Fraud-on-the-Market Class Certification: Theory, Tolling and Materiality
Kelly, William J., Defense Counsel Journal
This article originally appeared in the March 2013 Class Actions and Multiparty Litigation Committee newsletter.
I. The Fraud On The Market and Halliburton
THE "fraud-on-the-market" theory under Rule 10b-5 of the Securities Exchange Act of 19341 is based on the premise that the price of actively traded securities (that is, "securities traded on efficient capital markets") reflects all relevant publicly available information. Consequently, the theory goes, misrepresentations defraud investors who trade on efficient markets, even regardless of whether the investors directly rely on the misrepresentations. This is because the misrepresentations unfairly affect the market price of securities.2 Requiring proof of direct reliance "would place an unnecessarily unrealistic evidentiary burden on [a] plaintiff who has traded on an impersonal market."3 Whether putative class representatives needed to prove "loss causation" (that is, that the material misrepresentation at issue caused the economic loss) to obtain class certification had presented a split of authority among the circuits.
On June 6, 2011, the Supreme Court held In Erica P. John Fund\ Inc. v. Halliburton Co.,4 that securities fraud class representatives alleging fraud-on-the-market need not prove loss causation at the certification stage in order to get the benefit of the fraud-on-the-market presumption of reliance. In its unanimous decision, the Supreme Court held that to invoke the fraud-on-the-market rebuttable presumption, plaintiffs must demonstrate that the misrepresentation was known publicly, that there was an efficient market for the stock, and that the transaction occurred between the misrepresentation and the corrective statement. The Supreme Court held that requiring an additional loss causation requirement at the certification stage would "contravene fundamental premises" of the theory. "The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation," Justice Roberts said, "has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively through the fraud-on-the-market theory." Thus, the Court reasoned, "Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory."
Impact of Halliburton: Halliburton does not require plaintiffs to establish the materiality of alleged misstatements to invoke the fraud-on-the-market theory in support of class certification. To obtain certification, it is sufficient for plaintiffs to plead materiality and establish the elements of Rule 23. The tenants of loss causation are not dead in any trial on the merits of any litigation seeking to establish liability as between any plaintiff and any defendant. However, Justice Roberts' admonition that loss causation "has nothing to do with whether an investor relied on the misrepresentation in the first place" may provide plaintiffs a roadmap to circumnavigating a tight causational analysis at trial.
Proponents of securities fraud class actions hailed the Halliburton decision as a triumph of practicality, asserting that the Security Exchange Commission is not well equipped to be the sole policing agent to market fraud.5 To this group, the decision merely revived 13-year-old precedent on securities fraud law,6 and blocked the narrowing of class actions that allege manipulation of stock market prices. To proponents of the loss causation requirement, on the other hand, Halliburton may be seen as kicking the commonality can down the road, leading to a potentially over-inclusive class definition, an over-broad class notice, and the difficulties inherent in trying to "un-ring the bell" of improvidently overbroad certification.
Additionally, at the time of its ruling, some lawyers and commentators questioned the impact of Halliburton on other fraud consumer class theories invoking presumed reliance in support of class certification. (During oral argument, Justice Breyer inquired whether the common question aspects of the fraud-on-the-market theory might apply to all fraud cases.) However, recent "presumed reliance" certification cases - outside the context of securities fraud - continue to evaluate Rule 23 under the presumed reliance standards evinced by the Supreme Court in Affiliated Ute7 and under applicable state law.8 In general terms, Halliburton remains the leading certification standard as it relates to fraud-on-the-market theories.9
II. Short Swing Tolling and Credit Suisse
The "short-swing profits" rule allows shareholders to sue under Section 16(b) of the Act for disgorgement of any profits realized from the purchase and sale of the corporation's securities within a six-month time period, whether the transactions were conducted with any improper purpose or not. Section 16(b) applies whenever there is a sale and purchase, or purchase and sale, of a company's equity securities by an insider within a six-month period. It imposes strict liability on any director, certain officers, or any 10% beneficial owner of a public company who realizes profits. The rule is intended to deter and prevent "unfair use of information" by corporate insiders.
