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In re PolyMedica Corp. Securities Litigation

    Brief Fact Summary. In a securities fraud action in which the buyer (Plaintiff) of PolyMedica (Defendant) stock alleged that PolyMedica had made inaccurate statements that affected the value of its stock, the district court certified the action as a class action because the fraud-on-market assumption of reliance was appropriate due to there being abundantevidence that the market involved was proficient. PolyMedica argued that the district court used the wrong standard of market efficiency and so also made a mistake including evidence presented by PolyMedica as immaterial.

    Synopsis of Rule of Law. (1) In applying fraud-on-the-market presumption of reliance in resolutions regarding granting class certifications, for evaluation purposes a trial court may have to look beyond the pleadings. (2) An efficient market, regarding application of the fraud-on-the-market theory, is one in which the market price of the stock is totally transparent regarding all information made available to the public.

    Facts. PolyMedica Corp. (PolyMedica) was the parent of Liberty Medical Supply, Inc. (Liberty). Allegedly, over the course of eight months, PolyMedica falsely reported substantial gains in Liberty’s business(accounting for roughly 80% of PolyMedica’s profits) stated by a PolyMedicastock buyer. Traded on the NASDAQ and American Stock Exchange, these reports then led to considerable gains in PolyMedica’sstock and purportedlyinfluenced the buyer to purchase artificially inflated stock.  Once the truth came out, the value of PolyMedica’sstock plunged by 80%. The buyer filed suit and sought class certification, alleging that because of PolyMedica’s misstatement of sale figures, accounts receivable, earnings and fake press releases, that others in similar situations also purchased artificially inflated PolyMedica stock. The buyer stated that common questions of law and fact prevailed based on the fraud-on-the-market theory, which removes the need for a plaintiff to prove individualized reliance on a defendant’s misrepresentation by allowing a class-wide rebuttable presumption of reliance, thuspermitting a securities fraud class action to meet the commonalityobligation needed for class action certification. PolyMedica,contending that the fraud-on-the-market presumption of reliance was not applicable for the eight-month timeframe at issue (the “Contested Time Period”) due to themarket for PolyMedicastockfailing to meet the “efficiency†condition needed for applying presumption, opposed the motion. While both sides offered expert testimony supporting their individual stances, the buyer’s expert depended on five widely accepted market-efficiency elements and determined that PolyMedicastockmarket was efficient and depending on three different elements, PolyMedica’s expert, arrived at the opposite conclusion. The trial court disallowed the evidence provided by PolyMedica’sexpert as immaterial, and granted the buyer’s motion to certify the class for the whole proposed class period. By allowing this, the district court went past the four corners of the pleadings, bearing in mindthat each party had expert’s statements and hundreds of pages of exhibits fixated on market efficiency. An interlocutory appeal was filed by PolyMedica, and review was granted by the court of appeals.

    Issue. (1) In applying fraud-on-the-market presumption of reliance in resolutions regarding granting class certifications, for evaluation purposes,may a trial court have to look beyond the pleadings? (2) Is an efficient market, regarding application of the fraud-on-the-market theory, one in which the market price of the stock is totally transparent regarding all information made available to the public?

