Court Opinion

ID: 8407633
Source: CourtListenerOpinion
Date Created: 2022-11-02 16:29:58.237565+00
Date Added: 2024-06-11T16:47:29.413301
License: Public Domain

TALLMAN, Circuit Judge,
dissenting:
The Private Securities Litigation Reform Act (“Reform Act”) imposes strict requirements on plaintiffs pleading securities fraud claims. These include obligations to: plead that a defendant “made an untrue statement of material fact”; “specify each statement alleged to have been misleading[and] the reason or reasons why the statement is misleading”; and “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C. § 78u-4(b)(l)-(2). I respectfully dissent from the majority’s ruling that the plaintiffs’ complaint has met these stringent standards.
I
The majority critically errs by swiftly dismissing the key fact that the revelations of the maintenance problems and FAA settlement had no significant effect on America West’s stock price.
On June 22, 1998, America West’s stock closed at $28. The Wall Street Journal first reported on June 23, 1998, that the FAA was contemplating penalties against America West for its failures in supervising maintenance contractors. This was the first public disclosure of this information. That day, America West’s stock rose to close at $28 1/8.
The next disclosure of purported material information occurred on July 14, 1998. That day, America West announced that it had reached a compromise with the FAA; paying the FAA $5 million in fines. After this disclosure, America West’s stock closed at $30 1/4, higher than the previous day’s closing price of $29 15/16.
*947The last disclosure of allegedly material information occurred on July 20, 1998, when Air Safety Week published key provisions of the settlement agreement between the FAA and America West. America West’s stock closed down 3/8ths, from $28 3/4 on July 17 to $28 3/8 on July 20.
The market’s collective yawn to the allegedly material news is fatal to plaintiffs’ ability to successfully establish the reliance element of their cause of action when their complaint is founded upon a “fraud-on-the-market” theory. The majority’s analysis is contrary to what the Supreme Court and our sister circuits have said in similar cases.
II
In Basic Inc. v. Levinson, 485 U.S. 224, 231-32, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988), the Supreme Court adopted for Section 10(b) and Rule 10b-5 claims, the materiality standard articulated in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 96 S.Ct. 2126, 48 L.Ed.2d 757 (1976). Under Basic, an omitted fact is material if there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.” 485 U.S. at 231-32, 108 S.Ct. 978 (internal quotation marks omitted).
Basic also considered another required element of a securities fraud claim: reliance. The Supreme Court adopted the rebuttable presumption created by the fraud-on-the-market theory. Id. at 243-49, 108 S.Ct. 978. The premise of this theory is that in a modern and efficient securities market, the market price of a stock incorporates all available public information. Id. at 246-47, 108 S.Ct. 978. Therefore, any person who trades shares relies on the integrity of the market price. Id. at 246, 108 S.Ct. 978. Because of this, the Supreme Court created a rebuttable presumption of reliance by plaintiffs who traded stock while that stock’s price reflected inaccurate information. Id. at 248. Basic cited with approval the test laid out by the Sixth Circuit:
[I]n order to invoke the [fraud-on-the-market] presumption, a plaintiff must allege and prove: (1) that the defendant made public misrepresentations; (2) that the misrepresentations were material; (3) that the shares were traded on an efficient market; (4) that the misrepresentation would induce a reasonable, relying investor to misjudge the value of the shares; and (5) that the plaintiff traded the shares between the time the misrepresentations were made and the time the truth was revealed....

Given today’s decision regarding the definition of materiality as to preliminary merger discussions, elements (2) and (I) may collapse into one.

