Since 2007, there have been two primary approaches for determining whether plaintiffs in securities fraud class actions can invoke, at the class certification stage, a presumption of reliance on the alleged misrepresentation or omission at issue: (1) the Fifth Circuit’s approach which required plaintiffs to prove loss causation – that the misstatements or omissions alleged by plaintiffs actually caused their loss – in order to trigger the presumption; and (2) the approach of courts in nearly every other Circuit which did not require proof of loss causation. In Erica P. John Fund, Inc. v. Halliburton Co., No. 09-1403, 2011 U.S. LEXIS 4181 (June 6, 2011), the United States Supreme Court resolved this Circuit split, holding that the Fifth Circuit’s approach contravened prior Supreme Court precedent and that plaintiffs in federal securities fraud class actions do not need to prove loss causation in order to obtain class certification.
The Lower Courts’ Decisions in Halliburton
In Halliburton, the lead plaintiff (Erica P. John Fund) claimed that Halliburton Company and one of its executives artificially inflated the Company’s stock price in violation of federal securities laws by misrepresenting (1) Halliburton’s potential liability in asbestos litigation, (2) its expected revenue from certain construction contracts, and (3) the benefits of its merger with another company. The plaintiff alleged that when Halliburton later made corrective disclosures, the price of the Company’s stock fell, which caused investors to lose money.
Although this securities lawsuit survived Halliburton’s motion to dismiss, the district court refused to certify it as a class action under Federal Rule of Civil Procedure 23(b)(3) because the plaintiff failed to prove loss causation as required under the Fifth Circuit’s decision in Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F.3d 261 (5th Cir. 2007). In Oscar, the Fifth Circuit held that, as a prerequisite for class certification, a securities fraud plaintiff must prove loss causation by a preponderance of the evidence in order to invoke the fraud-on-the-market presumption of reliance developed in Basic v. Levinson, 485 U.S. 224 (1988). Under the Fifth Circuit’s reasoning, plaintiffs seeking class certification must demonstrate that an alleged misstatement “actually moved the market,” because if it did not, the market price of the stock at issue would not necessarily reflect or incorporate the alleged misstatement and, therefore, a presumption of reliance on the alleged misstatement would be unwarranted under the fraud-on-the-market theory. See Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 597 F.3d 330, 335-36 (5th Cir. 2010).
The plaintiff appealed the district court’s decision, and the Fifth Circuit affirmed, holding that the lower court correctly applied the Fifth Circuit’s standard. On January 7, 2011, the United States Supreme Court granted the plaintiff’s petition for a writ of certiorari to “resolve a conflict among the Circuits as to whether securities fraud plaintiffs must prove loss causation in order to obtain class certification.” Halliburton, supra, Slip Op. at 3.
The Parties’ Arguments to the Supreme Court
In its arguments for reversal, the plaintiff explained that the Supreme Court adopted the fraud-on-the-market theory and a rebuttable presumption of reliance in Basic so that investors in securities fraud litigation could proceed with their claims on a class-wide basis without having to prove that each member of the proposed class relied on the alleged misrepresentations. Requiring plaintiffs to prove loss causation at the class certification stage would negate the presumption of reliance established in Basic. The plaintiff also argued that, because Rule 23 does not afford a defendant the right to test the merits of a plaintiff’s claims at the class certification stage, the Fifth Circuit’s standard improperly required a premature merits inquiry in violation of the Federal Rules of Civil Procedure and Supreme Court precedent.
In seeking affirmance of the Fifth Circuit’s decision, Halliburton conceded that plaintiffs in securities class actions should not be required to prove loss causation to trigger the presumption of reliance under Basic, and argued that the Court of Appeals used the term “loss causation” merely as a shorthand for “price impact.” According to Halliburton, defendants in securities class actions are entitled to rebut the presumption of reliance at the class certification stage, and that, in doing so, they should be permitted to proffer evidence showing that an alleged misrepresentation did not inflate the market price plaintiffs paid for the securities at issue. Halliburton contended that if an alleged misrepresentation did not impact the stock price, then the causal connection between the misrepresentation and an investor’s reliance is “broken” and the presumption that all putative class members relied on a distorted market price is “gone.”
The Supreme Court’s Decision
The Supreme Court reversed the Fifth Circuit’s decision, holding that the Court of Appeals’ requirement of proof of loss causation for class certification “is not justified by Basic or its logic.” Halliburton, supra, Slip Op. at 6. The Court went on to explain that it has “never before mentioned loss causation as a precondition for invoking Basic’s rebuttable presumption of reliance,” and this is because “[l]oss causation addresses a matter different from whether an investor relied on a misrepresentation, presumptively or otherwise, when buying or selling a stock.” Id.
Specifically, reliance, or “transaction causation,” relates to the issue of why an investor elected to purchase a particular stock – i.e., the investor’s decision-making process – and under the fraud-on-the-market presumption of reliance, a purchaser is deemed to have relied on an alleged misrepresentation “if that ‘information is reflected in [the] market price’ of the stock at the time of the relevant transaction.” Id. at 6-7 (quoting Basic, supra).
Loss causation, by contrast, relates to the issue of whether the misrepresentation that is reflected in the market price of a security caused the economic loss allegedly suffered by the plaintiff. As noted in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), the fact that a stock’s “price on the date of purchase was inflated because of [a] misrepresentation” does not necessarily mean that the misrepresentation caused a later decline in the stock’s value. Halliburton, supra, Slip Op. at 7. Instead, the decline could have been the result of any number of intervening causes, including “changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events.” Id.
Thus, because an investor purchasing a stock could have relied on an alleged misrepresentation under the fraud-on-the-market theory without that misrepresentation ultimately being the cause of the investor’s alleged economic loss, the Supreme Court held that the Fifth Circuit wrongly required the plaintiff to prove loss causation in order to invoke the presumption of reliance permitted under Basic. The Court specifically noted that “[t]he fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively through the fraud-on-the-market theory.” Id. at 7. Accordingly, the Court vacated the Fifth Circuit’s judgment, and remanded the case for further proceedings consistent with its opinion.
Impact of Supreme Court’s Decision on Private Securities Litigation
The Supreme Court’s decision in Halliburton will have a significant impact on aggrieved investors who seek to institute suit in the Fifth Circuit, because as Chief Judge Easterbook noted in Schleicher v. Wendt, 618 F.3d 679 (7th Cir. 2010), the Fifth Circuit’s requirement in Oscar had the effect of “mak[ing] certification impossible in many securities suits . . . .” Now that Oscar has been overruled, securities plaintiffs will be emboldened in their efforts to pursue class claims in the Fifth Circuit. Of course, a plaintiff’s ultimate failure to prove loss causation will defeat its claim on the merits.
Even though the Supreme Court made clear that proof of loss causation is not a fraud-on-the-market prerequisite, it did not directly address Halliburton’s argument that a securities plaintiff cannot be deemed to have relied on an alleged misrepresentation if the misrepresentation did not have an impact on the price of the stock at issue. Thus, the price impact argument that Halliburton urged before the Supreme Court remains an argument by which defendants in securities cases can seek to rebut the presumption of reliance at class certification.
Robert L. Hickok, Gay Parks Rainville and Matthew D. Janssen