Third Circuit Rejects "Fraud Created The Market" As Basis For Class Certification

By Peter Breslauer, John G. Papianou, Richard G. Placey, Christa Frank High, Charles B. Casper, Christopher Scott D'Angelo, Janice G. Dubler, Patrick T. Ryan, Kristen E. Polovoy, Craig E. Ziegler
Montgomery McCracken Walker & Rhoads, LLP
Nov 1, 2010

In a case of first impression for the Court, the Third Circuit has rejected the so-called "fraud-created-the-market" theory as a basis for obtaining class certification through a presumption of investor reliance in securities fraud class actions. The Court, on August 16, 2010, ruled that "the theory lacks a basis in any of the accepted grounds for creating a presumption"-largely because investors are not justified in relying on SEC registration, and the availability of registered securities in the market, as a guarantee, or indeed even an indicator, that the securities are free of fraud. The Court declined to expand, to the "fraud-created-the-market" setting, the presumption of investor reliance found in "fraud-on-the-market" class actions under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Malack v. BDO Seidman, LLP, 617 F.3d 743 (3d Cir. 2010).

In Malack, investors sought certification of a class action alleging that BDO Seidman, the auditors of American Business Financial Services, Inc. ("ABFS"), improperly supplied clean audit opinions to help ABFS register high-interest notes with the SEC. The investors contended that BDO Seidman's allegedly fraudulent audit opinions paved the way for the notes, whose value declined to zero during the mortgage meltdown, to be registered for sale. Because reliance on a fraudulent misrepresentation is a necessary element of their section 10(b) claim-and because class certification is routinely denied if each buyer has to prove reliance individually at trial-the investors sought a presumption of reliance based on the SEC registration. If the SEC had known the audit opinions were fraudulent, the investors reasoned, the notes would never have been registered or available for sale and the purchasers would not have lost money.

The Third Circuit, affirming the district court, declined to expand the reliance presumption to "fraud-created-the-market" allegations. First, the Court rejected plaintiffs' "common-sense" argument, finding that "the entities most commonly involved in bringing a security to market"-company promoters along with underwriters, accountants, and attorneys the company retained-"do not imbue the security with any guarantee against fraud . . . [and] cannot be reasonably relied upon to prevent fraud" because each of them stands to gain if SEC registration occurs. Second, the Court found no basis for investors to conclude that SEC registration endorses the securities' "genuineness." In contrast to the reliance presumption in fraud-on-the-market cases, which the Supreme Court determined was justified on well-accepted economic principles in Basic Inc. v. Levinson, 485 U.S. 224 (1988), the "fraud-created-the-market" theory is supported by neither empirical studies nor economic theory. Finally, recognizing the "fraud-created-the-market" theory would not advance the securities laws' disclosure objectives.

In rejecting the "fraud-created-the-market" theory, the Third Circuit joined the Seventh Circuit in Eckstein v. Balcor Film Investors, 8 F.3d 1121 (7th Cir. 1993), and disagreed with the Fifth Circuit in Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981). The opinion continues the trend against expansion of securities fraud litigation seen in the Private Securities Litigation Reform Act of 1995 and many judicial decisions since then.