Malack v. BDO Seidman, LLP

PRECEDENTIAL

UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT

No. 09-4475

JOHN A. MALACK;
MICHAEL R. ROSATI;
VIRGIL MAGNON;
S. S. RAJARAM, M.D.;
HAYWARD PEDIATRICS, INC.;
HENRY MUNSTER,

Appellants

v.

BDO SEIDMAN, LLP

On Appeal from the United States District Court
for the Eastern District of Pennsylvania
District Court No. 2-08-cv-00784
District Judge: The Honorable Thomas N. O’Neill, Jr.

Argued June 23, 2010

1
 Before: SMITH, FISHER, and GREENBERG, Circuit
Judges

(Filed: August 16, 2010)

Todd S. Collins (argued)
Elizabeth W. Fox
Neil F. Mara
Berger & Montague
1622 Locust Street
Philadelphia, PA 19103
Counsel for Appellants

Jacob A. Goldberg
Faruqi & Faruqi
101 Greenwood Avenue
Suite 600
Jenkintown, PA 19046
Counsel for Appellants

Kurt B. Olsen
Klaftner, Olsen & Lessner
1250 Connecticut Avenue, N.W.
Suite 200
Washington, DC 20035
Counsel for Appellants

Jill M. Czeschin
Matthew A. Goldberg
Timothy E. Hoeffner (argued)
DLA Piper

2
1650 Market Street
One Liberty Place, Suite 4900
Philadelphia, PA 19103
Counsel for Appellee

OPINION

SMITH, Circuit Judge.

This appeal arises from the denial of class certification
in a securities fraud class action. John Malack purchased notes
issued by American Business Financial Services, Inc.
(“American Business”), a subprime mortgage originator, and
those notes were later rendered worthless during the subprime
mortgage meltdown. He now seeks compensation from BDO
Seidman LLP (“BDO”), an accounting firm that assisted
American Business in allegedly defrauding him and other
investors by providing American Business clean audit opinions
that were used to register the notes with the Securities and
Exchange Commission (“SEC”). Malack filed a putative
securities fraud class action against BDO based on § 10(b) of
the Securities Exchange Act of 19341 and Rule 10b-5.2 The

1
That provision of the Securities Exchange Act of 1934
states:

It shall be unlawful for any person, directly or

3
 indirectly, by the use of any means or
instrumentality of interstate commerce or of the
mails, or of any facility of any national securities
exchange--
...
(b) To use or employ, in connection with the
purchase or sale of any security registered on a
national securities exchange or any security not
so registered, or any securities-based swap
agreement (as defined in section 206B of the
Gramm-Leach-Bliley Act), any manipulative or
deceptive device or contrivance in contravention
of such rules and regulations as the Commission
may prescribe as necessary or appropriate in the
public interest or for the protection of investors.

15 U.S.C. § 78j(b).
2
Rule 10b-5 states:

It shall be unlawful for any person, directly or
indirectly, by the use of any means or
instrumentality of interstate commerce, or of the
mails or of any facility of any national securities
exchange,

(a) To employ any device, scheme,
or artifice to defraud,

4
District Court denied class certification, holding that Malack
did not satisfy the predominance requirement of Rule 23(b)(3)3
because he did not establish a presumption of reliance under the
fraud-created-the-market theory.4 Malack now appeals the
denial of class certification.

This case turns on the application vel non of the fraud-

(b) To make any untrue statement
of a material fact or to omit to state
a material fact necessary in order to
make the statements made, in the
light of the circumstances under
which they were made, not
misleading, or

(c) To engage in any act, practice,
or course of business which
operates or would operate as a
fraud or deceit upon any person,
in connection with the purchase or
sale of any security.

17 C.F.R. § 240.10b-5.
3
All references to “Rule 23” refer to Rule 23 of the
Federal Rules of Civil Procedure.
4
Malack did not seek certification of a class based on
actual reliance.

5
created-the-market theory of reliance. Without the presumption
of reliance afforded by that theory, Malack cannot receive class
certification. The theory’s validity is an issue of first
impression for this Court, and other Courts of Appeals are split
over whether it should be recognized. We join the Seventh
Circuit in rejecting the theory and will affirm the District
Court’s denial of class certification.

I.

The District Court had jurisdiction under 15 U.S.C. §
78aa and 28 U.S.C. § 1331. This appeal reaches us under 28
U.S.C. § 1292(e) and Rule 23(f). A district court’s decision on
class certification is reviewed for an abuse of discretion. In re
Hydrogen Peroxide Antitrust Litig., 552 F.3d 305, 312 (3d Cir.
2008). An abuse of discretion occurs “if the district court’s
decision rests upon a clearly erroneous finding of fact, an errant
conclusion of law or an improper application of law to fact.”
Id. (internal quotation marks omitted). “[W]hether an incorrect
legal standard has been used is an issue of law to be reviewed
de novo.” Id. (internal quotation marks omitted).

II.

Malack and other investors directly purchased notes from
American Business between October 3, 2002, and January 20,
2005. The notes promised to pay interest well above the prime
rate without the involvement of underwriters or brokers, were

6
non-transferrable, could only be cashed in after they matured,
and had no market for resale. The notes were issued pursuant
to American Business’s 2002 and 2003 registration statements
and prospectuses filed with the SEC. BDO provided the audit
opinions necessary to complete the filings with the SEC.

