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Investor Harold Zagoda tapped into the rags-to-riches dot-com era, getting initial public offering shares of VA Linux at $30 on the opening day in 1999 when it zoomed to close at $239 a share. In less than a year, the bubble burst. He lost $2.9 million when the stock plunged to $8, leaving Zagoda to join thousands of investors who sued 310 technology companies and the 55 underwriters who the investors allege rigged the market. Now a defense challenge to class certification in the case has raised the potential of the 2d U.S. Circuit Court of Appeals altering the very basis for the plaintiffs’ ability to file shareholder class cases under what is known as the fraud-on-the-market doctrine. Suddenly investors and their lawyers face an entirely new challenge. The 2d Circuit has indicated in a recent order that it wants to use the case to re-examine, or at least clarify, the fraud-on-the-market theory, the legal fuel for securities class actions. The suits allege that the underwriters employed secret deals with their IPO clients, requiring the clients to buy more shares on the open market at higher prices, thus creating an artificial demand, known as tie-in agreements, that helped drive some stocks to dizzying heights. Individuals and institutional investors also claim that some clients who received IPO shares had to kick back a share of the profits to the brokers and that the investment firms misused their securities analysts to hype the stocks. Pushed too far? The investors have relied on the fraud-on-the-market doctrine, which is helpful to plaintiffs, not just to pursue claims of alleged manipulation by the high-tech firms but also to hold the 55 well-heeled investment banking firms liable for the alleged misconduct. That may have pushed the appeals court too far. The 2d Circuit threw the long-running case into turmoil when it decided to take a new look at the ease with which class status was granted to these megainvestor suits under the fraud-on-the-market doctrine. Defense lawyers appealed U.S. District Judge Shira Scheindlin’s decision granting class status-a potential death knell for the defendants. They asked the 2d Circuit to review her decision immediately in Miles v. Merrill Lynch & Co., No. 04-8026. On June 30, the appellate panel not only agreed to examine Scheindlin’s 150-page grant of class certification, but also asked two additional questions. The judges wanted to know whether the circuit’s liberal class certification standard of “some showing” of an actual injury common to the class is consistent with recently amended federal rules, and whether the fraud-on-the-market doctrine can properly extend to alleged market manipulation by someone other than the company issuing the stock-in this case to the investment banks. Traditionally, investors who lost money buying stock based on company misstatements had to show they relied on those misstatements to make their investment. In cases with thousands of investors, it was all but impossible to show that each investor had read or heard, and relied on, the misrepresentations. But in 1988, that changed dramatically. The U.S. Supreme Court in Basic v. Levinson, 485 U.S. 224 (1988), opened the door to so-called “stock drop” class actions by holding that in an efficient market it is not necessary that each investor individually relies on a specific misstatement made by a company. For the first time, an investor could be a victim under a fraud-on-the-market theory even if he or she never heard the misstatement. The assumption was that in an efficient market like the New York Stock Exchange the stock price would rapidly reflect all the latest information-including intentional misstatements by a company. “ Basic really facilitated class actions,” said Merritt B. Fox, a professor at Columbia Law School. “The Supreme Court was very self-conscious in that it was trying to accommodate class actions,” he said. This is not the first time the 2d Circuit has expressed interest in examining the fraud-on-the-market standards. The central question in the WorldCom securities case was whether market analysts could be liable under a fraud-on-the-market theory for rosy predictions on stocks they in fact disfavored. But the case settled just days before arguments were to be heard. The core issue At its core, the issue is whether the existing presumption that the market relies on company statements to drive the stock price can lead one to assume that the market also relies on actions by investment bankers or their analysts, making them potentially liable in shareholder fraud claims. No other appeals court has addressed this issue, according to Laurie Smilan, co-chairwoman of securities litigation in the Washington office of Latham & Watkins, which is not involved in the appeal. “Is it appropriate to apply the fraud-on-the-market doctrine if the statement is not coming from the company? Why presume what analysts have to say, or investment bankers are doing, is reflected in the issuer’s stock price?” Smilan said. “Even district judges in the Southern District of New York have been struggling with this,” said Andrew Frackman of the New York office of O’Melveny & Myers, representing Robertson Stephens Inc. among the defense team. “The argument is [that] the statements by [the investment banks] have a different role and are given a different weight. You can’t assume they move the market [price for stock] the way [company] statements do,” Frackman said. In 2004, Judge Jed Rakoff denied a class certification in a case that alleged a Lehman Brothers analyst made buy recommendations for RealNetworks Inc. stock while privately holding negative views of the stock. Rakoff held that the plaintiffs had insufficient evidence to apply a fraud-on-the-market theory. DeMarco v. Lehman Brothers, 222 F.R.D. 243 (S.D.N.Y. 2004). He found a qualitative difference between a company statement and the opinion of an analyst. In January 2005, Judge Gerard Lynch granted class certification in a similar case by refusing to apply a higher standard for plaintiffs alleging fraud by analysts. He held that a fraud-on-the-market theory applied in DeMarco v. Robertson Stephens, 318 F. Supp. 2d 110 (S.D.N.Y. 2004). Another factor thrown into the mix: Nearly all the more than 300 companies reached a $1 billion settlement with the plaintiffs last year, and that amount will be offset by any recovery the plaintiffs get from the IPO underwriters. That gives the high-tech firms a big incentive to help the plaintiffs, which they are doing. Several plaintiffs’ lawyers contacted declined to comment on the circuit court’s action. However, in court papers they called the defense efforts to block class certification “nothing more than hyperbole based on a strained and incorrect presentation of the law and facts.” The plaintiffs’ lead attorney, Melvyn Weiss of New York’s Milberg Weiss Bershad & Schulman, argued that “market manipulation schemes which are intended to distort the price of a security, if successful, necessarily defraud investors who purchase the security in reliance on the market’s integrity. “Absent the fraud-on-the-market theory, parties injured by such manipulative schemes could not plead the necessary element of reliance,” Weiss wrote. The circuits have not been divided on the fraud-on-the-market doctrine, according to Martin Cunniff, a securities litigation defense attorney at Washington-based Howrey. “What you do see are varying degrees of diligence [among the courts] on whether a market is efficient,” he said. Judges will look at hybrid securities cases in narrowly traded stocks and allow a case to proceed “but if you drill in, you’ll see the market isn’t efficient and if it isn’t, the whole underpinning of the case floats away.” A dual framework Over the 17 years since Basic, lower federal courts have evolved a dual framework for looking at these cases. One requires a showing that the investor paid a higher price for a plunging stock because of the false statements, and the other requires a showing that investors would not have bought the stock but for belief in the misleading statements. “This effort of the lower courts to cram fraud-on-the-market cases into ill-fitting [dual frameworks] has led to muddy legal reasoning and consequent arbitrary results,” according to Fox. He said that because the Supreme Court has never weighed in on the evolving dual requirements of loss causation or transaction causation since the Basic decision, the court is therefore free to “end the confusion caused by the lower courts’ misapplication of a framework of their own making and throw it out, for fraud-on-the-market suits,” Fox wrote in a recent analysis of the doctrine. He said the high court should put in its place a simple requirement that plaintiffs “plead and prove that the defendant’s misstatement inflated the price the plaintiff paid.”

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