Breaking News

Opinion analysis: Fraud-on-market theory intact

Reviving an important 13-year-old precedent on securities fraud law, the Supreme Court has blocked the efforts of some lower courts to narrow the opportunity of a group of investors to join together to challenge a company’s alleged manipulation of the market price of its stock.   Investors, the Court ruled unanimously on Monday, may use the class-action device to claim securities fraud without first proving that market manipulation actually caused them to lose money on their investment.  The ruling came in Erica P. John Fund, et al., v. Halliburton Co., et al. (docket 09-1403).

 The ruling put a solid new foundation under the Court’s 1988 ruling in Basic Inc. v. Levinson, and under the “fraud-on-the-market” theory that the Court first outlined in that decision.    In the process, the Court removed doubts that had crept into the courts about both Basic and its fraud theory, producing conflicting rulings.

Under the fraud-on-the-market theory, investors are understood to rely generally upon what the stock market tells them about the value of a stock they are thinking about buying or selling.   If the market is functioning as it should, according to the theory, it will have taken into account in setting stock values all the information that is available publicly about that security — both good and bad.  So, if a company puts out flawed information, the market supposedly will absorb that in the auctioning of that company’s stock.

Relying on the market, investors are spared the duty in their class-action fraud case  of proving one critical element of their legal claim: that each investor in the class actually relied on the flawed information the company allegedly put out.   By asserting “reliance” in this way, however, the investors are given the benefit only of a “presumption” that they had depended upon the market.  The company they have sued can counter, or “rebut,” that presumption.   Still, the theory provides a significant advantage to the investors as a class.

Two lower appeals courts, the Fifth Circuit Court (in this case) and the Second Circuit, had put up another hurdle before they would clear the way for (certify) the investors to proceed with a class-action lawsuit.  In order to take advantage of the fraud-on-the-market theory, these lower courts had ruled (contrary to a decision of the Seventh Circuit), the investors would have to show “loss causation” — that is, that the price manipulation caused the investors to lose money in the market.  (In other words, the manipulation pushed up the stock in a given trading period, but then, when the truth came out, the stock price dropped, and the investment lost value.)

Ultimately, when the case goes to trial on the merits, the class of investors will, indeed, have to prove to the jury that they did, in fact, lose money on their investment, and that their loss was due to the alleged stock price manipulation.  But, the Supreme Court stressed on Monday, that “loss causation” requirement is decidedly a merits issue, and courts have no business requiring any proof of that when, early in the case, they are considering only whether to certify a class of investors to proceed.

The specific case before the Court was brought by a group of investment funds, retirement plans, and individual investors in September 2007, against Halliburton and its former president and CEO, David J. Lesar.  They had bought Halliburton common stock between June 3, 1999, and December 7, 2001.

The lawsuit claimed that the company and Lesar committed securities fraud by falsifying financial results and by issuing mislieading public statements about Halliburton’s financial condition — specifically, about the company’s liability for claims of injury or death due to exposure to asbestos, about the adequacy of its reserves to cover asbestos claims, about its ability to collect revenue on claims for construction contracts, and about the benefits of its merger with Dresser Industries.

Those statements, according to the investors, pushed up the price of Halliburton’s stock.  But, when the company later put out a number of corrections, the company stock’s price dropped, allegedly costing the investors a loss of value in their portfolios.

The suing investors sought to have the case certified as a class action.  They apparently met all of the requirements for use of that device under federal court Rule 23, but a federal judge and then the Fifth Circuit Court, following Circuit precedent, tacked on a requirement that they could not satisfy.   They were required, in order to rely on the fraud-on-the-market presumption, the Circuit Court held, to show up front that they had lost money on their transactions in the market.

The Fifth Circuit had added that further requirement in a 2007 decison (Oscar Private Equity v. Allegiance Telecom), concluding that it was necessary to “tighten” access to the class-action device.  This was done, it explained, to counter the “extraordinary leverage” that the class-action device gave to those suing by that method.  The Circuit Court also said it added the requirement because the Supreme Court’s ruling in Basic had given it permission to do so in order to make real the sued company’s right to rebut the market-fraud presumption, and because a failure to prove loss causation at the outset might well show that the price manipulation did not actually affect the market price of a stock.

The Supreme Court, in the opinion by Chief Justice John G. Roberts, Jr., swept aside all of those arguments for imposing a “loss caustion” requirement as a condition for approval of a class of investors.  “The Court of Appeals’ requirement,” the opinion said, “is not justified by Basic or its logic….We have never before mentioned loss causation as a precondition for invoking Basic‘s rebuttable presumption of reliance.  The term ‘loss causation’ does not even appear in our Basic opinion.”

The Chief Justice went on to conclude — as the U.S. Solicitor General had argued, in support of the investors’ class — that loss causation involves an entirely different question from whether an investor relied on a misstatement when buying or selling a stock.    Reiterating the formulation of the Basic decison, that reliance can be proved in a securities class-action case by relying upon the market’s assimilation of all information, the Court said that “loss causation” is unrelated to that because it requires proof that the misstatements caused the subsequent economic loss.

Even if manipulated information pushed up a stock’s price when investors bought the security, the Chief Justice wrote, that does not necessarily mean that the flawed information caused the stock price to drop later.  There could be other intervening causes for such a drop, the opinion said, and, if that proves true when the merits of a case are decided, the investors would not be able to prove a loss resulting from the manipulation.

“The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation,” Roberts said, “has nothing to do with whether an investor relied on the misrepresention in the first place, either directly or presumptively through the fraud-on-the-market theory.  Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.”

The unanimous opinion went on to dismiss, with brief remarks, an alternative argument that Halliburton had put forth to justify the Fifth Circuit’s ruling — that is, that the investors could not proceed as a class because they had not shown that the misstatements affected the market price in the first place.   That is a theory of “price impact,” which the company sought to distinguish from “loss causation.”

Roberts pointed out that the Fifth Circuit had used the phrase “loss causation” 21 times in its opinion.  “We take the Court of Appeals at its word,” the opinion concluded.  “Based on those words, the decision below cannot stand.”

The Court ordered the case returned to the Fifth Circuit, where Halliburton will be allowed to press any other arguments that it has kept alive against certifying the class.   “We need not, and do not, address any other question about Basic, its presumption or how and when it may be rebutted,” the Court said.

There are, among the Justices (especially Justice Antonin Scalia), various levels of skepticism about the class-action device in general.  But the decision in this case, limited as the Court stresssed that it was, revealed nothing about that more general proposition.   In fact, the Erica John Fund opinion simply reiterated the fundamental requirements for pursuing a class action under federal court Rule 23.

For the Court’s broader view of Rule 23, , Court watchers are awaiting the Justices’ almost certainly more important ruling in the case of WalMart Stores v. Dukes  (docket 10-277), a decision likely to be issued within the next three weeks.


Recommended Citation: Lyle Denniston, Opinion analysis: Fraud-on-market theory intact, SCOTUSblog (Jun. 12, 2011, 5:20 PM),