In Millowitz v. Citigroup Global Markets, Inc., 2008 WL 4426412 (2d Cir. Sept. 30, 2008), the United States Court of Appeals for the Second Circuit held that the fraud-on-the-market doctrine established in Basic Inc. v. Levinson, 485 U.S. 224 (1988), applies in Rule 10b-5 suits challenging alleged misstatements contained in research analyst reports. The fraud-on-the-market doctrine creates a presumption of reliance in 10b-5 securities fraud cases, and eliminates the need for plaintiffs to show individual reliance on the alleged fraudulent act. In Millowitz, the Second Circuit concluded that the district court in the case had properly invoked the doctrine to decide whether common questions of law and fact predominated over individualized ones for purposes of certifying a class under Fed. R. Civ. P. 23(b)(3). The Second Circuit also ruled that no showing of the analyst’s reports’ actual affect on the securities’ market price is required to trigger the presumption, something defendants had urged. The decision is important because it may impose a risk of class action liability on public misstatements of fact even when the speaker is neither the issuer nor an agent of the issuer, provided the misstatement is material.
Plaintiffs alleged that an influential research analyst, Jack Grubman, employed by Salomon Smith Barney, Inc. (SSB), issued reports containing false and misleading information about Metromedia Fiber Network (Metromedia). Grubman purportedly issued these favorable reports in order to attract business from Metromedia for SSB’s investment banking division, which increased Grubman’s personal compensation. The reports stated that Metromedia had obtained a $350 million commitment for a fully underwritten credit facility from Citicorp USA, Inc., an SSB affiliate, and that Metromedia expected the facility to fully fund its business plan. The reports failed to disclose, however, that the proposed facility had in fact suffered numerous problems and delays, information that plaintiffs alleged Grubman possessed due to a management-endorsed breach in the “Chinese Wall” between Grubman and the investment banking divisions and affiliates. According to plaintiffs, these omissions rendered the reports materially misleading and artificially inflated the market price of Metromedia securities.
In the district court, plaintiffs moved to certify the alleged class, advancing the fraud-on-the-market doctrine to show that the reliance element did not require individualized proof at trial. Defendants opposed, arguing primarily that, as alleged misstatements by a non-issuer, plaintiffs had to show that Grubman’s reports had some actual causal effect on the market price of Metromedia’s shares. The district court disagreed, stating that “nothing in the language of Basic limits its holding to issuer statements alone.” In re Salomon Analyst Metromedia Litig., 373 F. Supp. 2d 235, 236 (S.D.N.Y. 2005). Rather, all that is needed to trigger the presumption is a “1) publicly made 2) material misrepresentation 3) about stock traded on an impersonal, well-developed market.” Id. at 248 n.27. Finding a sufficient showing of these points, the district court certified the class.
On interlocutory appeal, the defendants argued that Basic should be limited to suits involving misleading statements by issuers because those made by third parties are less likely to materially affect market prices. The Second Circuit rejected that argument on the ground that the key premise underlying the fraud-on-the-market doctrine is that share prices reflect “all publicly available information, and hence, any material misrepresentations” regardless of “whether the misinformation was transmitted by an issuer, an analyst or anyone else.”
The Second Circuit also rejected defendants’ efforts to, in effect, cast the materiality element of the fraud-on-the-market doctrine in terms of an actual impact on market prices. It noted that Basic was careful to frame materiality in terms of whether a reasonable investor would view the misstated or omitted fact as significantly altering the total mix of available information. Basic thereby avoided burdening the plaintiff with the need to employ “sophisticated statistical analysis and . . . economic theory.” The court noted, “[t]he point of Basic is that the effect on market price is presumed based on the materiality of the information and a well-developed market’s ability to readily incorporate that information into the price of the securities.” Thus, the court determined that the burden of showing no actual impact on prices is properly placed on the defendant.
The district court in this case, however, did not permit defendants to rebut the fraud-on-the-market presumption at the class certification stage. Because Second Circuit precedent now requires a “definitive assessment” that the Rule 23(b)(3) predominance requirement is met, see In re Initial Public Offering Sec. Litig., 471 F.3d 24 (2d Cir. 2006), the court remanded the case to allow defendants the opportunity to make such showing.
This decision, at least in theory, places all public material misstatements about companies whose securities trade in efficient markets at risk of sparking class action litigation regardless of who is speaking or whether any individual investor is actually reviewing and relying on the information. The defendants in the case voiced this concern by noting that statements posted on the internet by an individual about an issuer could be actionable on a class-wide basis under Rule 10b-5 to the same extent as statements in SEC filings made by the issuer itself. The court called this concern “misplaced” because materiality would still need to be shown. In a footnote, the court stated that, under the materiality requirement, “the identity of the speaker may be significant, because a court may determine that the reasonable investor would rely only on misrepresentations by some speakers and not others.” It also noted that most third party statements would be in the form of predictions or opinions that are not generally actionable. This is a development to watch closely.