‘Fraud-Created-The-Market’ Theory Rejected By Third Circuit In Subprime Mortgage Case

The U.S. Court of Appeals for the Third Circuit has issued an important decision in a case of first impression arising from the denial of class certification in a securities fraud class action. The case arose when John Malack purchased notes issued by American Business Financial Services, Inc., a subprime mortgage originator, and those notes were later rendered worthless during the subprime mortgage meltdown. Malack sought compensation from BDO Seidman LLP, 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. 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. The district court denied class certification, holding that Malack did not satisfy the predominance requirement of Rule 23(b)(3) because he did not establish a presumption of reliance under the fraud-created-the-market theory. That 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.” 

Malack appealed the denial of class certification and the Third Circuit explained that the case turned on the application of the fraud-created-the-market theory of reliance. Without the presumption of reliance afforded by that theory, Malack could not receive class certification. The Third Circuit acknowledged that the courts of appeals are split over whether it should be recognized, and it joined the Seventh Circuit in rejecting the theory. According to the Third Circuit, 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, it declined to recognize a presumption of reliance based on the theory, and it affirmed the district court’s denial of class certification. 
 
The case is Malack v. BDO Seidman, LLP, No. 09-4475 (3rd Cir. Aug 16, 2010). Attorneys involved in the case include: Todd S. Collins, Elizabeth W. Fox, and Neil F. Mara, Berger & Montague; Jacob A. Goldberg, Faruqi & Faruqi; Kurt B. Olsen, Klaftner, Olsen & Lessner; and Jill M. Czeschin, Matthew A. Goldberg, and Timothy E. Hoeffner, DLA Piper.