Ninth Circuit Refuses to Recognize an “Integrity of the Market” Theory for Rule 10b-5 Class Actions
On July 29, 2009, the United States Court of Appeals for the Ninth Circuit affirmed a district court ruling refusing to certify a Rule 10b-5 market manipulation case as a class action. Desai v. Deutsche Bank, 9th Cir., No. 08-55081, 7/29/09. In doing so, the court declined plaintiffs’ invitation to adopt a presumption of reliance for class members who trade in a security the price of which has been affected by market manipulation. Plaintiffs sought the adoption of a novel “integrity of the market” theory of reliance, which would have played a role in market manipulation cases similar to that played by the “fraud on the market” theory in misrepresentation cases. However, the Ninth Circuit pronounced itself “chary” of expanding Rule 10b-5 liability and affirmed the lower court’s decision. The case is significant as an example of the Court of Appeals refusing to embrace a novel theory that would have expanded the liability of third parties, such as brokers, who become ensnared in fraudulent schemes perpetrated by issuers.
In Desai, plaintiffs alleged that officers of a company caused it to issue unregistered securities, which they then lent to a chain of brokers, including the defendant, receiving cash collateral from the brokers as security. The officers used the cash to manipulate the market price of the company’s stock through over-the-counter day trading. As the manipulative scheme caused the share price to rise, the brokers were required to provide additional cash collateral to cover the borrowed shares, funding further trading and manipulation. Eventually the scheme collapsed and the stock plummeted from $58 dollars a share to pennies.
The question at issue was whether plaintiffs’ claim against a broker defendant could be certified as a class action. Class certification could only be granted if the issue of reliance under Rule 10b-5 was common to all class members. In the district court, plaintiffs urged that reliance was a common issue because all class members should be presumed to have relied on the “integrity of the market.” The district court rejected that theory and denied class certification, holding that the issue of reliance would need to be adjudicated on an individual basis. The question before the Ninth Circuit was whether the district court erred in rejecting plaintiffs’ integrity of the market theory.
The Ninth Circuit began by noting that reliance is a necessary element in all Rule 10b-5 cases, including claims of market manipulation. There are two established ways of proving reliance on a class basis: (1) the presumption of reliance where purchases or sales take place in the context of a material omission, as discussed in Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972), and (2) the “fraud on the market” theory, which allows plaintiffs to allege reliance on a class basis where material misrepresentations affect the market price of a security traded in an efficient market. Basic Inc. v. Levinson, 485 U.S. 224 (1988).
In Desai, plaintiffs argued, first, that the Affiliated Ute presumption of reliance on material omissions should also apply to market manipulation because manipulation depends on non-disclosure of the manipulative scheme. However, the Ninth Circuit noted that the Supreme Court and appellate courts have distinguished the elements of market manipulation from misrepresentation or omission under Rule 10b-5. Allowing plaintiffs to re-characterize a manipulation case as an omission case would render the body of law concerning manipulation redundant, which the court was unwilling to do.
Plaintiffs did not ask the court to apply the fraud on the market theory. Instead they asked it to embrace a new “integrity of the market” theory. Under that theory there would be a presumption that all purchasers relied on the “integrity of the market”—i.e., a belief that the market for the security was free of manipulation—in making trades. That presumption would suffice to establish reliance on a class-wide basis in manipulation cases. Such a theory would solve several problems frequently faced by securities plaintiffs. First, plaintiffs would not need to show that the security in question was traded on an efficient market for the presumption of reliance to apply. Second, under both Affiliated Ute and the fraud on the market theory, plaintiff must point to some specific statement or omission by the defendant. Under Affiliated Ute, a material omission must be identified. Under the fraud on the market theory a misrepresentation that affected the market price of the shares must be alleged. An integrity of the market theory would provide a way to allege reliance as a common issue as to defendants who rendered assistance to a manipulative scheme but who did not speak to the market themselves, and had no duty to speak.
The Ninth Circuit refused to accept plaintiffs’ novel theory and affirmed the district court’s refusal to certify a class. It noted that the “integrity of the market” theory has not been recognized by the Supreme Court and cited recent Supreme Court opinions stressing the need to interpret implied causes of action such as Rule 10b-5 narrowly.
The Desai case can be seen as one more chapter in the ongoing saga of plaintiffs’ attempts to gain recognition for liability theories which can be used on a class basis against secondary defendants who did not themselves buy, sell, or speak to the market. Acceptance of the “integrity of the market” theory would have potentially expanded plaintiffs’ ability to pursue secondary actors such as brokers, professionals, and business partners of issuers, for their role in market manipulation cases. However, that more expansive interpretation of Rule 10b-5 would have conflicted with the recent decision of the Supreme Court in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008), in which the Supreme Court reaffirmed that Rule 10b 5 does not allow private plaintiffs to invoke theories of “scheme liability” to pursue secondary defendants who do not speak to the market. As the Supreme Court held in Stoneridge, permitting claims against secondary parties such as lawyers, bankers, and brokers “would reach the whole marketplace in which the issuing company does business; and there is no authority for this rule.”
In Desai, the Ninth Circuit rejected a creative attempt by plaintiffs to get around those recent authorities. Until the Supreme Court or Congress alters the law, the plaintiffs’ bar cannot use the integrity of the market theory to reach secondary actors who become ensnared in fraudulent schemes perpetrated by publicly traded companies.