In Malack v. BDO Seidman LLP, No. 09-4475, 2010 WL 3211088 (3d Cir. Aug. 16, 2010), decided on August 16, 2010, the Third Circuit rejected the so-called “fraud created the market” theory of reliance in Section 10(b) securities fraud cases. This doctrine, first recognized by the Fifth Circuit in 1981 and since adopted by two other circuits, would presume reasonable reliance when a market for securities would not have otherwise existed absent the fraudulent scheme. Courts that recognize the doctrine would permit shareholders to rely upon the integrity of the market itself, as policed by the issuers, underwriters, auditors, lawyers, and regulators who participate in the issuance of new securities. Courts that reject the presumption, now recently joined by the Third Circuit, recognize the doctrine as a scheme of investors’ insurance that would all but eliminate the reliance requirement in Section 10(b) claims. The carefully reasoned Malack opinion provides new guidance in support of limiting the creation of presumptions that would expand the scope of Section 10(b) liability.
Three Theories of Reliance: Affiliated Ute, Fraud on the Market, and Fraud Created the Market
To establish a Section 10(b) securities fraud case, a plaintiff must prove reliance upon a defendant’s deceptive acts. 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5. The reliance element requires a causal connection between a defendant’s misrepresentation and a plaintiff’s injury. Reliance is traditionally established by proof that the defendant’s misrepresentation or omission induced the plaintiff to make an investment decision he otherwise would not have made.
Proof of actual reliance is not always necessary to establish a Section 10(b) claim. Rather, given the difficulty of proving actual reliance, particularly in securities fraud cases brought as class actions, the Supreme Court has recognized two principal circumstances in which a plaintiff is entitled to a rebuttable presumption of reliance.
First, as articulated in Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972), a presumption of reliance arises in cases involving an omission of a material fact by a party with a duty to disclose. In such cases, all that is necessary is that the facts withheld be material in the sense that a reasonable investor might have considered them important to his or her investment decision.
Second, a plaintiff may establish a presumption of reliance under the “fraud on the market” doctrine established in Basic Inc. v. Levinson, 485 U.S. 224, 243 (1988). This doctrine is based on the principle that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business. In such an established and efficient market, public information pertaining to a particular security is reflected in its price. Accordingly, misleading statements will defraud purchasers of stock even if the purchasers do not actually rely on the misstatements. Although to benefit from the presumption, an investor’s reliance must be justified or reasonable, an investor’s reliance is reasonable if the investor simply does not ignore known or obvious risks.
In cases involving securities with established markets, plaintiffs commonly seek to invoke one of these two established presumptions of reliance. In cases involving securities purchased on inefficient primary markets, however, plaintiffs often cannot rely on either presumption. The Affiliated Ute presumption is unavailable when claims are based on misstatements rather than omissions, or are directed against auditors or others without a duty to the plaintiff. And the fraud-on-the-market presumption requires proof of an efficient primary market. Plaintiffs in these types of Section 10(b) cases have therefore argued for a third presumption: the fraud created the market theory of reliance.
First recognized by the Fifth Circuit in Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981) (en banc), the fraud created the market doctrine assumes that the availability of a security in a primary market indicates that the security is genuine and worthy of an investor’s reliance. In Shores, the Fifth Circuit reasoned that the securities laws are intended to “protect investors and instill confidence in the securities markets by penalizing unfair dealings.” The court accordingly deemed it appropriate to protect investors who rely on the integrity of the market itself to ensure that the securities offered for purchase are entitled to be in the marketplace.
Praise and Criticism for the “Fraud Created the Market” Doctrine
The fraud created the market doctrine initially gained support among other courts of appeals. In these cases, three interrelated categories of unmarketability of the securities—economic, factual, and legal—emerged to support the fraud created the market presumption. Economic unmarketability, as reflected in the Shores opinion, arises when the securities could not have been brought onto the market at any price had the true risks been fully disclosed. Factual unmarketability, also referenced in Shores, is satisfied if, absent the fraud, a regulatory entity would not have allowed the security to come onto the market at its actual price. Finally, other courts have embraced a narrower version of the fraud created the market presumption based upon legal unmarketability, which occurs when, absent the fraud, a legal or regulatory agency would have been required by law to prevent the security from being issued.
The year after the Fifth Circuit’s Shoresopinion, the Tenth Circuit adopted the legal unmarketability version of the presumption, holding that reliance is presumed when the plaintiff establishes that the securities were not legally qualified to be issued. T.J. Raney & Sons Inc. v. Fort Cobb, Oklahoma Irrigation Fuel Auth., 717 F.2d 1330, 1333 (10th Cir. 1983). The court assumed that regulation of newly issued securities should permit a purchaser to assume that the securities were lawfully issued, thereby supporting a presumption of reliance. The Eleventh Circuit also adopted the doctrine, accepting the broader version of the theory which entitles an investor to presume that the primary markets will exclude securities that are so tainted by fraud as to be unmarketable. Ross v. Bank South, N.A., 885 F.2d 723, 729 (11th Cir. 1989).
The Ninth Circuit has not specifically adopted or rejected any version of the fraud created the market doctrine as articulated by the Fifth Circuit in Shores. But, in an opinion pre-dating Shores, the Ninth Circuit expressed its acceptance of the principles underlying the doctrine, holding that investors in newly issued securities were not required to prove actual reliance on allegedly false and misleading statements, because the investors were entitled to rely on the integrity of the regulatory process and the truth of any representations made by the issuer at the time of issuance. Arthur Young & Co. v. United States District Court, 549 F.2d 686, 695 (9th Cir. 1977). The Ninth Circuit has not expressly revisited this issue since.
