The Second Opinion: U.S. Supreme Court to Reconsider Fraud-on-the-Market Theory

On November 15, 2013, the U.S. Supreme Court agreed to hear an appeal in which it will reconsider the "fraud-on-the-market" theory that has been one of the cornerstones of private securities litigation in the United States for the past 25 years.  The questions presented to the Court in Halliburton Co. v. Erica P. John Fund, Inc. are as follows:

1. Whether this Court should overrule or substantially modify the holding of Basic Inc. v. Levinson, 485 U.S. 224 (1988), to the extent that it recognizes a presumption of classwide reliance derived from the fraud-on-the-market theory.

2. Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock.

This is the second time the Halliburton case has come before the U.S. Supreme Court.  The Court previously decided in Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179 (2011) that plaintiffs need not prove loss causation to obtain class certification of secondary market misrepresentation claims under SEC Rule 10b-5.  But the potential implications of Halliburton 2 are much broader.

In order to establish liability under Rule 10b-5, the plaintiff must show that it relied upon the defendant's misrepresentation when purchasing or selling their security: Amgen Inc. v. Conn. Ret. Plans & Trust Funds, 133 S. Ct. 1184, 1192 (2013).  Although the parallel Canadian securities legislation permits secondary market claims without regard to the plaintiff's reliance, a similar reliance requirement exists in Canada for the common law torts of fraudulent and negligent misrepresentation: Parna v. G. & S. Properties Ltd., [1971] SCR 306 at 316-320; Sharbern Holding Inc. v. Vancouver Airport Centre Ltd.[2011] 2 SCR 175 at paras. 121 and 129.  When this requirement is applied in a class action, it can make certification very difficult to obtain, since the individual issues associated with proving reliance will often overwhelm the issues that are common to the class.

The fraud-on-the-market theory was developed to combat this difficulty.  As accepted in Basic Inc. v. Levinson, 485 U.S. 224, 241-242 (1988), to which the theory is generally traced, fraud-on-the-market creates a rebuttable presumption of class-wide reliance based on the following logic:

The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business. . . . Misleading statements will therefore  defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. . . . The causal connection between the defendants' fraud and the plaintiffs' purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations.

Since Basic was decided, the theory has been criticized by several courts and commentators.  In Canada, the theory was decisively rejected as a substitute for proof of reliance in common law tort claims in Kripps v. Touche Ross & Co. (1990), 52 B.C.L.R. (2d) 291 (S.C.), aff'd (1992), 94 D.L.R. (4th) 284 (B.C.C.A.), leave to appeal to S.C.C. refused, [1992] S.C.C.A. No. 490; Carom v. Bre-X Minerals Ltd. (1998), 41 O.R. (3d) 780 (Gen. Div.); and First Choice Capital Fund Ltd. v. First Canadian Capital Corp. (1999), 179 Sask. R. 221 (Q.B.).  Further as the Petition for a Writ of Certiorari filed in Halliburton 2 points out (Courtesy of SCOTUSblog), the "efficient market" hypothesis at the heart of Basic is under serious attack ("For instance, 'the market did not react to publicly available information about the impact of a breakthrough in cancer research on a corporation until the New York Times wrote about it more than five months after the original release.' ... Similarly, Wall Street Journal reports on insider trades appear to quickly affect a stock’s trading price, despite days-earlier disclosure of the same information by the SEC." Petition, at 16-17)

The Halliburton 2 appeal gives the U.S. Supreme Court a chance to revisit this debate.  Further, the appeal is a timely one.  As my colleague Kirsten Thompson noted in a previous post, in Amgen, decided less than 10 months ago, four of the nine justices criticized Basic or expressed a willingness to reconsider it if the issue were before the Court.  It will be interesting to see how these justices react to the question when it is squarely raised on appeal.

Whatever the U.S. Supreme Court decides, Halliburton 2 will be important to Canadian businesses in at least two ways.  First, it could serve to dramatically curtail the potential liability exposure of Canadian public companies that are listed or dual-listed in the United States.

Second, even within Canada itself, a ruling by the U.S. Supreme Court that rejects or criticizes the fraud-on-the-market theory could be a significant development.  Despite the Canadian cases cited above in which the fraud-on-the-market theory has been rejected, there are several other cases where certification judges have accepted a virtually identical doctrine, known as the "efficient market" theory, to find a rebuttable presumption of class-wide reliance: Silver v. Imax Corp. (2009), 86 C.P.C. (6th) 273 (Ont. S.C.J.) at paras. 56-70 and 190, leave to appeal to Ont. Div. Ct. refused, 2011 ONSC 1035; Dobbie v. Arctic Glacier Income Fund, 2011 ONSC 25 at paras. 88-91, leave to appeal to Ont. Div. Ct. granted, 2012 ONSC 773; Dugal v. Manulife Financial Corp., 2013 ONSC 4083 at para. 93.  This approach has been challenged by other certification judges as an attempt to reintroduce the fraud-on-the-market theory through the back door: McKenna v. Gammon Gold Inc., 2010 ONSC 1591 at paras. 151-161, var'd on other grounds, 2011 ONSC 3782 (Div. Ct.); Green v. Canadian Imperial Bank of Commerce, 2012 ONSC 3637 at paras. 595-600; Trustees of the Millwright Regional Council of Ontario Pension Trust Fund v. Celestica Inc., 2012 ONSC 6083 at paras. 163-173, reconsideration allowed, 2013 ONSC 1052; Bayens v. Kinross Gold Corp., 2013 ONSC 6864 at para. 242.

The U.S. Supreme Court's ruling in Halliburton 2 could be an important step to resolving this Canadian debate.

The McCarthy Tétrault Opinions Group consists of members of the firm’s litigation department whose practices focus on written advocacy and the provision of strategic advice and opinions in the context of complex business disputes and transactions.  The members of the Opinions Group are Anthony Alexander, Martin Boodman, Brandon Kain, Hovsep Afarian and Kirsten Thompson.

Halliburton; Erica P. John; fraud-on-the-market; reliance; Rule 10b-5; securities litigation; class actions; misrepresentation;

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