirect price impact evidence.” Id. at 22-23.
If price impact is a “precondition” for the Basic presumption of reliance, why didn’t the Court simply say that it is plaintiff’s burden to prove price impact in its motion for class certification? That burden could be satisfied by the Basic presumption if there is no contrary evidence, but if the defendant introduces credible contrary evidence, it would remain plaintiff’s burden to prove price impact, giving due consideration to the strength of the supporting indirect evidence (of market efficiency) and the strength of the contrary direct evidence on price impact. One might say that should be obvious, but the Court’s language suggests otherwise – it suggests that once the presumption is in place, the defendant has the burden of disproving the presumption though “more salient evidence.” As a result, the Court, without any stated justification, and despite recognizing that plaintiff has the burden of supporting class certification, appears to shift the burden to defendants to prove there was no price impact.
You may say it doesn’t matter that the Court never expressly recognizes the burden of proving price impact is on plaintiff – that it is implicit and obvious that this would be required. My reaction is that the language chosen by the Court strangely leaves that issue open, especially when Justice Ginsburg’s concurring opinion plainly identified that issue by saying that the concurring justices believe the majority opinion places the burden of proof on defendants (“the Court recognizes that it is incumbent upon the defendant to show the absence of price impact…. The Court’s judgment, therefore, should impose no heavy toll on securities-fraud plaintiffs with tenable claims.”). Id. (Ginsburg, J., concurring), at 1.
The reason the burden issue is critical relates to the nature of evidence that can realistically be generated on the issue of price impact. The question of whether specific disclosures had an impact on stock price is addressed by econometricians with an event study. That event study uses a regression analysis to predict expect market price based on historic price movement over time, and tests whether in the period following particular disclosures the stock price departed significantly (from a statistical standpoint) from the expected price. Critically, this type of analysis can show that stock price was not statistically different from expectations at the time of a disclosure, but often cannot show whether a specific disclosure had “no price impact.” That is because often such disclosures occur together with conflating information that make it difficult (or impossible) to determine the specific impact of different pieces of information disclosed at the same time. For example, the announcement of a past quarter’s earnings, future earnings expectations, and other business operational information in one press release or conference call makes it very difficult to test the stock price impact of each of those disclosures on its own. That is why the burden of proof is so critical. If the plaintiff has the burden of showing that an allegedly false disclosure impacted stock price, it will often have difficulty sustaining that burden. But if the burden is shifted to the defense to show that information had no stock price impact, it likewise will often have difficulty satisfying that burden. The presence of conflating information impedes either side from satisfying the burden, so where the burden is placed is critical.
So what happens now when the securities plaintiff sues by identifying one out of several disclosure as false and alleges that disclosure to be responsible for a stock price decline? As I read Halliburton, the plaintiff can rely on the Basic presumption, and even though it cannot sustain the burden of showing that this particular allegedly false disclosure had a price impact (and therefore cannot prove a “prerequisite” for applying the Basic presumption), the claim will proceed as a class action even if the defendant shows that plaintiff cannot support its allegation of price impact, if the defendant cannot go further by presenting “more salient evidence showing that the alleged misrepresentation did not actually affect the stock’s market price.”
Perhaps this won’t be what happens. Perhaps district courts and courts of appeals will see the fundamental inconsistency between placing the burden on plaintiffs to show certification is warranted but requiring the defendant to disprove a key prerequisite for that certification. Perhaps proof by defendants that plaintiff cannot show price impact will be treated by lower courts as shifting the burden back to plaintiffs to show they can. But if past history is prologue, by using language that creates ambiguity on this fundamental point, the Supreme Court will leave the lower courts in disarray and the issue will remain in doubt for years.
One thing is virtually certain. Given the amount of money at stake, each inch of ground will be hard fought by both sides, and millions upon millions of dollars will flow to the plaintiffs’ and defendants’ lawyers who man the trenches. That is apparent already from lawyer commentary here, and here.
In the end, the Supreme Court squandered an opportunity decades in the making to scrutinize seriously and with precision the highly flawed, quasi-legislative fraud-on-the-market theory pronounced in Basic. The Court chose not to take the hard path and ended up with a result that is unlikely to alter fundamentally the securities class action industry. Unless lower courts put a more restrictive gloss on the price impact requirement for class certification, future bear markets will bring investment losses to shareholders, lucrative class action plaintiff and defense work for lawyers, and large settlements for companies.
June 26, 2014
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