Securities Law | Expert Legal Commentary
November 12, 2010
Malack v. BDO Seidman: Rejecting the “Fraud-Created-The-Market” Theory of Reliance
Malack v. BDO Seidman, LLP
Josh Lawler of Zuber Lawler & Del Duca and Joel Ginsberg
The U.S. Court of Appeals for the Third Circuit has rejected the use of the “fraud-created-the-market” theory of reliability for securities fraud claims. In Malack v. BDO Seidman, LLP, 617 F.3d 743 (3rd Cir. 2010), the Third Circuit upheld denial of class certification in a securities fraud case because the plaintiffs could not satisfy the predominance requirement of Rule 23 by relying upon the “fraud-created-the-market” theory. The Third Circuit joins the Seventh Circuit in rejecting the “fraud-created-the-market” theory, further defining a split among the circuits as to the availability and application of the theory, and making the issue ripe for Supreme Court review.
Malack is among the current trend of subprime mortgage cases in which the plaintiff attempts to hold a third party liable for damages when the entity that would be the direct defendant is in bankruptcy. In Malack, the plaintiff had purchased notes issued by American Business Financial Services, Inc., a subprime mortgage originator. The notes were issued pursuant to registration statements and prospectuses that American Business had filed with the Securities and Exchange Commission. BDO Seidman, LLP provided the audit opinions necessary to complete the filings with the SEC.
The notes later became worthless during the subprime mortgage meltdown, and American Business went into bankruptcy. Malack filed a putative securities class action against BDO, alleging that its audits of American Business were deficient. Specifically, Malack alleged that had BDO done its job properly, it would not have issued clean audits to American Business. “[W]ithout clean audit opinions, American Business would not have been able to register the Notes with the SEC, the Notes would not have been marketable, and Malack and the other investors would not have purchased the Notes.” Malack v. BDO Seidman, LLP, 617 F.3d 743, 745 (3rd Cir. 2010).
Malack alleged that BDO had violated Section 10(b) of the Securities Exchange Act of 1934 and sought class certification. The U.S. District Court for the Eastern District of Pennsylvania denied class certification because Malack could not show that the proposed class was entitled to a general presumption of reasonable reliance. As a result, the proposed class could not satisfy the predominance requirement of Federal Rule of Civil Procedure Rule 23(b)(3). Malack appealed.
The Advent of the Fraud-Created-The-Market Theory
The Third Circuit began its opinion by reviewing the prevailing standards for reliance in securities fraud cases and the development of the fraud-on-the-market theory.
The Court noted that in order for a plaintiff to state a Section 10(b) claim, he must establish, among other things, “a causal nexus between the misrepresentation and the plaintiff’s injury, as well as a demonstration that the plaintiff exercised the diligence that a reasonable person under all of the circumstances would have exercised to protect his own interests.” AES Corp. v. Down Chem Co., 325 F.3d 174, 178 (3rd Cir. 2003). In other words, the plaintiff must prove that he reasonably relied on the defendant’s misrepresentations.
The U.S. Supreme Court has recognized two instances in which reasonable reliance by plaintiffs may be presumed: (1) Proof of materiality of an omitted fact is sufficient to enable a presumption of reliance in cases that primarily allege a failure to disclose. Affiliated Ute Citizens of Utah v. U.S., 406 U.S. 128 (1972); (2) The “fraud-on-the-market” theory can establish a presumption of reliance where a fraudulent misrepresentation affects the price of a security trading in an efficient market, even if the plaintiff never saw or read the misrepresentation. Basic Inc. v. Levinson, 485 U.S. 224 (1988).
But the Fifth Circuit has approved a third theory of reliance, the “fraud-created-the-market” theory, primarily applicable to new securities where no current, “efficient” market exists. Shores v. Sklar, 647 F.2d 462, 464 (5th Cir. 1981). In order to benefit from a presumption of reliance under this theory, the plaintiff must prove that the defendants conspired to bring to market securities that were not entitled to be marketed. The plaintiff must show that the securities offered were “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 participants in the scheme not acted with intent to defraud or in reckless disregard of whether the other defendants were perpetrating a fraud.” Id. at 468.
