The recent summary order from the US Court of Appeals for the Second Circuit in New Jersey Carpenters Health Fund v. RALI Series 2006-QO1 Trust, No. 11-1683-cv (2d Cir. Apr. 30, 2011), reaffirms the important principle of securities law that knowledge defenses can create individual factual questions sufficient to defeat class certification.
A central tenet of securities law is that a defendant in a securities fraud or misstatement case is not liable to anyone who knew about the alleged fraud or misstatements when the relevant purchase or sale took place. In a path-breaking 2006 decision—In re Initial Public Offerings Securities Litigation—the Second Circuit reversed class certification in a securities fraud and misstatement case in part because the proposed class included many purchasers who knew about the defendants’ allegedly wrongful practices.1 The purchaser-specific inquiries required to determine which class members had disqualifying knowledge made individual issues predominate over common ones and thus precluded class certification.
In the wake of that decision, district courts across the country have faced arguments that various evidence of class member knowledge should lead to the denial of class certification motions in securities fraud and misstatement suits. In some cases, those arguments succeeded.2 In others, they did not.3
The argument succeeded before the district court in the New Jersey Carpenters case. There, Judge Baer of the Southern District of New York declined to certify classes of mortgage-backed securities purchasers suing under Sections 11 and 12(a)(2) of the Securities Act.4 He ruled that common issues did not predominate because the proposed class would include investors with different levels of knowledge. Many purchasers were sophisticated investors with experience in the MBS markets. At least one purchaser learned of the supposedly hidden information by communicating directly with mortgage originators. And government actions, analyst reports, news items and raw data increasingly revealed the truth over the class period.5
Judge Baer also found that a class action was not superior to individual actions for several reasons. The class consisted of sophisticated investors capable of litigating their own claims. Different class members would have competing interests in prosecuting the action. And individual, purchaser-specific issues would make a class action difficult to manage.6
Pursuant to Federal Rule of Civil Procedure 23(f), the Second Circuit agreed to hear an interlocutory appeal from Judge Baer’s decision. After full briefing and oral argument, the court of appeals issued a summary order affirming the denial of class certification. The Second Circuit examined only Judge Baer’s ruling that common issues did not predominate over individual ones. It found no error in that determination.7
First, the Second Circuit ruled that even though the defendants’ evidence of knowledge “surely would not have sufficed to proved each knowledge defense on the merits,” the evidence adequately “indicated that individual inquiries might be necessary.”8 In the absence of discovery from absent potential class members, Judge Baer “permissibly determined that knowledge defenses would require extensive individual proceedings.”9
Second, the Second Circuit concluded that because the “cumbersome class definitions” included purchasers who bought at different times, Judge Baer did not err by supporting his decision with evidence that different purchasers “would have had available different levels of public information.”10 The “public information could constitute circumstantial evidence of individual purchaser knowledge.”11 Accordingly, variations in the available public information over time would indicate variations in potential class member knowledge and remove the possibility that the knowledge issue could be adjudicated on a class basis.12
Finally, the Second Circuit decided that Judge Baer’s analysis of the proposed classes’ cohesiveness was not an abuse of discretion. Whether viewed as a matter of predominance or superiority, there was no error in the conclusion that “differently situated class members might have competing interests in controlling the litigation.”13
Although the Second Circuit cautioned against attributing too much significance to its New Jersey Carpenters decision, the decision remains an important reaffirmation that class certification is not appropriate in a securities misstatement case when the evidence shows that class member knowledge is subject to individual proof.