The opinion of the court was delivered by: WALKER
The complaints in these consolidated securities fraud cases allege that due to improper conduct by the defendants, the price of Seagate common stock was fraudulently inflated for a period of several months. During this time, defendants allegedly made several partially curative disclosures. These partial disclosures caused the trading price of the stock to decline gradually, instead of dropping suddenly as is usually the case when a one-time full disclosure of fraud is released. As a result, some of those purchasing stock during this period also sold some or all of their shares at prices reflecting these partial disclosures.
As will be developed here, these purchasers have very different stakes in shaping the pertinent evidence from those purchasers who held their stock until after the fraud had been fully revealed. These divergent interests, which stem primarily from the measure of damages currently in use in fraud-on-the-market cases, may be so pervasive that the interests of the class members are not sufficiently aligned to satisfy the prerequisites of FRCP 23 and fundamental due process requirements. Accordingly, this litigation may be precluded from proceeding as a class action.
Apart from these concerns, defendants have established that this litigation can proceed only as to plaintiffs' allegations that defendants failed to disclose material information they were under a duty to disclose; any claims based on alleged affirmative misstatements by defendants cannot succeed.
During 1988, Seagate Technology, Inc. ("Seagate"), the issuer of a single class of NASDAQ-quoted common stock, encountered adverse conditions in its principal line of business, the manufacture of 5-1/4 inch rigid disk drives for personal computers. Instead of fully disclosing "the truth concerning its financial condition and business prospects," Second Consol Amended Compl P 53 at 30, plaintiffs allege that, starting with a press release on July 18, 1988, Seagate made a series of "grudging admissions of certain adverse facts -- no one of which was fully curative." Pls Submission re Ending Date of Class Period, June 3, 1991, at 2. Plaintiffs claim that the dissemination of these half-truths continued until October 5, 1988, when Seagate issued a press release announcing a loss for the quarter ended September 30 and the resignation of two sales executives. Second Consol Amended Compl at 33. With each disclosure, the trading price of Seagate common stock ratcheted down, dropping from $ 22 per share on April 13, 1988, to about $ 7 per share following Seagate's October 5 press release. See In re Seagate Technology II Securities Litigation, 802 F. Supp. 271, 272-74 (ND Cal 1992).
This litigation followed. Plaintiffs contend that defendants' fraudulent nondisclosures and their "grudging" partial disclosures distorted, to varying degrees, the price of Seagate common over the period from April 13, 1988, to October 5, 1988.
Certification for this period is provisional and subclasses shall be certified for the period 1) April 13, 1988 to July 19, 1988; 2) July 20, 1988 to August 7, 1988; 3) August 8, 1988 to September 24, 1988; 4) September 25, 1988 to October 7, 1988.
Although the litigation has thus far proceeded pursuant to that order, the parties now disagree on the effect of the order for purposes of completing pretrial preparation and trial.
The prior judge's decision provisionally to certify subclasses, rather than a single class, indicates serious misgivings about the suitability of this case for class treatment. In fact, as will be explained, any securities fraud case involving the slow leakage of partially curative disclosures into an active securities market creates the potential for troubling antagonisms among those purchasing the security during the relevant period. Evidently, the prior judge hoped that these conflicts could be avoided by the use of subclasses. Upon further analysis, as explained below, the court concludes that the subclassing contemplated by the prior judge is wholly inadequate to the task of resolving this problem. Instead, detailed factual analysis is necessary to determine the extent and severity of the conflicting interests, so that the court can evaluate whether due process requirements and the prerequisites of FRCP 23 are satisfied. For this purpose, the court concludes that an evidentiary hearing is warranted.
In addition to the class certification dispute, the court has before it defendants' motion for summary judgment. Defendants base their motion on three arguments. First, defendants mount a so-called "truth on the market" defense, arguing that Seagate's stock price was not distorted by any misstatements or omissions of defendants. In support of this contention, defendants offer a statistical analysis of the trading price of Seagate common throughout the class period. Second, defendants suggest that they had no affirmative duty to disclose adverse financial information to the public any sooner than they actually did so. Third, defendants claim that they are entitled to summary judgment on the issue of scienter. In response, plaintiffs have brought a cross-motion for partial summary judgment, contending that Seagate's stock price was biased by defendants' misstatements/omissions as a matter of law.
