The U.S. Supreme Court Deals a Blow to Corporations Facing Fraud-on-the-Market Securities Class Actions

            While several of the U.S. Supreme Court’s recent decisions have raised the bar for plaintiffs seeking to bring class actions, the divided Court’s February 27th decision in Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds, 568 U.S. ___ (2013) dealt a blow to corporate defendants in the securities fraud class action arena.  The Court heard arguments in Amgen in November, 2012 on the issue of whether plaintiffs in securities fraud class actions must prove the materiality of the alleged misrepresentation in order to obtain class certification based on the fraud-on-the-market theory established by the Supreme Court in Basic Inc. v. Levinson, 485 U. S. 224 (1988).  The Supreme Court majority resolved a Circuit Court split on the issue by ruling that materiality does not need to be proven at the class certification stage, while dissenters Justices Thomas, Kennedy, and Scalia urged that materiality must be determined before a class properly can be certified.  Each side proclaimed that the other has “put the cart before the horse” in its analysis, disagreeing on the propriety of analyzing materiality at the class certification stage because materiality of the misrepresentation is both a predicate to the fraud-on-the-market theory and a substantive element of the merits of a securities fraud claim.  To put it mildly, Justice Scalia stated: “Today’s holding does not merely accept what some consider the regrettable consequences of the four-Justice opinion in Basic; it ex­pands those consequences from the arguably regrettable to the unquestionably disastrous” (emphasis added).  We will take a look at the main points of contention raised in the Supreme Court’s majority and dissenting opinions, and why the majority opinion in Amgen may be potentially (or unquestionably) disastrous for corporate defendants.

            The Fraud-on-the-Market Theory. To recover damages in a private securities fraud action under §10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b–5, a plaintiff must prove reliance on a material misrepresentation or omission made by the de­fendant.  The fraud-on-the-market theory was created by the Court in Basic to make it easier for plaintiffs to establish their reliance on misrepresentations by establishing a rebuttable presumption of reliance if certain predicates were met – the materiality of the misrepresentation being one predicate.  The Amgen majority explained that “[r]equiring proof of direct reliance ‘would place an unnecessarily un­realistic evidentiary burden on [a] plaintiff who has traded on an im­personal market.’ Basic, 485 U. S. at 245.”  The fraud-on-the-market theory is even more critical in class action cases because, as explained by the Amgen majority:

Absent the fraud-on-the-market theory, the requirement that Rule 10b–5 plaintiffs establish reliance would ordinarily preclude certification of a class action seeking money damages because individual reliance issues would overwhelm questions common to the class. See Basic, 485 U. S., at 242. The fraud-on-the-market theory, however, facilitates class certification by recognizing a rebuttable presumption of class-wide reliance on public, material misrepresentations when shares are traded in an efficient market.

            Rule 23 Rigorous Analysis vs. Merits Inquiry. The Amgen majority held that materiality is not a question properly addressed at class certification because it is also an element of the merits of a securities fraud claim. The company in Amgen proffered that it had evidence available at the class certification stage which showed that the alleged misrepresentations were immaterial.  The Supreme Court also held, however, that it is improper to consider rebuttal evidence on the issue of materiality at the class certification stage.  The majority proclaimed that “[a]lthough we have cautioned that a court’s class-certification analysis must be “rigorous” and may “entail some overlap with the merits of the plaintiff’s underlying claim,” Wal-Mart Stores, Inc. v. Dukes, 564 U. S. ___, ___ (2011) (slip op., at 10), Rule 23 grants courts no license to engage in free-ranging merits inquiries at the certification stage.”  From the dissent’s perspective, it is of no import that determining materiality at the class certification stage also touches on a merits issue, since Dukes has made it clear that the Rule 23 rigorous analysis may overlap with merits inquiry to the extent necessary to determine if certification is proper.  The dissent views the majority’s analysis, which overlooks materiality until the merits phase, as erroneously permitting class actions to proceed even though reliance may not be a question that can be presumed to be common to the class.

            Establishing Common Proof of Materiality vs. Reliance. The majority also held that materiality need not be proved at the class certification stage because materiality is a question that is common to the class and satisfies Rule 23(b)’s requirement that issues common to the class predominate individual issues.  The majority further reasoned that “[b]ecause a failure of proof on the issue of materiality, unlike the issues of market efficiency and publicity, does not give rise to any prospect of individual questions overwhelming common ones, materiality need not be proved prior to Rule23(b)(3) class certification.”  But, is this reasoning contradictory to the majority’s recognition that (1) materiality “indisputably” is an “essential” predicate of the fraud-on-the-market theory and (2) the applicability of the theory flips the switch from the predominance of individual reliance issues to the presumption of reliance on a class-wide basis?  This depends on whether the majority was asking and answering the proper question.  Instead of asking whether reliance can be shown on a class-wide basis, the majority focused its analysis on whether materiality can be proven on a class-wide basis.  The dissent, however, believes that the proper question is whether reliance can be shown on a class-wide basis: A misrepresentation must be material in order to invoke the fraud-on-the-market theory in the first instance, which is the key to the presumption of reliance on a class-wide basis.  The dissent argued that if materiality is not shown at the class certification stage, the fraud-on-the market theory fails, individual circumstances will bear on and overwhelm the reliance inquiry, and class certification will be inappropriate.

            The Importance of Materiality in Basic. The differences in the majority and dissenting views seem grounded in a fundamental disagreement on the role of the materiality requirement in the development of the fraud-on-the-market theory in Basic.  The dissent urged that “[m]ateriality was central to the development, analysis, and adoption of the fraud-on-the-market theory both before Basic and in Basic itself….This history confirms that mate­riality must be proved at the time that the theory is invoked—i.e., at certification.”  But, the majority retorted that “we are unwilling to presume that Basic announced a rule requiring precertification proof of materiality when Basic failed to apply any such rule to the very case before it.”

            Are Corporate Defendants Facing Disaster?  Corporate defendants facing class actions of any type are under tremendous pressure to settle after a class is certified.  Whether or not we believe that the Amgen majority got it right, class action plaintiffs now have a green light to avail themselves of the fraud-on-the-market theory without addressing materiality until summary judgment or trial, if at all.  The dissent paints this picture of the practical result in a securities class action where the misrepresentation at issue is immaterial – a class is certified based on the fraud-on-the-market theory, the defendant is pressured to settle even though the statement was immaterial and reliance actually was an individualized inquiry which rendered certification of the class improper in the first instance.  The Amgen majority asserted that purpose of a Rule 23(b)(3) certification ruling “is not to adjudicate the case; rather, it is to select the ‘metho[d]’ best suited to adjudication of the controversy “fairly and efficiently.”  Query whether it is fair or efficient to certify that a class action is a suitable method of adjudication when individual issues of reliance actually predominate over common ones?  Wouldn’t most corporate defendants agree with the dissenting view that a putative class action should end prior to class certification if the immateriality of the alleged misrepresentation can be established to show that the fraud-on-the-market theory is inapplicable?

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