    Held. (1) Yes. In applying fraud-on-the-market presumption of reliance in resolutions regarding granting class certifications, for evaluation purposes, a trial court may have to look beyond the pleadings.Reviewing case law from another jurisdiction the buyer contends that a district court should restrain from weighing competing evidence, like experts’ reports, at the class-certification stage, and instead should restrict its review to the plaintiff’s complaint claims. This is due to the fact that courts may fail to perform a preliminary inquiry into the value of a suit to decide if it may be upheld as a class action. In regards to addressing this issue, the majority of courts of appeals have ruled that a district court is not restricted to the claims mentioned in the complaint and should raise any factual and legalqueries needed to make an informed determination of the certification issues.  This stance, adopted by PolyMedica, is based on the idea that determining class usually includes deliberations that are entangled in the factual and legal issues encompassing the plaintiff s cause of action and at times the court will need to investigate behind the pleadings prior to reaching the certification question. The majority approach is followed by this court, allowing the district court to go beyond the pleadings on grounds that it has to create a projection as to how particular concerns will play out in hopes of deciding if individual or common issues prevail in a certain case. Also, if and when the class action would be appropriate on one premise but not another, a court has the authority to test doubtful premises early on. So, the district court was authorized to investigate behind the pleadings to determine if the fraud-on-the-market presumption of reliance was applicable, and its class-certification questions resolution. Affirmed as to this issue.
    (2) Yes. An efficient market, regarding application of the fraud-on-the-market theory, is one in which the market price of the stock is totally transparent regarding all information made available to the public. One of the factors of a securities fraud action under § 10(b) of the Exchange Act and Rule 10b-5 is reliance.  Reliance is usually displayed on an individualized basis although to permit a securities fraud class action, the United States Supreme Court has accepted the fraud-on-the­ market theory, which removes the plaintiff’s onus of demonstrating individualized reliance on a defendant’s misrepresentation by allowing a rebuttable presumption that the plaintiff depended on the “integrity of the market price” which mirrored that misrepresentation. It is based on the theory that in a mature and open securities market, a company’s stock price is decided by the important information, inclusive of all significant misrepresentations, available pertaining to the company and its business. Seeing as investors depend on the “integrity of the market price,” they incidentally alsodepend on any misrepresentations because the price that they are buying or selling stock at inevitablymirrors that misrepresentation. “Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements,†under the fraud-on-the-market theory, however, to benefit from the presumption the plaintiff must provethat the market of concern was “efficient.”  The flow of information in the relevant market and the effect of that information on the price of the stockis referred to as “efficiency.â€Misstatements are mirrored in the stock price in an efficient market while in an inefficient market, the possibility exists that misstatements will not be reflected.  Ordinary investors cannot beat the market because all new information that could have potentially given an investor an “edge†in an efficient market is already reflected in the market price. The thought process behind this is that arbitrageurs who procure and dissect stock information, gleaned from a multitude of sources, drive stock prices to reflect recent public information regarding the stock and by incorporating public information into the market, prevent investors from trading on/profiting from it. This theory is mirrored under the prevalentdescription of market efficiency, which states when market price is completely transparent with regard to all public information, it is an efficient market. The district court clearly refused to accept this prevalent definition of market efficiency, opting instead to define an efficient market as one which “market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market pricesâ€, which the buyer’s also preferred. The prevalent definition is favored by PolyMedica, while the buyer favors the district favors the prevailing definition. The fraud-on-the-market presumption of reliance in Basic v. Levinson, 485 U.S. 224 (1988) was endorsed by the United States Supreme Court. While the language in Basicbacks both definitions, the cases depended upon by the Supreme Court in Basic favor the dominant definition. The view of the efficient market in those cases is one that is nearly perfect in information transparency and in market price showcasing all representations regarding the stock. This is inclusive of any available public information regarding the economy, about financial markets, and regarding the particular company involved. In the end though, market efficiency was not defined by the Supreme Court leaving the maturation of the description to the lower courts, which now must also be sought after for guidance. The predominant definition has tremendous support from most of those courts as well as the Securities and Exchange Commission (SEC). The definition of market efficiency accepted by the district court fails to remain consistent with the presumption of investor reliance which is the core of the fraud-on-the-market theory, based on these authorities and deliberations. By denying the predominant definition of market efficiency endorsed by PolyMedica, and instead concentrating on the general consideration by market professionals of most publicly publicized important statements regarding companies, the incorrect standard of efficient was applied by the district court. Informational efficiency is the efficiency needed by the dominantdefinition not necessarily fundamental value efficiency.  To establish the fraud-on-the-market presumption of reliance, investors are only required to demonstrate the market being informationally efficient. Informational efficiency refers to anestimate or inferenceregarding how quickly prices respond to information. So analysis of the structure of the market and the speed with which all publicly available information is reflected in price is involved in deciding if a market is informationally efficient.  Fundamental value efficiency is a wider definition, where market price is “fully reflected” by all information available to the public when it responds to information both quickly and correctly so that “market prices mirror the best possible estimates, in light of all available information, of the actual economic values of securities in terms of their expected risks and returns.”  Even though the two ideas are used interchangeably, deciding if a market is fundamental value efficient is inclusive of more technical analysis than in figuring out if it is informationally efficient.  A market can be information efficient while lacking what it needs to be fundamental value efficient. The fraud-on-the-market theory is not concerned with if a stock’s purchase price was “correct†in the fundamental but rather whether a market processes information in such a way as to justify investor reliance. Even though there are times when proof of fundamental value may have influence over if a market is informationally efficient, in general, trial courts, should not give consideration to such fundamental value proof at the class-certification stage, due to the risk of potentially turning the class-certification proceeding into a mini-trial on the merits, which should not be permitted. As far as the quantity of evidence required to back a demonstration of market efficiency and the rebuttable presumption that it is based upon, only “basic facts†need to be established by the plaintiff; the query is one of degree, note that the class-certification proceeding should not be transformed into an awkward mini-trial on the merits. In this case, applying the incorrect standard of market efficiency, the district court did not contemplate the elements of market efficiency. The facts the court did take into consideration were pertinent to the issue, they failed to be exhaustive. So, had the district court utilized the appropriate definition of market efficiency, additional elements mentioned by PolyMedicacould have also been considered pertinent to the efficiency investigation and could have possibly supported an oppositional finding. The district court’s mistake was the application of an inaccurate definition of market efficiency that hindered it from analyzing other arguably pertinent proof, not in analyzing the elements that it had. Vacated and remanded for application of the proper standard.

    Discussion. Deciding if a market is fundamental value efficient is a far more technical inquiry than defining informational efficiency itself. Contingent on the technique of assessment utilized, a stock’s fundamental value begins avaluation of various factors, including currentprocedures, upcoming growths rates, comparative risk levels, and the future levels of interest rates. Although, even some of the tests that claim to measure how closely prices reflect valuehave been extremely controversial, such as those which measure whether the variability of prices is greater than the variability of dividends over time, and observers have noticed that stock prices frequently and significantly meander away from current value models and also from financial variables that seem to provide a wealth of information pertinent to a computation of fundamental value. While others have mentioned that a “major drawback to fundamental value theory is that it requires a great deal of specific, sometimes unobtainable, information†which appears as though the court’s detention of its standard of efficiency to informational efficiency is partially due to an effort to evade at the class certification stage an examination of evidence that concernsintricate, technical, and provocativetheories so as to escape a mini-trial at that stage.



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