The opinion of the court was delivered by: LaVECCHIA, J.
On certification to the Superior Court, Appellate Division, whose opinion is reported at 324 N.J. Super. 344 (1999).
This appeal presents the question whether a class of plaintiffs in a common-law action for fraud can prove the element of reliance through the presumption of a fraud on the market. The theory of fraud on the market, as described by the United States Supreme Court in Basic Inc. v. Levinson, 485 U.S. 224, 108 S. Ct. 978, 99 L. Ed. 2d 194 (1988), allows plaintiffs to bring class actions under federal securities-fraud law by excusing those plaintiffs from the burden of proving individual reliance. Instead, plaintiffs may establish the reliance element of their claims by showing that they purchased securities in the secondary markets at attractive prices that had been artificially affected by an issuer's misrepresentations and omissions.
Plaintiff Susan Kaufman held shares of defendant i-Stat Corporation ("i-Stat") over a period during which i-Stat allegedly misrepresented certain financial matters and the misrepresentations were discovered and publicized. The misrepresentations were never made to Kaufman by i-Stat or any intermediary. Kaufman relied on the price of the stock in her decisions, and now contends that, because i-Stat's misrepresentations were reflected in the share price, she can make out claims for common- law fraud and negligent misrepresentation on the basis of the share price alone.
Even though the theory of fraud on the market has a place in the securities law of this nation, it is a stranger to New Jersey's securities laws. It is also not consistent with the current requirements for a common-law action for fraud in New Jersey. Use of the fraud-on-the-market theory is not the equivalent of proof of indirect reliance that is required minimally in a common-law fraud action. Because we discern no compelling reason to deviate from our current standard of proof for the reliance element in a common-law fraud action, and because we, like many commentators, cast a jaundiced eye on the worth of the fraud-on-the-market theory, we decline to expand our common law to permit its use. Accordingly, we reverse the judgment of the Appellate Division and reinstate the trial court's dismissal of plaintiff's fraud claim.
This matter comes before the Court as a result of the Law Division's grant of summary judgment for the defendants. Accordingly, we give the plaintiff the benefit of every positive inference to be drawn from the facts as she has pled them. See Brill v. Guardian Life Ins. Co. of Am., 142 N.J. 520, 523 (1995). In that light, we thus consider the facts.
i-Stat is a public New Jersey corporation that manufactures and markets diagnostic blood-analysis equipment designed to assist medical professionals at the point of patient care. Specifically, the company makes a hand-held blood analyzer and cartridges to test individual patients. The corporation's stock is traded on the NASDAQ National Market System. On October 31, 1995, during the events at issue in this action, i-Stat had 11,083,421 shares of common stock issued and outstanding.
On May 9, 1995, i-Stat announced its financial results for the first fiscal quarter of 1995, ending March 31. The company reported net sales of $3,359,000, as compared to reported net sales of $1,651,000 for the same period in the previous year. The company reported a net loss of $6,531,000 ($0.59 per share) for the first quarter as compared with a net loss of $6,056,000 ($0.55 per share) for the same period in the prior year. Kaufman alleges that, to produce the improved sales figures, i-Stat *fn1 misrepresented acceptance of the company's products to the public by "report[ing] sales that were not, in fact, true sales, but were, instead, loans on a trial basis." For example, i- Stat allegedly reported "sales" to certain hospitals without disclosing that the "sales" were induced by "charitable donations" from interested third parties to the purchasing hospitals. These sales practices resulted in an exaggerated representation of the company's sales and degree of market acceptance of its products.
On May 22, 1995, Susan Kaufman purchased one hundred shares of i- Stat common stock at 21 3/4, a total investment of $2175. Meanwhile, on that date, Forbes magazine reported that a medical investment newsletter believed i-Stat was experiencing difficulties and that its products were not economical. On June 21, 1995, an article in The Financial Post, a Canadian financial publication, reported "the expected profitability and growth of the Company," citing an interview with defendant Imants Lauks. On September 21, 1995, i-Stat reached its all-time high, trading at 43 3/4.
The bubble began to burst on January 28, 1996. On that date, The New York Times reported that Daniel R. Frank, manager of the Fidelity Advisor Strategic Opportunities Fund, whose successor is still the largest institutional holder of i-Stat, had made charitable contributions to hospitals to enable them to obtain i-Stat's diagnostic equipment.
