U.S. Supreme Court Issues Two Important Securities-Law Opinions
On February 27, 2013, the U.S. Supreme Court issued a pair of important securities-law decisions, one requiring the SEC to act more swiftly in pursuing fraud charges, and the other making it significantly easier for private plaintiffs to pursue securities fraud claims on a class-wide basis.
In Gabelli v. Securities and Exchange Commission, a unanimous Supreme Court established a five-year deadline for the SEC to pursue claims after the occurrence of an alleged fraud. The SEC had argued that the five-year clock should not start ticking until the date on which it discovered the alleged fraud, which may be significantly after the date on which the defendant’s misconduct took place. The Supreme Court rejected this argument. Unlike private plaintiffs, the SEC is not entitled to rely on the “discovery” rule to extend its limitations period.
In Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, the Supreme Court held that plaintiff shareholders of Amgen Inc. could pursue securities fraud claims against the biotechnology company on a class-wide basis, without first having to prove that the company’s alleged misrepresentations materially inflated its stock price. The 6-3 ruling resolves a circuit split over whether the element of “materiality” should be considered at the class certification stage.
Both of these decisions will have an immediate impact on securities litigation. The Gabelli decision will likely result in increased SEC activity, including more rigorous SEC examinations, faster-paced investigations, and potentially more actions being filed. The Amgen decision removes a barrier that discouraged the filing of securities cases in certain circuits, but may set up a new battle — whether the fraud-on-the-market doctrine, a key foundation of securities class actions, should be revised or abandoned altogether.
Gabelli v. SEC
In Gabelli, the SEC alleged that two officials at Gabelli Funds, LLC, a registered investment advisor, aided and abetted a fraud between 1999 and 2002 by permitting a large investor to secretly engage in “market timing” in a quid pro quo arrangement. In 2008, the SEC filed claims against the two officials under the Investment Adviser Act, seeking disgorgement, injunctive relief, and a civil monetary penalty. The defendants argued that the SEC’s claims were time-barred under 28 U.S.C. § 2462, which provides that “an action, suit or proceeding for the enforcement of any civil fine, penalty or forfeiture … shall not be entertained unless commenced within five years from the date when the claim first accrued.”
The district court agreed that the SEC’s request for a monetary penalty was time-barred, and it dismissed that claim. The Second Circuit reversed, reinstating the SEC’s civil-penalty claim. The appellate court held that the SEC is entitled to the benefit of the “discovery rule,” which means that its deadline to file a civil-penalty claim did not begin until it discovered (or reasonably could have discovered) the fraud.
The Supreme Court reversed the Second Circuit’s decision. In a unanimous opinion authored by Chief Justice Roberts, the Court held that when the government seeks a civil penalty, “the five-year clock…begins to tick when the fraud occurs, not when it is discovered.”
Chief Justice Roberts explained that the SEC does not need the protections afforded by the discovery rule. The rule was created to protect fraud victims “where a defendant’s deceptive conduct may prevent a plaintiff from even knowing that he or she has been defrauded.” The time for filing a fraud suit is extended because “private parties may be unaware that they have been harmed. Most of us do not live in a state of constant investigation; absent any reason to think we have been injured, we do not typically spend our days looking for evidence that we were lied to or defrauded. And the law does not require that we do so.”
But the SEC is different. “Unlike a private party who has no reason to suspect fraud, the SEC’s very purpose is to root it out, and it has many legal tools at hand to aid in that pursuit.” The Court noted that the SEC may examine the books and records of an investment adviser at any time, and it also may issue subpoenas for documents and testimony without filing suit. The Court opined that “[c]harged with this mission and armed with these weapons, the SEC as enforcer is a far cry from the defrauded victim the discovery rule evolved to protect.”
Furthermore, the Supreme Court was troubled by the impracticality of applying the discovery rule to the government, since trial courts would be forced to determine, among all of the agency’s offices, employees, and leadership, when the agency knew or should have known of the claim. Moreover, allowing the government to rely on the discovery rule would “leave defendants exposed” to punishment “not only for five years after their misdeeds, but for an additional uncertain period in the future,” which the Court found to be “utterly repugnant to the genius of our laws.”
