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Implications of Erica P. John Fund v. Halliburton Co.

By Peter M. Saparoff and Alec J. Zadek – January 31, 2012

In the recent decision, Erica P. John Fund v. Halliburton Co., 131 S. Ct. 2179 (2011), the Supreme Court addressed the Fifth Circuit’s requirement that a plaintiff must prove loss causation to invoke the fraud-on-the-market presumption of reliance. This standard, one that no other circuit court adopted, imposed an exceedingly high burden on plaintiffs seeking class certification.

Prior to the Supreme Court’s ruling, several circuit courts had declined to require securities-fraud plaintiffs to prove loss causation at the class-certification stage. For instance, the Seventh Circuit explicitly rejected the Fifth Circuit’s reasoning and held that the Fifth Circuit’s precedent “represents a go-it-alone strategy.” Schleicher v. Wendt, 618 F.3d 679, 687 (7th Cir. 2010). In addition to the Seventh Circuit, neither the Second Circuit nor Third Circuit required a plaintiff class to prove loss causation prior to class certification.

In a unanimous decision, authored by Chief Justice Roberts, the Supreme Court overturned the Fifth Circuit’s decision, holding that securities-fraud plaintiffs do not need to prove loss causation to obtain class certification.

The Fraud-on-the-Market Theory
In general, when a plaintiff alleges a securities fraud based on violations of section 10(b) of the Securities Exchange Act of 1934 and the Securities and Exchange Commission’s Rule 10b-5, the plaintiff has the burden of proving (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase and sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation. See, e.g., Erica P. John Fund, 131 S. Ct. at 2184. In addition to these requirements, when plaintiffs proceed as a class, it is their burden to prove that common issues predominate over individual ones. Fed. R. Civ. P. 23(b)(3).

In securities-fraud class actions, the predominance requirement presents a potential obstacle to class certification because proving that class members reasonably relied on the specific misrepresentations that are the subject of the lawsuit would ordinarily require individual factual inquiries that would overwhelm questions of fact that are common to the class as a whole. Basic, Inc. v. Levinson, 485 U.S. 224, 242 (1988). In Basic, the Supreme Court accepted the fraud-on-the-market theory as a practical resolution to this problem. Under the fraud-on-the-market theory, if the subject security trades in an efficient market, there is a rebuttable presumption that the price of the security incorporates all material information about that security that is available to the market and that investors accordingly relied upon the misstatements or omissions of the issuer. See, e.g., In re Salomon Analyst Metromedia Litig., 544 F.3d 474, 481 (2d Cir. 2008).

To invoke the fraud-on-the-market theory of reliance, plaintiffs must first prove that the security traded in an efficient market; that the misrepresentations were publicly made; and the misrepresentations were material. Once a plaintiff invokes the fraud-on-the-market theory, “any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his or her decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.” Basic, 485 U.S. at 248.

Loss Causation
The Supreme Court has described loss causation as the “causal connection between the material misrepresentation and the loss. . . .” Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 341 (2005). As one of the elements of a securities-fraud claim based on violations of section 10(b) or Rule 10b-5, securities-fraud plaintiffs must prove this connection to succeed on their claim. The burden of proving loss causation is not satisfied by proof that a material misstatement or omission inflated the purchase price of a stock. Id. at 342–343. Rather, the plaintiff must prove “that a misrepresentation that affected the integrity of the market price also caused a subsequent economic loss.” Erica P. John Fund, 131 S. Ct. at 2186 (emphasis in original). A plaintiff would not be able to prove loss causation when, for example, a change in economic circumstances or investor expectations solely caused the market price to drop.

