Monday, March 3, 2014
Torts scholars John Goldberg (Harvard) and Benjamin Zipursky (Fordham) have written a thoughtful analysis of the fraud-on-the-market issue that the Supreme Court will consider this week when it hears oral argument in Halliburton v. Erica P. John Fund. They gave me permission to post their analysis here, which I thought readers would find worthwhile. By breaking down the issues in fraud-on-the-market securities class actions, Goldberg and Zipursky help clarify the link between a defendant's allegedly wrongful conduct and widespread harm that plaintiffs allege was caused by that conduct -- a link that is at the core of mass tort disputes as well as securities litigation.
Parsing Reliance in Securities Fraud
John C.P. Goldberg, Harvard Law School
Benjamin C. Zipursky, Fordham Law School
In Halliburton v. Erica P. John Fund, Inc., to be argued before the Supreme Court on March 5, the Justices could drastically curtail federal-court class-action lawsuits for securities fraud. At issue in Halliburton is the Supreme Court’s 1988 decision in Basic v. Levinson. Basic held that it is not necessary for investors such as the Erica P. John Fund to prove that they actually read and relied upon the particular fraudulent statements alleged to have caused the their losses. Public misstatements by a company like Halliburton have the capacity to defraud the market as a whole and distort the prices for all investors. Basic’s “fraud-on-the-market” theory, as it is called, affords investors who can prove that the defendant made misrepresentations about important matters a presumption that the misrepresentations negatively affected the stock’s value. It is widely agreed that, without Basic’s presumption, securities fraud suits could rarely proceed as class actions. For a variety of reasons – the fact that Congress has weighed in extensively on securities fraud and left Basic untouched, the substantial pro-defendant changes that the Court and Congress have already made to securities fraud law, the expressed wishes of the S.E.C. to retain Basic because of the indirect regulatory force private actions supply, and the value of stare decisis – we think the Court would do best to leave Basic intact. It appears, however, that while some of the Justices may be similarly inclined, others are leaning toward overruling Basic, and others may be looking for a middle ground. With the fate of Basic in play, it is worth getting clear on some aspects of fraud-on-the-market doctrine that have typically been confused, and were in fact confused in Justice Blackmun’s Basic opinion itself.
The first and most important point to make about Basic’s so-called “presumption of reliance” is that it is not one presumption (as we have explained in a recent article offering a detailed analysis comparing securities fraud to common law fraud, see John C.P. Goldberg & Benjamin C. Zipursky, The Fraud-on-the-Market Tort, 66 Vanderbilt L. Rev. 1756 (2013)); Basic’s “presumption” is actually two presumptions (both favoring plaintiffs) and one affirmative defense (favoring defendants). Thus, if the Court decides to rethink “the presumption of reliance,” it will actually be rethinking two or three ideas, not one.
Basic’s first presumption allows a plaintiff to establish a legally cognizable injury by establishing that she bought or sold securities at a market price that was distorted by the defendant’s misrepresentations. This is an important departure from common law fraud, the tort from which the law of securities fraud has evolved. In a suit for common law fraud, it is critical for the plaintiff to establish that she, personally, made a decision in reliance on the information contained in the defendant’s misrepresentations. This is because the core injury at the heart of common law fraud is an interference with a person’s right to make decisions free from deception. Basic’sso called “presumption” of reliance – like many presumptions in the law – departed substantively from this aspect of the common law. A securities fraud plaintiff need not demonstrate that she was misled into believing that certain false propositions were true. Instead, according to Basic, she need only prove economic loss caused by the misrepresentation—that she bought or sold the defendant’s stock at a price distorted by the defendant’s misrepresentations, irrespective of whether she ever learned of the content of the defendant’s false statements.
Basic’s second presumption is evidentiary rather than substantive. It allows securities fraud plaintiffs to use a certain kind of circumstantial evidence to prove that the defendant’s misrepresentations in fact distorted market prices. If a misrepresentation is “material” and disseminated to the public, and if the securities are sold on an “efficient” market, it will be presumed that the misrepresentation caused a price distortion. Like many evidentiary presumptions, the materiality-based presumption of price distortion may be rebutted by evidence that the misrepresentation had no effect.
