In a unanimous opinion issued on June 6, 2011, the Supreme Court rejected the Fifth Circuit’s attempt to erect an additional hurdle for plaintiffs seeking class certification in securities fraud actions. In Erica P. John Fund, Inc. v. Halliburton Co., No, 09-1403, 2011 U.S. LEXIS 4181 (June 6, 2011), the Court held that the Fifth Circuit erred in requiring securities fraud plaintiffs to prove loss causation to obtain class certification. In a narrowly fashioned opinion, the Court resolved a circuit split which had pitted the Fifth Circuit against the Second and Seventh Circuits, and clarified that loss causation and reliance are distinct elements of a securities fraud claim. The commonality of the facts and law relating to the latter must be shown at the certification stage; the former is not required to be shown to obtain class certification.
The Erica P. John Fund, Inc. (the “Fund”) sued Halliburton in 2009, alleging that Halliburton made misrepresentations regarding (1) its liability in asbestos litigation, (2) its revenue from certain contracts, and (3) the benefits of a merger, all in an effort to inflate its stock price, and that the price dropped when the company later issued corrective disclosures. The Fund sought to represent a class of all investors who purchased Halliburton common stock between June 3, 1999, and December 7, 2001. The District Court found that the putative class met the class action requirements set forth in Rule 23(a), but denied certification under Rule 23(b)(3) on the basis of Fifth Circuit precedent requiring securities fraud plaintiffs to show loss causation to obtain class certification. Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., No. 02-cv-1152, 2008 U.S. Dist. LEXIS 89598 (N.D. Tex. Nov. 4, 2008). The Fifth Circuit panel affirmed, explaining that Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F.3d 261, 269 (5th Cir. 2007) established that loss causation must be proved at the class certification stage, and declining to overrule that decision absent an intervening en banc Fifth Circuit or Supreme Court decision. Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 597 F.3d 330, 334 n.2 (5th Cir. 2010).
The Fifth Circuit’s innovation in Oscar was to add loss causation as an additional element for plaintiffs to prove reliance. In Basic Inc. v. Levinson, 485 U.S. 224, 243 (1988), the Supreme Court established the fraud-on-the-market theory of reliance. Under the fraud-on-the-market doctrine, because the price of securities traded on an efficient market such as a public exchange reflects all the material, publicly disclosed facts about the issuer, investors who paid the market price are presumed to have relied on public misstatements. This theory allows securities plaintiffs to satisfy Rule 23 by showing that common questions of fact and law relevant to the essential element of reliance predominate, without requiring proof that all class members were aware of and relied on the particular statements alleged to be misleading. However, the doctrine creates only a rebuttable presumption that can be overcome by appropriate proof.
The Fifth Circuit conflated the concepts of reliance and loss causation, holding that plaintiffs must show loss causation to invoke the presumption of fraud-on-the-market and obtain certification, contrary to the law in the Second and Seventh Circuits. Cf. Archdiocese of Milwaukee 597 F.3d at 334, 335; Schleicher v. Wendt, 618 F.3d 679, 687 (7th Cir. 2010); In re Salomon Analyst Metromedia Litigation, 544 F.3d 474, 483 (2d Cir. 2008).
The Supreme Court granted certiorari to resolve this circuit split. A unanimous Court held that plaintiffs are not required under Rule 23(b)(3) to establish loss causation as a common issue at the class certification stage, as a condition of reliance or otherwise.
Chief Justice Roberts, writing for the Court, explained that loss causation and reliance are separate elements of a securities fraud claim, and that plaintiffs need not prove the former to establish the latter. The Fifth Circuit, the Court explained, had misinterpreted Basic. The fraud-on-the-market doctrine, which was endorsed by the Court in its landmark 1988 decision in Basic, relates entirely to reliance, or “transaction causation,” i.e., demonstrating that a plaintiff’s decision to purchase, or to purchase at a given price, was in reliance on the defendant’s misrepresentation. Loss causation operates at the other end of the causal chain, and requires that plaintiff prove the injury from the decline in stock price was related to the disclosure or discovery of the falsehood, rather than intervening or extraneous factors. However, loss causation is not an element that a plaintiff must prove at the certification stage.
Perhaps recognizing that the Fifth Circuit was out of the mainstream on this issue, Halliburton attempted to persuade the Court that the Fifth Circuit did not truly mean “loss causation” when it used the term in the decision below. Instead, Halliburton urged its view that the court below had used the term loss causation to mean only that plaintiffs must show that the alleged misrepresentations had an impact on the market price of the stock to invoke the fraud-on-the-market presumption. The Supreme Court squarely rejected this argument, explaining that “loss causation” is a term of art in securities law, and it means something separate and distinct from price impact. The Court opted to take the Fifth Circuit at its word when it said that proof of loss causation was required to show reliance at the certification stage. Having decided that the Fifth Circuit had erred as to the triggering standard for the rebuttable Basic presumption of reliance, the Court remanded, declining to address how and when the presumption may be rebutted, or whether certification was otherwise warranted.
Although the Fifth Circuit decision stood out from the law of other Circuits, the Halliburton decision may disappoint members of the defense bar who had hoped to use loss causation as another tool to defend securities class actions at the certification stage. Loss causation remains an important limitation on defendants’ liability in securities cases. Properly applied, it protects an issuer from exposure to losses caused by declines in share price unrelated to any alleged misrepresentation. Particularly in times of extreme market volatility, the loss causation doctrine can drastically reduce the value of a securities fraud suit.
The impact of the Halliburton decision may be limited. From one perspective, it simply corrects the Fifth Circuit’s reasoning to require distinct analyses of the discrete concepts of reliance and loss causation. Halliburton may also be seen as simply the latest skirmish over class certification. Since the Supreme Court “rejected a preliminary inquiry into the merits of a proposed class action” in Eisen v. Carlisle & Jacquelin, 417 U.S. 156, 178 (1974), parties have fought over whether a particular inquiry at the certification stage represents a forbidden merits inquiry, or whether it is simply a means of ensuring compliance with the commonality requirements of Rule 23. Some commentators had hoped that the Court would take the opportunity in Halliburton to clarify the extent of the Eisen “no-merits-inquiry” prohibition, but the Court’s avoidance of the issue leaves fertile ground for such arguments in the future. The next battleground may well be the rebuttal of the fraud-on-the-market doctrine at the class certification stage. The Second Circuit (which hears many more securities cases than the Fifth Circuit) has held that such rebuttal is fair game, and the Court in Halliburton provided its own direct admonition: “we need not, and do not, address any other question about Basic, its presumption, or how and when it may be rebutted.” Opinion at 9; see Salomon Analyst, 544 F.3d at 485. Indeed, nothing in Halliburton specifically foreclosed these arguments on remand if they were preserved.
Parties on both sides of class action litigation should observe the continuing developments in class certification and fraud-on-the-market. Still to come is the decision in First Derivative Traders v. Janus Capital Group, Inc., argued earlier this year, where the Supreme Court granted certiorari to review the Fourth Circuit’s decision that plaintiffs seeking to prove reliance based on the fraud-on-the-market presumption must prove that the investors (and the market at large) would attribute the allegedly misleading statements to the defendant. The Supreme Court is expected to address the murky boundaries between primary and secondary actors and decide whether private securities claims can be brought against parties who make no directly attributable statements.
- The Erica P. John Fund, Inc. is the current name of the Archdiocese of Milwaukee Supporting Fund, Inc.
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