Second Circuit Clarifies Standard of Proof for Certification of Class Action Under Rule 23 and Holds that IPOs are not “Efficient Markets” in Handing Defense Victory on Appeal
Beginning in 2001, hundreds of class action lawsuits were filed against Wall Street banks alleging violations of federal securities laws in connection with the initial public offerings of certain Internet companies. In re Initial Public Offering Securities Litig., 471 F.3d 24, 2006 WL 3499937, *1 (2nd Cir. December 5, 2006). Following the consolidation of 310 of the class action lawsuits, plaintiffs’ lawyers moved for class certification in six “focus cases.” Id., at *3. Defense attorneys objected to certification of a class action arguing primarily that individual issues predominate over common ones; the district court granted the motion finding that plaintiffs had made “some showing” of the elements required under Rule 23 to warrant certification, id., at *3-*5. The Second Circuit reversed, agreeing with defense attorneys that plaintiffs had not satisfied the requirements of Rule 23 and further that they could not satisfy those requirements.
The class action complaints alleged that underwriters, issuers and individual officers of the issuing companies defrauded investors through “tie-in arrangements, undisclosed compensation, and analyst manipulation” in connection with the IPOs of certain Internet companies, id., at *2. In certifying a class action, the district court perceived conflicting guidance in Supreme Court authority concerning the proper standard of proof required to warrant class action certification. Specifically, Supreme Court authority requires a “rigorous analysis” that may require the court to “probe behind the pleadings,” but a court may not “conduct a preliminary inquiry into the merits of a suit.” Id., at *4 (citations omitted). The district court rejected Fourth Circuit and Seventh Circuit authority requiring plaintiffs to “establish the requirements of Rule 23 by a preponderance of the evidence, even if resolving those issues requires a ‘preliminary inquiry into the merits . . ., or ‘overlap with issues on the merits.'” Id. (citations omitted). The court instead crafted an amorphous “some showing” test and, applying that new standard, concluded that plaintiffs had met their burden of proof. Id., at *4-*5.
The Second Circuit granted defense attorneys permission to appeal the district court’s order, and asked the parties to address two issues: “(1) Whether the Second Circuit’s “some showing” standard . . . is consistent with the 2003 amendments to Fed. R. Civ. P. 23; and (2) Whether the presumption of reliance established in Basic [Inc.] v. Levinson, 485 U.S. 224 (1988), was properly extended to plaintiffs’ claims against non-issuer defendants and to the market manipulation claims.” Id., at *6. The Circuit Court concluded that “use of a ‘some showing’ standard was error,” but admitted that prior circuit opinions had “been less than clear as to the applicable standards for class certification” and contained language that “understandably led [the district court] astray.” Id., at *7. The Court also rejected the applicability of Basic to the case before it, as explained below.
The Court performed an extensive analysis of the legal standards governing district court consideration of the class action certification requirements set forth in Rule 23, including the significance of the 2003 amendments. See id., at *7-*14. That analysis revealed case authority from several circuits “strongly support[ing] a requirement of findings that Rule 23 requirements are met” and some cases “explicitly reject[ing] the idea that something less than a clear finding is adequate just because a Rule 23 requirement overlaps with the merits.” Id., at *12. It also quoted with approval Eleventh Circuit authority which held:
While it is true that a trial court may not properly reach the merits of a claim when determining whether class certification is warranted, this principle should not be talismanically invoked to artificially limit a trial court’s examination of the factors necessary to a reasoned determination of whether a plaintiff has met her burden of establishing each of the Rule 23 class action requirements.
Id. (quoting Love v. Turlington, 733 F.2d 1562, 1564 (11th Cir. 1984)). The court then explicitly rejected the “some showing” standard, and held that district courts must require more substantial evidence than simply expert reports that are not “fatally flawed.” Id., at *13.
Turning to the merits, viewed in light of the proper standards, the Circuit Court held that remand was not necessary because the class action complaint itself demonstrated that individual issues clearly predominate over common questions, thus defeating class action certification requirements of Rule 23(b)(3). Id., at *16 et seq. The Second Circuit first addressed the question of reliance, and rejected plaintiffs argument that in an efficient market purchasers of securities are presumed to rely on price. While this presumption may constitute “some evidence” in support of class certification, “the market for IPO shares is not efficient,” id., and plaintiffs’ allegations demonstrate that the market reacted very slowly to correct the problem alleged despite “widespread knowledge” of the alleged scheme to defraud investors, corroborating that the IPOs in question presented “the very antithesis of an efficient market,” id., at *17. The Court also found that common issues regarding the necessary lack of knowledge also were missing; indeed, plaintiffs alleged in the class action complaint that knowledge of the alleged scheme was widespread, and they referred to an “industry-wide understanding” of key elements of their case. Id., at *17. The district court’s attempt to sole this problem by redefining the class to exclude “investors who exhibit the hallmarks of full participation in the alleged scheme” failed, because the widespread knowledge alleged in the complaint “would precipitate individual inquiries as to the knowledge of each member of the class,” id., at *18. And lastly the Second Circuit described questions concerning payment of undisclosed compensation as “litigation bristling with individual questions” because “[e]ach category of undisclosed compensation would require individualized determinations,” including attempting to determine the purchasers’ intent. Id.
The Second Circuit concluded that plaintiffs’ could not satisfy the predominance requirements of Rule 23(b)(3) and therefore reversed the district court order granting class certification in the six focus cases. Id., at *19.
NOTE: While plaintiffs’ lawyers have been quoted as expressing the opinion that the Second Circuit’s opinion is limited to the six cases at hand, the author expresses a contrary view. The six focus cases rely on allegations from a set of “‘Master Allegations’ applicable to all 310 consolidated actions and a ‘Class Action Complaint’ specific to each of the 310 issuers.” The Circuit Court’s reasoning concerning the number of individual issues presented by the “master allegations” applies equally to all class actions covered by those allegations.
Also, the Second Circuit opinion provides an excellent summary of the various standards of review applicable in class action cases, explaining at page *14:
To illustrate, again using the example of numerosity, review of the factual finding as to the size of the proposed class would be for clear error, review of the judge’s articulation of the legal standard governing numerosity would be de novo, and review of the ultimate ruling that applied the correct legal standard to the facts as found would be for abuse of discretion. Thus a ruling on numerosity, based on a finding of fact that is not clearly erroneous and with application of a legal standard that is correct, could be affirmed as within allowable discretion, in some circumstances, whether the ruling determined that this Rule 23 requirement was met or not met.