First published in Securities Litigation Insights, Issue 2, Winter 2010
By Steven R. Paradise and Hilary L. Preston
| Read more articles from Securities Litigation Insights, Winter 2010 here. |
With the heightened pleading standards imposed by the Private Securities Litigation Reform Act (PSLRA) and the attention given to pleading standards by the Supreme Court and the Court of Appeals,1 many litigants began to view the motion to dismiss stage as the tipping point in a securities fraud class action lawsuit. That is, if a case proceeds past a motion to dismiss, the automatic discovery stay imposed by the PSLRA lifts and the costs rapidly mount for the defense. As a result, the pressure to settle can intensify. But with many courts now willing to bifurcate class and merits discovery, this pressure can be alleviated until after the court’s consideration of whether the case can proceed as a class action. The class certification motion – which some largely considered a fait accompli in securities fraud suits after the Supreme Court endorsed the fraud-on-the market presumption of reliance in Basic v. Levinson2 – is again becoming a rigorous and increasingly challenging burden for plaintiffs. Courts of Appeals are reversing trial courts for failing to conduct the probing review Rule 23 requires. We outline below certain bases upon which defendants have had success in opposing class certification in securities fraud suits. We also discuss the opportunity for defendants to challenge preemptively class certification in appropriate cases, rather than waiting to respond to a plaintiff’s motion for class certification.
Adequacy
This element of Rule 23(a) of the Federal Rules of Civil Procedure requires that the class representative fairly and adequately protect the interests of the class. FED. R. CIV. P. 23(a). Folded into this analysis is a review of both the proposed class representative and its counsel, and – in perhaps one of the most interesting hot button adequacy issues – the relationship between the proposed representative and its counsel.3 Because one of the main purposes of the PSLRA was Congress’s desire to curb “abusive, lawyer driven litigation,”4 the circumstances behind how a plaintiff came to serve as a lead plaintiff and proposed class representative are fair game for class discovery.
Defense counsel should probe not only the typical adequacy topics such as the proposed representative’s knowledge of the allegations and the evidence supporting these allegations, but also any facts tending to show that the plaintiff was “recruited” into the case by class counsel. The PSLRA was designed to ensure that the “plaintiff will choose counsel rather than . . . counsel choosing the plaintiff,” see H.R. CONF. REP. NO. 104 369, at 35. Accordingly, defense counsel should probe the timing of plaintiff’s awareness of the suit or the facts giving rise to the suit and the timing of the engagement of counsel. Defendants should also seek the production of any engagement letters and “portfolio monitoring agreements.” The latter – which are agreements between class action law firms and institutional investors that give counsel access to the investor’s portfolios for the purpose of monitoring any “unusual activity,” (i.e., large stock price drops) that can give rise to a securities fraud claim and the filing of a lawsuit – have recently come under fire as potentially posing conflicts of interest for the class action firms.5
For purposes of class certification, these agreements may be most relevant as they raise the possibility that the lawsuit is driven by plaintiff’s counsel, instead of plaintiff, in contrast to the PSLRA’s goals. “The adequacy standard must reflect the governing principles of the [PSLRA] and, particularly, Congress’s emphatic command that competent plaintiffs, rather than lawyers, direct such cases.”6 If it can be shown that the proposed class representative was unaware of the facts underlying the suit, or perhaps even of its investment in the securities at issue, until class counsel advised it of the possibility of the suit, then there is a strong argument that the PSLRA’s mandate against lawyer-driven litigation is being thwarted and the proposed class representative and its counsel are inadequate representatives for the class.
Predominance
This element of Rule 23(b) requires that common issues of law and fact predominate over individual issues. This is the means by which loss causation (i.e., the requirement that there be “a causal connection between the material misrepresentation and the loss,”)7 is tested at the class certification stage. A brief explanation may help to clarify why loss causation must be considered as part of the class certification analysis.
