Opinion ID: 499747
Heading Depth: 1
Heading Rank: 3

Heading: THE Sec. 10(b) CLAIM

Text: 13 In order to state a claim under Sec. 10(b) and Rule 10b-5, a plaintiff must plead the following elements: 14 1) a false representation of 2) a material 3) fact; 4) defendant's knowledge of its falsity and his intention that plaintiff rely on it [although recklessness, as opposed to actual intent, will suffice]; 5) the plaintiff's reasonable reliance thereon; and 6) his resultant loss. 15 Peil v. Speiser, 806 F.2d 1154, 1160 & n. 9 (3d Cir.1986) (citing Eisenberg v. Gagnon, 766 F.2d 770, 785 (3d Cir.), cert. denied sub nom. Wasserstrom v. Eisenberg, 474 U.S. 946, 106 S.Ct. 342, 88 L.Ed.2d 290 (1985); 3 Loss, Securities Regulation 1431 (1961)). The District Court dismissed the complaint in this case because it found Zlotnick's amended complaint did not meet this requirement of pleading reliance. This is the sole issue on appeal.
16 Zlotnick asks this court to presume reliance because defendants have committed a fraud on the market. In Peil v. Speiser, 806 F.2d 1154 (3d Cir.1986), this court accepted that the showing of a fraud on the market may create a rebuttable presumption of reliance in favor of the plaintiff in certain cases. Where the purchaser of a stock shows he purchased in an open and developed market and that defendant has made a material misrepresentation, this court will presume that the misrepresentations occasioned an increase in the stock's value that, in turn, induced the plaintiffs to purchase the stock. Id. at 1161. While we will allow Zlotnick the opportunity to prove his reliance, based on the allegations in his complaint, we decline to presume it. 17 Underlying the presumption of reliance we made in Peil is a theory of indirect actual reliance. The purchaser relies on the market price of the stock as an indication of its value. Id. at 1160. In other words, the market price of the stock is itself a representation on which a purchaser may rely. Because the market price has been infected by fraud, that price is--at least to the extent it is artificially inflated--a misrepresentation. Compare, In re Associated Securities Corp., 40 S.E.C. 10, 14 (1960) (price not reasonably related to value is fraudulent), aff'd, 293 F.2d 738 (10th Cir.1961). Though the market actually sets the improper price, the defendant has participated in the setting of the price by making false statements in order to affect that price. Thus, the purchaser has in fact relied on the false statement of the defendant, if indirectly. 5 In Peil, we accepted this theory of reliance, and shifted to the defendant the burden of disproving such reliance. 18 The fraud-on-the-market theory creates a threefold presumption of indirect reliance. First, this court presumes that the misrepresentation affected the market price. Second, it presumes that a purchaser did in fact rely on the price of the stock as indicative of its value. Third, it presumes the reasonableness of that reliance. All of these presumptions are necessary to establish actual reliance. The first presumption is necessary to find that a misrepresentation was in fact made to the purchaser. Thus, if defendant rebuts this presumption by showing that the market did not respond to the misrepresentation, it does no more than show that the market price was not misrepresentative, and thus that no misrepresentation was made to the purchaser of the stock. The second presumption is necessary for a court to find that the plaintiff did in fact rely on the misrepresentation. Thus, a defendant may rebut this presumption by showing that the plaintiff would have purchased even if he had known about the misrepresentation. The final presumption, that reliance on the market price is reasonable, may be rebutted by showing that the plaintiff knows that a representation is false. If the plaintiff knows of a misrepresentation, he has reason to believe that the market price has been affected by it. In such a case, this court will not presume his reliance on that price reasonable. 6 19 This court will presume reliance only where it is  'logical to do so.'  Peil, 806 F.2d at 1161 n. 11 (quoting Sharp v. Coopers and Lybrand, 649 F.2d 175, 188 (3d Cir.1981), cert. denied, 455 U.S. 938, 102 S.Ct. 1427, 71 L.Ed.2d 648 (1982)). We do not find it logical in this case to make any of the presumptions discussed above. In Peil, we presumed that the market price reflected defendant's misrepresentation because we found that an open and developed market likely reflects all available information. 7 Here, Zlotnick sold short because he believed the market price of the stock overvalued Technicom's present earnings and underestimated its potential competition. Given Zlotnick's belief that in January, 1983, the market in Technicom stock did not reflect all available information, we do not find it logical to presume that the market did reflect all available information in March, 1983, when he made his covering purchases. 20 A presumption that Zlotnick relied on the price of the stock in making his investment decision is also unwarranted. An investor like Zlotnick sells short because he believes the price of a stock overestimates its true value. While it is possible that, when he decided to cover, Zlotnick did rely on the stock's price to determine investment value, this court will not presume such a fundamental change in investment strategy. Similarly, since Zlotnick decided that the market price was not an accurate valuation of the stock at the time of his short sale, we should not presume that it was reasonable for him to rely on the market price at the time of his purchase. We therefore decline to presume that Zlotnick relied on defendant's alleged misrepresentations in deciding to cover his purchase. While we believe that Zlotnick should be allowed to proceed with this action and prove all the necessary facts at trial, he should not be awarded the considerable additional advantage of the presumptions in his favor which he seeks through his analogy to the Peil decision.