On January 21, 2005, American Business filed a Chapter
11 petition for reorganization. On May 17, 2005, that
proceeding was converted to a Chapter 7 liquidation. Malack
and the other investors suffered substantial losses as a result.
On February 15, 2008, Malack filed a putative securities fraud
class action against BDO, alleging that its audits of American
Business were deficient. According to Malack, had BDO done
its job properly, it would not have issued American Business
clean audit opinions. Malack further alleges that without clean
audit opinions, American Business would not have been able to
register the notes with the SEC, the notes would not have been
marketable, and Malack and the other investors would not have
purchased the notes. Based on these allegations, Malack
asserted that BDO violated § 10(b) of the 1934 Act and Rule
10b-5.

Malack sought class certification. The District Court,
after a thorough analysis of the possible approaches through
which Malack might have obtained a presumption of reasonable
reliance based on the fraud-created-the-market theory, denied
his request, concluding that the proposed class did not satisfy

7
the predominance requirement of Rule 23.5 Malack timely
petitioned for permission to appeal under Rule 23(f). We
granted that petition and now must consider whether the District
Court erred in denying Malack class certification.

III.

Malack challenges the District Court’s predominance
determination.

5
The District Court’s opinion diligently marched
through the relevant facts and law, properly identifying the key,
relevant aspects of the class certification procedure as set forth
in In re Hydrogen Peroxide Antitrust Litigation. Malack v.
BDO Seidman, LLP, No. 08-0784, 2009 U.S. Dist. LEXIS
67785, at *7-9 (E.D. Pa. Aug. 3, 2009). In particular, the
District Court correctly stated that at class certification Malack
must “demonstrate that [each essential] element [of his claim]
. . . is capable of proof at trial through evidence that is common
to the class rather than individual to its members.” Id. at *11-12
(internal quotation marks omitted). After a discussion of the
elements of a Rule 10b-5 claim, including the element of
reasonable reliance, id. at *12-15, the District Court turned to
whether Malack could establish a presumption of reliance based
on the fraud-created-the-market theory, id. at *18-42. It
surveyed the various approaches to the theory, applied each
approach to Malack’s claim, and concluded that under no
approach could Malack receive a presumption of reliance. Id.

8
 Predominance “tests whether proposed classes are
sufficiently cohesive to warrant adjudication by
representation [. . . .]” “Issues common to the
class must predominate over individual issues . .
. .” Because the “nature of the evidence that will
suffice to resolve a question determines whether
the question is common or individual,” “‘a
district court must formulate some prediction as
to how specific issues will play out in order to
determine whether common or individual issues
predominate in a given case[.]’” “If proof of the
essential elements of the cause of action requires
individual treatment, then class certification is
unsuitable.”

In re Hydrogen Peroxide Antitrust Litig., 552 F.3d at 310-11
(internal citations omitted). “Accordingly, we examine the
elements of [Malack’s] claim ‘through the prism’ of Rule 23 to
determine whether the District Court properly [denied]
certifi[cation] [of] the class.” Id. at 311.

A § 10(b) private damages action has six elements:

(1) a material misrepresentation (or
omission);

(2) scienter, i.e., a wrongful state of
mind;

(3) a connection with the purchase

9
 or sale of a security;

(4) reliance, often referred to in
cases involving public securities
markets (fraud-on-the-market
cases) as “transaction causation”;

(5) economic loss; and

(6) “loss causation,” i.e., a causal
connection between the material
misrepresentation and the loss.

McCabe v. Ernst & Young, LLP, 494 F.3d 418, 424 (3d Cir.
2007) (quoting Dura Pharms., Inc. v. Broudo, 544 U.S. 336,
341-42 (2005)) (emphasis omitted). The District Court denied
class certification because Malack was unable to show that the
proposed class was entitled to a presumption of reasonable
reliance, AES Corp. v. Dow Chem. Co., 325 F.3d 174, 178 (3d
Cir. 2003) (explaining “reasonable reliance”). The reliance
element “requires a showing of a causal nexus between the
misrepresentation and the plaintiff’s injury, as well as a
demonstration that the plaintiff exercised the diligence that a
reasonable person under all of the circumstances would have
exercised to protect his own interests.” Id. Proving reliance for
individual class members can quickly become a cumbersome
endeavor that overwhelms the “questions of law or fact
common” to the proposed class, Fed. R. Civ. P. 23(b)(3), and
could preclude class certification, see id. It is likely that for this

10
reason, Malack sought to invoke a presumption of reliance.

A.

The Supreme Court has held that a presumption of
reliance exists in two circumstances. The first means for
establishing a presumption of reliance was set forth in Affiliated
Ute Citizens of Utah v. United States, 406 U.S. 128 (1972). In
that decision, the Supreme Court explained that “positive proof
of reliance is not a prerequisite to recovery” in cases “involving
primarily a failure to disclose” material facts by defendants
obligated to disclose such facts. Id. at 153. “All that is
necessary is that the facts withheld be material in the sense that
a reasonable investor might have considered them important in
. . . making . . . th[e] [investment] decision.” Id. at 153-54.

