Opinion ID: 500420
Heading Depth: 2
Heading Rank: 2

Heading: Reliance On The Integrity Of The Market

Text: 21 Reliance is a requirement in all 10b-5 cases. In the traditional 10b-5 misrepresentation case, the plaintiff must establish: (1) a misstatement or omission, (2) of a material fact, (3) made with scienter, (4) on which the plaintiff relied, (5) that proximately caused his injury. Huddleston v. Herman & MacLean, 640 F.2d 534, 543 (5th Cir. Unit A Mar. 1981), rev'd on other grounds, 459 U.S. 375, 103 S.Ct. 683, 74 L.Ed.2d 548 (1983); Dupuy v. Dupuy, 551 F.2d 1005, 1014 (5th Cir.1977), cert. denied, 434 U.S. 911, 98 S.Ct. 312, 54 L.Ed.2d 197 (1977). In these cases, plaintiffs' reliance established but for causation: had the investor known the truth he would not have purchased or sold the security. Huddleston, 640 F.2d at 549. Plaintiff must further establish that the untruth was in some reasonably direct, or proximate, way responsible for his loss (i.e., that the misrepresentation proximately caused the price of the security to fall). Id. The reliance and causation requirements prevent 10b-5 from becoming a private enforcement mechanism or a system of investor insurance. See Lipton v. Documation, Inc., 734 F.2d 740, 742 (11th Cir.1984), cert. denied, 469 U.S. 1132, 105 S.Ct. 814, 83 L.Ed.2d 807 (1985); Dupuy, 551 F.2d at 1016. 22 When the defendant has a duty to disclose, and the disclosure omits a material fact, plaintiff's reliance on the omission is presumed. Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-54, 92 S.Ct. 1456, 1472, 31 L.Ed.2d 741 (1972). The presumption is employed because it is so difficult for a plaintiff to prove a negative: that he purchased or sold the security because of what the defendant did not disclose. See Shores, 647 F.2d at 468. This presumption can be rebutted if defendant proves the plaintiff's decision would have been the same even if the omitted information had been disclosed. Lipton, 734 F.2d at 742. The presumption is also rebutted where the plaintiff admits that he never read or otherwise relied on the allegedly deficient disclosure statement. Shores, 647 F.2d at 468. 23 Courts have adapted the reliance requirement to allow recovery in some cases where the plaintiff admits that he did not read or otherwise rely directly on the relevant disclosure materials. In these cases, plaintiff's failure to rely directly upon the disclosure statement is not dispositive where the defendant's conduct constituted a fraud on the market. In order to satisfy the reliance requirement in these cases, plaintiff must establish that but for the fraud on the market he would not have purchased or sold the security. Shores, 647 F.2d at 471-72. Again, proof of reliance entails proof of causation in fact. 7 24 It is important to distinguish between the two general types of fraud on the market cases. The first type involves a claim by a plaintiff who purchases a security traded on a developed and open market, but who does not first read or otherwise rely on a prospectus or other relevant disclosure document. Typically, the plaintiff in such a case claims that the defendant's fraud artificially inflated the price of the security. When the fraud becomes public, the price of the security falls, and the plaintiff loses money. Whether or not the plaintiff in such a case relied on a specific misrepresentation or omission, she may be entitled to relief because she relied generally on the supposition that the market price is validly set and that no unsuspected manipulation has artificially inflated the price, and thus indirectly on the truth of the representations underlying the stock price.... 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). This formulation of the reliance requirement is consistent with the role of reliance as proof of causation. 25 Blackie, the seminal case in this area, has been followed by every court (including our court) faced with a similar situation. See, e.g., Peil v. Speiser, 806 F.2d 1154 (3d Cir.1986); Lipton v. Documation, Inc., 734 F.2d 740 (11th Cir.1984), cert. denied, 469 U.S. 1132, 105 S.Ct. 814, 83 L.Ed.2d 807 (1985); Rosenberg v. Digilog, Inc., 648 F.Supp. 40 (E.D.Pa.1985); Grossman v. Waste Management, Inc., 589 F.Supp. 395 (N.D.Ill.1984); In re LTV Securities Litigation, 88 F.R.D. 134 (N.D.Tex.1980). 26 Proof of reliance in this first type of fraud on the market case raises difficulties of proof similar to those raised in material omission cases. Thus, reliance is presumed. Lipton, 734 F.2d at 748; Blackie, 524 F.2d at 906. Plaintiff establishes a prima facie case by showing that she purchased the security and that the misrepresentation (or other deception) was material. Materiality circumstantially establishes the reliance of some market traders and hence the inflation in the stock price--when the purchase is made the causational chain between defendant's conduct and plaintiff's loss is sufficiently established to make out a prima facie case. Id. at 906 (citations omitted). The presumption, derived from Ute, is particularly appropriate for fraud on the open market cases because the causal nexus is adequately established indirectly, by proof of materiality coupled with the common sense that a stock purchaser does not ordinarily seek to purchase a loss in the form of artificially inflated stock. Id. at 908 (footnote omitted). 