On June 6, 2011, the Supreme Court issued a unanimous decision in Erica P. John Fund, Inc. v. Halliburton Co. (No. 09-1403), holding that it is not necessary for plaintiffs in federal securities fraud cases to establish “loss causation” in order for their cases to proceed as class actions. While this ruling will affect how class-action securities fraud cases are litigated in the Fifth Circuit, it should have little impact in other Circuits that have already rejected proof of loss causation as a prerequisite for class certification. The Supreme Court’s decision did not address how evidence regarding the price impact of alleged misstatements may be used in litigating whether the element of reliance is susceptible to class-wide treatment and thus left unaltered the law in several other Circuits, including the Second Circuit, on that issue.
In Erica P. John Fund, the plaintiff investors sued Halliburton and one of its executives over allegedly fraudulent misstatements concerning the company’s litigation exposure, its revenues and the effects of a merger. After defeating the defendants’ motion to dismiss the case, the plaintiffs sought to have the case proceed as a class action. Following prior Fifth Circuit case law, the district court declined to certify a class based on the plaintiffs’ failure to prove loss causation. On interlocutory appeal, the Fifth Circuit adhered to its precedents and affirmed the district court’s denial of class certification.
After granting certiorari, the Supreme Court reversed. It began by observing that in securities fraud cases, class action status “often turns on the element of reliance.” Id. at 4. In its seminal decision of Basic Inc. v. Levinson, 485 U.S. 224 (1988), the Court recognized a rebuttable presumption of reliance based on the “fraud-on-the-market” doctrine. This doctrine allows plaintiffs to prove reliance on a class-wide basis, even when not all investors in the class actually read or heard the defendants’ alleged misstatements. Based on principles of financial economics, the doctrine presumes that in an efficient market, material, public misrepresentations are quickly priced into a company’s share price, and that when investors buy stock at the prevailing market price, they are indirectly relying on any alleged misrepresentations that were affecting the price at the time of their purchase. Erica P. John Fund, slip op. at 4-5.
The Fifth Circuit had imposed an additional requirement to invoke the Basic presumption of reliance: namely, that the plaintiffs also must establish loss causation—that is, that their losses were caused when the alleged fraud was revealed to the market, and the share price declined as a result. Other Circuits, such as the Second, Third and Seventh Circuits, have held that proof of loss causation is not a prerequisite to invoking the fraud-on-the-market presumption or obtaining class action status.
In rejecting the Fifth Circuit’s approach, the Supreme Court held that requiring plaintiffs to establish loss causation at the class certification stage of a case “is not justified by Basic or its logic.” The Court distinguished between the fraud-on-the-market presumption of reliance and the separate element of loss causation, which “addresses a matter different from whether an investor relied on a misrepresentation, presumptively or otherwise, when buying or selling a stock.” Id. at 6. “The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation”—in other words, proof of loss causation, the Court held—“has nothing to do with whether an investor relied on the misrepresentation in the first place . . . .” Id. at 7.
The Court’s rejection of the Fifth Circuit’s loss causation requirement was not surprising, considering that even Halliburton had conceded “that securities fraud plaintiffs should not be required to prove loss causation in order to invoke Basic’s presumption or otherwise achieve class certification.” Id. at 8. The Court also declined to consider whether the Fifth Circuit’s loss causation analysis could still be relevant at the class certification stage to assessing whether the defendants’ alleged misstatements had any “market impact” on Halliburton’s stock price at the time of the plaintiffs’ purchases. Id. at 9. Instead, the Court allowed the Fifth Circuit to consider this question in the first instance on remand. Id.
The Court’s ruling in Erica P. John Fund should have no immediate effect on the law in other Circuits, such as the Second Circuit, which expressly permits defendants to attempt to rebut market impact as part of the class certification analysis. See In re Salomon Analyst Metromedia Litig., 544 F.3d 474, 485 (2d Cir. 2008). Further, the decision has no effect on what securities fraud plaintiffs are required to prove to prevail on their claims on the merits. Importantly, the Supreme Court reaffirmed that loss causation is an element of the plaintiff’s claim, and that proving loss causation requires evidence that the correction of the defendants’ alleged misstatements, and not some other factor, caused the decline in a company’s share price. Erica P. John Fund, slip op. at 6. The Court also reaffirmed that the Basic presumption of reliance is rebuttable, and that the presumption applies only “so long as” the alleged misrepresentation “was reflected in the market price at the time of [the plaintiff’s] transaction.” Id. at 7.
See a copy of the decision.