Second, in Basic Inc. v. Levinson, 485 U.S. 224 (1988),
the Supreme Court recognized the fraud-on-the-market theory
as a means for establishing a presumption of reasonable reliance
in an efficient market:

“The fraud on the market theory is based on 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 even if the purchasers

11
 do not directly rely on the misstatements. . . . The
causal connection between the defendants’ fraud
and the plaintiffs’ purchase of stock in such a
case is no less significant than in a case of direct
reliance on misrepresentations.”

Id. at 241-42 (quoting Peil v. Speiser, 806 F.2d 1154, 1160-61
(3d Cir. 1986)). “[I]n an efficient market[,] . . . misinformation
directly affects the stock prices at which the investor trades and
thus, through the inflated or deflated price, causes injury even
in the absence of direct reliance.” Newton v. Merrill Lynch,
Pierce, Fenner & Smith, Inc., 259 F.3d 154, 175 (3d Cir. 2001)
(internal quotation marks omitted). Therefore, “[r]eliance may
be presumed when a fraudulent misrepresentation or omission
impairs the value of a security traded in an efficient market.”
Id.

Some Courts of Appeals have held that a presumption of
reliance may be established through a third theory—the fraud-
created-the-market theory. Compare, e.g., Shores v. Sklar, 647
F.2d 462, 464 (5th Cir. 1981) (en banc) (setting forth the fraud-
created-the-market theory), with Eckstein v. Balcor Film
Investors, 8 F.3d 1121, 1130-31 (7th Cir. 1993) (rejecting the
theory). Malack seeks to rely on this theory to establish a
presumption of reliance for the proposed class.

12
 B.

The fraud-created-the-market theory posits that “[t]he
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.” Shores, 647
F.2d at 471. A presumption of reliance is established where a
plaintiff “prove[s] that the defendants conspired to bring to
market securities that were not entitled to be marketed.” Abell
v. Potomac Ins. Co., 858 F.2d 1104, 1121 (5th Cir. 1988)
(internal quotation marks omitted), vacated on other grounds
sub nom. Fryar v. Abell, 492 U.S. 914 (1989); 4 Thomas Lee
Hazen, Treatise on the Law of Securities Regulation §
12.10[6][C] (6th ed. 2010) (explaining that a fraud-created-the-
market claim involves “a fraudulent scheme depicting the
existence of a market which in fact would not exist upon full
and accurate disclosure”).

If [the plaintiff] proves no more than that the
[securities] 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. . . . Th[e] theory is not that [the
plaintiff] bought inferior [securities], but that the
[securities] he bought were fraudulently
marketed.

Shores, 647 F.2d at 470-71. To be unmarketable, the securities
must be “so lacking in basic requirements that [they] would

13
never have been approved by the [issuing entity] nor presented
by the underwriters had any one of the participants in the
scheme not acted with intent to defraud or in reckless disregard
of whether the other defendants were perpetrating a fraud.” Id.
at 468. To invoke the theory, a plaintiff must allege that (1)
“the existence of the security in the marketplace resulted from
the successful perpetration of a fraud on the investment
community” and (2) that she “purchased in reliance on the
market.” Id. at 464. Critical to the theory’s coherency is the
assumption that it is reasonable for an investor to rely “on [a]
[security’s] availability on the market as an indication of [its]
apparent genuineness[.]” Id. at 470.

“[Un]marketability, as envisioned by the Shores court, is
an elusive concept.” Ross v. Bank South, N.A., 885 F.2d 723,
735 (11th Cir. 1989) (en banc) (Tjoflat, J., concurring). Three
rough categories of unmarketability have emerged: legal,
economic, and factual. The lines distinguishing one from the
other are hazy. Legal unmarketability asks “if, absent fraud, a
regulatory agency or the issuing municipality would have been
required by law to prevent or forbid the issuance of the
security.” Ockerman v. May Zima & Co., 27 F.3d 1151, 1160
(6th Cir. 1994). Economic unmarketability asks if “no investor
would buy [the security] because, assuming full disclosure, [it]
is patently worthless.” Id. This approach focuses on
“hypothetical [securities] that could be issued at any
combination of price and interest rate.” Ross, 885 F.2d at 739
(Tjoflat, J., concurring). “[C]ould the [securities], because of

14
the enormous risk of nonpayment, have been brought onto the
market at any combination of price and interest rate if the true
risk of nonpayment had been known?” Id. at 736. Finally,
factual unmarketability looks to the actual securities issued, and
asks “whether, in the absence of fraud, the [securities] would
have been issued given the actual price and interest rate at
which they were issued.” Id. at 735 (emphasis omitted).
“Under this [approach], a [security] is unmarketable if, but for
the fraudulent scheme, some ‘regulatory’ entity (whether
official or unofficial) would not have allowed the [security] to
come onto the market at its actual price and interest rate.” Id.
at 736 (emphasis omitted).6

IV.