Then, on March 19, 1996, The Wall Street Journal reported that the Securities and Exchange Commission ("SEC") was investigating i-Stat's business. The article revealed that some of i-Stat's "sales" had been loans of the products to hospitals on a trial basis rather than actual sales. i-Stat responded with a press release confirming the SEC's investigation and inquiry into its sales procedures. On that same day, i-Stat's shares, which had been declining, tumbled 2½ to 28 3/4. Two million shares of i-Stat, nearly one sixth of the shares outstanding on that date, traded on March 19.
On May 20, 1996, Kaufman sold 50 shares at 20 1/4. On June 19, she filed suit as putative class representative on behalf of all purchasers of i-Stat common stock between May 9, 1995, and March 19, 1996, excluding the officers and directors of the company. Kaufman alleged common-law fraud and negligent misrepresentation, contending that i- Stat's deliberately false and misleading statements regarding its financial status and deceptive sales practices inflated the stock price during the class period. Kaufman also alleged that i-Stat's officers and directors illegally received over $2.9 million from insider trading during the class period.
i-Stat filed an answer alleging various affirmative defenses. Both parties stipulated to the following: (1) Kaufman did not "actually or directly receive or rely on any communication containing any misrepresentation . . . nor . . . actually receive or rely on any communication which omitted material facts[;]" (2) Kaufman purchased her stock through a brokerage firm and did not directly receive or rely on any communication from the brokerage firm concerning the i-Stat purchase; and (3) Kaufman "relied exclusively on the integrity of the market price of i-Stat stock at the time of her purchase." Therefore, Kaufman's satisfaction of the reliance element of the common-law fraud and negligent misrepresentation claims depends entirely on the fraud-on- the-market theory.
i-Stat moved for summary judgment on the ground that Kaufman failed to state a cause of action in fraud or in negligent misrepresentation because she could not satisfy the actual reliance requirement in each. The trial court granted the motion, dismissing Kaufman's claims with prejudice. Although the court agreed with the fraud-on-the-market theory Justice Blackmun espoused in Basic, supra, it rejected the theory as a substitute for reliance, believing it would be inappropriate for a trial court to expand the common law of New Jersey. The court concluded that the issue was better addressed by an appellate court or the Legislature.
On appeal, the Appellate Division reversed the dismissal of plaintiff's complaint on the common-law-fraud claim but affirmed the dismissal of the negligent-misrepresentation claim. Kaufman v. i-Stat Corp., 324 N.J. Super. 344, 348 (App. Div. 1999). The court concluded that plaintiff's reliance on the integrity of the market price of the security was sufficient to satisfy the reliance requirement of a common- law-fraud claim when the security was inflated artificially by the corporation's deliberate false statements, but declined to extend this form of proof of reliance to a negligent-misrepresentation claim, citing public policy considerations in favor of a more limited scope of liability for negligent communication of fraudulent misrepresentations. Because the Appellate Division broke new ground in allowing the fraud- on-the-market theory to serve as proof of reliance in a common-law-fraud cause of action, we detail the court's reasoning below.
The court began its analysis by noting that only the reliance element was at issue in this common-law-fraud claim and that New Jersey already allows proof of indirect reliance to satisfy this element. Id. at 349. Indirect reliance has also been adopted by the Restatement (Second) of Torts for situations involving reliance by party B on a false representation initially made to party A who the maker knew or had reason to expect would communicate the information to party B such that the information would influence party B's conduct in a transaction. Ibid. (citing Restatement (Second) of Torts § 533 (1977)).
Using a similar analysis, reasoned the Appellate Division, federal courts have permitted the reliance element of a securities-fraud claim under section 10(b) of the Securities Exchange Act of 1934 to be satisfied by reliance on the market price of the security. Id. at 350- 51 (citing Basic, supra). Under the fraud-on-the-market theory, the market price reflects the value of the stock to the investor based on all of the information available at the time. Therefore, an investor relying on a price that is actually based on misrepresentations is entitled to recover damages when he or she trades at a loss. Id. at 350. The Appellate Division concluded that the reasoning of the federal securities law cases should apply to common-law-fraud claims for securities fraud because "the reliance element of a securities fraud claim under these regulatory provisions is substantially the same as in a common law fraud action." Id. at 351.
