Fraud-on-the-market (“FOTM”) suits are thought to generate considerable benefits for society – namely, those associated with increased stock-market price accuracy and liquidity. But these suits are also said to impose exceptionally large social costs relative to even those associated with more typical class-action litigation. The federal courts have thus long tried to efficiently screen out FOTM claims that do not sufficiently implicate the benefits at issue, even if judges do not always consider or describe their work in this area in these terms.

In a recent article, I argue for a nuanced, yet likely far-reaching reform to the relevant screening framework in light of the current emergence of ESG disclosure: For FOTM claims targeting non-financial disclosure, plaintiffs should have to prove price impact in front of a panel of independent financial economists at the beginning of the litigation to receive a FOTM presumption of reliance.

The existing approach grants plaintiffs a presumption of both price impact and reliance at the class-certification stage upon a mere showing that the market for the securities at issue is efficient but allows the defendants a window to rebut that two-pronged presumption by showing a lack of price impact. Yet that approach is likely far from optimal for FOTM claims – including both those targeting financial disclosure and those targeting non-financial disclosure.

A significant part of the problem with the status quo is that the district court judges who make the class-certification decision (understandably) lack expertise in financial economics while also having much incentive to rule in favor of the plaintiffs on the class-certification motion. In anything resembling a close case, the lack of expertise will tend to result in the judge using the burden of proof to make the decision rather than ruling that the evidence presented by one party’s financial economist is more compelling than that of the other party. So, with publicly traded stocks generally trading in efficient markets and thus plaintiffs meeting their burden in showing market efficiency with relative ease in the vast majority of all public-company cases, the relevant burden of proof that matters most is the one on defendants to show a lack of price impact. The courts thus err on the side of finding that the defendants have failed to carry that burden, thereby paving the way for class certification. Moreover, making the alternative finding (i.e., that defendants have carried their burden in showing a lack of price impact) likely means the end of the case for the representative plaintiff – and thus a much higher chance of allowable appeal. In fact, given that appeals from a class-certification decision are discretionary and that judges in circuits like the Second Circuit are reluctant to grant them, a finding for the representative plaintiff leads to a relatively low-cost removal of the case from the court’s docket since class-certification in a FOTM almost always leads to settlement given the costs (including risk) associated with proceeding further into the litigation.

To be sure, for FOTM cases targeting financial disclosure (including ESG-based financial disclosure), the market-efficiency-centered approach may be acceptable enough for now for two main reasons. First, Halliburton II (2014) rejected arguments in favor of moving to a screening approach that required the representative plaintiff to prove price impact to receive the FOTM presumption of reliance. It thus represents relatively recent precedent that (1) the Supreme Court is unlikely to revisit for all FOTM cases absent a significant relevant development and (2) involves a niche aspect of securities litigation that Congress might be reluctant to overturn broadly. Second, there’s rough justice to this approach for FOTM cases targeting this type of disclosure. When a material misstatement about, for example, a firm’s quarterly earnings is made to the public, the chances are perhaps high enough that the statement will be reflected in the market price of the firm’s stock when that stock trades in an efficient market. In this way, the market-efficiency showing leads to a one-two punch of logical presumptions that allow courts to certify a class of aggrieved investors: one of price impact and one of reliance. And at least since Halliburton II, defendants in these cases have a perhaps fair chance to bear their heavy burden of proving a lack of price impact at the class-certification stage. This status quo may thus be acceptable even though it will allow many cases targeting financial disclosure to proceed where there is in fact no price impact, but defendants are unable to persuade the district court that that was the case.

When it comes to FOTM claims targeting non-financial disclosure, it is much harder to come to the same conclusion about the current market-efficiency-centered approach being perhaps good enough. The chances of these claims triggering the price-accuracy and liquidity benefits associated with imposing FOTM liability are lower than those for claims targeting the narrow, cash-flow-focused disclosure (i.e., financial disclosure) that has traditionally dominated public-company disclosure. And relative to the traditional mix of corporate disclosure, ESG disclosure is far more likely to be motivated by broader social concerns and, therefore, far more likely to consist of non-financial disclosure. It follows that, as the current mix of public-company disclosure shifts in the ESG era to include more non-financial disclosure relative to that included in the traditional mix of corporate disclosure, the extent to which the market-efficiency-centered approach (with defendants’ carrying the above-described burden of proving a lack of price impact) should continue to be used over the price-impact-centered one like that for which I argue should be questioned for at least claims targeting non-financial disclosure.

As discussed in the article, proof of price impact by the plaintiff to a panel of independent financial economists at the Securities and Exchange Commission in cases targeting non-financial disclosure would better ensure the presence of the causal connection between the defendant’s misstatement and the plaintiff’s harm that sits at the heart of the FOTM theory of liability. These financial economists would better be able to identify and analyze the key issue for identifying FOTM claims that implicate the social benefits of attaching FOTM liability to corporate disclosure: whether the misstatement had price impact. And the economists would make that determination with far less concern for appeal. Indeed, a district court that overruled a properly appointed panel of independent financial economists on a price-impact determination would generally embarrass itself, and the panel would have little reputation loss in that situation. And with this price-impact inquiry coming at the very beginning of the litigation, the end result would likely be the more efficient (1) weeding out claims targeting non-financial disclosure that fail to sufficiently implicate the social benefits of attaching FOTM liability to corporate disclosure and (2) fast-tracking of those that do sufficiently implicate those benefits past the existing screening hurdles. This reasoning, along with the other benefits to FOTM litigation and considerations beyond the courtroom detailed in the article, support the centering of the FOTM screening framework at issue on the above-described threshold price-impact inquiry for claims targeting non-financial disclosure at this time.

This post comes to use from Professor Kevin S. Haeberle at the University of California Irvine School of Law. It is based on his recent article, , “Fraud-on-the-Market Liability in the ESG Era,” published in the Tulane Law Review and available here.