On October 17, 2013, U.S. District Judge Ronald A. Guzman of the Northern District of Illinois entered a judgment in favor of 10,902 class members with claims against HSBC Holdings’ subsidiary, Household International, Inc., in the total amount of $2,462,899,616.21. Lawrence E. Jaffe Pension Plan v. Household Int’l, Inc., No. 02-C-5893 (N.D. Ill. Oct. 17, 2013), ECF No. 1898. In this securities fraud class action, the plaintiff investors alleged that lender Household International and its officers made false and misleading statements that artificially inflated the company’s share price.
Just a few weeks earlier, on October 1, 2013, the U.S. District Court for the District of New Jersey approved a $215 million settlement in a class action securities fraud case against Merck and Co. and Schering-Plough Corp., bringing the total of combined settlements in the consolidated securities fraud cases against Merck and Schering-Plough to $688 million. In re Schering-Plough Corp. Enhance Secs. Litig., 2013 U.S. Dist. LEXIS 141475 (D.N.J. Oct. 1, 2013), ECF No. 49. The Merck/Schering-Plough litigation arose from allegations that the worldwide pharmaceutical companies had concealed material information and made misleading representations relating to their Vytorin and Zetia cholesterol drugs. The plaintiffs alleged that the companies withheld results of a clinical trial that had disproved the companies’ public statements about the performance of the drugs.
The class certification of these two cases, as well as the staggering damages judgment amounts in class action securities fraud lawsuits over the past 25 years, was made possible by the U.S. Supreme Court decision in Basic, Inc. v. Levinson, 485 U.S. 224 (1988),which opened an avenue by which plaintiffs could obtain class certification to sue companies in mass. However, on November 15, 2013, the Supreme Court granted certiorari in Halliburton Company v. Erica P. John Fund, Inc., No. 13-317 (referred to as “Halliburton II” because this is the second appearance of this case in the Supreme Court), which could fundamentally change the current plaintiff-favorable approach, and possibly preclude the ability to bring security fraud class actions altogether.
At issue in this case is the most powerful engine of civil liability ever established in American law: the fraud-on-the-market presumption of reliance under Section 10(b) of the Securities Exchange Act of 1934. That presumption serves as the foundation of a massive, multibillion-dollar litigation industry, and its impact, along with the controversy it has created, has been remarkable.
Brief for Former SEC Commissioners and Officials and Law Professors as Amici Curiae Supporting Petitioners at 3, Halliburton II, No. 13-317 (filed Oct. 11, 2013).
The Presumption Adopted in Basic v. Levinson
In Basic, the Supreme Court issued a landmark ruling that has allowed plaintiffs to band together against corporations in securities fraud class actions without showing that individual investors made investment decisions based on the defendants’ fraudulent misrepresentations. Basic, 485 U.S. at 247. The Basic Court created the “fraud-on-the-market” presumption, permitting large numbers of investors to obtain class certification, and lucrative settlements, without any individual showing that an investor relied on the alleged misrepresentations of the company when investing in that company. The Supreme Court established a rebuttable presumption of class-wide reliance on the purported misrepresentations based on the fraud-on-the-market theory as follows:
An investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price. Because most publicly available information is reflected in the market price, an investor’s reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action.
Id. at 244–47.
“Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. The causal connection between the defendants’ fraud and the plaintiffs’ purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations.” Id. at 241–42. As such, the evidentiary standard to show common reliance to certify a class requires merely a showing that the security was traded on an efficient market—a standard often easily satisfied by the company’s stock being traded on a stock exchange.
The district court in Merck also rejected the defendants’ arguments that the plaintiffs had purchased the stock in question through “mechanical index purchasing and basket trades” and, therefore, could not have relied on the defendants’ alleged misstatements.
