Class Actions - Presumption of Reliance under SEC Rule 10b-5

Harvard Law Review, November 2014 | Go to article overview

Class Actions - Presumption of Reliance under SEC Rule 10b-5


To recover damages in a securities fraud class action under section 10(b) of the Securities Exchange Act of 1934 (1) (1934 Act), investors must prove that they relied on the defendant's misrepresentation in connection with the purchase or sale of a security. In Basic Inc. v. Levinson, (2) the Supreme Court held that investors could satisfy the reliance requirement by invoking a rebuttable presumption of classwide reliance. (3) This presumption, based on the "fraud-on-the-market theory," has two related components: first, that the price of a security traded in an efficient market reflects all material public information and, second, that the buyer of a security may be presumed to have relied on the integrity of the market price. (4) In order to invoke the presumption, a plaintiff seeking class certification must establish that the security traded in an efficient market, among other predicates. (5)

By dispensing with proof of individualized reliance, Basic fueled a multibillion dollar shareholder class action industry. (6) Last Term, in Halliburton Co. v. Erica P. John Fund, Inc. (Halliburton II), (7) the Supreme Court considered whether to "overrule or substantially modify" the Basic presumption (8)--the linchpin of modern private securities litigation. The Court declined to overturn Basic, but held that defendants can defeat the presumption at the class certification stage by introducing evidence that the alleged misrepresentation did not affect the stock price. (9) Although Halliburton II implicates substantive issues at the intersection of economic theory, financial markets, and securities regulation, the case was not decided on those terms. Instead, the outcome reflects adherence to stare decisis and reluctance to fundamentally alter securities class action practice.

In June 2002, the Erica P. John Fund (the Fund) filed a securities fraud class action in the Northern District of Texas against Halliburton Co. and its CEO David Lesar (together, "Halliburton"). (10) The complaint alleged that, between June 3, 1999 and December 7, 2001, Halliburton made a series of misrepresentations--downplaying asbestos liabilities, overstating revenues from construction contracts, and overstating the benefits of a merger--in an attempt to inflate its stock price. (11) The Fund further alleged that the stock price declined after Halliburton made corrective disclosures, resulting in financial loss. (12) Five years later, the Fund invoked the Basic presumption and moved to certify a class pursuant to Federal Rule of Civil Procedure 23. (13)

In November 2008, the district court denied the class certification motion. (14) The court found that the Fund had failed to establish "loss causation"--a causal connection between the defendant's alleged representations and the plaintiffs' economic losses (15)--and therefore could not invoke Basic's presumption of classwide reliance to satisfy the Rule 23(b)(3) requirement that "questions of law or fact common to class members predominate over any questions affecting only individual members." (16) The Fifth Circuit affirmed. (17) The Supreme Court reversed, stating that requiring loss causation as a precondition for invoking the Basic presumption is "not justified by Basic or its logic." (18)

On remand, Halliburton argued that class certification was inappropriate because the evidence introduced to disprove loss causation also revealed that the alleged misrepresentations did not impact the stock price. Absent any "price impact," Halliburton contended, the proposed class could not invoke the Basic presumption, and investors would have to prove reliance on an individual basis. (19) The district court declined to consider Halliburton's argument, noting that price impact does not bear on the inquiry of common issue predominance under Rule 23(b)(3), and certified the class. (20)

The Fifth Circuit affirmed. (21) Writing for a unanimous panel, Judge Davis (22) found that Halliburton's price impact evidence could be used to refute the presumption of reliance at trial, but not at class certification. …

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