Id. at 248 n. 27, 108 S.Ct. 978 (emphasis added and citation omitted). The Sixth Circuit test contemplates that, to invoke the fraud-on-the-market theory, a reasonable investor would have misjudged the value of the shares. How a reasonable investor would judge a stock’s value based on misinformation “collapse[s]” into the reasonable investor standard for materiality. They are not separate and unrelated concepts in securities law. Though Basic refused in the pre-merger context to formulate bright-line tests for materiality, the Supreme Court obviously understood the common-sense relationships between materiality, reliance, market value, and market price.
These relationships have not been ignored by our sister circuits. The Third Circuit has held that in an efficient market, the concept of materiality “translates into information that alters the price of the firm’s stock.” In re Burlington Coat Factory Sec. Litig., 114 F.3d 1410, 1425 (3d *948Cir.1997). The Third Circuit observed that since “efficient markets are those in which information important to reasonable investors ... is immediately incorporated into stock prices,” information not important to reasonable investors “will have a negligible effect on the stock price.” Id.; see also Oran v. Stafford, 226 F.3d 275, 282 (3d Cir.2000) (following Burlington and holding that “when a stock is traded in an efficient market, the materiality of disclosed information may be measured post hoc by looking to the movement, in the period immediately following disclosure, of the price of the firm’s stock.”).
The Fifth Circuit — also following the analysis in Basic — has elaborated that the Third Circuit’s requirement that the misrepresentation affect the stock price is more properly rooted in the reliance element of stock fraud than the materiality element. Nathenson v. Zonagen Inc., 267 F.3d 400, 415 (5th Cir.2001). Though grounded in reliance, the Fifth Circuit still requires a showing that the misrepresentation affected a stock’s price in fraud-on-the-market cases. ABC Arbitrage Plaintiffs Group v. Tchuruk, 291 F.3d 336, 361 (5th Cir.2002).
The First Circuit, also recognizing that Basic employed the fraud-on-the-market theory only for reliance, has nonetheless found that in such cases the failure of the market to react to previously undisclosed information also controls the materiality inquiry:
This presumption of investor reliance on the integrity of stock prices has the primary effect of obviating the need for plaintiff purchasers to plead individual reliance. But by its underlying rationale, the presumption also shifts the critical focus of the materiality inquiry. In a fraud-on-the-market case the hypothetical “reasonable investor,” by reference to whom materiality is gauged, must be “the market” itself, because it is the market, not any single investor, that determines the price of a publicly traded security.
Shaw v. Digital Equipment Corp., 82 F.3d 1194, 1218 (1st Cir.1996).
These cases are instructive. The Fifth Circuit’s placement of the stock price in the context of reliance more faithfully follows the Supreme Court’s decision in Basic. Indeed, the fraud-on-the-market theory is premised on the fact that a misrepresentation has affected the stock’s price incongruently to the stock’s true “value.” 485 U.S. at 246^7, 108 S.Ct. 978. Only then is detrimental reliance presumed because a plaintiff traded stock relying on the integrity of the market price. But if information later revealed does not significantly affect a stock’s price, it follows that there was no difference between the stock’s price and the stock’s true value at the time of the misrepresentation. There is then no reliance causing injury. Under these circumstances, as the Fifth Circuit has held, the failure of newly released information to change stock prices prevents recovery for plaintiffs in a fraud-on-the-market case. Nathenson, 267 F.3d at 415.
Stock price changes — or lack thereof— are also relevant to the determination of materiality. As the First and Third Circuits have recognized, the fact that a stock price does or does not change is interconnected with the materiality analysis in fraud-on-the-market cases. The Basic materiality test asks what a reasonable investor would consider significant; the market demonstrates the reactions of reasonable investors. At a minimum, the static or dynamic nature of a stock price after the disclosure of previously withheld information is strong evidence of how reasonable investors view the significance of the information.
*949To successfully plead a securities fraud claim under the fraud-on-the-market theory, a plaintiff must establish that: (1) a defendant made a material misrepresentation of fact; (2) which affected a stock’s market price; and (3) the plaintiff detrimentally traded the stock during the period in which the stock’s price reflected the material misrepresentation. Evidence of whether a stock price significantly changes following the disclosure of alleged previously misrepresented facts is relevant to two required elements in stock fraud causes of action. In fraud-on-the-market cases, the failure of a stock’s price to significantly change following disclosure eliminates the reliance presumption. Nathenson, 267 F.3d at 415; see also Basic, 485 U.S. at 243-49, 108 S.Ct. 978. Unless other facts supporting reliance are pled, a claim relying on the fraud-on-the-market presumption fails unless the stock price reacts to the information when it is finally disclosed.
No significant change in the stock price is also strong evidence that the information was immaterial. Conversely, the fact that a firm’s stock price does significantly change is strong evidence of materiality. Cf. In re Apple Computer Sec. Litig., 886 F.2d 1109, 1116 (9th Cir.1989) (“Dramatic [stock] price movements in response to an optimistic statement would provide a strong indication that the statement itself was material.... ”).
III
The district court was right to dismiss the complaint before us. There is no question that plaintiffs relied on the fraud-on-the-market theory to establish reliance. The plaintiffs allege in their complaint that America West’s stock is traded “in an efficient market on the New York Stock Exchange” and that “Class members were damaged [because] [i]n reliance on the integrity of the market, they paid artificially inflated prices for America West stock.”1 (emphasis added). There is simply no dispute that, following the public disclosure of the information that is now alleged to have been withheld, America West’s stock price did not significantly move in reaction to the news.
