The trouble with Basic: price distortion after Halliburton.

• Author: Fisch, Jill E.
• Position: F. Hodge O'Neal Corporate and Securities Law Symposium: The Future of Class Actions

ABSTRACT

Many commentators credit the Supreme Court's decision in Basic, Inc. v. Levinson, which allowed courts to presume reliance rather than requiring individualized proof, with spawning a vast industry of private securities fraud litigation. Today, the validity of Basic 'S holding has come under attack as scholars have raised questions about the extent to which the capital markets are efficient. In truth, both these views are overstated. Basic's adoption of the fraud on the market presumption reflected a retreat from prevailing lower court recognition that the application of a reliance requirement was inappropriate in the context of impersonal public market transactions. And, contrary to arguments currently being made to the Supreme Court in the Amgen case, fraud on the market theory does not require a strong degree of market efficiency--but merely that market prices respond to information.

The Basic decision had another, less widely-recognized effect, however. It began shifting the nature of private securities fraud claims from transaction-based claims to market-based claims, a shift that was completed by the Court 'S later decision in Dura. The consequence of this shift was to convert the nature of the plaintiff's harm from a corruption of the investment decision to one of transacting at a distorted price.

The legal significance of price distortion was at the heart of the Halliburton decision. The lower court confused two temporally distinct concepts: ex ante price distortion, which is part of the reliance inquiry, and ex post price distortion, which is a component of loss causation. The Supreme Court limited its holding in Halliburton to identifying this confusion, leaving examination of the appropriate role of price distortion for future cases. In Amgen, the Court may be forced to tackle this question. This Article argues that Amgen highlights the incongruity of considering price distortion at the class certification stage and provides an opportunity for the Court to reconsider and reject Basic's insistence on retaining a reliance requirement.

INTRODUCTION

The Supreme Court's decision in Basic, Inc. v. Levinson (1) is widely credited with spawning a vast industry of securities fraud litigation by removing the requirement of individualized proof of reliance as an obstacle to class certification. (2) Modern criticisms of private litigation coupled with questions about the validity of the economic premises on which Basic relied have led critics to question the legitimacy of the Court's holding in Basic. (3) Most recently, with the Supreme Court's decision to grant certiorari in Amgen, (4) commentators are again speculating that the Court may use this case as an opportunity to overrule Basic. (5)

Generally, criticism of Basic mischaracterizes the decision. Basic did not release federal securities fraud from its moorings in common law fraud and deceit. Rather, by retaining the reliance requirement in federal securities fraud litigation, Basic reflected judicial conservatism. Despite contemporaneous recognition by lower courts and commentators that a reliance requirement was anomalous in the context of impersonal transactions in the public securities markets, (6) the Supreme Court refused to reject reliance outright. Instead, the Court constructed a complex theory of market integrity relying on the fact that, in an efficient market, fraudulent public statements distort stock prices. (7) According to the Basic Court, the existence of this price distortion justifies a rebuttable presumption of reliance. (8)

The Basic presumption simplified the class certification inquiry for a time by relieving plaintiffs of the need to establish individualized reliance. The rationale for the Basic presumption, however, reflected a shift in the underlying objectives of securities fraud litigation. Specifically, as this Article will explain, the price distortion theory on which Basic was premised had the effect of converting securities fraud from a transaction-based wrong--akin to common law deceit--into a market-based claim. (9)

At the same time, because it used the fraud on the market theory ("FOTM") as the basis for its ruling, Basic deflected the reliance inquiry into an analysis of market efficiency. Following Basic, courts rapidly limited the availability of the Basic presumption to cases involving efficient markets. (10) Although market efficiency is neither a necessary nor a sufficient condition to establish that misinformation has distorted prices, most courts have concluded that the threshold inquiry in Basic is satisfied by proof that the misrepresentations were publicly made and "that the stock traded in an efficient market." (11)

