Saturday, March 8, 2014
On Wednesday, the Supreme Court heard oral arguments in Halliburton Co. v. Erica P. John Fund, Inc., 13-317 (Halliburton II), where it was being urged to overturn, or curtail, the fraud on the market presumption approved in Basic, Inc. v. Levinson (1988). Judging by the transcript, and as numerous reports indicated, it seems as though the Justices were attracted to the idea of tweaking Basic to require that plaintiffs prove the “market impact” of a particular false statement. Most surprisingly, although this was the fallback position urged by the defendants, it was also endorsed by Malcolm Stewart of the Solicitor General’s office, who was nominally arguing on the plaintiff’s side. Though one can never tell what will happen in the end, it does seem like this may be the direction in which the Court is headed – and if so, it could have significant implications for fraud-on-the-market cases in the future.
[More under the cut]
The first thing to note is that the fraud on the market doctrine is actually two separate, but related, presumptions in favor of the plaintiffs. First, that in an open and well-developed market, security prices reflect publicly available material information (the “objective” presumption); and second, that investors “rely” in some sense on market prices when they transact in such a market (the “subjective” presumption). From a doctrinal perspective, both presumptions are necessary for plaintiffs to satisfy the element of reliance in a Section 10(b) action.
In practice, lower courts have demanded that the plaintiffs demonstrate that markets are “efficient,” in an informational sense, before they will allow plaintiffs to proceed using the fraud on the market presumptions. This is a relatively demanding test for efficiency – it requires that plaintiffs show that the stock price is heavily traded, followed by multiple analysts, and that new public information is rapidly – often within hours – incorporated in security prices. Though the test has been severely (and justly) criticized, it does ultimately require that the plaintiffs show that the market is very well developed, and the security heavily traded and widely followed.
The position of Halliburton and some of its amici is that even these kinds of markets are not perfectly efficient, and therefore the first presumption - the objective presumption - is improper. Courts should not assume that all public information is incorporated into stock prices. Instead, they argue that plaintiffs should prove, statement by statement, that the defendant’s falsehoods impacted market prices. They argue that tools like event studies, to detect abnormal price movement, are an appropriate way of making such determinations. And it is this position that the Supreme Court seemed willing to consider.
What the Court did not seem to appreciate is that in most fraud cases, the defendant’s lies are not designed to move the stock price up, but to keep prices level – or to slow a stock price descent. Typically, the defendant makes statements about company performance that are true at the time. The market develops certain expectations for future performance, and coalesces around a stock price. Later, problems develop, and the defendant lies to cover them up, or to minimize them. The defendant commits accounting fraud to meet analyst expectations, or claims that a product in development is proceeding precisely as expected, while concealing the fact that the product does not function properly.
Because market prices only respond to unexpected information, for these frauds, the stock price does not move up in response to the false statement; it remains steady. Or it even falls, but it falls less than it would have had the truth been told.
Event studies are useless in these situations; there’s simply no market movement to detect. But that doesn’t mean the fraud didn’t have an effect; it just means that the fraud’s effect was to keep stock prices from falling to their natural levels.
It has been suggested in that in such situations – which are the majority of cases – the plaintiff can prove price impact by demonstrating that the price fell in response to a corrective disclosure, rather than proving that the price moved up when the lie first issued. The problem, however, is that there will never be a case that doesn’t have some kind of disclosure, and a stock price drop. That’s certain because plaintiffs don’t bring any other kind of case – a loss in response to negative news is what gets the ball rolling.
So most battles aren’t about whether the stock reacted to a disclosure. Most battles are about whether the disclosure is the right kind of disclosure. There is a developing circuit split on this issue, and under the strictest view, many cases don’t have any disclosures – ever. This is because a confession at Time 2 is not the same thing as the misstatement at Time 1 – indeed, the Supreme Court recognized as such in Erica P. John Fund, Inc. v. Halliburton Co. (2011) (“Halliburton I”), when it refused to require that loss causation be proved at the class certification stage.
Sometimes a company discloses that its prior statements were false – it issues a restatement, for example. But most of the time, the company just discloses a poor business development – poor sales, for example, or the denial of an FDA product application. The plaintiffs contend that there were problems hidden from view all along – the product didn’t work, the drug wasn’t safe – and the defendants deny any such thing. Certainly, the market was never told of these purported problems. Has there been a “disclosure” at all?
