July 15, 2004

Applying The Fraud-On-The-Market Theory To Research Analysts

Whether and how to apply the fraud-on-the-market theory (i.e., reliance by investors on an alleged misrepresentation is presumed if the company's shares were traded on an efficient market) to research analyst statements is a controversial issue. It was the subject of a recent appeal by Citigroup in the WorldCom litigation, but the appeal was mooted by the settlement of the case just before the scheduled oral argument.

The 10b-5 Daily has argued that the Second Circuit, in its opinion granting Citigroup's request for interlocutory appeal, appeared favorably disposed to finding that the fraud-on-the-market theory was not generally applicable to research analyst statements. Judge Rakoff of the S.D.N.Y. apparently agrees with this reading of the opinion.

In DeMarco v. Lehman Brothers, 2004 WL 1506242 (S.D.N.Y. July 6, 2004), a case alleging that a Lehman analyst made buy recommendations for RealNetworks, Inc. stock while secretly holding negative views of the stock, the court has denied the motion for class certification. The court noted that there is a "qualitative difference" between a statement of fact from an issuer and a statement of opinion by a research analyst. In particular, a "well-developed efficient market can reasonably be presumed to translate the former into an effect on price, whereas no such presumption attaches to the latter." As a result, the court held that the fraud-on-the-market doctrine can apply to a case based on research analyst statements "only where the plaintiff can make a prima facie showing that the analyst's statements materially impacted the market price in a reasonably quantifiable respect."

The plaintiffs relied on Lehman Brothers' promotional materials touting its analyst's abilities and influence and an expert report (largely based on general studies of the effect of analyst recommendations on stock prices) in arguing that the analyst's statements inflated the market price for RealNetworks' stock. The court found that this evidence was insufficient to "warrant invocation of the fraud-on-the-market presumption."

Holding: Motion for class certification denied.

Quote of note: "[A] statement of opinion emanating from a research analyst is far more subjective and far less certain, and often appears in tandem with conflicting opinions from other analysts as well as new statements from the issuer. As a result, no automatic impact on the price of a security can be presumed and instead must be proven and measured before the statement can be said to have 'defrauded the market' in any material way that is not simply speculative."

The New York Law Journal has an article (via law.com - free regist. req'd) on the decision. Thanks to Adam Savett for sending in a copy of Judge Rakoff's opinion.

Posted by Lyle Roberts at July 15, 2004 9:15 PM | TrackBack
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