Application of Loss Causation to the Fraud-on-the-Market Theory
Loss causation, while a well-established requirement for recovery of damages in a case alleging securities fraud, has not traditionally been relevant to class certification. Prior to the Supreme Court’s decision, the Fifth Circuit was the only court of appeals to make proof of loss causation a precondition to invoking the fraud-on-the-market theory at the class-certification stage. In Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F.3d 261, 269 (5th Cir. 2007) (abrogated by Erica P. John Fund, 131 S. Ct. at 2179), the Fifth Circuit held that a securities-fraud plaintiff must prove loss causation before it could invoke the fraud-on-the-market presumption. Loss causation, the court explained, “speaks to the semi-strong efficient market hypothesis on which classwide reliance depends. . . .” Oscar Private Equity Inv., 487 F.3d at 269. In Erica P. John Fund v. Halliburton Co., the district court and Fifth Circuit applied the loss-causation requirement established by Oscar Private Equity to deny certification of a securities class action brought against Halliburton Co. and one of its executives (collectively “Halliburton”).

The case, Erica P. John Fund, has a long and somewhat unique history. The initial complaint was filed in June 2002. Two years later, in September 2004, the district court rejected a proposed settlement of the plaintiffs’ claims that would have resolved the entire case for $6,000,000 and, since then, there have been several changes in class counsel. It was not until 2008 that the district court rejected the lead plaintiff’s motion for class certification giving rise to the appeal to the Fifth Circuit and subsequent petition for certiorari.

The lead plaintiff, Erica P. John Fund, previously known as the Archdiocese of Milwaukee Supporting Fund, alleged that Halliburton deliberately made false statements about (1) the scope of its potential liability in asbestos litigation; (2) its expected revenue from certain construction contracts; and (3) the benefits of its merger with another company. On September 17, 2007, the Fund filed a motion to certify a class of all persons and entities who purchased or otherwise acquired common stock in Halliburton during the class period, June 3, 1999, and December 7, 2001.

The district court, applying Oscar, held that the fund “must demonstrate loss causation in order to trigger the fraud-on-the-market presumption of class reliance.” Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., No. 3:02-CV-1152-M, 2008 WL 4791492 (N.D. Tex. Nov. 4, 2008), aff’d, Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 597 F.3d 330 (5th Cir. 2010) (vacated by Erica P. John Fund, 131 S. Ct. at 2179). Although the district court noted that this prerequisite to class certification imposes an “exceedingly high burden on Plaintiffs at an early stage of the litigation,” the district court explained that it was “justified because of ‘the in terrorem power of class certification, the extraordinary leverage bestowed upon plaintiffs with certification and the due process rights of the parties.’” Id. (citing Oscar, 487 F.3d at 266–67). It appears that, but for the Fund’s perceived inability to prove loss causation, the court would have certified the class.

On appeal, the Fifth Circuit affirmed the decision. Archdiocese of Milwaukee Supporting Fund, 597 F.2d at 338. The court of appeals reasoned that the applicability of the fraud-on-the-market presumption required proof not only that the price at which securities were purchased was affected by the effect of fraudulent misrepresentations or omissions on an efficient market, but also that there was a causal link between such misrepresentations or omissions in the form of a price change associated with correction of the misleading statements. With respect to the fund’s allegations, the court held that the truth revealed by Halliburton’s collective disclosures must show that Halliburton more likely than not misled or deceived the market with earnings misstatements that inflated the stock price and are actionable. Id. This requirement—one that no other circuit court imposed—constituted an extraordinary burden for plaintiffs seeking class certification. Nevertheless, the Fifth Circuit affirmed the district court’s decision to deny the fund’s motion for class certification. Id.

Prior to the Supreme Court’s decision in Erica P. John Fund, no other circuit court applied the reasoning of the Fifth Circuit, and at least seven district courts within other circuits rejected it. The Second Circuit, for example, held that “plaintiffs do not bear the burden of showing an impact on price” when moving for class certification. In re Salomon Analyst Metromedia Litig., 544 F.3d at 483. The Court explained, “[t]he point of Basic is that an effect on market price is presumed based on the materiality of the information and a well-developed market’s ability to readily incorporate that information into the price of securities.” Id. (emphasis in original). Although the Second Circuit’s opinion did not specifically address the Fifth Circuit’s precedent, the Court’s holding conflicted with it.

