West v. Prudential Securities, Inc., 02-8001.

• Decision Date: 07 March 2002
• Docket Number: No. 02-8001.,02-8001.
• Citation: 282 F.3d 935
• Parties: Dean WEST and Lyndell Eickholz, individually and on behalf of a class of investors in Jefferson Savings Bancorp, Inc., Plaintiffs-Respondents, v. PRUDENTIAL SECURITIES, INCORPORATED, Defendant-Petitioner.
• Court: U.S. Court of Appeals — Seventh Circuit

282 F.3d 935

Dean WEST and Lyndell Eickholz, individually and on behalf of a class of investors in Jefferson Savings Bancorp, Inc., Plaintiffs-Respondents, v. PRUDENTIAL SECURITIES, INCORPORATED, Defendant-Petitioner.

No. 02-8001.

United States Court of Appeals, Seventh Circuit.

Submitted January 30, 2002.

Decided March 7, 2002.

Leonard A. Spivak, Cahill, Gordon & Reindel, New York, NY, Gerald P. Greiman, Spencer, Fane, Britt & Browne, St. Louis, MO, for petitioner.

Rex Carr, Carr Korein, Tillery, Kunin, Montroy & Glass, East St. Louis, IL, for respondent.

Before EASTERBROOK, MANION, and KANNE, Circuit Judges.

EASTERBROOK, Circuit Judge.

According to the complaint in this securities-fraud action, James Hofman, a stockbroker working for Prudential Securities, told 11 of his customers that Jefferson Savings Bancorp was "certain" to be acquired, at a big premium, in the near future. Hofman continued making this statement for seven months (repeating it to some clients); it was a lie, for no acquisition was impending. And if the statement had been the truth, then Hofman was inviting unlawful trading on the basis of material non-public information. He is a securities offender coming or going, see Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 105 S.Ct. 2622, 86 L.Ed.2d 215 (1985), as are any customers who traded on what they thought to be confidential information — if Hofman said what the plaintiffs allege, a subject still to be determined. What we must decide is whether the action may proceed, not on behalf of those who received Hofman's "news" in person but on behalf of everyone who bought Jefferson stock during the months when Hofman was misbehaving. The district judge certified such a class, invoking the fraud-on-the-market doctrine of Basic, Inc. v. Levinson, 485 U.S. 224, 241-49, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988). Prudential asks us to entertain an interlocutory appeal under Fed.R.Civ.P. 23(f). For two reasons, this is an appropriate case for such an appeal, which we now accept. See Blair v. Equifax Check Services, Inc., 181 F.3d 832 (7th Cir.1999).

First, the district court's order marks a substantial extension of the fraud-on-the-market approach. Basic held that "[b]ecause most publicly available information is reflected in market price, an investor's reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action." 485 U.S. at 247, 108 S.Ct. 978. The theme of Basic and other fraud-on-the-market decisions is that public information reaches professional investors, whose evaluations of that information and trades quickly influence securities prices. But Hofman did not release information to the public, and his clients thought that they were receiving and acting on nonpublic information; its value (if any) lay precisely in the fact that other traders did not know the news. No newspaper or other organ of general circulation reported that Jefferson was soon to be acquired. As plaintiffs summarize their position, their "argument in a nutshell is that it is unimportant for purposes of the fraud-on-the-market doctrine whether the information was `publicly available' in the ... sense that ... the information was disseminated through a press release, or prospectus or other written format". Yet extending the fraud-on-the-market doctrine in this way requires not only a departure from Basic but also a novelty in fraud cases as a class — as another court of appeals remarked only recently in another securities suit, oral frauds have not been allowed to proceed as class actions, for the details of the deceit differ from victim to victim, and the nature of the loss also may be statement-specific. See Johnston v. HBO Film Management, Inc., 265 F.3d 178, 185-92 (3d Cir.2001). See also, e.g., Szabo v. Bridgeport Machines, Inc., 249 F.3d 672 (7th Cir.2001). The appeal thus presents a novel and potentially important question of law.

Second, very few securities class actions are litigated to conclusion, so review of this novel and important legal issue may be possible only through the Rule 23(f) device. What is more, some scholars believe that the settlements in securities cases reflect high risk of catastrophic loss, which together with imperfect alignment of managers' and investors' interests leads defendants to pay substantial sums even when the plaintiffs have weak positions. See Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements in Securities Class Actions, 43 Stan. L.Rev. 497 (1991); Reinier Kraakman, Hyun Park & Steven Shavell, When Are Shareholder Suits in Shareholder Interests?, 82 Geo. L.J. 1733 (1994) Roberta Romano, The Shareholder Suit: Litigation Without Foundation?, 7 J.L. Econ. & Org. 55 (1991). The strength of this effect has been debated, see Joel Seligman, The Merits Do Matter, 108 Harv. L.Rev. 438 (1994), but its existence is established. The effect of a class certification in inducing settlement to curtail the risk of large awards provides a powerful reason to take an interlocutory appeal.

Because the parties' papers have developed their positions fully, and the district court has set a trial date less than two months away, we think it best to resolve the appeal promptly, and thus we turn to the merits.

Causation is the shortcoming in this class certification. Basic describes a mechanism by which public information affects stock prices, and thus may affect traders who did not know about that information. Professional investors monitor news about many firms; good news implies higher dividends and other benefits, which induces these investors to value the stock more highly, and they continue buying until the gains are exhausted. With many professional investors alert to news, markets are efficient in the sense that they rapidly adjust to all public information; if some of this information is false, the price will reach an incorrect level, staying there until the truth emerges. This approach has the support of financial economics as well as the imprimatur of the Justices: few propositions in economics are better established than the quick adjustment of securities prices to public information. See Richard A. Brealey, Stewart C. Myers & Alan J. Marcus, Fundamentals of Corporate Finance 322-39 (2d ed.1998).

No similar mechanism explains how prices would respond to non-public information, such as statements made by Hofman to a handful of his clients. These do not come to the attention of professional investors or money managers, so the price-adjustment mechanism just described does not operate. Sometimes full-time market watchers can infer important news from the identity of a trader (when the corporation's CEO goes on a buying spree, this implies good news) or from the sheer volume of trades (an unprecedented buying volume may suggest that a bidder is accumulating stock in anticipation of a tender offer), but neither the identity of Hofman's customers nor the volume of their trades would have conveyed information to the market in...