26 Jun 2014

Shareholder class actions dodge a bullet

by Ross McInnes, Nicholas Mavrakis, Shamus Toomey

By allowing the defendants to challenge the presumption of reliance at an early stage, the US Supreme Court in Halliburton took a small step forward in reducing the costs of shareholder claims.

In Australian shareholder class action litigation, the ultimate game of brinkmanship is being played out before the courts. While numerous cases have been commenced, and some have run to trial, all shareholder class actions to date have settled. This means that the question of how shareholders as a class prove causation – a necessary element for the award of damages – remains clouded in uncertainty. A final decision on this issue could throw fuel onto the shareholder class action fire, or destroy the viability of this kind of action.

In the United States there has been a greater degree of judicial direction. Since 1988 the Courts have accepted the "fraud-on-the-market" theory which establishes a presumption of reliance on an efficient market and that shareholders traded in reliance on the integrity of the market price for securities. This rebuttable presumption absolves United States claimants from having to establish that they personally relied on the impugned conduct in making purchasing decisions about their securities.

The recent decision of the United States Supreme Court in Halliburton Co v Erica P John Fund (No.13-317, decided 23 June 2014) had the potential to overturn the "fraud-on-the-market" theory of causation. Even though it did not, what it did decide could influence how Australian courts consider the issue.

The debate in Australia

Australian shareholder class actions are generally brought in respect of two causes of action:

  • misleading or deceptive conduct in respect of inaccurate or incomplete statements and/or a failure to disclose or correct certain information; or
  • breach of a listed company’s continuous disclosure obligations.

For both causes of action, establishing causation is essential in a claim for damages.

The question is, what must a claimant do to establish causation?

Is it necessary for each claimant to separately prove actual reliance on the contravening conduct (direct causation)? Or can the claimant establish causation by showing that the impugned conduct caused the market price of the shares to be inflated and that by purchasing shares at the inflated price, the shareholders have suffered loss (indirect causation)?

Fraud-on-the-market theory

Indirect causation has some similarities with the United States "fraud-on-the-market" theory, which was first endorsed in Basic v Levinson (485 US 224 (1988)), in the context of securities class actions under the US Securities and Exchange Commission Rule 10b-5.[1]

In Basic the US Supreme Court created a rebuttable presumption of shareholder reliance on a company's material public misrepresentations. The Court based that presumption on the "fraud-on-the-market" theory, which holds that:

  • well-developed capital markets efficiently incorporate all publicly available information into a company's market price – the so-called "efficient market hypothesis"; and
  • investors buy or sell stock in reliance on the market price conveying the company's true value,

such that misleading, or improperly withheld, information will affect the market price of the security and can therefore be presumed to be the cause of loss to shareholders following a market correction, once the information is disclosed or corrected. In a representative action, that means that proof of individual investor reliance on the conduct is unnecessary, instead allowing common proof of reliance.

The presumption of reliance in Basic was rebuttable, if the link between the alleged misrepresentation and either the price paid, or the decision to trade, could be severed.

The "fraud-on-the-market" theory had real resonance in the United States, because it has a "certification" requirement – a judicial endorsement that the claim can proceed as a class action. One of the necessary elements of certification is that "the questions of law or fact common to class members predominate over any questions affecting only individual members". This is a hurdle which would be insurmountable in shareholder class actions in the absence of the "fraud-on-the-market" theory.

While the presumption has not been adopted in Australia, it does have some similarities with the indirect causation approach, which means the recent decision in Halliburton was keenly awaited by the class action industry in Australia.

The background to Halliburton

In deciding to hear the appeal,[2] the US Supreme Court considered:

  • whether it "should overrule or substantially modify" the holding in Basic to the "extent that it recognizes a presumption of classwide reliance derived from the fraud-on-the-market theory"; or
  • whether defendants may rebut that presumption at the class certification stage.

In Halliburton the claim alleges that Halliburton misrepresented its financial position regarding asbestos litigation, a merger, and costs-overruns on fixed price contracts. As those misrepresentations were discovered or were corrected, Halliburton's share price dropped. The Erica P. John Fund asserted that these misrepresentations defrauded Halliburton's investors and sought class certification to recover investors' losses from Halliburton.

Halliburton had urged the Supreme Court to overrule Basic's presumption of reliance and to instead require every plaintiff to prove that he or she actually relied on the defendant's misrepresentation in deciding to buy or sell a company's stock. Halliburton's primary argument was that there was no longer any justification for the "fraud-on-the-market" theory.

The Halliburton decision

The Supreme Court determined that Halliburton had not established the necessary "special justification" for the presumption of reliance established in Basic to be overruled. In particular, Halliburton "had not identified the kind of fundamental shift in economic theory that could justify overruling a precedent on the ground that it misunderstood, or has since been overtaken by, economic realities".

However, the Supreme Court agreed with one of Halliburton's alternative arguments, namely, that defendants must be afforded an opportunity to rebut with evidence of a lack of price impact the presumption of reliance before class certification.

In other words, the Court would permit defendants to lead direct evidence that an alleged misrepresentation did not actually affect the stock's price, and so the Basic presumption should not apply. Without the presumption, the claim would not be certified because the common issues would not "predominate" over individual ones.

Implications for Australia: shareholder class actions dodge a bullet

The US Supreme Court, in declining to overrule Basic, has in effect affirmed the adoption of the "fraud-on-the-market" theory in establishing a rebuttable presumption of reliance. The viability of that theory of causation in the United States provides some support for proponents of indirect causation in Australian shareholder class actions.

By granting the defendants a procedural victory which enabled them to challenge the presumption at an early stage of the proceedings, the Supreme Court took a small step forward in reducing the costs of shareholder claims in the United States. This, in turn, is likely to reduce the attractiveness of the more speculative shareholder class action suits.

Australian courts have, to varying degree, previously looked to US developments in class actions, and so this decision has been awaited in Australia with some eagerness. Although it has not been as decisive as some might have hoped, it will provide some guidance to the first Australian court to rule on the appropriate rule for causation in shareholder class actions.

Until a decision is made in Australia, and while the issue remains unresolved, however, the game of brinkmanship continues. Both plaintiffs and defendants take a risk in allowing a matters to proceed to judgment – a decision either way on an essential element in obtaining damages will have a major impact on these kinds of class actions in the future.


[1] The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. Back to article

[2] Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317, 82 U.S.L.W. 3119 (U.S. Nov. 15, 2013) Back to article

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.