The Third Circuit Rejects the "Fraud-Created-The-Market" Theory for Presuming Reliance in a Private Securities Fraud Action
In affirming the denial of a securities fraud class certification, the Third Circuit flatly rejected the "fraud-created-the-market" theory as a basis for establishing a presumption of reliance to satisfy the requirements of a Section 10(b) claim and thus the predominance requirement of Rule 23(b)(3). Malack v. BDO Seidman, LLP, 2010 WL 3211088 (3rd Cir. Aug. 16, 2010). In so ruling, the Third Circuit joined the Seventh Circuit, Eckstein v. Balcor Film Investors, 8 F.3d 1121 (7th Cir. 1993), in rejecting a theory adopted by the Fifth Circuit, Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981) (en banc), and other courts.
The case involved American Business Financial Services, Inc., a subprime mortgage originator, which issued notes registered with the Securities and Exchange Commission ("SEC"). The notes later became worthless during the subprime mortgage meltdown. Malack had purchased such notes and he filed a putative securities fraud class action against BDO, based on § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, for allegedly assisting American Business in defrauding him and others by providing clean audit opinions used to register the notes with the SEC. Malack thus alleged that without the clean audit opinions the notes could not have been registered, they would not have been marketable, and neither Malack nor the other investors would have been able to purchase them.
One of the elements to make out a Section 10(b) claim is to show a causal nexus between the misrepresentations and the plaintiffs' purchase of the security, and that plaintiffs exercised the diligence that a reasonable person under all the circumstances would have exercised to protect their interests, i.e. reasonable reliance.
The Third Circuit noted that the United States Supreme Court had upheld a presumption of reliance where there is a failure to disclose material facts by defendants obligated to disclose such facts; and, because markets are presumed to be efficient, where misleading statements affect the overall price of a company's stock and thus harm all purchasers, even those who did not personally rely on the misstatements (who are entitled to a presumption of reliance under the "fraud-on-the-market" theory).
In contrast to the "universally" accepted fraud-on-the-market theory, the Third Circuit stated that the fraud-created-the-market theory ("FCTMT") posits that the securities laws allow an investor to rely on the integrity of the market to the extent that the securities it offers to him for purchase are entitled to be in the market place. Such a presumption of reliance would be applicable where a plaintiff proves that the defendant conspired to bring to market securities that were not entitled to be marketed because they are so lacking in basic requirements that they would never have been approved by the issuing entity nor presented to the underwriters had any one of them not acted with intent to defraud or reckless disregard of whether the other defendants were perpetrating a fraud. The Third Circuit noted that, critical to the theory's coherency, is the assumption stated in Shores that it is reasonable for an investor to rely on a security's availability on the market as an indication of its apparent genuineness.
The Third Circuit rejected the FCTMT, stating, "No matter what approach is taken, however, the theory lacks a basis in any of the accepted grounds for creating a presumption." First, the Court noted that presumptions typically are adopted because direct proof is difficult, because they are consistent with congressional policy, and/or because of a general belief that proof of fact B renders the inference of fact A so probable that it is sensible and timesaving to assume the truth of fact A until the adversary disproves it. The Court concluded that the FCTMT rests on the conjecture that the security's availability on the market is an indication of its apparent genuineness. Then the Court analyzed the underpinning for this theory and concluded that common sense called for rejecting the theory. The Court noted that the entities most commonly involved in bringing a security to market (promoters, underwriters, counsel, etc.) do not imbue it with any guarantee against fraud. All of them have a self-interest in marketing the securities at a price greater than their true value. And the SEC cannot be reasonably relied upon to prevent fraud because it does not review the merits of the registration statement and offering, and does not vouch for either the substantive value of any issue or the veracity of the issuer's representations. The SEC seeks only to confirm adequate disclosure of information relating to the security. The Court characterized Malack's argument as advocating for a kind of investor insurance that eliminates the need for proving reliance in any securities fraud case.
Additionally, the Court noted other factors weighing against a new presumption. The theory does not serve the securities laws' goal of informing investors via disclosures that permit the investors to help themselves. Rather, the FCTMT would eliminate the obligation of investors to examine issuers' disclosures, counter to Congress' policy. Additionally, the Court noted that recent Supreme Court decisions and Congressional actions have reflected the view that § 10(b) liability should remain narrow and limited to its current contours, and that any expansion is to be made by Congress, not the courts. Adoption of the FCTMT would extend § 10(b) liability beyond those contours.
