On June 23, 2014, the U.S. Supreme Court released its long-awaited decision in Halliburton Co. v. Erica P. John Fund, in which the Court had taken up the question whether or not to set aside the presumption of reliance based on the fraud on the market theory that the Court first recognized in its 1988 decision in Basic, Inc. v. Levinson. The case was closely watched because its outcome had the potential to transform securities class action litigation in the United States.
In the end, the Court, in an opinion written by Chief Justice John Roberts and joined by five other justices, declined to overturn Basic, but held that a securities class action defendant should have the opportunity at the class certification stage to try to rebut the presumption by showing that the alleged misrepresentation did not impact the defendant company’s share price. The Supreme Court’s opinion can be found here. Justice Thomas, joined by Justices Scalia and Alito, wrote an opinion concurring in the judgment in which he contended that the Court should have overturned Basic.
While the Court’s decision will not alter the securities litigation landscape as much as might have been the case if it had overturned Basic, the Court’s holding that defendants may at the class certification stage seek to rebut the presumption of reliance based on the absence of price impact could have a significant effect on securities litigation. In many cases, plaintiffs may be unable to obtain class certification where in the past they might have been able to have a class certified. In any event, the class certification phase likely will become more costly as the parties dispute the issues surrounding the impact of the alleged misrepresentation on the share price.
Background
Since the U.S. Supreme Court’s 1988 decision in Basic, Inc. v. Levinson, securities plaintiffs seeking class certification have been able to dispense with the need to show that each of the individual class members relied on the alleged misrepresentation, based on the presumption that in an efficient marketplace, a company’s share price reflects all publicly available information about a company, including the alleged misrepresentation, and that the plaintiff class members relied on the market price.
In the U.S. Supreme Court’s 2013 decision in Amgen (about which refer here), at least four justices (Alito, Scalia, Thomas and Kennedy) appeared to question the continuing validity of the presumption. In his concurring opinion, Justice Alito asserted that the presumption “may rest on a faulty economic premise,” and specifically stated that “reconsideration” of the Basic presumption “may be appropriate.”
Recognizing the opportunity to have the Court reconsider the fraud on the market theory, the defendants in the long-running Halliburton securities class action litigation sought to have the Court consider whether the Court should “overturn or significantly modify” the Basic presumption of “class wide reliance derived from the fraud on the market theory.”
The Halliburton case has been pending since 2002. In their complaint, the plaintiffs allege that the company and certain of its directors and officers understated the company’s exposure to asbestos liability and overestimated the benefits of the company’s merger with Dresser Industries. The plaintiffs also allege that the defendants overstated the company’s ability to realize the full revenue benefit of certain cost-plus contracts.
For several years, the parties in the case have been engaged in full-scale combat on the issue of whether or not a class should be certified in the case. Indeed, the class certification issue in the case has already been before the U.S. Supreme Court; in 2011, the Court unanimously rejected the company’s argument (and the Fifth Circuit’s holding) that in order for a plaintiff to obtain class certification, the plaintiff must first establish loss causation.
Following the Supreme Court’s earlier ruling, the case was remanded back to the lower courts. In June 2013 the Fifth Circuit affirmed the certification of a shareholder class in the case. In its opinion, the Fifth Circuit expressly affirmed the district court’s holding that Halliburton could not present evidence at the class certification stage that the alleged misrepresentation did not impact the company’s share price and therefore that there was no basis for the presumption of reliance. Halliburton filed a petition for writ of certiorari, which the U.S. Supreme Court granted.
The Court’s June 23, 2014 Opinion
In an opinion for the Court written by Chief Justice Roberts, the Court vacated the Fifth Circuit’s judgment and remanded the case for further proceedings.
At the outset, the Court declined to overturn Basic, noting that “before overturning a long-settled precedent … we require a special justification,” and concluding that “Halliburton had failed to make that showing.” In reaching this conclusion, the Court rejected Halliburton’s argument based on statutory analysis that plaintiffs should always have to prove individual reliance. The Court also rejected Halliburton’s argument that Basic should be overturned based on changes in economic theory surrounding the “efficient market” hypothesis on which the fraud on the market theory is based.
The Court also declined to overturn Basic in reliance on principles of stare decisis, holding that these principles have “special force in respect to statutory interpretation.” While noting Halliburton’s argument that the Basic presumption produces a number of “serious and harmful consequences,” such as allowing plaintiffs to “extort large settlements from defendants for meritless claims,” the Court said that “these concerns are more appropriately addressed to Congress, which has in fact responded to some extent to many of the issues Halliburton raised,” for example, through the PSLRA.
The Court also rejected Halliburton’s argument that in order to obtain class certification the plaintiffs should have to prove that the alleged misrepresentation actually affected the defendant company’s share price. The Court said requiring the plaintiffs to make this showing “would radically alter the required showing for the reliance element” in a 10b-5 case. The Court said that “for the same reasons we declined to completely jettison the Basic presumption, we decline to effectively jettison half of it by revising the prerequisites for invoking it.”
