Clampdown On Class-Action Certifications

An influential federal appeals court has given corporate defendants new ammunition to help defeat class certification in securities lawsuits.

The New York-based 2nd U.S. Circuit Court of Appeals last month overturned class certification in the largest consolidated securities class action in U.S. history, directing the trial judge to view more skeptically claims that a purported class had satisfied the standards set by the Federal Rules of Civil Procedure.

The court said plaintiffs cannot merely make “some showing” of compliance with the rules concerning the number of the class members, which typically include the named plaintiff’s claims, the existence of questions of law or fact common to the entire class, and whether the named plaintiff would adequately represent the class.

Rather, the court ruled in In re Initial Public Offering Securities Litigation, “a district judge is to assess all of the relevant evidence admitted at the class certification stage and determine whether each [Federal] Rule 23 requirement has been met, just as the judge would resolve a dispute about any other threshold prerequisite for continuing a lawsuit.” The opinion also noted that in some cases this would mean addressing issues touching on the merits of the suit.

Securities-litigation experts say the decision should make it easier for corporations to defeat class-certification attempts and magnifies the importance of pushing for an evidentiary hearing.

Andrus

“They’re tightening the reigns,” says Sarah Andrus, with the law firm Buchalter Nemer. No longer, she says, can a judge only do a quick check to ensure the plaintiff’s evidence is fatally flawed. “Each element of Rule 23 must be established by accessing all the evidence,” Andrus says.

Schwinger

Robert Schwinger, of the Chadbourne & Park law firm, says the standard set by the 2nd Circuit will “whittle out” some of the more flimsy cases that, until now, have won class-action status because judges could not consider the merits of the overall case when granting the class certification. Schwinger says the ruling reflects a trend in federal courts to toughen the standard for class certification and will be influential in other jurisdictions.

“If you’re in one of the other circuits that’s [still] doing it the other way, you’re well within your rights to say to the judge, ‘Look how other courts have reevaluated this in recent years. You should reevaluate it too,’” he says.

Fraud Alleged In IPOs

The 2nd Circuit’s decision arises out of an action consolidating suits filed by thousands of investors in 2001 that allege that 55 underwriters, 310 issuers, and hundreds of their officers had engaged in a scheme to defraud the investing public in violation of the Securities Act of 1933 and the Securities Exchange Act of 1934.

DECISION

An excerpt follows from the 2nd Circuit’s decision in IPO.

Clarifying the standards for the Second Circuit.

…

It would seem to be beyond dispute that a district court may not grant class certification without making a determination that all of the Rule 23 requirements are met. We resist saying that what are

required are “findings” because that word usually implies that a district judge is resolving a disputed issue of fact. Although there are often factual disputes in connection with Rule 23 requirements, and such disputes must be resolved with findings, the ultimate issue

as to each requirement is really a mixed question of fact and law. A legal standard, e.g., numerosity, commonality, or predominance, is being applied to a set of facts, some of which might be in dispute.

The Rule 23 requirements are threshold issues, similar in some respects to preliminary issues such as personal or subject matter jurisdiction. We normally do not say that a district court makes a

“finding” of subject matter jurisdiction; rather, the district court makes a “ruling” or a “determination” as to whether such jurisdiction exists. The judge rules either that jurisdiction exists or that it does not. Of course, in making such a ruling, the judge often resolves underlying factual disputes, and, as to these disputes, the judge must be persuaded that the fact at issue has been established. The same approach is appropriate for Rule 23 requirements. For example, in considering whether the numerosity requirement is met, a judge might need to resolve a factual dispute as to how many members are in a proposed class. Any dispute about the size of the proposed

class must be resolved, and a finding of the size of the class, e.g., 50, 100, or more than 200, must be made. At that point, the judge would apply the legal standard governing numerosity and make a ruling as to whether that standard, applied to the facts as found, establishes numerosity.

The Rule 23 requirements differ from other threshold issues in that, once a district court has ruled, the standard for appellate review is whether discretion has been exceeded (or abused). This standard of review implies that a district judge has some leeway as to Rule 23 requirements, and, unlike rulings as to jurisdiction, may be affirmed in some circumstances for ruling either that a particular

Rule 23 requirement is met or is not met. Of course, this leeway, as with all matters of discretion, is not boundless. To the extent that the ruling on a Rule 23 requirement is supported by a finding of fact, that finding, like any other finding of fact, is reviewed under the “clearly erroneous” standard. And to the extent that the ruling involves an issue of law, review is de novo.

To illustrate, again using the example of numerosity, review of the factual finding as to the size of the proposed class would be for clear error, review of the judge’s articulation of the legal standard governing numerosity would be de novo, and review of the ultimate

ruling that applied the correct legal standard to the facts as found would be for abuse of discretion. Thus a ruling on numerosity, based on a finding of fact that is not clearly erroneous and withapplication of a legal standard that is correct, could be affirmed as within allowable discretion, in some circumstances, whether the ruling

determined that this Rule 23 requirement was met or not met.

The more troublesome issue arises when the Rule 23 requirement overlaps with an issue on the merits. With Eisen properly understood to preclude consideration of the merits only when a merits issue is unrelated to a Rule 23 requirement, there is no reason to lessen a district court’s obligation to make a determination that every Rule 23 requirement is met before certifying a class just because of some or even full overlap of that requirement with a merits issue. …

In one respect, however, overlap between a Rule 23 requirement and a merits issue justifies some adjustment in a district court’s procedures at the class certification stage. To avoid the risk that a Rule 23 hearing will extend into a protracted mini-trial of substantial portions of the underlying litigation, a district judge must be accorded considerable discretion to limit both discovery and the extent of the hearing on Rule 23 requirements. But even with some limits on discovery and the extent of the hearing, the district judge must receive enough evidence, by affidavits, documents, or testimony, to be satisfied that each Rule 23 requirement has been met.