27 As in a Ute omission case, the presumption of reliance in a Blackie fraud on the market case is rebuttable. Defendant can rebut the presumption either by disproving materiality or by proving that; (1) despite materiality, an insufficient number of traders relied on the deception so as to inflate the price; or (2) the individual plaintiff purchased despite knowledge of the deception; or (3) the plaintiff would have purchased even if he had known of the deception. Blackie, 524 F.2d at 906. 28 The second (and far less common) type of fraud on the market cases involve fraud in the issuance of securities traded on an undeveloped (primary) market. These cases involve plaintiffs who purchased newly-issued securities without reading the offering circular or similar disclosure documents. When these investments result in a loss, plaintiffs may in some cases recover under 10b-5 if they can show that but for defendant's fraud the security would not have been marketed and that they relied on the integrity of the market to produce marketable securities. Shores v. Sklar is the lead case of this type. See also T.J. Raney & Sons, Inc. v. Fort Cobb, 717 F.2d 1330 (10th Cir.1983) (adopting Shores ), cert. denied, 465 U.S. 1026, 104 S.Ct. 1285, 79 L.Ed.2d 687 (1984). 29 In Shores, plaintiff alleged a pervasive fraudulent scheme on the part of a developer, bond counsel, underwriter, accountant, and indenture trustee designed to induce a municipality to issue, and the public to buy, otherwise unmarketable bonds. The developer knew his company did not have the financial capability to construct the mobile homes which were to be sold to repay the bonds. He nevertheless determined, as part of a scheme to defraud the investing public, to induce the town of Frisco City, Alabama, to issue the bonds. Bond counsel drafted the offering circular but intentionally or recklessly omitted facts impugning the developer's integrity and financial stability. The defendant accountant prepared a financial statement which he knew was materially misleading as to the developer's financial stability. The underwriter offered the bonds for sale, even though it knew the offering circular contained material misrepresentations and omissions. The indenture trustee knowingly or recklessly disregarded its duty to ensure that the developer maintained at least $400,000 in working capital. As a result of this fraudulent scheme, the town issued bonds which, but for the fraud, could not have been marketed at any price. Plaintiff Bishop purchased the bonds based solely on his broker's oral representations that tax-free industrial bonds generally were a good investment. He did not read or otherwise rely upon the misleading offering circular. The bonds subsequently went into default and the investors received approximately one-third of their original investment. Bishop brought a class action suit on behalf of the bond holders. 647 F.2d at 463-67. 30 The district court dismissed Bishop's 10b-5 claim because Bishop admitted that he had never read or otherwise relied on the offering circular. On appeal, the en banc court affirmed the dismissal to the extent the complaint alleged the usual 10b-5(b) misrepresentation claim. Bishop's failure to rely directly on the offering circular precluded a claim that he relied directly on the misrepresentations or omissions contained therein. Id. at 468. 31 Notwithstanding Bishop's failure to read the offering circular, the majority held he did state a cause of action under the broader language of 10b-5(a) and (c). 8 Bishop's complaint alleged that the defendants engaged in an elaborate scheme to create a bond issue that would appear genuine but was so lacking in basic requirements that the bonds could never have been approved by the Board nor presented by the underwriters had any one of the participants in the scheme not acted with intent to defraud in reckless disregard of whether the other defendants were perpetrating a fraud. 647 F.2d at 468. When the fraud alleged is of such a broad scale as to undermine the validity of the bonds' very existence, plaintiff's lack of reliance on the offering circular is not determinative. Id. at 469. Instead, plaintiff must show that: 32 (1) The defendants knowingly conspired to bring securities onto the market which were not entitled to be marketed, intending to defraud purchasers, 33 (2) Plaintiff reasonably relied on the bonds' availability on the market as an indication of their apparent genuineness, and 34 (3) As a result of the scheme to defraud, plaintiff suffered a loss. 35 Id. at 469-70. See also Lipton, 734 F.2d at 743-45 (summarizing the holding and rationale of Shores ). 36 The instant case requires our court to examine for the first time the nature of the reliance requirement in a case brought under Shores. It is only after examining this requirement that we can assess the impact of defendant's asserted nonreliance defense on the maintainability of this class action. As is explained above, plaintiff in a Blackie fraud on the market case must demonstrate causation in fact in order to satisfy the reliance requirement. This same guiding principle should govern under Shores. The court pointed out that the role of reliance in securities actions is to establish causation, and that [w]henever the Rule 10b-5 issue shifts from misrepresentation or omission in a document to fraud on a broader scale, the search for causation must shift also. 647 F.2d at 471-72; see T.J. Raney, 717 F.2d at 1333. Reliance in a Shores type case arises not from reading a disclosure statement but instead from the bond buyer's reliance on the market to produce securities that were not fraudulently created. 