Since the U.S. Supreme Court agreed to revisit the “fraud on the market” theory by granting cert in the Halliburton case a few weeks ago, many commentators (including this blog) have considered whether the Court might wind up taking an intermediate position that addresses criticisms of the theory while preserving securities plaintiffs’ ability to try to establish reliance at the class certification stage,
In a December 2013 paper entitled “Rethinking Basic” (here), Harvard Law School Professors Lucian Bebchuk and Allen Ferrell suggest an intermediate path for the Court to take. They propose a “meaningful modification” of the Court’s holding in Basic, Inc. v. Levinson, to ensure that the reliance inquiry at the class certification stage avoids the “efficient market” debate and asks instead whether or not the alleged misrepresentation caused “fraudulent distortion” to the defendant company’s share price.
Background
Since its adoption by the Supreme Court in the Basic case, the fraud on the market theory has provided a way for securities plaintiffs to pursue their claims on behalf of similarly situated shareholders, without having to establish that each of the shareholders relied on the alleged misrepresentation. As Justice Ginsburg put it in her majority opinion in the Supreme Court’s 2013 Amgen decision, “the fraud-on-the-market premise is that the price of a security traded on an efficient market will reflect all of the publicly available information about a company; accordingly, a buyer of the security may be presumed to have relied on the information in purchasing the security.’
Among the many criticisms of the Court’s adoption of the fraud on the market presumption is that the “efficient market” premise on which the presumption is based is the subject of a heated and long-running debate. Coincidentally, the most recognized proponents of the two schools of thought in the “efficient market” debate were among the winners of the 2013 Nobel Prize for Economics – University of Chicago Business School Professor Eugene Fama, who is the leading proponent of the efficient market hypothesis, and Yale economist and business school professor Robert Shiller, who is the hypothesis’s leading critic.
From the time of the Basic decision, commentators have questioned whether the Supreme Court should be basing its decisions on disputed economic theories. Indeed, in his dissenting opinion in Basic, Justice Byron White expressed his concern that “with no staff economists, no experts schooled in the ‘efficient capital market hypothesis,’ no ability to test the validity of empirical market studies, we are not well-equipped to embrace novel constructions of a statute based on contemporary economic theory.”
The Authors’ Proposal
In their recent paper, the authors suggest a “reformulation” of Basic that shifts the judicial focus away from the debated issues of market efficiency to the issue of “fraudulent distortion.” The authors propose to limit class-wide reliance to “reliance on the market price of a security not being fraudulently distorted – that is, reliance on the market price not being impacted by (and thus reflecting) misstatements and omissions that produced a price different from what it would have been in the absence of fraud.”
In other words, the authors suggest that in order to determine whether the reliance requirement can be presumed to be satisfied, the focus should be on “whether the misrepresentation actually affected the stock price” – and not on whether the market in general or the market for a specific company’s securities are or are not efficient.
In order to establish whether or not “fraudulent distortion” has occurred, the authors advocate the use of “financial econometric tools” such as event studies to measure the impact of the alleged misrepresentation. The authors suggest that the burden with respect to the price distortion showing could either be on the plaintiffs or the defendants, but that either way the defendants would have the opportunity to attempt to rebut the showing. The authors suggest that their proposed approach would eliminate the problems of over-inclusiveness and under-inclusiveness in class litigation, and provide a means to eliminate frivolous suits as well.
An amicus brief has been filed with the Supreme Court in the pending Halliburton case on behalf of several law professors — not including the article’s authors — arguing (without express reference to the article) that that the fraud on the market presumption does not require dependence on the “efficient market” hypothesis, and that instead of the "efficient market" premise the focus in the reliance inquiry should be on the effect of the alleged misrepresentation on the share price. The amicus brief can be found here.
Discussion
The authors’ proposal has much to recommend it. Among other things, it preserves the ability of plaintiffs to establish reliance at the class certification stage in Section 10(b) misrepresentation cases, and it would remove the Court from the uncertain challenge of taking sides in the “efficient markets” debate. It also allows the opportunity for defendants to try to rebut the basis for applying the “fraudulent distortion” presumption, which is an option defendants have sought with respect to the current fraud on the market presumption.
Certain objections to the authors’ proposal can be expected. In noting the possible objections here, I am simply attempting to identify potential issues, not criticize the authors’ analysis, as that is an exercise for which I am not qualified.
Among other things, it likely will be suggested that the authors’ focus on the impact of the alleged misrepresentation on the company’s share price may simply be raising by other means the issues of materiality and loss causation – both of which issues the Supreme Court recently has said are merits issues not appropriately taken up at the class certification stage. (The Supreme Court addressed materiality in its 2013 decision in Amgen, and it addressed loss causation in its prior consideration of class certification issues in the Halliburton case in 2011.)
The authors address both of these issues in their article. In a footnote, the authors contend that their suggested analysis is “not equivalent to a legal determination of materiality” because, among other things, the determination of materiality “involves the consideration of several specific legal issues.” Similarly, the authors reject the suggestion that their proposed analysis and particularly their proposed use of an event study in the fraudulent distortion determination “conflates loss causation.” The authors state that the question they propose and the loss causation question are simply different, contending that the fact that the share price has been fraudulently distorted does not establish that loss causation exists.