Justice Blackmun’s opinion in Basic also bundled a third idea into the so-called “presumption of reliance,” but this idea is actually an affirmative defense for the defendant, one akin to the consent defense to the tort of battery and the assumption of risk defense to the tort of negligence. Even if it is established that the defendant’s misrepresentations caused a price distortion and a loss to the plaintiff, the defendant can nonetheless escape liability by proving that the plaintiff was actually aware of the falsity of the misrepresentation and chose to engage in the market transaction nevertheless. Defendant Halliburton’s petition to overrule Basic has nothing to do with this third aspect of Basic.
Halliburton’s challenge to Basic’s presumption of reliance relates to the combination of the substantive and evidentiary presumptions described above. The Court in Basic allowed that materiality (given an efficient market) was enough, from an evidentiary point of view, to create a rebuttable presumption of price distortion, and it additionally concluded – as a substantive matter – that distortion suffices to replace the impact-on-plaintiff finding that reliance fulfills in the common law tort of fraud. It is these two ideas, taken together, that have permitted securities fraud plaintiffs to go forward without direct proof of reliance. Crucially, although Basic itself describes the combined effect of these two presumptions as establishing indirect proof of reliance, that description is inaccurate. Taken together, they instead amount to indirect proof of distortion, not of reliance.
Clarifying the distinction between the evidentiary and substantive aspects of the presumption in Basic is critical for evaluating what is and what is not at issue in Halliburton. Halliburton contends that Basic should be overruled because the efficient-market hypothesis has been rejected by economists during the quarter century since Basic was decided. Whether the efficient-market hypothesis actually has been rejected is a highly contentious issue. Even assuming, however, that it is unsound, that affects only the evidentiary aspect of the presumption of reliance—that is, only the part of Basic which states that material representations in an open market will be reflected in the market’s pricing of securities, and hence can be presumed to have distorted their price. If the evidentiary side of Basic is rejected or modified, that still leaves intact the substantive side of the presumption of reliance – the side which states that price distortion caused by the misrepresentations will suffice in place of individual reliance.
Appreciating the irrelevance of the efficient-market hypothesis to the substantive side of Basic is critically important for two reasons. First, the substantive side of Basic has received little cogent criticism over the decades. The courts that first recognized private rights of action under federal securities laws did so on the ground that those laws were established in the midst of the Great Depression to protect investors from losses resulting from deceptive practices. Under these circumstances, it was eminently sensible for these courts to interpret federal law as including an individual right to be free from economic harm caused by deceptive practices, whether through price distortion or individual reliance. And since then, both Congress and the Court have shown a steady commitment to the substantive side of Basic.
Second, price distortion is a common issue of fact in securities fraud litigation. This means that the securities defense bar’s effort to undermine securities class actions through a critique of the efficient-market hypothesis is misconceived. The alleged shakiness of the efficient-market hypothesis is an argument against the evidentiary side of Basic, not against its substantive side. But the substantive side -- the move from reliance to price distortion – is what makes class actions an appropriate vehicle for 10b-5 claims. If the Court is truly persuaded by the efficient-market hypothesis critique, and is not moved by stare decisis or any other reasons to leave Basic untouched, then it is, at most, the evidentiary side of the presumption of reliance that might bear revisiting. Of course, new questions might then arise at or before trial as to whether event studies or other sorts of evidence will suffice to establish price distortion, but that is a different matter, unconnected to the general question of whether distortion-based 10b-5 claims can be adjudicated as class actions.
The wrong of causing economic loss through misrepresentations that distort market prices is not identical to common law fraud. But it is closer to what Congress actually sought to protect in the Securities Exchange Act, it is consistent with what Congress has very thoughtfully kept alive in its more recent securities legislation, and its justifiability has nothing to do with the soundness of the efficient-market hypothesis. So long as this wrong remains the core of 10b-5 claims, class actions will continue to be an appropriate means for resolving them.