Malack asks us to embrace the legal unmarketability

6
Although we have yet to consider the fraud-created-
the-market theory, the district courts of this Circuit have applied
both the economic and factual unmarketability approaches.
Compare, e.g., Gruber v. Price Waterhouse, 776 F. Supp. 1044,
1052 (E.D. Pa. 1991) (endorsing economic unmarketability and
stating that the theory “only applies where the underlying
business is an absolute sham, worthless from the beginning”),
with Wiley v. Hughes Capital Corp., 746 F. Supp. 1264, 1293
(D.N.J. 1990) (applying factual unmarketability approach). We
confront the fraud-created-the-market theory head-on—rather
than assuming, without deciding, that it is valid—to provide
future guidance to the district courts.

15
approach to the fraud-created-the-market theory. No matter
what approach is taken, however, the theory lacks a basis in any
of the accepted grounds for creating a presumption.

“Presumptions typically serve to assist courts in
managing circumstances in which direct proof, for one reason
or another, is rendered difficult.” Basic Inc., 485 U.S. at 245
(citing D. Louisell & C. Mueller, Federal Evidence 541-42
(1977)). “[C]onsiderations of fairness, public policy, and
probability, as well as judicial economy,” often underlie the
creation of presumptions. Basic Inc., 485 U.S. at 245; United
States Dep’t of Justice v. Landano, 508 U.S. 165, 174 (1993);
Fed. R. Evid. 301 advisory committee’s note. Another relevant
concern in the creation of a presumption is whether it is
“consistent with . . . congressional policy[.]” Basic Inc., 485
U.S. at 245. “Common sense” also plays a role. Id. at 246.
Courts may also create presumptions “to correct an imbalance
resulting from one party’s superior access to the proof,”
Kenneth S. Broun, George E. Dix, Edward J. Imwinkelreid,
D.H. Kaye, Robert P. Mosteller & E.F. Roberts, McCormick on
Evidence § 343 (John W. Strong ed., 5th ed. 1999), where
“social and economic policy incline the courts to favor one
contention,” id., or “to avoid a[] [factual] impasse,” id.
“Generally, however, the most important consideration in the
creation of presumptions is probability. Most presumptions
have come into existence primarily because judges have
believed that proof of fact B renders the inference of the
existence of fact A so probable that it is sensible and timesaving

16
to assume the truth of fact A until the adversary disproves it.”
Id.

The fraud-created-the-market theory rests on the
conjecture that a “[security’s] availability on the market [i]s an
indication of [its] apparent genuineness[.]” Shores, 647 F.2d at
470. Malack points to “common sense and probability” as
support for this conjecture, but neither of these considerations
bolsters the idea that securities on the market, by the mere virtue
of their availability for purchase, are free from fraud. Other
considerations relevant to the creation of a presumption also
counsel for rejection of the fraud-created-the-market theory.

A.

“Common sense,” to the extent Malack invokes it as
support, calls for rejecting the proposition that a security’s
availability on the market is an indication of its genuineness and
is worthy of an investor’s reliance. For a security’s availability
on the market to be an indication of its genuineness there must
be some entity involved in the process of taking the security to
market that acts as a bulwark against fraud. Yet the entities
most commonly involved in bringing a security to market do not
imbue the security with any guarantee against fraud.

The security’s promoter and other entities involved in the
issuance, such as the underwriter, the auditor, and legal
counsel—the very entities often charged with fraud—cannot be

17
reasonably relied upon to prevent fraud. Ross, 885 F.2d at 739-
41 (Tjoflat, J., concurring).

All of the parties involved in an issuance have a
significant self-interest in marketing the securities
at a price greater than their true value. The
promoter/corporation and the issuer (if a separate
entity) have an obvious interest in marketing the
securities regardless of their true fair market
value. Likewise, the [legal] counsel and
underwriter, who are often retained under a
contingency fee contract, are interested in
marketing the securities at an inflated price. The
underwriter in particular, who, like an insurer,
can spread the risk of loss among many stock or
bond subscriptions, has a reduced incentive to
investigate thoroughly the true value of the
securities it underwrites.

Id. at 740. If we were to credit the fraud-created-the-market
theory based on the entities involved in the issuance “we [would
have to] believe that an initial investor may reasonably rely on
clearly self-interested (perhaps dishonest) parties to make
decisions that are at least burdensome and at most economically
irrational.” Id.7 Such a belief runs counter to common sense.

7
One could argue that an issuer and related entities
“benefit when [they] develop[] a reputation for disclosing
accurate information to investors” and therefore they would

18
 The SEC likewise cannot be reasonably relied upon to
prevent fraud because it does not conduct “merit regulation.”
Rather, it seeks to confirm that the issuer adequately disclosed
information pertaining to the security:

The SEC does not review the merits of the
registration statement and the offering. [I]n
reviewing 1933 Act registration statements, as is
the case with SEC review of filings generally, the
focus is on the adequacy and clarity of the
disclosure. Specifically, the SEC will consider
whether the applicable disclosure items are
explained in sufficient detail and with sufficient
clarity. In addition to the review of the adequacy
of the disclosures, the SEC will examine clarity

generally seek to disclose accurate information. Robert A.
Prentice, The Inevitability of a Strong SEC, 91 Cornell L. Rev.
775, 781 (2006). Yet recent economic history undermines this
argument. Id. Many entities now forgo the long term benefits
of accurate disclosures for the prospect of short term gain. Id.
at 782. Indeed, a significant amount of academic literature is
devoted to examining the factors influencing issuers and related
entities to, on the whole, act less honestly than we once believed
they did. See, e.g., Ronald J. Gilson & Reiner Kraakman, The
Mechanisms of Market Efficiency Twenty Years Later: The
Hindsight Bias, 28 Iowa J. Corp. L. 715 (2003); John C. Coffee,
Jr., What Caused Enron? A Capsule Social and Economic
History of the 1990s, 89 Cornell L. Rev. 269 (2004).