But while the Court declined to require plaintiffs to directly prove price impact in order to invoke the Basic presumption, the Court did agree that defendants “should at least be allowed to defeat the presumption at the class certification stage through evidence that the misrepresentation did not in fact affect the stock price.”
The Court noted that the defendants already may introduce price impact evidence at the merits stage and that in many cases plaintiffs already introduce price impact evidence (such as event studies) at the class certification stage to show that the market price of the defendant’s stock responds to information about the company, to establish that the market for the company’s shares is efficient. The court reasoned that if plaintiffs were allowed to present price impact evidence to satisfy the efficient market requirement (which requirement the Court described as “an indirect proxy for price impact”), it makes no sense to preclude the introduction of evidence for the direct purpose of showing that the alleged misrepresentation did not impact the price:
Price impact is thus an essential precondition for any Rule 10b-5 class action. While Basic allows plaintiffs to establish that precondition 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 market’s price and, consequently that the Basic presumption does not apply.
The Court concluded by saying with respect to the Basic presumption of reliance that “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.”
In a separate opinion in which he concurred in the Court’s judgment, Justice Thomas, joined by Justices Scalia and Alito, argued that Basic should be overruled noting that “Logic, economic realities, and our subsequent jurisprudence have undermined the foundations of the Basic presumption.”
Discussion
Because the Court did not, as Justice Thomas urged in his separate opinion (a dissenting opinion in all but name), overturn Basic, the Court’s second Halliburton opinion will not have the dramatic impact on class action securities litigation that it might have. Nevertheless, the Court’s ruling will have a significant impact on class certification in misrepresentation cases under Rule 10b-5. It will introduce a significant level of inquiry and dispute at the class certification stage, and it will result in some cases in the denial of class certification motions in cases in which class certification might have been granted in the past.
At a practical level, there will be a lot of issues for the lower courts to sort out. There undoubtedly will be significant disputes regarding the type of evidence that is permitted to address the issue of price impact. There will be disputes about the quantum of evidence the defendants must provide in order to rebut the presumption. There undoubtedly will be issues surrounding the type and scope of discovery permitted as the parties wage a battle of experts on the price impact issue. The lower courts could be wrestling with these issues for years.
Because the price impact dispute will require the parties to present expert analyses on the question of whether or not the alleged misrepresentation affected the share price, the dispute could prove costly, particularly as the parties and the courts sort out the issues noted in the preceding paragraph. These processes could significantly increase defense expenses at an earlier stage of the proceedings. Justice Ginsburg, in a concurring opinion in which Justices Breyer and Sotomayor joined, noted that because the Court recognized that “it is incumbent upon the defendant to show the absence of price impact,” the Court’s holding “should impose no heavy toll on securities fraud plaintiffs with tenable claims.” Her opinion makes no comment with respect to the additional costs defendants undoubtedly will incur at the class certification stage in an effort to try to rebut the presumption.
Another consequence of the Court’s opinion is that it may affect the way that plaintiffs plead their cases. The Basic presumption only applies to misrepresentation cases under Rule 10b-5. It does not apply to cases in which the allegedly misleading statement is an omission. In omissions cases, the plaintiffs rely on a different presumption, the Affiliated Ute presumption, which arguably is unaffected by the Court’s holding in this case. In addition, the Basic presumption does not apply to cases in which the plaintiffs allege violations of Sections 11 and 12 of the ’33 Act. In order to try to avoid the procedural hurdles that the Court’s opinion in Halliburton introduces, plaintiffs may seek to cast their cases as omissions cases or may prefer to pursue ’33 Act claims rather than claims under the ’34 Act and Rule 10b-5.
From an insurance perspective, the Court’s holding in this case will not have the disruptive impact that it might have had if the Court had overturned Basic. The Court’s ruling that defendants may seek to rebut the presumption of reliance by showing the absence of price impact may result in classes being certified in fewer cases, which would be beneficial for defendants and their insurers. However, the dispute of price impact issues could increase overall defense expenses, perhaps significantly, which could have its own impact on D&O insurers. Whether the ruling will result in fewer cases being filed remains to be seen.
In the end, the insurance marketplace will have to wait and see how these issues play out, and in the interim it seems unlikely there will be any immediate changes in the way D&O insurance is underwritten and priced. There will, however, be some discussion in the marketplace about the extent of coverage available for the kind of price impact event studies that the Halliburton court discussed. At least one carrier has already introduced, in anticipation of the Halliburton ruling, an endorsement providing that no retention is applicable to the cost of an event study. There may be other marketplace developments along these lines as the marketplace responds to the Court’s ruling.
Very special thanks to the several readers who sent me copies of the Halliburton decision.