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Introduction

In Douglas Millowitz v. Citigroup Global Markets et al (“In Re Salomon Analyst Metromedia Litigation”), 544 F.3d 474 (2nd Cir. 2008), the Second Circuit extended the fraud-on-the-market presumption of reliance, first set forth in Basic v. Levinson, 485 U.S. 224 (1988), to analyst reports. The Court also stated that defendants should be afforded the opportunity to rebut that presumption at the class certification stage in an effort to prevent certification. The opinion may make it harder to pursue class actions in some securities fraud cases.

Background

In re Salomon Analyst Metromedia Litigation, 544 F.3d 474 (2nd Cir. 2008),  (“Salomon”), the plaintiffs – an alleged class — were investors in Metromedia Fiber Network Inc. (“Metromedia”). They claimed that defendants Citigroup, Citicorp USA, Salomon Smith Barney, and Salomon’s research analyst Jack Grubman defrauded buyers and sellers of Metromedia stock through materially false and misleading statements in Grubman’s analyst reports, in violation of section 10(b) of the Securities Exchange Act of 1934 and the SEC Rule 10b-5. Grubman’s reports, which included “Buy” recommendations, were overly optimistic about Metromedia’s potential and touted a $350 million Citicorp credit facility for Metromedia without disclosing problems and delays with the facility.

Plaintiffs alleged that Grubman made the false and misleading statements to attract business for Salomon from Metromedia, which would increase Grubman’s income. As Grubman was an influential analyst, his positive reports were able to drive up share prices.

The Southern District of New York had granted class certification, finding that the proposed class representatives met the Federal Rule of Civil Procedure Rule 23(a) requirements of numerosity, commonality, typicality, and adequacy; it also determined that common questions of law or fact among class members predominated over individual class member questions, pursuant to Rule 23(b)(3).

The district court agreed with the plaintiffs that their reliance on the statements could be presumed under the fraud-on-the-market doctrine set forth in Basic v. Levinson, 485 U.S. 224 (1988) (discussed in detail below), and that the doctrine could be applied to analysts as well as issuer statements. The district court rejected the defendants’ argument that plaintiffs had to show materiality of the statements by showing that those statements actually “moved the market” – the district court determined that plaintiffs’ demonstration of a “substantial likelihood” that the analyst reports altered the total mix of information available to the public was sufficient.

The Fraud-on-the-market presumption and its application to analysts

In order to successfully pursue a 10b-5 claim, plaintiffs must prove “(1) a misstatement or omission (2) of a material fact (3) made with scienter (4) upon which the plaintiff relied (5) that proximately caused the plaintiff’s loss.” McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir.1989) (citation omitted). The fraud-on-the-market doctrine holds that when certain conditions are present, the element of reliance (the fourth element listed above) may be presumed.

The fraud-on-the-market presumption was established in the Basic case in recognition of the fact that “[t] he modern securities markets, literally involving millions of shares changing hands daily, differ from the face-to-face transactions contemplated by early fraud cases.” 485 U.S. at 243-44. The Basic court held that plaintiffs in a securities fraud action are entitled to a presumption of reliance on the misleading statements where: (1) the security was traded in an open, impersonal, efficient market; (2) the alleged misrepresentations were publicly made; and (3) the misrepresentations were material. Id. at 244-47. The Basic court based this doctrine on the notion 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.” Id. at 243.

The Basic court ruling certainly benefitted securities fraud plaintiffs, and purported classes in particular. Since class members have to prove that common questions of fact or law predominate to obtain certification, a presumption of reliance obviates the need to individually query each class member to ascertain a common claim of reliance. The presumed reliance makes it more likely that class certification is appropriate.

In Salomon, the district court held – and the Second Circuit agreed – that the fraud-on-the-market presumption set forth in Basic can be applied to more than merely issuer statements. Both courts rejected defendants’ argument that Basic was not applicable to analysts, noting that nothing in the Basic opinion suggested such a restriction. 544 F.3d at 481. The Second Circuit stated that “the premise of Basic is that, in an efficient market, share prices reflect all publicly available information, and, hence, any material misrepresentations” and therefore 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.” Id. While the court did not go so far as to allow Basic to be applied to all speakers, it confirmed applicability of the doctrine to secondary actors such as analysts. Id. at 484, n.8.

Plaintiffs’ proof of materiality of the misrepresentation

Under the Basic doctrine, the plaintiffs still have to prove that the misrepresentation was “material” in order to establish the presumption of reliance. As noted above, the Salomon defendants argued that plaintiffs had to establish that the misrepresentation “moved the market” – had a measurable impact on the stock price – in order to prove materiality. This argument was rejected by both the district and circuit courts.

However, the Second Circuit set forth a new standard for proof of materiality that leaves open questions and conflict between Circuits. The Second Circuit stated that “plaintiffs must show that the statement is material (a prima facie showing will not suffice).” 544 F.3d at 486, n.9. In other words, the Second Circuit would require more than a prima facie showing of materiality, but less than proof that the statement “moved the market.” The Second Circuit did not specify how much or how little evidence would be sufficient to meet this in-between standard, leaving that question open for future litigants.

This new standard articulated by the Second Circuit conflicts with the Fifth Circuit’s opinion in Oscar Private Equity Investments v. Allegiance Telecom Inc., 487 F.3d 261 (5th Cir. 2007). The Oscar court required the plaintiffs to prove “loss causation – that an alleged misstatement ‘actually moved the market’” before they could establish a presumption of reliance at the class certification stage. 487 F.3d at 265. The Oscar court required this level of proof “to tighten the requirements for plaintiffs seeking a presumption of reliance.” Id.

Although the Second Circuit was aware of the Oscar decision when it wrote the Salomon opinion, the Second Circuit did not acknowledge the conflict between its holding and Oscar in its opinion.

Defendants may rebut the presumption at the class certification stage

The fraud-on-the-market presumption is rebuttable. Defendants can rebut the elements that gave rise to the presumption by showing, “for example, that the market price was not affected by the alleged misstatements, other statements in the ‘sea of voices’ of market commentary were responsible for price discrepancies, or particular plaintiffs may not have relied on market price.” 544 F.3d at 485. The question before the Second Circuit in Salomon, however, was when defendants can present their rebuttal evidence.

The district court had determined that it could not consider defendants’ rebuttal evidence prior to class certification because that would require the court to weigh merits-related evidence at the class certification stage, which was prohibited under Caridad v. Metro-North Commuter R.R., 191 F.3d 283 (2nd Cir. 1999). However, after the district court issued its opinion and before the appellate briefing, the Second Circuit decided In re Initial Public Offering Sec. Litig., 471 F.3d 24 (2d Cir. 2006), which overruled Caridad on this issue. In re IPO required a district court to make a “definitive assessment” that the Rule 23(b)(3) predominance requirement had been met, necessitating consideration defendants’ rebuttal arguments.

As a result, the court clarified that defendants should be able to present their rebuttal arguments at the class certification stage. As a result, the Second Circuit reversed and remanded the case to give defendants the opportunity to present evidence rebutting the Basic presumption prior to class certification.

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