The Supreme Court agreed on Friday to reconsider a 1988 decision that has been the key to investors’ right to sue when they lose money because of securities fraud — the ruling in Basic Inc. v. Levinson. That is the main issue in Halliburton Co. v. Erica P. John Fund, Inc. — a case that was before the Court two years ago.
The Court’s decision in the Basic Inc. case a quarter-century ago laid down the rule that a group of investors who claim that they lost money because of distorted information about a stock need not show that they had actually relied upon the misinformation. The Court, relying upon a theory that an efficient stock exchange will reflect all of the information that there is about a given security, said that investors could be presumed to have relied upon the distortions without specific proof that they had done so. The presumption could be rebutted, though. The shortcut that investors are allowed to take is known to lawyers and judges as the “fraud-on-the-market” presumption.
Basic Inc. was a four-to-two decision, with only six Justices taking part. The only two current Justices then on the Court — Justices Anthony M. Kennedy and Antonin Scalia — did not take part in that ruling. Four of the current Justices, though, have said that, at some point, they would be willing to reconsider the Basic Inc. precedent.
Halliburton Co., locked for years in a lawsuit over investors’ claims that the company put out seriously misleading information that affected the company’s stock price, argued in the new case that the Basic Inc. decision was based upon a flawed economic theory. The company contended that the presumption of “reliance” was especially misplaced when investors sue in a class-action lawsuit, because it enables them to proceed as a class even without proving that their own losses could be traced to distorted information.
The issues on which the Court granted cert are pretty broad:
(1) Whether this Court should overrule or substantially modify the holding of Basic Inc. v. Levinson, to the extent that it recognizes a presumption of classwide reliance derived from the fraud-on-themarket 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 and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock.
So it could either nix the theory or, if it keeps some version, broaden the ability of defendants to rebut the presumption.
Alison Frankel comments:
Basic’s fraud-on-the-market theory freed securities class action lawyers from having to show that individual shareholders made investment decisions based on fraudulent misrepresentations, permitting the certification of enormous classes of investors. If the justices decide to chuck Basic’s presumption of reliance, it’s hard to imagine how plaintiffs’ lawyers will be able to win certification of securities fraud class actions. As Max Bergerof Bernstein Litowitz Berger & Grossmann said at a securities litigation conference on Tuesday, “I seldom lose sleep at night, but one of the things that keeps me up is what the Supreme Court is going to do in Halliburton. It’s a game changer.”
Well, yes, but ... As Frankel notes, under current law it is virtually impossible to rebut the presumption of reliance. Worse yet, it is trivially easy for plainitffs to establish the presumption under current law. As a result, Basic effectively wrote reliance out of the 10b-5 cause of action, with no basis in the rule or statute for doing so.
In addition, as Frankel notes in quoting former SEC Commissioner Joseph Grundfest, the trial lawyers are protesting too much:
Grundfest pointed out that even if the court eliminates the presumption of classwide reliance, investors in some cases will still be able to bring class actions under Section 11 of the Securities Act of 1933, which does not require a showing of reliance but holds defendants strictly liable for material misstatements in offering materials. Individual investors with sizeable losses may also still sue for fraud under both state and federal law, as long as they can show that they relied on alleged misrepresentations, Grundfest said. ...
And even if the Supreme Court eliminates its fraud-on-the-market precedent, shareholders can still bring Exchange Act class actions based on allegedly fraudulent omissions, rather than misrepresentations, according to Paul Vizcarrondo of Wachtell, Lipton, Rosen & Katz .... Because the Supreme Court has previously held that shareholders do not have to establish that they relied on such omissions, Vizcarrondo predicted in an interview Friday, plaintiffs’ lawyers will likely try to reframe cases to claim that defendants deliberately failed to disclose material information. So, for instance, instead of arguing that JPMorgan Chase CEO Jamie Dimon misstated the bank’s risk when he called losses from trades by the so-called London Whale “a tempest in a teapot,” shareholder lawyers might argue that JPMorgan officials fraudulently avoided revealing the magnitude of losses by its chief investment office. Plaintiffs’ lawyers, as we all know, are nothing if not resourceful.
