Cammer v. Bloom
1989 WL 39761, 1989 U.S. Dist. LEXIS 4160, 711 F. Supp. 1264 (1989)
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Rule of Law:
The 'fraud on the market' theory, which provides a rebuttable presumption of reliance in securities fraud cases, can apply to stocks traded in the over-the-counter market if the market for that specific security is shown to be efficient and well-developed, with neither national exchange listing nor S-3 eligibility serving as dispositive bright-line tests. Furthermore, a defendant's status as a director and officer of a small company, coupled with legal counsel duties and significant stock holdings, is sufficient to plead 'controlling person' liability under Section 20(a) of the Exchange Act. However, state common law claims for fraud and negligent misrepresentation consistently require a showing of direct reliance by the plaintiff.
Facts:
- Coated Sales, Inc. (Company), incorporated in New Jersey in 1974, developed and sold specially treated fabrics.
- Coated Sales became a public company in 1984, with its common stock trading in the over-the-counter market and listed on NASDAQ.
- During the class period (May 6, 1987, to June 14, 1988), Coated Sales engaged in fictitious "bill and hold" transactions, creating phony invoices marked "Bill and Hold, Do Not Call," to materially overstate revenue in fiscal years 1987 and 1988.
- Company officers also perpetrated a $6,000,000 phony equipment acquisition in Fall 1987, capitalizing the amount as a deposit on machinery.
- Peat Marwick Main & Co. (PMM), Coated Sales' independent public auditor, issued an unqualified opinion on the fraudulent 1987 financial statements.
- On May 6, 1988, PMM discovered the $6,000,000 deposit for machinery was a sham transaction and reported this to Coated Sales' Board of Directors at its May 20, 1988 meeting.
- On May 28, 1988, Coated Sales announced PMM's resignation as auditors due to dissatisfaction with management representations regarding the $6,000,000 payment.
- On May 31, 1988, Coated Sales publicly conceded that the $6,000,000 deposit never took place, that net assets were overstated, and that material irregularities in accounts receivable were discovered, leading to the termination of many individual defendants from senior management positions.
- Following the May 31, 1988 announcement, the market price of Coated Sales common stock dropped 2.5 points per share.
- Coated Sales filed for Chapter 11 bankruptcy on June 16, 1988.
- Philip I. Kagan served as an outside director, assistant secretary, and attorney for Coated Sales, with his law firm receiving significant fees, and sold 2,000 shares of Coated Sales stock on June 29, 1987, and an additional 10,000 shares between April 13-18, 1988.
Procedural Posture:
- Holders of Coated Sales common stock brought an action against Coated Sales, individual officers/directors (Bruce M. Bloom, Richard Bober, Ernest Glantz, Michael S. Weinstein, Dennis Lustig, Philip I. Kagan), and its former independent auditors, Peat Marwick Main & Co. (PMM).
- Seventeen individual actions filed in this court and one action in the Eastern District of New York were consolidated by court order on July 20, 1988.
- Plaintiffs filed a Consolidated Amended Class Action Complaint (Amended Complaint) alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 (Count I), common law fraud and deceit under New Jersey law (Count II), and negligent misrepresentation under New Jersey law (Count III).
- PMM filed a motion to dismiss Count I pursuant to Fed.R.Civ.P. 12(b)(6) (for failure to allege necessary elements of securities fraud claims) and 9(b) (for failure to allege fraud with particularity). PMM also moved to dismiss Counts II and III pursuant to Fed.R.Civ.P. 9(b), 12(b)(1) (lack of subject matter jurisdiction), and 12(b)(6).
- Kagan filed a motion to dismiss Counts I, II, and III pursuant to Fed.R.Civ.P. 12(b) (for failure to allege facts giving rise to controlling person’s liability) and 9(b) (for failure to allege specific fraud).
- Plaintiffs requested and were granted leave to further amend the Amended Complaint.
- The court converted PMM's motion to dismiss into a motion for summary judgment under Fed.R.Civ.P. 56 due to the consideration of matters submitted outside the pleadings, specifically the Poser Affidavit.
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Issue:
1. Is the fraud on the market theory applicable to substitute direct reliance for stocks traded in the over-the-counter market, and what specific factual allegations are sufficient to establish an efficient market for such stock? 2. Under Section 20(a) of the Securities Exchange Act, does alleging a defendant is a corporate director, assistant secretary, and legal counsel for a small company suffice to plead "controlling person" status, or must a plaintiff allege actual control over daily operations? 3. Do common law claims for fraud and negligent misrepresentation under New Jersey law permit the "fraud on the market" presumption of reliance or require direct reliance, and what class of plaintiffs can assert such claims against auditors?
