Rehearing and Rehearing En Banc Denied July 23, 1984.
KRAVITCH, Circuit Judge:
The plaintiffs brought this proposed class action on behalf of themselves and other purchasers of Documation, Inc. securities, alleging violations of § 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission rule 10b-5.
The defendants moved to dismiss the complaint on the ground that it failed to state a claim upon which relief can be granted, because the plaintiffs had failed to allege direct reliance on the purportedly misleading documents. The district court denied the defendants' motion, concluding that the former Fifth Circuit in Shores v. Sklar, 647 F.2d 462 (5th Cir.1981) (en banc), cert. denied, 459 U.S. 1102, 103 S.Ct. 722, 74 L.Ed.2d 949 (1983),
I.
Reliance is one of the essential elements that a plaintiff must prove to recover in a rule 10b-5 action. Dupuy v. Dupuy, 551 F.2d 1005 (5th Cir.), cert. denied, 434 U.S. 911, 98 S.Ct. 312, 54 L.Ed.2d 197 (1977). Requiring the plaintiff to show that he reasonably relied on the defendants' misrepresentations is a means of establishing the "causal link between the misrepresentation or omission and the injuries suffered by the private plaintiff," id. at 1016, and of ensuring that the federal securities laws do not expose defendants to limitless liability or become transformed into merely private enforcement mechanisms. Id.; Wilson v. Comtech Telecommunications Corp., 648 F.2d 88, 92 (2d Cir.1981); List v. Fashion Park, Inc., 340 F.2d 457 (2d Cir.), cert. denied, 382 U.S. 811, 86 S.Ct. 23, 15 L.Ed.2d 60 (1965).
The courts have recognized, however, that in certain contexts requiring the plaintiff to prove actual reliance would effectively preclude recovery although causation in fact did exist. The Supreme Court in Affiliated Ute Citizens v. United States, 406 U.S. 128, 92 S.Ct. 1456, 31 L.Ed.2d 741 (1972), thus held that where the plaintiff's claim is primarily one of failure to disclose,
406 U.S. at 153-54, 92 S.Ct. at 1472 (citations omitted). In nondisclosure cases, therefore, a plaintiff may prove reliance through a rebuttable presumption that he relied on the undisclosed information, subject to the defendant proving that the plaintiff's decision would have been unaffected even if the omitted information had been disclosed. Rifkin v. Crow, 574 F.2d 256, 262-63 (5th Cir.1978).
Since Blackie, four other circuits have adopted the fraud on the market theory to varying degrees for rule 10b-5 actions. See T.J. Raney & Sons, Inc. v. Fort Cobb, Oklahoma Irrigation Fuel Authority, 717 F.2d 1330 (10th Cir.1983), cert. denied, 465 U.S. 1026, 104 S.Ct. 1285, 79 L.Ed.2d 687 (1984); Panzirer v. Wolf, 663 F.2d 365 (2d Cir.1981), vacated as moot sub nom. Price Waterhouse v. Panzirer, 459 U.S. 1027, 103 S.Ct. 434, 74 L.Ed.2d 594 (1982); Shores v. Sklar, 647 F.2d 462 (5th Cir.1981) (en banc), cert. denied, 459 U.S. 1102, 103 S.Ct. 722, 74 L.Ed.2d 949 (1983).
The fraud on the market theory also has received generally favorable treatment from the commentators. See Black, Fraud on the Market: A Criticism of Dispensing with Reliance Requirements in Certain Open Market Transactions, 62 N.C.L.Rev. 435 (1984); Rapp, Rule 10b-5 and "Fraud-On-the-Market" — Heavy Seas Meet Tranquil Shores, 39 Wash. & Lee L.Rev. 861 (1982); Note, Fraud on the Market: An Emerging Theory of Recovery Under SEC Rule 10b-5, 50 Geo.W.L.Rev. 627 (1982); Note, The Fraud-on-the-Market-Theory, 95 Harv.L.Rev. 1143 (1982). The theory has been viewed as most sound where it is used in the context of class actions to eliminate the necessity of each class member proving subjective reliance and where the securities were traded on a developed and open market, so that market prices reflect available information about the corporation.
II.
It is against this background of case law and commentary that we approach the former Fifth Circuit's en banc decision in Shores. In Shores, the plaintiff had bought industrial revenue bonds and alleged under rule 10b-5 that the defendant had fraudulently marketed the bonds by, among other acts, the issuance of a misleading Offering Circular. The plaintiff
The en banc court affirmed the dismissal of the plaintiff's "usual 10b-5" claim based on the Offering Circular's alleged misrepresentations and omissions, because the plaintiff had failed to show the essential element of reliance. 647 F.2d at 468. The closely divided court, however, held that the plaintiff had stated a viable claim in alleging a "broader theory [under which] it would have availed him nothing to have read the Offering Circular ... The securities laws allow an investor to rely on the integrity of the market to the extent that the securities it offers to him for purchase are entitled to be in the market place." Id. at 470-71.