647 F.2d at 472. 37 Accordingly, a prima facie showing of reliance is established in a Shores type case upon proof of a scheme to bring securities onto the market which were not entitled to be marketed. But for the fraud in such a case, plaintiff could not have purchased the bond because the bonds would not have been offered for sale. As one district court has said: 38 If plaintiffs employ a fraud on the market theory, individual issues of reliance virtually disappear because a sufficient causal link is established by the mere presence of the bonds in the marketplace. Individual questions of knowledge and reliance simply become irrelevant. 39 Dekro v. Stern Bros. & Co., 540 F.Supp. 406, 417 (W.D.Mo.1982). If plaintiff can prove the type of pervasive fraud necessary to establish a fraudulent marketing of securities, 9 he has perforce satisfied the cause in fact reliance requirement of 10b-5. 40 Defendants point to language in Shores indicating that plaintiff must make an additional showing of reliance on the integrity of the market in order to recover. Indeed, the court in Shores set out as a separate element of the action that plaintiff must prove he reasonably relied on the bonds' availability on the market as an indication of their apparent genuineness. 647 F.2d at 469-70. Further, the court indicated that the requisite element of causation in fact would be established if [plaintiff] proved the scheme was intended to and did bring the bonds onto the market fraudulently and proved he relied on the integrity of the offerings of the securities market. Id. at 469 (emphasis added). According to defendants, this language requires a Shores plaintiff to prove in some way that his decision to purchase the security was based entirely on his individual assessment of the market as a filtering mechanism and that he would have purchased the securities even if he had read the offering circular. We do not read Shores to impose any such burden of proof. 41 Shores recognized that the securities laws allow an investor to rely on the integrity of the market to the extent that the securities it offers to him for purchase are entitled to be in the marketplace. 647 F.2d at 471. 10 As in the Blackie case on which Shores relied, such reliance is presumed with respect to all purchasers of securities. It is common sense that purchasers do not ordinarily seek to purchase a loss in the form of a fraudulently marketed bond. Consequently, once the plaintiff proves that the deception was material (i.e., without it, the bonds would not have been marketed), reliance on the integrity of the market is presumed. 42 The rebuttal of this presumption is more difficult under Shores than under Blackie. In a Blackie type case, the defendant can show that his fraud had no effect on the market price. 524 F.2d at 906. This defense severs the causal link between the fraud and the plaintiff's loss. A Shores defendant can make no such showing, however, because his fraud creates the bond itself. Without the fraud, the plaintiff could not have purchased the bond. Shores, 647 F.2d at 464 n. 2. 43 A Shores defendant can rebut the presumption of reliance only by showing that the plaintiff's reliance was not reasonable. Reliance on the market is reasonable so long as the plaintiff did not intentionally refuse to investigate known or obviously present risks associated with the bonds. Shores, 647 F.2d at 470 n. 6 (quoting Dupuy v. Dupuy, 551 F.2d at 1020). This rebuttal could include a showing that an individual plaintiff purchased despite knowledge of the falsity of a representation, or that he would have, had he known of it. Blackie, 524 F.2d at 906. Unless the defendant shows a compelling reason, such as plaintiff's inside information regarding the fraud or unreasonable failure to investigate, defendant has not rebutted the general presumption that investors rely on the integrity of the market to produce bonds which are entitled to be marketed. 44 The defendants argue that Shores turns 10b-5 into an investor insurance policy. Indeed, once it can be established that the defendant fraudulently marketed a bond issue, most (if not all) of the purchasers of those bonds will have a cause of action, even if they did not read the offering circular. We do not suggest that sellers of bonds guarantee to bond purchasers that economic conditions will remain stable so that the bonds will be paid off. Investors must, of course, take the risk of default into account when making their purchases, because in the absence of fraud it is the investor who must bear the risk. But where the sellers of bonds are aware that the bonds are doomed to end in early default, and are aware that the bonds would be unmarketable but for fraudulent nondisclosure, the sellers must be held accountable to all purchasers who were unaware of the facts rendering the bonds unmarketable. If this result resembles insurer liability, it is only because the defendant's fraud affected the entire class of purchasers. Shores stands for the simple proposition that fraud on a broader scale that permeates the very issuance of the bonds gives rise to liability on a broader scale.