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In Szabo v. Bridgeport Machines Inc., a distinguished panel of the 7th U.S. Circuit Court of Appeals rejected the argument that a district court considering class certification is obliged to assume the truth of the plaintiff’s allegations. [FOOTNOTE 1]Although this nonsecurities case addressed only the decision whether or not to certify a class, the opinion is likely to influence judicial thinking in securities cases in which the dispute is often not so much whether a class should be certified — but for what period and whether subclasses should be required. In securities cases, the length of the class period and the number of purchasers encompassed can have the same substantial implications, especially in settlement positioning, which led to the Szabodecision. THE ‘SZABO’ CASE In Szabo, the U.S. District Court for the Northern District of Indiana had certified a nationwide class of all persons who purchased a certain computerized machine from January 1996 to the present. [FOOTNOTE 2] Szaboasserted claims of breach of warranty, fraud, and negligent misrepresentation. In response to certain of Bridgeport’s arguments contesting the facts alleged by Szabo, the district court held that it was obliged to accept the substantive allegations of the complaint as true and rejected Bridgeport’s arguments as an inappropriate attempt to litigate the merits of the claims. [FOOTNOTE 3] Judge Frank Easterbrook, joined by Judges Richard Posner and Ann Williams, granted Bridgeport’s request for discretionary appellate review under the new Rule 23(f), [FOOTNOTE 4]for two reasons. First, the class certification turns a $200,000 dispute � into a $200 million dispute. Such a claim puts a bet-your-company decision to Bridgeport’s managers and may induce a substantial settlement even if the customers’ position is weak. This is a prime occasion for the use of Rule 23(f), not only because of the pressure that class certification places on the defendant but also because the ensuing settlement prevents resolution of the underlying issues. [FOOTNOTE 5] Second, the district court’s decision “implies that important legal principles have evaded attention by appellate courts,” insofar as the district court cited only decisions by other district courts that had not been subject to appellate review. The 7th Circuit noted that the district courts had not correctly understood the applicable principles. [FOOTNOTE 6] Then, vacating the district court’s certification of the class, Judge Easterbrook pinpointed the fundamental flaw in the lower court’s approach: “The proposition that a district judge must accept all of the complaint’s allegations when deciding whether to certify a class cannot be found in Rule 23 and has nothing to recommend it.” [FOOTNOTE 7]He observed that, whereas a Rule 12(b)(6) motion to dismiss tests the legal sufficiency of a pleading the factual sufficiency of which will be tested later (through a Rule 56 motion or at trial), a class certification order is usually the last word on the subject. Therefore, a judge should “make whatever factual and legal inquiries are necessary under Rule 23.” [FOOTNOTE 8]That would include receiving evidence, if only by affidavit, and resolving any disputes relating to the Rule 23(a)(1) and 23(b)(3) factors before deciding whether to certify the class. “And if some of the considerations � overlap the merits, � then the judge must make a preliminary inquiry into the merits.” [FOOTNOTE 9] Judge Easterbrook emphasized that such an inquiry is no different from the factual inquiries that courts routinely make on Rule 12(b) motions addressing jurisdiction, venue, and other preliminary issues. When such determinations depend upon contested facts, the judge is free to hold a hearing and resolve the dispute before allowing the case to proceed. The Rule 12(b)(6) standard of accepting a plaintiff’s allegations is unique and should not be extended to Rule 23 determinations. [FOOTNOTE 10] Judge Easterbrook then took issue with the common interpretation of Eisen v. Carlisle & Jacquelin, 417 U.S. 156, 177-78 (1974), that it mandates a Rule 12(b)(6) approach for Rule 23 decisions. [FOOTNOTE 11]In the relevant portion of the Eisendecision, the Supreme Court disapproved of the district court’s holding a preliminary hearing on the merits to determine that plaintiff would likely prevail and on that basis imposing the cost of class notice on the defendant. That kind of prejudgment on the merits, the Court ruled, allowed a plaintiff inappropriately to secure the benefits of a class action without first satisfying the requirements for it. [FOOTNOTE 12]Explaining the limited point being made by the EisenCourt, Judge Easterbrook observed that