On Wednesday, March 5, 2014 the Supreme Court will hear argument in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317 [an enhanced version of the Fifth Circuit opinion appealed from is available to lexis.com subscribers]. The case has the potential to rewrite the rules for how securities class actions are brought. This three part series discusses the issues and arguments presented. Part I, published yesterday, outlines the arguments being presented by Petitioners. Part II, set forth below, outlines the arguments being presented by Respondents. The concluding segment, to be published tomorrow, will outline the arguments presented, and key questions posed, by the Justices at oral argument.
Respondents position keys to the supposition that Basic was correctly decided and the disputes regarding the efficient market theory do not impact the underlying rationale of the decision which is the predicate for the securities laws and SEC regulation. In support of this position Respondents advance six key arguments: 1) Basic is predicated on a common-sense rationale and was correctly decided; 2) criticism of the efficient market hypothesis do not justify overruling Basic; 3) the doctrine of stare decisis applies with special force here because of Congress; 4) overturning Basic would represent the demise of securities class actions and undercut SEC regulation; 5) Halliburton’s Section 18(a) claims are wrong; and 6) Basic is consistent with the Court’s class certification jurisprudence. Respondents also contend that requiring plaintiffs to establish price impact at certification – Petitioners’ alternate argument – is contrary to the Court’s class certification decisions.
First, basic is predicated on common sense principles and was correctly decided, according to Respondents. In deciding Basic, the Court’s decision was consistent with the position of the SEC, nearly every court which had considered the issue and the economic reality of the securities markets. Interposed between the buyer and seller is the market. The economic presumption on which the decision is based “recognizes that, in well-developed markets, material public information is generally reflected in the market price of a security and that investors generally rely in common on the integrity of this market price in making investment decisions.” The presumption is also consistent with the congressional policy embodied in the 1934 Act since “’Congress expressly relied on the premise that securities markets are affected by information, and enacted legislation to facilitate an investor’s reliance on the integrity of those markets . . .’”
The Basic presumption is not based on the mere fact that the stock is publically traded. Rather, plaintiffs must demonstrate that the market for the security is open and well-developed, that misrepresentations were made and in time the truth was revealed. “Establishing these predicates demonstrates that reliance for all class members will rise or fall together, and that common questions will predominate over individual ones.” Contrary to Petitioners’ claims, courts have frequently found that plaintiffs have failed to establish the prerequisites for invoking the presumption.
Citing the Court’s prior decisions in Affiliate Ute [Affiliated Ute Citizens of Utah v. U.S., 406 U.S. 128 (1972) [enhanced version]] and Mills [Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970) [enhanced version]], Respondents claim that Basic was correctly decided since it is grounded in the underlying rationale of the securities laws. The disclosure approach adopted in the statutes is built on the theory that there cannot be honest markets without honest publicity. The statutes were enacted “against the backdrop of widespread acceptance of the fraud-on-the-market principle.” In adopting that principle in Basic, the Court utilized the approach of Affiliated Ute which dispensed with the requirement for positive proof of reliance in omission cases. That decision was built on Mills which held that a plaintiff alleging a violation of Exchange Act Section 14(e) need not prove reliance at all since it would not be feasible. There the Court held that the requisite causal connection was supplied by proof of materiality, meaning that the misstatement or omission may have been important to the investor.
Second, Halliburton’s claim that economic disputes over the efficient market theory undercut the foundation of Basic is simply wrong. Whatever the merits of those arguments, Basic is not predicated on establishing perfect efficiency. Rather, the question is whether the market segment where the stock is traded has sufficient efficiency properties such that misinformation is likely to distort the price of the security. Thus several of the articles cited by Halliburton acknowledge that the presumption does not “rise or fall with the . . .” efficient market hypothesis.
Third, in this case the doctrine of stare decisis applies with special force. Halliburton’s claim that Congress has not addressed Basic’s presumption is incorrect. At the time Congress considered the PSLRA, the House of Representatives had before it a bill which would have required actual reliance, effectively doing away with the fraud-on-the-market theory of liability. As the Court noted in Amgen, that bill was supported by testimony. Congress recognized that the bill would undo Basic and did not adopt it. Rather, it enacted a statute which is structured in such a fashion that it is effectively based on the presumption. As the Court stated in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) [enhanced version], “’Congress thus ratified the implied right of action [in adopting the PSLRA]’ and’[i]t is appropriate for us to assume that when [the PSLRA] was enacted Congress accepted the Section 10(b) private cause of action as then defined but chose to extend it no further.” (emphasis original).
Fourth, overruling Basic would have an untoward impact on private securities actions and the deterrent role they play as well as undercut SEC regulation. Overruling Basic would preclude certification in the “vast majority of private securities-fraud class actions . . .” This would leave many defrauded investors without recourse. That would be contrary to the repeated statements of the Court noting that private securities litigation is an “essential supplement” to criminal prosecutions and SEC civil enforcement – a position which has also been repeatedly asserted by the SEC. It would also undercut their recognized deterrent impact of the suits on fraud. Adopting the position of Halliburton would also call into question “the very premise of the federal securities laws that ‘[t]he investing public has a legitimate expectation that the prices of actively traded securities reflect publicly available information about the issuer of such securities.’” This would indirectly undercut SEC regulation and policy.
Fifth, Halliburton’s claim that the reliance element of a Section 10(b) claim should be modeled on Exchange Act Section 18(a) misses the mark. Not only does that argument ignore the history of the PSLRA but also the fact that Section 9 of the Exchange Act is the proper comparison. Section 18 does not address price manipulation and is narrowly limited to statements in published documents filed with the SEC. Section 9, however, addresses manipulation as does Section 10. Both Sections address intentional conduct, unlike Section 18 which does not. Importing the Section 18 reliance requirement into Section 10 would destroy the symmetry between Sections 9 and 10.
