Wednesday, November 08, 2017

What is the level of proof needed to invoke the Basic presumption of reliance?

By Rodney F. Tonkovic, J.D.

A petition for certiorari asks the Supreme Court to consider the proof required to establish the Basic presumption of reliance. The petitioner, Brazilian oil giant Petrobras, maintains that in a decision granting class certification, the Second Circuit erroneously concluded that the Basic presumption can be based entirely on factors unrelated to whether the alleged misstatement had even an indirect impact on share price. The petition also asks the Court to address Rule 23's requirement that class membership can be ascertained through administratively feasible means (Petroleo Brasileiro S.A. - Petrobras v. Universities Superannuation Scheme Limited, November 1, 2017).

Kickbacks. The action was brought by purchasers of debt securities in Petrobras. Once one of the largest companies in the world, Petrobras's value plummeted after the exposure of a multi-year, multi-billion-dollar money-laundering and kickback scheme, carried out by a cartel of Brazilian construction contractors, suppliers, and corrupt Petrobras executives. According to the investors, Petrobras, which denied any wrongdoing, was complicit in concealing information about the kickback cartel from investors and the public.

The district court certified two classes for money damages: one asserting claims under the Securities Act, and the other under the Exchange Act. Petrobras appealed, arguing that court erred in finding a class-wide presumption of reliance under the "fraud on the market" theory. The company also challenged the court's conclusion that the proposed classes were ascertainable and administratively manageable.

The Second Circuit affirmed the district court’s ruling that the Exchange Act class was entitled to a presumption of reliance under Basic. Petrobras argued that the district court gave undue weight to the plaintiffs' empirical test, which measured the magnitude of responsive price changes in Petrobras securities without considering the direction of those changes. The panel, however, declined to impose a blanket rule requiring district courts to rely on directional event studies and directional event studies alone at the class certification stage. The panel also rejected the argument that the district court should have applied a "heightened" ascertainability requirement, under which any proposed class must be "administratively feasible." According to the panel, courts must weigh the competing interests inherent in any class certification decision, and a class is ascertainable if it is defined using objective criteria that establish a membership with definite boundaries.

Basic presumption. The petition first asks the court to consider whether the legal standard to invoke Basic's presumption of reliance at minimum requires empirical evidence that a security general reacted in a directionally appropriate manner to new material information, or can the presumption be based entirely on other factors unrelated to whether the alleged misstatement had price impact. Petrobras asserts that the Second Circuit's ruling has dramatically lowered the threshold for class certification in securities fraud class actions and conflicts with the Supreme Court's ruling in Halliburton II. According to the petition, under the Second Circuit's decision, a plaintiff can benefit from the Basic presumption without showing even indirect evidence of price impact, and a defendant is prevented from using even direct evidence of price impact to rebut the presumption.

Under the Second Circuit's ruling, the petition maintains, a plaintiff can establish reliance by showing that a security had any price reaction without showing a predictable cause-and-effect relationship between the news and the price movement. If the price movement is in the wrong direction, there is no basis to presume that the price reflects the fraud such that the plaintiff could be presumed to have purchased in reliance on the alleged misrepresentation. Further, the Second Circuit made the presumption effectively irrebuttable by implying that directional event studies are of limited utility due to "methodological constraints."

The petition goes on to note that, in the 29 years since Basic, district courts have struggled with the standard for the presumption of reliance and differ greatly as to how market efficiency must be established. While the Cammer test is influential, the petition says, it has come under criticism for uncertainty and imprecision. And, courts have added more factors to the Cammer test, resulting in an ad hoc approach with similar circumstances yielding different determinations of market efficiency. This case, the petition contends provides a rare opportunity to resolve almost 30 years of confusion on an important issue.

Administrative feasibility. The petition asks further whether Rule 23 requires proponents of class certification to show that class membership can be reliably ascertained through administratively feasible means. Three circuits (the Third, Fourth, and Eleventh) have held so, the petition says, while four more (the Second, Sixth, Seventh, and Ninth) have taken the contrary position. In this case, the Second Circuit held that Rule 23 does not contain an independent feasibility requirement and requires only that a class can be defined using objective criteria that establish a membership with definite boundaries.

Here, Petrobras noted that its notes are traded over-the-counter across four continents, and there is no administratively feasible means to ascertain whether the notes were purchased in "domestic transactions," as required by Morrison. If putative class members cannot determine whether they are members, the petition asserts, they are unable to make fundamental decisions affecting their rights. In addition to due process concerns, the Second Circuit's decision allows a named plaintiff to demand billions of dollars on behalf of "domestic" purchasers without worrying about whether class members can be ascertained. The Second Circuit, the petition states in closing, has abdicated an essential gatekeeping function by not requiring an administratively feasible means of ascertaining class membership.

The petition is No. 17-664.