19
 and also will conduct a “plain English” review of
those portions of the registration statement that
are subject to the SEC’s plain English disclosure
requirements.

1 Thomas Lee Hazen, Treatise on the Law of Securities
Regulation § 3.7[2]. “The SEC does not read all of the publicly
available information about an offering and then determine the
legitimate price for the security . . . [n]or does [it] endorse any
of the documents involved in the issuance of securities.”
Joseph v. Wiles, 223 F.3d 1155, 1165-66 (10th Cir. 2000)
(internal citation omitted).8

Disclosure of adverse information may lower the price of
a security, but it will not prevent that security from going to
market:

The existence of a security does not depend on, or
warrant, the adequacy of disclosure. Many a

8
For example, the federal regulation pertaining to the
“[f]orepart of [a] [r]egistration [s]tatement and [the] [o]utside
[f]ront [c]over [p]age of [a] [p]rospectus” states that if a
commission legend is needed it must “indicate[] that neither the
[SEC] nor any state securities commission has approved or
disapproved of the securities or passed upon the accuracy or
adequacy of the disclosures in the prospectus and that any
contrary representation is a criminal offense.” 17 C.F.R. §
229.501(b)(7).

20
 security is on the market even though the issuer
or some third party made incomplete disclosures.
Federal securities law does not include “merit
regulation.” Full disclosure of adverse
information may lower the price, but it does not
exclude the security from the market. Securities
of bankrupt corporations trade freely; some
markets specialize in penny stocks. Thus the
linchpin of Shores—that disclosing bad
information keeps securities off the market,
entitling investors to rely on the presence of the
securities just as they would rely on statements in
a prospectus—is simply false.

Eckstein, 8 F.3d at 1130-31 (internal citations omitted); Note,
The Fraud-on-the-Market Theory, 95 Harv. L. Rev. 1143, 1158
(1982) (“[A]ny argument about an expectation fostered by SEC
regulation is severely undermined by the fact that the SEC does
not vouch for either the substantive value of any issue or the
veracity of the representations by any issuer.”). In short, the
“fil[ing] [of] a misleading document with [the SEC] does not
lend any more credibility or veracity to the document than if [it]
had simply [been] given . . . to investors.” Joseph, 223 F.3d at
1166.

Malack all but outright concedes that there is no common
sense justification for the proposition that a security’s presence
on the market is an indication of its genuineness upon which an
investor may reasonably rely. In his brief, he conceded that the

21
SEC does not conduct merit regulation. At oral argument, he
agreed that even if BDO had not committed the alleged fraud,
the notes still would have passed SEC review and would have
made it to market:

THE COURT: What if [BDO] had said in
all candor, well, the
company here, [American
Business], is using a
discount rate that may be
lower than what the market
among similar [interest-only
strips] that are being . . .
sold across this country
would indicate. And in fact,
they may be understating
their default rate in
comparison to similarly
situated issues. But having
said that, these are the facts
which a buyer should be
aware of. And this is,
indeed, a risky investment
which pays a high interest
rate.

* * *

THE COURT: The SEC would’ve said
accepted, go ahead and sell.

22
 [MALACK’S Certainly, if that disclosure
COUNSEL]: had been provided in the
prospectus in the
registration statement[.]

Oral Argument Tr. 9:7-9:24, June 23, 2010. If the American
Business notes would have gone to market with or without
BDO’s allegedly fraudulent audit, then there is no common
sense connection between BDO’s audit and Malack’s ability to
purchase the notes. Thus, there is no reason to view the notes’
presence on the market as being indicative of their genuineness.

B.

Malack’s vague invocation of probability also fails to
lend any support to the assertion that a security’s availability on
the market is an indication of its genuineness. Unlike the fraud-
on-the-market theory, which was supported by empirical studies
and economic theory, see Basic Inc., 485 U.S. at 246-47, the
fraud-created-the-market theory has the support of neither.9

9
Stripped of its fortuitously similar name—which may
have bolstered its credibility with some courts—the fraud-
created-the-market theory gains no support from the universally
accepted fraud-on-the-market theory. The latter is ultimately
grounded in the efficient market hypothesis, which, while
imperfect, has a basis in economics. See In re Burlington Coat
Factory Sec. Litig., 114 F.3d 1410, 1425 (3d Cir. 1997). The
same cannot be said for the former. The fraud-created-the-

