Searching for fraud on the market

The controversial fraud-on-the-market doctrine continues to create discord amongst courts and economists alike. On Feb. 2, the doctrine was thrust back into the limelight when Barclays PLC asked the U.S. Supreme Court to review the 2nd U.S. Circuit Court of Appeals' decision in Waggoner v. Barclays PLC, 16-1912 (Nov. 6, 2017). The 2nd Circuit's decision affirmed class certification in a securities class action in which plaintiffs relied on the fraud-on-the-market doctrine to establish the presumption of class-wide reliance. Barclays, like many other issuers subject to the federal securities laws, is seeking clarification of the rules for defendants attempting to rebut this presumption.

The core tenet of the fraud-on-the-market doctrine is based on the efficient market hypothesis that the market price of an issuer's stock embodies all publicly available information. The Supreme Court in Basic v. Levinson, 468 U.S. 224 (1988), first relied on this hypothesis to allow shareholders of publicly traded companies to establish the presumption that material misstatements or omissions made by the issuer are incorporated into the company's share price in an efficient market. In these circumstances, the fraud-on-the-market doctrine allows courts to presume class-wide reliance on the fraudulent misstatement or omission for purposes of class certification.

As economists grew skeptical of the efficient market hypothesis and divergent views emerged, the Supreme Court revisited the presumption set forth by Basic in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) (Halliburton II). There, the Supreme Court agreed that while the market price of a stock generally reflects all available information if the stock trades in an efficient market, it sometimes does so in an imperfect manner. The Supreme Court used this distinction to acknowledge an important caveat to the efficient market hypothesis. While Halliburton II still assigns plaintiffs the burden of proving the prerequisites for the efficient market hypothesis, it also allows issuers facing securities class actions to rebut at the class certification stage the presumption that the alleged fraud impacted the stock price. Halliburton II penned this rebuttable presumption in broad strokes, leaving the details of how issuers can rebut the presumption to be sorted out by the lower courts.

While courts have grappled with the fraud-on-the-market presumption, two important questions remain after the 2nd Circuit issued its opinion in Waggoner. First, which party has the burden of persuasion where a defendant attempts to rebut the fraud-on-the-market presumption? In answering this question, the 2nd Circuit split with 8th Circuit precedent, holding that defendants bear the ultimate burden of rebutting the presumption of market efficiency. The 2nd Circuit acknowledged the split, but determined that the 8th Circuit's view was merely dicta. Regardless of whether the 2nd Circuit's decision represents a circuit split, Barclays argues, as many others have, that this ruling warrants Supreme Court review given the lack of clarity.

Second, can plaintiffs invoke the fraud-on-the-market presumption without direct evidence that the price of the security responded to the new, material information during the class period? The 2nd Circuit held that plaintiffs may rely exclusively on "indirect factors" (such as market size and trading volume) to show market efficiency, rather than direct evidence that the price of the security reacted to new information. This holding only served to intensify existing confusion among the lower courts regarding the sufficiency of evidence needed to establish market efficiency for the purpose of invoking the fraud-on-the-market presumption.

Read together, the 2nd Circuit's ruling arguably allows plaintiffs to obtain class certification without establishing the presumption's core tenet -- that the market price actually reflects and reacts to all material, public information. Although the Supreme Court explained in Halliburton II that the fraud-on-the-market presumption is meant to be a substitute for proof of a plaintiff's direct reliance on the misrepresentation or omission, the 2nd Circuit's decision eliminates the need for a plaintiff to prove that the market actually incorporated the new information. Further, the ruling places on issuers the burden of disproving market efficiency, potentially rendering a defendant's rebuttal to indirect evidence of market efficiency all but a nullity.

In the petition, Barclays argues that this ruling not only is wrong, but also contributes to the pervasive uncertainty surrounding the fraud-on-the-market presumption. Without guidance from the Supreme Court, it is unclear exactly what a plaintiff must show to invoke the presumption and what a defendant must show to rebut it. Moreover, the 2nd Circuit's decision has significant practical consequences, both on the number of class certifications and on the cost of settlement that will ensue for those claims that survive a motion to dismiss.

Barclays is not the only party to raise these concerns with the position that the 2nd Circuit has taken on this issue. In 2017, Petrobras, the multinational oil and gas company, also sought review of a 2nd Circuit decision upholding certification of a securities class where plaintiffs lacked direct evidence of a market response to alleged misrepresentations. Petrobras argued in its petition that the 2nd Circuit's decision eviscerates the reliance requirement while also destroying a defendant's ability to rebut the presumption of fraud-on-the-market reliance. Petrobras settled the class action before the Supreme Court reviewed its petition.

The questions raised by Barclays' petition require answers to clarify application of the fraud-on-the-market theory in securities class action litigation. The Supreme Court should take this opportunity to explain the standards necessary for plaintiffs to establish, and for defendants to rebut, this presumption.