In a significant decision issued on December 5, 2006 (Miles v. Merrill Lynch & Co., No. 05-3349), the Second Circuit reversed class certification in a multi-billion-dollar securities fraud suit challenging conduct of the Nation's leading underwriters in hundreds of initial public offerings. The opinion, authored by Judge Newman and joined by Judges Hall and Sotomayor, rejects a weak class certification standard in favor of a rule requiring district courts to resolve all legal and factual disputes relevant to the Rule 23 requirements for class certification, even if they overlap with merits issues. The opinion also concludes that the plaintiffs cannot prove reliance or lack of knowledge on a class-wide basis, precluding the common-issue predominance necessary for a class action.
In the wake of the bursting of the stock market bubble in 2000, Milberg Weiss and other leading plaintiffs' counsel alleged that the nation's principal investment banks violated the securities laws by manipulating the stock prices of hundreds of companies for which they conducted initial public offerings (IPOs). Consolidated before Judge Shira Scheindlin in the Southern District of New York, these 310 suits alleged that underwriters inflated stock prices following IPOs by conditioning allocation of IPO shares on investor agreements to purchase additional shares in the open market at increasing prices ("laddering"), by requiring investors to pay excessive commissions on unrelated transactions in exchange for receiving IPO shares, and by having research analysts issue "buy" recommendations on the IPO stocks. In October 2004, the district court certified six "focus cases" as class actions, ruling that plaintiffs who purchased the stocks between the time of each IPO and December 6, 2000, had made "some showing" that each of the Rule 23 class certification requirements had been satisfied.
Reviewing the class certification decision pursuant to Fed. R. Civ. Proc. 23(f), the Second Circuit first addressed the "some showing" standard applied by Judge Scheindlin. Acknowledging considerable confusion concerning the controlling standard in its own prior decisions, the court of appeals clarified "that use of a 'some showing' standard was error." District judges, instead, must definitively determine that each Rule 23 requirement has been met after resolving any relevant factual disputes and weighing all of the relevant evidence. No longer may district judges in the Second Circuit defer factual disputes on matters (such as reliance, causation, and knowledge) that will determine whether a case can proceed on common evidence. Deciding such matters based entirely on a minimal showing by the plaintiff is also now forbidden; the district court must consider all of the evidence, including that introduced by defendants. The court of appeals further ruled that the "obligation to make such determinations is not lessened by overlap between a Rule 23 requirement and a merits issue, even a merits issue that is identical with a Rule 23 requirement." Adoption of this standard brings the Second Circuit-in which most securities fraud suits are filed-into line with the majority of federal courts of appeals and clarifies earlier Second Circuit decisions such as Caridad v. Metro-North Commuter R.R., 191 F.3d 283 (2d Cir. 1999) and In re Visa Check/Master Money Antitrust Litig., 280 F.3d 124 (2d Cir. 2001), which some district courts had understood to mandate lenient class certification standards to avoid inquiries that touched upon the merits.
After outlining the new class certification standard, the Second Circuit turned to the merits of the district court's certification of classes. Holding that the litigation was "bristling with individual questions," the court of appeals ruled that certification was improper because the plaintiffs could not meet the Rule 23 requirement that issues of common proof predominate over issues only provable on a class member-by-class member basis. The reliance and lack of knowledge elements of the plaintiffs' securities fraud claims, in particular, defied common proof. Class member reliance would have to be proved individually because it could not be presumed for all class members, as it is in many other securities fraud suits under the fraud-on-the-market theory of Basic Inc. v. Levinson, 485 U.S. 224 (1988). The court held that the Basic presumption did not apply because "the market for IPO shares is not efficient," and further doubted "whether the Basic presumption can be extended, beyond its original context, to tie-in trading, underwriting compensation, and analysts' reports." Common proof that class members traded in ignorance of the alleged manipulation was also impossible, the court ruled, because allegations of manipulation was widely disseminated before and during the class periods. By the plaintiffs' own admission, many thousands of investors participated in the allegedly manipulative practices, which plaintiffs asserted were the subject of an "industry-wide understanding" about the allocation of IPO shares. Other investors learned of the allegedly manipulative practices through press reports describing the practices. The court concluded that such widespread knowledge "would precipitate individual inquiries as to the knowledge of each member of the class."
Finally, the Second Circuit found "further support for our basic conclusion that individual questions will permeate this litigation" in the class definition. Judge Scheindlin had attempted to solve the problems of widespread knowledge by redefining the class to exclude certain presumably knowledgeable investors. One requirement for exclusion was payment of "undisclosed commissions." The plaintiffs, however, had defined "undisclosed commissions" to turn on the intent of the investor, making it impossible to determine class membership without conducting individual inquiries. The IPO court thus concluded that the certified class was not ascertainable.
In short, the Miles decision is a major turning point: it brings Second Circuit class certification law into line with the more restrictive precedents of other circuits and disapproves class certification in what is probably the largest securities fraud litigation ever filed. Steve Shapiro and Tim Bishop of Mayer Brown's Chicago office represented defendant Merrill Lynch in the case and had a principal role in devising the underwriters' arguments and preparing their briefs in both the district court and court of appeals.