Rule 23 was amended in 1966 to put the certification decision ahead of the merits adjudication (as contrasted with prior procedure, which allowed opt-ins after the decision on the merits was made). Rule 23 does not permit a court to make certification decisions on the basis of which side it thinks will win. However, Judge Easterbrook noted, “nothing in the 1966 amendments to Rule 23, or the opinion in Eisen, prevents the district court from looking beneath the surface of a complaint to conduct the inquiries identified in that rule and exercise the discretion it confers.” [FOOTNOTE 13] DIFFICULT ISSUES Judge Easterbrook further observed that deferring to the plaintiff’s allegations is contrary to the Supreme Court’s subsequent ruling in General Telephone Co. v. Falcon, 457 U.S. 147 (1982). There the Court, in rejecting an approach that required a court to assume that all members of a proposed class were similar to the plaintiff, said that “sometimes it may be necessary for the court to probe beyond the pleadings before coming to rest on the certification question. [A]ctual, not presumed, conformance with Rule 23(a) remains indispensable.” [FOOTNOTE 14]Judge Easterbrook found this rule equally applicable to Rule 23(b) requirements, for to treat a plaintiff’s allegations as incontestable is to put the discretion that should be the court’s into the hands of the plaintiff’s attorneys, to the possible detriment of both defendants and absent class members. [FOOTNOTE 15] In remanding to the district court, Judge Easterbrook noted the nagging issues in Szaboconcerning choice of law, commonality, manageability and the non-necessity of class treatment given the relatively large size of the claim. He suggested that a piercing of the allegations of the complaint by the district court, now freed from its perceived restraints, might lead it to either deny the request for class treatment or certify a more limited class. [FOOTNOTE 16] IN SECURITIES CASES The Szaboopinion makes a compelling case that there is no good reason for a court to defer to a plaintiff’s allegations and avoid any inquiry into merits-related issues in making a class certification decision. The Szabocourt’s concern that a deferential certification decision may turn a $200,000 dispute into a $200 million dispute has equal force in Rule 10b-5 cases where a lengthy class period is often sought despite the absence of any coherent justification. Permitting a plaintiff to certify a 12-month class period when in fact only a six-month period is justified by the public statements at issue, or when the plaintiff is only truly typical of purchasers during a six-month period, puts unwarranted pressure on a defendant and creates unreasonable expectations in the plaintiff (and counsel and class members). Although theoretically the certification order “is inherently tentative” and may be modified at any time before trial, [FOOTNOTE 17]in reality that rarely occurs. Litigation and settlement decisions are based on the magnitude of the case as defined by the class that is certified early on. A class period that is logically overbroad in relation to the fraud alleged – because, for example, it starts months before the first allegedly false statement was made or ends months after corrective information was published — might be trimmed down years later in an in limine ruling after full discovery and expert reports. However, defendant companies often make their decisions on how much to spend in litigation, and in settlement, at an earlier stage in the litigation and therefore must, as a practical matter, base those decisions on the potential liability framed by the overinclusive certified class. As Judge Easterbrook pointed out, uncritical deference to a plaintiff’s allegations effectively abdicates the essential role of independent judicial analysis. “Certifying classes on the basis of incontestable allegations in the complaint moves the court’s discretion to the plaintiff’s attorneys — who may use it in ways injurious to other class members, as well as ways injurious to defendants.” [FOOTNOTE 18]The court’s decision whether to certify a class at all or whether the proposed scope or duration of a class should be modified is often the last word on the subject and therefore ought to rest on a thorough and critical evaluation. Both absent class members and defendants are “entitled to the protection of independent judicial review of the plaintiff’s allegations.” [FOOTNOTE 19]What is needed under Rule 23 is “a rigorous analysis” [FOOTNOTE 20]of whether all requirements are met, even if that requires some delving into the merits. It remains to be seen whether the 2nd Circuit will re-evaluate its view following the Szabodecision and permit such merits analysis