With a few exceptions, courts have ruled that an independent analysis of price distortion is unnecessary to obtain the Basic presumption.12 One of the exceptions was the Fifth Circuit. (13) In Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton, (14) the Fifth Circuit held that, to obtain class certification under Basic, the plaintiffs must prove that the defendant's misrepresentation affected the market price of the security. (15) The court explained that this price impact could be established in one of two ways--through a stock price reaction at the time of the fraudulent statement or through a stock price response to the revelation of truth. (16) The latter showing is equivalent to that required to establish the element of loss causation. (17)

The Halliburton case thus offered the Supreme Court an opportunity to reexamine Basic's fundamental premises, specifically, the normative implications of focusing on price distortion in defining the contours of a claim for private securities fraud. The Court declined the invitation. Reluctant to disturb the delicate balance created by its prior decisions, and perhaps wary of entrusting policing the markets to the Securities and Exchange Commission (SEC) in light of ongoing questions about the vigor of the agency's enforcement efforts, (18) the Court eschewed a broad-based holding and relied instead on a rigid characterization of the lower court's analysis. Although it reaffirmed the vitality of the Basic presumption, the Court explicitly refused to consider the role of price distortion in obtaining that presumption. (19)

The Halliburton decision reflected the Fifth Circuit's confusion between two temporal concepts (20)--price distortion at the time of the fraud and price impact when the fraud is revealed to the market--that serve distinct objectives. Understanding these objectives is critical in determining the appropriate scope of private securities fraud litigation. At the same time, the Supreme Court's narrow holding in Halliburton did not confront the increasing stress placed on Basic by the evolving approach to class certification. (21) That issue is squarely presented to the Supreme Court in the Amgen case. (22) In Amgen, the Court is specifically asked to decide whether proof of price distortion is necessary to obtain class certification.23 This Article argues that the natural outgrowth of the Court's market-based approach to securities fraud justifies resolving the tension in Amgen by overruling that aspect of the Basic decision which retains a reliance requirement.

Part I of this Article places Halliburton in historical context, first by describing the decisions that preceded Basic and then by examining Basic's adoption of the presumption of reliance. Part II examines the aftermath of Basic, including the Court's subsequent decision in Dura. In Part III, the Article explains the collective impact of Basic and Dura-specifically, the move to a market-based conception of securities fraud and the role of price distortion in that conception. Part IV positions Halliburton as the natural outgrowth of this conceptual tension and explains why Halliburton's analysis of these issues was both correct and incorrect. Part V describes the evolution of the class certification analysis and explains how this evolution has complicated the Basic inquiry. Part VI suggests that the natural solution to this problem is to overrule Basic and reject a reliance requirement, and then briefly identifies the policy considerations implicit in this approach.

1. BASIC AND ITS PAST

   1. Early Cases and Commentary

      Many commentators cite Basic as the foundation of modern securities fraud litigation. (24) Basic did not reflect, however, a doctrinal shift. (25) From the earliest cases addressing the implied private right of action under section 10(b) of the Securities Exchange Act (26) and SEC Rule 10b-5, the lower courts recognized that it was impractical to impose a reliance requirement in federal securities fraud litigation. (27) Commentators similarly questioned the theoretical premise for requiring proof of reliance. (28) The reliance requirement had its origins in common law fraud, which served as the initial source of the elements of federal securities fraud. (29) Common law fraud included a requirement that plaintiffs prove subjective reliance. (30) As one court explained it, the test was "whether [an individual] plaintiff would have been influenced to act differently than he did act if the defendant had disclosed to him the undisclosed fact." (31)

      Courts promptly began to question whether it was appropriate to apply the reliance requirement to federal securities fraud. The reliance requirement appeared anomalous for several reasons. The issue arose initially in the early securities fraud cases involving non-disclosure or omission. (32) Proof of reliance in a non-disclosure case essentially required a counterfactual analysis. As a student commentator explained in a Harvard Law Review note: "Since nothing is affirmatively represented in a nondisclosure case, demanding proof of reliance would require the plaintiff to demonstrate that he had in mind the converse of the omitted facts, which would be virtually impossible to demonstrate in most...