Corporations have spent billions of dollars defending, and frequently settling, the inevitable class action litigation brought by shareholders (or more precisely, aggressive counsel) accusing corporations and their boards of securities fraud whenever there is a drop in the corporation’s stock price. For the last three decades, a key driver of those litigations has been the widespread application of the “fraud-on-the-market” presumption of reliance. Under the fraud-on-the-market doctrine, the putative class plaintiff need not demonstrate that any (or all) class members actually relied on an alleged false or misleading statement. Rather, the plaintiff class relies on a rebuttable presumption that, in an efficient market, the company’s stock price reflects all publicly available information. However, a series of recent decisions suggests that courts are actively considering the continued viability of the fraud-on-the-market doctrine.
Earlier this year in Amgen Inc. v. Connecticut Ret. Plans & Trust Funds, the Supreme Court held that proof of materiality is not required to satisfy the “predominance” requirement for class certification under Rule 23(b) (the Court did acknowledge that plaintiffs must prove materiality to prevail on the merits). The flip side of materiality is reliance; in other words, investors can only rely on information if it is material. In that vein, the Court’s majority and dissenters expressed doubts as to the fraud-on-the-market presumption of reliance and, specifically, the notion of market efficiency on which that theory is based. As the Court noted in Amgen, “[t]he fraud-on-the-market theory . . . facilitates class certification by recognizing a rebuttable presumption of classwide reliance on public, material misrepresentations when shares are traded in an efficient market.” Thus, absent an efficient market (i.e., a market in which all relevant information is impounded into the security price), the reliance requirement would ordinarily preclude class certification because individual questions of investor reliance would predominate over common ones.
The Amgen Court did not squarely address the viability of the fraud-on-the-market presumption, instead deciding the case by focusing narrowly on the materiality question before it. However, the Supreme Court has now been asked to confront this very issue in the petition for certiorari recently filed in Erica P. John Fund v. Halliburton. Halliburton, backed by leading economic and finance experts, challenges the notion of market efficiency and asks the Court to overturn the presumption of class-wide reliance first set out twenty-five years ago in Basic v. Levinson. Such a ruling, plaintiffs argue, would effectively dismantle securities class actions. The Court’s decision in Halliburton’s certiorari petition is pending; for corporations and the class action bar, the stakes are obviously exceptionally high.
In the interim, corporate defendants may be able to overcome a class-wide presumption of reliance under the fraud-on-the-market theory by demonstrating that the market on which the securities in question traded was not efficient. That is precisely what happened in a recent decision from the Southern District of New York. On July 3, 2013, in George v. China Auto. Sys., Inc., Judge Forrest, applying the “rigorous analysis” required at the class certification stage, refused to certify the proposed investor class because plaintiffs failed to show that the securities at issue — common stock and options — traded in an efficient market. In doing so, the court recognized that, absent a class-wide presumption, individual questions as to whether any particular investor “in fact” relied on any purported misrepresentation or omission “may overwhelm the common questions” such that a class action “is neither feasible nor a superior means of resolution.”
Judge Forrest specifically noted that plaintiffs asserting the fraud-on-the-market theory to establish reliance “bear the burden of proving market efficiency by a preponderance of the evidence”; defendants need not demonstrate that the market is inefficient, but only that “plaintiffs’ proffered proof of market efficiency falls short of the mark.” After oral argument and an evidentiary hearing of the parties’ experts (including five separate analyses conducted by plaintiffs’ expert as to the cause and effect relationship between unexpected corporate disclosures and changes in the stock price), the court concluded that plaintiffs failed to carry this burden and denied class certification. In particular, the court agreed with defendants that the plaintiffs’ expert could not show that the stock price “consistently reacted to new, value-relevant information, which is the essence of market efficiency.” For example, the court noted that there were numerous days in the class period in which news events did not result in any statistically significant price movement.
Class certification is a critical point in securities litigation; in the vast majority of cases, a certified class leads to the ultimate (and typically expensive) settlement of the case. Thus, corporations and their counsel are well served by a vigorous challenge to the fraud-on-the-market presumption at the class certification stage. Until such time as the Supreme Court abolishes the presumption altogether, courts will require plaintiffs to demonstrate reliance and market efficiency at the class certification stage. Where possible, corporations should strategically defend the all-too-common (and often frivolous) class action fraud claim by challenging market efficiency so as to rebut the presumption of reliance required for class certification. The benefit of such a successful defense is plain: a dramatic reduction in exposure to class action claims, and, as a result, the significant reduction of the corporation’s legal defense costs.