Saturday, July 13, 2019
I just recently came across the Ninth Circuit’s decision in In re Atossa Genetics Inc Securities Litigation, 868 F.3d 78 (9th Cir. 2017), and it struck me because it highlights an ongoing tension between the reliance/materiality distinction in fraud-on-the-market cases in general, and in the Supreme Court’s jurisprudence in particular.
And I’ll say up front that a lot of what I’m about to discuss in this post is stuff I’ve laid out in more detail in my essay, Halliburton and the Dog that Didn’t Bark. The Atossa case is just a nice demonstration of the issue.
And hey, this got long, so – more after the jump.
In Basic Inc. v. Levinson, 485 U.S. 224 (1988), the Supreme Court held that a fact is material if it “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” The Court further endorsed the fraud-on-the-market doctrine, namely, that in an “open and developed market” it may be presumed that public, material information impacts stock prices; therefore, individuals who transact at the market price may be said to have “relied” on any material false statements, even if they did not personally hear and absorb them.
Subsequent courts established what is commonly described as a corollary to the fraud-on-the-market doctrine: the truth-on-the-market doctrine. It’s exactly what it sounds like: If false public information may be presumed to have impacted stock prices, truthful countervailing information may also offset the effects of the fraud and restore prices to their unmanipulated levels.
One might describe truth-on-the-market as a reliance doctrine, in just the same way that fraud-on-the-market is so described, so that if defendants can make the appropriate truth-on-the-market showing, the plaintiffs’ claim fails for lack of reliance. Yet truth-on-the-market is often discussed as a doctrine of materiality, i.e., that given the truthful countervailing information, the false information is no longer material. Or, to put in in Basic-speech, the truthful information renders the false information no longer significant in light of the “total mix.”
But that phrasing masks a real distinction between the two concepts. Suppose a defendant publicly lies, but the truth is known to a select group of wealthy, professional investors. They might, with their informed trades, offset the pricing impact of the lie. At the same time, some smaller number of uninformed retail investors might still hear the lie, believe it, and invest on that basis. What then? Certainly, the information only known to the professionals cannot reasonably be considered part of the “total mix” of information available to the retail investor.
As a doctrinal matter, then, you would expect that the retail investors would still be able to establish both materiality and reliance on an individualized basis, if not under the fraud-on-the-market doctrine. (Basic itself even contemplated such a scenario; it held the fraud-on-the-market presumption of reliance might be rebutted if “‘market makers’ were privy to the truth.”)
And that’s exactly what the Ninth Circuit made clear in Atossa. There, one defendant was alleged to have made a statement in a press release that falsely described the FDA-approval status of a new drug. Among other things, he argued that the truth was evident from language in the company’s IPO documents. The Ninth Circuit reject that argument – it held the documents were not sufficiently clear – but further pointed out that the plaintiffs were alleging reliance both under a fraud-on-the-market theory, and under a direct reliance theory. For the latter, it was irrelevant if the truth was revealed in some other place:
Plaintiffs can allege that they were aware of, and specifically relied on, Quay’s false statements when deciding to purchase or sell Atossa shares. Under this theory of reliance, it does not matter whether Atossa’s alleged offering documents previously revealed that the ForeCYTE Test was not cleared. If Quay’s alleged statements contained false information about a subject that reasonable investors would consider important, and Plaintiffs relied on those statements, then those statements are material. See In re Apple Comput. Sec. Lit., 886 F.2d 1109, 1114 (9th Cir. 1989) (“Ordinarily, omissions by corporate insiders are not rendered immaterial by the fact that the omitted facts are otherwise available to the public.”); Miller v. Thane Int'l, Inc., 519 F.3d 879, 887 (9th Cir. 2008) (“[I]nvestors are not generally required to look beyond a given document to discover what is true and what is not.”).
Certainly the calculus for materiality would change where Plaintiffs allege reliance less directly, for example solely through a “fraud-on-the-market” theory….
