On Appeal from the United States District Court for the Eastern District Court for the Eastern District of Pennsylvania, D.C. Civil No. 82-1289.
Before: SEITZ, HIGGINBOTHAM and BECKER, Circuit Judges.
BECKER, Circuit Judge.*fn1
In this securities fraud case, purchasers of corporate stock, suing as a class, seek damages against the corporation and its officers, alleging that the officers' misrepresentations about the corporation's business prospects artificially inflated the price of its stock and induced the purchasers to make a losing investment. The plaintiffs alleged violations of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b); section 11 of the Securities Act of 1933, 15 U.S.C. § 77k; and the common law. With respect to their rule 10b-5 claim plaintiffs alleged violations of clauses (a), (b) and (c) of 17 C.F.R. § 240.10b-5 (1986). Following a five-week jury trial the district court directed a verdict in favor of the defendants on the Rule 10b-5(b) claim and submitted the remaining claims to the jury which found for all defendants, including the corporations' underwriters on a bond issue, on all claims. In part I, we unanimously affirm the judgment entered on the verdicts returned by the jury.
Because the class representative did not prove direct reliance upon the defendants' representations, we are called upon to consider the soundness of the "fraud on the market" theory of causation. Under this widely accepted theory, see infra part II, the purchasers can establish causation by showing that, in making their purchase, they relied on the price of the stock, which in turn had been skewed by the fraudulent actions. In part II, we unanimously approve of this theory and establish it as the law of this circuit. However, we must also address the question of the applicability of the fraud on the market theory to claims of individual misstatements or omissions under rule 10b-5(b). The defendants urge us to limit the use of the fraud on the market theory to claims of a scheme to defraud under rules 10b-5(a) and (c), 17 C.F.R. § 240.10b-5(a) and (c). Because the market is distorted by a 10b-5(b) violation as well as by a 10b-5(a) or (c) violation, we decline to recognize such a distinction, and therefore hold, in Part III, that the district court should have submitted the rule 10b-5(b) claim to the jury on a fraud on the market theory, rather than directing a verdict for defendants on that issue.*fn2 However, we also find that, in view of the manner in which the rule 10b-5(a) and (c) claims were submitted to the jury, the verdict on the rule 10b-5(a) and (c) claims serves as a bar to a new trial on the rule 10b-5(b) claims.*fn3 The judgment of the district court will therefore be affirmed in all respects.
I. Facts and Procedural History
Defendant Health-Chem Corporation is a company involved in various lines of business, most relevantly the development of technology that permits the regulated release of chemicals through plastic membranes. The individual defendants are officers of Health-Chem: Marvin Speiser, Chairman of the Board and President; Roy Marcus, Senior Vice President; Leon C. Baker, a member of Health-Chem's Executive Committee; and Agis Kydonieus, Executive Vice-President of Health-Chem's Hercon Division. Drexel Burnham Lambert, an investment banking firm that underwrote an April 15, 1981 offering of Health-Chem convertible debentures, is a defendant with respect to the claim brought by plaintiffs under § 11 of the Securities Act of 1933, 15 U.S.C. § 77K. The plaintiff class consists of individuals who purchased Health Chem's stock from April 15, 1980 through November 2, 1981 and sold at a loss.
During the late 1970's, Health-Chem developed technology designed to combat gypsy moths with the aid of an aphrodisiac called "pheromone."*fn4 During 1980 and 1981, when gypsy moth defoliation was a matter of great concern, Health-Chem's work attracted the attention of security analysts, newspapers, scientific journals, and gardening journals. Although the price of Health-Chem's stock rose substantially during the latter half of 1980 and early 1981, it subsequently declined. Named plaintiff Raymond K. Peil purchased 500 shares of Health Chem's stock on December 5, 1980, in the midst of the stock's surge. After the decline of the stock's price, he sold his shares for a loss in excess of $6,000. The other members of the plaintiff class made similarly unprofitable investments in Health-Chem's stock during this period.
Peil brought this action in the United States District Court for the Eastern District of Pennsylvania, on behalf of himself and all others similarly situated, alleging that Health-Chem Corporation and its officers and directors had violated section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and section 11 of the Securities Act of 1933, 15 U.S.C. § 77k and had committed various common law offenses. With respect to their rule 10b-5 claim, plaintiffs alleged that Health-Chem and its directors and officers had violated clauses (a), (b) and (c) of 17 C.F.R. § 240.10b-5 (1986). Peil also claimed that Drexel Burnham Lambert, Inc., had violated Section 11 of the Securities Act of 1933, 15 U.S.C. § 77k.
