Reprinted from the November / December 2010 issue of the Financial Fraud Law Report.
Summary: The authors discuss several cases addressing the “fraud-created-the-market” theory for securities fraud claims based on Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, which theory has been asserted by plaintiffs who failed to read issuers’ disclosure statements. These include the Fifth Circuit decision that adopted the theory, dissents in that case and in a later Eleventh Circuit case disagreeing with the theory, and more recent decisions by the Third and Seventh Circuits rejecting the theory.
The Third Circuit Rejects the “Fraud-Created-the-Market” Theory
For Presuming Reliance in a Private Securities Fraud Action,
Reflecting a Continuing Split among the Circuits
In affirming the denial of a securities fraud class certification, the Third Circuit recently rejected the “fraud-created-the-market” theory as a basis for establishing a presumption of reliance in a plaintiffs’ suit under Section 10(b) of the Securities Exchange Act of 1934 (“Section 10(b)”) and Rule 10b-5 when plaintiffs had not read the issuer’s prospectus. Malack v. BDO Seidman, LLP.1 In so ruling, the Third Circuit joined the Seventh Circuit in rejecting a theory adopted by the Fifth Circuit in Shores v. Sklar2 in 1981. This article will discuss the reasoning and dissents in these cases.
The Third Circuit Decision in Malack
Malack v BDO Seidman, LLP involved American Business Financial Services, Inc. (“ABFS”), a subprime mortgage originator which had issued notes registered with the Securities and Exchange Commission (“SEC”). Malack had purchased these notes which later became worthless during the subprime mortgage meltdown. Malack filed a securities fraud class action against BDO, based on Section 10(b) and Rule 10b-5, for allegedly assisting ABFS in defrauding him and others by providing clean audit opinions used to register the notes with the SEC. Typically such a claim requires proof of a causal nexus between defendant’s misrepresentations and/or omissions and plaintiffs’ injury, and that plaintiffs exercised the diligence that a reasonable person under all the circumstances would have exercised to protect their interests (i.e. by reviewing and relying on the issuer’s prospectus -- considered “reasonable reliance”). Malack asserted that in this case reasonable reliance could instead be proven by evidence common to the class under the fraud-created-the-market theory (“FCTMT”), and thus there was no need to show that class members had reviewed and relied on the company’s prospectuses filed with the SEC.
The Third Circuit first noted that the Supreme Court had upheld a presumption of reliance in certain situations where there is a failure to disclose material facts by defendants obligated to disclose such facts.3 And it noted decisions upholding a presumption of reliance where misleading statements affect the overall price of a company’s stock in an established market and thus harm all purchasers, even those who did not personally rely on the misleading statements (commonly termed the “fraud-on-the-market” theory).4 And then the Court turned to the FCTMT articulated in Shores. And, it noted that the Seventh Circuit had rejected the theory.5
The Court stated that the 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 defendants conspired to bring to market securities that were not entitled to be marketed. This would apply when the securities are so lacking in basic requirements that they would never have been approved by the issuing entity nor presented by the underwriters had any one of the individuals involved 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 . . . , 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 proposition 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 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, which would be contrary to the goals of the securities laws. The Court also concluded that the FCTMT is not supported by probability.
Additionally, the Court noted other factors weighing against such a new presumption. It found that the theory does not serve the securities laws’ goal of requiring issuers to inform investors via disclosures putting investors into a position from which they can evaluate securities offered in the market, which the Supreme Court has repeatedly said is the fundamental purpose of the federal securities laws. The FCTMT would eliminate the obligation of investors to examine issuers’ disclosures, counter to Congress’s policy. Additionally, the Court noted that recent Supreme Court decisions and Congressional declination to adopt certain expansions to the right to sue and adoption of heightened pleading and loss causation requirements for any private action arising from the securities laws 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 its current contours.
Further, 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 would be a powerful tool for plaintiffs seeking class certification -- it would 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.”
The Fifth Circuit Decision in Shores v. Sklar
The Fifth Circuit 1981 en banc decision in Shores v. Sklar articulated what was then a new rationale for permitting a securities fraud case to continue in District Court, which later came to be known as the fraud-created-the-market theory. The decision did not address liability on the facts, as the facts had not been addressed by the court below. The Fifth Circuit's reversal directing the District Court to consider additional legal claims was based on the complaint’s detailed allegations of a wide-scale fraud by several people to bring to market industrial revenue bonds (“Bonds”) when they knew, or recklessly disregarded, facts indicating that the Bonds had no real chance of paying significant returns to investors, and that the lessee of the facilities constructed with the bond revenues ceased all operations and defaulted on its payment obligations shortly after construction was complete. The en banc Court was sharply divided, with twelve Judges joining the majority opinion and ten joining a much longer dissent.
The case had been brought on behalf of Plaintiff Bishop (by his executor Shores) and the class of purchasers of the Bonds. Bishop had purchased some of the Bonds, relying on advice from his broker. He did not know of, and did not rely on statements or omissions in, the Offering Circular. For this reason, the District Court had dismissed the case.
