Materiality and the Fraud-on-the-Market Presumption

In November 2012, the United States Supreme Court will again hear an appeal of a federal securities class action in Amgen Inc. v. Connecticut Retirement Plans & Trust Funds (No. 11-1085) (“Amgen”). In the past two years, the Supreme Court has heard no less than five appeals arising from securities class actions.

Amgen requires the Court to reconsider its own landmark decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988), adopting a rebuttable classwide presumption of reliance based on the “fraud-on-the-market” (“FOTM”) theory. The FOTM theory assumes that the market price of securities traded in an efficient market reflects all publicly-available information, including any material misrepresentations. Twenty-five years later, the parties in Amgen ask the Court to resolve whether, in such a case, a district court must (1) “require proof of materiality” concerning the challenged statements and/or (2) “allow the defendant to present evidence rebutting the applicability of the fraud-on-the-market theory” before certifying a class under Fed. R. Civ. P. 23(b)(3). To fully understand the import of these questions, some background on the relevant concepts is helpful.

To state a claim for securities fraud under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 promulgated thereunder, a plaintiff must plead, among other things, a material misstatement or omission. The materiality element is satisfied when there is “a substantial likelihood that the disclosure of the [truth] would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1318 (2011) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). Although this standard, based on a hypothetical “reasonable investor,” is objective in nature (see TSC, 426 U.S. at 445), courts have consistently rejected bright-line rules to gauge materiality in favor of a multi-faceted, “fact-specific” inquiry incorporating both qualitative and quantitative factors. See, e.g., Matrixx, 131 S. Ct. at 1321 (any approach that “designates a single fact or occurrence as always determinative of an inherently fact-specific finding such as materiality, must necessarily be overinclusive or underinclusive”) (internal quotations and citations omitted); Litwin v. Blackstone Grp., L.P., 634 F.3d 706, 717-20 (2d Cir.), cert. denied, 132 S. Ct. 242 (2011) (finding statements qualitatively material despite the lack of sufficient quantitative evidence).

Materiality is relevant to 10(b) cases not only as an element of the substantive claim, but also as a foundation for the FOTM theory underlying Basic’s presumption of reliance. Reliance, in turn, is another separate and “essential” element of a 10(b) claim, supplying the “‘requisite causal connection between a defendant’s misrepresentation and a plaintiff’s injury.’” Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 159 (2008) (quoting Basic, 485 U.S. at 243). However, the reliance element of a Section 10(b) claim historically presented a near-insurmountable hurdle in securities fraud class actions, where obtaining individualized proof of every class member’s reliance on a defendant’s public statements invariably ran afoul of Fed. R. Civ. P. 23(b)(3) prohibiting class certification unless “questions of law or fact common to class members predominate over any questions affecting only individual members.” The Basic court, acknowledging this issue, adopted a presumption of reliance in such cases based in part on the FOTM theory. 485 U.S. at 241-47. The Court in Basic explained that the FOTM 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.” Id. at 241 (emphasis added) (citation omitted). “Indeed,” the Court continued, “nearly every court that has considered the proposition has concluded that where materially misleading statements have been disseminated into an impersonal, well-developed market for securities, the reliance of individual plaintiffs on the integrity of the market price may be presumed.” Id. at 247 (emphasis added).

Importantly, however, the Basic Court recognized that the presumption of reliance arising under the FOTM theory is not absolute; rather, “[a]ny 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 . . . .” Id. at 248. In so holding, the Court noted that any facts showing “that the market price would not have been affected by the[] misrepresentations” would be sufficient to break the “causal connection” supplied by the FOTM theory. Id.

With this background, the issues in Amgen come into sharper focus. In Amgen, Connecticut Retirement Plans and Trust Funds (“Connecticut Retirement”) brought a putative class action under the Exchange Act alleging that Amgen and several of its directors and officers misstated and failed to disclose safety information about two of the company’s pharmaceutical products. Although Connecticut Retirement provided no evidence concerning the materiality of Amgen’s alleged misstatements, the district court nonetheless certified the proposed class, holding that Connecticut Retirement “need only establish that an efficient market exists” to take advantage of the Basic presumption. Conn. Ret. Plans & Trust Funds v. Amgen, Inc., 2009 WL 2633743, at *12 (C.D. Cal. Aug. 12, 2009). On appeal, the Ninth Circuit identified a circuit split on this issue originating from divergent interpretations of a footnote in Basic. See Basic, 485 U.S. at 248 n.27 (observing without explicitly endorsing the Sixth Circuit holding below that “in order to invoke the presumption, a plaintiff must allege and prove . . . that the misrepresentations were material”).

