June 2014
Wolters Kluwer Law & Business Briefing
Special Report
Supreme Court affirms fraud-on-the-market
reliance presumption, injects price impact
showing at classification stage
Highlights
✔ Reliance presumption of Basic valid despite
recent challenge
✔ Court held that price impact is an essential
precondition for any Rule 10b–5 class action
✔ There is no reliable evidence that Congress
will ever modify the judicially created
reliance doctrine
✔ University of Michigan Law Professor
Adam Pritchard told Wolters Kluwer that
the Court missed an opportunity to make
class certification more efficient and more
consistent with fraud deterrence
By Jim Hamilton, J.D., LL.M.
In the most serious challenge to the fraud-on-the-market doctrine in
decades, the U.S. Supreme Court ruled that the reliance presumption
of Basic, Inc. v. Levinson (U.S. 1988) remains valid, but that a company
defending a securities fraud action should have the opportunity to rebut
the presumption of reliance before class certification with evidence of a lack
of price impact. Writing for the Court, Chief Justice Roberts said that if
reliance is to be shown through the Basic presumption, the publicity and
market efficiency prerequisites must be proved before class certification;
otherwise, the fraud-on-the-market theory completely collapses, rendering
class certification inappropriate.
Investors can recover damages in a private securities fraud action only if
they prove that they relied on the defendant’s misrepresentation in deciding
to buy or sell a company’s stock. In Basic, the Court held that investors
could satisfy this reliance requirement by invoking a presumption that
the price of stock traded in an efficient market reflects all public, material
information, including material misstatements. In such a case, anyone who
buys or sells the stock at the market price may be considered to have relied
on those misstatements.
The vehicle for the attack on the fraud-on-the-market presumption is
the case of Halliburton v. Erica P. John Fund, which posed the question of
rebutting the presumption of reliance at the class action certification stage
and indeed challenged the continued efficacy of Basic itself.
Efficient market hypothesis. In 1988, the Supreme Court created a
bedrock principle of substantive securities law by endorsing the fraud-onthe-market theory, under which a plaintiff in a securities fraud action can
invoke a rebuttable presumption of reliance on misrepresentations regarding
securities trading in an efficient market.
The Basic Court adopted a legal presumption that the market price of
shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations, and that an investor
who buys or sells stock generally relies on the integrity of the market price.
In an amicus brief filed in the action, the SEC said that the presumption
rests on the common sense premise that material information about a public
company affects the price of the company’s stock. The presumption also
reflects the view that investors may reasonably assume that the market price
has not been tainted by material misinformation.
Holding. The Court declined to overrule the Basic decision based on
new economic theories advanced since 1988. However, the Court held that
price impact is an essential precondition for any Rule 10b–5 class action.
While Basic allows plaintiffs to establish that precondition indirectly, it
does not require courts to ignore a defendant’s direct, more salient evidence
showing that the alleged misrepresentation did not actually affect the
©2014 CCH Incorporated. All Rights Reserved.
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Special Report—Supreme Court affirms fraud-on-the-market reliance presumption
stock’s market price and, consequently, that the Basic
presumption does not apply.
The Court’s judgment was unanimous, but only
Justices Kennedy and Kagan completely joined the Chief
Justice’s opinion. Justices Thomas, Alito, and Scalia
wanted to overrule Basic, and only concurred in the
Court’s judgment. Justice Ginsburg wrote a concurring
opinion, joined by Justices Sotomayor and Breyer,
clarifying that the Court’s opinion recognizes that it is
incumbent upon the defendant to show the absence of
price impact. The Court’s judgment, therefore, should
impose no heavy toll on securities-fraud plaintiffs with
tenable claims.
In concurring only in the judgment, Justices
Thomas, Alito, and Scalia said that “Basic took an
implied cause of action and grafted on a policy-driven
presumption of reliance based on nascent economic
theory and personal intuitions about investment
behavior. The result was an unrecognizably broad
cause of action ready-made for class certification.” In
the Justices’ view, time and experience have shown
the error of the Court’s decision, in Basic, to conform
securities law to the alleged new realities of financial
markets rather than leave that to Congress.
Thus, there was a 6-3 vote to endorse the fraudon-the-market presumption of reliance in Rule 10b-5
securities fraud actions, albeit with a price impact
requirement at the class certification stage, tempered
by the concurrence by Justice Ginsburg, without which
the Court’s opinion does not have a majority. The
Ginsburg concurrence, while short, takes on enormous
importance because of this and molds the opinion in
the understanding by Justices Ginsburg, Sotomayor and
Breyer that it will be incumbent upon the defendant to
show the absence of price impact.