Resourceful is one way of putting it. Slick, devious, sneaky, and insatiable also come to mind as apt descriptors.
In any event, I am pleased to be one of the co-signers of an amicus brief signed by a slew of prominent former SEC Commissioners and law professors. The amici are:
- The Honorable Paul S. Atkins served as a Commissioner of the SEC from 2002 to 2008.
- Professor Stephen M. Bainbridge is the William D. Warren Distinguished Professor of Law at the University of California, Los Angeles School of Law.
- Brian G. Cartwright served as General Counsel of the SEC from 2006 to 2009.
- Richard A. Epstein is the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution.
- Professor Allen Ferrell is the Greenfield Professor of Securities Law at Harvard Law School.
- The Honorable Edward H. Fleischman served as a Commissioner of the SEC from 1986 through 1992.
- The Honorable Joseph A. Grundfest is the W.A. Franke Professor of Law and Business at Stanford Law School and served as a Commissioner of the SEC from 1985 to 1990.Professor M. Todd Henderson is a Professor of Law at the University of Chicago Law School.
- Simon M. Lorne served as General Counsel of the SEC from 1993 through 1996.
- Professor Jonathan R. Macey is the Sam Harris Professor of Corporate Law, Corporate Finance and Securities Law at Yale Law School.
- Professor Richard W. Painter is the S. Walter Richey Professor of Corporate Law at the University of Minnesota Law School.
- Professor Kenneth E. Scott is the Ralph M. Parsons Professor of Law and Business, Emeritus, at Stanford Law School.
- The Honorable Laura S. Unger served as a Commissioner of the SEC from 1997 through 2002 and as acting Chairman from February to August 2001.
- Andrew N. Vollmer served as Deputy General Counsel of the SEC from 2006 through early 2009.
A pretty high-powered bunch, eh?
Here's the summary of our argument:
The fraud-on- the-market presumption was, instead, the work of a bare majority of a bare quorum of this Court. A judicially created rule, tacked on to a judicially created right of action, the fraud-on-the-market presumption did not derive from the text, structure, or history of the federal securities laws. Instead, it embodied two raw judicial policy judgments—first, a belief that “[r]equiring proof of individualized reliance” should be dispensed with, so that Section 10(b) plaintiffs could be free to “proceed with a class action”; and, second, an acceptance of what were then “[r]ecent empirical studies” supporting the efficient capital markets hypothesis, the theory “that the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations.” Basic Inc. v. Levinson, 485 U.S. 224, 242, 246 (1988).
Whatever its merits as an economic theory, the [efficiant capital markets] hypothesis was not designed or intended to be used to prove reliance in securities fraud cases. And twenty-five years on, it has become clear that this expansive theory cannot, as a practical matter, be applied by judges to actual cases. The petition thus correctly contends that the judiciary should not be an arbiter of economic theory, that it is ill-equipped to assess market efficiency, and that these are good and sufficient reasons why Basic should be overruled. On a narrower level, the petition is also right that, if Basic is to be retained, there is a sharp and consequential circuit split over how it applies, a split that by itself requires the attention of this Court.
But there are other reasons why Basic should be constrained, if not overruled. The first that we present below, in contrast to rendering judgments on economic theory and market efficiency, does involve a task that a court of law is particularly well-suited to perform—the application of settled principles of construction to interpret a federal statute. Applying those principles to the Securities Exchange Act makes clear that there is no basis for imposing a presumption of reliance to actions seeking damages under Section 10(b).
... The rule of Basic has become exactly what the dissent in that case feared—“[a] nonrebuttable presumption of reliance” that “effectively convert[s] Rule 10b–5 into a scheme of investor’s insurance.” Basic, 485 U.S. at 252 (White, J., dissenting; citation and internal quotation marks omitted). The decision to create such “an investor insurance scheme should” have—and should still—“come from Congress, and not from the courts.” Id. at 256–57 (White, J. dissenting).