The Second Circuit And Market Efficiency On Class Certification

The Second Circuit handed down a decision on Tuesday which may become of increasing importance as the market crisis continues to spawn litigation. The court clarified its prior guidance on the standard of proof required for class certification and ruled on the application of the fraud-on-the-market presumption in a securities class action based on trading in mortgage backed “certificates” among sophisticated institutional investors.

In Teamsters Local 445 Freight Division Pension Fund v. Bombardier, Inc., Case No. 06-3794 (2nd Cir. Oct. 14, 2008), the circuit court affirmed an order denying certification of the class. Plaintiffs purchased what are called “certificates” issued by Bombardier Capital Mortgage Securitization Corporation, a wholly owned subsidiary of Bombardier, Inc. The “certificates,” sold in seven offerings between 1998 and 2001, were each secured by a pool of mobile home loan contacts and mortgages. The certificates traded infrequently. Plaintiffs claimed that defendants disregarded underwriting standards, regularly under wrote loans to borrowers who were not creditworthy and purchased large quantities of facially defective and deficient mobile home loans. All of this caused escalating delinquency rates which were systematically underreported. Once the certificates were downgraded below investment grade and there were news stories regarding possible write offs by defendants, the market collapsed.

The court began its analysis by clarifying the evidentiary standard which a plaintiff must meet at class certification. In this regard the court held that “we dispel any remaining confusion and hold that the preponderance of the evidence standard applies to evidence proffered to establish Rule 23’s requirements.” This clarified the circuit’s prior cases which the circuit court conceded were unclear.

In the next part of its opinion, the court concluded that the Teamsters could not satisfy Rule 23(b)’s predominance requirement as to reliance utilizing the fraud-on-the market theory of Basic Inc. v. Levinson, 485 U.S. 224 (1988). Accordingly, class certified was properly denied.

The resolution of this question hinged on whether the market is efficient. To analyze the issue, the court focused on three of the factors identified in Cammer v. Bloom, 711 F. Supp. 1264 (D.N.Y. 1989), which had considered the question as to the equity markets. First, the court considered whether there were financial analysts who report on the security. If there are a number of analysts following the security, that fact would support an inference that the market is efficient. Here, the court rejected expert testimony offered by plaintiff claiming that in fact analysts followed the security. The court noted that the testimony was based on the fact that analysts followed publicly traded Bombardier, not the “certificates” involved here.

The court also found that plaintiff failed to meet its burden on a second key prong of the test – whether market makers were making a market in the securities, since this promotes efficiency. The securities here were traded infrequently among institutions. The fact that the lead underwriter would furnish bids and quotes on request did not make it a market maker.

Finally, the court rejected evidence offered by the Teamsters that the price of the securities reacted immediately to news of unexpected corporate events, another hallmark of efficiency. Plaintiff’s expert economist offered an event study which they claimed supported the argument that in fact the securities reacted to such information. The court rejected this evidence as inadequate however, because the study focused on the disclosure of information immaterial to the certificates and which related primarily to the parent company.

In conducting its analysis, the court acknowledged that Cammer is based on the equity rather than the bond markets and that there are differences between the two markets. Here, however, the factors from the case were properly used as an “analytical tool” to evaluate the question of efficiency the court noted.