Make no mistake, six Justices have strongly endorsed
the continued viability of the Basic opinion and the
fraud-on-the-market presumption of reliance. The Court
described the presumption of reliance announced in
Basic as a substantive doctrine of federal securities law.
Indeed, it has become a bedrock principle in a number
of securities fraud actions. And this is true even though
the presumption of reliance is a judicially created
doctrine designed to implement a judicially created
cause of action under Rule 10b-5.
The Court is aware, as was the Basic Court at the time,
of the economic theories about the degree to which
the market price of a company’s stock reflects public
information about the company. That debate is not new.
But the Court said that the academic debates have not
refuted the modest premise underlying the presumption
©2014 CCH Incorporated. All Rights Reserved.
of reliance. Basic’s presumption of reliance thus does not
rest on a binary view of market efficiency. In making the
presumption rebuttable, Basic recognized that market
efficiency is a matter of degree and accordingly made it a
matter of proof.
In one of the most elucidating observations on the
presumption of reliance, the Court explained that
the Basic presumption incorporates two constituent
presumptions. First, a showing that the defendant’s
misrepresentation was public and material and that the
stock traded in a generally efficient market entitles the
plaintiff to a presumption that the misrepresentation
affected the stock price. Second, plaintiffs who show that
they purchased the stock at the market price during the
relevant period are entitled to a further presumption that
they purchased the stock in reliance on the defendant’s
misrepresentation. Requiring plaintiffs to prove price
impact directly would take away the first constituent
presumption, held the Court.
Stare decisis. The Court’s respect for precedent, the
principle of stare decisis, had special force here since this
is a statutory interpretation and not a constitutional one
and therefore Congress remains free to alter what the
Court has done and said. The presumption of reliance
provides a way of satisfying the reliance element of the
Rule 10b–5 cause of action. As with any other element
of that cause of action, Congress may overturn or
modify any aspect of the Court’s interpretation of the
reliance requirement, including the Basic presumption
of reliance. Given that possibility, the Court saw no
reason to exempt the Basic presumption from ordinary
principles of stare decisis.
Congress. There is no reliable evidence that Congress
will ever modify the judicially created reliance doctrine,
and indeed Congress has not done so despite having
had several opportunities. The most notable example of
this congressional opportunity was the Private Securities
Litigation Reform Act of 1995. While comprehensively
overhauling the private securities fraud class action
world, Congress left intact the Basic fraud-on-themarket presumption of reliance.
The Court mentions the PSLRA as an example of
Congress addressing concerns about class actions, such
as the concern raised by Halliburton and its amici that
facilitating securities class actions allows plaintiffs to
extort large settlements from defendants for meritless
claims. The Court says that these concerns are more
appropriately addressed to Congress. After all, said
the Court, in the PSLRA Congress sought to combat
perceived abuses in securities litigation with, among
other things, heightened pleading requirements, limits
June 2014
www.wolterskluwerlb.com
on damages and attorney’s fees, and a safe harbor
for certain kinds of statements. While the Court is
undoubtedly correct that such legislation demonstrates
Congress’s willingness to consider policy concerns, there
is no realistic possibility that Congress will legislatively
examine the fraud-on-the-market presumption of
reliance in the near term.
Recent precedent. The Court rejected the idea that
the recent trend away from expanding the judicially created private rights of action like Rule 10b-5 should work
against the fraud-on-the-market presumption of reliance
created in Basic. This idea is misplaced, the Court noted,
adding that the Basic doctrine did not expand the Rule
10b-5 private right of action.
While the Court acknowledged that in rulings after
Basic the Court refused to recognize aiding and abetting liability in a private securities fraud action (Central
Bank) and refused to extend Rule 10b–5 liability to
secondary actors who did not make the misstatements
(Stoneridge), the Basic presumption does not eliminate
the reliance requirement but rather provides an alternative means of satisfying it. While the presumption
makes it easier for plaintiffs to prove reliance, reasoned
the Court, it does not alter the elements of the Rule
10b–5 cause of action, and thus maintains the action’s
original legal scope.
Reactions to Halliburton. A representative of the
U.S. Chamber of Commerce said that the Supreme
Court “took a small first step in a long journey toward
reducing the costs of securities class actions for investors.” Lisa A. Rickard, president of the U.S. Chamber
Institute for Legal Reform, said that the group was
“disappointed, however, that the Court missed an
important opportunity to correct the mistake that Basic
has turned out to be for investors” by allowing securities
class actions that “benefit only a few plaintiffs’ lawyers
and ultimately cost investors billions.” The Chamber
urged Congress to act to cut back on meritless classaction litigation. While the decision “inches toward
bringing securities law back in line with the ordinary
rules for proving fraud cases, much more can and should
be done,” said Lily Claffee, general counsel of the U.S.