23
Moreover, Malack does not articulate any reason why
probability supports his view. If his reliance on probability is
based on the idea that almost all marketed securities are, in fact,
legally marketable, and therefore we should presume that
anything offered on the market has not been stained by fraud,
then Malack is advocating for a kind of investor insurance that
eliminates the need for proving reliance in any securities fraud
case. Any investor who purchases any security could point to
the security’s availability on the market to satisfy the reasonable
reliance element of a § 10(b) claim. Such insurance “expand[s]

market theory has no underlying economic justification and any
attempt to ride the coattails of the fraud-on-the-market theory is
easily rejected. The fraud-created-the-market theory, according
to its proponents, may be invoked for any security—even when
the market is inefficient, such as in the case of newly issued
securities—because its chief prerequisite is that the security
have simply made it to market. See Ross, 885 F.2d at 739
(Tjoflat, J., concurring); Jonathan R. Macey & Geoffrey P.
Miller, Good Finance, Bad Economics: An Analysis of the
Fraud-on-the-Market Theory, 42 Stan. L. Rev. 1059, 1060 n.5
(describing the Shores decision as “[p]erhaps the most striking
example of the misapplication of [the efficient market
hypothesis]”). In its most expansive incarnation, the fraud-
created-the-market theory would render superfluous the fraud-
on-the market theory advanced in Basic Inc. and the
presumption of reliance set forth in Affiliated Ute because it
could be invoked in any instance where a security has made it
to market.

24
the SEC’s role beyond its intended or realistic scope.” Joseph,
223 F.3d at 1165.

The establishment of investor insurance is contrary to the
goals of securities laws. See Basic Inc., 485 U.S. at 252 (White,
J., concurring in part and dissenting in part); Fener v. Operating
Eng’rs Const. Indus. & Miscellaneous Pension Fund (Local
66), 579 F.3d 401, 411 (5th Cir. 2009); Robbins v. Koger
Props., 116 F.3d 1441, 1447 (11th Cir. 1997); Ockerman, 27
F.3d at 1162; Grigsby v. CMI Corp., 765 F.2d 1369, 1376 (9th
Cir. 1985); List v. Fashion Park, Inc., 340 F.2d 457, 463 (2d
Cir. 1965). “[T]he securities laws enacted by Congress in the
1930s were not intended to create a scheme of investors’
insurance or to regulate directly the underlying merits of various
investments. Compared to the consumer-oriented legislation of
the late 1960s and 1970s, the federal securities laws leave a
great many potential ‘harms’ (in the sense of economic losses
by individual investors) unremedied.” Shores, 647 F.2d at 482
(Randall, J., dissenting).

Because Malack has not articulated any justification for
his argument that probability supports the fraud-created-the-
market theory, and because the most obvious possible
justification is flawed, we are comfortable stating that the theory
is not supported by probability and decline to further speculate
on the issue.

C.

25
 Other considerations relevant to whether a presumption
should be created similarly point toward rejecting the fraud-
created-the-market theory. First, the theory does not serve the
securities laws’ goal of informing investors via disclosures. “In
Affiliated Ute, the Supreme Court described the 1934 Act and
its companion legislative enactments (including the Securities
Act of 1933) as embracing a ‘fundamental purpose to substitute
a philosophy of full disclosure for the philosophy of caveat
emptor and thus to achieve a high standard of business ethics in
the securities industry.’” Id. (quoting Affiliated Ute, 406 U.S.
at 151); Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 477-78
(1977) (noting that the Supreme Court has “repeatedly . . .
described the ‘fundamental purpose’ of the [Securities
Exchange] Act as implementing a ‘philosophy of full
disclosure’”); SEC v. Zandford, 535 U.S. 813, 819 (2002);
Gustafson v. Alloyd Co., Inc., 513 U.S. 561, 571 (1995) (“The
primary innovation of the 1933 Act was the creation of federal
duties -- for the most part, registration and disclosure
obligations -- in connection with public offerings.”).

“[T]he federal securities laws are intended to put
investors into a position from which they can help themselves
by relying upon disclosures that others are obligated to make.”
Shores, 647 F.2d at 483 (Randall, J., dissenting). The fraud-
created-the-market theory, contrary to this goal, allows
“monetary recovery [for] those who refuse to look out for
themselves.” Id. Investors need not examine a disclosure
because, no matter what, the security’s presence on the market

26
would be enough to satisfy the reasonable reliance element of
a § 10(b) claim. See id. Indeed, an investor stands to lose
nothing by blindly purchasing securities without examining any
disclosure because the damages award for a fraud-created-the-
market claim would be the same as the measure of damages for
a Rule 10b-5 claim based on actual reliance:

[T]he only workable measure of damages in a
Shores action would be the full price paid by the
plaintiff for the new issue. That being so, a
Shores award would simply be the plaintiff’s
out-of-pocket expenses caused by the fraud -- the
same measure of damages for a standard Rule
10b-5 recovery based upon actual reliance, see L.
Loss, Fundamentals of Securities Regulation 967
(2d ed. 1988) (out-of-pocket normally means
difference between price paid and value of
securities). Thus, under Shores, any incentive to
read disclosures essentially disappears since
plaintiffs would receive the full purchase price
for their securities without having to read
disclosure information.

