The Trouble with Basic: Price Distortion after Halliburton

The Supreme Court’s decision in Basic, Inc. v. Levinson is widely credited with spawning a vast industry of securities fraud litigation by removing the requirement of individualized proof of reliance as an obstacle to class certification. Modern criticisms of private litigation coupled with questions about the validity of the economic premises on which Basic relied have led critics to question the legitimacy of the Court’s holding in Basic. Most recently, with the Supreme Court’s decision to grant certiorari in Amgen, commentators are again speculating that the Court may use the Amgen case as an opportunity to overrule Basic.

In my article, The Trouble with Basic: Price Distortion After Halliburton (forthcoming in Washington University Law Review), I argue that this criticism of Basic mischaracterizes the decision. Basic did not release federal securities fraud from its moorings in common law fraud and deceit. Rather, by retaining the reliance requirement in federal securities fraud litigation, Basic reflected judicial conservatism. Despite contemporaneous recognition by lower courts and commentators that a reliance requirement was anomalous in the context of impersonal transactions in the public securities markets, the Supreme Court lacked the courage to reject reliance outright. Instead, the Court constructed a complex theory of market integrity relying on the fact that, in an efficient market, fraudulent public statements distort stock prices. According to the Basic Court, the existence of this price distortion justifies a rebuttable presumption of reliance.

The Basic presumption simplified the class certification inquiry, for a time, by relieving plaintiffs of the need to establish individualized reliance. This relief came at a price, however. The price was a shift in the underlying conception of securities fraud litigation. As my article explains, the price distortion theory on which Basic was premised had the effect of converting securities fraud from a transaction-based wrong — akin to common law deceit — into a market-based claim.

At the same time, because it used the fraud on the market theory as the basis for its ruling, Basic deflected the reliance inquiry into an analysis of market efficiency. Following Basic, courts rapidly limited the availability of the Basic presumption to cases involving efficient markets. Although I argue that market efficiency is neither a necessary or sufficient condition to establish that misinformation has distorted prices, most courts have concluded that the threshold inquiry in Basic is satisfied by proof that the misrepresentations were publicly made and that the stock trades in an efficient market.

One of the exceptions was the Fifth Circuit. In Halliburton, the Fifth Circuit held that, to obtain class certification under Basic, the plaintiff had to prove that the defendant’s misrepresentation affected the market price of the security. The court explained that this “price impact” could be established in one of two ways — through a stock price reaction at the time of the fraudulent statement or through a stock price response to the revelation of truth. The latter showing is equivalent to that required to establish the element of loss causation. The Halliburton case thus offered the Supreme Court an opportunity to reexamine the normative implications of focusing on price distortion in defining the contours of a claim for private securities fraud.

The Court declined the invitation. Reluctant to disturb the delicate balance created by its prior decisions, and perhaps wary of entrusting policing the markets to the SEC in light of ongoing questions about the vigor of its enforcement efforts, the Halliburton Court eschewed a broad-based holding and relied instead on a rigid characterization of the lower court’s analysis. Although it reaffirmed the vitality of the Basic presumption, the Court explicitly refused to consider the role of price distortion in obtaining that presumption.

The Halliburton decision reflected the Fifth Circuit’s confusion between two temporal concepts — price distortion at the time of the fraud and price impact when the fraud is revealed to the market — that serve distinct objectives. I term these concepts ex ante price distortion and ex post price distortion. Understanding the objectives behind these concepts is critical in determining the appropriate scope of private securities fraud litigation. In Amgen, the Court is specifically asked to decide whether proof of price distortion is necessary to obtain class certification. This Article argues that proof of price distortion should not be required at the class certification stage. Rather, the natural outgrowth of the Court’s market-based approach to securities fraud justifies resolving the tension in Amgen by overruling that aspect of the Basic decision that retains a reliance requirement.

The full article is available for download here.