The Supreme Court and the Fraud on the Market Class Action

The class action is indispensable to private enforcement of SEC Rule 10b-5, which prohibits fraudulent practices in the secondary securities market.  Though Rule 10b-5 is a criminal provision, courts have long inferred a private civil right of action, allowing defrauded buyers or sellers of securities to sue for damages. Many Rule 10b-5 plaintiffs, however, have “negative-value” claims: Their financial loss is not large enough to justify individual litigation. Without class litigation under Federal Rule 23, these claims would not be pursued and, to that extent, the anti-fraud policy of Section 10(b) would not be vindicated.

The U.S. Supreme Court under Chief Justice John Roberts has shown remarkable interest in the class action generally and in the “fraud on the market” securities class action in particular.  Since 2010, the court has decided more than 25 class cases, including four fraud on the market cases. These involve a misleading statement that affects the price of publicly-traded securities. Based upon that statement, investors buy (or sell) the stock.  Later, the misleading nature of the statement is exposed, and the stock price corrects – it goes down if the corporate statement painted too rosy a picture or goes up if the misleading statement painted too bleak a picture.  The investors who suffered a loss have a Rule 10b-5 claim for damages, which might be pursued as a class action under Rule 23(b)(3).

In a Rule 23(b)(3) class action, questions common to the class must predominate over questions relating to individual claims.  Whether this and other requirements are satisfied is determined at the “certification” stage of the class, when the class representative moves to certify the class.  This is the watershed event in the case.  If certification is denied, the negative value plaintiff will drop her individual case.  If certification is granted, the defendant faces cumulative liability and, likely, irresistible pressure to settle.  The Supreme Court has front-loaded the process by imposing increased burdens on the class representative at the certification stage. It has raised the bar for showing “commonality” and made certification more expensive by requiring  the representative to present evidence (not mere allegations) demonstrating by a preponderance of the evidence that the certification requirements are satisfied.  This procedural front loading affects every class suit.

The Supreme Court’s four fraud on the market cases are remarkable for the defendants’ efforts to impose substantive front-loading on class representatives as well.  At one level, these efforts have failed, but the defense persistence appears finally to have paid off most recently. The effort at substantive front-loading started with the argument that a class representative must demonstrate “loss causation” at the certification stage. A unanimous court rejected the effort in Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804, 813 (2011)(Halliburton I).  Loss causation (imposed as a substantive requirement by the Private Securities Litigation Reform Act) is a merits issue, and the representative need not litigate the issue until the adjudication phase of the case.

More serious questions arise when considering two other merits requirements of Rule 10b-5 claims:  reliance and materiality.  A generation ago, the Supreme Court saved fraud on the market classes in Basic Inc. v. Levinson, 485 U.S. 224, 246-47 (1988).  There, it held that reliance is presumed as to all class members, so long as the class claims involve a public misrepresentation concerning securities traded on an efficient public market.  The court relied on economic research showing that stock prices on public markets are based on the overall mix of available public information, including the misrepresentation. Without this presumption, each class member would be required to show that she relied on the misstatement.  Individual questions would swamp the common questions, and certification under Rule 23(b)(3) would be impossible.  To invoke the presumption of reliance under Basic, the class representative must demonstrate, at certification, that (1) the misstatement was public, (2) the class members bought or sold during the relevant period, and (3) the security was traded on an efficient market (which is not difficult with registered securities).

Defendants have attacked Basic relentlessly, frontally and by end-run.  In Amgen, Inc. v. Connecticut Retirement Plans & Trust Funds, 568 U.S. 455, 459 (2013), they emphasized that reliance and materiality are closely related.  After all, who would rely on a misstatement that was not material to the price of the securities?  Defendants asserted in Amgen that the representative must demonstrate the materiality of the misstatement at certification.  The Supreme Court rejected the effort.  Materiality, like loss causation, is a merits issue and need not be proved at certification. Moreover, even then, materiality will be susceptible to aggregate proof, and therefore will not present individual issues that would thwart class treatment under Rule 23(b)(3).

At this point, the efforts to impose substantive front-loading had failed.  But the defendants were just getting started.  Halliburton I was remanded, and the defendant asserted that the Basic presumption could not apply because its misstatement had had no “price impact” under the facts of the case. The Fifth Circuit rejected the argument and held that the case should proceed to adjudication with the Basic presumption intact. The case went back to the Supreme Court in Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014)(Halliburton II). During oral argument in Amgen, Justice Scalia raised a bombshell question: In light of recent economic studies, should Basic and its presumption of reliance be overruled? The court put the issue on the docket in Halliburton II.  Defendants were able to launch a frontal assault on Basic, but it failed.  The court in Halliburton II refused to overrule Basic.

But Halliburton II opened an important door for defendants.  Yes, materiality is a merits issue, and the representative need not prove it at certification.  But the Supreme Court drew a line between materiality and price impact.  Of the three things that the representative must demonstrate at certification to invoke the Basic presumption, two (public nature of the misstatement and efficient market) are relevant to price impact.  Because those two issues are litigated at certification, the court concluded in Halliburton II, the defendant must be given the opportunity at that time to demonstrate lack of price impact.

All this seems rather circular.  Consider how a certification hearing may unfold: After the representative shows a public misstatement, an efficient market, and the relevant time frame, the defendant admits the misrepresentation but argues that it had no price impact.  At that point, the burden shifts to the representative to demonstrate that the misstatement was something a reasonable investor would consider in making an investment decision.  How is this any different from requiring the representative to show (at certification) that the misstatement was material?  The same court that said materiality need not be proved at certification has now permitted the defendant to force litigation of precisely that issue – at certification.

Halliburton II raised so many questions that the Supreme Court had to return to the thicket.  It did so in June, in Goldman Sachs Group, Inc. v. Arkansas Teacher Retirement System,  141 S. Ct. 1951 (2021). There, the class argued that various misstatements about Goldman’s conflict-of-interest policy were misleading and served to prop up the price of the company’s stock at inflated levels. When the truth emerged that Goldman had engaged in transactions with conflicts of interest, the stock price dropped. Class members had purchased stock at the allegedly artificially high price. They sought to invoke the Basic presumption.

The defendants contended, at certification, that its statements about conflicts of interest were so anodyne as to be irrelevant to stock price.  The Supreme Court agreed: “[t]he generic nature of a misrepresentation often will be important evidence of lack of price impact.”  Moreover, the certification decision is based on “all probative evidence,” even if it overlaps with the merits of materiality. Ultimately, the judge may look to expert testimony and engage her common sense to determine whether the misstatement had an impact on price.  Again, all of this is on the table at the certification stage.

But the Supreme Court had some good news for plaintiffs.  Defendants cannot defeat the Basic presumption merely by presenting evidence that the misstatement did not affect the stock price.  Instead, the defendant must prove – by a preponderance of the evidence – the lack of price impact.

At the end of the day, then, defense persistence seems to have paid off.  Though the defense bar failed in its efforts to overturn Basic and failed to get the Supreme Court to require a class representative to prove loss causation or materiality at certification, it got the court to permit litigation of materiality at that stage.  The defendant has the ultimate burden of proving that its misstatement had no price impact.  But the issue of price impact – and, inevitably, the materiality of the misstatement – must be litigated in full in this pretrial phase.  Chalk one up for the defense:  In addition to the procedural front-loading mandated by the court, the representative must be prepared to litigate this substantive issue at certification as well.

This post comes to us from Richard D. Freer, Charles Howard Candler Professor of Law at Emory University.  It is based on his recent article, “The Robert Court and Class Litigation:  Revolution, Evolution, and Work to be Done,” available here.

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