After the Fraud on the Market Doctrine: What Should Replace It?
Like children on Christmas Eve, securities defense attorneys and corporate executives are waiting in hopeful anticipation for the U.S. Supreme Court's coming decision in Halliburton v. Erica P. John Fund (Halliburton II), which may overrule the "fraud on the market" doctrine (FOTM) that was announced over a quarter century ago in Basic v. Levinson.1 Academics are divided, with probably the majority fearing the loss of general deterrence if the securities class action is substantially undercut. Conversely, a minority (including this author) believe it is remarkable that FOTM has survived as long as it has because it is extraordinarily ill-suited to the real world of securities fraud (as hereafter explained). A third more nervous group of spectators are the managing partners of litigation-oriented law firms, who know that FOTM's potential abolition would likely imply a steep decline in securities litigation, which is the staple of their practice. Ironically, some of the securities defense attorneys eagerly awaiting FOTM's demise may next year be learning how to litigate patent cases. Be careful then what you wish for, as you may get it.
Last week, several of the amicus curiae briefs in Halliburton II were filed with the court, and, in light of them, this column will first survey the arguments being made to the court and then turn to the likely options before the court. It will argue that there is a middle ground available to the court that does not necessitate overruling long-established precedent but that would curb many of the abuses in contemporary securities litigation: namely, to focus the class certification hearing on the likelihood of price distortion (based on event studies and other evidence), while dropping any inquiry into the irrelevant issue of market efficiency. This would enhance defendants' leverage without burying the securities class action. As usual, both plaintiff attorneys and defense counsel will stoutly resist this compromise and hope for an all-or-nothing victory.
The Basics of 'Basic'
Because some readers may be humble corporate practitioners (and not litigators), it is useful to begin with the "basics" by recalling that Basic v. Levinson established a "presumption of reliance," which enables the putative class to gain class certification under Rule 23(b)(3) of the Federal Rules of Civil Procedure (which rule requires that common questions of law or fact "predominate" over individual questions). Absent this presumption, reliance, which is a requisite element of a Rule 10b-5 cause of action, would generally be an individual question that would preclude class certification. Basic made reliance a common question by announcing that "[a]n investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price."2 It justified this result on the premise that "the market price of shares traded on well-developed markets reflects all publicly available information," including "any public material misrepresentation."3 The chain of logic thus flows from the premise that a material misrepresentation will be reflected in a security's price to the conclusion that investors' reliance on that misrepresentation "may be presumed for purposes of Rule 10b-5 action."4
One can easily think of counterexamples. For example, an indexed investor is probably not relying on the "integrity" of the market price, because it knows that, if it broadly invests in the market, it will be buying both overvalued and undervalued stocks (and expects them to average out over the long run). Still, the greater problem in Basic's logic is its use of market efficiency to support the entirely valid idea that when the market incorporates fraudulent information into price, a "fraud on the market" results. In truth, whenever the market price is distorted by fraudulent material information, investors suffer an injury, whether they individually relied or not and whether the market is efficient or not. The efficiency of the market determines only the speed at which the material misinformation is incorporated into price.
Prior to Basic, the federal courts that had accepted the FOTM doctrine required the plaintiff to make a showing that "a lie, misleading statement, or omission has affected the price of the stock."5 Today, such a showing would be described as directed at loss causation and would be postponed until trial or summary judgment pursuant to the court's holding in its first Halliburton decision.6 Because the vast majority of certified securities class actions settle, this postponement effectively trivializes this central question of whether the market price was in fact distorted.
Despite the original focus of the FOTM doctrine on whether there was in fact a price distortion, courts after Basic v. Levinson shifted their focus from whether the market price has been distorted to whether the market was efficient. Very quickly, the operative interpretation of Basic became that if the market was efficient, then a "presumption of reliance" followed, the class would be certified, and the question of actual market distortion became submerged. To be sure, the issue of the loss causation was later rediscovered in 2005 by the court in Dura Pharmaceuticals v. Broudo,7 but loss causation has remained the caboose on the securities fraud train. Juries tend not to understand it, and on a motion for summary judgment, the burden is high and on the defendant to prove that no reasonable jury could believe that the specific misstatement at issue caused the stock drop.
As a result, the FOTM doctrine operates in both an underinclusive and overinclusive fashion. On the underinclusive side, courts have generally refused to certify Rule 10b-5 classes in cases involving stocks traded in thin markets, in IPO cases, and in cases of securities (such as bonds) that are not traded on exchanges. Worse yet, since Cammer v. Bloom8 in 1989, courts have used a primitive and ill-fitting list of arbitrary factors to determine whether the market was efficient. As a result, in those areas where a fraud remedy is most needed (for example, in "pump and dump" and similar cases involving OTC stocks and the lower rungs of Nasdaq), class certification will be generally unavailable on the grounds that the market is not efficient, even though price distortion may seem clear.
On the overinclusive side, defendants are even more dissatisfied because class certification is virtually automatic in Rule 10b-5 cases, at least once it is determined that the market is efficient. The defense that the misstatement was immaterial or that the stock drop was attributable to other, unrelated factors cannot be heard until late in the litigation and thus tends to be nullified by the defendant's normal reluctance to gamble on a jury trial in a potential billion dollar case. To be sure, defendants are hardly disarmed, as the Private Securities Litigation Reform Act gives them effective weapons. But if plaintiffs can plead a securities fraud claim with the requisite particularity, the reality is that the issue of whether the alleged misstatement in fact distorted the market price tends to fall by the wayside.
In short, both sides have good reason to be dissatisfied with the FOTM doctrine in its actual operation (although plaintiffs are desperately dependent on some means of satisfying their need to make reliance a "common" issue under Rule 23(b)(3)).
What Might the High Court Do?
The court granted certiorari on two issues in Halliburton II:
(1) Whether this court should overrule or modify the holding of Basic v. Levinson, to the extent that it recognizes a presumption of classwide reliance derived from the fraud on the market theory; and (2) whether in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption of reliance and prevent class certification by introducing evidence that the alleged misrepresentation did not distort the market price of its stock.
In my judgment, the court is more likely to resolve Halliburton II on the second above question by permitting the defendant to rebut the presumption at class certification in some fashion.