On March 26, 2012, in Credit Suisse Securities (USA) LLC v. Simmonds,w the Supreme Court held that the two-year statute of limitations for suits under "short-swing" liability rules'1 is not tolled until an insider files a Section 16(a) disclosure statement; the limitations period generally begins running even if the disclosure statement is filed at a later date or never filed at all. The decisions will be welcome to corporate officers and directors; they no longer face potentially open-ended liabilities under the Act to disgorge allegedly prohibited short-swing profits. The Supreme Court's decision prevents degradation of the Act's explicit statute of limitations under § 16(b).
The Court did not foreclose all tolling principals in the context of Section 16(b). The Court left open the notion of Section 16(b) tolling pursuant to "long-settled equitable-tolling principles" such as, for example, where a plaintiff might demonstrate that he has been pursuing his rights diligently and that some extraordinary circumstance prevented timely assertion of the claim.12 The Court also noted that a Section 16(b) claim might be tolled because of fraudulent concealment, but that the tolling would end when the plaintiff discovers, or should have discovered, those facts. The decision was clearly aimed at the inequity and lack of textual support for an alleged insider to "face the prospect of Section 16(b) litigation in perpetuity." "Had Congress intended the possibility of such endless tolling," the Court reasoned, "it would have said so."
III. The Materiality of Materiality at the Certification Stage
On February 27, 2013, in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds,13 the Supreme Court ruled that the fraud-on-the-market theory of reliance does not require proof of materiality of the fraudulent statement at the class certification stage. The Court ruled that shareholders could bring a securities fraud class action against the company without first showing that misinformation had materially and fraudulently inflated the company's stock price.
Justice Ruth Bader Ginsburg, writing for the majority in the 6-3 decision, asserted that the plaintiffs' assertion was enough for purposes of class certification, because the question at the certification stage is merely whether "questions of law or fact common to class members predominate over any questions affecting only individual members." "The class is entirely cohesive: it will prevail or fail in unison," the majority reasoned. "In no event will the individual circumstances of particular class members bear on the inquiry." The Court framed "the pivotal inquiry" as whether proof of materiality is needed to ensure that the questions of law or fact common to the class will "predominate over any questions affecting only individual members" as the litigation progresses. For two reasons, the majority concluded, the answer to this question is "no." First, materiality is judged according to an objective standard. It can be proved through evidence common to the class.14 Thus, it is a common question for Rule 23(b)(3) purposes. Second, a failure of proof on the common question of materiality would not result in individual questions predominating. Instead, it would end the case, for materiality is an essential element of a securities-fraud claim.15
In support of its argument, Amgen had pointed to Haäiburton to note that securities fraud plaintiffs must prove "that the alleged mis representations were publicly known that the stock traded in an efficient market, and that the relevant transaction took place 'between the time the misrepresentations were made and the time the truth was revealed.'" If these fraud-on-the-market predicates must be proved before class certification, Amgen contended, materiality-another fraud-on-the-market predicate-should be treated no differently. The majority disagreed. The requirement that a putative class representative establish that it executed trades "between the time the misrepresentations were made and the time the truth was re vealed" relates primarily to the Rule 23(a)(3) and (a)(4) inquiries into typicality and adequacy of representation, not to the Rule 23(b)(3) predominance inquiry. While the failure of common, classwide proof of market efficiency or publicity leaves open the pro spect of individualized proof of reliance, the failure of common proof on the issue of materiality ends the case for all class members, so the Court reasoned.
Impact of Amgen: The import of Amgen may be significantly more fer reaching, and potentially as far reaching as the Court's decision in Dukes v. Wal-Mart,16 While the specific language of the Amgen decision speaks of materiality in the context of fraud-on-the-market theories and its operational rules, the import of this decision is that materiality need not always be established to meet the Rule 23 elements of predominance in a consumer securities class. Plaintiff counsel may seek to extend this theory, citing the majority's rationale to urge that materiality is, de facto, an element common to the class in any consumer fraud class. Plaintiffs may also cite Amgen as standing for the proposition that materiality is, de facto, a merits issue, improperly considered at the certification stage. Both arguments would be overreaching, and defendants should be prepared to prove how materiality could have a significant impact to the predominance inquiry, particularly as to any claim where causation and liability proof will be unique to each class member. In other words, defense should demonstrate, in opposition to certification, not only that materiality impacts a claim's viability, but how it does so on an individual basis. By demonstrating how the operational rules of the asserted causes of action rise and fall individually, a defendant might best evidence how the predominance inquiry is not always a merits issue, and that unique and common presumptions contained in the fraud-on-the-market claim distinguish Amgen.