But here, Plaintiffs pled both that they relied directly on the statements by Quay and Atossa, as well as the integrity of Atossa’s stock price. So even if the alleged IPO documents were assumed to have conveyed the truth about clearance for the ForeCYTE Test (which we conclude they did not), and even if such truthful information canceled out the effect of Quay’s alleged false statements on Atossa’s stock price, Quay’s alleged statements would still be material under a theory of direct reliance, which Plaintiffs here adequately pled.
But here’s where things get sticky: Can plaintiffs in this scenario prove loss causation or damages?
Well, that depends on your theory. If plaintiffs are only entitled to damages equivalent to the inflationary effect of the lie – the extent to which they overpaid based on some objective measure of the security’s worth – there are no damages (and can be no loss causation). That’s exactly what Daniel Fischel advocated in his article, Use of Modern Finance Theory in Securities Fraud Cases Involving Actively Traded Securities, 38 Bus. Law. 1 (1982).
But if plaintiffs are entitled to damages based on their individualized assessment of the security’s worth – beyond the “average” judgment represented by the market – they should be able to receive damages even if the market as a whole disregarded the lie.
That’s the direction the Fifth Circuit chose in Ludlow v. BP, P.L.C., 800 F.3d 674 (5th Cir. 2015). BP was alleged to have lied about its safety measures; the truth was revealed when, due to lack of appropriate precautions, the Deepwater Horizon explored, causing BP’s stock price to plummet. Naturally, the size of the price drop was well in excess of the inflationary effects of the original falsehood. That is, if you imagine what BP’s price would have been if it had told the truth about inferior safety measures before the explosion, the drop occasioned by the explosion itself was far larger. The Fifth Circuit held damages in such a circumstance would be very different for fraud-on-the-market plaintiffs versus direct-reliance plaintiffs.
In the Fifth Circuit’s view, fraud-on-the-market plaintiffs simply bought the average pricing for a certain risk profile; presumably, even if BP had told the truth about its poor safety measures, they would have purchased the stock, but at a price adjusted to account for the increased risk. Therefore, they were only damaged to the extent that the price they paid was a little too high (artificial inflation damages). Conversely, plaintiffs who actually read and relied on BP’s statements may have been unwilling to tolerate the increased risk of an explosion had they known the truth, and therefore should be permitted to recover all of the damages incurred when disaster struck.
So what does all of this have to do with the Supreme Court?
Well, as I explain in Halliburton and the Dog that Didn’t Bark, in both the Supreme Court’s Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014) decision, and in its earlier decision in Amgen, Inc. v. Conn. Ret. Plans & Tr. Funds, 468 U.S. 455 (2013), the Court strongly suggested that, in an efficient market, if a lie did not impact prices, then no plaintiff can bring a Section 10(b) claim, individual reliance or no individual reliance. For example, in Amgen, the Court held that materiality is an issue common to all class members – all class members will offer the same proof, whether or not their claims are brought individually or as a class – and therefore it is inappropriate for a court to make a materiality determination at the class certification stage. When it comes to materiality, all claims will stand, or fall, together. But when you examine the actual materiality argument advanced by the defendants in Amgen, it was something akin to truth-on-the-market. So if Amgen is correct, it means that a truth-on-the-market defense could defeat all Section 10(b) claims, even those predicated on actual reliance - exactly as Dan Fischel argued in 1982. Halliburton, in a roundabout way, made a similar suggestion when comparing price impact and materiality.
Anyhoo, that’s the tension underlying the Atossa case, and for what it’s worth, I don’t think this is just an angels-on-pinheads kind of dispute. Because it has very serious implications for class action procedure. Right now, there are a lot of battles over the kinds of facts that can be adjudicated at the class certification stage, and the question whether truth-on-the-market and similar kinds of arguments are rooted in materiality (prohibited by Amgen), loss causation (prohibited by the first Halliburton case, Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011)), or reliance (fair game for adjudication at class cert under Halliburton) often takes center stage. Right now, there is no clear answer.