The United States Supreme Court recently released its long awaited opinion in Halliburton Co. v. Erica P. John Fund, Inc. There were two central questions before the Court: (1) could plaintiffs in a Rule 10b-5 action for misrepresentation invoke a rebuttable presumption of reliance; and (2) what rebuttal evidence could a defendant properly put forward at the class action certification stage. The Court was in essence being asked to revisit its controversial 1988 decision, Basic v. Levinson, 485 U.S. 224 (1988), where the Court first recognized that reliance in a securities fraud case could be presumed where shares were traded on an efficient market. By doing away with the need to prove individual reliance, the Court in Basic opened the door for plaintiffs to pursue securities fraud claims by way of class action suits. Some believed that the current Supreme Court might lean in a more business-friendly direction and abandon the presumed reliance doctrine. However, in a 6-3 decision, the Court reaffirmed the presumed reliance doctrine as established in Basic, but equipped defendants with an important new weapon to contest certification motions – the ability to rebut the presumption at the certification stage by leading direct evidence that the alleged misrepresentation had no impact on the price of shares.
In Halliburton, the plaintiff alleged that Halliburton deliberately made false statements. The plaintiff further alleged that Halliburton made a number of corrective disclosures that resulted in a drop in the stock price resulting in losses to investors.
In the United States, misrepresentations made in connection with the purchase or sale of a security are prohibited under the Securities Exchange Act. Under Rule 10b-5, which was enacted under section 10(b) of the Act, the plaintiff must prove that it relied on the misrepresentation in order to recover damages. Based on the U.S. Supreme Court’s decision in Basic, reliance could be presumed in circumstances where the plaintiff could prove that the misrepresentations were publicly made and material, and that the market where the shares were traded was well developed and efficient. These elements were found to be common issues that can be decided on a class-wide basis and are therefore amenable to determination in a class action.
The basis for the Court’s recognition of presumed reliance in Basic was the “fraud on the market” theory which posits that in an efficient market all material information (including any misrepresentation) that is publicly disclosed is reflected in the share price. Therefore, an investor who purchases shares at a certain price is presumed to rely on all of the information that is reflected in that price, including the misrepresentation.
Halliburton challenged the validity of the “fraud on the market” theory arguing that (1) empirical evidence gathered since Basic demonstrates that markets are not efficient and therefore not all publicly available information is reflected in the share price; and (2) not all investors relied on the integrity of the share price in order to make investment decisions (e.g. value investors looked for discrepancies between the share price and the actual value of the company). The Court rejected both arguments.
With respect to the first argument the Court refused to wade into an academic debate among economists on the validity of the theory. Instead, the Court said it was relying on the more modest proposition that “market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.”
The Court spent little time dismissing the second argument saying only that Basic was not premised on the fact that such value investors did not exist and that even value investors rely on market prices eventually incorporating publicly available information within a reasonable time and share prices not being distorted by fraud. As a result, the Court upheld the presumed reliance doctrine.
Although the Court reaffirmed the presumed reliance doctrine, the Court also held that defendants can put forward evidence of “a lack of price impact” at the certification stage. The Court held that “price impact” was an essential precondition for any Rule 10b-5 class action and went directly to the issue of whether common questions predominate over individual ones. Accordingly, the issue was appropriate to deal with at the certification stage.
The Court made it clear, however, that it was not requiring plaintiffs to prove “price impact”, which in the Court’s view would take away the presumption of reliance that is established when the plaintiff shows that the misrepresentation was made public, and the shares traded on an efficient market. Instead, it was giving defendants an opportunity to rebut that presumption by leading direct evidence of “a lack of price impact”.
In Canada, the fraud on the market theory has not been adopted by the courts and the question of presumed or inferred reliance is often of limited importance because the provincial Securities Acts already provide for “deemed reliance” in both primary and secondary market claims. Nonetheless, plaintiffs in Canada still frequently assert common law misrepresentation claims on behalf of secondary market purchasers and plead that reliance should be inferred or presumed. One can expect that defendants will emphasize “price impact” when contesting such claims following Halliburton.