While the authors are satisfied that their proposed analysis does not involve issues the Supreme Court has already said are not appropriately considered at the class certification stage, concerns may nevertheless remain. The question whether or not a misrepresentation distorted a company’s share price does feel a lot like an inquiry whether or not the alleged misrepresentation was material. The proposed use of an event study or other tool to determine whether or not the alleged misrepresentation caused a distortion in the company’s share price does feel a lot like a loss causation inquiry.
Indeed, there would be significant irony if the Supreme Court, having already said in the Halliburton case itself that loss causation is not an appropriate issue at the class certification stage, were now to come out and say — on reconsideration of class certification issues in the very same case– that in order to determine the issue of reliance at the class certification stage, the district court must determine whether or not the alleged misrepresentation caused a distortion in the company’s share price.
Critics of the authors’ proposed approach may also contend that the proposed use of “event studies” or similar tools present their own set of issues. What types of “financial econometric tools” can be used to determine whether or not there has been “fraudulent distortion”? What legal principles will govern the analysis of the econometric validity of the proposed tools? Doesn’t the proposed use of econometric tools raise the specter of substituting a different economic debate for the “efficient market” debate, as the parties vie for the use of their preferred econometric tool? And as a practical matter, wouldn’t the deployment of these tools introduce a potentially cumbersome, evidentiary-based process at the class certification stage that could be ungainly, time-consuming and costly?
While the authors’ proposal does raise a number of questions, it does provide a way for the Court to try to step out of the “efficient market” debate while preserving a way for securities plaintiffs to try to establish class-wide reliance at the class certification stage. For that reason, the authors’ proposal merits consideration.
Several members of the Court likely will be looking for an intermediate path that avoids eliminating altogether the ability of securities plaintiffs to pursue Section 10(b) cases on behalf of all similarly affected shareholders. The authors’ proposal may provide an attractive intermediate path for the Court.
While I have identified above a number of questions that may be asked about the authors’ proposal, I will stipulate that others are far more qualified than I am to discuss these issues and other questions the authors’ proposal may raise. I hope that readers with reactions to the authors’ proposal will add their thoughts to this post using the blog’s comment feature.
Special thanks to Professor Ferrell for providing me with a copy of the article.
More About Halliburton: One of the preferred arguments among those who want to keep the Basic presumption unchanged is that Congress modified the securities laws significantly in 1995, but did not set aside the fraud on the market theory or the presumption of reliance. Justice Ginsberg cited this fact in the majority opinion in Amgen, suggesting that Congress’s inaction on the issue amounted to Congressional approval of the approach. Justice Ginsburg wrote that rather than eliminating the presumption, “Congress rejected calls to undo the fraud-on-the-market presumption of classwide reliance endorsed in Basic.”
However, as Alison Frankel notes in a January 7, 2014 post on her On the Case blog (here), an amicus brief filed in the Halliburton case takes a contrary view on how to interpret Congress’s supposed inaction. The amicus brief (which can be found here) was filed by five former Republican members of Congress and seven former Congressional and Securities and Exchange Commission staffers, all of whom were involved in the passage of securities litigation reform in 1995. Frankel summarized the amicus brief as saying that “The 1995 law passed by both houses, overriding a veto by President Clinton, didn’t actually end up addressing the fraud-on-the-market theory of classwide investor reliance at all – which, according to the brief, should not be construed by the Supreme Court as a rejection of efforts to repudiate the precedent.”
“Congress did not answer any of the competing calls to overturn, modify, or codify the Basic presumption,” the amici argue. “Congress was simply silent in response to those various requests, and this court should not take Congress’s silence as implicit acceptance or rejection of Basic’s fraud-on-the-market theory.”
Another amicus brief filed by a separate group of law professors and former SEC Commissioners, including Stanford Law Professor Joseph Grundfest, argues that the correct legislative history for the Court to consider is the history regarding the original passage of the Exchange Act in 1934. These professors argue that “the 1934 Act’s legislative history leaves no doubt that, had the Seventy-Third Congress addressed the question, it would not have created a private Section 10(b) right unless that right required proof of actual reliance … That history further underscores that Congress would not have condoned a presumption of reliance.” Interestingly, the professors joining this brief, which can be found here, includes Professor Ferrell, one of the authors of the paper I discussed above.
A Day at Lloyd’s: On Monday, January 27, 2014 – that is, the day before the 2014 PLUS D&O Symposium – at the St. John’s School of Risk Management in New York, the American Bar Association Torts and Insurance Practice Section (TIPS) will be reprising its successful program on claims processes at Lloyd’s. This year’s program is entitled “A Day at Lloyd’s of London Part II and Alternative Dispute Resolution.” The program is “designed to encourage a greater understanding between the U.S. and international insurance market of how the Corporation of Lloyd’s of London works and the practical issues that arise.”
Among the program moderators is my good friend Perry Granof and the faculty includes an all-star casts of insurance professionals and claims attorneys. In addition, the program’s keynote speaker is Hank Greenberg, currently the Chair and CEO of C.V. Starr. Information about the program including registration information can be found here.