The gravamen of plaintiffs' case was that the price of Health-Chem's stock had been artificially inflated by the defendants' false and misleading statements about Health-Chem's business prospects, and that the price of the shares induced plaintiffs to purchase Health-Chem's stock. Plaintiffs alleged that they had suffered financial losses when the falsity of defendants' representations became apparent and the stock fell to its true value.
Following certification of a class pursuant to Fed. R. Civ. P. 23(b)(3), the case proceeded to a five-week jury trial during which plaintiffs presented 29 witnesses and 200 exhibits. Plaintiffs sought to establish that defendants,*fn5 knew that the pheromone was not likely to be effective, and that they intentionally disseminated false and misleading information in order to increase the value of Health-Chem's stock.*fn6 Plaintiffs also sought to establish: 1) that as a result of the misrepresentations and material omissions, Health-Chem's stock was very heavily traded and was a leading percentage gainer on the American Stock Exchange in 1980; 2) that the pheromone never lived up to its billing and was eventually abandoned by Health-Chem; and 3) that plaintiffs suffered losses as a result of their purchase of Health-Chem's stock.
The most significant testimony was Peil's own. Peil testified that he had purchased the stock on the recommendation of his broker, who advised him of an article in Financial World magazine that predicted an enormous increase in Health Chem's stock. The article included allegedly false representations by individual defendants about Health-Chem's outstanding prospects. Peil conceded that he had never read the Financial World article and that, apart from that article, he had neither read nor heard of defendants' alleged misrepresentations.
After plaintiffs presented their evidence, defendants moved for a directed verdict on the rule 10b-5 and common law claims on the ground that Peil had failed to produce evidence from which a jury could conclude that he had relied on defendants' alleged misrepresentations and omissions. The district court granted a directed verdict for defendants on the common law claims and the rule 10b-5(b) claim. The court stated that Peil's own testimony that he was unaware of defendants' representations conclusively rebutted that presumption: "no reasonable person could conclude that the named plaintiff relied in any way on any recommendation or misrepresentation by defendants . . . The named class representative's own testimony rebuts the presumption of reliance." App. at 1867-68. The district court then decertified the class with respect to the rule 10b-5(b) and common law claims. The court, however, denied defendants' motion for a directed verdict with respect to the rule 10b-5(a) and (c) claims. It stated that "direct" reliance by plaintiffs on defendants' misrepresentations is not an essential element of those claims. Rather, it stated, defendants could be found liable if they committed a a fraud on the market, i.e., if they were involved in a scheme that affected the market price of the stock which, in turn, induced appellants to purchase the stock, see infra pp. 13-21.
The court then submitted plaintiffs' rule 10b-5(a) and (c) and § 11 claims to the jury by special interrogatories, Fed. R. Civ. P. 49(a). On the basis of the jury's responses to the interrogatories, and the district court's previous rulings on defendants' motions for directed verdicts, the court entered judgment for the defendants on all claims.
Plaintiffs moved for judgment n.o.v. on the § 11 claim, but the court denied the motion. Judgment was entered on the verdicts and plaintiffs appealed, seeking 1) vacatur of the verdicts and the final judgment; 2) reversal of the judgment on the § 11 claims; 3) a new trial on plaintiffs' § 10 and pendant common law claims; and 4) a trial on a civil RICO claim that the district court refused to allow plaintiffs to amend their complaint to interpose. Our jurisdiction is pursuant to 28 U.S.C. § 1291.
Although plaintiffs allege a number of trial errors, with the exception of the point discussed in part III infra, the allegations are without merit.*fn7 Because the challenge to the rule 10b-5(a) and (c) judgments is based solely on such allegations, we will affirm the judgment of the district court insofar as it is based on those claims. We also find the plaintiffs' challenges to the § 11 verdict and the directed verdict on the common law claims are meritless.*fn8
The district court's directed verdict on the rule 10b-5(b) claim is troublesome, however, and our evaluation of it requires resolution of a legal question heretofore unaddressed by this court -- the applicability of the "fraud on the market" theory to ...