One of the elements of a securities fraud suit is reliance, and whether a particular class member relied on a particular misrepresentation is a classically individualized inquiry that could predominate over class wide inquiries and prevent class certification in securities fraud suits. But in Basic v. Levinson, the Supreme Court endorsed the theory of a fraud-on-the-market presumption of reliance, which presumes that investors rely on the integrity of a stock’s market price when purchasing stock and posits that the stock’s market price reflects all publicly available information about the stock if it trades in an efficient market.8 To demonstrate that the market is efficient such that the presumption can attach, the plaintiff must show either that the stock price increased following the alleged misrepresentation (hence showing the artificial inflation in the stock price) or that the stock price decreased following the corrective disclosure (hence showing the removal of the artificial inflation).9 Thus, at the class certification stage, a plaintiff must show loss causation by a preponderance of the evidence.10
One issue that has become challenging for parties and the courts is how to assess loss causation when a disclosure involves more than one piece of corrective information, some of which is wholly unrelated to the alleged fraud. How do the parties and the courts untangle the effects of the various pieces of information simultaneously available to the market? The Fifth Circuit has not answered the question of how it can be done, but has imposed a clear mandate that it be done – requiring that when multiple pieces of information are released at once, the plaintiff must prove, at the class certification stage, that “the cause of the decline in price is due to the revelation of the truth and not the release of . . . unrelated negative information.”11 Defense counsel should be attuned to this issue and closely scrutinize whether the plaintiff has provided sufficient evidence of the effect of one disclosure versus another.
Preemptively Challenging Class Certification
The normal course for raising class certification issues in securities fraud cases is for defendants to wait until a plaintiff makes a motion for class certification, and then oppose it. But there is nothing that prevents a defendant from preemptively challenging class certification in appropriate cases. Rule 23 mandates that a court must evaluate class certification at “any early practicable time after a person sues . . . as a class representative.” FED. R. CIV. P. 23. “In some instances, the propriety vel non of class certification can be gleaned from the face of the pleadings.”12 If that is the case, then a motion to strike class allegations can be brought simultaneously with a motion to dismiss.
More often, however, some discovery is usually needed to assess the propriety of class certification in securities fraud cases. In those cases, a motion to deny class certification can be brought, but likely only after some class and expert discovery have taken place. If a defendant assesses the case at an early stage and determines that it has a strong challenge to class certification, it may make sense to consent to a partial lift of the automatic discovery stay such that the motion to deny class certification could be brought even before resolution of the motion to dismiss. Obviously, a defendant should weigh the likelihood of succeeding on such a motion against the additional cost that would be incurred. In most instances, however, a preemptive motion to deny class certification makes sense only if a court has denied a defendant’s motion to bifurcate discovery. In that circumstance, the defendant may be facing burdensome merits discovery and would prefer to obtain a ruling on the issue of class certification. This will clarify the scale of the case going forward, before the defendant is required to complete and bear the burden of full merits discovery.
Conclusion
A denial of class certification, while technically not a final disposition of the case, can in practice have the same effect. It is generally not economical for a plaintiff’s firm taking the case on contingency to continue prosecuting an individual, as opposed to class, action, and thus a denial of class certification can quickly lead to an inexpensive settlement. Given that and many courts’ renewed interest in conducting a rigorous analysis of Rule 23’s requirements in securities fraud suits, defense counsel is well advised to ensure that adequate resources and analysis are devoted to this stage of the case.
For more information, please contact Vinson & Elkins lawyers Steven Paradise or Hilary Preston. Visit our website to learn more about V&E's Securities Litigation practice. Get a .pdf of this issue of Securities Litigation Insights e-newsletter here.
1 E.g., Tellabs, Inc. v. Makor Issues & Rights, Inc., 551 U.S. 308 (2007).
2 485 U.S. 224 (1988).
3 See Stirman v. Exxon Corp., 280 F.3d 554, 563 (5th Cir. 2002).
4 Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 126 S.Ct. 1503, 1510-11 (2006).
5 See e.g., Transcript of Proceedings, April 1, 2009, Iron Workers Local 25 Pension v. Credit Based Asset Servicing, No. 08-cv-10841 (S.D.N.Y.), at 9 (Judge Rakoff commenting that portfolio monitoring agreements were “about as obvious an instance of conflict of interest as I’ve ever encountered in my life”).
6 Berger v. Compaq Computer Corp., 257 F.3d 475, 484 (5th Cir. 2001).
7 Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005).
8 Basic, Inc. v. Levinson, 485 U.S. 224, 241-42 (1988).
9 Greenberg, 364 F.3d at 665-66.
10 Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261, 266 (5th Cir. 2007).
11 Oscar, 487 F.3d at 265; see also Fener v. Belo Corp., No. 08 20576, 2009 WL 2450674 (5th Cir. Aug. 12, 2009) (requiring that the plaintiff isolate the effect of the relevant information on the stock price).
12 Mills v. Foremost Ins. Co., 511 F.3d 1300, 1309 (11th Cir. 2008).