Ross, 885 F.2d at 743 (Tjoflat, J., concurring). Moreover, “an
investor might rationally seek to avoid reading disclosures in
order to preserve a possible claim under Shores.” Id. at 744.
The less an investor knows about the security, aside from the
fact that it is on the market, the less likely it is that she will learn
of information that would sever the link between the alleged

27
fraud and her decision to purchase the security. Cf. Basic Inc.,
485 U.S. at 248 (explaining how fraud-on-the-market
presumption may be rebutted). Discouraging investors from
examining disclosures accompanying securities runs contrary to
Congress’s goal of empowering investors with the information
they need to make educated, prudent investment decisions.

Malack argues that the fraud-created-the-market theory
would serve Congress’s goals of promoting honesty and fair
dealings in the securities markets. Shores, 647 F.2d at 470; see
7 Alba Conte & Herbert Newberg, Newberg on Class Actions
§ 22:1 (4th ed. 2002) (“[T]he federal securities laws were
designed to deter future wrongdoing in the securities field and
promote the integrity of the securities market, and the class
action has been recognized as an effective means to realize
these goals.”). Promoting honesty and fair dealings is certainly
an important concern, but it is also an exceedingly abstract
concern. If we were guided mainly by the promotion of free
and honest securities markets, then we would seek to expand §
10(b) liability whenever possible to prevent fraud. But that has
not been the approach taken by the federal courts. The
securities laws are not a catchall for any fraudulent activity
committed in connection with a securities offering. For
example, the Supreme Court in Central Bank of Denver, N.A.
v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994),
held that “a private plaintiff may not maintain an aiding and
abetting suit under § 10(b).” Id. at 191. It did so over a dissent
that cited the Exchange Act’s goal of “creati[ng] and

28
maint[aining] . . . a post-issuance securities market that is free
from fraudulent practices.” Id. at 193 (Stevens, J., dissenting)
(internal quotation marks omitted).

More recently, in Stoneridge Investment Partners, LLC
v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008), the Supreme
Court cast further doubt on the legitimacy of expansively
presuming reliance to promote honesty and fair dealings. In
Stoneridge, the Supreme Court noted that, at least since Central
Bank, Congress has approved of narrowing the scope of § 10(b)
liability. As already explained, in Central Bank, the Supreme
Court held that Ҥ 10(b) liability did not extend to aiders and
abettors.” Stoneridge, 552 U.S. at 157. “Th[at] decision . . . led
to calls for Congress to create an express cause of action for
aiding and abetting within the Securities Exchange Act.” Id. at
158. But Congress declined to do so. Id. “Instead, in § 104 of
the Private Securities Litigation Reform Act of 1995 (PSLRA),
109 Stat. 757, [Congress] directed [that] prosecution of aiders
and abettors [be carried out] by the SEC.” Id. (citing 15 U.S.C.
§ 78t(e)). The PSLRA also instituted heightened pleading and
loss causation requirements for “any private action” arising
from the Securities Exchange Act. Stoneridge, 552 U.S. at 165-
66. Therefore, Congress’s actions after Central Bank were in
accord with the Supreme Court’s view that § 10(b) liability
should remain narrow and limited to its current contours. See
id. at 165 (“Congress . . . ratified the implied right of action
after the [Supreme] Court moved away from a broad
willingness to imply private rights of action.”); cf. Merrill

29
Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71, 80-
82 (2006) (explaining that Congress passed the Securities
Litigation Uniform Standards Act of 1998 to stem the shift of
securities litigation from federal to state courts sparked by the
PSLRA); 15 U.S.C. § 78bb(f)(1).

In addition, the Stoneridge Court explained that
“[c]oncerns with the judicial creation of a private cause of
action caution against” the expansion of the § 10(b) cause of
action. Stoneridge, 552 U.S. at 165. Extending the cause of
action “is for Congress, not for [the courts].” Id. The Supreme
Court, after describing the two accepted presumptions of
reliance set forth in Affiliated Ute and Basic Inc., id. at 159,
stated unequivocally that “the § 10(b) private right should not
be extended beyond its present boundaries,” id. at 165.
Although the Stoneridge Court was not specifically considering
the fraud-created-the-market theory, we view its instruction as
general support for rejecting such new presumptions of reliance.
See id. at 159; cf. Desai v. Deutsche Bank Sec. Ltd., 573 F.3d
931, 942 (9th Cir. 2009) (per curiam). Adoption of the fraud-
created-the-market theory would extend § 10(b) liability far
beyond its current contours.

Policy concerns also support rejection of the fraud-
created-the-market theory. Congress has made it clear that it is
hostile to frivolous § 10(b) litigation. E.g., 15 U.S.C. § 78u-
4(b)(2) (requiring particularity in securities fraud complaint
where “plaintiff may recover money damages only on proof that

30
the defendant acted with a particular state of mind”); id. § 78u-
4(c) (providing sanctions for abusive litigation). Yet the fraud-
created-the-market theory encourages exactly such litigation by
essentially eliminating the reliance requirement for a § 10(b)
claim. This has at least two negative impacts.

