In late June the US Supreme Court released its highly-anticipated decision in Halliburton Co. v. Erica P. John Fund, which invited the court to oust the so-called “fraud on the market” presumption applicable to securities class-action certification.
Had the court accepted the invitation, Halliburton might well have been a game changer that markedly altered the securities class action landscape — and perhaps also the directors and officers liability insurance market.
The court declined.
Nevertheless, while clearly not the game changer that publicly-traded companies and their D&O insurance carriers may have hoped for, Halliburton offers securities-class action defendants a significant new arrow in their litigation quiver: companies may now attempt to rebut the presumption at the class certification stage rather than wait for a trial on the merits. Although the full impact of the decision will be realized over time, the decision clearly has the potential to change the way that securities claims are litigated, and may be of very significant benefit to companies and their D&O insurers. It also already has precipitated, in advance, at least one new D&O insurance policy endorsement.
The Basic Presumption
Rule 10b-5, enacted under § 10(b) of the Securities Exchange Act of 1934 (1934 Act), prohibits the making of any material misstatement or omission in connection with the purchase or sale of any security. A critical element of a Rule 10b-5 cause of action is reliance on a company’s alleged misrepresentation. The element of reliance provides the requisite causal connection between the misrepresentation and a plaintiff’s alleged injury.
Under the “fraud on the market” presumption, however, Rule 10b-5 plaintiffs seeking class certification under Federal Rule of Civil Procedure 23 need not demonstrate that each individual plaintiff relied upon alleged misrepresentations.
Instead, plaintiffs are entitled to a rebuttable presumption that, in well-developed markets, a company’s share price reflects all publicly available information about the company, including any material misrepresentations, and that the plaintiffs relied upon the share price and, therefore, presumably also relied upon the misrepresentations in deciding to buy or sell a company’s stock.
As a result, whenever an investor buys or sells stock at the market price, his “reliance on any public material misrepresentations … may be presumed for purposes of a Rule 10b–5 action.”
The Supreme Court first adopted the presumption in its prior decision in Basic, Inc. v. Levinson. In Basic, a group of former shareholders brought a putative class action against Basic Inc. its directors, asserting false or misleading public statements in connection with merger negotiations in violation of the 1934 Act and Rule 10b-5. The Northern District of Ohio adopted a presumption of reliance by members of the plaintiff class upon the company’s public statements, thus enabling the court to conclude the proposed class satisfied all the requirements of Rule 23 because, among other things, common questions of fact or law predominated over particular questions pertaining to individual plaintiffs as required by Rule 23(b)(3).
The Sixth Circuit affirmed the class certification. The Supreme Court in Basic ruled the courts below properly applied a presumption of reliance in certifying the class, reasoning that “[t]he presumption of reliance … is consistent with, and, by facilitating Rule 10b-5 litigation, supports, the congressional policy embodied in the 1934 Act.”
Without the presumption, it would be much more difficult for Rule 10(b) plaintiffs to obtain class certification — and therefore much more difficult for the plaintiffs’ bar to use the specter of massive class damages to extract from companies and their D&O insurers the types of enormous settlements (for potentially meritless claims) that are a current feature and reality of securities class action litigation. In view of this, had the Supreme Court in Halliburton set aside the Basic presumption, that could have had a an enormous potential impact on securities class action litigation — and potentially the D&O insurance market. The Court declined to do so, but its decision nevertheless is helpful to companies facing Rule 10b-5 litigation and their insurers.
In Halliburton, a group of investors brought a putative class action against Halliburton and one of its executives asserting misrepresentations in violation of the 1934 Act and Rule 10b-5. For years, the parties have been fighting as to whether a class should be certified. And, to date, the fight over certification has resulted in two separate Supreme Court decisions:
In considering the plaintiffs’ motion for class certification in the first instance, the Northern District of Texas applied Fifth Circuit precedent requiring securities plaintiffs to prove “loss causation”—i.e., a causal connection between the company’s alleged misrepresentations and the plaintiffs’ economic losses—in order to invoke the Basic presumption of reliance and obtain class certification. Because the plaintiffs failed to demonstrate such a connection for any of the alleged misrepresentations, the District Court refused to certify the proposed class for failure to satisfy Rule 23(b)(3). The Fifth Circuit affirmed the denial of class certification. The Supreme Court granted certiorari, vacated the judgment and remanded the case, “finding nothing in ‘Basic or its logic’ to justify the Fifth Circuit’s requirement that securities fraud plaintiffs prove loss causation at the class certification stage in order to invoke Basic’s presumption of reliance.”
