Despite being importuned by three former SEC Commissioners to resolve a split among the federal circuits and rule that the efficient market theory that underlies the fraud-on-the-market reliance element of Rule 10b-5 must be equally applied to the antifraud rule’s loss causation and materiality elements, the US Supreme Court refused to hear the appeal and left intact a Ninth Circuit panel ruling that the Commissioners said did not reach a permissible result. The former SEC officials had contended, in an amicus brief, that the Ninth Circuit ruling represented an unwarranted expansion of the Rule 10b-5 implied cause of action that threatens the careful balance Congress has struck in securities fraud actions. Amici are former Commissioners Charles Cox, Joseph Grundfest, and Roberta Karmel and former SEC General Counsel Simon Lorne. . Apollo Group, Inc. v. Policemen’s Annuity and Benefit Fund of Chicago, Dkt. No. 10-649.
Unlike traditional fraud actions, noted amici, modern securities fraud class actions depend on a series of presumptions and methods of proof that substitute for the traditional forms of evidence such as investor testimony. In almost every Rule 10b-5 class action investor reliance on the alleged misrepresentations is presumed on the theory that the impersonal market swiftly assimilates all new material information and incorporates it in securities prices. This presumption was enshrined in Rule 10b-5 by the Supreme Court in its 1988 opinion in Basic Inc. v. Levinson, which formally adopted the fraud-on-the-market theory of investor reliance.
Judicial acceptance of the efficient market theory of swift market incorporation of new, material information gave plaintiffs a powerful weapon since by pleading and proving that a market is efficient they can recover damages without proof that anyone actually relied on an alleged misrepresentation, based on the theory that the unsleeping eye of the market took notice and incorporated the misrepresentation into its prices.
But the circuit courts of appeal have split over how to apply the efficient market theory to market responses to true information for purposes of proving the elements of loss causation and materiality under Rule 10b-5. Some Circuits hold that if the market fails to react to an initial corrective disclosure of facts, the plaintiffs cannot prove that such disclosures were the cause of their losses, even if those losses followed some later disclosure repackaging and commenting on the same facts.
The Ninth Circuit, in this case, took the opposite view. The market for the company’s stock, whose efficiency was presumed for purposes of reliance, did not show a statistically significant response to initial reports of an adverse report by the Department of Education that undermined the company’s prior statements, nor to subsequent extensive press reports detailing the troublesome findings of that report. Yet, noted the former Commissioners, the Ninth Circuit found it legally permissible for plaintiffs to establish loss causation. from the market’s delayed reaction to the analyst reports and to recover damages from the days when the original facts were disclosed. It is the view of amici that, under the efficient capital market theory as it is applied to the reliance inquiry, and as it is applied in other Circuits to materiality and loss causation, this is not a permissible result.
Further, in amici’s view, the split among the Circuits creates an unpredictable landscape for securities class actions and encourages forum shopping in search of courts that will judicially expand the boundaries of recoverable losses. The Ninth Circuit’s rule leaves the determination of recoverable losses under Rule 10b-5 uncertain from case to case and Circuit to Circuit, and untethered from the efficient market theory that gives the claim life in the first instance.
The former SEC Commissioners had urged the Court to put an end to the confusion by granting certiorari and clarifying that any lawsuit using the efficient capital market theory to establish the reliance element of the claim must apply the same theory to establish the materiality and loss causation elements as well. If the efficient market theory is to form the basis of a lawsuit, they reasoned, it must be applied consistently to all elements of the claim.
Amici also argued that the Ninth Circuit’s loss causation amounts to a judicial expansion of the implied Rule 10b-5 cause of action, enabling plaintiffs to selectively use the efficient capital market theory to sustain a presumption of reliance while disregarding precisely the same theory for purposes of proving loss causation and materiality. Noting that the Supreme Court has consistently rejected such expansions, the former Commissioners invited the Court to take this opportunity to rein in unreasonable extensions of the efficient markets theory.