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Expert Analysis
Class Action Law360 / Financial Services Law360 / Securities Law360
October 25, 2010
Schleicher V. Wendt And Fraud-On-The-Market Doctrine
The fraud-on-the-market presumption of reliance has proven to be a
powerful tool for plaintiffs seeking to obtain class certification, and
the attendant settlement leverage, in Section 10(b) securities fraud
cases.
Recognizing that class certification has important practical
consequences, the Fifth Circuit has held plaintiffs to a rigorous
standard, holding that the presumption does not apply if the plaintiff
cannot demonstrate loss causation at the class certification stage.
The Second Circuit has adopted similar reasoning, allowing
defendants an opportunity to rebut the fraud-on-the-market
presumption at the class certification stage rather than delay the
issue for a trial on the merits.
Michele D. Johnson
Partner
Colleen C. Smith
Associate
Colin Vandell
Associate
Jenny Allen
Associate
These courts’ heightened requirements for establishing the fraudon-the-market presumption in the context of class certification have
drawn significant criticism. In its recent Schleicher v. Wendt decision,
the Seventh Circuit joined these critics, rejecting the Fifth Circuit’s
approach outright and allowing only a “peek” at facts that might
contradict the elements necessary for class certification.
Schleicher creates a clear circuit split. The considerable differences
between these two courts’ requirements will have a dramatic impact
upon plaintiffs’ ability to obtain class certification, and may lead the
U.S. Supreme Court to resolve the debate in the near future.
Background
In Basic Inc. v. Levinson, 485 U.S. 224, 243 (1988), the Supreme Court allowed plaintiffs in Section 10(b) securities fraud
class actions to establish a classwide presumption of reliance under the “fraud-on-the-market” doctrine.
The fraud-on-the-market doctrine is based on the premise that the price of well-followed and frequently traded stock
reflects the public information available about a company. Accordingly, misleading statements about a company will
defraud purchasers of that company’s stock even if the purchasers do not directly rely on the misstatements.
The fraud-on-the-market doctrine has had a significant impact upon plaintiffs’ ability to obtain class certification in Section
10(b) cases. Class certification under Rule 23 requires a showing that questions of law or fact common to the class
predominate over individual questions. In Basic, the court recognized that it would be virtually impossible for plaintiffs to
satisfy the Rule 23(b) predominance test if each member of the proposed class were required to prove reliance.
The fraud-on-the-market doctrine relieves plaintiffs of this burden, allowing plaintiffs to benefit from a rebuttable
presumption of reliance upon a showing of market efficiency.
Oscar Private Equity
The Supreme Court in Basic did not clearly define a test for the fraud-on-the-market doctrine. The court required plaintiffs
to demonstrate an efficient market but did not elaborate on the specific procedural and substantive rules for application of
the doctrine.
Given this analytical gap, some courts of appeals have concluded that there is room for each of the circuits to develop its
own fraud-on-the-market rules. The Fifth Circuit has done exactly that, crafting a demanding test for establishing the fraudon-the-market presumption of reliance in its 2007 decision in Oscar Private Equity Investments v. Allegiance Telecom Inc.,
487 F.3d 261 (5th Cir. 2007).
In Oscar Private Equity, investor plaintiffs alleged that executives of a telecommunications provider had misrepresented the
company’s telephone line installation counts. When these counts were restated and reduced by 125,000 lines, the
corporation’s stock price plummeted. The district court accepted plaintiffs’ theory of loss causation and certified a class.
The central issue on appeal was whether the district court properly allowed plaintiffs to rely upon the fraud-on-the-market
theory to support class certification.
In a 2-1 split decision, the Fifth Circuit panel rejected the district court’s ruling. The majority held that plaintiffs seeking to
establish the fraud-on-the-market presumption of reliance must prove “that the misstatement actually moved the market.”
Thus, plaintiffs may rely on the presumption only if they can prove that the defendant’s misrepresentation materially
affected the market price of the security. Under the Fifth Circuit’s test, then, plaintiffs must establish loss causation to
obtain the fraud-on-the-market presumption.
The Fifth Circuit’s holding was based upon the Supreme Court’s statement in Basic that the fraud-on-the-market
presumption may be rebutted by any showing that severs the link between the alleged misrepresentation and the price of
the security. According to the Fifth Circuit, the link is severed, and the presumption rebutted, by “a showing that the market
price would not have been affected by the alleged misrepresentations, as in such a case the basis for finding that the fraud
had been transmitted through the market price would be gone.”
To the Fifth Circuit, the showing required to rebut the fraud-on-the-market presumption is so light that defendants
effectively are able to rebut the presumption “on arrival.” Accordingly, the court concluded, it is appropriate to require
plaintiffs to prove loss causation, rather than to require defendants to disprove loss causation to rebut the presumption.
The Fifth Circuit’s conclusion that plaintiffs are required to establish loss causation at the class certification stage was
informed by its view of the dramatic impact of the fraud-on-the-market doctrine upon Section 10(b) claims. The court
observed that “the efficient market doctrine facilitates an extraordinary aggregation of claims” and gives rise to an “in
terrorem power of certification.”
Moreover, the Rule 23 class certification process has been revised in that it no longer requires district courts to rule on class
certification “as soon as practicable” (but instead “at an early practicable time”) and no longer describes the class
certification order as “conditional,” explaining in the advisory committee notes that “*a+ court that is not satisfied that the
requirements of Rule 23 have been met should refuse certification until they have been met.”
These revisions “recognize that a district court’s certification order often bestows upon plaintiffs extraordinary leverage.”
