Why the U.s. Supreme Court Should Reaffirm the "fraud-on-the-market" Presumption in Securities Fraud Cases

• Publication year: 2014

Why the U.S. Supreme Court Should Reaffirm the "Fraud-on-the-Market" Presumption in Securities Fraud Cases

Jonathan Massey

WHY THE U.S. SUPREME COURT SHOULD REAFFIRM THE "FRAUD-ON-THE-MARKET" PRESUMPTION IN SECURITIES FRAUD CASES

Jonathan Massey^*

On March 5, 2014, the Supreme Court heard argument in one of the most important securities law cases in decades: Halliburton Co. v. Erica P. John Fund, No. 13-317. The defendant company in the case, Halliburton, is asking the Court to overturn its landmark 1988 decision in Basic Inc. v. Levinson, which adopted a rule known as the "fraud-on-the-market" presumption, enabling securities fraud class action lawsuits to be brought.¹

The "fraud-on-the-market" rule is a rebuttable presumption that securities prices in an open and developed market like the New York Stock Exchange reflect material public information and that investors rely on the integrity of the market price.² Under this presumption, investors who bought or sold stock during the relevant time period are able to bring their fraud claims without proving that they personally knew of and relied on a misrepresentation in making their decision to buy or sell.³ It's assumed that the information (or omission) is "baked into" the market price.⁴

Halliburton contends that the Court should overrule Basic and eliminate the fraud-on-the-market presumption.⁵ Here's why it is wrong:

• There has always been bipartisan support for the presumption. In 1988, the SEC (under the Reagan Administration) urged the Supreme Court to adopt the fraud-on-the-market presumption and warned that, without it, private securities actions would face insuperable hurdles.⁶ In 1995, when Republicans held a majority in both houses, Congress considered proposals to abolish the

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fraud-on-the-market presumption and warned that, without it, private securities actions would face insuperable hurdles.⁷ In 1995, when Republicans held a majority in both houses, Congress considered and rejected proposals to abolish the fraud-on-the-market presumption.⁸ Today, the SEC continues to support the fraud-on-the-market presumption and filed a brief in Halliburton strongly expressing that view.⁹ Congress and the SEC are better able than the Court to evaluate the defendants' policy objections to the presumption.

• Numerous other groups and scholars filed briefs in Halliburton defending the presumption.¹⁰ AARP filed a brief stressing the dangers to consumers and investors if the presumption were eliminated.¹¹ Fourteen academic economists, including Eugene Fama of the University of Chicago (who shared in last year's Nobel Prize), submitted a brief supporting the presumption.¹² More than two-dozen other scholars did so as well.¹³ Charles Fried, the former solicitor general who represented the SEC in 1988, filed a brief twenty-six years later urging the Court to adhere to its prior decision in Basic as a matter of stare decisis.¹⁴ Former SEC Chairmen William H. Donaldson and Arthur Levitt, Jr. agreed,¹⁵ as did twenty-one states and the territory of Guam.¹⁶

• Stare decisis principles are particularly forceful in non-constitutional cases, where Congress is free to alter the Court's decisions if it wishes.¹⁷ Here, there is no basis for departing from Basic.¹⁸ Halliburton's legal arguments are largely recycled from the dissenting opinion in Basic by Justices White and O'Connor.¹⁹ The Court rejected those arguments in 1988, and they are no more persuasive now.²⁰

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• Meanwhile, Basic has become a firmly settled, indispensable part of securities law. Without the fraud-on-the-market presumption, securities class actions would face enormous hurdles, because each individual stockholder would have to show that he or she knew of and relied on the misrepresentation, and the case could not be tried in class form. Millions of investors would be left without a remedy, because the costs of trying individual claims would exceed the potential damages.

• Even separate suits by large institutional investors rely on the fraud-on-the-market presumption, so overturning Basic would threaten individual suits by investors as well as class actions.

• Institutional investors increasingly use passive investment strategies (such as index investing) that rely on the integrity of the market (within the meaning of Basic) and the presumption that relevant public information is incorporated into price.²¹ These investment strategies are built on the bedrock premise that prices reflect available public information. If the Supreme Court were suddenly to hold that this assumption is false, it would call into question the central pillar of many investing strategies.²² Institutional investors representing millions of pension beneficiaries and over $1.36 trillion of assets under management warned the Supreme Court in the Halliburton case that overturning Basic would force the re-evaluation of many settled investment practices and the adoption of new and unpredictable guidelines.²³ At the very...