'Fraud on the market' theory survives challenge in the US

In brief

Perhaps the most important unanswered question in Australian class action law is how causation may be established in the context of a shareholder class action. In the United States, this issue has been addressed by the 'fraud on the market' theory. This week the US Supreme Court rejected a challenge to the validity of that theory. Partners Ross Drinnan and Jenny Campbell and Senior Associate Mark Hare report.

Causation in Australian shareholder class actions

The claims made in Australian shareholder class actions are typically founded on allegations that a company's disclosure, or non-disclosure, of material information was misleading or deceptive and a breach of a listed company's continuous disclosure obligations. Proving that the alleged disclosures or non-disclosures caused shareholder loss is an essential element of these claims.

A critical issue, which is yet to be determined by Australian courts, is the method by which causation should be established in shareholder class actions. In particular, whether:

• it is necessary for each claimant to prove actual reliance on the contravening conduct (direct causation); or
• the requirement can be satisfied by general notions of reliance by the market affecting the price at which each claimant purchased and/or sold their shares (market-based causation).

Whether or not direct causation is required will determine the process by which claims are dealt with following the determination of the common issues. That is, whether:

• those claims can be determined collectively with causation essentially being presumed; or
• each claimant must come forward individually to establish that the company's contravening conduct caused their loss.

The uncertainty created by the lack of settled law is an important issue for plaintiffs and defendants alike. As a result, it increases the prospects of shareholder class actions settling before judgment.

The 'fraud on the market' theory

The 'fraud on the market' theory was adopted by a majority of the US Supreme Court in 1988, in Basic v Levinson¹. In that case, the court recognised a rebuttable presumption of shareholder reliance on a company's material public misrepresentations in the context of securities class actions under SEC Rule 10b-5.

The presumption is based on the economic theory that:

• well-developed capital markets efficiently incorporate material information into a company's market price – the 'efficient market hypothesis'; and
• investors purchase stock in reliance on the market price conveying the company's true value.

The effect of the presumption is that misleading, or improperly withheld, information will affect the market price of the security and can therefore be presumed to be the cause of loss to shareholders following a market correction, once the information is disclosed or corrected – proof of individual investor reliance on the conduct is unnecessary.

By dispensing with the need for proof of individual reliance, the 'fraud on the market' theory enables securities class actions to be certified under Rule 23 of the US Federal Rules of Civil Procedure. Without the presumption, the vast majority of securities class actions in the US would not be certified because issues common to the class would not 'predominate' over individual issues.

'Fraud on the market' revisited

The challenge to the Basic presumption (and the underlying 'fraud on the market' theory) arose in the long-running battle for certification of a shareholder class action against Halliburton Co in relation to a series of alleged misrepresentations between June 1999 and December 2001 about its potential liability in asbestos litigation, its expected revenue from certain construction contracts and the anticipated benefits from a merger.

At a hearing before the US Supreme Court in March 2014, Halliburton asked the court to overrule Basic's presumption of reliance and to require every securities fraud claimant to prove that they actually relied on the company's misrepresentation in deciding to buy or sell the company's stock.

'Fraud on the market' survives challenge

This week, the US Supreme Court delivered its judgment.²

By a 6:3 majority, the Supreme Court upheld the presumption of reliance adopted in Basic on the basis that Halliburton had not established the 'special justification' that would be required to overturn such a long settled precedent.

The primary arguments made by Halliburton and the basis for the Supreme Court's rejection of them were as follows:

• Halliburton argued that Basic was founded on an unjustifiably robust view of the 'efficient market hypothesis'. In support of its position, it relied on empirical evidence that had come to light since Basic was decided in 1988 that capital markets are not fundamentally efficient. The court rejected this submission on the basis that Basic was founded on the 'fairly modest' premise that 'market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices' – a principle the court said was accepted by 'even the foremost critics of the efficient-capital-markets hypothesis' and acknowledged by Halliburton in oral argument.
• Halliburton also contested the notion that shareholders invest in reliance on the integrity of the market price. This, it said, ignores investors for whom price integrity is not important – for example, 'value investors' who believe that a stock is overvalued or undervalued and attempt to beat the market by buying undervalued stocks and selling overvalued stocks. The court rejected Halliburton's argument on the bases that:
  • Basic concluded only that most investors will rely on the market price of a share as an unbiased assessment of its value; and
  • the 'value investor' also presumably tries to estimate how undervalued or overvalued a particular stock is, and such estimates can be skewed by a market price tainted by fraud.

Halliburton (and amicus briefs filed in support of its position) also contended that, by facilitating shareholder class actions, the Basic presumption produces a number of serious and harmful consequences. Such class actions, they said, 'allow plaintiffs to extort large settlements from defendants for meritless claims; punish innocent shareholders, who end up having to pay settlements and judgments; impose excessive costs on businesses; and consume a disproportionately large share of judicial resources'. The Supreme Court declined to grapple with these concerns on the basis that they were more appropriately addressed to Congress.

It did, however, rule that defendants may seek to defeat the Basic presumption through direct evidence at the class certification stage, rather than having to wait until trial. This development is being portrayed by legal commentators in the US as an important 'check' in the certification process that will make it harder for claims to be certified, and a potentially powerful tool for defendants.

Relevance to Australian shareholder class actions

In making the case for 'market-based causation', Australian claimants have not typically relied directly on the 'fraud on the market' theory, and have preferred to seek to bring the argument within the framework of common law principles of causation. The economic theory underpinning the 'fraud on the market' theory is, however, highly relevant to their argument.

If the US Supreme Court had overturned the Basic presumption on the basis that the underlying economic theory was outdated, the case for recognising 'marked-based causation' in Australia would have been substantially weakened. This would have significantly changed the context in which shareholder class action risk is assessed and the basis on which settlements are negotiated.

The survival of the theory preserves the status quo and brings us no closer to knowing how the Australian position will be resolved. Accordingly, the 'causation question' remains a serious risk for plaintiffs and defendants alike.

Australian class action procedures do not include a certification process. Nor is it necessary for common issues to predominate over individual issues – in Australia, it is sufficient for there to be one substantial common issue of law or fact. As a result, shareholder class actions can be commenced and run to judgment on the common issues without the aid of a presumption which makes causation a common (rather than individual) issue. If, however, 'direct causation' is required, it will be necessary for each claimant to come forward individually (after the common issues have been determined) to establish that the company's contravening conduct caused their loss. That would be a significant blow for the promoters of shareholder class actions, and may well raise questions about the extent to which they remain a viable commercial proposition for the funders and law firms involved.