Thus, the Fifth Circuit concluded, the “bite” of class certification should dictate the requirements of the class certification
process. Rather than overlook the merits inquiries, courts must give full and independent weight to the facts relevant to
each Rule 23 requirement. Applied in a Section 10(b) action, the Fifth Circuit mandated a complete analysis of fraud-on-themarket indicators — including loss causation — at the class certification stage.
The dissent criticized the majority’s opinion as “a breathtaking revision of securities class action procedure that eviscerates
Basic’s fraud-on-the-market presumption, creates a split from other circuits by requiring mini-trials on the merits of cases at
the class certification stage, and effectively overrules legitimately binding circuit precedents.”
In re Salomon Analyst Metromedia Litigation
The Second Circuit has adopted a more middle-of-the-road approach. In In re Salomon Analyst Metromedia Litigation, 544
F.3d 474 (2d Cir. 2008), the Second Circuit examined whether loss causation should be considered in evaluating the fraudon-the-market presumption of reliance. Looking to Basic, the court concluded that plaintiffs need not prove loss causation
at the class certification stage, but rather that defendants are entitled to present evidence that the misleading statements
did not move the market, thereby rebutting the presumption.
The Second Circuit acknowledged that courts may, and sometimes must, resolve factual disputes at the class certification
stage, in order to assess the Rule 23 requirements. In a Section 10(b) case, this assessment necessarily includes
consideration all of the evidence relevant to the fraud-on-the-market presumption of reliance.
Schleicher
The Seventh Circuit weighed in this summer in Schleicher v. Wendt, No. 09-2154, 2010 WL 3271964 (7th Cir. Aug. 20, 2010),
categorically rejecting the Fifth Circuit’s Oscar Private Equity approach. In an animated opinion by Judge Frank Easterbrook,
the Seventh Circuit held that plaintiffs are not required to prove loss causation or materiality at the class certification stage
under the fraud-on-the-market doctrine. Instead, courts may only “peek” at aspects of the merits impacting “decisions
essential under Rule 23.”
The Seventh Circuit attacked the Fifth Circuit’s reasoning in two principal respects. First, the Seventh Circuit rejected the
notion that the Supreme Court’s Basic opinion gives circuit courts the power to “tighten” Rule 23’s requirements through
development of the fraud-on-the-market doctrine.
Under the Seventh Circuit’s view, the Fifth Circuit’s Oscar Private Equity decision requires a complete examination of the
merits at the class certification stage, in direct conflict with Supreme Court precedent requiring courts to separate class
certification from the decision on the merits. Moreover, the Seventh Circuit observed that even if Basic allowed the lower
courts some room to develop procedural and substantive rules for applying the fraud-on-the-market doctrine, the Fifth
Circuit had done more than simply “tighten” Rule 23’s requirements.
Rather, the Fifth Circuit had made class certification “impossible” in at least some securities fraud cases, such as when true
and false statements are made simultaneously and their separate effects on stock price cannot be easily identified to prove
loss causation.
Second, the Seventh Circuit rejected what it viewed as the Fifth Circuit’s attempt to create heightened barriers to class
certification in securities fraud class actions to prevent an “in terrorem” effect. Aware that its decision would render class
certification a fairly simple process for securities fraud plaintiffs, the court observed that “*b+ecause each investor’s loss
usually can be established mechanically, common questions predominate and class certification is routine, if a suitable
representative steps forward.”
The Seventh Circuit minimized the increased settlement leverage that results from class certification, reasoning that
Congress chose to deal with settlement pressure by creating the heightened pleading standards of the Private Securities
Litigation Reform Act of 1995. The court thus adopted a lenient class certification standard reflecting a relaxed view of the
proof requirements of the Basic fraud-on-the-market doctrine.
The Seventh Circuit did not expressly reject or adopt the Second Circuit’s Salomon approach. Rather, the Seventh Circuit
labeled the Fifth Circuit’s Oscar Private Equity decision an outlier, which “has not been adopted by any other circuit” and
which Salomon implicitly rejected. The Seventh Circuit’s silence on the Second Circuit’s Salomon approach leaves room for
further development of Section 10(b) class certification standards.
The Future
The Schleicher decision creates an unambiguous circuit split between the Fifth and Seventh Circuits. Given the significant
distinction between the two approaches to class certification in Section 10(b) cases, the Supreme Court may soon resolve
this split. A petition for certiorari is pending in Erica P. John Fund Inc. v. Halliburton Co., a recent Fifth Circuit decision
applying Oscar Private Equity. On Oct. 4, 2010, the high court asked the solicitor general’s office for its views regarding
whether certiorari should be granted — a signal that the court will consider the petition carefully.
Until the court resolves this debate, the split between the Fifth and Seventh Circuits will have significant implications for
securities fraud class action lawsuits. Whereas the Fifth Circuit sets a high bar for plaintiffs, requiring a showing of loss
causation at the class certification stage, the Seventh Circuit would not require plaintiffs to make nearly that substantial of a
showing to certify a class.
Instead, if plaintiffs can establish that shares are traded in an efficient market, the fraud-on-the-market presumption
applies, and actual loss causation need not be shown to certify the class. The considerable differences between these two
courts’ requirements will likely lead to dramatically different class certification success in Section 10(b) cases.
--By Michele D. Johnson, Colin Vandell, Colleen C. Smith and Jenny Allen, Latham & Watkins LLP
Michele Johnson (michele.johnson@lw.com) is a partner in the Orange County, Calif., office of Latham & Watkins. Colin
Vandell (colin.vandell@lw.com) is an associate in the firm's Los Angeles office. Colleen Smith (colleen.smith@lw.com) is an
associate in the firm's San Diego office. Jenny Allen (jenny.allen@lw.com) is an associate in the firm's Orange County office.
The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients or Portfolio
Media, publisher of Law360.