Fraud on the market: short sellers' reliance on market price integrity.

AuthorSmith, Douglas A.

TABLE OF CONTENTS INTRODUCTION I. SECURITIES FRAUD, RELIANCE, AND THE FRAUD-ON-THE-MARKET PRESUMPTION II. SHOULD SHORT SELLERS BENEFIT FROM THE FRAUD-ON-THE-MARKET PRESUMPTION? A. Preventing the Fraud-on-the-Market Presumption from Arising: Short Sellers and the Theoretical Underpinnings of the Presumption's Predicate Facts B. Rebutting the Fraud-on-the-Market Presumption's Presumed Fact of Reliance 1. Deciding To Engage in a Securities Transaction at a Fraudulently Affected Price Versus Trading at a Fraudulently Affected Price a. Deciding To Engage in a Securities Transaction at a Fraudulently Affected Price b. Trading at a Fraudulently Affected Price 2. Resolving the "Deciding" Versus "Trading" Paradox III. MISAPPLYING THE FRAUD-ON-THE-MARKET PRESUMPTION TO SHORT SELLERS A. Courts Effectively Make the Fraud-on-the-Market Presumption's Presumed Fact of Reliance Unrebuttable B. Courts Incorrectly Assume that Short Sellers Do Not Rely on the Integrity of the Market Price Because Disclosure of the Fraud Would in Some Cases Achieve the Short Sellers' Investment Goals C. Courts Inappropriately Apply a Per Se Rule Against Short Sellers No Matter the Factual Situation Supporting the Claim IV. WHEN SHORT SELLERS SHOULD BENEFIT FROM THE FRAUD-ON-THE-MARKET PRESUMPTION OF RELIANCE A. The Factual Scenario in Which the Fraud Inflates or Deflates the Security's Price Before the Investing Transaction and Disclosure Occurs Before the Divesting Transaction B. The Factual Scenario in Which the Fraud Inflates or Deflates the Security's Price After the Investing Transaction and Disclosure Occurs After the Divesting Transaction C. The Factual Scenario in Which Both the Investing and Divesting Transactions Occur Between the Fraud's Perpetration and Disclosure D. The Factual Scenario in Which the Class Action Includes Only Purchasers or Sellers E. The Factual Scenario in Which a Short Seller Does Not Believe that a Security's Market Price Is Overvalued CONCLUSION INTRODUCTION

Investors constantly determine "whether a given [security] should be bought, sold, retained, or exchanged for some other." (1) In making these determinations, investors often seek to discern whether a security's market price overvalues or undervalues the security relative to the investor's personal opinion or analysis. (2) According to the logic of some courts, however, an investor's belief that a security is either overvalued or undervalued may either prevent the fraud-on-the-market (FOM) presumption of reliance from arising, or may rebut it. (3)

The FOM presumption often provides the sole vehicle by which plaintiffs in class actions can prove the reliance element in Rule 10b-5 securities fraud cases involving publicly traded securities. (4) Underlying the presumption is the assumption that security prices adjust to reflect fraudulent misrepresentations or omissions and that by relying on the integrity of the market price when undertaking buy or sell transactions, an investor indirectly relies on the fraudulent misrepresentation or omission incorporated into the security's price. (5) The FOM presumption thus renders unnecessary a plaintiffs need to prove actual reliance on either the defendant who had a duty to disclose or the defendant's misrepresentation, as was previously required in securities fraud cases. (6) Instead, a plaintiff merely has to prove reliance on the integrity of the market price. (7)

In regard to investors known as short sellers, (8) who generally believe that market prices for securities are overvalued, (9) a substantial split exists among federal district courts regarding whether a short seller's belief in overvaluation prevents the short seller from benefiting from the FOM presumption of reliance. (10) This issue largely arises in pretrial class certification decisions in which judges, pursuant to Federal Rule of Civil Procedure 23, determine whether a class representative presents claims or defenses typical of other class members (11) and whether a class action provides the best vehicle for the lawsuit in that questions of law or fact common to class members will predominate over questions affecting only individual members. (12) For example, courts have rendered an investor atypical of other class members and therefore unsuited to act as the class representative merely because the investor was a short seller. (13) Similarly, courts, after asserting that short sellers cannot benefit from the FOM presumption, have excluded short sellers from a proposed class because their inclusion would result in individual issues of reliance overwhelming questions common to the rest of the class. (14) In both of these examples, the courts' underlying rationale was that short sellers would have to prove actual reliance on either the defendant who had a duty to disclose or on the defendant's misrepresentation rather than benefiting, like other types of investors in the class, from the FOM presumption of reliance. (15)