Before discussing the conclusions the court has reached on these various issues, it is imperative to set in perspective the FRCP 23 prerequisites to class certification, the elements of a Rule 10b-5 claim, and the measure of damages currently used in securities fraud cases; this follows presently. Part II then reviews the impact of the fraud-on-the-market theory on the substantive law of Rule 10b-5. As will be shown, this theory dramatically amplified the importance of certain types of class conflicts, rendering them serious obstacles, under the requirements of FRCP 23, to class certification. Part III details two such disturbing conflicts, the "seller-purchaser" conflict and the "equity" conflict, both of which are present in the case before the court. Part IV demonstrates that these conflicts may be particularly troublesome in cases, such as the instant one, involving partial curative disclosures. Finally, Part V addresses the summary judgment motion of defendants, and the partial summary judgment motion brought by plaintiffs.
The prerequisites to class certification are by this time well known. To qualify for class treatment, an action must first meet the requirements of FRCP 23(a):
In addition to satisfying the prerequisites of FRCP 23(a), the action must also meet one of the three sub-parts of FRCP 23(b). Securities fraud cases in which damages are sought, however, are almost exclusively certified under FRCP 23(b)(3). See Herbert Newberg and Alba Conte, 4 Newberg on Class Actions § 22.44 (McGraw-Hill, 3d ed 1992) (hereinafter, "Newberg"). This so-called "(b)(3)" class action requires the court to find:
That the questions of law or fact common to the members of the class predominate over any questions affecting only individual members, and that a class action is superior to other available methods for the fair and efficient adjudication of the controversy.
Therefore, in order to certify a class action under FRCP 23(b)(3), six elements must be established: numerosity, commonality, typicality, adequacy of representation, predominance, and superiority. Of these six, the numerosity, commonality and predominance prerequisites are relatively straightforward and require little discussion; the remaining three, however, require some explanation. Typicality exists where:
the [named] plaintiff's claims * * * arise from the same event or practice or course of conduct that gives rise to the claims of the other class members, and his or her claims [are] based on the same legal theory. In these circumstances, the plaintiff will advance the interests of the class members by advancing her or his own self-interest.
Newberg, § 22.17 at 22-58 (footnotes omitted). The adequacy of representation requirement has come to encompass two inquiries: (1) whether there is an absence of antagonism between the named plaintiff and the other class members; and (2) whether the absent class members can be assured of a vigorous prosecution by the named plaintiff and his or her counsel.
See Newberg, § 22.24 at 22-102. Only if both questions can be answered affirmatively can the named plaintiff be deemed an "adequate representative." Finally, in determining whether a class action is the superior means of proceeding, the court is to be guided by numerous factors, including:
(A) the interest of members of the class in individually controlling the prosecution or defense of separate actions; (B) the extent and nature of any litigation concerning the controversy already commenced by or against members of the class; (C) the desirability or undesirability of concentrating the litigation of the claims in the particular forum; (D) the difficulties likely to be encountered in the management of a class action.
Although Rule 10b-5 has been invoked to redress a wide variety of deleterious tactics in the trading of securities, of particular concern here is its use to remedy improper "corporate disseminations." See Hazen, § 13.7 at 117. This phrase refers to either of two things: (1) affirmative misstatements made by corporate officers or directors in information releases issued by the corporation; or (2) omissions of information which render the statements actually made in such a release misleading. In order to prevail on a Rule 10b-5 claim for an improper corporate dissemination, a plaintiff must establish, inter alia: (1) a misstatement or omission; (2) the materiality of the misstatement or omission;
(3) scienter on the part of those making the misstatement or omitting the information; (4) reliance by the plaintiff if a misstatement is alleged; (5) the damages suffered by the plaintiff; and (6) a causal link between the plaintiff's damages and the issuer's misstatement or omission making the latter the proximate cause of the former.
See generally Louis Loss and Joel Seligman, IX Securities Regulation Ch 11.C.4.d (Little, Brown & Company, 3d ed 1992) (hereinafter, "Loss").
The heretofore widely accepted measure of damages in securities fraud litigation is the so-called out-of-pocket
measure. See Affiliated Ute Citizens v. United States, 406 U.S. 128, 31 L. Ed. 2d 741, 92 S. Ct. 1456 (1972). This measure of damages looks to the plaintiff's loss as opposed to the gain of the defendant. See, e.g., Arrington v. Merrill Lynch, Pierce, Fenner & Smith, 651 F.2d 615, 621 (9th Cir. 1981) ("the difference between the value of the consideration [plaintiff] gave and the value of the security [plaintiff] received"); Foster v. Financial Technology, Inc., 517 F.2d 1068, 1071 (9th Cir. 1975); Note, Rule 10b-5 Damage Computation: Application of Financial Theory To Determine Net Economic Loss, 51 Fordham L Rev 838, 838-39 (1983); Note, The Measure of Damages Under Section 10(b) and Rule 10b-5, 46 Md L Rev 1266, 1268 (1987).