Opinions:
Majority - Lechner, District Judge
1. Yes, the 'fraud on the market' theory can apply to substitute for direct reliance for stocks traded in the over-the-counter market, provided the specific security trades in an efficient and well-developed market, and neither listing on a national exchange nor S-3 eligibility are dispositive bright-line tests. The court denied Peat Marwick Main & Co.'s (PMM) motion for summary judgment on the Rule 10b-5 claims. The court emphasized that the determination of market efficiency is a factual inquiry focused on the trading characteristics of the individual stock itself, rather than presuming inefficiency based solely on its trading venue (e.g., over-the-counter market) or SEC registration eligibility (e.g., Form S-3 status). The court rejected PMM's argument for bright-line tests, stating it would be illogical to apply a presumption of reliance without considering the specific stock's trading characteristics. Given the plaintiffs' submission of the Poser Affidavit, which detailed factors such as significant trading volume, numerous market makers, and analyst coverage for Coated Sales stock, the court found that genuine issues of material fact regarding market efficiency existed, making summary judgment inappropriate. The court also clarified that the decision to apply a rebuttable presumption of reliance is a determination for the trial judge, not a jury, and that an evidentiary hearing on market efficiency was not necessary at this stage due to the substantial factual showing by plaintiffs. 2. Yes, alleging Kagan was a director, assistant secretary, and legal counsel for Coated Sales, a small company where he also held significant stock and whose law firm received substantial fees, is sufficient to plead 'controlling person' status under Section 20(a) of the Securities Exchange Act, allowing the claim to survive a motion to dismiss. The court denied Kagan's motion to dismiss the Section 20(a) claim. The Third Circuit jurisprudence gives "heavy consideration to the power or potential power to influence and control the activities of a person, as opposed to the actual exercise thereof" (citing Rochez Brothers, Inc. v. Rhoades). While Rochez involved a CEO/owner, later cases like Gould v. American-Hawaiian S.S. Co. indicated that influence "short of actual direction" could be sufficient. For pleading purposes, given Coated Sales' size and Kagan's multiple influential roles, it can be presumed he had "at least some global responsibilities for, and interest in, corporate affairs," thereby meeting the liberal pleading requirements for Section 20(a). Kagan would still have the opportunity to assert a good faith statutory defense. 3. No, common law claims for fraud and negligent misrepresentation under New Jersey law do not permit the "fraud on the market" presumption of reliance, instead requiring direct reliance by individual plaintiffs. The court dismissed common law fraud and deceit claims against PMM for plaintiffs who could not allege direct reliance, and dismissed negligent misrepresentation claims against PMM for plaintiffs who could not prove they received the PMM report directly "from the Company" for a specific business decision and individually relied upon it. Citing Peil v. Speiser, the court affirmed that "direct reliance remains a requirement of a common law securities fraud claim." For negligent misrepresentation, the court referred to Rosenblum v. Adler, which narrowly defined the class of foreseeable users, requiring them to have obtained audited statements directly from the company "for a proper business purpose to influence a business decision." The court found that "business decision" implies something more than a general investment decision, thereby precluding the general investing public. The court further dismissed the aiding and abetting claim against PMM for lack of specific allegations of knowing and substantial participation in the fraud, and dismissed common law fraud and negligence claims against Kagan for lack of particularity regarding his knowing or reckless participation or breach of duty.
Analysis:
This case is significant for clarifying the scope and application of the "fraud on the market" theory in federal securities litigation, particularly its extension to over-the-counter markets based on a multi-factor analysis of market efficiency rather than rigid listing requirements. The established test provides crucial guidance for plaintiffs seeking to leverage the presumption of reliance, shifting the burden onto defendants to rebut market efficiency. Additionally, the decision reinforces a broad interpretation of "controlling person" liability under Section 20(a), lowering the pleading bar for plaintiffs by emphasizing potential influence over actual day-to-day control, which is vital in cases involving officers and directors in smaller entities. Conversely, the strict adherence to direct reliance for state common law fraud and negligent misrepresentation claims underscores the fundamental distinctions between federal and state remedies in securities matters, forcing plaintiffs to demonstrate a more direct causal link for state claims.