Ultimately, the Ninth Circuit agreed with the Seventh Circuit’s decision in Schleicher v. Wendt, 618 F.3d 679 (7th Cir. 2010), and therefore ruled that Connecticut Retirement must only “plausibly allege—but need not prove . . . that the claimed misrepresentations were material” to avail itself of the FOTM presumption at the class certification stage. Conn. Ret. Plans & Trust Funds v. Amgen Inc., 660 F.3d 1170, 1172 (9th Cir. 2011). For the same reason, the Ninth Circuit also denied Amgen the opportunity to rebut the FOTM presumption by establishing a lack of materiality. Id. This approach differs from that of the Second and Fifth Circuits, which require plaintiffs to prove materiality at the class certification stage to utilize the FOTM presumption, and which also allow defendants an opportunity to rebut that showing. See In re Salomon Analyst Metromedia Litig., 544 F.3d 474 (2d Cir. 2008); Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 401 F.3d 316 (5th Cir. 2005). The Third Circuit takes a middle-of-the-road approach that does not require evidence of materiality to invoke the FOTM presumption, but does permit defendants an opportunity to rebut the presumption by showing a lack of materiality. See In re DVI, Inc. Sec. Litig., 639 F.3d 623 (3d Cir. 2011).

The Amgen parties’ written submissions to the Supreme Court largely echo this circuit split. Connecticut Retirement advances the position of the Seventh Circuit in Schleicher and the Ninth Circuit below, i.e., that materiality is not an essential predicate to the Basic presumption. Instead, pointing to the Supreme Court’s “more recent formulations” of the FOTM theory in Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179 (2011), and Wal-Mart Stores, Inc. v. Dukes, 131 S. Ct. 2541 (2011), Connecticut Retirement argues that the only indispensable FOTM prerequisites are (1) “that the security in question was traded in an efficient market,” and (2) “that the alleged misrepresentations were public.” Br. for Resp’t in Opp’n to Cert. at *9, Amgen (No. 11-1085), 2012 WL 1666404 (U.S. May 11, 2012). Once this efficient market is demonstrated, says Connecticut Retirement, certification is appropriate because “falsehood and materiality affect [all] investors alike” and “if the misrepresentations turn out to be immaterial, then every plaintiff’s claim fails on the merits.” Id. at *13.

In contrast, Amgen argues for application of the Second and Fifth Circuits’ position, asserting that because the FOTM theory assumes that “efficient” markets incorporate only new material information, courts have no basis to presume that immaterial statements are reflected in the market price of a security (and thereby affect all plaintiffs equally). Br. for Pet’rs at *17-19, Amgen (No. 11-1085), 2012 WL 3277030 (U.S. Aug. 8, 2012). Thus, without a showing of materiality, Amgen argues that common issues cannot predominate under Rule 23(b)(3). Amgen also challenges the Ninth Circuit’s conclusion that materiality is an issue common to the class (and therefore inappropriate for determination at the class certification stage), contending that this position fails to distinguish materiality from the other FOTM predicates such as market efficiency and publicly-made statements, which are also elements common to the entire class. Id. at *38-39.

Connecticut Retirement further asserts that the unique role of materiality in securities fraud class actions (serving as both a FOTM predicate and an element of the substantive claim) threatens to turn class certification proceedings into inefficient mini-trials on materiality. See Br. for Resp’t at 20 para. C, Amgen (U.S. Sept. 20, 2012) (“The practical difficulties of requiring proof of materiality at the class-certification stage are not justified by Amgen’s repeated invocation of the ‘in terrorem’ effect of class certification.”). Yet, after Wal-Mart,

[t]hat cannot be helped. The class determination generally involves considerations that are enmeshed in the factual and legal issues comprising the plaintiff’s cause of action. Nor is there anything unusual about that consequence: The necessity of touching aspects of the merits in order to resolve preliminary matters, e.g., jurisdiction and venue, is a familiar feature of litigation.

131 S. Ct. at 2551-52 (internal quotations and citations omitted). After Wal-Mart, then, there can be no doubt that even a “merits” issue like materiality must be adjudicated on a motion for class certification if it also bears on Rule 23’s requirements.

In addition to finding Amgen’s arguments more persuasive on the law, we think that the Supreme Court will rely, as it did in Basic, on “considerations of fairness, public policy, and probability, as well as judicial economy” and “common sense” underpinning Rule 23 to resolve this debate in favor of Amgen. Basic, 485 U.S. at 247. Such considerations are particularly germane here, where the issues relate to a judicially-created presumption in an implied private right of action. See, e.g., Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 749 (1975). Indeed, Connecticut Retirement’s view of the Basic presumption appears to work substantial hardship on class action defendants. Amgen and amici persuasively note the remarkably small percentage of certified classes that reach trial on the merits (the next realistic opportunity for defendants to challenge materiality, see Pet. for a Writ of Cert. (“Cert. Pet.”) at 15 n.6, Amgen (No. 11-1085) (Mar. 1, 2012)), as well as the “hydraulic pressure” that class certification places on defendants—even those with meritorious defenses—to settle “rather than incur the costs of defending a class action.” See, e.g., id. at 14. In contrast, adopting Amgen’s view guarantees that commonality of reliance is present “in fact” (not just adequately pleaded) as required by Rule 23 and Wal-Mart, 131 S. Ct. at 2552, ensuring that classes with no ultimate chance of recovery are halted at an early stage before the court and defendants waste significant amounts of time and money on meritless cases. At the same time, Amgen’s position creates little prejudice for plaintiffs, who can offer proof on materiality as readily at the class certification stage as at trial. See Br. for Pet’rs, 2012 WL 3277030, at *27-30.