In so holding, the majority distinguished between claims based on rule 10b-5(2) and those based on rule 10b-5(1) and (3).
Finally, the majority looked to the purpose of the reliance requirement for 10b-5 actions. Finding that reliance is a means of ensuring that causation exists between the defendant's acts and the plaintiff's harm, it reasoned that what constitutes a prima facie showing of causation varies with the factual context:
Despite the apparently broad reach of the Shores holding and its reliance on Blackie, the defendants contend that the majority adopted only a very narrow version of the fraud on the market theory, limiting its operation to the context where the securities would never have been placed on the market but for the fraud. In support of their position, the defendants note that the court stated at one point that "if [the plaintiff] proves no more than that the bonds would have been offered at a lower price or a higher rate, rather than that they would never have been issued or marketed, he cannot recover." Id. at 470. In another passage, the majority similarly observed that the plaintiff's "theory is not that he bought inferior bonds, but that the bonds he bought were fraudulently marketed. The securities laws allow an investor to rely on the integrity of the market to the extent that the securities it offers him for purchase are entitled to be in the market place." Id. at 471.
We believe that much of the confusion surrounding the Shores opinion
The Shores holding was thus necessarily confined to the limited setting of newly issued securities traded on an undeveloped market and did not determine whether the fraud on the market theory should apply to the open market context. It is that question which is now before this court.
III.
Although the Shores court did not decide the precise issue before us, we still find that to a large degree the decision dictates that this circuit recognize the fraud on the market theory as a basis for recovery where the defendant's deception inflates open market stock prices. To hold otherwise would result in this circuit adopting the theory in a setting where its applicability has been questioned, and rejecting its use where it best advances the goals of the federal securities laws.
As noted above, the fraud on the market theory finds its greatest justification when applied to class actions alleging fraudulent misrepresentations or omissions that affected security prices on a developed open market. In such a context, it is reasonable to assume that misinformation disseminated into the marketplace will affect the market price. It is also reasonable to
The Shores opinion has been criticized primarily because it extended fraud on the market to new issues in an undeveloped market. In such a setting, it is not necessarily reasonable to presume that misinformation will affect the market price, as information on an undeveloped market does not readily affect market prices and, in the case of new securities, the price will be set by the offeror and underwriters, not the market. See, Note, 95 Harv.L.Rev. at 1156-58; Black, 62 N.C.L.Rev. at 453. Moreover, the causal nexus between the misleading information and the plaintiff's decision to purchase is more direct when it affects a security's market price than when the misleading information goes merely to the legitimacy of the issuance of the securities themselves. See, Rapp, 39 Wash. & Lee L.Rev. at 886-87.
Without impugning the ultimate soundness of the decision in Shores, it strikes us as untenable to adopt the fraud on the market theory in a context where its application is most questionable, while precluding its application to transactions in a developed open market, as in this case, where its operation is most justifiable. Moreover, when viewed from this perspective, the language in Shores disallowing recovery by a plaintiff where his claim is simply that the price of newly issued securities was adversely affected by a deficient Offering Circular, 647 F.2d at 471, becomes understandable not as a rejection of the general fraud on the market theory, but as a limitation on the theory's application to the unique context of new issue offerings.
We also find support for our conclusion in the reasoning and language of the Shores opinion itself. First, the majority relied heavily on the Blackie decision and other fraud on the market cases, 647 F.2d at 469, 471 n. 11, without any indication that it would reject the full scope of their holdings when applied to the open market context. Second, the opinion specifically stated that a plaintiff need not show actual reliance on a misleading document where the allegation is "one of a scheme to inflate common stock prices by misleading statements,"
We thus read Shores as implicitly approving of the general fraud on the market theory, although limiting its application where new securities are involved to situations where but for the fraud the securities would not have been marketable. The bottom line of Shores is that a plaintiff cannot recover if his only claim is that documents on which he did not rely contained misrepresentations; he can recover, however, where the allegation is of fraud "on a broader scale"
Finally, we find independently of the reasoning in Shores that this circuit should recognize the fraud on the market theory when applied to class actions alleging that the defendant's deception inflated stock prices in the open market. We agree with the Ninth Circuit that:
Blackie, 524 F.2d at 906 (citations omitted).
Nor do we find, as the defendants argue, that the legislative history of the Securities Exchange Act of 1934 necessitates a different conclusion because Congress intended to make reliance on the misleading statements a prerequisite for recovery.
IV.
Having concluded that the former Fifth Circuit's decision in Shores v. Sklar implicitly approved of the general fraud on the market theory, and that the theory advances the purposes of the Securities Exchange Act of 1934, the district court's order denying the defendants' motion to dismiss the complaint is AFFIRMED.
FootNotes
Id. at 695.
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