Audit, Compliance and Risk Blog

Section 10(b) of the Securities Exchange Act of 1934 prohibits use of “any manipulative or deceptive device” in connection with purchases or sales of securities. Since its adoption, this provision has provided SEC with an important enforcement tool. Beginning in 1975, the US Supreme Court also empowered aggrieved shareholders to use this Section to support private lawsuits against alleged violators (Blue Chip Stamps v. Manor Drug Stores). The substantive and procedural contours of this private right have continued to evolve in the subsequent four decades, as courts address arguments by plaintiffs and defendants. In 1988, the Supreme Court ruled that plaintiffs who buy or sell shares through an “efficient market” are entitled to a presumption that they relied on that market’s price, not knowing that the market was tainted by manipulative or deceptive information (Basic, Inc. v. Levinson).

Last week, the US Supreme Court offered its latest review of private actions under Section 10(b) (Halliburton Company v. Erica P. John Fund, Inc.). Appellant Halliburton sought to reduce plaintiffs’ opportunities by overturning important elements of the Basic decision’s “fraud on the market” feature; the Supreme Court has now made limited changes but reaffirmed most features.

What Must Plaintiffs Prove To Win A 10(b) Case?

As parsed by decades of litigation, a securities fraud claim under Section 10(b) and SEC Rule 10b-5 requires the plaintiff to allege the following:

1. A misstatement or omission.

2. Of a material fact.

3. In connection with the purchase or sale of securities.

4. Made with scienter.

5. On which the plaintiff relied.

6. Which proximately caused plaintiff’s injury.

Although each of these elements has been the topic of litigation, the last three are usually the most fought-over. Item Number 5 was the focus of the Halliburton Company case—how do plaintiffs demonstrate that they relied on defendants’ misstatements?

Reliance in Class Action Cases – Was There “Fraud on the Market”?

Plaintiffs consistently want to be able to “prove” that they relied on defendants’ statements by simply showing that they bought or sold the securities at a point in time when those (misleading) statements provided important (material) information. Since the Basic decision, courts have allowed individual plaintiffs, and groups of plaintiffs pursuing class action lawsuits, to apply the “fraud on the market” presumption to satisfy item Number 5. Cases require plaintiffs to show:

1. The alleged misrepresentations were publicly known.

2. They were material.

3. The securities traded on an efficient market.

4. The plaintiff(s) bought or sold shares after the misleading statements were made and before the truth was revealed.

This formulation helps plaintiffs, because an important criterion for certifying a class action is that factors common to all group members must have “predominance” over individual plaintiffs’ unique issues—if all plaintiffs face one market price, that’s an important common element. Defendants sometimes seek to rebut this presumption by showing that misleading information was not “material” because the market price didn’t change after the mis-information was corrected (i.e., because the market was efficient and didn’t react), that the market was not “efficient” for some reason so the plaintiff(s) couldn’t reasonably rely on the market prices, or that particular plaintiff(s) actually relied on information other than the market’s price (their assessment of long term fundamentals, or insider information, for instance).

In this case, Halliburton made multi-layered arguments.

First, Halliburton claimed that “the efficient capital markets hypothesis” has been disproven since 1988, by evidence that markets aren’t actually efficient because they don’t promptly and consistently incorporate changing information into prices.

Second, Halliburton argued that not all plaintiff investors relied on fluctuating market prices, claiming some were “value investors” who looked to longer-term fundamental attributes of the company to decide which shares to buy and hold. Halliburton thus claimed that the existence of a publicly quoted market price isn’t important to all investors—so the common fact of a price was insufficient to forge a “class” of investors who might have weighted it very differently when making their individual investment decisions.

Third, Halliburton sought to require plaintiffs to argue that the revelation of corrected information had a direct price impact—rather than a more generalized argument that revelation and price changes coincided.

Most importantly, Halliburton wanted to be able to provide evidence on these points while a trial court was deciding whether or not to certify a class, arguing that early attention to these matters could head off inappropriate class certifications that Halliburton argued give huge and unfair advantages to plaintiffs in securities litigation and lead to longer and more expensive cases than need be.

What Did the Supreme Court Decide?

The Supreme Court rejected Halliburton’s argument about the lack of “efficient markets,” stating that the Basic decision hadn’t gone so far as to require a “binary” yes-no answer to the hypothetical question “is this market efficient?” Instead, the Court reaffirmed that in 1988 it had merely observed that markets are sufficiently efficient that prices tend to change to reflect changes in available information—and that this observation remains valid.

The Court did give some weight to Halliburton’s arguments about varying investor criteria. It reaffirmed that plaintiffs should receive a presumption that all putative class members relied on an efficient market price, and that price changes occurred because of revised information— but changed pre-existing practice to state that defendants like Halliburton must be given the opportunity to present evidence to rebut that presumption before the class is certified. The Court left defendants the burden of doing so, however, rather than increasing plaintiffs’ burden at the class certification stage.

These changes appear not to make major changes in the weight of arguments likely to be made in securities fraud cases, but the actual impacts will depend on subsequent lawsuits.

Self-Assessment Checklist

Am I responsible for any disclosures by or on behalf of my organization?

• If so, do I take steps to ensure that all formal disclosures satisfy Section 10(b) and SEC’s related rules?

• If so, am I careful not to make any public statements that might be attributed to my organization unless they satisfy Section 10(b) and SEC’s related rules?

Do I invest in securities?

• If so, have I considered whether the markets are robust enough to “efficiently” reflect available information?

• If so, how do I include reliance on securities prices in the criteria I use to buy and sell securities?

Where Can I Go For More Information?

• Halliburton Company decision (on Supreme Court website) 

• SEC website 

Specialty Technical Publishers (STP) provides a variety of single-law and multi-law services, intended to facilitate clients’ understanding of and compliance with requirements. These include:

• Directors' and Officers' Liability

• Securities Law: A Guide to the 1933 and 1934 Acts and their Amendments, including Sarbanes-Oxley and Dodd-Frank

• SEC Disclosures Checklists Including Financial Statement, MD&A, and Sarbanes-Oxley Checklists

• Directors' Liability in Canada

About the Author

Jon Elliott is President of Touchstone Environmental and has been a major contributor to STP’s product range for over 25 years. He was involved in developing 16 existing products,including The Complete Guide to Environmental Law and Securities Law.

photo credit: David Paul Ohmer via photopin cc