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03.08.2013 Supreme Court Justices Indicate Willingness to Reconsider Fraud-on-the-Market Theory

BY: CHARLES W. KEMP

Last week, a divided Supreme Court ruled in Amgen v. Connecticut Retirement Plans and Trust Funds that plaintiffs in a Rule 10b-5 fraud claim do not have to prove the materiality of alleged misrepresentations or omissions before class certification. 

To recover damages in securities fraud class actions under Rule 10b-5, a plaintiff must prove, among other things, reliance on a material misrepresentation or omission made by the defendant.  Since proving direct reliance by each plaintiff in a securities fraud class action would be difficult, if not impossible, such plaintiffs use the fraud-on-the-market theory, which permits them to prove reliance on a classwide basis.  The fraud-on-the-market theory was established, or “invented” as Justices Kennedy, Scalia and Thomas say, by the Supreme Court in its 1988 Basic v. Levinson decision.  The theory is premised on efficient markets reflecting all publicly available information in the market price of shares and enables securities fraud plaintiffs to invoke a rebuttable presumption of reliance on material misrepresentations aired to the general public.

The majority in Amgen recognized that materiality was an essential predicate of the Basic fraud-on-the-market theory, but concluded that proof of materiality was only necessary at the summary judgment or trial stage.  The dissent urged that materiality was central to the development, analysis and adoption of the fraud-on-the-market theory and that, until materiality of a misstatement is shown, there is no reason to believe that all market participants have relied equally on it.

Perhaps even more important than the materiality question decided in this case was the open questioning by Justices Alito, Kennedy, Scalia and Thomas of the Basic fraud-on-the-market theory itself.  In a three sentence concurrence with the majority, Justice Alito succinctly stated his and the dissenters’ openness to reconsidering the theory as follows:

"I join the opinion of the Court with the understanding that the petitioners did not ask us to revisit Basic’s fraud-on-the-market presumption. As the dissent observes, more recent evidence suggests that the presumption may rest on a faulty economic premise. In light of this development, reconsideration of the Basic presumption may be appropriate. [citations omitted]"

The majority, however, did not come to the defense of Basic.  In fact, almost with a sense of relief that the issue had not been argued, the majority stated in a footnote that Justice Thomas’ dissent had even acknowledged that the Court had not been asked to revisit that issue.   

Considered together, there is clearly an opening for the right case to challenge Basic’s fraud-on-the-market presumption, with four Justices viewing that Basic decision as “questionable,” and the other five failing to come to its defense.  If Basic is reconsidered and the fraud-on-the-market theory is disavowed, the win that securities fraud plaintiffs received in Amgen could become irrelevant.