Also, the Court noted that adoption of a presumption of reliance based on the FCTMT would have two negative impacts. It would lead to an increase of costly Rule 10b-5 litigation, and — because the presumption is a powerful tool for plaintiffs seeking class certification — put pressure on defendants to settle even frivolous claims. The Court concluded, "The [FCTMT] lacks a basis in common sense, probability, or any of the other reasons commonly provided for the creation of a presumption."
Given that there is a clear, established split among the Circuits between those that have adopted the FCTMT and those that have rejected it, this issue might well be taken up by the Supreme Court.
The case involved American Business Financial Services, Inc., a subprime mortgage originator, which issued notes registered with the Securities and Exchange Commission ("SEC"). The notes later became worthless during the subprime mortgage meltdown. Malack had purchased such notes and he filed a putative securities fraud class action against BDO, based on § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, for allegedly assisting American Business in defrauding him and others by providing clean audit opinions used to register the notes with the SEC. Malack thus alleged that without the clean audit opinions the notes could not have been registered, they would not have been marketable, and neither Malack nor the other investors would have been able to purchase them.
One of the elements to make out a Section 10(b) claim is to show a causal nexus between the misrepresentations and the plaintiffs' purchase of the security, and that plaintiffs exercised the diligence that a reasonable person under all the circumstances would have exercised to protect their interests, i.e. reasonable reliance.
The Third Circuit noted that the United States Supreme Court had upheld a presumption of reliance where there is a failure to disclose material facts by defendants obligated to disclose such facts; and, because markets are presumed to be efficient, where misleading statements affect the overall price of a company's stock and thus harm all purchasers, even those who did not personally rely on the misstatements (who are entitled to a presumption of reliance under the "fraud-on-the-market" theory).
In contrast to the "universally" accepted fraud-on-the-market theory, the Third Circuit stated that the fraud-created-the-market theory ("FCTMT") posits that the securities laws allow an investor to rely on the integrity of the market to the extent that the securities it offers to him for purchase are entitled to be in the market place. Such a presumption of reliance would be applicable where a plaintiff proves that the defendant conspired to bring to market securities that were not entitled to be marketed because they are so lacking in basic requirements that they would never have been approved by the issuing entity nor presented to the underwriters had any one of them not acted with intent to defraud or reckless disregard of whether the other defendants were perpetrating a fraud. The Third Circuit noted that, critical to the theory's coherency, is the assumption stated in Shores that it is reasonable for an investor to rely on a security's availability on the market as an indication of its apparent genuineness.
The Third Circuit rejected the FCTMT, stating, "No matter what approach is taken, however, the theory lacks a basis in any of the accepted grounds for creating a presumption." First, the Court noted that presumptions typically are adopted because direct proof is difficult, because they are consistent with congressional policy, and/or because of a general belief that proof of fact B renders the inference of fact A so probable that it is sensible and timesaving to assume the truth of fact A until the adversary disproves it. The Court concluded that the FCTMT rests on the conjecture that the security's availability on the market is an indication of its apparent genuineness. Then the Court analyzed the underpinning for this theory and concluded that common sense called for rejecting the theory. The Court noted that the entities most commonly involved in bringing a security to market (promoters, underwriters, counsel, etc.) do not imbue it with any guarantee against fraud. All of them have a self-interest in marketing the securities at a price greater than their true value. And the SEC cannot be reasonably relied upon to prevent fraud because it does not review the merits of the registration statement and offering, and does not vouch for either the substantive value of any issue or the veracity of the issuer's representations. The SEC seeks only to confirm adequate disclosure of information relating to the security. The Court characterized Malack's argument as advocating for a kind of investor insurance that eliminates the need for proving reliance in any securities fraud case.
Additionally, the Court noted other factors weighing against a new presumption. The theory does not serve the securities laws' goal of informing investors via disclosures that permit the investors to help themselves. Rather, the FCTMT would eliminate the obligation of investors to examine issuers' disclosures, counter to Congress' policy. Additionally, the Court noted that recent Supreme Court decisions and Congressional actions have reflected the view that § 10(b) liability should remain narrow and limited to its current contours, and that any expansion is to be made by Congress, not the courts. Adoption of the FCTMT would extend § 10(b) liability beyond those contours.
Also, the Court noted that adoption of a presumption of reliance based on the FCTMT would have two negative impacts. It would lead to an increase of costly Rule 10b-5 litigation, and — because the presumption is a powerful tool for plaintiffs seeking class certification — put pressure on defendants to settle even frivolous claims. The Court concluded, "The [FCTMT] lacks a basis in common sense, probability, or any of the other reasons commonly provided for the creation of a presumption."
Given that there is a clear, established split among the Circuits between those that have adopted the FCTMT and those that have rejected it, this issue might well be taken up by the Supreme Court.
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