Sixth, Basic is consistent with the Court’s recent class certification jurisprudence. To secure certification a securities fraud plaintiff utilizing Basic must establish the efficiency of the market, the timing of the class members’ trades and that the defendants’ misstatements were public. Those requirements are consistent with Rule 23 which is the predicate for the Court’s recent decisions in Wal-Mart and Comcast. Indeed, Wal-Mart “approvingly discussed the fraud-on-the-market presumption without suggesting that it was somehow inconsistent with its holding that Rule 23 compliance must be ‘affirmatively demonstrate[d].’’
Finally, Petitioners’ proposed modification of Basic is inconsistent with the Court’s prior decision in this case and Amgen. In Amgen, which built on the Court’s first determination in this case, the Court held that a securities law plaintiff need not establish materiality at the class certification stage because it can be proven through evidence common to the class. There is no risk that a failure of proof would result in individual questions predominating, a key Rule 23 question. The same principles apply to the question of price impact. Proof of that element, which frequently requires discovery, goes to the merits, not the Rule 23 issues.
Amicus briefs: Several amicus briefs were filed in support of Respondents. One was submitted by the United States and the SEC. That brief, premised on the notion that the economic theory of Basic also constitutes the underpinnings of the securities laws, begins by arguing that the fraud-on-the market presumption is an appropriate manner in which to prove reliance in a private securities damage action. Securities are traded in impersonal markets. The fraud-on-market presumption, as a method for proving reliance, is based on two “overarching premises about the operation of developed securities markets. The first is that material, publicly-disseminated information about stock traded on such a market generally influences the stock’s price. . . Second, the decision in Basic reflects the additional premise that investors typically do, and reasonably may, rely on the integrity of the market price . . .” Adopting a presumption premised on those points furthered the policies of Congress in enacting the Exchange Act in 1934 which in part was to “facilitate an investor’s reliance on the integrity of those markets.” At the same time, the Court did not adopt “a particular economic theory” or determine how rapidly information might be absorbed into price. The Court did make it clear that the presumption does not apply in every case and that it may be rebutted.
The government went on to note that Congress has acquiesced in the fraud-on-the-market presumption. In adopting the PSLRA, Congress recognized, as Amgen states, that private securities-fraud actions further important public policy interests such as providing restitution to defrauded investors. In both the PSLRA and SLUSA Congress not only refined the contours of the Section 10(b) private right of action, but expressly rejected efforts to end the use of the fraud-on-the market doctrine.
Academic debate regarding the efficient market theory does not detract from Basic. Economists debate various versions of the theory “in order to determine when investors can take advantage of arbitrage opportunities.” The soundness of the fraud-on-the market theory does not depend on whether or when prices react to information. “Whatever the state of academic debate on that particular question, there is widespread agreement on the basic point that public disclosure of material information generally affects the prices of securities traded on efficient markets.” And, the Basic framework is sufficiently flexible to accommodate criticism of the presumption and permit defendants to present evidence that the markets did not have the specific information.
Finally, it would be inappropriate to permit evidence of price impact at the certification stage. Price impact is “integrally related to the element of loss causation. Unless the alleged misstatements impacted the stock price, the plaintiff will be unable to show that he relied on a distorted price and suffered losses when the truth came to light.” This merits element is thus properly considered at a later stage in the proceeding, not at certification.
A group of Financial Economists also filed an amicus brief in support of Respondents. The group included Professor Eugene Fama of the University of Chicago, widely regarded as the father of the efficient market theory and the winner of the 2013 Nobel Price in Economics for his work on the efficiency of the capital markets. The group acknowledges that, as Petitioners claim, there is controversy about the efficient market theory. Those controversies focus on the various forms of the theory – labeled “weak,” “semi-strong” and “strong.” The debate has played out through a series of empirical studies. “But economists generally do not disagree about whether markets respond to material information. As Professor Shiller – a leading critic of the efficient market theory — recently wrote in explaining the extent of his disagreement with Professor Fama, ‘Of course, prices reflect available information.’” (emphasis original). In this regard “it is important to be clear that economists generally agree that stock prices respond to material information in a predictable direction.” The brief concludes by noting that “[m]ost important, economists generally agree that material information – whether truthful or fraudulent – will generally affect the price of a stock and that the effect will be in a predictable direction.”
Finally, an amicus brief was submitted in support of Respondents by former SEC Chairmen William H. Donaldson and Arthur Levitt, Jr. Congress, in designing the federal securities laws, based the statutes on the supposition that available, material information is reflected in the price of securities, according to the two former Chairmen. The SEC has followed the lead of Congress. The Commission has “long relied on the principle that market prices of actively traded securities generally reflect publicly available information in fashioning regulations. It has actively worked to foster the relationship between prices and information, so that investors may continue to invest with confidence in the integrity of market prices.”
The Commission has also used this approach to simplify and lessen the burden of regulation. For example, in adopting the rules relating to the integrated disclosure system the agency stated that “’integrated disclosure has, since its inception, been premised on the idea that a company’s disclosure in its registration statement can be streamlined to the extent that the market has already taken that information into account.’” (emphasis original). Rejecting that approach would call into question the rationale for many of the SEC’s regulations and would require additional, burdensome regulation. “In short the proposition that market prices of actively traded securities generally reflect publicly available information is a key premise of the system of federal securities regulation . . . This Court’s recognition in Basic that investors too rely on that premise is well-supported and should be reaffirmed.”
Next: Argument before the Court – Part III (conclusion).
For more commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.
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