Recent class action jurisprudence has been increasingly permissive toward courts considering the merits at the class certification stage. This week, however, the Supreme Court placed a firm limit on this practice, unanimously striking down a Fifth Circuit rule requiring securities class action plaintiffs to prove “loss causation” as a prerequisite for class certification.
In Erica P. John Fund, Inc. v. Halliburton Co., the sole obstacle to class certification was Fifth Circuit precedent that securities fraud plaintiffs must first prove a causal connection between the material misrepresentation and the economic loss suffered by investors, i.e., “loss causation.” As articulated by the Fifth Circuit in affirming the denial of class certification, proving loss causation meant showing “that the corrected truth of the former falsehoods actually caused the stock price to fall and resulted in the losses.” The Fifth Circuit reasoned that this element was necessary to establish that reliance was capable of resolution on a classwide basis; otherwise, according to the Fifth Circuit, individual issues would predominate over common issues, and resolving the dispute as a class action would be inappropriate.
According to the Fifth Circuit, loss causation was necessary to invoke the “fraud on the market” presumption articulated by the Supreme Court in 1988 in Basic Inc. v. Levinson. In Basic, the Court held that securities fraud plaintiffs may invoke a rebuttable presumption of reliance based on the theory that the market price reflects all public information, including the alleged misstatements, and that an investor who buys stock at the market price therefore relies on the misstatements in doing so. While Basic requires plaintiffs seeking to invoke this presumption to prove such fundamental facts as the public availability of the misrepresentations, the efficiency of the market in which the stock traded, and the occurrence of a stock purchase between the making of the misrepresentation and the revelation of the truth, the Fifth Circuit added loss causation to the list of prerequisites.
This precedent was in conflict with decisions of the Second, Third, and Seventh circuits, which have not required proof of loss causation at the class certification stage. In resolving the split, the Court soundly rejected the Fifth Circuit rule, holding that “[l]oss causation addresses a matter different from whether an investor relied on misrepresentation, presumptively or otherwise, when buying or selling a stock.” While reliance relates to the facts surrounding the investor’s decision to buy or sell, loss causation requires a decline in the value of the stock subsequent to that decision, which may have occurred for reasons unrelated to the correction of the misrepresentation.
In essence, the Court’s decision draws a line between commonality—a critical issue at the class certification stage—and the merits. The presumption of a fraud on the market is a step toward resolving the element of reliance on a classwide basis; by successfully invoking the presumption, class counsel avoids the need for individual adjudications of each class member’s knowledge and state of mind at the time of the transaction. The loss causation requirement, however, effectively required plaintiffs who have established common reliance to show, in order to obtain class certification, that their reliance caused injury. As the Court recognized, while the absence of economic loss may ultimately doom the lawsuit on the merits, it has nothing to do with whether common issues predominate over individual ones. For this reason, it is not terribly surprising that even this Court, which is hardly known for a predisposition toward class action plaintiffs, unanimously struck down the Fifth Circuit rule.