Client Update: US Supreme Court to reconsider 'fraud on the market'
28 November 2013
In brief: Perhaps the most important unanswered question in Australian class action law is how causation may be established in the context of a shareholder class action. In the United States, this issue has been addressed by the 'fraud on the market' theory. The US Supreme Court has, however, recently decided to hear a challenge to the validity of that theory. The outcome in that case is likely to be significant in determining how the causation issue is resolved in Australia. Partners Ross Drinnan (view CV) and Jenny Campbell (view CV) and Lawyer Thomas Bagley report.
- Causation in Australian shareholder class actions
- The 'fraud on the market' theory
- 'Fraud on the market' to be revisited
- Relevance to Australian shareholder class actions
- Next steps
The claims made in Australian shareholder class actions are typically founded on allegations that a company's disclosure, or non-disclosure, of material information was misleading or deceptive and a breach of a listed company's continuous disclosure obligations. Proving that the alleged disclosures or non-disclosures caused shareholder loss is an essential element of these claims.
A critical issue, which is yet to be determined by the courts, is the method by which causation can be established in Australian shareholder class actions. In particular, whether:
- it is necessary for each claimant to prove actual reliance on the contravening conduct (direct causation); or
- the requirement can be satisfied by general notions of reliance by the market affecting the price at which each claimant purchased and/or sold their shares (or other securities) (indirect causation).
Whether or not direct causation is required will determine the process by which claims are dealt with following the determination of the common issues. That is, whether:
- those claims can be determined collectively with causation essentially being presumed; or
- each claimant must come forward individually to establish that the company's contravening conduct caused their loss.
The uncertainty created by the lack of settled law is an important issue for plaintiffs and defendants alike. As a result, it increases the prospects of shareholder class actions settling before judgment.
The 'fraud on the market' theory was adopted by a majority of the US Supreme Court in 1988, in Basic v Levinson1. In the context of securities class actions under SEC Rule 10b-5, it creates a rebuttable presumption of shareholder reliance on a company's material public misrepresentations.
The presumption is based on the economic theory that:
- well-developed capital markets efficiently incorporate material information into a company's market price – the 'efficient market hypothesis'; and
- investors purchase stock in reliance on the market price conveying the company's true value.
The effect of the presumption is that misleading, or improperly withheld, information will affect the market price of the security and can therefore be presumed to be the cause of loss to shareholders following a market correction, once the information is disclosed or corrected – proof of individual investor reliance on the conduct is unnecessary.
By dispensing with the need for proof of individual reliance, the 'fraud on the market' theory enables securities class actions to be certified under Rule 23 of the US Federal Rules of Civil Procedure. Without the presumption, the vast majority of securities class actions would not be certified because issues common to the class would not 'predominate' over individual issues.
On 15 November 2013, the US Supreme Court decided to consider whether it 'should overrule or substantially modify' the holding in Basic to the 'extent that it recognizes a presumption of classwide reliance derived from the fraud-on-the-market theory'.
The issue will be considered in the context of Halliburton Co v Erica P John Fund 2, a long-running securities class action alleging non-disclosure of Halliburton's asbestos liabilities. Halliburton has sought to challenge the 'fraud on the market' theory, on the basis that it is founded on outdated economic theory (including the 'efficient markets hypothesis').
The Supreme Court's decision follows comments made by four justices earlier this year, to the effect that they were open to reconsidering the appropriateness of the decision in Basic3.
A successful challenge to the applicability of the 'fraud on the market' theory will be highly relevant to the ongoing debate about causation in the context of Australian shareholder class actions.
In making the case for 'indirect causation', Australian claimants have not typically relied directly on the 'fraud on the market' theory to establish their case, preferring, instead, to bring the argument within the framework of common law principles of causation4. The economic theory underpinning the fraud on the market theory – particularly its basis in the 'efficient markets hypothesis' – is, however, central to their argument.
In those circumstances, a reconsideration of the validity of the economic theory underlying fraud on the market – in particular, the unquestioned link between material information and share price – is highly relevant to the question of causation and may well have implications for the way in which the question is resolved in Australia.
Unlike the US procedures, Australian class action procedures do not include a certification process. Nor is it necessary for common issues to predominate over individual issues. In Australia, it is sufficient for there to be one substantial common issue of law or fact. As such, a finding that the 'fraud on the market' theory is not based on sound economic theory is unlikely to have the same impact on Australian class actions as it may have on US class actions (where they may be incapable of certification). Nonetheless, such a finding would undermine the case for indirect causation under Australian law and make the scenario under which each claimant must come forward individually to establish that the company's contravening conduct caused their loss closer to being a reality. That would be a significant blow for the promoters of shareholder class actions, and may well raise questions about the extent to which they remain a viable proposition for the funders and law firms involved.
The US Supreme Court will hear submissions on this issue in the Halliburton case in early March 2014. We will continue to monitor the progress of the issue and report on any notable developments.
- 485 U.S. 224 (1988).
- No 13-317.
- Amgen, Inc v Connecticut Retirement Plans and Trust Funds, 133 S Ct. 1184 (2013).
- See eg Ross Drinnan and Jenny Campbell, 'Causation in Securities Class Actions', University of New South Wales Law Journal, Volume 32, Number 3, 2009, 928.
- Ross DrinnanPartner, Practice Leader, Disputes & Investigations,
Ph: +61 2 9230 4931
- Jenny CampbellPartner,
Ph: +61 2 9230 4868
- Duncan TravisPartner,
Ph: +61 3 9613 8175
- Peter O'DonahooPartner,
Ph: +61 3 9613 8742
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