Key to this theory is the assumption that investors are entitled “to rely on a security’s availability on the market” as an “indication of its apparent genuineness.” Id. at 470. Malack pointed to “common sense and probability” as support for this assumption.
The Third Circuit Rejects the Fraud-Created-The-Market Theory
The Third Circuit disagreed with Malack, holding that neither common sense nor probability support the notion that securities on the market, merely by virtue of being on the market, are presumptively free from fraud.
The Court first reviewed the factors that enable the establishment of a factual presumption. Presumptions have traditionally been recognized in circumstances where direct proof is difficult, and factors of fairness, public policy, probability and judicial economy support the establishment of a presumption. Malack, 617 F.3d at 749. Presumptions have also been used to correct imbalances “resulting from one party’s superior access to the proof,” to further congressional policy, or to avoid a “factual impasse.” Id. In this case, the Third Circuit determined, none of those circumstances were present to warrant the establishment of a “fraud-created-the-market” presumption of reliance.
“Common sense,” invoked by Malack, actually calls for rejecting the assumption that a security’s availability on the market somehow signifies its trustworthiness and true marketability. Id. This could only be true if there were “some entity involved in the process of taking the security to market that acts as a bulwark against fraud.” Id. However, no such entity exists. The private actors involved in bringing a security to market have incentives to act in self-interest and therefore they are not impervious to dishonesty. Id. at 749-750.
Nor does the SEC serve as that “bulwark against fraud.” The SEC’c role is limited to reviewing a registration statement to ensure that it contains adequate disclosures. Id. at 750. The SEC does not conduct “merit regulation” of securities, and SEC approval of registration statements does not constitute a warranty of truthfulness or marketability. Id. at 750-751.
The Court characterized Malack’s position as improperly advocating a kind of securities market investor insurance that would eliminate the need to prove reliance in any securities fraud case, quite contrary to the purpose of securities laws. Id. at 752.
The Third Circuit pointed out additional policy considerations that weighed against adopting a fraud-created-the-market theory. First, the theory would actually reduce investors’ incentive to carefully read and review offering materials and fully research their investment and “allow monetary recovery to those who refuse to look out for themselves.” Id. at 753 (citation omitted) The Court expressed a concern that, if the theory were established, “an investor might seek rationally to avoid reading disclosures in order to preserve a possible claim.” Id. (citation omitted)
Second, the Third Circuit noted Supreme Court decisions and Congressional action supporting the recent trend of limiting the contours of Section 10(b) liability. Id. at 754. Those recent actions reflect the view that any expansion of Section 10(b) liability should be made by Congress, not the Courts; adoption of the fraud-created-the-market theory of reliance would extend Section 10(b) liability beyond its current contours. Id. The unwanted effect of such an inappropriate expansion would be an increase in costly Rule 10b-5 litigation and, because it would much easier for plaintiffs to seek and obtain class certification, increased pressure on defendants to settle even frivolous claims. Id. at 755.
For these reasons, the Third Circuit flatly rejected the “fraud-created-the-market” theory. Without the ability to rely on this presumption, each member of the purported class would have to prove individual reliance, thus defeating the predominance requirement for class certification.
Malack intensifies the split among federal circuit courts regarding the availability and application of the “fraud-created-the-market” presumption of reliance, thus increasing the likelihood that the U.S. Supreme Court will take up and resolve the issue at some point.
But Malack also reflects two prevailing trends among many circuit courts. First, it highlights the concern expressed by many federal courts with judicial expansion of Section 10(b) private causes of action beyond its current parameters. Moreover, it likely reflects the skepticism of many courts when it comes to securities fraud claims against third-party defendants. Results in cases like Malack and the dismissal of law firm Mayer Brown from the Refco civil suit earlier this year may signify how courts will decide other third-party cases still in the pipeline.
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