The US Supreme Court ruled that plaintiffs in a private securities fraud do not have to prove loss causation in order to obtain class certification. At the invitation of the Supreme Court, the SEC had filed an amicus brief asking the Court to resolve a split in the federal circuits over when a plaintiff in a securities fraud action relying on a fraud-on-the-market reliance presumption must demonstrate loss causation to obtain class certification. The question presented is a recurring and important one, emphasized the SEC. The Court has now resolved that split among the federal circuits and held that an inability to prove loss causation would not prevent a plaintiff from invoking the rebuttable presumption of reliance.. Erica P. John Fund, Inc. v. Halliburton Co., et al., Dkt. No. 09-1403.
Writing for a unanimous Court, Chief Justice Roberts noted that the Court has never before mentioned loss causation as a precondition for invoking the rebuttable presumption of reliance as enunciated in the Court’s 1988 opinion in Basic, Inc. v. Levinson. Indeed, the term “loss causation” does not even appear in the Basic opinion, and for good reason, said the Chief Justice, since loss causation addresses a matter different from whether an investor relied on a misrepresentation, presumptively or otherwise, when buying or selling a stock.
In order to certify a case as a class action, a fed¬eral district court must determine that the proposed class satisfies all of the requirements contained in Fed¬eral Rule of Civil Procedure 23, one of which is that questions of law or fact common to class members predominate over any questions affecting only individual members. Whether common questions of law or fact predominate in a securities fraud action often turns on the element of reliance. The Fifth Circuit determined that the plaintiffs had to prove the separate element of loss causation in order to establish that reliance was capable of resolution on a common, class wide basis.
The Chief Justice noted that the traditional and most direct way plaintiffs can demonstrate reliance is by showing that they were aware of a company’s statement and engaged in a relevant transaction, such as purchasing common stock, based on that specific misrepresentation. In that situation, the plaintiff plainly would have relied on the company’s deceptive conduct. A plaintiff unaware of the relevant statement, on the other hand, could not establish reliance on that basis.
The Court recognized in Basic, Inc. v. Levinson, however, that limiting proof of reliance in such a way would place an unnecessarily unrealistic evidentiary burden on the Rule 10b–5 plaintiff who has traded on an impersonal market. The Court also observed that requiring proof of individualized reliance from each member of the proposed plaintiff class effectively would prevent them from proceeding with a class action, since individual issues would overwhelm the common ones.
The Court in Basic sought to alleviate those related concerns by permitting plaintiffs to invoke a rebuttable presumption of reliance based on what is known as the fraud-on-the-market theory, under which the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations. Because the market transmits information to the investor in the processed form of a market price, it can be assumed that an investor relies on public misstatements whenever he or she buys or sells stock at the price set by the market. The Court also made clear that the presumption could be rebutted by appropriate evidence.
Chief Justice Roberts noted that it is undisputed that securities fraud plaintiffs must prove certain things in order to invoke Basic’s rebuttable presumption of reliance. It is common ground, for example, that plaintiffs must demonstrate that the alleged misrepresentations were publicly known, else how would the market take them into account, that the stock traded in an efficient market, and that the relevant transaction took place between the time the misrepresentations were made and the time the truth was revealed.
The Fifth Circuit holding that the plaintiffs also had to establish loss causation at the certification stage to trigger the fraud-on-the-market presumption was not justified by Basic or its logic, said the Court. Under Basic’s fraud-on-the-market doctrine, an investor presumptively relies on a defendant’s misrepresentation if that information is reflected in [the] market price of the stock at the time of the relevant transaction. Loss causation, by contrast, requires a plaintiff to show that a misrepresentation that affected the integrity of the market price also caused a subsequent economic loss.
The Court said that it made clear in its earlier Dura Pharmaceuticals ruling that the fact that a stock’s price on the date of purchase was inflated because of a misrepresentation does not necessarily mean that the misstatement is the cause of a later decline in value. The Court observed that the drop could instead be the result of other intervening causes, such as changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events. If one of those factors were responsible for the loss or part of it, a plaintiff would not be able to prove loss causation to that extent. This is true even if the investor purchased the stock at a distorted price, and thereby presumptively relied on the misrepresentation reflected in that price.
A rule that an inability to prove loss causation would prevent a plaintiff from invoking the rebuttable presumption of reliance would contravene Basic’s fundamental premise that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction. The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, reasoned the Court, either directly or presumptively through the fraud-on-the-market theory. Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.
In its amicus brief, the SEC noted that the Fifth Circuit’s approach to class certification in securities-fraud cases conflicts with the decisions of two other courts of appeals. The Seventh Circuit has ex¬pressly rejected the Fifth Circuit’s approach, said the Commission, and the Sec¬ond Circuit, while allowing some consideration of the merits at the class certification stage, does not require the putative class representative to prove loss causation.