where necessary to resolve class certification issues. To date, the 2nd Circuit’s position has been that, while material outside the pleading may be considered, the court should give plaintiffs the benefit of the doubt and avoid resolving any merits-related issues. [FOOTNOTE 21]The 2nd Circuit’s opinion in Caridad v. Metro-North Commuter Railroadexemplified an approach akin to the Rule 12(b)(6) standard rejected by the 7th Circuit. [FOOTNOTE 22]While the court acknowledged the plaintiffs’ burden to demonstrate the existence of a claim warranting class treatment, [FOOTNOTE 23]the court indicated that consideration of any contrary facts which go to the merits is precluded. In discussing the parties’ proffers of statistical evidence on the alleged disparate impact, the court ruled that the district court should not have credited defendant’s expert evidence over the plaintiffs’ because “district courts must not consider or resolve the merits of the claims of the purported class” and “[s]uch a weighing of the evidence is not appropriate at this stage in the litigation.” [FOOTNOTE 24]The court explained that the plaintiffs’ proffered materials, even if not ultimately persuasive, “are sufficient to demonstrate common questions of fact” thereby justifying class certification. [FOOTNOTE 25] CIRCUIT COURTS DIFFER The distinction between the 7th Circuit approach, which requires resolution by district courts of any Rule 23 issue even if it reaches the merits, and the 2nd Circuit approach, which requires that district courts defer to plaintiffs on any conflict that goes to the merits, can be critical to the scope of a case and therefore to its settlement posture. Under the 7th Circuit analysis, plaintiffs cannot “tie the judge’s hands” by making allegations relevant to both class certification and the merits. [FOOTNOTE 26]Perhaps the 2nd Circuit will take another look at the issue in light of the strong language used by the 7th Circuit in setting forth the responsibilities of district courts to evaluate all issues that affect the proper scope and duration of a class, even if those issues overlap with the merits of the case. The 2nd Circuit might find, as the 7th Circuit did, that the district courts have not uniformly understood the principles applicable to Rule 23 class certification motions. Sarah S. Gold and Leon P. Gold are partners at Proskauer Rose. Karen E. Clarke, an associate at the firm, assisted in the preparation of this article. ::::FOOTNOTES:::: FN1249 F.3d 672 (7th Cir. 2001). FN2 Szabo v. Bridgeport Machines, Inc., 199 F.R.D. 280, 284 (N.D. Ind. 2001). FN3 Id.at 284, 286, 293-94. FN4Fed. R. Civ. P. 23(f), added in 1998, provides that “[a] court of appeals may in its discretion permit an appeal from an order of a district court granting or denying class action certification,” but offers no guidelines for the exercise of that discretion. Judge Easterbrook wrote the seminal opinion establishing guidelines for Rule 23(f) appeals, Blair v. Equifax Check Servs. Inc., 181 F.3d 832, 834-35 (7th Cir. 1999). Presaging his Szaboruling, Judge Easterbrook noted in Blair that “Disputes about class certification cannot be divorced from the merits — indeed, one of the fundamental unanswered questions is whether judges should be influenced by their tentative view of the merits when deciding whether to certify a class .” Id.at 835. FN5249 F.3d at 675. FN6 Id. FN7 Id. FN8 Id.at 675-76. FN9 Id.at 676. FN10 Id.at 676-77. FN11 Id.at 677. FN12 Eisen, 417 U.S. at 177. FN13249 F.3d at 677. FN14 General Telephone, 457 U.S. at 160. FN15 Szabo, 249 F.3d at 677 FN16 Id.at 678. FN17 General Telephone, 457 U.S. at 160 (quoting Coopers & Lybrand v. Livesay, 437 U.S. 463, 469 n.11 (1978)); Fed. R. Civ. P. 23(c) (“An order under this subdivision may be conditional, and may be altered or amended before the decision on the merits.”) FN18 Szabo, 249 F.3d at 677. FN19 Id. FN20 General Telephone, 457 U.S. at 161. FN21 See Caridad v. Metro-North Commuter Railroad, 191 F.3d 283, 291-93 (2d Cir. 1999), cert. denied, 529 U.S. 1107 (2000); Philip Morris Inc. v. National Asbestos Workers Med. Fund, 214 F.3d 132, 135 (2d Cir. 2000) (quoting Sirota v. Solitron Devices, Inc., 673 F.2d 566, 571-72 (2d Cir. 1982)). See also Ansoumana v. Gristede’s Operating Corp., 2001 WL 563906, *3, 5 (S.D.N.Y. 2001); Rodolico v. Unisys Corp., 199 F.R.D. 468, 473, 475-76 (E.D.N.Y. 2001). FN22191 F.3d 283, 291-93 (2d Cir. 1999). FN23191 F.3d at 292 (“Of course, class certification would not be warranted absent some showing that the challenged practice is causally related to a pattern of disparate treatment or has a disparate impact.”) FN24 Id.at 293. FN25 Id.at 292. FN26 Szabo, 249 F.3d at 677.

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