The Appellate Division acknowledged that no other state appellate court had permitted the fraud-on-the-market theory to satisfy the reliance requirement of common-law fraud, but found the reasoning of the dissenting justices of the California Supreme Court in Mirkin v. Wasserman, 858 P.2d 568, 584-95 (Cal. 1993) (Kennard & Mosk, JJ., concurring in part and dissenting in part), to be persuasive on the issue. The Appellate Division determined that that dissent more correctly interpreted principles of indirect reliance articulated in Basic and section 533 of the Restatement (Second) of Torts, and provided victims of securities fraud with an appropriate remedy under state law. Kaufman, supra, 324 N.J. Super. at 352. The court rejected i-Stat's argument that plaintiff already had an adequate remedy under federal securities law because Congress enacted the Securities Exchange Act of 1934 to supplement, rather than preempt, existing remedies. Id. at 353.
In examining the negligent-misrepresentation claim, the Appellate Division concluded differently. The court acknowledged that the measure of liability for negligent misrepresentation "`involves a weighing of the relationship of the parties, the nature of the risk, and the public interest in the proposed solution.'" Ibid. (quoting Goldberg v. Housing Auth., 38 N.J. 578, 583 (1962)). In H. Rosenblum, Inc. v. Adler, 93 N.J. 324, 352 (1983), this Court imposed liability on an independent accountant who issued financial statements on which reasonably foreseeable recipients relied for business purposes. Given the facts in that matter, the Court did not reach the issue of claims by individuals who do not receive audited statements from the company, like purchasers of the corporation's stock. Id. at 353. Later, the Court clarified that limited liability was necessary in a negligent misrepresentation claim to avoid "potentially unlimited liability." Petrillo v. Bachenberg, 139 N.J. 472, 484 (1995), quoted in Kaufman, supra, 324 N.J. Super. at 355. The Appellate Division therefore believed it was constrained by the precedent of Rosenblum, and declined to broaden the scope of liability for negligent misrepresentation. Ibid. The court reasoned that this result complied with the public policy of the Restatement (Second) of Torts § 552, as well as Rule 10b-5 of the Securities Exchange Act of 1934, which requires scienter as an element of fraud. Id. at 355-56. Similarly, the Mirkin dissent declined to extend liability under a negligent misrepresentation cause of action where investors indirectly relied on the market price rather than on direct misstatements. Id. at 356 (citing Mirkin, supra, 858 P.2d at 595 (Kennard & Mosk, JJ., concurring in part and dissenting in part)).
We granted certification. 162 N.J. 489 (1999).
Assuming the allegations made by plaintiff Susan Kaufman on behalf of a putative class are correct, and because this is an appeal of a grant of summary judgment we give her the benefit of every inference that they are, then the misrepresentations and omissions made by the management of i-Stat corporation caused her to lose money. If she can prove that her loss resulted from an act prohibited under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.A. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, she is entitled to compensation for that loss.
Rule 10b-5 makes it unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
The misdeeds that plaintiff alleges i-Stat to have committed, if proven, clearly fall within the ambit of the Rule. Many actions based on similar claims, some using the fraud-on-the-market theory, have been brought before the federal courts over the last sixty years. But since 1995, plaintiffs in these actions have increasingly turned to state courts. See SEC, Office of the General Counsel, Report to The President and The Congress on The First Year of Practice under The Private Securities Litigation Reform Act of 1995 (April 1997).
The change has come about neither because state courts have greater expertise in these matters nor because they are more convenient. The impetus for these state court filings was provided by Congress' passage of the Private Securities Litigation Reform Act of 1995, 109 Stat. 737 ("PSLRA"). Congress enacted the PSLRA to reduce or eliminate class- action strike suits filed by investors when the price of a stock declined. PSLRA's provisions have made litigating such cases much more difficult for plaintiffs.
