Halliburton deals with one part of a securities-fraud claim called the reliance issue. In short, what information did an investor rely on when purchasing or selling the security? Historically, when a person sued for injury from a false statement about a security, courts required proof that the plaintiff heard or read the defendant’s misstatement and relied on it when buying or selling.
The Supreme Court removed that requirement in 1988 when it adopted the “fraud-on-the-market” theory of reliance in Basic v. Levinson . According to the new theory, the price of shares traded on efficient secondary markets reflects all publicly available information, including any misrepresentations. Because the market sends information to the investor through a market price, the courts assumed that an investor relied on the integrity of the market price—and therefore on misinformation. Specific proof of actual reliance was no longer necessary.
The theory became the bedrock of securities class actions brought against companies that allegedly made a false statement to public markets. All investors who traded in the public market at issue could join a class action without proof that each investor actually heard or read the misstatement.
The need to show actual reliance had been an important requirement of traditional common-law fraud cases. It defined a person who had been directly wronged by the defendant, even though others could suffer indirect loss from a false representation. Eliminating the need for this proof broke from the tradition as well as securities-law precedent. It was also inconsistent with the court’s decision to narrow the reliance element in the 2008 caseStoneridge v. Scientific-Atlanta, and the court’s decision to toughen class-certification standards in Wal-Mart v. Dukes in 2011 and again in 2013 with Comcast v. Behrend.
The foundation for the fraud-on-the-market theory was the efficient-capital-markets hypothesis championed by economist Eugene Fama. The hypothesis holds that share prices fully reflect information available at the time. But modern economic research, primarily in the field of behavioral finance, has cast doubt on the theory. Economists now recognize that the connections among public information, trading decisions and market prices require more than simple analysis. Information can affect market prices quickly or slowly depending on many factors.
Furthermore, fraud-on-the-market cases greatly expand the size of the plaintiff class. Class actions based on this theory have included hundreds or thousands of investors, such as the Royal Ahold case, which had more than 198,000 claimants. Thus, cases certified as class actions—and 77% of decided motions for class certifications are granted, according to a 2014 study by consulting firm NERA—threaten defendants with financial ruin. They subject defendants to relentless pressure to settle, even in cases with weak merits.
Rejecting the fraud-on-the-market theory would not end private enforcement. Traditional, cohesive class actions and individual securities cases would both remain and serve as a deterrent against securities misconduct.
Securities class actions would continue because many sophisticated investors actually hear, read and rely on the public disclosures from companies to make investment decisions. They attend investor conferences and hear management speakers; they receive the same earnings reports by blast emails; and they listen as a group to earnings calls and other important corporate announcements. Harmed investors could prove reliance and still cohere as a class under these circumstances.
In addition, institutional investors are increasingly bringing their own lawsuits when they believe a company’s disclosures were false and harmful, reducing the need for class actions to act as a deterrent. A 2013 study by Cornerstone Research of investors opting out of class-action settlements to bring their own cases showed that 53% of settlements valued at more than $500 million had an opt-out. Class actions were only 15%-20% of the total number of federal securities and commodities cases brought in 2012.
I joined a brief urging the court to accept the case for review. In Halliburton, the Supreme Court should abandon the deeply flawed fraud-on-the-market theory for an actual reliance requirement.
Mr. Vollmer, a professor and director of the law and business program at the University of Virginia School of Law, is a former deputy general counsel of the Securities and Exchange Commission.