The U.S. Supreme Court issued the latest in a string of important securities law decisions¹ today, holding that plaintiffs in securities fraud class actions are not required to demonstrate loss causation to certify a class. In Erica P. John Fund, Inc. v. Halliburton Co., a unanimous Supreme Court rejected the Fifth Circuit’s contrary view.² Although the decision left open the question whether courts have been properly applying the “fraud on the market” theory that plaintiffs have used to satisfy the reliance element for pleading securities fraud, its decision represents a setback for defendants in the Fifth Circuit, which had previously been the only circuit to impose a loss causation requirement for class certification.

Although the element of reliance usually raises individual questions that preclude certification of a class, the Supreme Court in Basic Inc. v. Levinson, 485 U.S. 224 (1988), held that in securities fraud class action suits, a prospective class of plaintiffs could invoke a rebuttable presumption of reliance by invoking the “fraud on the market” theory, which provides that “[a]n investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price.” Id.at 247, 250. However, Basic did not establish precisely what plaintiffs must demonstrate to invoke the presumption of reliance. Courts have agreed that Basic’s presumption of reliance required plaintiffs to show that the market for the security was efficient, that the alleged misrepresentations were public, and that the relevant transaction took place at a time when the misrepresentation was public but not yet shown to be false. But there was no agreement among the circuits about what else, if anything, plaintiffs must show. 

Prior to the Erica P. John Fund opinion, the Fifth Circuit was the only circuit to require plaintiffs to show loss causation at the class certification stage; the Second, Third, and Seventh Circuits held that loss causation was not required to certify a class. In Oscar Private Equity Investments v.Allegiance Telecom, Inc., the Fifth Circuit held that plaintiffs must show “loss causation” to qualify for Basic’s presumption of reliance. That meant that a class representative would have to show that a decline in the price of the relevant security was “because of the correction to a prior misleading statement” and “that the subsequent loss could not otherwise be explained by some additional factors revealed then to the market.” The Fifth Circuit instituted this requirement in part because without such a showing, there would be no “causal link between the alleged falsehoods and its losses in order to invoke the fraud-on-the-market presumption” — a requirement specifically noted by the Basic Court. Although other circuits explicitly rejected this approach, the Fifth Circuit’s loss causation requirement eluded Supreme Court review until now, and numerous securities fraud cases within the Fifth Circuit were dismissed or denied class certification on these grounds.

In Erica P. John Fund, the Court held that there was no requirement that loss causation be shown at the class-certification stage. In doing so, the Court observed that Basic does not discuss or even mention loss causation. Moreover, it stressed, the question of whether there is loss causation, is altogether different from the question “whether an investor relied on a misrepresentation . . . when buying or selling a stock,” and “has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.” Rejecting the argument that the Fifth Circuit’s references to loss causation were “shorthand” for a requirement that the plaintiffs show “price impact” — that is, that the alleged misrepresentation had an impact on a stock’s price — the Court declined to consider whether a showing of price impact would be an appropriate requirement under Basic. The Court did suggest, however, that the presumption of reliance was appropriate “so long as [the alleged misrepresentation] was reflected in the market price at the time of his transaction” and that the reasons for the subsequent loss would be relevant to loss causation but not to the question of reliance. The Court declined to decide any other questions raised by the parties, concluding, “[b]ecause we conclude the Court of Appeals erred by requiring EPJ Fund to prove loss causation at the certification stage, we need not, and do not, address any other question about Basic, its presumption, or how and when it may be rebutted.”

The Erica P. John decision invalidates Oscar Private Equity and its progeny, and rejects the Fifth Circuit’s loss-causation requirement — at least to the extent that it required a showing of true loss causation, rather than mere price impact, at the class-certification stage. The Court’s decision was a narrow one, however. Erica P. John Fund’s explicit refusal to specify what plaintiffs must show at the class-certification stage — such as whether price impact is an appropriate requirement at this stage, and when the Basic presumption should be rebutted — affords some leeway for lower courts to consider these questions at the class certification stage.

For more information, please contact Vinson & Elkins lawyers Kenneth Held, Steven Paradise, John Elwood, or Alithea Sullivan. Visit our website to learn more about V&E's Securities Litigation and Enforcement practice, or e-mail one of the practice contacts. 

¹ See, e.g., Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. __ (2011) (discussing statistical materiality); Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) (holding that  §10(b) private right of action does not reach defendants who had no role in preparing or disseminating alleged misrepresentations); Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) (discussing standard of pleading scienter under PSLRA); Dura Pharms., Inc. v. Broudo, 544 U.S. 336 (2005) (holding that loss causation requires corrective disclosure followed by stock price decline).