The Second Circuit Court of Appeals recently ruled that plaintiffs alleging securities fraud based on material misstatements or omissions by analysts are entitled, under certain circumstances, to a rebuttable presumption that they relied on those statements. In re Salomon Analyst Metromedia Litigation1 is significant because the Second Circuit is the first Circuit court to hold that the fraud-on-the-market presumption of reliance applies to fraud allegations premised on materially misleading analyst reports. The case also is significant because the Second Circuit held that defendants are entitled at the class certification stage to present evidence rebutting the presumption. Courts must therefore consider defendants' rebuttal arguments and evidence before certifying a class — increasing the hurdles plaintiffs will face in pursuing securities class actions and placing a premium on defendants engaging as early as possible experts who will help rebut fraud-on-the-market arguments at the class certification phase.
Salomon expands upon Basic Inc. v. Levinson, in which the Supreme Court held that under the "fraud-on-the-market" theory a plaintiffs class in a securities fraud action is entitled to a presumption of reliance on affirmatively misleading statements made by an issuer where (1) the security was traded in an open, efficient market; (2) the alleged misrepresentations were publicly made; and (3) the misrepresentations were material.2 Basic accepted "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."3 As such, plaintiffs do not need to establish reliance — an element of securities fraud — as to each plaintiff because a materially misleading public statement by an issuer would cause a taint on the integrity of the price even as to those purchasers who had never seen the statement. By providing plaintiffs with a way around the reliance element at the class certification phase, Basic represented a significant strategic benefit to class action plaintiffs. (It is important to note, however, that Basic only created a rebuttable presumption that misrepresentations by an issuer affect the price of securities traded in the open market.)4
The District Court Ruling in Salomon
In Salomon, plaintiffs alleged that defendants Citigroup, Citicorp USA, Salomon Smith Barney, and Salomon's research analyst Jack Grubman defrauded purchasers and sellers of stock in Metromedia Fiber Network, Inc. through Grubman's overly optimistic analyst reports.5 The district court ultimately dismissed portions of the complaint, but let stand certain claims relating to analyst reports issued by Grubman that allegedly contained false "Buy" recommendations and falsely touted a $350 million Citicorp credit facility, which was crucial to Metromedia's business plan, without disclosing problems with that credit facility. The district court certified a class relating to those allegations, and held that plaintiffs could use the Basic presumption as to the Grubman analyst reports to satisfy the reliance element of their claims. The court refused to require plaintiffs to show that the alleged misstatements had an actual effect on the price of the securities. Based on then Second Circuit authority, the district court did not allow defendants to rebut the fraud-on-the-market presumption as to the analyst reports before certifying the class.
The Second Circuit's Decision in Salomon
The Second Circuit agreed with the district court that "[n]othing in the language of Basic limits its holding to issuer statements alone."6 The court also found that its decision was supported by the Supreme Court's recent decision in Stoneridge Investment Partners, LLC v. Scientific Atlantic, Inc.,7 which foreclosed aiding and abetting-type civil claims under the federal securities laws, but did not foreclose suits against non-issuers for alleged misrepresentations provided a plaintiff could establish that those parties were primary actors.8
The Second Circuit then held that in satisfying the Basic test, plaintiffs need not show that the alleged misrepresentations "moved the market," but in order to get a class certified must make more than a prima facie showing that any alleged misstatement was material.9 The court did not specify what level of evidentiary showing plaintiffs must make. Similarly, the Second Circuit also held that defendants should be given an opportunity before class certification to rebut the fraud-on-the-market presumption by showing "for example, that the market price was not affected by the alleged misstatements, other statements in the 'sea of voices' of market commentary were responsible for price discrepancies, or particular plaintiffs may not have relied on market price." Accordingly, the court vacated the district court's decision to certify the class and remanded the case for further proceedings in the district court.10
Although district courts in other circuits have held that the Basic presumption of reliance can apply in the context of analyst reports,11 the Second Circuit is the first federal appellate court to so hold. As the Salomon court explained, however, this extension of Basic may be of limited benefit to plaintiffs, because most analyst statements are "predictions or opinions" concerning "uncertain future event[s]" which should not be actionable under the federal securities laws.12 Moreover, Basic requires that any allegedly misleading statement be public, which should make it difficult to extend the reasoning of Basic and Salomon to other documents prepared by non-issuers, such as private offering materials.13
Finally, the court's clarified evidentiary standard for class certification may also limit Salomon's potential benefit to plaintiffs, because plaintiffs must make more than a bare prima facie showing to support use of the fraud-on-the-market presumption. In so holding, the Second Circuit parted ways with the Fifth Circuit in rejecting the argument that plaintiffs should be required to make an affirmative showing that analyst reports directly affected pricing. (In Oscar Private Equity Investments v. Allegiance Telecom Inc., the Fifth Circuit held that, in order to gain the benefit of the fraud-on-the market presumption of reliance, plaintiffs were required to make an affirmative showing of materiality by showing that the statements had an actual affect on the market.)14
The Second Circuit's ruling in Salomon, while potentially expanding somewhat the class of defendants who may be swept into securities suits, is consistent with the recent trend that achieving class certification is getting harder for plaintiffs in securities actions. Salomon also highlights the crucial importance for defendants to retain experts early in a case to begin examining trading and pricing data. Under In re IPO and Salomon, defendants will have ample opportunity prior to a class being certified to challenge plaintiffs' ability to meet the requirements of Rule 23. With regard to the Basic presumption, that will mean the opportunity to show that an analyst report did not move the price of affected securities, the securities in question did not trade in an efficient market, or the time period of any purported class should be narrower than that alleged in the complaint.15 (It also will mean, under other recent decisions, an opportunity to challenge other elements of plaintiffs' case, including loss and transaction causation.)16