On August 16, 2010, a unanimous three-judge panel of the United States Court of Appeals for the Third Circuit, in Malack v. BDO Seidman, LLP , No. 09-4475, 2010 US App Lexis 17090 (3d Cir. Aug. 16, 2010) (precedential), rejected the "fraud-created-the-market" theory in securities fraud cases. The Court 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 creation of a presumption."
The Dispute
From 2002 through 2005, John Malack purchased notes issued by American Business Financial Services, Inc. ("American Business"), a subprime mortgage originator. The notes were issued pursuant to American Business's registration statements and prospectuses filed with the Securities and Exchange Commission ("SEC"). BDO Seidman LLP ("BDO"), an accounting firm, issued the audit opinions necessary to complete the filings with the SEC.
In 2005, American Business filed for bankruptcy. Malack and other investors suffered substantial losses. In 2008, Malack filed a putative securities fraud class action against BDO based on section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Malack claimed that had BDO done its job properly, it would not have issued clean audit opinions and American Business would not have been able to register the notes with the SEC. The District Court denied Malack's Motion for Class Certification on the ground the proposed class did not satisfy the predominance requirement of Rule 23. Malack filed an appeal.
For a securities fraud class action to succeed, the plaintiffs must show they relied on a statement that later turned out to be fraudulent.Because it is difficult to establish what individual class members read or heard, plaintiffs often invoke the "presumption of reliance" rather than actual reliance theory.
Malack argued that the Third Circuit should adopt the fraud-created-the-market theory and certify a class of American Business investors. Under that theory, a plaintiff can establish a presumption of reliance if he proves the defendants conspired to sell securities that were not legally entitled to be sold.
The Third Circuit's Analysis
The Third Circuit noted that presumptions are created based on considerations of fairness, public policy, probability, and judicial economy, but that such considerations do not support the fraud-created-the-market theory. The Court reasoned that common sense does not support the theory because the entities involved in the issuance of the securities are clearly self-interested and the SEC does not conduct merit regulation. The Court also rejected Malack's argument that probability supports his view. "If his reliance on probability is based on the idea that almost all marketed securities are, in fact, legally marketable, and therefore we should presume that anything offered on the market has not been stained by fraud, then Malack is advocating for a kind of investor insurance that eliminates the need for proving reliance in any securities fraud case .... The establishment of investor insurance is contrary to the goals of securities laws."
The Court also noted that the theory does not serve the securities law's goal of informing investors via disclosures and discouraging frivolous section 10(b) litigation.
Published December 6, 2010.
