Supreme Court to Consider Circuit Split on Proof of Loss Causation at the Class Certification Stage
Conflicting opinions in the past two years from the Second, Fifth, and Seventh Circuits have created uncertainty regarding the extent to which, in a private action under Section 10(b) of the Securities Exchange Act of 1934, a plaintiff who invokes the fraud-on-the-market presumption of reliance must prove loss causation at the class certification stage in order to be able to proceed on behalf of a class.
On January 7, 2011, the Supreme Court granted certiorari in Erica P. John Fund Inc. v. Halliburton Co. (No. 09-1403) to review the Fifth Circuit's decision on this issue in The Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 597 F.3d 330 (5th Cir. 2010). Briefing for both parties closed on March 31, 2011. In addition to the Petitioner's and Respondents' briefs, eight amicus briefs were filed in support of each side. Oral argument is scheduled for April 25, 2011, and a decision is expected by the end of June.
The outcome of the case will have a significant impact on all companies, executives, and board members, who constantly face the threat of securities litigation. To prevail in a securities fraud action, an investor has to prove that he or she relied on a misrepresentation or omission. Under the fraud-on-the-market doctrine, investors can seek to satisfy the reliance requirement by claiming that, in an efficient market, the price of a stock reflects the market's absorption of all available information about the company. Therefore, an investor who bought stock at a price that was inflated by the misrepresentation or omission can claim that she relied on the misrepresentation or omission, even though she was not personally aware of it.
The fraud-on-the-market presumption is therefore a key tool in enabling plaintiffs to obtain class treatment for securities fraud claims. Halliburton deals with the critical issue of the quantum of admissible evidence that a plaintiff must present in order to obtain certification of a case as a class action at the early stages. Since most securities cases that survive a defense motion to dismiss are settled before trial, and settlement value is often significantly affected by whether a class can been certified, the standards governing class certification and the resolution of this Circuit split are of particular importance.
In Halliburton, plaintiff filed a putative class action in the Northern District of Texas alleging that Halliburton and its CEO violated Section 10(b) by misleading the public about three areas of its business: (1) its potential liability in asbestos litigation, (2) its accounting for revenue in its engineering and construction business, and (3) the benefits of a merger with Dresser Industries. 597 F.3d at 334. The district court denied plaintiff's motion for class certification under Federal Rule of Civil Procedure 23, noting that because plaintiff "presented no evidence that a false, non-confirmatory positive statement caused a positive effect on the stock price, [in order to prevail on class certification] Plaintiff would have to show (1) that an alleged corrective disclosure causing the decrease in price is related to the false, non-confirmatory positive statement made earlier, and (2) that it is more probable than not that it was this related corrective disclosure, and not any other unrelated negative statement, that caused the stock price decline." Id. at 337. After examining each of the alleged corrective disclosures identified by plaintiff, the district court determined that plaintiff had not met this burden.
The Fifth Circuit affirmed the lower court's decision and reiterated the standard it had established previously that plaintiffs "must show that an alleged misstatement 'actually moved the market.' Thus, '[the Circuit] require[s] plaintiffs to establish loss causation in order to trigger the fraud-on-the-market presumption.' And [it] require[s] this showing 'at the class certification stage by a preponderance of all admissible evidence.'" Id. at 335 (quoting Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261, 265, 269 (5th Cir. 2007)).
Oscar significantly tightened the requirements for plaintiffs seeking a presumption of reliance in the Fifth Circuit. While other Circuits have cited Oscar, none has yet adopted its approach in total. In fact, opinions from the Second and Seventh Circuits offer alternative standards regarding the appropriateness of merits review during the class certification stage.
While the Second Circuit does not require proof of loss causation at the class certification stage, it is not opposed to a limited merits inquiry. In In re Salomon Analyst Metromedia Litig., 544 F.3d 474 (2d Cir. 2008), the Second Circuit held that plaintiffs are not required to prove that alleged misrepresentations "had a measurable effect on the stock price" on a motion for class certification. Id. at 482. But, the Circuit also noted that the court is required to make a definitive assessment that the Rule 23 predominance requirements have been met and must resolve "factual disputes relevant to each Rule 23 requirement." Id. at 484. Thus, defendants in the Second Circuit may seek to demonstrate the absence of a price impact to rebut the presumption of reliance. Id.
