West v. Prudential Securities, Inc.
282 F.3d 935 (2002)
Rule of Law:
The fraud-on-the-market doctrine, which presumes investor reliance on the integrity of the market price for purposes of a securities fraud class action, does not apply to non-public misrepresentations made to a small number of individuals.
Facts:
- James Hofman, a stockbroker for Prudential Securities, told 11 of his customers that Jefferson Savings Bancorp was 'certain' to be acquired at a premium in the near future.
- Hofman continued making these false statements to his clients over a seven-month period.
- The information regarding the supposed acquisition was never made public through press releases, news reports, or other channels of general circulation.
- The clients who received the information from Hofman believed they were acting on non-public, confidential information.
- During the period Hofman was spreading the rumor, the price of Jefferson Savings stock increased by approximately 20%.
Procedural Posture:
- Investors who purchased Jefferson Savings Bancorp stock filed a securities fraud class action lawsuit against Prudential Securities in federal district court.
- The plaintiffs moved for class certification on behalf of all persons who bought the stock during the period of Hofman's alleged misrepresentations.
- The district court certified the class, invoking the fraud-on-the-market doctrine to presume reliance for all class members.
- Prudential Securities petitioned the U.S. Court of Appeals for the Seventh Circuit for permission to file an interlocutory appeal of the class certification order, which the appellate court granted.
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Issue:
Does the fraud-on-the-market doctrine, which presumes reliance for class action purposes, extend to non-public misrepresentations made to a small group of investors?
Opinions:
Majority - Easterbrook
No. The fraud-on-the-market doctrine does not extend to non-public misrepresentations because there is no reliable causal mechanism through which such private statements can be shown to affect the price of a security in an efficient market. The doctrine, as established in Basic, Inc. v. Levinson, is premised on the theory that public information is swiftly incorporated into a stock's price by professional investors. In contrast, non-public statements made to a few individuals do not trigger this price-adjustment mechanism. The court rejected the plaintiffs' expert's theory that increased demand from a few buyers could alone inflate a stock's price, holding that in an efficient market, it is information, not abstract demand, that determines prices. The plaintiffs failed to establish a causal link between Hofman's private statements and the increase in Jefferson's stock price, and did not exclude other potential causes for the price movement.
Analysis:
This decision significantly limits the scope of the fraud-on-the-market doctrine, confining its application to misrepresentations that are publicly disseminated. By refusing to extend the doctrine to private statements, the court reinforces the importance of a clear causal mechanism linking the fraudulent statement to a distortion in the public market price. This ruling makes it substantially more difficult to certify securities fraud class actions based on rumors or non-public tips, as individual questions of reliance would predominate over common ones. It solidifies the distinction between public information, which is presumed to affect the market, and private information, which is not.
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