In Basic, Inc. v. Levinson, the Supreme Court recognized a rebuttable presumption of fraud on the market for securities-fraud cases. That presumption allowed for certification of a number of securities class actions. Plaintiffs since have taken that presumption and tried to apply it to various other sets of facts, most notably tobacco (although that attempt was ultimately unsuccessful) and drug marketing (also unsuccessfully). But the fact that class-action plaintiffs keep arguing for this presumption means that it’s important for defense counsel to understand the theory underlying it.
So let’s look at the actual Basic case. Basic, Inc. made chemical refractories for the steel industry. It became the subject of a merger bid. During the time it was talking with its merger partner, it made several statements denying that it was in merger talks. (Why do this? Announcing a merger would have put the company into play, wreaking havoc with its stock price, and jeopardizing the impending merger.) Once Basic publicly announced the merger, some of its shareholders filed a class action, claiming they had been harmed because they had sold shares after its denials depressed the stock price, and before it suspended trading in anticipation of the merger.
The trial court certified a class (presuming that the plaintiffs relied on Basic’s public statements), but then granted summary judgment to Basic. The Sixth Circuit reversed the summary judgment, but affirmed the certification of the class. At that point, Basic filed a petition of certiorari to the Supreme Court.
The Court took on the case, in part to
determine whether a person who traded a corporation’s shares on a securities exchange after the issuance of a materially misleading statement by the corporation may invoke a rebuttable presumption that, in trading, he relied on the integrity of the price set by the market.
In doing so, the Court set out its statement of the fraud-on-the-market theory. As abridged:
The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business…. Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements…. The causal connection between the defendants’ fraud and the plaintiffs’ purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations …
The modern securities markets, literally involving millions of shares changing hands daily, differ from the face-to-face transactions contemplated by early fraud cases, and our understanding of Rule 10b-5′s reliance requirement must encompass these differences …
In drafting that Act, Congress expressly relied on the premise that securities markets are affected by information, and enacted legislation to facilitate an investor’s reliance on the integrity of those markets … Recent empirical studies have tended to confirm Congress’ premise that the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations. …
Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.
(Internal footnotes and quotation omitted.)
As one might expect, allowing a presumption of reliance under any circumstances is hardly a defense-oriented ruling. However, in the limited circumstances of the Basic case (a freely-traded market for securities, where public information rapidly translated into changes in stock price), the holding makes economic sense. More importantly, Basic’s actual holding provides defense lawyers with several avenues of opposing class certification.
First, it limits "fraud on the market" to securities markets, where information is freely disseminated. That means that markets for consumer goods, for example, are not subject to fraud on the market theories, and plaintiffs will still have to prove individual reliance in cases like these. In fact, few markets have the characteristics that allow for a Basic presumption.
Second, it provides a way to argue against even securities fraud cases. The Court held that the Basic presumption is rebuttable. That means that if the defendant can show why it is that the alleged misrepresentation did not cause (or could not have caused) the harm, the plaintiff is not entitled to the presumption.
Fraud class actions are not going away any time soon. As a result, it is fair to expect that plaintiffs will try to avoid the problems of proving reliance on fraudulent statements any way they can. If for no other reason than that, the Basic presumption will remain an important piece of legal doctrine for class-action lawyers for some time to come.