In August 2010, the Seventh Circuit took a different approach in Schleicher v. Wendt, 618 F.3d 679 (7th Cir. 2010), and rejected any review of the merits that is not strictly required under Rule 23. As the court explained, although a "peek at the merits" is permissible, "this peek must be limited to those aspects of the merits that affect the decisions essential under Rule 23." Id. at 685. Furthermore, since falsehood and materiality may be resolved on a classwide basis, any decision on those matters should be delayed until motion for summary judgment or trial. Id. at 687. The Seventh Circuit's approach rejects the notion that "class certification is proper only when the class is sure to prevail on the merits," instead noting that "Rule 23 allows certification of classes that are fated to lose as well as classes that are sure to win." Id. at 685-86.
In light of this apparent circuit split, Petitioner Erica P. John Fund Inc. argues that the Fifth Circuit has improperly developed its own fraud-on-the-market jurisprudence—something it says Basic v. Levinson, 485 U.S. 224 (1988), does not allow. Petitioner maintains that placing the burden on plaintiffs to establish loss causation is inconsistent with the Basic fraud-on-the-market theory, and confuses the relationship between loss causation and reliance. Petitioner also argues that the Fifth Circuit's approach imposes a premature merits inquiry in violation of Rule 23, violates the Sixth Amendment right to trial by jury, and unduly limits securities plaintiffs' access to the courts.
Eight groups filed briefs as amicus curiae in support of Petitioner, including a brief submitted by the U.S. Solicitor General. The majority of the briefs echo Petitioner's arguments that the Fifth Circuit decision is based on a misunderstanding of Basic. They also maintain that the Fifth Circuit wrongly predicated class certification on the likelihood of success on the merits and further compounded its error by using a preponderance standard. Several public employee pension funds argued that existing heightened pleading standards are more than adequate to address the Fifth Circuit's fairness concerns, and that the additional requirements imposed by the Fifth Circuit would hamper their ability to satisfy their role as trustees and protect the fund assets through litigation.
Respondents in turn argue that Basic created only a rebuttable presumption of reliance, which may be overcome by a showing that the misrepresentation in fact did not lead to a distortion of price. In Respondents' view, a successful rebuttal "breaks" the "causal connection" between the misrepresentation and the plaintiffs' reliance because the alleged fraud is not transmitted through the market price. Respondents also argue that plaintiffs are not relieved of presenting evidence that they have satisfied Rule 23 simply because some of that evidence may overlap with merits evidence. A contrary rule would, according to Respondents, drain judicial resources and unfairly relieve class plaintiffs of proving each of the class certification requirements.
Eight groups also filed briefs as amicus curiae in support of Respondents. Generally, the briefs focus on the argument that, because the presumption of reliance is a pivotal Rule 23 issue, certification of a class in a securities fraud lawsuit will never be warranted in the absence of that presumption. Where defendants' evidence is sufficient to rebut the presumption, defendants should be relieved of the unjustifiable costs and risks associated with an erroneous class certification decision. As one group of insurance companies argued, the Fifth Circuit's opinion was appropriate because district courts should conduct "rigorous analysis" of class certification requirements in order to balance judicial economy with fairness to defendants. Another amicus brief filed by a group of law professors argued that the lower courts' attempts to estimate efficiency have been inconsistent and empirically inaccurate. As such, courts should follow the Fifth Circuit's lead by shifting their fraud-on-the-market focus from the market's overall efficiency to the market effect of the alleged misstatements at issue.
With oral argument scheduled for April 25, 2011, and a decision expected by the end of June, the Supreme Court could soon clarify the issue of what review of loss causation evidence is appropriate and/or necessary during the class certification stage.
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