Among the restrictions imposed was a stay of discovery during the pendency of any motion to dismiss, Congress having found that plaintiffs often used this period as a fishing expedition to discover information that would underlie the suit. 15 U.S.C.A. § 78u-4(b)(3). Similarly, the level of specificity required in pleadings was raised to a "strong inference of fraud," so that any material misstatement has to be identified, and the information about, or belief in, any material omission stated with particularity. Id. (1), (2). The plaintiff must prove that the misstatement led to the loss. Id. (4). Forward-looking statements are protected by a safe-harbor provision. 15 U.S.C.A. § 78u- 4(g). Class certification is more difficult as a result, and there are penalties for abusive litigation. Id. (a), (c). The PSLRA also has reduced plaintiffs' potential recovery, limiting damages to the difference between the purchase or sale price paid or received, as appropriate, by the plaintiff for the subject security and the mean trading price of that security during the 90-day period beginning on the date on which the information correcting the misstatement or omission that is the basis for the action is disseminated to the market. [15 U.S.C.A. § 78u-4(e)(1).]
These changes have led plaintiffs to attempt to "avoid some of the new provisions of the [PSLRA] by seeking procedural advantages available in state courts." Sara Beth Brody & Ted F. Angus, Securities Litigation in State Court, 1070 WESTLAW PLI/Corp 413 (1998). The result has been "a significant forum shift in class action securities fraud litigation, from federal to state court." Michael A. Perino, Fraud and Federalism:
Preempting Private State Securities Fraud Causes of Action 50 Stan. L. Rev. 273, 273 (1998). "Plaintiffs are filing `weaker' cases in state court, i.e., cases in which the plaintiffs' attorney has a lower expectation that the complaint will survive a motion to dismiss under the act's `strong inference of fraud' pleading standard [because] in state court proceedings . . . the `strong inference of fraud' standard does not apply." Id. at 278, 315.
Most of those cases newly brought in state court have been, as this one is, substitutes for Rule 10b-5 actions. *fn2 To maintain those actions' viability, the plaintiffs bringing them have sought to have the courts hearing them incorporate the doctrine of fraud on the market into the common law of their respective states. Plaintiff, however, has cited no case in which a state court ruling on its common law has accepted the invitation. Defendants, by contrast, have found several cases declining to allow the fraud-on-the-market theory to establish reliance at common law. See Mirkin v. Wasserman, 858 P.2d 568, 580 (Cal. 1993) (declining to expand common-law cause of action when procedurally controlled state statutory remedy, amenable to fraud-on- the-market presumption, already available); Malone v. Brincat, 722 A.2d 5 (Del. 1998) (declining to expand common-law cause of action when federal statutory remedy available); Kahler v. E.F. Hutton Co., 558 So. 2d 144 (Fla. Dist. Ct. App. 1990); Constantine v. Miller Indus., No. E1999-01575-COA-R3-CV, 2000 WL 336663 (Tenn. Ct. App. March 31, 2000). See also Rosenthal v. Dean Witter Reynolds, Inc., 908 P.2d 1095, 1104 (Colo. 1995) (rejecting related doctrine of "fraud created the market" and requiring actual reliance on substance of misrepresentation). Our research reveals that one court has accepted the theory in dictum, but no claim based directly on the theory appears to have been adjudicated in the jurisdiction. Allyn v. Wortman, 725 So. 2d 94 (Miss. 1998).
The federal courts with jurisdiction in New Jersey have rejected the idea that fraud on the market can create a common-law action for fraud. Thus, the Third Circuit, in one of the landmark decisions on fraud on the market, Peil v. Speiser, 806 F.2d 1154 (3d Cir. 1986), on which the Supreme Court relied extensively in Basic, declined to allow a state-law claim to proceed because "no state courts have adopted the theory, and thus direct reliance remains a requirement of a common law securities fraud claim." Id. at 1163 (adjudicating Pennsylvania-law claim). The District of New Jersey has also rejected the invitation to expand the common law of fraud. See Weikel v. Tower Semiconductor Ltd., 183 F.R.D. 377, 400 n.12 (D.N.J. 1998); Easton & Co. v. Mutual Benefit Life Ins. Co., 1993 WL 89146, at *6 (D.N.J.); Cammer v. Bloom, 711 F. Supp. 1264, 1298 (D.N.J. 1989); In re ORFA Sec. Litig., 654 F. Supp. 1449, 1460 (D.N.J. 1987) ("There does [sic] not appear to be any common law exceptions to the requirement of individual reliance (analogous to the judicially created Rule ...