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Despite the demonstrable increase in securities class action filings and related case law since the passage of the Private Securities Litigation Reform Act in 1995, why are issues relating to class certification of these contests largely undeveloped? Perhaps the answer is that common questions of law or fact are usually presumed by the litigants and the courts. However, suing under the fraud on the market hypothesis, an occasional panacea for a class relying on a common theme, does not automatically warrant certifying a securities class action in every situation. Clearly, changes in market fundamentals, divergent investor trading habits and class action damage models when coupled with the most recent U.S. Supreme Court decision on class certification, Amchem Products, Inc. v. Windsor, mandate a rethinking as to when class certification is appropriate. This article explores the issues that may impact future legal decisions concerning the certification of securities class actions. Rule 23 governs all federal court class actions. Rule 23(a) states four threshold requirements that must be established by the party seeking class certification: numerosity, commonality, typicality, and adequacy of representation. Additionally, the party seeking class certification must show that an action is maintainable under Rule 23(b)(1), (2) or (3). “A class action may be maintained only when it satisfies all requirements of Rule 23 (a) and at least one of the alternative requirements of Rule 23(b).” [FOOTNOTE 1] Before certifying a class, a district court must be persuaded, “after a rigorous analysis, that the prerequisites of Rule 23(a) have been satisfied.” [FOOTNOTE 2] “Framed for situations in which class action treatment is not clearly called for � Rule 23(b)(3) permits certification where the class suit may nevertheless be convenient and desirable.” [FOOTNOTE 3] Rule 23(b)(3) provides in pertinent part that: [a]n action may be maintained as a class action if the prerequisites of subdivision (a) are satisfied, and in addition � (3) the court finds that the questions of law or fact common to the members of the class predominate over any questions affecting only individual members.” That common questions of law or fact predominate over individualized questions means that “the issues in the class action that are subject to generalized proof, and thus applicable to the class as a whole, must predominate over those issues that are subject only to individualized proof.” [FOOTNOTE 4] Courts have noted that “[T]he predominance inquiry focuses on ‘the legal or factual questions that qualify each class member’s cases as a genuine controversy,’ and is ‘far more demanding’ that Rule 23(a)’s commonality requirement.” [FOOTNOTE 5] CONTESTING THE CLASS Given the “demanding” class certification requirements, why are defendants in securities suits not contesting class certification more often? Perhaps it’s the fraud on the market theory, which “is based upon the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business. � Misleading statements will therefore defraud purchasers of stock. � The causal connection between the defendants’ fraud and plaintiffs’ purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations.” [FOOTNOTE 6] The fraud on the market theory presumes reliance for all class members, and has eased the predominance requirement of Rule 23(b) by shifting the inquiry of reliance from the individual to the “class.” The Basic v. Levinson court implicitly endorsed the class action mechanism as the preferred means for privately enforcing Rule 10b-5. Following Basic, other courts have reached similar conclusions. Perhaps lost in the class certification analysis, is the fact that plaintiffs’ presumption of reliance is merely rebuttable, and not conclusive. It is one thing to recognize that the fraud on the market theory has eased the predominance requirement of Rule 23(b)(3), but quite another to assume that this allegation automatically converts the reliance element of a Rule 10b-5 cause of action into a common inquiry for all members of the class regardless of when they purchased or sold their securities. Simply put, alleging fraud on the market does not constitute a prima facie grounds for certifying a class action in securities litigation. Quickly waiving the rigorous requirements of Rule 23 in favor of class certification is dangerous. In Broussard v. Meineke Discount Muffler Shops, Inc., [FOOTNOTE 7] the plaintiffs, current and former franchisees of defendant Meineke Discount Muffler Shops, Inc., brought a nationwide class action against Meineke alleging, among other things, a breach of their individual Franchise and Trademark Agreements (FTAs). However, the plaintiff class was not common as the former franchisees terminated their FTAs prior to the commencement of the trial, while other plaintiffs actually signed a new dealer agreement, called an Enhanced Dealer Package (EDP) with Meineke (the EDP plaintiffs). Still other plaintiffs simply continued as franchisees under the FTAs. After a jury trial that awarded the plaintiff class more than $200 million in damages, Meineke immediately appealed, asserting among other errors, that the trial court improperly certified the litigation as a class action. The 4th U.S. Circuit Court of Appeals agreed, and reversed the jury verdict, finding that the requirements of Rule 23 were not satisfied by the plaintiffs. Significantly, the 4th Circuit, in logic very applicable to securities class actions, found conflicts among the class members of the purported class. For example, the former franchisees had