Although the issue of whether short sellers can benefit from the FOM presumption largely arises in pretrial class certifications, these decisions are not reviewed at the trial or appellate level due to the high settlement and dismissal rates for securities fraud cases. (16) Indeed, only the Third Circuit has thus far considered whether short sellers can benefit from the FOM presumption. In Zlotnick v. TIE Communications, the Third Circuit held that short sellers cannot benefit from the FOM presumption, (17) but it did so shortly before the Supreme Court's decision in Basic v. Levinson, which officially adopted the FOM presumption of reliance in federal securities fraud cases. (18) By precluding short sellers from benefiting from the FOM presumption, the Third Circuit made proving reliance in Rule 10b-5 cases extremely difficult for short sellers, especially given today's highly impersonal securities markets, and severely weakened the possibility of short sellers succeeding at trial. The Third Circuit's reasoning, however, has been criticized, (19) and in 2004, even a district court within the circuit questioned whether the Third Circuit's reasoning comports with the Supreme Court's adoption of the FOM presumption in Basic. (20) This Note examines whether short sellers should be entitled to the FOM presumption and, if entitled, whether showing a short seller's belief in market price overvaluation is sufficient for a defendant to rebut the presumption. In doing so, this Note seeks to resolve the split among federal district courts and to discern whether Zlotnick was correctly decided.

Part I discusses securities fraud, the reliance requirement in Rule 10b-5 cases, and how the FOM presumption changed the reliance requirement. Part II discusses whether short sellers should benefit from the FOM presumption and argues that merely because an investor is a short seller this should not prevent the FOM presumption from arising. After discussing the ways in which a defendant can rebut the FOM presumption and how they apply to short sellers, this Part also argues that in some factual scenarios, a court could logically, but paradoxically, conclude that the FOM presumption is simultaneously rebutted and not rebutted. Arising from this paradox is a question yet to be directly addressed by any court: whether transaction causation is met in FOM cases if a plaintiff does not rely on the integrity of the market price when deciding to enter into a securities transaction, but does rely on the integrity of the market price when trading so as not to suffer a loss or reduction in profit. (21) Drawing on Federal Rule of Evidence 301, Part II will argue that when these competing conclusions about reliance arise, they should "burst" the FOM presumption and result in short sellers having to prove actual reliance. In that regard, this Note argues that Zlotnick's holding is not entirely wrong if interpreted as holding that a defendant may be able to rebut the FOM presumption by showing that the plaintiff was a short seller who believed the fraudulently affected security to be overvalued.

Part III examines FOM cases involving short sellers and argues that the divergent holdings in these cases exist because courts have (1) ignored the presumption's capability of being rebutted, (2) incorrectly assumed that short sellers do not rely on the integrity of the market price because disclosure of the fraud would in some cases achieve a short seller's investment goals, or (3) inappropriately applied a per se rule against short sellers without regard to the factual scenario that gave rise to the securities fraud claim. After arguing in Part III that courts have misapplied the FOM presumption to short sellers, this Note, in Part IV, will outline--in a matrix of factual scenarios that give rise to Rule 10b-5 securities fraud cases--when a short seller who believed a security to be overvalued, and conversely, when a long investor who believed a security to be undervalued, should benefit from the FOM presumption.

  1. SECURITIES FRAUD, RELIANCE, AND THE FRAUD-ON-THE-MARKET PRESUMPTION

    In response to the stock market abuses that precipitated the Great Depression, Congress adopted the Securities Exchange Act of 1934 to protect against stock price manipulation. (22) Promulgated pursuant to the 1934 Act, Rule 10b-5 makes it unlawful for a person in connection with the purchase or sale of any security to make any untrue statement of material fact or to omit a material fact necessary to make a statement not misleading. (23) To prevail in a Rule 10b-5 case, a plaintiff must meet the statutory and regulatory prerequisites as well as the traditional common law elements for fraud, including causation. (24) Causation under federal securities laws is a two-pronged requirement, as "[i]t is long settled that a securities-fraud plaintiff 'must prove both transaction and loss causation." (25) Transaction causation, which is tantamount to reliance, requires the plaintiff to prove that...

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