BDO Siedman Investor Class Certification Denied - Third Circuit Rejects Fraud Created the Market Theory
In Malack v. BDO Seidman, LLP, the Third Circuit affirmed the district court’s denial of class certification in a putative securities class action and rejected the so-called “fraud-created-the-market” theory. The unanimous panel concluded that “[t]he fraud-created-the-market theory lacks a basis in common sense, probability, or any of the other reasons commonly provided for the creation of a presumption.” (Id. at 35.) With its decision, the Third Circuit contributed to a circuit split on this issue, which may prompt the Supreme Court to address this issue sometime soon. Compare, e.g., Shores v. Sklar, 647 F.2d 462, 464 (5th Cir.1981) (en banc) (setting forth the fraudcreated-the-market theory), with, Eckstein v. Balcor Film Investors, Seventh Circuit, 1993 (rejecting the theory).
In affirming the district court, the Third Circuit concluded that the fraud-created-the-market theory is not an appropriate basis for creating a presumption of reliance and lacks any grounding in common sense or probability. The panel concluded there is nothing in the process of bringing a security to market that would “imbue the security with any guarantee against fraud.” Those entities involved in the issuance of the security, such as the underwriter, auditor, and legal counsel, have an interest in marketing the security at the highest (possibly inflated) price possible. The panel concluded that it “runs counter to common sense” to rely on such interested parties to be a “bulwark against fraud.” Likewise, because the SEC does not regulate the merit of disclosures in connection with a security, investors cannot reasonably rely upon it to prevent fraud.
This is an important decision in the Third Circuit. Reliance is an essential element of a securities fraud claim. It can be extremely difficult to establish reliance on a class-wide basis with respect to securities that are not traded in an efficient market. And that challenge can frequently lead to denial of class certification, as it did in Malack, because individual questions of reliance would likely predominate over other questions common to the class. As a result, the fraud-created-the-market theory is very important to would-be plaintiffs. Without that presumption of reliance, obtaining class certification becomes exceedingly difficult. And, as a practical matter, if class certification is denied in a securities fraud case, that almost always ends the case.