So, Halliburton Co. v. Erica P. John Fund, Inc. (2014) (“Halliburton II”) came down, and to call it a change in the law is too generous – at best, it might qualify as a “clarification.” After all of the angst over the possibility that the Court might give plaintiffs the burden of proving the price impact of a particular misstatement, the Court soundly rejected that argument, reaffirmed Basic, Inc. v. Levinson (1988), and instead merely allowed defendants to rebut the fraud on the market presumption. Because demonstrating a lack of price impact is as difficult as showing price impact in the first place, I don’t expect Halliburton II to change much in existing law – if anything, some of the rhetoric may make matters easier for plaintiffs.
[More under the cut]
As I’ve previously explained, fraud on the market theory – which the Supreme Court reaffirmed in Halliburton II – is actually two separate presumptions in the plaintiffs’ favor. The first is that in an open and well-developed market, material information affects stock prices. Therefore, if the defendant issues false material information, the relevant stock prices will be distorted. The second presumption is that investors who trade in such a market do so with subjective reliance on the market price. Together, the two presumptions satisfy the element of reliance in a 10b-5 fraud claim. If the plaintiff subjectively trusts the market to supply her with the “right” price, and the price is distorted by the defendant’s fraud, the plaintiff has “relied” on the defendant's fraud.
In Halliburton II, the defendants mounted a number of challenges to the fraud on the market presumptions. Among other things, the defendants argued that the market simply is not “efficient enough” to justify the presumptions. As a fallback, the defendants claimed that, at minimum, the plaintiffs should have the initial burden of demonstrating that a particular misstatement affected stock prices, rather than obtaining the benefit of a presumption to that effect.
As I previously posted, this would have been an enormous challenge for plaintiffs. This is because most of the time, a false statement isn’t designed to push stock prices up, but to keep stock prices level – or even to slow their descent. The defendants might falsely claim, for example, that earnings met analyst expectations for the quarter, or came in just slightly under expectations when in fact there had been a precipitous drop. In such circumstances, there will not be any detectable price movement in response to the lie.
Usually, then, plaintiffs might try to show “price impact” by demonstrating that the market reacted to disclosure of the truth. The problem with that, however, is that a disclosure at Time 2 is never quite the same thing as a misstatement at Time 1. For example, if a company claims to comply with federal safety standards, and then there’s an explosion that destroys one of its plants, what does the resulting stock price drop tell you about how the market treated the original misstatements about safety? Nothing, really – whether or not the market reacted to the original misstatements, you’d still expect to see a drop upon catastrophic news.
But the Supreme Court didn’t go that route. Instead, the Court simply held that the defendants may rebut the presumption of price impact. This possibility was raised in Basic itself, which explicitly held that the presumption might be rebutted if the defendants showed that, for example, the truth was known, or became known, to a sufficient number of market actors. Basic, however, suggested that this rebuttal showing might only be appropriate at the trial stage, leaving some degree of uncertainty about whether rebuttal evidence could be offered at class certification.
Despite that uncertainty, however, two circuits – the Second and the Third – both definitively held years ago that defendants had the right to rebut price impact at class certification. See In re Salomon Analyst Metromedia Litig., 544 F.3d 474 (2d Cir. 2008); In re DVI, Inc. Sec. Litig., 639 F.3d 623 (3d Cir. 2011). No circuit, until the Fifth Circuit in Halliburton II, had ever explicitly held to the contrary. This is why I call the Supreme Court’s holding a “clarification” rather than a change in law.
That said, defendants have a heavy burden here, for the same reason that the plaintiffs would have had a heavy burden if the Supreme Court had forced them to prove price impact in the first instance. There might not be any stock price movement when the initial lie is uttered, but that only tells you that the market was expecting the news – not that the news had no impact on prices. Or, to put it another way, had the defendants told the truth (earnings were below expectations) or remained silent (failed to issue a required earnings report), the stock price would have fallen. The lie kept the stock price level.
If defendants cannot prove a lack of price impact by showing that prices remained steady when the lie was first uttered,they may instead try to prove lack of price impact by showing lack of price movement upon disclosure of the truth. The problem is that the defendants then run smack into Erica P. John Fund, Inc. v. Halliburton Co. (2011) (“Halliburton I”) – which laid out all the reasons why a lack of loss causation has nothing to do with whether the stock price was inflated initially. Maybe, for example, the truth leaked out in some way that caused the stock price to fall in gradual, undetectable increments. Maybe some horrible catastrophe intervened and brought the stock price so low that new information had no further effect. All of these possibilities bear on plaintiffs’ ability to satisfy the element of loss causation in a 10b-5 action, but they tell you nothing about whether the price was impacted initially.
It is for this reason that in the past, defendants have not usually fought for the right to rebut price impact per se – instead, they have tried to get courts to accept proxies for price impact that are easier to prove, namely, loss causation and materiality. But the Supreme Court rejected those proxies in Halliburton I and Amgen Inc. v. Conn. Ret. Plans & Trust Funds (2013).
What does make Halliburton II interesting, however, was the manner in which the Court described market efficiency.
One ongoing debate in 10b-5 litigation concerns how efficient is efficient. Plaintiffs are only permitted the benefit of the fraud on the market presumptions if they can first show that the market was open and well-developed – sometimes described by courts as “efficient,” even though the concept of efficiency in the legal context bears little resemblance to how that term is used by economists.
Courts have developed a rather strict test for 10b-5 efficiency, generally requiring the plaintiffs to show that the market rapidly and fully reflects available information. How rapidly? What is fully? There are no bright line rules, but courts have often wanted to see information fully incorporated into stock prices within hours of its announcement.
The problem, of course, is that no market is perfect – which is exactly the argument that the Halliburton defendants made. Studies show, for example, that new information may take weeks to be fully impounded into a stock’s price, even for stocks that are widely followed and traded.
As a result, scholars have often argued that courts’ tests for efficiency are not only too open-ended, but they are also too demanding. So, maybe a stock shows abnormal returns for a prolonged period of time after new information is announced, suggesting that it is continuing to react to the information – so what? Why should that mean that a plaintiff whose purchase was only partly affected by the false information – because the information was not yet fully reflected in the stock price – should be denied any recovery at all? Doesn’t it make more sense to sort out the precise degree to which prices were affected in the damages phase, rather than in the class certification phase? See, e.g., Donald Langevoort, Basic at Twenty: Rethinking Fraud on the Market, Wis. L. Rev. 151 (2009); Bradford Cornell & James Rutten, Market Efficiency, Crashes, and Securities Litigation, 81 Tul. L. Rev. 443 (2006).
Interestingly enough, the Supreme Court’s language in Halliburton II opens a path to a looser definition of efficiency that more closely comports with the relevant legal question, i.e., whether the market has characteristics that make it reasonable to assume that false statements affect stock prices in some way. In his opinion for the Court, Chief Justice Roberts described the Basic presumption as “modest,” and emphasized that the presumption does not depend economists’ definitions of efficiency, or on a theory of how quickly or completely market prices are affected by material information. He even recognized that an investor “relies” on market efficiency when she purchases stock in the belief that the market has failed to recognize its true value – because she is necessarily expecting that the market will correct itself “within a reasonable period.” This is an extremely generous concept of “market efficiency,” apparently allowing for even a substantial delay between the issuance of information and its reflection in stock prices. If lower courts read the Court’s opinion this way, plaintiffs may find that they have an easier time proving efficiency in borderline cases.