An oft-cited explanation of the method of calculating damages under the out-of-pocket rule was provided in Judge Sneed's concurring opinion in Green v. Occidental Petroleum Corp., 541 F.2d 1335, 1341 (9th Cir. 1976). Judge Sneed's analysis starts with the rather simple concept that where the fraud-on-the-market is one involving either a false positive statement or a failure to disclose a negative fact, the price of the security will remain at a level above its unbiased value until a full corrective disclosure is isssed.
Accordingly, Judge Sneed put forth the concepts of a "price line" and a "value line," in order to trace the degree of price inflation at various points in time. The price line is relatively easy to obtain, as it is merely a plot, over time, of the various prices at which trades in the security occurred. Obtaining the value line, however, is a much more difficult task and warrants some explanation before any detailed discussion of Judge Sneed's methodology is undertaken.
Decoding how much of the price behavior of a security is attributable to alleged market manipulation requires statistical analysis. A first step in such an analysis is the elimination of non-fraud related influences. Note, Estimating Aggregate Damages in Class-Action Litigation Under Rule 10b-5, 59 Fordhan L Rev 811 (1991). These include, among others, overall conditions in the securities markets. Securities, after all, compete with other investments (e.g., real estate and commodities), and different types of securities compete among themselves (e.g., computer stocks with consumer product stocks). Overall securities market conditions are often eliminated by using a broad-based standard market index such as the Standard & Poor's 500 stock index or the Wilshire 5000 index.
Securities prices are, of course, also influenced by economic conditions in the industry in which the issuer competes. As a result, it is necessary to eliminate these economic factors through the use of industry indices. Industry indices reflect the price behavior of similar types of securities issued by publicly traded companies. Usually, industry indices need to be specially constructed because most companies do not fit neatly into a single industry category.
The next step in the analysis consists of compiling the daily returns for a period not affected by the alleged fraud and then, using a regression model, calculating correlation coefficients or betas for each index. These coefficients are used with the index values for the period of the fraud to determine the unexplained random error term or portion of price behavior that cannot be explained by the market or industry indices. An analysis of these residual or unexplained price changes is undertaken to determine which of these might be explained by the influence of firm-specific, but non-fraud related, information, and which might be attributed to the fraud alleged.
By separating out the fraud-related component of a security's price behavior in this fashion, it is possible to obtain the price profile the security likely would have exhibited had there been no fraud. This, by definition, is the "value line" Judge Sneed envisioned. Judge Sneed recognized that drawing the "value line" could be "difficult and complex," but, with sunny optimism about the capabilities of district judges, thought it nonetheless "practicable." Green, 541 F.2d at 1341.
Having constructed the price line and the value line for the appropriate period, Judge Sneed's analysis proceeds as follows. First, Judge Sneed recognized that there are potentially two types of plaintiffs -- those who suffered "retention" damages and those who suffered "in/out" damages. Retention damages arise where a plaintiff purchased securities during the period of inflation, and then held the securities throughout the remainder of the class period. In/out damages, on the other hand, arise where the plaintiff purchases a number of securities during the price inflation, but then also sells all of those securities before the end of the class period. It is even possible for a single plaintiff to have both types of damages, provided he purchased a certain number of securities during the class period and sold a smaller number before the end of the period.
Judge Sneed's description of the method for calculating an individual plaintiff's damages, whether retention or in/out damages, can be conveniently represented in the following mathematical form:
D = P *(PL[p] - VI[p]) - S * (PL[s] - VL[s]),
The determination of retention damages is relatively straightforward. The retention plaintiff is injured when required to pay an inflated price for the securities at the date of purchase. Since the retention plaintiff never sells any securities, he never benefits from the fraudulently inflated price in any manner. Hence, his damages are simply the difference, at the time of purchase, between the price line and the value line, multiplied by the number of securities bought.
Turning to the above formula, since the retention plaintiff has not sold any shares in the period, S = 0. Therefore, the second term drops out, and the purchaser's damages are wholly captured by the first term, i.e., P *(PL[p] - VL[p]).
In/out damages require a slightly more elaborate discussion. Assuming for the moment that the in/out plaintiff sold, in the class period, securities equal in number to those he purchased in the period, the analysis is as follows. Just as the retention plaintiff, the in/out plaintiff is injured when forced to pay an inflated price at the time of purchase. Unlike the retention plaintiff, however, the in/out plaintiff recoups at least some (perhaps all) of his loss when he sells at the inflated price. Thus, in awarding him damages, it is only fair to subtract from his injury upon purchase the amount of his recoupment upon sale. In other words, the plaintiff's profits from reselling are deducted from his losses.
