The 10b-5 Daily

The U.S. Supreme Court has issued a decision in the Halliburton case holding that defendants can rebut the fraud-on-the-market presumption of reliance at the class certification stage with evidence of a lack of stock price impact. It is a 9-0 decision authored by Chief Justice Roberts, although Justice Thomas (joined by Justices Alito and Scalia) concurred only in the judgment. As discussed in a February 2010 post on this blog, Halliburton has a long history that now includes two Supreme Court decisions on class certification issues. A summary of the earlier Supreme Court decision can be found here.

Under the fraud-on-the-market presumption, reliance by investors on a misrepresentation is presumed if the misrepresentation is material and the company’s shares were traded on an efficient market that would have incorporated the information into the stock price. The fraud-on-the-market presumption is crucial to pursuing a securities fraud case as a class action – without it, the proposed class of investors would have to provide actual proof of its common reliance on the alleged misrepresentation, a daunting task for classes that can include thousands of investors.

The fraud-on-the-market presumption, however, is not part of the federal securities laws. It was judicially created by the Supreme Court in a 1988 decision (Basic v. Levinson). In Halliburton, the Court agreed to revisit that decision, but ultimately decided that there was an insufficient “special justification” for overturning its own precedent.

The Court rejected the following key arguments. First, Halliburton argued that the fraud-on-the-market presumption was no longer tenable because (a) there is substantial empirical evidence that capital markets are not fundamentally efficient, and (b) investors do not always invest in reliance on the integrity of a stock’s price. The Court found, however, that the Basic decision was not undermined by either of these arguments because it was based “on the fairly modest premise that market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.” Accordingly, “[d]ebates about the precise degree to which stock prices accurately reflect public information are . . . largely beside the point” and it is sufficient that most investors do rely, either directly or indirectly, on the accuracy of stock prices.

Second, Halliburton argued that the fraud-on-the-market presumption could not be reconciled with more recent Court decisions making it clear that plaintiffs must prove that their proposed class meets all of the certification requirements imposed by the Federal Rules of Civil Procedure. The Court disagreed, noting that plaintiffs who invoke the fraud-on-the-market presumption must still prove certain prerequisites for that presumption – publicity, market efficiency, and market timing – before class certification.

Finally, Halliburton argued that the fraud-on-the-market presumption, by facilitating securities class actions, “allow[s] plaintiffs to extort large settlements from defendants from meritless claims; punish innocent shareholders, who end up having to pay settlements and judgments; impose excessive costs on businesses; and consume a disproportionately large share of judicial resources.” The Court found that these “concerns are more appropriately addressed to Congress, which has in fact responded, to some extent, to many of the issues raised by Halliburton and its amici.” Moreover, the fact that Congress “may overturn or modify any aspect of our interpretations of the reliance requirement, including the Basic presumption itself” supports the notion that the principle of stare decisis should be applied to the Basic decision.

Although the Court was unwilling to overturn Basic, it did agree with Halliburton that defendants should be able to rebut the fraud-on-the-market presumption with evidence that the alleged misrepresentation did not actually affect the stock price. Notably, price impact evidence is already used at the class certification stage “for the purpose of countering a plaintiff’s showing of market efficiency” by establishing that the stock price did not react to publicly reported events. If it can be used to rebut this prerequisite for the fraud-on-the-market presumption (which is nothing more than “an indirect showing of price impact”), the Court found that it also should be available to directly rebut the presumption as to the specific misrepresentation.

Holding: Vacated judgment and remanded for further proceedings consistent with opinion.

Notes on the Decision:

(1) There are two concurrences, which go in radically opposite directions. A concurrence authored by Justice Ginsburg (joined by Justices Breyer and Sotomayor) simply states that she joins the opinion because she understands that it “should impose no heavy toll on securities-fraud plaintiffs with tenable claims.” In contrast, Justice Thomas (joined by Justices Scalia and Alito) concurs only in the judgment and forcefully argues that the Basic decision should be overturned, noting that “[t]ime and experience have pointed up the error of that decision, making it all too clear that the Court’s attempt to revise securities law to fit the alleged new realities of financial markets should have been left to Congress.”

(2) Missing from the fray is Justice Kennedy, who joined Justice Thomas’ dissent in the recent Amgen decision. In that dissent, Justice Thomas expressed skepticism about the continued vitality of the fraud-on-the-market presumption. A number of commentators therefore assumed that Justice Kennedy was interested in overturning the Basic decision. Apparently not.

Disclosure: The author of The 10b-5 Daily submitted an amicus brief on behalf of the Washington Legal Foundation in support of petitioner. The amicus brief primarily argued that the Court should permit defendants to rebut the fraud-on-the-market presumption with price impact evidence.

In 2003, America Online (AOL) investors brought a securities class action alleging that Credit Suisse First Boston (CSFB) fraudulently withheld relevant information from the market in its reporting on the AOL-Time Warner merger. After many years of litigation, the D. of Mass. granted summary judgment to CSFB, finding that the plaintiffs had failed to raise a triable issue of fact as to loss causation.

The key basis for the district court’s decision was its rejection of the plaintiffs’ expert study. In particular, the district court found that the study improperly (a) cherry-picked days with unusual stock price volatility, (b) overused dummy variables to make it appear that AOL’s stock price was particularly volatile on the days CSFB issued its reports, (c) attributed “volatility in AOL’s stock price to the reports of defendants analysts when, at the time of the inflation or deflation, an efficient market would have already priced in the reports,” and (d) failed to conduct “an intra-day trading analysis for each event day with confounding information (which is, to say, nearly all of them) in order to provide the jury with some basis for discerning the cause of the stock price fluctuation.”

