Malack v. Seidman

• Decision Date: 16 August 2010
• Docket Number: No. 09-4475.,09-4475.
• Citation: 617 F.3d 743
• Parties: John A. MALACK; Michael R. Rosati; Virgil Magnon; S.S. Rajaram, M.D.; Hayward Pediatrics, Inc.; Henry Munster, Appellantsv.BDO SEIDMAN, LLP.
• Court: U.S. Court of Appeals — Third Circuit

617 F.3d 743

John A. MALACK; Michael R. Rosati; Virgil Magnon; S.S. Rajaram, M.D.; Hayward Pediatrics, Inc.; Henry Munster, Appellantsv.BDO SEIDMAN, LLP.

No. 09-4475.

United States Court of Appeals Third Circuit.

Argued June 23, 2010.

Filed: Aug. 16, 2010.

Todd S. Collins (argued), Elizabeth W. Fox, Neil F. Mara, Berger & Montague, Philadelphia, PA, for Appellants.

Jacob A. Goldberg, Faruqi & Faruqi, Jenkintown, PA, for Appellants.

Kurt B. Olsen, Klaftner, Olsen & Lessner, Washington, DC, for Appellants.

Jill M. Czeschin, Matthew A. Goldberg, Timothy E. Hoeffner (argued), DLA Piper, Philadelphia, PA, for Appellee.

Before: SMITH, FISHER, and GREENBERG, Circuit Judges.

OPINION

SMITH, Circuit Judge.

This appeal arises from the denial of class certification in a securities fraud class action. John Malack purchased notes issued by American Business Financial Services, Inc. (“American Business”), a subprime mortgage originator, and those notes were later rendered worthless during the subprime mortgage meltdown. He now seeks compensation from BDO Seidman LLP (“BDO”), an accounting firm that assisted American Business in allegedly defrauding him and other investors by providing American Business clean audit opinions that were used to register the notes with the Securities and Exchange Commission (“SEC”). Malack filed a putative securities fraud class action against BDO based on § 10(b) of the Securities Exchange Act of 1934 ¹ and Rule 10b-5.² The District Court denied class certification, holding that Malack did not satisfy the predominance requirement of Rule 23(b)(3) ³ because he did not establish a presumption of reliance under the fraud-created-the-market theory.⁴ Malack now appeals the denial of class certification.

This case turns on the application vel non of the fraud-created-the-market theory of reliance. Without the presumption of reliance afforded by that theory, Malack cannot receive class certification. The theory's validity is an issue of first impression for this Court, and other Courts of Appeals are split over whether it should be recognized. We join the Seventh Circuit in rejecting the theory and will affirm the District Court's denial of class certification.

I.

The District Court had jurisdiction under 15 U.S.C. § 78aa and 28 U.S.C. § 1331. This appeal reaches us under 28 U.S.C. § 1292(e) and Rule 23(f). A district court's decision on class certification is reviewed for an abuse of discretion. In re Hydrogen Peroxide Antitrust Litig., 552 F.3d 305, 312 (3d Cir.2008). An abuse of discretion occurs “if the district court's decision rests upon a clearly erroneous finding of fact, an errant conclusion of law or an improper application of law to fact.” Id. (internal quotation marks omitted). “[W]hether an incorrect legal standard has been used is an issue of law to be reviewed de novo.” Id. (internal quotation marks omitted).

II.

Malack and other investors directly purchased notes from American Business between October 3, 2002, and January 20, 2005. The notes promised to pay interest well above the prime rate without the involvement of underwriters or brokers, were non-transferrable, could only be cashed in after they matured, and had no market for resale. The notes were issued pursuant to American Business's 2002 and 2003 registration statements and prospectuses filed with the SEC. BDO provided the audit opinions necessary to complete the filings with the SEC.

On January 21, 2005, American Business filed a Chapter 11 petition for reorganization. On May 17, 2005, that proceeding was converted to a Chapter 7 liquidation. Malack and the other investors suffered substantial losses as a result. On February 15, 2008, Malack filed a putative securities fraud class action against BDO, alleging that its audits of American Business were deficient. According to Malack, had BDO done its job properly, it would not have issued American Business clean audit opinions. Malack further alleges that without clean audit opinions, American Business would not have been able to register the notes with the SEC, the notes would not have been marketable, and Malack and the other investors would not have purchased the notes. Based on these allegations, Malack asserted that BDO violated § 10(b) of the 1934 Act and Rule 10b-5.