First, Rule 10b-5 litigation, by its very nature, is costly.
An increase in frivolous litigation drives up the overall costs of
issuing securities, ultimately harming everyone involved. In
Central Bank, the Supreme Court noted that Rule 10b-5
litigation presents a “danger of vexatiousness different in
degree and in kind from that which accompanies litigation in
general.” Central Bank, 511 U.S. at 189 (internal quotation
marks omitted). As support, the Court pointed to Senator
Sanford’s statement that “in 83% of 10b-5 cases major
accounting firms pay $ 8 in legal fees for every $ 1 paid in
claims.” Id. (citing 138 Cong. Rec. S12605 (Aug. 12, 1992)
(remarks of Sen. Sanford)). Secondary actors, like accounting
firms, must “expend large sums even for pretrial defense and
the negotiation of settlements.” Central Bank, 511 U.S. at 189.
These costs infect the function of the entire securities market,
harming professionals (lawyers, accountants, etc.), the
companies they serve, and investors:

[N]ewer and smaller companies may find it
difficult to obtain advice from professionals. A
professional may fear that a newer or smaller
company may not survive and that business

31
 failure would generate securities litigation against
the professional, among others. In addition, the
increased costs incurred by professionals because
of the litigation and settlement costs under 10b-5
may be passed on to their client companies, and
in turn incurred by the company’s investors, the
intended beneficiaries of the statute.

Id.

Second, the presumption of reliance is a powerful tool
for plaintiffs seeking class certification and class certification
puts pressure on defendants to settle claims, even if they are
frivolous. See In re Hydrogen Peroxide Antitrust Litig., 552
F.3d at 310 (noting that “class certification may force a
defendant to settle rather than incur the costs of defending a
class action and run the risk of potentially ruinous liability”)
(internal quotation marks omitted); Dabit, 547 U.S. at 80
(“Even weak cases brought under . . . Rule [10b-5] may have
substantial settlement value . . . because [t]he very pendency of
the lawsuit may frustrate or delay normal business activity.”)
(internal quotation marks omitted); In re Constar Int’l Inc. Sec.
Litig., 585 F.3d 774, 780 (3d Cir. 2009) (explaining that class
certification is an “especially serious decision”); Newton, 259
F.3d at 162 (recognizing “that denying or granting class
certification is often the defining moment in class actions . . .
[because] it may . . . create unwarranted pressure to settle
nonmeritorious claims on the part of defendants”). A frivolous

32
class action becomes much more troublesome when it is aided
by a presumption of reliance and defendants may seek to settle
early and often to avoid litigation costs and the risk of getting
hit with a large verdict at trial. Rewarding frivolous actions
with settlements is clearly undesirable.

V.

Assuming, hypothetically, that we were to endorse the
fraud-created-the-market theory, and that we followed Malack’s
approach to the theory, his appeal would still fail.10 Malack
urges us to follow the legal unmarketability test offered in T.J.
Raney & Sons, Inc. v. Fort Cobb, Oklahoma Irrigation Fuel
Authority, 717 F.2d 1330 (10th Cir. 1983). But even if we did
so, he would not be able to successfully invoke a presumption
of reasonable reliance. In T.J. Raney & Sons, the Tenth Circuit
held that “[f]ederal and state regulation of new securities at a
minimum should permit a purchaser to assume that the
securities were lawfully issued.” Id. at 1333. Importantly, it
added that its holding “does not imply in any way that the
regulatory body considers the worth of the security or the
veracity of the representations made in the offering circular nor
does it establish a scheme of investors’ insurance.” Id. (internal
quotation marks omitted). Instead, it extended the protection of

10
To be clear, our holding rejecting the fraud-created-
the-market theory in its entirety is in no way weakened by the
following discussion.

33
Rule 10b-5 to “cases in which the securities were not legally
qualified to be issued” and there was “a scheme to defraud or
act to defraud.” Id. Applying its legal unmarketability test to
the facts of the case, the Tenth Circuit observed that the entity
accused of fraud was found not to be a valid public trust during
Chapter IX proceedings and therefore its issuance of bonds was
prohibited by state law. Id. Based on this observation, the
Tenth Circuit held that the plaintiff “reasonably relied on the
availability of the bonds [for sale] as indicating their lawful
issuance[.]” Id.

The instant case does not meet the T.J. Raney & Sons test
for legal unmarketability. Critical to that Court’s reasoning was
the observation that the relevant bonds were issued in violation
of state law because the issuer was not a valid public trust. See
id. Because the issuer never had the legal right to issue the
bonds and the bonds were marketed with the intent to defraud,
the bonds were legally unmarketable. See id. There was no
similar legal impediment to American Business issuing notes.
Malack conceded at oral argument that had BDO properly
conducted the audit and disclosed the deficiencies he argues
were present in the allegedly fraudulent audit, the SEC still
would have permitted the notes to go to market. According to
the Tenth Circuit, “[t]here is a significant difference between
securities which should not be marketed because they involve
fraud, and securities which cannot be marketed because the
issuers lack legal authority to offer them.” Joseph, 223 F.3d at
1165 (emphasis added). Malack’s own arguments in this appeal

34
place American Business’s notes squarely into the former
category, and such securities do not satisfy the Tenth Circuit’s
fraud-created-the-market test, id.

VI.

The fraud-created-the-market theory lacks a basis in
common sense, probability, or any of the other reasons
commonly provided for the creation of a presumption. As such,
we decline to recognize a presumption of reliance based on the
theory and will affirm the District Court’s denial of class
certification.

35