The plaintiffs’ complaint fails to plead sufficient facts establishing both reliance and materiality. Regarding the reliance element, the plaintiffs here cannot invoke the fraud-on-the-market theory since the information America West allegedly withheld did not affect America West’s stock price when it was revealed to the market. The plaintiffs suffered no detrimental reliance since the alleged misrepresentations did not skew the stock price in relation to the stock’s true value. The plaintiffs have not alleged any other theory of reliance other than the fraud-on-the-market theory. Therefore, their claims fail as a matter of law.
*950Similarly, the fact that the stock price did not significantly change undermines the plaintiffs’ allegation that the misrepresentations were material. Examining how the market reacted is at least telling of what a reasonable investor would consider significant.
The plaintiffs do, however, assert that the third-quarter shortfall and consequential price drop in September 1998 more accurately reflect the materiality of the alleged misrepresentations. They also claim that contemporaneous statements made by America West officers at the time the information was revealed explains the market’s failure to react to the allegedly material news.
While we are required to draw all inferences in favor of plaintiffs for purposes of a motion to dismiss, under the Reform Act the burden remains on the plaintiffs to plead with specificity the facts showing a materially misleading statement. 15 U.S.C. § 78u-4(b)(lH2). The plaintiffs here have not alleged with specificity facts that would support the inferences the plaintiffs ask us to draw.
What the plaintiffs fail to show is any causal connection between the FAA investigation and fine and the poor third-quarter performance. How do we know that the settlement affected or caused the operational problems and the third-quarter shortfall? The plaintiffs allege that the settlement forced America West to “spend millions” in corrective measures, which caused the third-quarter shortfall. This is not what the settlement agreement states.
Furthermore, plaintiffs have not shown when, where, or why these millions were spent, let alone how these millions accounted for the depressed profits in the third quarter. America West had been warning investors that its performance could be materially impacted by ongoing and serious labor unrest, yet plaintiffs cannot present any facts demonstrating that these warnings were false and must have served as a convenient cover-up for the alleged real cause of the shortfall: maintenance problems and the FAA settlement. Since these questions are left unanswered by the complaint, we cannot under the Reform Act simply give the plaintiffs the benefit of the doubt and view the market’s reaction in September as indicative of the materiality of the misleading statements regarding the FAA investigation and settlement.
Nor is the majority’s attempt to explain away the failure of the stock price to drop by focusing on the contemporaneous statements released by America West sufficient to mend this pleading deficiency. The majority blames America West for stating that the FAA settlement would not affect operational performance as the cause for the failure of the stock price to drop. This might have some validity if the plaintiffs had properly shown the link between the FAA settlement and third-quarter profitability. In fact, plaintiffs have not even alleged with any specificity that these statements made by America West after the settlement were false. Therefore, how can one conclude that it is proper to excuse the failure of the market to react in this case? See Oran, 226 F.3d at 283 (rejecting a similar contention that the defendants’ contemporaneous statements with the newly released information explained the failure of the stock price to respond to the allegedly material information).
The plaintiffs’ other allegations regarding materiality do not meet the Reform Act’s standards. The misleading statements that are at the core of this case concern the FAA’s investigation into America West’s maintenance programs. There is little in the complaint to suggest that this information, if revealed, would have “significantly altered the total mix of information available” to a reasonable in*951vestor in this huge corporation. Basie, 485 U.S. at 231-32, 108 S.Ct. 978. The plaintiffs have not sufficiently explained why or how the FAA investigation and settlement is significant enough to alter the views of reasonable investors. The market’s non-responsiveness further supports this conclusion: plaintiffs cannot show importance to a reasonable investor because, in the market, reasonable investors cared little about the FAA fíne and settlement.
IV
There is no doubt that in this post-Enron era suspicions have been raised regarding corporate malfeasance and insider trading. But the law is the law. Under the Reform Act, the burden to plead facts with particularity establishing the required element of materiality remains squarely on plaintiffs. Plaintiffs also maintain the burden to plead detrimental reliance. These pleading standards have not been met here. The district court properly dismissed the second amended complaint. I respectfully dissent.

. In light of these allegations, which we must construe as true for purposes of a motion to dismiss, I am at a loss to understand what evidence the majority employs to discount the non-reaction of the market because the “market is subject to distortions.” What distortions? The plaintiffs have not alleged any, and in fact have alleged the opposite in order to invoke the fraud-on-the-market theory. A vital premise to the fraud-on-the-market theory is the efficient nature of the marketplace. While surely a plaintiff in some other case might allege facts that would show distortions in the market preventing the efficient dissemination of information to investors, and thus lessen the significance of any consistency, or inconsistency, in stock price, the plaintiffs here have not. In fact, even the majority’s invocation of a quote from Basic regarding a “free and open public market” stands for exactly the opposite proposition for which the majority quotes it. See 485 U.S. at 245-46, 108 S.Ct. 978.