For over 20 years, securities class actions in the U.S. have relied on the ‘fraud-on-the-market’ theory of reliance for investors. This was established by the 1988 case Basic Inc v Levinson. Recently some have question this theory. Earlier this week the Supreme Court released its decision in Halliburton co v Erica P John Fund. This decision upheld Basic and the fraud-on-the-market theory.
The most important issue in a class action is whether it can be “certified”—that is, whether it qualifies to be a class action at all. In the United States, securities class actions have been amenable to certification since the 1988 Supreme Court decision, Basic Inc. v. Levinson (“Basic”).[i] The Court has changed in the last 26 years, and some thought that it would finally kill off securities class actions in Halliburton Co. v. Erica P John Fund (“Halliburton II”), which was released on June 23.[ii] It did not.
The Supreme Court’s ruling in Halliburton II is a victory for American investors. The presumption of reliance established in Basic allows private actions for securities fraud to be certified and thus gives investors access to justice and compensation. From an Ontario perspective, the case, while interesting, will have little if any impact.
Securities class actions in the U.S. are primarily judge-made and are based on SEC Regulation 10b-5 and the Securities Exchange Act of 1934. This unusual origin led one Supreme Court Justice to comment that securities class actions are “a judicial oak which [have] grown from little more than a legislative acorn.”[iii]
At the core of nearly all securities class actions is a “presumption of reliance” that allows a plaintiff to certify the claims of an entire group of investors into one class action. In 1988, Basic established the presumption and countless cases have relied on it since.
Basic stood for over 20 years. Last year, the Supreme Court released Amgen Inc. v. Connecticut Retirement Plans and Trust Funds,[iv] and in a dissenting opinion, conservative members of the bench (Justices Scalia, Thomas and Alito, joined by Kennedy) questioned Basic. This set the stage for the ruling in Halliburton II.
The Efficient Market
At the core of the opposition to Basic is a challenge to the economic theory underpinning it: the efficient market hypothesis. That hypothesis holds that in efficient markets, security prices reflect all publicly available information. Hence, any public misrepresentations impact the stock price, and thus the market as a whole (this is known as, “fraud-on-the-market”). As investment decisions are based on share prices, when an investor sells or buys a security they do so based on prices that in turn reflect misrepresentations. Thus, reliance on that misrepresentation can be presumed through the act of transacting in securities.[v] In recent years, some academics have challenged this theory, though only at the margins.
Prior to Basic, U.S. investors could only recover in a private securities action if they could show individual reliance on the defendant’s misrepresentation.[vi] For a class action to be certified, U.S. law requires that the common issues predominate over the individual ones (Canadian law does not). Given the traditional need to show individual reliance, a securities fraud class action could not be certified because reliance would predominate over any common issues. The fraud-on-the-market theory helps establish a rebuttable presumption of reliance class-wide, allowing securities fraud class actions to be certified.
Chief Justice Roberts, writing for the majority of the Supreme Court in Halliburton II, upheld Basic. Halliburton, the defendant in a securities class action, had challenged Basic on two grounds.
First, it challenged the continuing viability of the fraud-on-the-market theory and the efficient market hypothesis.[vii] According to Halliburton, and accepted by Justice Thomas (joined by Justices Alito and Scalia) in a concurrence-in-name-but-dissent-in-substance, the presumption could no longer stand because the economic theory (“muddled logic and armchair economics,” in Justice Thomas’ words) was not supportable given modern research.[viii]
Chief Justice Roberts, writing for the Court, rejected that argument. He found that the presumption is not based on the absolute correctness of any one economic theory. Rather, the extent to which a stock price reflects public information, including misrepresentations, is a matter of degree and any issues with making the presumption can be addressed since it is rebuttable.[ix] In short, Chief Justice Roberts recognized that the theoretical underpinnings were not perfect but sufficed for the purposes of establishing a rebuttable presumption.
Second, the Court (thus the conservative wing’s concurrence) agreed with Halliburton that the defendants should be able to defeat the presumption at the certification stage by proving that there was no price impact from the misrepresentation at certification. As the presumption attempts to indirectly show price impact, direct evidence that there was no price impact dictates that the presumption not apply. In a one paragraph concurrence, Justice Ginsburg (joined by Justices Breyer and Sotomayor) noted that the decision “should impose no heavy toll on securities-fraud plaintiffs with tenable claims.”[x]
On any standard, this decision is a victory for investors and America’s public markets. Had Basic fallen, it would effectively ended securities class actions and thus investor access to justice. The decision does have the potential to make the certification of securities fraud class actions more difficult—and expensive—as evidence on price impact, now admissible at certification, is complex and expensive.
Impact in Ontario?
It is not clear that there would be any impact of this decision in Ontario.[xi] Nonetheless, U.S. decisions are cited from time-to-time in Canadian Courts. The Supreme Court’s ruling in Halliburton II is unlikely to have any material impact on Ontario securities class actions, but had Basic been struck down, defendants would undoubtedly have tried to make use of the decision here.
Indeed, in Green v Canadian Bank of Commerce[xii] the Ontario Court of Appeal rejected arguments for certification on “inferred common reliance based on the ‘fraud on the market’ or ‘efficient market’ economic theories,” but nonetheless held that certification was proper. As we have discussed elsewhere, Canadian law does not require that common issues “predominate,” and thus securities misrepresentation claims are properly certified as class actions even if reliance is an individual issue.[xiii]
Siskinds’ class actions team includes lawyers admitted in Ontario, New York, Australia and elsewhere. Let us know how we can help.
Daniel E.H. Bach is a Partner in Siskinds LLP’s Toronto office. Garett Hunter is a 2nd year law student at the University of Toronto and summer student at Siskinds LLP.