Despite an early trend toward acceptance of the fraud created the market doctrine, other circuits have disagreed. Led by a concurrence by Judge Tjoflat in the Eleventh Circuit’s Ross decision, the Sixth and Seventh Circuits have refused to adopt the presumption, criticizing it in three principal respects. See Ockerman v. May Zima & Co., 27 F.3d 1151 (6th Cir. 1994); Eckstein v. Balcor Film Investors, 8 F.3d 1121 (7th Cir. 1993).
The leading criticism is that the presumption incorrectly extends the efficient-market premise to primary markets involving any newly issued securities. Unlike in efficient secondary markets, the price for newly issued securities in primary markets is set by the participants in the issuance, including the issuer and the underwriter, rather than by the market operating on publicly available information. Because these participants have a vested interest in marketing the securities, they cannot reasonably be relied upon to police the primary market. There is thus no economically sound reason for an investor to rely upon the price and terms set in the primary market.
The fraud created the market presumption has also been subject to criticism because it may discourage investors from reviewing disclosures and becoming well-informed about the securities they purchase. The more risks investors read about, the more knowledge they gain that may overcome the presumption of reliance. In markets for new, untested securities in which public information has likely not been incorporated into the price, a disincentive to becoming well-informed is particularly irrational.
Finally, critics have argued that calculation of damages is difficult under this theory. Because there is no way to value securities that were not entitled to be marketed in the first place, the only rational measure of damages is the purchase price of the securities. Yet refunding the purchase price to the buyer effects a rescissionary measure of damages, generally an unavailable remedy in Section 10(b) securities fraud actions.
Malack v. BDO Seidman LLP: The Third Circuit Rejects “Fraud Created the Market” Reliance
After vigorous debate among the federal circuits in the 1980s and early 1990s, courts of appeals have not addressed the fraud created the market doctrine since the adoption of the Private Securities Litigation Reform Act of 1995 —until now. In Malack, the Third Circuit reopened the discussion, and joined the Sixth and Seventh Circuits in declining to recognize the presumption.
In Malack, the plaintiff purchased notes issued by a subprime mortgage originator that were rendered worthless with the subprime mortgage meltdown. The plaintiff alleged violations of Section 10(b) and Rule 10b-5 against BDO Seidman, the accounting firm that issued audit opinions used to register the notes. The plaintiff alleged that the audits were deficient, and without those audits, the notes could not have been issued.
The district court denied class certification on the ground that the plaintiff failed to satisfy the predominance requirement for class certification because he failed to establish a presumption of reliance. The Third Circuit affirmed, holding that the fraud created the market doctrine—the only theory available to the plaintiff in the case—may not give rise to a presumption of reliance under any theory.
Embracing the reasoning of other critics, the Malack court observed that the fundamental flaw of the presumption is the notion that a security’s availability on the market is an indication of its genuineness. This premise defies common sense. There is no entity involved with bringing a security to the market that imbues the security with any guarantee against fraud. Rather, all of the entities involved in an issuance “have a significant self-interest in marketing the securities at a price greater than their true value,” due to contingent fee compensation and other structural incentives. Similarly, the Securities and Exchange Commission cannot be reasonably relied upon to prevent fraud in the issuance of securities because the SEC’s function is to review the adequacy and clarity of the disclosure, not to review the merits of the offering. Because of the low probability that an investor could reasonably rely upon the actors in the market to ensure a security’s genuineness, a presumption of reliance is improper.
The court also accepted prior critics’ view of the fraud created the market presumption as inconsistent with existing securities laws. An assumption that almost all marketed securities are legally and economically marketable would give rise to something akin to investor insurance. “Any investor who purchases any security could point to the security’s availability on the market to satisfy the reasonable reliance element of a § 10(b) claim.” The goals of the securities laws are to ensure adequate disclosures, rather than to insure the merits of securities or investments. A presumption that would discourage, rather than encourage, investors to read disclosures before purchasing a newly issued security would run contrary to those goals.
Finally, the court reasoned that a fraud created the market presumption would amount to an unjustified expansion of Section 10(b) liability. The Supreme Court’s decision in Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 165 (2008), recited the two “accepted” presumptions of reliance, and held that “the § 10(b) private right should not be extended beyond its current boundaries.” This pronouncement, as well as Congress’s consistent limitation of Section 10(b) liability, counseled the Third Circuit against recognizing a fraud created the market presumption of reliance.
The Third Circuit hypothetically considered whether the plaintiff investor’s claims would satisfy the narrower legal unmarketability version of the fraud created the market presumption urged by the plaintiff based on the Tenth Circuit’s opinion in T.J. Raney & Sons. In T.J. Raney, the Tenth Circuit relied on legal unmarketability to presume reliance not for fraud that impacts the value of the security, but rather only when the securities were not legally qualified to be issued. The Malack court found no legal impediment to the issuance of the securities, and therefore held that the plaintiff’s claims would fail the T.J. Raney legal unmarketability test even if such a test were valid.
The Third Circuit’s Malack opinion is significant in several ways. As the only circuit court to evaluate the fraud created the market doctrine following the PSLRA, Malack resoundingly rejects the would-be presumption as an unwarranted scheme of investors’ insurance. The court looked to the Supreme Court’s 2008 Stoneridge decision as further support for rejecting a presumption of reliance that would amount to an improper expansion of securities fraud liability. It remains to be seen whether other circuits in which the doctrine found early favor, including the Ninth Circuit, will follow suit in post-PSLRA securities fraud cases.