Supreme Court Rules Loss Causation Is Not Required for Class Certification in Private Securities Class Actions

On June 6, 2011, the Supreme Court clarified in Erica P. John Fund, Inc. v. Halliburton Co., et al. that “loss causation” is not a necessary element to obtain class certification in a private securities class action.  The Supreme Court overruled a line of cases from the 5th Circuit that had required securities plaintiffs to first prove loss causation before being able to “trigger” the fraud-on-the-market presumption permitting class certification in efficient markets.  According to the Supreme Court’s decision, an investor is required to prove the presence of an efficient market in order to take advantage of the fraud-on-the-market presumption at the class certification stage, but does not need to prove loss causation.  The reasoning of the decision, a unanimous ruling authored by the Chief Justice, is narrow and brief—limited to overruling the 5th Circuit’s loss causation/class certification analysis—and the case is unlikely to lead to a sea change in securities class actions outside the 5th Circuit.  However, the decision may have an impact on the number of future securities class action filings in the 5th Circuit, which has seen a precipitous decline in the last few years with certain 5th Circuit rulings placing limiting requirements on plaintiffs at the pleading and class certification stages.  In addition, the decision in Halliburton leaves open certain questions concerning the elements of proof applicable to the fraud-on-the-market presumption that may be considered in the future by the Supreme Court.

The Fraud-on-the-Market Presumption and the 5th Circuit’s Loss Causation Test

In private securities class actions, like other federal class actions, the plaintiff must meet the class certification requirements of Federal Rule of Civil Procedure 23(b)(3), which requires that individual issues of law or fact do not predominate over common issues.  In fraud cases, the need to prove the element of reliance on an alleged misstatement would ordinarily cause individual issues to predominate over common issues.  But in the context of securities class actions, the Supreme Court recognizes a fraud-on-the-market presumption in efficient stock markets.[1]  Under this theory, “the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations.”[2]  Accordingly, any investor who buys or sells stock at the price set on a well-developed market is presumed to have relied on public misstatements.

The 5th Circuit sought to “tighten” the Supreme Court’s requirements in Basic by insisting that a securities plaintiff also prove “loss causation” before “triggering” the fraud-on-the-market presumption at the class certification stage.[3]  Under the 5th Circuit’s test, in order to invoke the fraud-on-the-market presumption of reliance, a putative securities class action plaintiff must first prove that the decline in stock was “because of the correction to a prior misleading statement” and “that the subsequent loss could not otherwise be explained by some additional factors revealed then to the market.”[4]

Before the Supreme Court’s decision in Halliburton, other circuits—specifically, the 2nd, 3rd and 7th circuits—had rejected the 5th Circuit’s loss causation test for class certification and had found that loss causation was not a prerequisite to class certification.[5]  In line with the 5th Circuit precedents, however, the district court in Halliburton denied class certification.  The district court concluded that the plaintiff had failed to establish loss causation, but made clear that absent the loss causation requirement, it would have granted class certification.  The 5th Circuit affirmed based on its loss causation precedents.[6]

The Supreme Court Rejects Loss Causation as a Class Certification Prerequisite

In a unanimous decision, the Supreme Court vacated the 5th Circuit’s decision in Halliburton, holding that proof of loss causation is not a prerequisite to class certification.  The Court noted that “loss causation” was not contemplated by the Basic decision formulating the fraud-on-the-market presumption and indicated that loss causation addresses different considerations than reliance in a § 10(b) claim.   The Court held that reliance focuses on “facts surrounding the investor’s decision to engage in the transaction,” while loss causation “requires a plaintiff to show that a misrepresentation that affected the integrity of the market price also caused a subsequent economic loss.”[7]  The Supreme Court noted that even if an investor purchased stock at a distorted price—and thereby presumptively relied on the misrepresentation reflected in that price—the investor still must prove loss causation (i.e., that the decline in the stock’s value was caused by the misstatement) in order to recover.[8]  Thus, in order to take advantage of the fraud-on-the-market presumption at the class certification stage, a putative class action plaintiff need only prove the existence of a misrepresentation, made in an efficient market and before the time of a corrective disclosure, but need not prove loss causation.

The Supreme Court specifically left open the question of whether a plaintiff must prove price impact in order to first invoke the fraud-on-the-market presumption or, instead, whether a plaintiff need only prove price impact after the defendant has successfully rebutted that presumption.[9]  The Supreme Court’s explanation of the fraud-on-the-market presumption, indicating that “an investor presumptively relies on a defendant’s misrepresentation if that ‘information is reflected in [the] market price’ of the stock at the time of the relevant transaction,” appears to signal that a plaintiff likely must first prove that a misstatement impacted the stock price before the presumption may be invoked.

Impact of the Halliburton Decision

The Supreme Court’s decision in Halliburton may have a large impact on securities class actions filed in the 5th Circuit, but it is not likely to impact other jurisdictions that had previously rejected the 5th Circuit’s test.  Loss causation is still a necessary element that a securities plaintiff must prove to ultimately recover, but the plaintiff need not prove loss causation at the class certification stage.

The impact of the Halliburton decision in the 5th Circuit is not likely to be known for some time, however.  Securities plaintiffs have become increasingly reticent to file claims within the 5th Circuit, due largely to that court’s “tightening” of the pleading requirements under the Private Securities Litigation Reform Act and the class certification requirements.

Time will tell whether the Halliburton decision—as well as the Supreme Court’s decision earlier this term in Matrixx Initiatives v. Siracusano[10], finding a securities plaintiff had adequately pled a material misstatement where information was known to the corporation that called into question previous statements—will impact the number of securities class actions filed within the 5th Circuit.  For now, while plaintiffs will have one less hurdle to jump at the class certification stage, the 5th Circuit will remain a difficult jurisdiction in which to bring securities class actions.

^{[1] Basic Inc. v. Levinson, 485 U.S. 224, 243 (1988).} 

^{[2] Basic, 485 U.S. at 246.}  

^{[3] See Oscar Private Equity Invs. v. Allegiance Telecom, 487 F.3d 261 (5th Cir. 2007).} 

^{[4] Erica P. John Fund, Inc. v. Halliburton Co., 597 F.3d 330 (5th Cir. 2010).}

^{[5] In re Salomon Analyst Metromedia Litig., 544 F.3d 474, 483 (2d Cir. 2008); Schleicher v. Wendt, 618 F.3d 679, 687 (7th Cir. 2010); In re DVI, Inc. Sec. Litig., No. 08-8033, 2011 WL 1125926 (3d Cir. Mar. 29, 2011).} 

^{[6] 597 F.3d at 344.}

^{[7] Op. at 6-7 (emphasis in original).} 

^{[8] Op. at 7.} 

^{[9] Op. at 8 n.*.} 

^{[10] See Akin client alert, “Supreme Court Gives Guidance on Materiality Standard Under Federal Securities Laws,” (March 24, 2011).}