THIRD CIRCUIT REJECTS “FRAUD-CREATED-THE-MARKET” THEORY
Reliance is a critical element of proof in a private securities fraud suit. Thus, in rejecting a theory of scheme liability two years ago, the Supreme Court predicated its decision in part on a close reading of the reliance element. Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008).
One way to establish reliance in a class action is through the use of the efficient market theory. Under that theory, as adopted by the Supreme Court in Basic Inc. v. Levinson, 485 U.S. 224 (1988), in an open and developed or efficient market, the price of a security is determined by the available material information about the company and its stock. Stated differently, the material information about the stock is absorbed into its price. This includes misstatements. Under this theory reliance is presumed in a fraud on the market case.
In Malack v. BDO Seidman, LLP, Case No. 09-4475 (3rd Cir. Aug. 16, 2010), the court considered a theory of reliance with a similar title, but called the fraud-created-the-market theory. This theory posits that the investor relied on the integrity of the market to the extent that the securities were entitled to be in the marketplace. The presumption can only be used where it can be established that the defendants conspired to bring the securities to the market and they were not entitled to be there.
In Malack, the Third Circuit rejected the fraud-created-the-market theory as essentially baseless. The case arose from a note offering by American Business Financial Services, Inc., a subprime mortgage originator. Defendant BDO issued an unqualified audit opinion on the financial statements. After issuance, American Business collapsed and was liquidated. The notes became worthless. Plaintiffs brought suit against BDO, claiming fraud in violation of Exchange Act Section 10(b). The district court denied class certification, concluding that plaintiff had failed to establish the predominance requirement of Federal Civil Rule 23(b)(3) because he did not demonstrate a presumption of reliance.
A presumption of reliance is permissible the court held in two instances. First, where there is a material omission and a duty to disclose. Second, under the fraud on the market theory of Basic. Some courts, such as the Fifth and Tenth Circuits, have accepted the fraud-created-the-market theory as a third alternative. Others such as the Seventh Circuit have not.
Plaintiffs here argued that the securities were legally unmarketable. Regardless of the theory however, the Third Circuit concluded that the case must fail. Common sense suggests that in fact the theory is wrong, the circuit court concluded. If the availability of the securities in the market suggests that they are genuine, there must be some entity involved in the issuance process that “acts as a bulwark against fraud.” There is not. The SEC’s review of securities is not based on merit, but disclosure. If this theory were credited, investors would be free to rely only on the fact that the securities have been issued. In effect, the theory would create a kind of investor insurance policy. That notion is contrary to the basic premise of securities regulation which is that investors armed with the material facts can make their own investment decision. It is also contrary to the teachings of Stoneridge which cautioned against expansive readings of the reliance requirement, particularly in view of the fact that the cause of action under Section 10(b) has been crafted by the courts, not Congress.
While the fraud-created-the-market theory has a name which is similar to that of the fraud on the market theory, it lacks a sound foundation. The fraud on the market theory is built on economics. The fraud-created-the-market theory is not. Rather, the “fraud-created-the-market theory lacks a basis in common sense, probability, or any other reasons commonly provided for the creation of a presumption. As such we decline to recognize” it.