In recent months, the legal world has been abuzz over the future of the so-called “fraud on the market” doctrine. This probably has many people asking, “Should I care?” The short answer is yes. The fraud on the market doctrine is the conceptual linchpin used by courts to allow most securities fraud claims to be brought as shareholder class actions. Reflecting the ambiguity with which such claims are viewed, the Supreme Court has described them at times as presenting “a danger of vexatiousness different in degree and in kind” from other cases, and at others as “an essential supplement to [public enforcement].” Now, the Supreme Court recently agreed to take up the issue of whether the doctrine should continue to have any vitality in the United States. In short, the future of the most common form of securities fraud class action may be at stake.
Over a perhaps prescient dissent by Justice Byron White, a plurality of the Supreme Court adopted the fraud on the market doctrine in the seminal case of Basic, Inc. v. Levinson. The essence of the doctrine is that shareholders seeking to pursue a class action for securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 may invoke a rebuttable presumption of reliance on public, material misrepresentations regarding securities traded in an efficient market. Without such a presumption, in order to establish their claims, the individual shareholders who purchased the securities in question would be required to prove that they each personally read (or heard) and relied on the alleged misrepresentations. As the Supreme Court recognized in Basic, this would effectively preclude the shareholders from proceeding with a class action, because the individual issues related to reliance would overwhelm any common issues.
One of the concerns expressed by Justice White when he dissented in Basic was that the fraud on the market doctrine is premised on a theory of economics known as the “efficient market hypothesis.” According to this theory, the price of a security trading in an efficient market will rationally impound all material public information about that security. The reasoning behind the fraud on the market doctrine is that, if this is true, then shareholders who purchase securities in reliance on the integrity of the market price may be deemed to have indirectly relied on whatever misinformation may be incorporated into that price.
At the time Basic was decided, the efficient market hypothesis was broadly accepted within the economics community. Nevertheless, Justice White noted that it was still just a theory, “which may or may not prove accurate upon further consideration.” He expressed concern that the Court was venturing into “this area beyond its expertise,” and ignoring “the dangers when economic theories replace legal rules as the basis for recovery.”
Despite Justice White’s warning, after Basic plaintiffs and the lower courts embraced the fraud on the market doctrine, ushering in an era (continuing to this day) in which hundreds of securities class actions are filed every year against public companies throughout the United States. For many years, the “efficient market” foundation of the doctrine was effectively taken as given in these cases. In the rare cases where defendants challenged the issue, courts usually applied a fairly simplistic analysis of market efficiency and most often decided the issue in favor of class certification.
However, cracks eventually started to show in the foundation. Economists started to question whether investors really act rationally in making investment decisions and identified numerous examples where markets failed to price securities in a manner consistent with the efficient market hypothesis. The boom and bust of the “dot-com” bubble, in particular, helped focus attention on the issue. Yale’s Robert Schiller recently won the Nobel Prize for work that includes his book about the Internet bubble, aptly titled Irrational Exuberance.
Courts have started to take notice, and challenges to class certification based on the efficient market issue are becoming more common. Though courts still struggle at times with what standards to apply, they appear to be increasingly open to these challenges. Indeed, there have been a number of recent orders denying class certification in cases where plaintiffs failed to meet their burden of showing that the securities in question traded in an efficient market.
And that is not all. In a case last term involving Amgen, a number of justices on the Supreme Court openly expressed an interest in revisiting Basic and the fraud on the market doctrine. Taking heed, defendants promptly filed a petition for certiorari in a case where a class was certified with respect to securities claims against Halliburton. The Court granted the petition in mid-November and is now expected to take up the issue this term.
In short, the battle is joined. If not eliminated altogether, the fraud on the market doctrine may at least be limited on a going-forward basis by more rigorous standards for plaintiffs to meet in order to invoke it.