an interest only in maximizing any damages Meineke would have to pay, whereas the EDP plaintiffs had a “residual, forward-looking interest, as current franchisees, in Meineke’s continued viability.” [FOOTNOTE 8] Further, the court determined that variations in the factual and legal arguments made by the members of the purported class meant that the case did not satisfy the typicality and commonality requirements of Rule 23. [FOOTNOTE 9] Finally, because of the differences in the class members claims, the calculation of class-wide damages was improper. The court noted that “each putative class member’s claim for lost profit damages was inherently individualized and thus not easily amenable to class treatment. [FOOTNOTE 10] Equally instructive is Rutstein v. Avis Rent-A-Car Systems, Inc., [FOOTNOTE 11] which was commenced by Jewish individual and corporate customers of Avis, under Section 1981 of the Civil Rights Law. Specifically, plaintiffs alleged that Avis had “adopted as an official corporate policy a practice to discriminate against Jewish customers as a class of people and had instructed its employees to decline to open a corporate account for a business owned by this class of people.” On appeal, the 11th U.S. Circuit Court of Appeals reversed the determination of the district court which certified the plaintiffs as a class. First, the circuit court noted that in order to establish discrimination under Section 1981, the plaintiffs would have to prove, among other things, that the defendants intended to discriminate on the basis of race. Plaintiffs argued that the issue of whether Avis maintained a policy or practice of discrimination predominated over all legal and factual questions affecting only individual members of the class. The 11th Circuit disagreed, stating that “[g]iven that each plaintiff must demonstrate that he or she suffered from intentional discrimination” class certification was not appropriate. The court then focused on the damages issue and significantly observed: “To establish that they are entitled to compensation, plaintiffs will have to prove that they actually suffered some injury, whether it be emotional or otherwise. The idea that individual injury could be settled on a class-wide basis is preposterous. � To understand, further, why liability for damages is a necessarily individualized inquiry, we have only to consider the disaster that would befall any class-wide settlement of this case. Suppose that the district court was called upon to approve a settlement fund to compensate all worthy plaintiffs in the class. First, what could possibly be a fair amount for such a fund? $100 thousand? $10 million? $100 million? We have no idea, and neither would the district court. � Any class-wide figure arrived at would not just be a guess at a fair settlement amount; the court might as well come up with ten numbers at random, take their average, square that amount, and add six.” Finally, in Amchem Products, Inc. v. Windsor, [FOOTNOTE 12] the U.S. Supreme Court affirmed the decision of the 3rd U.S. Circuit Court of Appeals, vacating a decision of the district court certifying a class of plaintiffs, for settlement purposes only, based upon the mere exposure to asbestos products. In a wide-ranging decision which commented on class certification issues under Rule 23 (a), (b)(3), and (e), the Supreme Court rejected the finding of predominance based upon the mere exposure to asbestos, and agreed with the 3rd Circuit that “[c]lass members were exposed to different asbestos-containing products, for different amounts of time, in different ways, over different periods. Some class members suffer no physical injury or have only asymptomatic pleural changes, while others suffer from lung cancer. � Given the number of questions peculiar to the several categories of class members, and to individuals within each category, and the significance of those uncommon questions, any � dispute about the health consequences of asbestos exposure cannot satisfy the Rule 23(b)(3) predominance standard .” Id. The Meineke, Rutstein and Amchem decisions are instructive in determining the appropriateness of certifying a plaintiff class in a securities litigation. For example, in In Re Merrill Lynch, the plaintiffs, investors who purchased and sold securities on the Nasdaq market during the class period, brought suit under Rule 10(b)(5) against the defendant broker-dealers, claiming their buy and sell orders were not executed at the best possible price to maximize their economic benefit, contrary to their representations. [FOOTNOTE 13] Though finding that issues of misrepresentation and scienter presented questions of fact common to the proposed class, the court rejected class certification, agreeing with the defendants that: “[T]he transactions in which the defendants � involved multiple circumstances which bear decisively upon the existence of reliance and damages. The degree of sophistication of the putative class members varies widely. � Most critical is the fact that whether a class member suffered damages would have to be determined on a trade by trade basis � [U]nder the plaintiffs’ theory of liability some class members would have suffered damages; while some would not have suffered damages.” [FOOTNOTE 14] Similar questions encountered by the above-referenced courts may arise in the context of when a securities action is suitable for class certification. HYPOTHETICAL EXAMPLE For example, consider an accounting restatement case in which a high-technology company makes both innocent statements and alleged misstatements of material fact concerning quarterly results during the class period (i.e. during a 17-month class period). Further, assume that some of the alleged misstatements concerning revenue recognition are alleged to have been made with the requisite scienter, while other restated figures simply reflected innocent departures from GAAP. Also, let us assume some of the restatements during this hypothetical class period positively impacted GAAP earnings, rather than decreasing them. Depending upon the timing of the purchases and/or sales during the class period, it is likely that each plaintiff will have a significant challenge in proving that 1) the alleged intentional misstatement on the date of the quarterly disclosures materially affected the stock price on the days they purchased or sold, 2) that they suffered damage as a result, and 3) that this material effect was distinct from any other alleged influence on the stock price, including an innocent misstatement/departures from GAAP, or other intervening events. Under this scenario, can it be said that common questions of law or fact will predominate over those affecting individual members of the purported class? Further throw into the mix the divergent trading habits and sophistication of the purported plaintiff class. Are the plaintiffs mutual funds or pension plans that were merely trying to mimic the Russell 3000 stock index for the class period, or are they individual investors buying for their own retirement accounts? Is the plaintiff class composed of investors like Mr. and Mrs. John Smith who bought during the class period, held through the curative disclosures, and remained shareholders until the end of the class, or are they more sophisticated like Mr. and Mrs. Joe Day Trader who were “in and out” of the stock in question four times during the class period. First, what were the circumstances behind the individual trades of Mr. and Mrs. John Smith, and what information was available to them at the time of their investment decisions? Were they trading upon information just read about in The New York Times, or did they have access, like Mr. and Mrs. Joe Day Trader, to the latest news over a DSL connection to the Internet? [FOOTNOTE 15] Second, like purported class in Meineke, there likely would be conflicts among the class members such as Mr. and Mrs. Smith on the one hand, and Mr. and Mrs. Joe Day Trader on the other. Mr. and Mrs. John Smith, who hope for a fruitful retirement, might have little interest in seeking to maximize the monetary damages sought against the defendant, since their interest is “forward-looking.” However, Mr. and Mrs. Joe Day Trader would probably seek to maximize the recoverable damages, regardless of the impact of Meineke. Further, like the purported class in Rutstein, claims for damages in the above hypothetical, and in any securities class action, might vary immensely from plaintiff to plaintiff. For example, Mr. and Mrs. Smith, under some circumstances, might have a valid claim for damages. Mr. and Mrs. Joe Day Trader might not. The critical point is that assessing damages in a securities class action is an individual one, as each plaintiff is limited to his/her actual out-of-pocket loss. [FOOTNOTE 16] Section 28(a) of the 1934 Act “limits the claimant’s recovery to an amount not in excess of this actual damages on account of the act complained of.” [FOOTNOTE 17] At least one popular method or model relied upon by the plaintiffs’ bar in calculating damages on a class-wide basis has met with judicial disapproval. [FOOTNOTE 18] In light of the out-of-pocket loss standard for damages under Rule 10b-5, whether any valid and judicially sustainable method or model exists of calculating class-wide damages in securities class action remains to be seen. As noted above, we have yet to see any real discussion of issues relating to predominance, class conflicts and securities class action damages in Post-Reform Act case law as they relate to class certification of these actions. It is not suggested here that these issues automatically make securities class actions unsuitable for class certification. However, there is little doubt that a closer look as to how these issues might affect certification is warranted. Paul A. Ferrillo is vice-president and associate general counsel of National Union Fire Insurance Company of Pittsburgh, Pa., a wholly-owned subsidiary of the American International Group, Inc. The opinions expressed in this article are his own. Michael K. Rappaport, an assistant vice-president of National Union and an attorney, assisted in the preparation of this article. ::::FOOTNOTES:::: FN1 Jackson v. Motel 6 Multipurpose, Inc., 130 F.3d 999, 1005 (11th Cir. 1997). FN2 General Telephone Co. v. Falcon, 457 U.S. 147, 161 (1982). FN3 Amchem Products, Inc. v. Windsor, 521 U.S. 591 (1997). FN4 Kerr v. City of West Palm Beach, 875 F.2d 1546, 1558 (11th Cir. 1989). FN5 Jackson, 130 F.3d at 1005 (quoting Anchem, 521 U.S. at 623-24). FN6 Basic, Inc. v. Levinson, 485 U.S.224 (1988), quoting Peil v. Speiser, 806 F2d. 1154,1160-61 (3rd Cir. 1986). FN7 155 F.3d 331 (4th Cir. 1998). FN8 155 F.3d at 337-338. FN9 Id. at 340. FN10 Id. at 342-343. FN11 ___ F.3d ___ (11th Cir. 2000). FN12 521 U.S. 591 (1997). FN13 In Re Merrill Lynch, 191 F.R.D 391 (D.N.J. 1999). FN14 Id. at 396. FN15 See e.g., Zimmerman v. Bell, 800 F.2d 386 (4th Cir. 1986) (denying class certification in a securities class action). FN16 See In re Storage Technology II, (slip op.) (D. Colo. May 16, 1994). FN17 See Huddleston v. Herman & Maclean, 640 F.2d 534, 556 (5th Cir. 1981). FN18 See Kaufman v. Motorola, Inc., et al., No. 95 C 1069 (N.D. Ill. Sept. 19, 2000).

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