The Fifth Circuit upheld the dismissal under Rule 10b-5(2). However, in its central analysis, occupying approximately two pages of the Federal Reporter,6 the Court held that the District Court had erred in construing the remainder of Bishop’s complaint as narrowly confined to charges of misrepresentations and omissions in the Offering Circular that would have defrauded investors who did rely on it. The Court held that the complaint also permitted proof that defendants engaged in an elaborate scheme to create a bond issue that would appear genuine but was so lacking in basic requirements that the Bonds would never have been approved by the Industrial Development Board nor presented by the underwriters had any one of the participants in the scheme not acted with intent to defraud or in reckless disregard of whether the other defendants were perpetrating a fraud. Rather than containing the entire fraud, the Court stated, the Offering Circular was only one step in the course of an elaborate scheme.
The Court noted that Rule 10b-5 has three parts, quoting as follows:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails,
(1) to employ any device, scheme, or artifice to defraud,
(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or
(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
The Court noted that Bishop’s claims tracked the language of all three subparts of the Rule. It agreed that Bishop’s claim under 10b-5(2) could not withstand his admitted lack of reliance on the Offering Circular. However, the Court went on to hold that Bishop’s Rule 10b-5(1) and Rule 10b-5(3) claims asserted something more that prevented dismissal at the case’s preliminary stage. The Court noted that Bishop could prove that he sought to make investments in securities that were entitled to be marketed. The concept of defendants’ scheme, the Court stated, had as its core objective that the potential victim engage in the purchase of the Bonds for which the scheme was conceived. The Court reasoned that the requisite element of causation in fact would be established if Bishop proved that the scheme was intended to and did bring the Bonds onto the market fraudulently and proved that he relied on the integrity of the offerings of the securities market. The Court reasoned that Bishop’s lack of reliance on the Offering Circular, only one component of the overall scheme, was not determinative.
The Court concluded its primary analysis by holding that Bishop had alleged the necessary elements of an action under 10b-5(1) or 10b-5(3). To prevail, in the words of Rule 10b-5, Bishop must be able to show a “scheme to defraud or (an) act, practice or course of business which operates as a fraud or deceit upon (him) in connection with the sale of (the Bonds).” It stated that Bishop’s burden of proof would be to show that (1) the defendants knowingly conspired to bring securities onto the market which were not entitled to be marketed, intending to defraud purchasers, (2) Bishop reasonably relied on the Bonds’ availability on the market as an indication of their apparent genuineness, and (3) as a result of the scheme to defraud, he suffered a loss. The Court held 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.
The Court then addressed points in the dissent.7 It held that the purposes of the securities laws and Rule 10b-5 are far broader than providing full disclosure and fostering informed investment decisions. It stated that the role of the Offering Circular will continue undiminished because the claim that the Court was recognizing was that the alleged fraud was what allowed the Bonds to be sold on the market, and not merely that the Bonds would have been offered at a lower price or a higher rate. And it rejected the dissent’s position that Rule 10b-5 must be read all together, holding that Rule 10b-5(1) and Rule 10b-5(3) may -- standing alone -- be the basis for a private securities fraud action, citing cases.8
There was a very substantial dissent in Shores by Judge Randall on behalf of ten Judges.9 It described the majority opinion as a new theory that was completely without supporting precedent and in conflict with the prior decisions of the federal courts, and which would permit recovery to one who did not read what the seller was obligated to disclose, thus defeating the primary objective of the Rule (investors making informed investment decisions), and increasing the volume of litigation under Rule 10b-5 and protracting litigation that would previously have been terminated by summary judgment.10
Judge Randall reasoned that clauses (1) and (3) of Rule 10b-5 cannot be separated from clause (2), and that there were no cases that did so, and thus the majority’s analysis was based on a misreading of Rule 10b-5. And she discussed and interpreted various cases, including cases relied on by the Court, to distinguish “fraud-on-the market” cases and to show that reasonable reliance is an element in all Rule 10b-5 cases.
Then the dissent turned to the policy behind the requirement of investor reliance on defendants’ misrepresentations or omissions. It noted that the language of Rule 10b-5 can be read quite broadly, that it was the courts that recognized a private right of action under the statute and the rule, and that the securities laws enacted by Congress were not intended to create a scheme of investors’ insurance or to regulate directly the underlying merits of various investments. Rather, the federal securities laws are based on the premise that the federal government’s role is merely to ensure the free flow of complete and accurate information within the securities markets and that, once full disclosure is achieved, individual investors are expected to look out for their own interests. In this light, courts have sought to construct workable limits to liability under the statute and rule. One such limit is a requirement of reliance, which precludes recovery by a plaintiff that has ignored the information required to be disclosed by the securities laws. Judge Randall asserted that this system is not furthered by allowing monetary recovery by those who refuse to read and rely on the defendants’ public disclosures. Further, the basic requirements for an action under Rule 10b-5 have remained largely intact and the Supreme Court has consistently turned back efforts to eliminate or water down those requirements. The dissent concluded stating that, given that the case involved a sale of securities associated with an Offering Circular, the majority’s decision would make the reliance requirement a dead letter in the one situation in which it most typically applies.12
The Eleventh Circuit Decision in Ross
Ross v. Bank South, N.A.13 was a 1989 en banc, split decision by the Eleventh Circuit (eight years after the Shores decision and the Eleventh Circuit’s creation out of the Fifth Circuit). For the majority, Judge Anderson -- joined by four other members of the Court -- referenced Shores, but held that the Court did not need to address the argument that the Court should overrule Shores because the District Court was correct in determining that plaintiffs had not established a prima facie case of Shores reliance. Four members of the Court dissented, arguing that the facts did not support the District Court’s summary judgment.
