The U.S. Supreme Court may not be willing to go as far some had hoped in overruling its precedents. That is the message from the Supreme Court’s June 23, 2014 decision in Halliburton Co. v. Erica P. John Fund, Inc. Adherence to precedent won the day in Halliburton, as the Court upheld the so-called “fraud on the market” presumption that enables securities fraud suits to be brought as class actions.
The specific issue of the case was of significance to Wall Street, investors, class action lawyers, and publicly traded corporations. But the larger question was how willing the current Supreme Court is to overturn its own precedents.
At stake in Halliburton was whether the Supreme Court would reconsider the fraud on the market presumption, first embraced by the Court in Basic, Inc. v. Levinson, 485 U. S. 224 (1988). It is no exaggeration to say that overruling Basic would have put an end to securities fraud class actions. Many on Wall Street and in corporate boardrooms have long sought that result, to eliminate what they see as a nuissance that has become ubiquitous. Many investors (and their lawyers), on the other hand, would have mourned the death of what they consider to be an importance source of deterrence against fraud and a means (albeit limited) of obtaining compensation for fraud when it occurs.
What is the the fraud on the market presumption and why is it so important? The presumption solves a basic problem in securities class actions. For a case to proceed as a class action, the plaintiffs must show, among other things, that the claims can be tried on behalf of a class of persons who are similarly situated to the plaintiffs (without the class members individually trying their claims) because most of the issues to be tried are common to all members of the class, i.e., if each class member were to bring suit individually, each would need to prove the same thing that the plaintiffs will prove in the class action trial. This factor is known as predominance — common questions must predominate over individual questions.
As is true of fraud claims generally, to prove securities fraud under the federal securities laws, the plaintiff must prove not only that the defendant made a fraudulent statement, but that the plaintiff relied on the fraudulent statement to his/her/its detriment. Whether any individual relied on a statement is generally an individualized inquiry. Did the individual hear or read the statement? Did he/she/it believe the statement? Did he/she/it take action (or refrain from taking action) because he/she/it believed it?
Such individualized inquiries are considered to prevent common questions from predominating over individual questions. Thus, if proof of actual reliance were required, a class action asserting claims of securities fraud could not be successfully maintained.
The fraud on the market presumption solves that problem. It is based on the efficient markets hypothesis, which posits that when securities trade on an efficient market, the price of the securities will tend to incorporate all available information about the underlying business.Thus, if a corporation or its executive leadership makes a statement about the financial health of the corporation, investors will assimilate the information provided and the share price of the corporation will be affected.
The fraud on the market presumption incorporates that principle, such that a misrepresentation by a corporation or executive is presumed to have impacted the price of the corporation’s securities. So any investor who purchases the corporation’s securities at a price that was impacted (artificially inflated) by a misrepresentation, without showing direct reliance on the statement itself, can show reliance indirectly, by showing that he/she/it relied on the integrity of the price of the securities, which was artificially inflated by the misrepresentation.
All securities fraud class actions rely on the fraud on the market presumption. If the plaintiffs can show that the securities traded on an efficient market, that the misrepresentation was known to the public and material, that the plaintiff bought securities after the false statement was made but before the truth came to light, they are entitled to the fraud on the market presumption, thus making it unnecessary to prove individual reliance.
The defendants can then try to rebut the presumption, by disproving that the statement affected the prices of the securities, or by showing that the plaintiff did not actually rely on the price of the securities as being accurate.
Economists have for years debated whether the efficient market hypothesis is truly valid. And correspondingly, lawyers have argued over the wisdom of the adoption of the fraud on the market presumption in Basic.
Seizing on that debate, and what some see as a Supreme Court that is willing to overturn even 25-year old precedents, the defendants in Halliburton expresly asked the Supreme Court to overrule Basic. And in granting certiorari, the Supreme Court agreed to consider doing so.
But, ultimately, only three dissenting justices saw fit to overrule Basic, with six — Chief Justice Roberts and Justices Kennedy, Ginsburg, Breyer, Sotomayor, and Kagan — voting to uphold it.
In so doing, Chief Justice Roberts, writing for the Court, indicated that the Court still adheres to its traditional hesitance to overrule settled precedent that has not always been evident in recent decisions. Even if the Court thinks the precedent was wrong, that is not enough to overturn it:
Before overturning a long-settled precedent,…we require “special justification,” not just an argument that the precedent was wrongly decided.
Moreover, the Court noted, “the principle of stare decisis has ‘special force'” when the issue is one of statutory interpretation, as was the issue in Basic.
Halliburton’s main reasons for overturning Basic were (1) that it was decided contrary to Congressional intent; and (2) that advancements in economic theory have undermined the validity of the efficient market hypothesis.
The Court rejected both arguments. It was unnecessary to address the first argument at length, because it was discussed by the dissenters in Basic but rejected by the Court majority. There was “no new reason to endorse it now.”
The second argument was rejected because Halliburton had only pointed out that there is a debate among economists as to how quickly markets incorporate information and that there are variations in efficiency among markets. But that debate was ongoing at the time when Basic was decided. And Basic did not assume that markets were perfectly efficient, only that stock prices are responsive to public information about a corporation.
Although the Court rejected Halliburton’s efforts to overrule Basic, it agreed that defendants should have the opportunity to offer evidence to defeat the presumption of reliance, by showing at class certification that the price of the securities at issue was not affected by the statement at issue. Basic expressly contemplated that defendants would be permitted to rebut the presumption, the Court explained.
So securities class actions continue to be viable, to the chagrin of some and the relief of others, while defendants may have gained some additional ammunition to fight them. But in the bigger picture, what the decision portends is that the principle of stare decisis (hesitance to overrule prior decisions) remains vibrant, especially in the realm of statutory interpretation.