While the Court drew a bright line for Government actions for civil penalties, it left open two important issues. First, the Court did not define, beyond a monetary penalty, what remedies constitute a civil penalty under 28 U.S.C. § 2462. The SEC commonly seeks other remedies such as disgorgement of ill-gotten gains, injunctions barring individuals from working in the securities industry, and injunctions barring individuals from serving as an officer or director of a public company. The Court’s decision leaves open the question of whether these and other such remedies are also subject to a strict five-year statute of limitations. Second, the Court left open the possibility that the Government could obtain additional time to file suit if a defendant has acted to affirmatively conceal the fraudulent conduct.
In the last few years, the SEC has made significant changes to its enforcement program, which has resulted in an increase of enforcement activity. The Gabelli decision is likely to generate more changes at the Commission. Those changes may include additional referrals from compliance examiners to the enforcement division, an increased number of informal inquiries by enforcement staff, faster-paced investigations, and almost certainly, additional requests for tolling agreements with persons being investigated.
Amgen Inc. v. Connecticut Retirement Plans and Trust Funds
Both Congress and the Supreme Court have recognized the adverse impact that securities litigation can have on public companies. The costs of defense are high and the potential liability can be ruinous, often forcing defendants to settle even unmeritorious claims.
In 1995, Congress passed the Private Securities Litigation Reform Act, which created significant pleading hurdles for plaintiffs who attempt to bring class action claims under the federal securities laws. The Supreme Court has further narrowed the playing field for securities plaintiffs. See Tellabs Inc. v. Makor Issues & Rights, 551 U.S. 308 (2007) (heightened standards for pleading scienter); Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148 (2008) (limiting liability of secondary actors); Morrison v. National Australia Bank, 130 S. Ct. 2869 (2010) (limiting extraterritorial jurisdiction); Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011) (further limiting claims against secondary actors).
In addition to the foregoing limitations, several decisions from lower federal courts have created new hurdles for plaintiffs at the class certification stage. Those decisions have focused on the level of proof necessary to invoke the “fraud-on-the-market” presumption, established in 1988 by the Supreme Court’s decision in Basic v. Levinson. The fraud-on-the-market theory creates a rebuttable presumption that investors have relied on any material misrepresentations or omissions that have been disseminated to the general public.
In Basic, the Court explained that the fraud-on-the-market presumption is supported by “common sense and probability,” noting that “an investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price. Because most publicly available information is reflected in market price, an investor's reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action.” The ability to invoke this presumption is crucial to class-action plaintiffs. Without it, individual issues of reliance and causation would be likely to dominate over common questions.
There has been considerable disagreement among lower courts concerning the requisite proof needed to invoke the presumption at the class certification stage. Two years ago, in Erica P. John Fund, Inc. v. Halliburton Co., the Supreme Court unanimously rejected a proposed barrier to class certification created by the Fifth Circuit. The Supreme Court held that plaintiffs do not have to prove “loss causation” (i.e., that the defendant’s misconduct directly caused the plaintiffs’ losses) in order to invoke the fraud-on-the-market doctrine.
The Fifth Circuit had required plaintiffs to prove, at the class certification stage, that the defendants’ alleged misstatements (as opposed to other contemporaneous disclosures or market forces) independently moved the market before they were entitled to invoke Basic’s fraud-on-the market presumption of reliance. The Supreme Court, however, found that the Fifth Circuit’s loss causation requirement was “not justified by Basic.” Chief Justice Roberts explained that the Fifth Circuit approach “contravene[d] Basic’s fundamental premise – that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction. The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively through the fraud-on-the-market theory. Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.”
Although Halliburton eliminated the certification-stage examination of loss causation, many lower courts continued to require proof of the materiality of the defendant’s alleged misrepresentation at the class certification stage in order to invoke the fraud-on-the-market presumption. In Amgen, the Supreme Court made clear that proof of materiality also is improper at the class certification stage.
