Arguments to Keep the Fraud on Market Theory, and Thinking About a World Without It

Arguments to Keep the Fraud on Market Theory, and Thinking About a World Without It

 As the March 5, 2014 date for oral argument before the United States Supreme Court in the closely-watched Halliburton case approaches, the briefing process in the case has continued to unfold. On January 29, 2014, the Erica P. John Fund, the respondent (the plaintiff in the underlying action) filed its merits brief in the case, arguing that the Court should uphold the fraud on the market theory. But while the plaintiff contends that the Court should preserve the status quo, other commentators are looking ahead considering what the securities litigation world might look like if the Supreme Court overturns Basic v. Levinson (the 1988 decision in which the Court first recognized the fraud on the market theory) [an enhanced version of this opinion is available to subscribers].

As well-analyzed by Alison Frankel in a January 30, 2014 post on her On the Case blog (here), the plaintiff has urged the court to uphold Basic based on the history of the securities laws and the principles of stare decisis, and out of deference to Congress and regulators. The plaintiff  side-steps the debate whether the “efficient market hypothesis” on which the fraud on the market theory is based is valid, arguing that the debate is “irrelevant” and contending  that at the heart of Basic v. Levinson is “the simple economic truth” in “the proposition that developed markets generally respond to material information.”

The plaintiff argues that in adopting the securities laws in the wake of the Great Depression, Congress recognized, consistent with the fraud on the market theory, that a company’s share price incorporates all publicly available information about the company. According to the plaintiff, the Supreme Court itself recognized as much in several cases prior to the Basic case. And since Basic was decided, the Court has expressly endorsed the fraud on the market theory several times – including just three years ago in a unanimous decision in the Halliburton case itself, when the case was previously before the Court.

In other words, the plaintiff argues, the Supreme Court could only dump the fraud on the market theory by reversing its own precedent and overlooking an established body of its own case law. For the Court to overturn its own statutory precedent is an event so rare that, according to the plaintiff, it has been over 50 years since the last time the Court did so.

Not only would the Court have to overturn its own precedent, but it would implicitly override Congress, which has revised the securities laws numerous times since Basic was decided but has not altered the fraud on the market theory. “Congress,” the plaintiff argues “has expressly considered overturning Basic, and could have done so at any time over the past quarter century,” but instead it left the current arrangements in place. In addition, the plaintiff argues, both the SEC and the Department of Justice rely on the fraud on the market theory in connection with their enforcement of the securities laws.

The most fundamental reason for leaving Basic alone, the plaintiff argues, is that if the fraud on the market theory is discarded, “securities-fraud class actions and many individual fraud actions simply could not be brought in 10(b) and 10b-5 cases based on affirmative misrepresentations.” As a result, “most defrauded investors would be left without any legal recourse from fraud.” Were this to happen, “the legal landscape would be worse for the change.”

The reason that the plaintiff emphasized the importance of the fraud on the market theory in misrepresentation cases in particular is that in a case based on alleged omissions rather than alleged misrepresentations, the claimant does not have to depend on the fraud on the market theory to establish a presumption of reliance. Instead, in an omissions case, the claimant simply does not have to establish reliance. In a case that preceded Basic, the 1972 decision in Affiliated Ute Citizens v. United States [enhanced version], the Supreme Court said that proof of reliance is not necessary to support a claim based on alleged omissions.

In light of this case law, many commentators have speculated that if the Supreme Court were to overturn Basic and make it impossible for plaintiffs to pursue Section 10(b) misrepresentation cases as class actions, the plaintiffs will simply recast their allegations and contend that investors were misled by the defendants’ omissions, instead of trying to contend that the defendants’ misrepresentations had misled investors.

However, it could be far trickier for the plaintiffs to pursue this approach that the commentators are suggesting. As Claire Loebs Davis notes in a January 28, 2014 post on the D&O Discourse blog (here), Affiliated Ute “does not offer a quick fix” to the potential elimination of the fraud on the market theory.   Rule 10b-5, she argues, does not simply create a cause of action for omissions as well as for false and misleading statements; rather, she emphasizes, the provision refers to “false or misleading statements and omissions of material fact necessary to make statements made not misleading.”

In other words, omissions are only actionable if they cause an affirmative statement to be false or misleading because of the information that was omitted. It is not enough for a plaintiff to argue that something material was omitted; the omitted information must have made an affirmative statement materially misleading. Accordingly, she argues, “plaintiffs cannot simply recast their securities fraud allegations as ‘omission’”; plaintiffs “may only state a claim under 10b-5(b) based on an affirmative misstatement – whether that affirmative statement was misleading because of what it said, or because of what it did not say.”

She concludes her post by noting ‘that “one thing is clear: Affiliated Ute does not offer a straightforward solution for plaintiffs’ lawyers if the Halliburton Court takes away the fraud-on-the-market presumption. Whether they phrase their allegations as claims of affirmatively false statements or statements made false by omission, they are still claims based on statements, not omissions, and current law requires that plaintiffs find a way to show class-wide reliance.”

Davis’s commentary is both noteworthy and very interesting. Some commentators considering the possible outcomes of the Halliburton case have tried to suggest that not that much would change if the Supreme Court were to dump the fraud on the market theory, since, they suggested, plaintiffs could simply plead their claims as omissions cases and rely on Affiliated Ute to avoid the reliance problem. Davis’s post suggests that it may not be that simple and that even in an omissions case the plaintiffs will have to establish class-wide reliance.

 Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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