Do Conflicts between Class Members Vitiate Class Action Securities Fraud Suits?
Ross, David J, St. John's Law Review
DAVID J. Ross
Many commentators believe that the enhanced pleading requirements of the recently enacted Private Securities Litigation Reform Act1 will reduce the number of private securities fraud suits.2 However, a recent, but little noticed federal district court decision may also greatly affect litigation of securities fraud suits brought under Section 10(b) of the Securities & Exchange Act of 1934(3) and Rule 10b-5, promulgated thereunder by the Securities and Exchange Commission.4 Plaintiffs in these cases typically seek to have their cases certified as class actions under Federal Rule of Civil Procedure ("FRCP") 23(b)(3). Qualification as a "(b)(3)" class action requires the establishment of six elements: numerosity, commonality, typicality, adequacy of representation, predominance and superiority.5 Until recently, courts had routinely found that securities cases satisfied these requirements and, accordingly, certified them as class actions.6 However, in a lengthy and thoughtful opinion, the United States District Court for the Northern District of California, in In re Seagate Technology II Securities Litigation,7 identified potential conflicts between class members which call into question the ability of securities fraud class actions to satisfy the typicality and adequacy of representation elements of FRCP 23(a) and FRCP 23(b)(3).8
The Seagate II court identified two situations in which conflicts can arise. The first situation, identified as the "sellerpurchaser conflict," arises when members of the proposed class both bought and sold the security at issue during the relevant period (such persons are called "seller-purchasers").9 The second situation, identified as the "equity conflict," arises when members of the proposed class hold equity in the security's issuer at the time of the litigation (such persons are called "current holders").10 For an actively traded security, it is virtually certain that both circumstances will be present to some extent: some class members will have both purchased and sold securities during the class period and some class members will be holding equity in the security's issuer while the case is being litigated.
The court's analysis in Seagate II demonstrates that securities cases in which the proposed class contains seller-purchasers or current holders cannot meet the requirements of FRCP 23(b)(3) and, therefore, should not be certified as class actions. The court, however, was unwilling to reach this conclusion and, instead, ordered an "evidentiary hearing" to determine the actual extent of the potential conflicts.11 The Seagate II court did not describe the evidence that would be relevant in such a hearing and, because the plaintiffs elected to seek certification of a class that did not contain seller-purchasers rather than submit evidence about conflicts in the class initially proposed, no hearing was ever held.12
The proceedings in Seagate II can be interpreted in two ways. Under one interpretation, securities fraud cases could never be certified as class actions if the proposed class contained either seller-purchasers or current holders. Under the alternative interpretation, securities fraud cases could only be certified as class actions following an evidentiary hearing to determine the actual extent of potential conflicts. This article considers both interpretations. Section I explains why conflicts arise and the reason these conflicts should prevent class certification. Section II considers and rejects the arguments and proposed procedures that courts have used to certify securities fraud cases as class actions despite the existence of class conflicts. Section III discusses the court's resolution of Seagate II and explains how readily available evidence could be used in an evidentiary hearing regarding the extent of class conflicts. Section IV concludes by discussing the implications of Seagate II on future securities fraud class actions.