The Court disagrees with the fundamental premise of this contention, however, and finds that the law fully supports the notion that index purchases and the like are in fact a perfect example of reliance on the market. As the Central District of California noted, “Because index purchases seek only to match the index and exclude other considerations, index purchases rely exclusively upon the market to impound representations (including misrepresentations) into securities prices.”
In re Schering-Plough Corp. Enhance Secs. Litig., 2012 U.S. Dist. LEXIS 138078, ECF No. 314, at 19 (D.N.J. Sept. 25, 2012).
The current standard does not require evidence that the price was actually affected by a misrepresentation—that is presumed because of the accepted efficiency of the market in incorporating information.
In the HSBC case, not only did the theory support certification of a massive class of investors, but it also provided an example of how Basic’s fraud-on-the-market analysis could impact the scope of discovery. Following class certification, the defendants served 14 subpoenas on plaintiffs’ representatives and advisors. The defendants claimed that the discovery was necessary to disprove the necessary element of reliance. “Reliance is an element of a Rule10b-5 cause of action. Reliance provides the requisite causal connection between a defendant’s misrepresentation and the plaintiffs’ injury.” However, the court granted the plaintiffs’ motion to quash the subpoenas, holding that “plaintiffs are pursuing a fraud-on-the-market theory under which they can satisfy the reliance element of securities fraud without proving direct reliance on false representations. The fraud-on-the-market theory allows plaintiffs to establish a class-wide rebuttal presumption of reliance on Household’s alleged misrepresentations.” Lawrence E. Jaffe Pension Plan v. Household Int’l, Inc., No. 02-C-5893, 2005 U.S. Dist. LEXIS 8610, at *7 (N.D. Ill. Apr. 18, 2005). Without such a presumption, plaintiffs would need to show “proof of individualized reliance from each member of the proposed plaintiff class[,] effectively . . . prevent[ing plaintiffs] from proceeding with a class action, since individual issues then would have overwhelmed the common ones.” Basic, 485 U.S. at 242.
The bounty for class action plaintiffs, as well as lawyers and experts on both sides of these cases, created by the legal fiction of fraud-on-the-market reliance, could come to an abrupt halt in 2014. The Supreme Court granted certiorari in Halliburton II to revisit the fraud-on-the-market exception to the reliance requirement for certification of class action securities fraud cases. As explained below, recent Supreme Court opinions signal the likelihood that the Basic fraud-on-the-market exception could be drastically altered or completely eliminated, thereby requiring proof of individualized reliance from each member of a proposed class and effectively preventing individual investors from banding together to sue large corporations for securities fraud.
Possible Implications of a Supreme Court’s Decision in Halliburton II
The Supreme Court certified two questions for review in Halliburton II. The first asks whether the theory allowing a class-wide presumption of reliance should be overruled or, at least, substantially modified. The second asks whether, if the presumption is not eliminated or modified, a defendant can rebut that presumption at the class-certification stage by showing that the purported misrepresentation did not actually distort the subject security price. While the Court has already stated that the presumption may be rebutted by such a showing, it is not clear whether that rebuttal may occur at the class-certification stage. The possibility of allowing the rebuttal early on is significant, and may be outcome determinative, as the certification of a class is generally the threshold barrier that will often determine whether a company will settle the case or expose itself to crippling class-wide damages. By certifying the class based on Basic’s fraud-on-the-market theory, the district court sent the Merck case down a path that has become very familiar. Within months, the case settled.
It appears that the Court has three options by which to resolve Halliburton II. It may (1) maintain the status quo as to the evidentiary showing for class-wide reliance, either by explicitly affirming the current law or by avoiding the issue on procedural grounds; (2) eliminate or substantially modify the threshold showing that plaintiffs must make to demonstrate class-wide reliance; or (3) adopt the approach suggested in the second certified question and allow defendants to rebut the initial presumption for class certification at that stage. If the Supreme Court adopts the first option, the fraud-on-the-market theory, as articulated above, will remain the standard. The second two options create interesting questions and are more thoroughly addressed below.
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