In light of the foregoing discussion, we reach the following conclusions: (1) a district judge may certify a class only after making determinations that each of the Rule 23 requirements has been met; (2) such determinations can be made only if the judge resolves factual disputes relevant to each Rule 23 requirement and finds that whatever underlying facts are relevant to a particular Rule 23 requirement have been established and is persuaded to rule, based on the relevant facts and the applicable legal standard, that the requirement is met; (3) the obligation to make such determinations is not lessened by overlap between a Rule 23 requirement and a merits issue, even a merits issue that is identical with a Rule 23

requirement; (4) in making such determinations, a district judge should not assess any aspect of the merits unrelated to a Rule 23 requirement; and (5) a district judge has ample discretion to circumscribe both the extent of discovery concerning Rule 23 requirements and the extent of a hearing to determine whether such requirements are met in order to assure that a class certification motion does not become a pretext for a partial trial of the merits.

In drawing these conclusions, we add [these] observations. First, our conclusions necessarily preclude the use of a “some showing” standard, and to whatever extent Caridad might have implied such a standard for a Rule 23 requirement, that implication is disavowed. Second, we also disavow the suggestion in Visa Check that an expert’s

testimony may establish a component of a Rule 23 requirement simply by being not fatally flawed. A district judge is to assess all of the relevant evidence admitted at the class certification stage and determine whether each Rule 23 requirement has been met, just as the judge would resolve a dispute about any other threshold prerequisite

for continuing a lawsuit.

Source

In Re: Initial Public Offering Securities Litigation (2nd U.S. Circuit Court of Appeals; Dec. 5, 2006; See Pages 37 – 42)

In these suits, the plaintiffs allege that the defendants improperly conditioned allocation of initial public offering shares on agreements to purchase the issuers’ shares in the aftermarket at escalating prices, and required customers who received allocations of IPO shares to pay undisclosed compensation to the underwriters. In addition, the plaintiffs claim that the underwriters inflated the price of the shares by preparing analyst reports that contained inaccurate information and improper recommendations influenced by conflicts of interest.

In 2003, a federal judge in the Southern District of New York certified a class in six “focus cases,” finding that the plaintiffs had made “some showing” under Rule 23 that common questions of law or fact predominate over individual questions and that a class action would be superior to other methods of resolving the claims.

Rule 23 states that members of a class may sue or be sued as representative parties on behalf of all “only if (1) the class is so numerous that joinder of all members is impracticable, (2) there are questions of law or fact common to the class, (3) the claims or defenses of the representative parties are typical of the claims or defenses of the class, and (4) the representative parties will fairly and adequately protect the interests of the class.” The rule also provides that a class action is only appropriate if the questions of law common to all members predominate over questions affecting the individual members “and … a class action is superior to other available methods for the fair and efficient adjudication of the controversy.”

The 2nd Circuit overturned the class certification in IPO, however, saying that the judge didn’t sufficiently probe the plaintiffs’ claims to ensure that all of the requirements of Rule 23 were met. Specifically, the court found that the plaintiffs had not shown a predominance of common questions because they were not entitled to rely on a legal presumption that everyone in the class relied on any misrepresentations.

In clarifying the law in the 2nd Circuit—which, according to Cornerstone Research, had the highest number of securities-action filings in 2005—the court said that judges should not be afraid to address issues involving the merits of a suit if doing so was necessary to determine whether certification was appropriate. Plaintiffs in other cases have argued, sometimes successfully, that a previous U.S. Supreme Court decision precluded consideration of the merits when making a certification decision. This ruling seals off that tactic.

“[T]he obligation to make such determinations is not lessened by overlap between a Rule 23 requirement and a merits issue, even a merits issue that is identical with a Rule 23 requirement,” the court said.

Certification Not Automatic

Hurd

Susan Hurd, a partner with the law firm Alston & Bird, says the 2nd Circuit has “debunked the myth” that consideration of the merits at the certification stage is inappropriate, and “sends a message to district court judges that they need to seriously examine these issues before they certify a class.”

Such a “well-reasoned decision by a very respected court is going to carry a lot of weight,” she says. “I would argue that all the circuits should follow this rule and all of them will ultimately follow this rule, though it takes a while for the cases to percolate in the system.

Frederico

Donald Frederico, of the Greenberg Traurig law firm, says the 2nd Circuit’s decision strengthens the ability of corporate defendants to persuade a judge to look closely at the evidence on both sides, and “enhances the ability of [defendants] to obtain an evidentiary hearing on certifications.”

Although many corporate defendants already fight class certification aggressively, the 2nd Circuit’s analysis “makes it incumbent to strongly request an evidentiary hearing on these motions that would consider both factual and expert testimony,” says Frederico, who adds that he’s already cited IPO in cases he’s handling outside of the 2nd Circuit.

Tu

Michael Tu, a partner with the law firm Orrick, Herrington & Sutcliffe, says that “plaintiffs often approach class certification as almost ... automatic in many cases. At least in my experience, many defense firms also treat it the same way. What this decision highlights is that, under the right circumstances, that doesn’t necessarily have to be the case.”

Tu says the 2nd Circuit’s reasoning can apply to cases well beyond the complicated schemes alleged in the IPO litigation, to any securities class action where a question exists about whether certification is appropriate. He says the court’s thinking could have an influence on many judges who at present “routinely” certify securities class actions.