If the plaintiff resells all the securities purchased during the period, then in the above formula P = S, and the formula reduces to:
D = P *[ (PL[p] - VL[p]) - (PL[s] - VL[s]) ]
Finally, if the plaintiff is one who has suffered both in/out damages and retention damages, the same formula may be used. Mathematically, the "combination" plaintiff poses the situation in which the number of shares purchased in the period exceeds the number sold in the period, i.e., P > S. Therefore, the existence and amount of damages will depend on the relative magnitudes of the purchases, sales, and amounts of fraudulent price inflation prevailing at the corresponding dates.
The use of the class action device has long been the favored approach of courts faced with a Rule 10b-5 action in which numerous traders have allegedly been injured. Apart from the usual advantages in judicial economy conferred by the class action, the securities field has been characterized as "particularly well suited for representative litigation under [FRCP] 23." Newberg, § 22.10 at 22-5.
Two strong sentiments seem to underlie a great many class certification decisions. First, because the damages suffered by any one securities action plaintiff are often too small to justify litigation, the class action affords a large number of plaintiffs with relatively small claims a chance to obtain redress through aggregation. Second, the class action device is viewed as a necessary and desirable supplement to the enforcement efforts of the Securities and Exchange Commission. Thus, courts have concluded that in securities cases, "any doubts should be resolved in favor of allowing a class action,"
that the court "should err in favor of allowing the class to go forward,"
and that "the requirements of Rule 23 should be liberally construed in favor of class actions."
These strong sentiments may have precipitated, at least in part, the advent of the fraud-on-the-market theory of liability. As developed below, this theory eased satisfaction of the "predominance" prerequisite of FRCP 23, thus apparently making the class action device more readily available in securities fraud cases. At the same time, however, adoption of the theory had another effect that was surely unintended and has yet to be acknowledged: certain forms of class conflicts have taken on a central role in the class certification process. In order to appreciate fully the impact of the fraud-on-the-market theory, it is instructive to compare class certification decisions made before the theory with those made afterwards.
Prior to the Basic plurality's adoption of the fraud-on-the-market theory, a plaintiff, in order to state a valid Rule 10b-5 "corporate dissemination" claim, had to establish each of the six requirements discussed above -- i.e., a misstatement or omission, materiality, scienter, reliance, damages, and proximate causation. A court contemplating class certification in such a case, of course, had to ensure that the six prerequisites of a "(b)(3)" class action were satisfied -- i.e., numerosity, commonality, typicality, adequacy of representation, predominance, and superiority.
In corporate dissemination securities fraud cases involving shareholders or traders in a publicly traded or listed security, the numerosity requirement of FRCP 23 was almost always satisfied. Newberg, § 22.09 at 22-20. In addition to the fact that such cases often involved large numbers of potential plaintiffs, id., these plaintiffs were often geographically widely dispersed. Id. at 22-28. Because both of these factors tended to make joinder impracticable, defendants rarely contested class certification on numerosity grounds. Id. at 22-20.
Likewise, the commonality requirement did not pose a significant obstacle to class certification; plaintiffs could ordinarily point to a number of questions of law and fact that would be common to their individual suits. The first element of a 10b-5 claim, the existence of a misstatement or omission, obviously posed numerous common factual inquiries concerning the knowledge and actions of the defendants. Additionally, the materiality inquiry necessitated by a 10b-5 claim always posed a "common question" -- i.e., whether there was a substantial likelihood that a reasonable investor would consider the information significant in the total mix of information. See Basic, 485 U.S. at 231-232. Finally, the third element of a 10b-5 claim, scienter, also constituted a common question, since the relevant inquiry was into the intent of the defendants. Therefore, three of the six elements of a 10b-5 claim -- i.e., misstatement/omission, materiality, and scienter -- posed common questions.
The typicality requirement of FRCP 23 was also generally satisfied without great difficulty.
Where a number of plaintiffs sought recovery based on a single misstatement or omission, typicality was easily satisfied since all claims arose "from the same event," and were "based on the same legal theory." See Newberg, § 22.17 at 22-58. Similarly, where the plaintiffs alleged a series of misstatements or omissions which arguably constituted a scheme to defraud, or a "course of conduct," typicality was also met. Id. In essence, if the elements which the named plaintiff had to prove to prevail were substantially similar to those elements which the class members had to establish, typicality was satisfied. Id. at 22-86.