The specific questions presented in Amgen were: (1) whether the district court must require proof of materiality before certifying a plaintiff class based on the fraud-on-the-market theory; and (2) whether the district court must allow the defendant to present evidence rebutting the applicability of the fraud-on-the-market theory before certifying a plaintiff class. The Court answered “no” to both questions.
Writing for the majority, Justice Ruth Bader Ginsburg emphasized that the key question is not whether materiality is an essential element of the fraud-on-the-market theory —“indisputably it is.” Rather, the question is whether proof of materiality is necessary at the class certification stage in order to demonstrate that common questions will predominate over individual issues.
For two reasons, the Supreme Court concluded that proof of materiality is not required at the class certification stage. First, the question of materiality “is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor.” Therefore, “materiality can be proved through evidence common to the class.” Second, a failure of proof on the element of materiality does not result in individual questions. “Instead, the failure of proof on the element of materiality would end the case for one and for all; no claim would remain in which individual reliance issues could potentially predominate.”
The Court stressed that the early stages of class-action litigation are meant to ensure that cases are litigated fairly and efficiently. Amgen “would have us put the cart before the horse,” Ginsburg wrote. “Congress, we count it significant, has addressed the settlement pressures associated with securities-fraud class actions through means other than requiring proof of materiality at the class-certification stage.”
On its face, Amgen represents a victory for the plaintiffs’ bar, especially coming on the heels of the Court’s previous ruling in Halliburton. In both cases, the Supreme Court has rejected lower court attempts to raise the bar for plaintiffs at the class certification stage. Plaintiffs will continue to face strict scrutiny of their complaints at the pleading stage, but if they can survive a motion to dismiss, the road to certification has become easier. From the defense perspective, the Court’s decision is likely to increase legal costs and force defendants to engage in lengthy legal battles before they can dispose of unmeritorious claims.
Ultimately, however, Amgen may lead to a fundamental reconsideration of the fraud-on-the-market doctrine, which would be a significant victory for the defense bar. At least four Justices appear willing to revisit the holding in Basic. Writing in dissent, Justice Scalia argued that Basic itself was “regrettable” and the majority opinion in Amgen is “unquestionably disastrous.” According to Justice Scalia, while investors may indeed rely on the stock market to set the correct price for a stock, that doesn’t mean that every misrepresentation a company makes contributed to that price — only those that are demonstrably material.
Justice Thomas (joined by Justice Kennedy) also dissented from the Court’s opinion arguing that plaintiffs should be required to prove materiality in order to invoke the fraud-on-the-market doctrine. Thomas added: “The Basic decision itself is questionable. Only four Justices joined the portion of the opinion adopting the fraud-on-the-market theory. Justice White, joined by Justice O’Connor, dissented from that section, emphasizing that ‘[c]onfusion and contradiction in court rulings are inevitable when traditional legal analysis is replaced with economic theorization by the federal courts’ and that the Court is ‘not well equipped to embrace novel constructions of a statute based on contemporary microeconomic theory.’ Justice White’s concerns remain valid today.”
Justice Alito concurred with the majority, but did so only because “the petitioners did not ask us to revisit Basic’s fraud-on-the-market presumption.” According to Justice Alito, “more recent evidence suggests that the presumption may rest on a faulty economic premise. In light of this development, reconsideration of the Basic presumption may be appropriate.”
Even Justice Ginsburg acknowledged the concerns over Basic’s economic underpinnings, but concluded that Amgen was “a poor vehicle” for revisiting the Basic decision.
When the fraud-on-the-market theory was adopted by the Court in 1988, securities markets were widely viewed as efficient, in that the price of a stock was believed to reflect all available information about the company — including any misstatements. Empirical research has demonstrated, however, that modern stock markets aren’t perfectly efficient. Markets incorporate some kinds of information more quickly than other kinds. And many trades are not based on the fundamental value of a company, but on speculation, momentum, and high-frequency algorithms.
With only four justices required to take up a new case, the Supreme Court may be ready to revisit the fraud-on-the-market theory. If so, Amgen may be remembered as a hollow victory for the plaintiffs’ bar.