Loss Causation and Class Certification: Erica P. John Fund, Inc. v. Halliburton Co.

In Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179 (2011), the Supreme Court agreed to resolve a discrepancy in the way circuit courts certified class actions in securities fraud cases. The issue was whether plaintiffs had to demonstrate “loss causation” in order to obtain certification as a class under the Fed. R. Civ. P. 23(b)(3).

EPJ Fund alleged that Halliburton violated SEC Rule10b-5 when it knowingly made false statements about its potential liability in asbestos litigation, its expected revenue from construction contracts, and its benefits of a merger with another company.  Under Rule 10b-5, a plaintiff must prove “‘(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.’”

EPJ Fund contended that Halliburton’s stock price declined once Halliburton announced corrective disclosures and that the connection between the defendant’s misrepresentation and the plaintiff’s injury was sufficient to be granted certification as a class under Basic’s fraud-on-the-market doctrine.  Basic Inc. v. Levinson, 485 U.S. 224 (1988).  The fraud-on-the market doctrine presumed that an investor relied on the defendant’s misrepresentation during the relevant transaction and that the misrepresentation was “reflected in the market price.” Defendant asserted and the appellate court agreed that EPJ Fund also had to establish loss causation at the certification stage to “trigger the fraud-on-the-market presumption.”   Because plaintiff had not sufficiently alleged the element, the class was not certified.   

On June 6, 2011, the Supreme Court unanimously decided that the Fifth Circuit erred in requiring the plaintiffs to prove loss causation to obtain class certification and remanded the case for further proceedings.  The Court held that at the class certification stage EPJ Fund only needed to meet the requirements of Fed. R. Civ. P. 23(b)(3), and not the loss causation element of SEC Rule 10b-5.  Fed. R. Civ. P. 23(b)(3) states that a court must  find “that the questions of law or fact common to class members predominate over any questions affecting only individual members, and that a class action is superior to other available methods for fairly and effectively adjudicating the controversy.” 

In securities fraud cases, reliance on the defendant’s alleged misrepresentation is the essential element and question of law that predominates the underlying action. Basic allowed plaintiffs to obtain class certification based on a fraud-on-the-market theory alone, and did not require additional evidence of loss causation.   As the Court observed:

The Court of Appeals’ requirement is not justified by Basic or its logic. To begin, we have never before mentioned loss causation as a precondition for invoking Basic’s rebuttable presumption of reliance. The term “loss causation” does not even appear in our Basic opinion. And for good reason: Loss causation addresses a matter different from whether an investor relied on a misrepresentation, presumptively or otherwise, when buying or selling a stock.

The Court spent a considerable portion of the opinion discussing the differences between loss causation and reliance and finally concluded that “[l]oss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.” 

The Court, therefore, concluded that loss causation, as an element of reliance, did not have to be established at the class certification stage.  However, according to the Corporate Law Daily, the only place that this decision has an impact is the Fifth Circuit, because it was the sole circuit that required loss causation for class certification.

The primary materials for this case may be found on the DU Law Corporate Governance website.