Judge Tjoflat, who had joined the dissent in Shores before the Circuit split, specially concurred in Ross, agreeing with the result in the case but articulating his strong view that Shores was fundamentally flawed.14 Among other points, he reasoned that reliance on a primary market to exclude an unmarketable bond is not reasonable. This is because all of the parties involved in an issuance of securities have a significant self-interest in marketing the securities at a price greater than their true value, regardless of their true value. Further, he reasoned, to determine when a security is worthless is nearly, if not completely, impossible. (Three of the other Judges concurring with Judge Anderson’s decision -- Judges Hill, Fay and Cox -- noted that the Court’s decision was not a holding in the sense that the Court had endorsed Shores, and that if the Court had reached the Shores issue they would have preferred that the theory be abandoned. 15)
Thus the decision of the en banc majority in Shores adopting what came to be known as the FCTMT has been challenged from the beginning. There was a strong dissent in the closely divided Fifth Circuit decision in Shores, and subsequently a strong dissent in the Eleventh Circuit decision in Ross. The recent Third Circuit decision rejected FCTMT on legal grounds and policy grounds in a well articulated decision that incorporated significant parts of the reasoning of the Shores and Ross dissents.
It appears to the authors that the reasoning of the Third Circuit in Malack and of the Seventh Circuit in Eckstein, and of the dissents in Shores and Ross, is much stronger than that of the majority in Shores. It is our expectation that the FCTMT will remain, at best, a minority view and that, if the Supreme Court were to consider the issue, it would reject the FCTMT.
John H. Korns and Stanley Yorsz are shareholders in the Washington, D.C. office of Buchanan Ingersoll & Rooney PC (Mr. Yorsz is also in the Pittsburgh office). The authors may be contacted at firstname.lastname@example.org and email@example.com. Their practices include litigation and federal regulation.
1 Malack v. BDO Seidman, LLP, 617 F.3d 743, 2010 WL 3211088 (3rd Cir. Aug. 16, 2010) (Judge Smith for the panel).
2 Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981) (en banc), cert. denied, 459 U.S. 1102 (1983).
3 Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972).
4 Basic, Inc. v. Levinson, 485 U.S. 224 (1988).
5 In its ruling, Malack referenced Eckstein v. Balcor Film Investors, 8 F.3d 1121 (7th Cir. 1993) (Judge Easterbrook for the panel), cert. denied, 510 U.S. 1073 (1994) as having rejected the FCTMT. In Eckstein, in a brief discussion within a longer decision, the Seventh Circuit rejected the FCTMT, stating that the Sixth Circuit had repudiated the FCTMT and that it agreed with the Sixth Circuit. Eckstein held as follows with respect to the FCTMT:
The existence of a security does not depend on, or warrant, the adequacy of disclosure. Many a security is on the market even though the issuer or some third party made incomplete disclosures. Federal securities law does not include “merit regulation.” (citations omitted) Full disclosure of adverse information may lower the price, but it does not exclude the security from the market. Securities of bankrupt corporations trade freely; some markets specialize in penny stocks. Thus the linchpin of Shores -- that disclosing bad information keeps securities off the market, entitling investors to rely on the presence of the securities just as they would rely on statements in a prospectus -- is simply false.
8 F.3d at 1130-31. The Sixth Circuit decision, Freeman v. Laventhol & Horwath, 915 F.2d 193 (6th Cir. 1990), was incorrectly cited, as -- despite discussing the FCTMT -- it did not in fact decide whether to adopt the FCTMT, holding that the issue was not properly before the Court. 915 F.2d at 200.
6 647 F.2d at 468-70.
7 647 F.2d at 470-72.
8 In T.J. Raney & Sons, Inc. v. Fort Cobb Oklahoma Irrigation Fuel Authority, 717 F.2d 1330 (10th Cir. 1983), cert. denied, 465 U.S. 1026 (1984), the Tenth Circuit with little discussion and some confusion between the fraud-on-the-market theory and the Shores fraud-created-the-market theory, found Shores persuasive and adopted its approach.
9 647 F.2d 472-87.
10 647 F.2d at 472-73.
11 647 F.2d at 473-81. The discussion included analyses of List v. Fashion Park, Inc., 340 F.2d 457 (2nd Cir.), cert. denied, 381 U.S. 811 (1965), Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972), and Blackie v. Barrack, 524 F.2d 891 (9th Cir. 1975), cert. denied, 429 U.S. 816 (1976).
12 647 F.2d at 481-86.
13 Ross v. Bank South, N.A., 885 F.2d 723 (11th Cir. 1989), cert. denied, 495 U.S. 905 (1990).
14 885 F.2d at 732-45.
15 885 F.2d at 745.