On remand, Halliburton argued that class certification was inappropriate because the evidence it had earlier introduced to disprove loss causation also showed that none of its alleged misrepresentations had actually affected its stock price and, therefore, it had rebutted the Basic presumption. The District Court rejected this argument, applying the Basic presumption and certifying the class. The Fifth Circuit affirmed. While acknowledging that “‘Halliburton’s price impact evidence could be used at the trial on the merits to refute the presumption of reliance,” the Fifth Circuit held that Halliburton “could not use such evidence for that purpose at the class certification stage.”
The Supreme Court again granted certiorari “to resolve a conflict among the Circuits over whether securities fraud defendants may attempt to rebut the Basic presumption at the class certification stage with evidence of a lack of price impact.” The Court also “accepted Halliburton’s invitation to reconsider the presumption of reliance for securities fraud claims that [the Court] adopted in Basic.”
In an opinion authored by Chief Justice John Roberts, and joined by Justices Anthony Kennedy, Ruth Bader Ginsburg, Stephen Breyer, Sonia Sotomayor and Elena Kagan, the Court declined to overturn Basic, noting that “[b]efore overturning a long-settled precedent” the Court would “require ‘special justification,’ not just an argument that the precedent was wrongly decided.” Court ultimately found the justification lacking. The Court emphasized, however, that “[t]he Basic presumption does not relieve plaintiffs of the burden of proving—before class certification—that [the predominance requirement of Rule 23(b)(3)] is met and “does not … allow plaintiffs simply to plead that common questions of reliance predominate over individual ones, but rather sets forth what they must prove to demonstrate such predominance.” Noting Halliburton’s argument that the Basic presumption “allow[s] plaintiffs to extort large settlements from defendants for meritless claims,” among other negative consequences, the Court stated that “These concerns are more appropriately addressed to Congress.”
While declining to overturn Basic, the Court held that securities class action defendants “must be afforded an opportunity before class certification to defeat the presumption through evidence that an alleged misrepresentation did not actually affect the market price of the stock.” Indeed, the Court emphasized the “bizarre results” that may ensue if defendant companies were not afforded this opportunity. The Court noted in this regard that plaintiffs and defendants both submit price impact evidence prior to class certification for purposes of demonstrating (and rebutting) general market efficiency and that this evidence may show “an efficient market, on which the alleged misrepresentation had no price impact.” The court found that, if certification were granted in that circumstance, “[s]uch a result is inconsistent with Basic’s own logic,” and clarified that “[w]hile Basic allows plaintiffs to establish [price impact] indirectly, 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.”
Because the courts below denied Halliburton the opportunity to defeat the presumption, the Court vacated the judgment and remanded the case.
As the Court declined the invitation to overturn the Basic presumption, Halliburton is not the game changer that it might have been. However, the decision clearly has the potential to change the way that Rule 10b-5 securities claims are litigated, and may be of significant benefit to companies and their D&O insurers. For starters, although it remains to be seen whether the case will result in fewer cases filed, or a significant number of cases re-cast as omission cases (as opposed to affirmative misrepresentation cases), it certainly will result in the denial of class certifications in cases in which certification previously would have been granted. Although the decision may increase defence costs at the class certification stage (for expert testimony and discovery battles surrounding the types of, and quantum of, price impact evidence that companies may rely upon to rebut the Basic presumption), to the extent certification is avoided, plaintiffs lawyers are obviously curtailed in their ability to extract enormous settlements based on the spectre of massive class-wide damages — which clearly is of benefit to companies and their D&O insurers.
Public-traded companies should also be aware that, anticipating the Halliburton decision, at least one insurer has issued a new endorsement stating that the policy’s retention will not apply to class certification price event study expenses. The insurer has stated that it created the endorsement to provide funds to obtain the event studies “early in the litigation process, potentially to head off class certification.”