Fraud-on-the-Market Theory in Securities Class Actions Threatened

The U.S. Supreme Court heard oral arguments in Halliburton Co v. Erica P. John Fund, Inc. last week, the case in which the Court has the opportunity to reverse or limit the 26-year old fraud-on-the-market doctrine adopted by the court in 1988. While the doctrine’s fate remains in question, the justices’ comments at the hearing indicate they are weighing options to make it more difficult for investors to sue.

Class action litigation for stock fraud increased dramatically after the Court introduced the fraud-on-the-market theory.  Given the potential of a huge jury verdict at trial, most of these cases are settled once the case is allowed to proceed as a class action.  Attorneys who represent investors say that if the Supreme Court overturns the fraud-on-the-market doctrine the ruling could devastate the future of securities class actions.  Given the high cost of litigation, if shareholders were unable to sue as a class under this theory, all but the largest institutional investors would be virtually unable to overcome the burden. Attorneys who represent corporate defendants argue that the fraud-on-the-market theory has not only created excessive litigation, but with modern trading practices, it is no longer relevant since the “market” for stock and its price is affected by a host of factors other than company information.

The fraud-on-the-market doctrine was first upheld by the Supreme Court in 1988 the case of Basic Inc. v Levinson (485 U.S. 224).  It allows a class action to proceed against a company on behalf of every investor who sells stock at a loss upon discovery that the company made false or misleading representations about its products or corporate health.  The doctrine is premised on the efficiency and integrity of the market – that a stock’s price is reflective of all publicly available information.  In theory, when a company makes false statements, conceals negative information or makes other misrepresentations, then that information is considered to have defrauded the market.  The fraud-on-the-market theory makes it easier for investors to sue by eliminating the need for each individual investor to prove his or her actual reliance on the company’s misinformation and instead proceed as a group of investors who relied on the integrity of that market.

In the Halliburton case, a group of investors sued who bought company shares between 1999 and 2001 claim that the company made misleading statements about its financial position, including overstating the benefits of a merger and understating its asbestos litigation liability, which inflated its stock price.  When the information was eventually revealed, the stock price plummeted and investors sued using the fraud-on-the-market theory.

When the case went to the Court of Appeals for the Fifth Circuit, the court held that plaintiffs in securities fraud actions must also prove that the “market fraud” on which they relied is what caused the stock to drop in value.  The investors took the case to the Supreme Court arguing that requiring such proof of loss-causation at the class-certification stage undermines the presumption of reliance on the market that the Supreme Court afforded to investors in developing the fraud-on-the-market doctrine in Levinson.   

The justices’ comments at the recent Halliburton hearing indicate the Court may decide to limit the fraud-on-the-market theory, to make it harder to bring a class action, rather than altogether abandoning the doctrine.  Justice Scalia reportedly noted: “Once you get the class certified, the case is over.  Right?” (highlighting the fact that most securities-class action lawsuits settle). Justice Kagan also reportedly noted that Congress has the ability to revise stock fraud laws, as it has done several times since the court’s 1988 ruling.  These comments indicate the Court is leaning toward limiting the fraud-on-the-market doctrine at the class-certification stage, rather than totally overruling the longstanding precedent.

If you believe you may have been the victim of securities fraud, contact the attorneys at Audet & Partners, LLP for a free consultation.  Call us at (800) 965-1461 or fill out the confidential case inquiry form on the right side of this webpage.

* Source: Savage, David G., (2014, March 5); Retrieved from http://www.latimes.com/business/la-fi-scotus-stock-fraud-20140306,0,3100980.story#axzz2vDSuxy8c 

See also the Halliburton case at the U.S. Court of Appeals for the Fifth Circuit here:  http://www.ca5.uscourts.gov/opinions%5Cpub%5C12/12-10544-CV0.wpd.pdf.

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