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.