The Seventh Circuit, however, explicitly rejected the reasoning applied in Oscar. While the petition for a writ of certiorari was pending in Erica P. John Fund, the Seventh Circuit, in Schleicher, addressed the logic applied by the Fifth Circuit. In Schleicher, the Seventh Circuit held, “It gets the cart before the horse to insist that [proof of loss causation] be made before any class can be certified.” Schleicher v. Wendt, 618 F.3d 679, 687 (7th Cir. 2010). The court emphasized, “[t]he chance, even the certainty, that a class will lose on the merits does not prevent its certification.” Id.

Most recently, the Third Circuit also declined to apply the Fifth Circuit’s precedent. See In re DVI, Inc. Sec. Litig., 639 F.3d 623 (3d Cir. 2011). In DVI Securities Litigation, the defendant urged the court to adopt the requirement that the plaintiff prove loss causation at the certification stage to invoke the fraud-on-the-market presumption of reliance. Id. at 636. The court declined the defendant’s invitation. Instead, the court found that the Fifth Circuit’s precedent appeared to have undermined the presumption of reliance and held that plaintiffs do not need to demonstrate loss causation at class certification. Id.

To resolve the conflict among the circuit courts as to whether securities-fraud plaintiffs must prove loss causation to obtain class certification, the Supreme Court granted the Erica P. John Fund’s petition for certiorari. Erica P. John Fund, 131 S. Ct. at 2184.

Supreme Court Unanimously Rejected Fifth Circuit’s Requirement
The Supreme Court unanimously held that the Fifth Circuit erred by imposing the requirement that plaintiffs must prove loss causation prior to class certification. Specifically, the Court held, “[the Fifth Circuit’s] requirement is not justified by Basic or its logic. . . .” “Such a rule,” the Court said, “contravenes Basic’s fundamental premise—that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction.” Id. at 2185–2186. The Court also provided guidance to courts applying the fraud-on-the-market theory, noting that before invoking the rebuttable presumption of reliance, plaintiffs must demonstrate that the alleged misrepresentations were publicly known, that the stock traded in an efficient market, and that the relevant transaction took place between the time the misrepresentations were made and the time the truth was revealed. Whether or not correction of misrepresentations resulted in a change in the price of securities simply is not relevant to the question of whether the price at which the security was purchased may be deemed to have incorporated such misrepresentation, thereby permitting a plaintiff to establish class-wide reliance by proof common to the class as a whole. Accordingly, the Supreme Court vacated the Fifth Circuit’s decision and remanded the case for further proceedings.

The Supreme Court’s decision will have an immediate effect in the Fifth Circuit, where securities-fraud plaintiffs will no longer be required to prove loss causation before obtaining class certification. While the holding eliminated this obstacle to plaintiffs in securities-fraud class actions, the practical impact of the Court’s rejection of the Fifth Circuit’s precedent will be limited because no other circuit court imposed this onerous requirement.

The more widespread effect of the Supreme Court’s decision may be on the application of “price impact,” which is “the effect of a misrepresentation on a stock price.” Erica P. John Fund, 131 S. Ct. at 2187. The Supreme Court discussed price impact, but it did not provide guidance as to its application at class certification. Halliburton, however, has argued on remand that the Supreme Court’s holding amounted to a meaningless victory for the Fund because the Court did not reject their argument that it could defeat the Fund’s motion for class certification by showing the absence of price distortion. Halliburton’s argument is supported in part by the Third Circuit’s decision in DVI Securities Litigation, where the court held that “the lack of market impact may indicate the misstatements were immaterial—a distinct basis for rebuttal.” DVI Sec. Litig., 639 F.3d at 638. According to the Third Circuit, this issue “falls within the ambit of issues that, if relevant, should be addressed by district courts at the class certification stage.” Id. It is not yet clear how other courts will consider price impact at the class certification stage, but further decisions in Erica P. John Fund may be instructive on this issue.

Keywords: securities litigation, fraud on the market theory, loss causation, Supreme Court

Peter M. Saparoff is a member and Alec J. Zadek is an associate at Mintz, Levin, Cohn, Ferris, Glovsky & Popeo, P.C., in Boston, Massachusetts.

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