Malack sought class certification. The District Court, after a thorough analysis of the possible approaches through which Malack might have obtained a presumption of reasonable reliance based on the fraud-created-the-market theory, denied his request, concluding that the proposed class did not satisfy the predominance requirement of Rule 23.⁵ Malack timely petitioned for permission to appeal under Rule 23(f). We granted that petition and now must consider whether the District Court erred in denying Malack class certification.

III.

Malack challenges the District Court's predominance determination.

Predominance “tests whether proposed classes are sufficiently cohesive to warrant adjudication by representation [.... ]” “Issues common to the class must predominate over individual issues....” Because the “nature of the evidence that will suffice to resolve a question determines whether the question is common or individual,” “ ‘a district court must formulate some prediction as to how specific issues will play out in order to determine whether common or individual issues predominate in a given case[.]’ ” “If proof of the essential elements of the cause of action requires individual treatment, then class certification is unsuitable.”

In re Hydrogen Peroxide Antitrust Litig., 552 F.3d at 310-11 (internal citations omitted). “Accordingly, we examine the elements of [Malack's] claim ‘through the prism’ of Rule 23 to determine whether the District Court properly [denied] certifi[cation] [of] the class.” Id. at 311.

A § 10(b) private damages action has six elements:

(1) a material misrepresentation (or omission);

(2) scienter, i.e., a wrongful state of mind;

(3) a connection with the purchase or sale of a security;

(4) reliance, often referred to in cases involving public securities markets (fraud-on-the-market cases) as “transaction causation”;

(5) economic loss; and

(6) “loss causation,” i.e., a causal connection between the material misrepresentation and the loss.

McCabe v. Ernst & Young, LLP, 494 F.3d 418, 424 (3d Cir.2007) (quoting Dura Pharms., Inc. v. Broudo, 544 U.S. 336, 341-42, 125 S.Ct. 1627, 161 L.Ed.2d 577 (2005)) (emphasis omitted). The District Court denied class certification because Malack was unable to show that the proposed class was entitled to a presumption of reasonable reliance, AES Corp. v. Dow Chem. Co., 325 F.3d 174, 178 (3d Cir.2003) (explaining “reasonable reliance”). The reliance element “requires a showing of a causal nexus between the misrepresentation and the plaintiff's injury, as well as a demonstration that the plaintiff exercised the diligence that a reasonable person under all of the circumstances would have exercised to protect his own interests.” Id. Proving reliance for individual class members can quickly become a cumbersome endeavor that overwhelms the “questions of law or fact common” to the proposed class, Fed.R.Civ.P. 23(b)(3), and could preclude class certification see id. It is likely that for this reason, Malack sought to invoke a presumption of reliance.

A.

The Supreme Court has held that a presumption of reliance exists in two circumstances. The first means for establishing a presumption of reliance was set forth in Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 92 S.Ct. 1456, 31 L.Ed.2d 741 (1972). In that decision, the Supreme Court explained that “positive proof of reliance is not a prerequisite to recovery” in cases “involving primarily a failure to disclose” material facts by defendants obligated to disclose such facts. Id. at 153, 92 S.Ct. 1456. “All that is necessary is that the facts withheld be material in the sense that a reasonable investor might have considered them important in ... making ... th [e] [investment] decision.” Id. at 153-54, 92 S.Ct. 1456.

Second, in Basic Inc. v. Levinson, 485 U.S. 224, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988), the Supreme Court recognized the fraud-on-the-market theory as a means for establishing a presumption of reasonable reliance in an efficient market:

“The fraud on the market theory is based on the hypothesis 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.... Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.... The causal connection between the defendants' fraud and the plaintiffs' purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations.”

Id. at 241-42, 108 S.Ct. 978 (quoting Peil v. Speiser, 806 F.2d 1154, 1160-61 (3d Cir.1986)). “[I]n an efficient market[,] ... misinformation directly affects the stock prices at which the investor trades and thus, through the inflated or deflated price, causes injury even in the absence of direct reliance.” Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F.3d 154, 175 (3d Cir.2001) (internal quotation marks omitted). Therefore, “[r]eliance may be presumed when a fraudulent misrepresentation or omission impairs the value of a security traded in an efficient market.” Id.

Some Courts of Appeals have held that a presumption of reliance may be established through a third theory-the fraud-created-the-market theory. Compare, e.g., Shores v. Sklar, 647 F.2d 462, 464 (5th Cir.1981) (en banc) (setting forth the fraud-created-the-market theory) with Eckstein v. Balcor Film Investors, 8 F.3d 1121, 1130-31 (7th Cir.1993) (rejecting the theory). Malack seeks to rely on this theory to establish a presumption of reliance for the proposed class.

B.

The fraud-created-the-market theory posits that “[t]he securities laws allow an...