The sixth element
to FRCP 23(b)(3) class certification is a finding of superiority. This requirement, in the context of Rule 10b-5 corporate dissemination cases, often possessed little independent content. In some cases, the courts stated that a class action was superior to individual actions due to the fact that small-claim plaintiffs may not be able to sue individually. See, e.g., Simon v. Westinghouse Electric Corp., 73 EF.R.D.F 480, 487 (ED Pa 1977); Herbst v. Able, 47 EF.R.D.F 11, 17 (SDNY 1969) ; Feldman v. Lifton, 64 EF.R.D.F 539, 549 (SDNY 1974). In other cases, the court addressed the manageability inquiry specified by FRCP 23(b)(3)(D), see supra, by suggesting that class conflicts could be made manageable through the use of subclasses. See, e.g., Simon, 73 FRD at 48; Koenig v. Smith, 88 EF.R.D.F 604, 610 (EDNY 1980); Jenson v. Continental Financial Corp., 404 F. Supp. 806, 814 (D Minn 1975). In still others, courts have referred to general notions of judicial economy as supporting the superiority of proceeding by class action. See, e.g., Herbet v. Able, 47 EF.R.D.F at 17; Jenson, 404 F. Supp. at 814. Given that the courts, in discussing the superiority requirement, often merely reiterated points made in considering other FRCP 23 requirements, it is not surprising that the superiority element of FRCP 23(b)(3) rarely precluded class certification.
The only significant hurdles to class certification in the era before the fraud-on-the-market theory were provided by the remaining two prerequisites of FRCP 23 -- predominance and adequacy of representation.
In considering the predominance requirement of FRCP 23, courts sometimes had difficulty. As mentioned above, three of the six Rule 10b-5 elements (misstatement/omission, materiality, and scienter) provided common questions of law and/or fact, thus satisfying the commonality requirement. Prior to the adoption of the fraud-on-the-market theory, the remaining three Rule 10b-5 elements -- reliance, damages, and proximate cause -- all constituted individual questions of law and/or fact. Each plaintiff had to show that he personally relied on the particular misstatement at issue.
Similarly, each plaintiff had to establish the existence and amount of his own damages and prove that these damages were proximately caused by the defendants' misstatement/omission.
The relevant inquiry was thus whether the three common questions "predominated" over the three individual ones.
The specter of individual determinations of reliance and/or damages, for a large plaintiff class, rightly gave the courts serious cause for concern about whether the common questions could predominate. Nonetheless, due perhaps to the sentiment for "liberal" application of FRCP 23 in the securities fraud context, see supra p 17, courts routinely found the predominance requirement satisfied despite the presence of extensive individual issues. See, e.g., Koenig, 88 EF.R.D.F at 607; Simon, 73 EF.R.D.F at 486; Jenson, 404 F. Supp. at 814; Herbst v. International Telephone & Telegraph, 495 F.2d 1308, 1321 (2d Cir. 1974); Feldman, 64 EF.R.D.F at 548; Herbst v. Able, 47 EF.R.D.F at 16. As stated by the Second Circuit, in an often-cited passage:
[defendant] earnestly argues that each person injured must show that he personally relied on the misrepresentation in order to recover and thus any common issues of misrepresentations do not predominate over the individual questions of reliance. Even if [defendant] is correct in its assertion of the need for proof of reliance * * * we must still reject the argument. Carried to its logical end, it would negate any attempted class action under Rule 10b-5, since as the District Courts have recognized, reliance is an issue lurking in every 10b-5 action. * * * We see no sound reason why the trial court, if it determines individual reliance is an essential element of the proof, cannot order separate trials on that particular issue, as on the question of damages, if necessary. The effective administration of 23(b)(3) will often require the use of the "sensible device" of split trials.
As exemplified by this passage, the conclusions of various courts that common questions predominated over individual ones suffered from two fundamental flaws. First, these holdings, instead of being based on actual comparisons of the relative weights of the common questions and the individual questions, were driven primarily by vague policy considerations. Thus, it appears that the courts may have certified classes in situations where the individual issues actually equalled or outweighed the common questions. The second flaw in these holdings is that the "solution" of using separate or split trials on the individual questions is illusory. As one court noted:
use of the bifurcation method * * * does not resolve what appears to be an inherent conflict between proof of the reliance element of a 10b-5 action and the "predominance of common issues" requirement of Rule 23(b)(3); it merely delays resolution of the problem until a later date. * * * That is, if actual individual reliance in its common law sense need be proved by each class member, the trial of that issue, even at a later stage in the proceedings, would tax the court's (and counsels') resources to an intolerable extent. Accordingly, ...