Second Circuit Rejects Class Certification in IPO Securities Litigation, Imposing Strict New Standards on Plaintiffs Lawyers

December 8, 2006

On December 5, 2006, the Second Circuit Court of Appeals dealt a significant blow to the plaintiffs’ bar, issuing an opinion that answered the “surprisingly unsettled” question of what standards govern a district judge in deciding a motion for class certification under Rule 23 of the Federal Rules of Civil Procedure. The ruling makes it more difficult for plaintiffs to win class certification by requiring district courts to make “determinations” as to whether all of the Rule 23 requirements are met and have been established by the facts. 

The Court vacated a district court opinion granting class certification in six “focus” cases out of 310 consolidated class actions alleging violations of the securities laws in connection with initial public offerings. The decision, in In re Initial Public Offering Securities Litigation, brought the Second Circuit in line with other circuits in establishing that, before certifying a class, a district court must assess the evidence before it and make a determination that every requirement of Rule 23(b) of the Federal Rules of Civil Procedure has been met. 

Moreover, in concluding that this standard could not be met in the case before it, the Second Circuit made a significant finding with respect to the availability of the fraud-on-the-market presumption of reliance in cases involving IPO securities. The Court stated that “the market for IPO shares is not efficient,” strongly suggesting that IPO stock offerings are never entitled to a presumption of reliance for purposes of § 10(b) because that presumption cannot logically apply to an IPO, where there is no well-developed market for the security. 

Description of Case and Procedural History

The case before the Second Circuit was notable for its size and scope. In 2001, thousands of investors filed suit against 55 underwriters and 310 issuers alleging a scheme to defraud the investing public in violation of the federal securities laws. The cases were consolidated and transferred to Judge Shira Scheindlin of the Southern District of New York. The consolidated complaint alleged three basic fraudulent devices. First, plaintiffs alleged that the underwriters conditioned the allocation of IPO shares on agreements to purchase shares in the aftermarket (so-called “tie-in agreements”). Second, they alleged that the underwriters required customers who received IPO allocations to pay three forms of “undisclosed compensation” to the underwriters, including inflated brokerage commissions, commissions on churned transactions in unrelated securities, and the purchase of other unwanted securities from the underwriter. Third, they alleged that the underwriters used their research analysts improperly, including by tying analyst compensation to performance of the underwriter’s investment banking division and failing to disclose these conflicts of interest. 

In October 2004, Judge Scheindlin issued an order granting in part and denying in part plaintiffs’ motions for class certification in the six cases that had been selected by the parties as “focus” cases. In re IPO Secs. Litig., 227 F.R.D. 65 (S.D.N.Y. 2004). Judge Scheindlin expressly considered the standard of proof that must be met to obtain class certification. Citing the U.S. Supreme Court’s decisions in General Telephone Co. of the Southwest v. Falcon, 457 U.S. 147, 160-61 (1982), and Eisen v. Carlisle & Jacquelin, 417 U.S. 156, 177 (1974), Judge Scheindlin noted that a court must conduct a “rigorous analysis” in which it “may be necessary for the court to probe behind the pleadings,” but emphasized that the court cannot “conduct a preliminary inquiry into the merits of a suit.” Id., 227 F.R.D. at 90-91. Although other circuit courts, including the Fourth and Seventh Circuits, had issued decisions holding that the requirements of Rule 23 must be met by a preponderance of the evidence, even if resolving those issues requires a “preliminary inquiry into the merits,” Szabo v. Bridgeport Machines, Inc., 249 F.3d 672, 676 (7th Cir. 2001), or an “overlap with issues on the merits,” Gariety v. Grant Thorton, LLP, 368 F.3d 356, 366 (4th Cir. 2004), Judge Scheindlin disagreed. She concluded that applying the preponderance standard is not appropriate where those elements are “enmeshed” with the merits. Instead, Judge Scheindlin found that plaintiffs need only make “some showing” that they had satisfied the requirements of Rule 23. Judge Scheindlin also concluded that weighing competing expert reports was inappropriate and that plaintiffs had satisfied their burden by offering a theory of loss causation that was not “fatally flawed.” 227 F.R.D. at 114-15. Applying the “some showing” standard, Judge Scheindlin found that plaintiffs had sufficiently met the Rule 23 requirements. 

