Sunday, March 16, 2014

Supreme Court Oral Argument in Fraud-on-the-Market Case Reveals Effort to Avoid Overruling Basic

The U.S. Supreme Court heard oral argument in a case involving the continued efficacy of the fraud-on-the-market presumption of reliance in securities fraud actions endorsed by the Court in its 1988 ruling in Basic, Inc. v. Levinson. It became clear during the arguments that the Justices, with their abiding sense of precedent and respect for stare decisis, were looking for a way to come to grips with the argument that the efficient market theory underlying the presumption may not be relevant without directly overruling the Basic decision. Justice Kennedy, for example, seized on the event study idea enunciated by a group of law professors in their amicus brief. Other Justices explored the event study position as a way to avoid the dramatic consequences of overruling the Basic decision. Halliburton v. Erica P. John Fund, Dkt. No. 13-317,

In their amicus brief, the law professors said that an event study measuring the effect of an event, such as an earnings announcement, on a company’s stock price is the best available tool to show reliance and examine market distortion. They described an event study as the gold standard for determining if the market relied on a misstatement.

Arguing for the petitioner, Aaron Streett urged the Court to overrule Basic v. Levinson because it was wrong when it was decided and it is even more clearly erroneous today. Basic substituted economic theory for the bedrock common law requirement of actual reliance that Congress embraced in the most analogous express cause of action, argued counsel, and substituted economic theory for the bedrock common law requirement of actual reliance.

Justice Kennedy noted that the law professors offer what the Justice called a ``midway position’’ that there should be an event study. In his view, this position would be a substantial answer to the challenge to the economic premises of the Basic decision. Even under the Basic framework, reasoned Justice Kennedy, at the merits stage there has to be something that looks very much like an event study. That being said that you are going to do an event study anyway, he continued, why not have it at the class certification stage. But Justice Sotomayor was concerned that this would turn the class certification into a full-blown merits hearing. Chief Justice Roberts said that an event study would be a lot more difficult and laborious to show than market efficiency in a typical case.

Justice Alito questioned how accurately an event study could distinguish between the effect on price of the facts contained in a disclosure and an irrational reaction by the market, at least temporarily, to the facts contained in the disclosure. Mr. Streett said that event studies are very effective at making that sort of determination.

David Boies, for the respondent, emphasized that the premise of the Basic decision was not economic theory, but rather commerce. It is also a premise of Congress. It is the premise of the securities laws that when you make fraudulent misrepresentations you make them public and it affects the market price.

But it must affect the market price almost immediately, said Justice Alito, adding that why should a purchaser an hour or two after the disclosure be entitled to recovery if in that particular market there is a lag time in incorporating the new information.

Justice Kennedy asked if the event study theory is flawed. Mr. Boies replied that it is not, adding that you can have event studies that try to determine whether or not a particular price movement was related to a particular piece of information.

Chief Justice Roberts asked Deputy Solicitor General Malcolm Stewart if the feasibility and prevalence of event studies were around in 1988 when Basic was decided. They were around, he replied, but were probably much less sophisticated. But they could be used to establish both market efficiency and the price impact of the misstatement.  

Justices Kagan and Kennedy both asked how adopting the law professors’ position on event studies would affect the securities industry and individual decision making regarding securities. Mr. Stewart understands the event study position to be advocating a shift away from analyzing the general efficiency of the market and focusing only on the effect or lack of effect on the particular stock. In that sense, he said,  the consequences of adopting the event study position would not be nearly as dramatic as overruling Basic.

Mr. Streett said that Basic’s judicially-created presumption preserves an unjustified exemption from Rule 23 that benefits only securities plaintiffs. He contended that the most direct course of action would be to overrule Basic altogether and require a showing of actual reliance.

Justice Ginsburg noted that the Basic presumption of reliance is a rebuttable presumption that does not rely strictly and exclusively on an economic theory. The Exchange Act, probability and common sense would also lead to the reliance presumption. Justice Kagan observed that it is a presumption that is dependent on the facts in a particular case.

Justice Alito queried how often defendants have been successful in rebutting the Basic presumption of reliance. It is virtually impossible to do so, replied Mr. Streett, adding that it is very unusual outside of the Second Circuit, which allows rebuttal with regard to price impact. Outside of the Second Circuit, rebuttal of the reliance presumption is as rare as hen’s teeth, said counsel. While the Basic Court thought that the presumption could be rebutted, he continued, it has turned out that the federal courts have treated it as essentially irrebuttable.

Mr. Boies noted that the fraud-on-the-market presumption is a substantive doctrine of federal securities law. It has been ratified by Congress in the Private Securities Litigation Reform Act and the Securities Litigation Uniform Standards Act. These pieces of legislation were enacted against the backdrop of the fraud-on-the-market theory.


Justice Scalia cautioned that to act on the assumption that the courts are going to do what they have been doing is quite different from approving what they have been doing. Congress passed the PSLRA and SLUSA under the assumption that the courts were going to continue Basic. That is not necessarily a ratification of Basic, said the Justice, but just an acknowledgement of reality.  

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