Does the fraud-on-the-market presumption, pursuant to which reliance by investors on a material misrepresentation is presumed if the company’s shares were traded on an efficient market, apply in suits alleging misrepresentations by analysts (and other non-issuers)?
The U.S. Court of Appeals for the Second Circuit was poised to answer that question in 2004, but Citigroup’s settlement of the claims against it in the WorldCom litigation rendered its appeal moot. Based on the order granting the appeal, issued a day after the agreement to settle was reached, it appeared that the court was inclined to limit the reach of the fraud-on-the-market presumption. Four years later, before a completely different panel, the plaintiffs’ bar has a significant win on the same issue.
In In re Salomon Analyst Metromedia Litigation, No. 06-3225 (2nd Cir. Sept. 30, 2008), the court found that nothing in Basic, the Supreme Court case creating the fraud-on-the-market presumption, limited the presumption’s application to misrepresentations by issuers. Indeed, the “logic” of the Basic decision, which is based on the economic theory that share prices reflect all publicly available information in an efficient market, suggests “it does not matter, for purposes of establishing entitlement to the presumption, whether the misinformation was transmitted by an issuer, an analyst, or anyone else.”
In the alternative, the defendants argued that to establish the materiality of the misrepresentations, and thereby invoke the fraud-on-the-market presumption, the plaintiffs had the burden of proving that the misrepresentations had a quantifiable effect on the company’s stock price. The court disagreed, holding that inherent in the fraud-on-the-market theory is the presumption that material misrepresentations have an effect on stock price. Therefore, it was the defendants’ burden to rebut the presumption by demonstrating the absence of a price impact.
A couple of notes on the decision:
(1) The Second Circuit cited the Supreme Court’s recent Stoneridge decision in support of its holding. In Stoneridge, however, the Court found that the fraud-on-the-market presumption was inapplicable to the non-issuer defendants based on the fact that their “deceptive acts” were not communicated to the public. The issue of the scope of the fraud-on-the-market presumption was not squarely before the Court. Moreover, the Court expressed grave reservations about expanding securities fraud liability, something the Second Circuit’s decision arguably does.
(2) The Second Circuit brushed aside the defendants’ arguments concerning the expansion of liability (see full quote below), but offered an interesting codicil in a footnote. The court noted that “the identity of the speaker may be significant, because a court may determine that the reasonable investor would only rely on misrepresentations made by some speakers, but not by others.”
Holding: Vacate order of class certification and remand for further proceedings (including providing the defendants with an opportunity to rebut the presumption of a price impact).
Quote of note: “Defendants worry that if no heightened test is applied in suits against non-issuers, any person who posts material misstatements about a company on the internet could end up a defendant in a Rule 10b-5 action. The worry is misplaced. The law guards against a flood of frivolous or vexatious lawsuits against third-party speakers because (1) plaintiffs must show the materiality of the misrepresentation, (2) defendants are allowed to rebut the presumption, prior to class certification, by showing, for example, the absence of a price impact, and (3) statements that are ‘predictions or opinions,’ and which concern ‘uncertain future event[s],’ such as most statements made by research analysts, are generally not actionable.”