A Basic Question: Is Materiality The Better Standard For Class Certification In Securities Fraud Lawsuits?

First published in Bloomberg Law Reports, February 13, 2012

The growing disagreement among federal courts over the timing for proving materiality in securities-fraud class actions highlights how unworkable the fraud-on-the-market (FOTM) inquiry currently is. In Basic Inc. v. Levinson,1 the U.S. Supreme Court held that a purported class of shareholders may take advantage of the FOTM presumption of reliance if it can make certain showings at the class-certification stage. In the intervening 20-plus years, Courts of Appeals have become divided on whether this showing includes proof at the class certification stage that the misstatement at issue is "material." In other words, are plaintiffs merely required to prove that a security is traded on an efficient market, which assumes any material misstatement impacts the price, or must plaintiffs also prove that the statement at issue was, in fact, material, thus impacting the price of the stock?

It is likely only a matter of time before the Supreme Court will need to address this issue. Three Courts of Appeals have held that plaintiffs must prove materiality to take advantage of the FOTM presumption, while three other Courts of Appeals have held the opposite.

When the Supreme Court does resolve this circuit split, the best approach may be to reexamine one of the core premises in Basic: its reliance on efficiency. Basic's holding rests on the assumption that perfectly efficient markets exist, and in such efficient markets, any material statement will have a corresponding effect on price. But numerous examples over the last two decades have revealed that this assumption is not always true: While many material statements will affect price in a reasonably "efficient" market, no market is so perfectly efficient that price impact can be assumed. A better inquiry would focus on the market effect on the price when the statement was issued. Using this approach, there is no question that the statement at issue moved the market—and thus, no question that the FOTM presumption is appropriate. This, in essence, is a materiality inquiry.

Looking to market impact (and thus, to materiality) at the class certification stage has several practical benefits. Besides being a more theoretically sound application of the FOTM theory, looking to market impact instead of market efficiency would discourage strike suits of well-traded stocks, allow more meritorious suits of less widely traded stocks, and provide lower courts with a more administrable class certification process. These benefits provide ample reason to reexamine Basic.

Basic's Vague Materiality Holding and the Circuit Split that It Engendered

The FOTM theory is a necessary presumption for securities fraud suits to proceed as class actions. Federal Rule of Civil Procedure 23(b) requires plaintiff to demonstrate that common issues predominate over individualized issues. If reliance must be established for each member of the class, it normally will prevent class certification because individualized issues will predominate over common ones. In Basic, the Supreme Court resolved this conflict by holding that a purported class may invoke 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," to enjoy a rebuttable presumption of reliance.2

Courts around the nation agree that in order to take advantage of Basic's presumption of reliance, a plaintiff must show that the misrepresentation at issue was public and that the stock at issue traded in an "efficient" market—that is, a market that quickly incorporates all information. But Basic did not state clearly whether materiality should be a required showing to enjoy the FOTM presumption at the class certification stage, or only considered as a merits issue.

Basic's lack of clarity on this point has caused a circuit split. The First, Second, and Fifth Circuits have held that a materiality showing is required at the class certification stage.3 These decisions rely either on Basic's footnote 27, which notes that the Court of Appeals below had stated that, among other things, "in order to invoke the presumption, a plaintiff must allege and prove . . . that the misrepresentations were material," or on Basic's admonition that "the presumption of reliance may be rebutted by '[a]ny showing that severs the link between the alleged misrepresentation and the price received (or paid) by the plaintiff.'"4 The Fifth Circuit also has considered the policy reasons for establishing a materiality requirement at this stage.5

Taking a contrary tack, the Third and Seventh Circuits—and most recently, the Ninth Circuit in its November 2011 decision Connecticut Retirement Plans and Trust Funds v. Amgen, Inc.6— have declared that a materiality analysis should wait until the merits stage because it is a merits inquiry common to the entire class.7 These decisions generally reason that the positions of the First, Second, and Fifth Circuits misread Basic's footnote 27, and in reality, "[a]ll note 27 in Basic does is state that the court of appeals deemed materiality essential; the Justices did not adopt it as a precondition to class certification."8

Why Basic's Current Efficiency-Based Framework Does Not Work

With three Courts of Appeals in favor of imposing a materiality requirement at the class certification stage and three against, it appears that the circuit split will continue to grow until the...