Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Tuesday, August 17, 2010

Third Circuit: Fraud Created the Market Theory Makes No Sense

The Third Circuit rejected the fraud-created-the market theory of presumed reliance in federal securities class actions, holding that it "lacks a basis in common sense, probability, or any of the other reasons commonly provided for the creation of a presumption."  Malack v. BDO Seidman, LLP (3d Cir. Aug. 16, 2010)(Download MalackvBDOSeidman)

The class consisted of investors that purchased notes directly from the issuer American Business in registered offerings.  The notes promised to pay above-market rate interest, were non-transferable, could only be cashed in after they matured, and had no resale market.  They brought this action against the accounting firm after the company's bankruptcy filing, alleging that its audits were deficient.  The district court denied class certification, concluding that the proposed class did not meet the predominance requirement of Rule 23 because the investors could not establish a presumption of reliance. 

In affirming, the Third Court rejects the fraud-created-the market theory, as set forth in the Fifth Circuit's 1981 Shores v. Sklar opinion, that allows investors to rely on the integrity of the market to the extent that the offered securities are entitled to be in the marketplace.  Unlike the fraud on the market theory, which is based on the efficient market thesis, the fraud-created-the market theory has no underlying economic justification.  The Third Circuit cited the Supreme Court's 2008 Stoneridge opinion as casting doubt on the legitimacy of expansive presumptions of reliance and also recited concerns over frivolous Rule 10b-5 litigation:  A a frivolous class action becomes much more troublesome when it is aided by a presumption of reliance and defendants may seek to settle early and often to avoid litigation costs and the risk of getting hit with a large verdict at trial."

The Third Circuit joins the Seventh Circuit in rejecting the fraud-created-the-market theory.

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I thought the court's analysis of the lack of reasonable reliance on the issuer, the underwriter, the independent auditor and the issuer's lawyer was amazing. It is one thing to suggest that they cannot be expected to detect every fraud, but it is quite another to suggest that because they are working for a fee, they cannot be expected to be on the lookout.

Posted by: R E B | Aug 17, 2010 10:09:28 AM

For anyone looking for more info on this case, we just posted a great article by Michele Johnson and Colleen Smith of Latham & Watkins on the Securities Law Practice Center. Here is a link:

Posted by: Kara O'Brien | Oct 14, 2010 11:18:33 AM

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