Even within securities consumer class actions, however, Amgen is an undeniably significant decision. In his dissent, Justice Scalia made his opinion of the impact on Amgen on future class litigation clear:
Certification of the class is often, if not usually, the prelude to a substantial settlement by the defendant because the costs and risks of litigating further are so high. ... Today's holding does not merely accept what some consider the regrettable consequences of the four-Justice opinion in Basic [recognizing the fraud-on-the-market theory]; it expands those consequences from the arguably regrettable to the unquestionably disastrous.17
1 17 C.F.R. S240.10b-5 (1990).
2 Zachary Alan Starr, Fraud on the Market and the Substantive Theory of Class Actions, 65 St. John's L. Rev. (1991), available at: http://scholarship. law.stjohns.edu/lawreview/vol65/iss2/2.
3 Basic Inc. v. Levinson, 485 U. S. 224, 245 (1988).
4 131 S.Ct. 2179, 2185, 180 L.Ed.2d 24 (2011).
5 See, e.g. AARP Amicus Brief, ("The SEC does not have the resources to adequately police the securities marketplace, and studies show that private enforcement actions are an essential tool not only in stopping misconduct, but in compensating victims.").
6 Basic Inc. v. Levinson, 485 U.S. at 248, n. 27.
7 Affiliated Ute Citizens v. United States, 406 U.S. 128, 92 S.Ct. 1456, 31 L.Ed.2d 741 (1972).
8 See, e.g., Local 703, I.B. ofT. Grocery and Food Employees Welfare Fund v. Regions Financial Corp., 282 F.R.D. 607 (N.D. Ala. 2012).
9 See, e.g., Pennsylvania Ave. Funds v. Inyx Inc., 2011 WL 2732544 (S.D.N.Y. 2011); Brinker v. Chicago Title Ins. Co., 2012 WL 1081182 (M.D. Fla. 2012).
10 No. 10-1261, 2012 WL 986812 (Mar. 26 2012).
11 Section 16(b) of the Securities Exchange Act of 1934, as amended; 17 C.F.R. 240.16(b) (1990).
12 Citing Pace v. DiGuglielmo, 544 U. S. 408, 418 (2005).
13 No. 11-1085, slip op. (Feb. 27, 2013).
14 Citing TSC Industries, Inc. v. Northway, Inc., 426 U. S. 438, 445 (1976).
15 In a concurrence, Justice Alito said that it may be time to reconsider the fraud-on-the-market theory in light of research suggesting that it may sometimes rest on a faulty premise. Justices Scalia, Thomas, and Kennedy dissented. Justice Clarence Thomas, joined by Justice Anthony M. Kennedy and in part by Justice Antonin Scalia, dissented. Justice Thomas agreed that the theory was questionable and added that materiality must be shown at the certification stage.
16 564 U.S. (2011). '
17 Slip Op. Scalia, Dissent, at p. 4.
William J. Kelly, III, is a commercial litigator and founding member of Kelly, Stacy & Rita in Denver, Colorado, focusing his practice in the areas of class actions and employment litigation. Bill litigates class action cases throughout the country; his experience includes serving as National Employment Counsel to a Fortune 25 Global company, Outside General Counsel to a Flonda based federal contractor, and National Litigation Counsel to a Fortune 500 company. He is also General Counsel and Secretary to Red Cloud Digital, a technology start-up company based in St. Louis, Missouri. Mr. Kelly is listed as a Colorado Super Lawyer, is in America's Best Lawyers and has achieved the "AV" highest rating for legal ability in Martindale-Hubbell.…
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Publication information: Article title: Fraud-on-the-Market Class Certification: Theory, Tolling and Materiality. Contributors: Kelly, William J. - Author. Journal title: Defense Counsel Journal. Volume: 80. Issue: 3 Publication date: July 2013. Page number: 307+. © 1999 International Association of Defense Counsels. Provided by ProQuest LLC. All Rights Reserved.
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