Normally, this battle is discussed in terms of the element of “loss causation” – the requirement that the plaintiffs prove that their losses were “caused” by the defendants’ fraud. But there is no reason to think that battles over “disclosures” and price impact would play out any differently. Many frauds do not involve “disclosures” in the strictest sense; companies are often not eager to admit that they lied about the business, and try to attribute problems to other, innocent causes. At the same time, a disclosure of poor sales or poor earnings or an increase in reserves or a denial of an FDA drug application or an industrial accident – to name a few common scenarios – does not say anything about the price impact of a lie on those topics at an earlier time point. Markets are likely to respond negatively to poor business developments, even if there had been no lies at all, but instead merely silence. BP’s stock price plummeted in response to the Deepwater Horizon explosion; does that fact alone prove its stock price was impacted by earlier statements about its adherence to safety regulations?
This is exactly the problem in Halliburton itself. Among other things, the plaintiffs argued that Halliburton intentionally lied about the sufficiency of its reserves for expected asbestos liability, claiming that the reserves were adequate when it knew they were not. After several jury verdicts showed that Halliburton’s liabilities would be greater than they claimed, Halliburton was forced to increase its reserves, which resulted in a stock price drop. The Fifth Circuit held that the stock price drop was not sufficient to show that the price had been inflated initially, because the market may have been responding to a bad business development – there was no proof that the market had specifically been correcting for any artificial inflation caused by the initial lie.
So the issue is never whether there has been a price drop – there’s always a price drop. The issue is whether the disclosure that caused the price drop can be taken to mean that the market recognized – and corrected for – the earlier lie.
The problem with the Fifth Circuit’s approach (which is also the approach of the Sixth and Ninth Circuits) is that the evidence they seek is economically meaningless. Take the case of Deepwater Horizon. The reason that poor safety practices are relevant to investors is that they might result in a disaster. Once the disaster happens, it hardly matters whether the market “knows” that it was earlier lied to; from the market’s point of view, all that matters now is that there’s been a disaster. I mean, sure, at the margins, it might matter, if the market is calculating various potential liabilities, etc, but the basic idea is that at the time the lie was initially told, the reason the undisclosed facts mattered was because they altered the risk of a problem developing – once the problem develops, information about earlier risks is stale, and unlikely to exert much of an effect on prices. Even if, after the fact, the market learns that the disaster was caused by an earlier-concealed problem, the stock price reaction might be minimal – after all, the risk materialized; what difference does it make that a year earlier the market thought the risk was less likely than it actually was?
To put it another way, suppose a company lies about a new drug application to the FDA. Its chances of being approved are 20%; it tells the market the chances are 80%. Later, it reports that the FDA denied its drug application. The stock price drops. Does this tell you anything about whether the market absorbed earlier lies about the precise odds of the application being approved? Even if the market ignored the company’s lies entirely, you’d still expect its stock price to fall now that the chances of approval are zero. And when the company admits the earlier lie, you wouldn’t expect any stock price movement at all – who cares, now that the chances of approval are zero? (Jill Fisch at U Penn describes the issue in great detail here.)
To be sure, when the question is price impact, there will be many situations where there will be collateral evidence that can boost the plaintiff's case - analyst reports issued at the time of the false statements, for example, that explain the impact of the statements on their price targets. This is almost certain to be the situation for financial frauds, or frauds involving products or business lines with projected revenue streams, and so forth. And some cases will exhibit an upward price movement pattern. But for fuzzier types of information that serves at best to maintain stock prices, plaintiffs will face an uphill battle.
Surprisingly, in Halliburton II, the plaintiffs and their amici did not brief this issue in great detail – although previous plaintiff-side amicus briefs filed in Halliburton I and Amgen Inc. v. Conn. Ret. Plans & Trust Funds (2013) explained it pretty well. But this time around, the most vigorous opposition to the price impact approach came, surprisingly, from SIFMA, one of the defendants’ amici.
But there are a lot more implications of the price impact approach than simply the increased burdens on plaintiffs (which are substantial).
First, many have argued that Section 18 of the Exchange Act has been improperly superceded by Section 10(b), and that plaintiffs should bring these kinds of claims under Section 18. That provision has been interpreted to require "actual" reliance - no presumptions allowed - but it also has some benefits to plaintiffs over Section 10(b), in that it does not require proof of scienter, among other things. But what many seem to have missed is that Section 18, by its terms, also requires that the plaintiff prove that the misstatement affected the security's trading price. If the Court holds that plaintiffs are no longer entitled to a presumption that misstatements affect trading prices even in "open and well-developed" markets, presumably that will increase the burdens on plaintiffs bringing Section 18 claims, as well, thus further marginalizing that Section, and maintaining 10(b)'s dominance.