The Second Circuit’s Opinion

In October 2005, the underwriters appealed Judge Scheindlin’s decision to the Second Circuit. The Court first considered whether Judge Scheindlin had applied the appropriate legal standard in concluding that the four prerequisites for class certification had been met. While acknowledging that its prior decisions had been “less than clear as to the applicable standards for class certification,” the Court concluded that Judge Scheindlin’s use of a “some showing” standard was erroneous. In re IPO Secs. Litig., 2006 WL 3499937, *7 (2d Cir. Dec. 5, 2006). Examining Supreme Court and other precedent, the Court explained that statements in those opinions had been taken out of context, and clarified that there was “no basis” for concluding “that a specific Rule 23 requirement need not be fully established just because it concerns, or even overlaps with, an aspect of the merits.” Id., 2006 WL 3499937, at *8. In particular, the Court explained that the Supreme Court’s decision in Eisen, properly understood, precludes consideration of the merits only when a merits issue is unrelated to a Rule 23 requirement. After examining the Second Circuit cases upon which Judge Scheindlin had relied, decisions from other circuits, and the 2003 amendments to Rule 23, the Court concluded that clarification of the standard applicable in the Second Circuit was required. 

The Court reached the following conclusions: (1) a district court may certify a class only after making “determinations” that all of the Rule 23 requirements are met; (2) in making such determinations, the judge must resolve factual disputes relevant to each Rule 23 requirement and determine that each requirement has been established by the facts; (3) the district court must make such determinations even if there is an overlap between a Rule 23 requirement and a merits issue, even a merits issue identical to a Rule 23 requirement; (4) a district court, in making such determinations, must not assess any aspect of the merits unrelated to a Rule 23 requirement; and (5) a district judge has ample discretion to circumscribe the extent of discovery concerning Rule 23 requirements and the extent of a hearing to determine whether they have been met in order to assure that a class certification motion does not become a pretext for a partial trial on the merits. Id., 2006 WL 3499937, at *15. The Court expressly disavowed any suggestion in its prior decisions that a “some showing” standard would suffice and that an expert’s testimony may establish a component of a Rule 23 requirement simply by being not “fatally flawed.” Id. The Court noted that “we thus align ourselves with Szabo, Gariety, and all of the other decisions . . . that have required definitive assessment of Rule 23 requirements, notwithstanding their overlap with merits issues. As Gariety usefully pointed out, the determination as to a Rule 23 requirement is made only for purposes of class certification and is not binding on the trier of facts, even if that trier is the class certification judge.” Id.

After articulating the appropriate standard for evaluating class certification, the Court found that the consolidated cases before it could not be certified as class actions, because the plaintiffs’ own evidence demonstrated that the prerequisite of a predominance of common questions over individual ones could not be met with respect to either reliance or knowledge. The Court rejected plaintiffs’ invocation of the fraud-on-the-market presumption of reliance, concluding that the presumption was inapplicable because the market for IPO shares is not efficient and because the plaintiffs’ own allegations as to how slowly the market corrected the alleged price inflation indicated “the antithesis of an efficient market.” Id., 2006 WL 3499937, at *17. As an example of why the presumption cannot apply in the IPO context, the Court pointed to the fact that during the 25-day “quiet period,” analysts cannot report concerning IPO securities, thereby precluding the numerous, contemporaneous analyst reports that are a characteristic of an efficient market. Without the benefit of that presumption in this case, individual questions of reliance would predominate. As to knowledge, the Court concluded that plaintiffs’ claim that common issues of a lack of knowledge of the scheme would predominate was undermined by their own allegations as to the widespread nature of the scheme. 

Accordingly, the Court vacated Judge Scheindlin’s order granting class certification and remanded for further proceedings.   

Gibson, Dunn & Crutcher’s Securities Litigation Practice Group is available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn attorney with whom you work or or:

Jonathan C. Dickey (650-849-5324, [email protected]),
Robert F. Serio (212-351-3917, [email protected]), or
Wayne W. Smith (949-451-4108, [email protected]).

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.