21 Zlotnick argues that, as a short seller, he relied upon the integrity of the market. Though he believed the price of the stock overvalued at the time of the short sale, he relied on the market's ability, given accurate information, to correct its valuation of the stock and set a better price. By falsely inflating the price of the stock, defendants interfered with the market's ability to correct itself. Once he had sold short, Zlotnick was unable to protect himself from this fraud. Therefore, he argues, requiring him to prove individual reliance on defendant's misrepresentations  'imposes an unreasonable and irrelevant evidentiary burden.'  Peil, 806 F.2d at 1160 (quoting Blackie v. Barrack, 524 F.2d 891, 907 (9th Cir.1975), cert. denied, 429 U.S. 816, 97 S.Ct. 57, 50 L.Ed.2d 75 (1976)). 22 Reliance on the integrity of the market in a stock differs from reliance on the integrity of the market price in that stock. An investor relying on the integrity of a market price in fact relies on other investors to interpret the relevant data and arrive at a price which, at the time of the transaction, reflects the true worth of the company. By contrast, an investor relying on the integrity of the market relies on the continuing ability of investors to interpret data subsequent to the transaction; he relies on future conditions. In the context of a short sale, the difference between these two types of reliance is more pronounced. The traditional purchaser depends on the market to determine a present value for the stock that allows the purchaser an adequate return on his investment. On the other hand, the short seller depends for a return on his investment on the market realizing that the value of the stock at the time of the short sale does not allow for an adequate return on the investment. This realization is what drives the price of the stock down and allows the short seller his profit. 23 More important, reliance on the integrity of the market price is actual, if indirect, reliance. The short seller is not injured because he knew of or depended on the misrepresentation; he is injured because others investing in the stock so relied. The fraud of which Zlotnick complains was truly perpetrated on the market, and not, even indirectly, on Zlotnick as an investor in the market. We are mindful that reliance is not an abstract requirement in the securities laws: plaintiff must prove reliance in order to prove that the misrepresentation caused actual injury. Reliance is therefore one aspect of the ubiquitous requirement that losses be causally related to the defendant's wrongful acts. Sharp v. Coopers & Lybrand, 649 F.2d 175, 186 (3d Cir.1981), cert. denied, 455 U.S. 938, 102 S.Ct. 1427, 71 L.Ed.2d 648 (1982). Zlotnick may, as discussed above, be able to prove his own actual, indirect reliance upon the market price. However, to the extent Zlotnick argues he is entitled to recover for the reliance of third parties, we reject his claim. 24 Zlotnick alleges that defendants misrepresented the truth, and that such misrepresentations caused the price of the stock to rise at the time he sold short. He concludes that since the fraudulently-induced rise in the stock caused him to lose money, he is entitled to recover. Under Zlotnick's theory, he would be allowed to recover even if he purchased after deciding, based solely on accurate information, that the stock was not overvalued and his short sale was ill-conceived. 8 Yet, in such a case, Zlotnick is no different from the traditional purchaser who buys at a fraudulently-inflated price but actually relies solely on accurate information in purchasing: both have made bad valuations of the stock, but those valuations were independent of any alleged fraud. Zlotnick cannot recover his loss on his covering purchase unless he shows that his decision to cover was somehow connected with the fraud.
25 That Zlotnick states his claim in terms of reliance on the market's integrity does not preclude the conclusion that a fraudulent market price was a material factor in his decision to cover. Zlotnick might have changed his investment strategy and actually relied on the integrity of the inflated market price. The rise in price itself may have changed his opinion of the stock's value. The rise may also have increased his risk of loss beyond acceptable levels, causing him to purchase. It may have led him to conclude that the stock would take so long to decline in value that the cost of maintaining his short position would exceed his potential gain. In Peil, this court accepted that a market price which reflects a defendant's misrepresentation may pass that misrepresentation on to potential purchasers. It is only logical to hold that the same price which may communicate a misrepresentation to the traditional investor may also communicate a misrepresentation to the short seller. 26 Zlotnick is entitled to have this court consider as true both his allegations and all reasonable inferences from those allegations. Wisniewski, supra. We find Zlotnick's amended complaint sufficient to support a reasonable inference of actual, if indirect, reliance. 9 Defendants, on the other hand, have not made sufficient proof of either the reason for Zlotnick's decision to cover or the materiality of the price in these circumstances to entitle them to dismissal. We will therefore vacate the District Court's order dismissing the complaint and remand for further proceedings. However, unlike the plaintiff in Peil, Zlotnick is not entitled to a presumption at trial that the market price did actually pass defendants' misrepresentations on to him, or that he did actually rely on the inflated market price in making his decision to cover. We hold no more than that Zlotnick is entitled to a chance to prove such actual reliance to a finder of fact.