Second, advocates of the price impact approach typically argue that it is superior to current approaches because it allows courts to eschew the “efficiency” inquiry. It doesn’t matter if the market is efficient; the only question is whether the market price responded to the false information. If the Supreme Court adopts this approach, then plaintiffs can – theoretically – bring cases for all kinds of thinly traded markets, so long as they can prove that the misstatement affected the security’s price in that market. Which in some cases will certainly be possible – even thinly traded markets respond to surprising, significant information.
But this raises a question: What does this do to the second half of fraud on the market, the presumption of subjective reliance on market prices? If the Court holds as a matter of law that prices cannot be presumed to incorporate information, and if investors can bring fraud on the market claims even in inefficient markets, can investors still be said to reasonably have relied on market prices? Courts have already held that it’s unreasonable for plaintiffs to subjectively rely on prices in primary markets – they have no reason to think those prices are “reliable.” See, e.g., Malack v. BDO Seidman, LLP, 617 F.3d 743 (3d Cir. 2010). How thinly traded must a secondary market be before the same argument holds?
Of course, that only begs the question - why even limit the presumption to securities, if the only question is whether the plaintiff can prove price impact? I recently bought a car, and in so doing, I relied heavily on the sale prices listed at Kelley Bluebook. Those prices influenced my decision as to which model to buy, and what price to negotiate for. If it turned out the manufacturer of my car lied about some feature – a feature that didn’t matter to me at all, but nonetheless lowered the KBB price of the car, and its resale price – can I be said to have relied on pricing? If I bear the burden of proving the effect of the lie on prices, do I have a cause of action against the manufacturer?
In fact, courts have previously rejected this kind of argument outside the securities context, where it has been made with respect to prescription drugs and cigarettes, among other things. (Also, so there are no misunderstandings, this is just a hypothetical - I bought a Hyundai Accent, and so far so good. No complaints, Hyundai!)
But my point is that the two presumptions of Basic are distinct, but not independent, and if the first one is disturbed, it has implications for the other. Courts may not be able to quite exit the business of determining the conditions that make it reasonable for investors to rely on market prices – and those conditions must have something to do with assuming the price reflects information. And if it’s reasonable for investors to have that presumption, why shouldn’t courts?
Another issue that comes up is whether an alteration in plaintiffs’ burden of proof should affect how courts think about materiality. Right now, it’s very common for courts to dismiss at least some claims on the grounds that the statements are not “material” to investors and therefore cannot be presumed to have impacted stock prices. But if plaintiffs are going to have to prove price impact anyway, why should courts dismiss any allegations of materiality on the pleadings? Shouldn’t they wait at least until there’s evidence of how real life investors treated the information?
Relatedly, in many cases, the defendants argue that the allegedly false statements had no impact on prices because the truth had already been disclosed, in some fashion, to the market – this was the argument in Amgen, for example. Courts are very inconsistent in how they address this argument, but in some cases, they are remarkably free with assuming that in an efficient market, any nominally public information – no matter how obscure, or piecemeal – may be presumed to offset the impact of a corresponding lie – resulting in a dismissal on the pleadings, either on materiality or loss causation grounds. (This is an issue that Stefan Padfield has tackled, here). In a world where plaintiffs have the burden of proving the price impact of the lie, however, shouldn’t defendants have the same burden?
However these issues shake out, it’s certain that we have interesting times ahead. One thing I do have to note, though: at least with respect to the question of what kind of disclosure is a “sufficient” disclosure, the Chief Justice has already telegraphed his inclinations. In Halliburton I, one of the plaintiff’s amici briefed the issue in detail, explaining that, among other things, in well-known frauds like Vivendi, Enron, and Parmalat, often the market only learned that the company was having economic problems – disclosures of the fraud came later, possibly too late to have an impact on stock prices (because, for example, the company was already in bankruptcy). Nonetheless, in Halliburton I, Roberts quoted the Fifth Circuit’s definition of loss causation approvingly: he held that loss causation means that the decline in price was “because of the correction to a prior misleading statement.” He also described loss causation as “the revelation of a misrepresentation.” Thus, it seems he’s willing to side with the Fifth, Sixth, and Ninth Circuits on this issue – that a loss is not a loss due to fraud unless it specifically results from the market recognizing, and correcting for, the earlier lie.