Chamber and executive vice president of the National
Chamber Litigation Center.
Halliburton’s counsel, Baker Botts L.L.P., released a
statement noting, “The Supreme Court’s reasoning is
important because in this case and in many other securities cases, there is little proof that the company’s alleged
misstatements distorted the stock price.” According to
Aaron Streett, who argued the case for Halliburton,
“This decision is good news for companies and shareholders that have suffered under the weight of meritless
©2014 CCH Incorporated. All Rights Reserved.
3
class actions.” The firm said that the Court’s ruling “will
enable lower courts to weed out meritless cases before
classes are certified.”
But the Alliance for Justice feared that, while not
expressly overturning the Basic precedent, “the Supreme
Court has placed new barriers in front of shareholders
that could make it far more difficult for them to stand
up for their rights in court against corporations that
have defrauded them.” In a statement, the Alliance urged
the lower federal courts to “heed Justice Ginsburg’s
warning that this decision ‘should impose no heavy toll
on securities-fraud plaintiffs with tenable claims,’” but
the Alliance fears that it will.
Lisa A. Rickard, president of the
U.S. Chamber Institute for Legal
Reform, said that the group was
“disappointed, however, that
the Court missed an important
opportunity to correct the mistake
that Basic has turned out to be for
investors” by allowing securities
class actions that “benefit only
a few plaintiffs’ lawyers and
ultimately cost investors billions.”
Expert analysis. University of Michigan Law Professor Adam Pritchard told Wolters Kluwer that the Court
missed an opportunity to make class certification more
efficient and more consistent with fraud deterrence. As
a result of the Court’s ruling, he said, we now have both
market efficiency and price impact. He also noted that
the perverse policy implications of Basic remain intact,
but that some defendants will now be able to defeat class
certifications. Professor Pritchard predicted that the price
impact determination will become a war of experts.
Impact. While the full impact of the Court’s ruling
will not be known until district courts begin to apply
the new test, companies and other defendants will
June 2014
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Special Report—Supreme Court affirms fraud-on-the-market reliance presumption
now have the opportunity to present evidence of price
impact at the certification stage. More specifically, the
Court said that defendants must be given the chance
before class certification to defeat the presumption
through evidence that an alleged misrepresentation
did not actually affect the market price of the stock.
To be sure, this is a victory for those defending against
securities fraud class actions, but not momentously
significant since the Court recognized that price
impact evidence could always be submitted at the
merits stage.
The more momentous ruling is that by a 6-3 margin
the Court delivered a strong endorsement of the
continued viability of the Basic presumption of reliance
and the fraud-on-the-market doctrine that underpins it
at a time when many commenters thought it was going
down along with the efficient market theory. Since it is
highly unlikely that Congress will, after 26 years and
numerous opportunities, disturb the Basic presumption
of reliance in securities fraud cases, the Court’s opinion
ensures that Basic will be part of the securities regulation firmament for many years to come.
About the Author
James Hamilton is a Principal Analyst at Wolters Kluwer
Law & Business, a leading provider of corporate and
securities information and a prolific blogger
(Jim Hamilton’s World of Securities Regulation, at
http://jimhamiltonblog.blogspot.com). Hamilton has been
tracking, analyzing and explaining securities law and
regulation for over 30 years as an analyst for Wolters
Kluwer Law & Business. He has written and spoken
extensively on federal securities law and is cited as an
authority in the Senate Banking Committee Report
(S. 111-176) of the Dodd-Frank Act. His analysis of
that legislation, the Dodd-Frank Wall Street Reform and
Consumer Protection Act: Law, Explanation and Analysis,
is widely read. His earlier analysis of the Sarbanes-Oxley
Act, the Sarbanes-Oxley Manual: A Handbook for the Act
and SEC Rules, is considered a definitive explanation of
the Act. His other works include the popular guidebook
Responsibilities of Corporate Officers and Directors under
Federal Securities Law and the monthly newsletter
Hedge Funds and Private Equity: Regulatory and Risk
Management Update. In addition to his many books
and articles, Hamilton serves as a leading contributor
to Securities Regulation Daily and the industry-standard
publication, the Federal Securities Law Reporter.
Hamilton received an LL.M. from New York University
School of Law.
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June 2014
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