On appeal, the First Circuit affirmed the exclusion of the expert testimony and the grant of summary judgment. See Bricklayers and Trowel Trades Int’l Pension Fund v. Credit Suisse Securities (USA) LLC, 2014 WL 1910961 (1st Cir. May 14, 2014). The appellate court disagreed that the expert’s use of dummy variables was “inconsistent with the methodology or goals of a regression analysis” and concluded that it was a “dispute that should be resolved by the jury.” However, the other three deficiencies identified by the district court were “more than sufficient” to find that the district court had not abused its discretion.

The plaintiffs argued that affirming the district court’s decision was inappropriate because it was uncontested that 5 of the event days identified by the expert as having “statistically significant abnormal returns” (out of a total of 57 days) “did not suffer from any methodological infirmities.” While the appellate court conceded that it could be an abuse of discretion to reject “mostly salvageable expert testimony for narrow flaws,” in this case it “confront[ed] the reverse situation – pervasive problems with [the expert’s] event study that, allegedly, still leave a few dates unaffected.” Under these circumstances, the district court properly treated the entire event study as inadmissible.

Holding: Affirming exclusion of expert testimony and grant of summary judgment to defendants.

Quote of note: “Requiring judges to sort through all inadmissible testimony in order to save the remaining portions, however small, would effectively shift the burden of proof and reward experts who fill their testimony with as much borderline material as possible. We decline to overturn the district court’s ruling on this specious logic.”

In its Morrison decision, the U.S. Supreme Court held that Section 10(b) (the primary federal anti-securities fraud statute) only provides a private cause of action for claims based on “[1] transactions in securities listed on domestic exchanges, and [2] domestic transactions in other securities.” A number of subsequent lower court decisions have explored the scope of those two categories, with most of the decisions taking the view that they should be strictly construed to limit Section 10(b) claims to transactions that take place within the United States.

In the UBS securities litigation, for example, the court dismissed two sets of claims that Morrison arguably precluded. First, the court held that claims asserted by foreign plaintiffs who purchased UBS stock on a foreign exchange (“foreign-cubed claims”) were barred even though UBS common stock is cross-listed on the New York Stock Exchange. Second, the court held that claims asserted by U.S. investors who purchased UBS stock on a foreign exchange (“foreign-squared claims”) were barred even though the orders were placed from the United States.

On appeal, in a case of first impression at the appellate level, the Second Circuit has affirmed that decision. In City of Pontiac Policeman’s and Firemen’s Retirement System v. UBS AG, 2014 WL 1778041 (2d Cir. May 6, 2014), the court found that the plaintiffs’ listing theory “is irreconciliable with Morrison read as a whole,” in which the court “makes clear that the focus of both prongs was domestic transactions of any kind, with the domestic listing acting as a proxy for a domestic transaction.” In addition, the Second Circuit test for whether a transaction is domestic is if “the parties incur irrevocable liability to carry our the transaction within the United States or when title is passed the United States.” The fact that the purchaser is a U.S. entity or placed the order in the U.S. does not establish that it has met this test.

Holding: Dismissal of “foreign-cubed” and “foreign-squared” claims affirmed.

The U.S. Court of Appeals for the Fourth Circuit has issued an opinion – Yates v. Municipal Mortgage & Equity, LLC, 2014 WL 890018 (4th Cir. March 7, 2014) – that clarifies the court’s position on several securities fraud issues.

(1) Core operations (scienter) – Core operations is a scienter theory that infers that facts critical to a business’s ‘core operations’ or an important transaction are known to the company’s key officers. Exactly how and to what extent the theory can be invoked to satisfy a plaintiff’s burden to plead a strong inference of scienter has been the subject of some judicial debate. In Yates, the Fourth Circuit held that “such allegations are relevant to the court’s holistic analysis of scienter,” but without other allegations “establishing the defendant’s actual exposure to the . . . problem, the complaint falls short of the PSLRA’s particularity requirement.”

(2) Rule 10b5-1 trading plans – Two of the individual defendants sold shares pursuant to non-discretionary Rule 10b5-1 trading plans. The court found that the use of these plans “further weakens any inference of fraudulent purpose” caused by the sales, but also noted that because one of the plans was instituted during the class period, it did “less to shield [that defendant] from suspicion.”

(3) Statute of repose for Section 11 claims – The case included Section 11 claims based on an alleged misrepresentation in a registration statement that was declared effective on January 14, 2005. The plaintiffs argued that their Section 11 claims were not barred by the applicable 3-year statute of repose – despite being brought on February 1, 2008 – because the actual offering did not commence until two weeks after the effective date. The court adopted what it described as the majority position: “Section 11 is violated when a registration statement containing misleading information becomes effective.” The fact that the plaintiffs “did not know that the registration statement was effective as of January 14 is of no consequence for statute of repose purposes.”

Holding: Dismissal affirmed.

Securities litigation? Check. Then you are well on your way to getting your cert petition granted by the U.S. Supreme Court. After agreeing just last week to hear Omnicare and resolve a circuit split over the pleading of false opinions in Section 11 claims, the Court has come back this week with yet another grant of cert in a securities case.

Public Employees’ Retirement System of Mississippi v. IndyMac MBS, Inc. presents the question of whether the filing of a securities class action tolls the applicable statute of repose for individual class members. The Second Circuit found that the statute of repose cannot be tolled because it “create[s] a substantive right in those protected to be free from liability after a legislatively-determined period of time” and “[p]ermitting a plaintiff to file a complaint or intervene after the repose period . . . has run would therefore necessarily enlarge or modify a substantive right and violate the Rules Enabling Act.” The Court will hear the case next term.