PIABA Bar Journal (Fall 2004, Vol. 11, # 3)

Judge Pollack's Merrill Lynch Research Analyst Decisions 
-  Lost in [Info]Space
                               
by Mark A. Tepper  Written with Josh Katz    Securities Fraud Attorneys

Judge Pollack's Merrill Lynch research analyst decisions are an anachronism which are out of step with the majority of courts that have considered research analyst issues.  "Warp speed" cannot bring Judge Pollack's decisions in line with 21st century thought. 

Judge Pollack follows the now misplaced concept of blaming the victim.  He concluded that victims from across the country were aware of the scattered articles of general interest that appeared in some newspapers.  Apparently, Judge Pollack believed that each victim had the obligation to "google" Merrill Lynch 24/7 to protect their investments.  This unrealistic burden was laid to rest by the New York Attorney General's office which had to resort to its vast arsenal of legal resources to unmask the fraud.  Other federal courts have questioned Judge Pollack's analysis, since the articles were only of general interest and not specific to any particular fraud.

The remainder of this article compares Judge Pollack's legal analysis with the contrary views of his colleagues.  It is elementary that only the legendary investigatory skills of a Sherlock Holmes (or the subpoena power of the New York Attorney General's office) could have uncovered what Judge Pollack erroneously assumed everyone knew that brokers offered fraudulent positive research coverage for investment banking fees.  Other federal courts had less difficulty
understanding that victims were not detectives and  that victims made their investment decisions without the benefit of hindsight.
   

The Pollack Decisions

Judge Pollack dismissed research analyst cases against Merrill Lynch, because the Class "Plaintiffs have failed to adequately plead that defendant and its former chief internet analyst caused their losses."  In re Merrill Lynch & Co. Research Reports Sec. Litig., 273 F.Supp.2d 351, 358 (S.D.N.Y. 2003)(dismissing the 24/7 and Interliant claims)(emphasis in original); see In re Merrill Lynch, 289 F.Supp.2d 416 (S.D.N.Y. 2003)(dismissing claims based on research reports covering eToys, Homestore.com, iVillage, Lifeminders, LookSmart, Openwave Systems, Pets.com, and Quokka Sports); see also In re Merrill Lynch, 272 F.Supp.2d 243 (S.D.N.Y. 2003)(dismissing claim against proprietary mutual fund based on misrepresentations and omissions). 

The Class Plaintiffs failed to adequately plead with the particularity required under Fed. R. Civ. P. 9(b) and the Private Investors Securities Litigation Reform Act of 1995 ("Reform Act").  The Class Plaintiffs did not see or read the research reports alleged to be fraudulent, but relied on allegedly inflated prices when deciding to purchase.  The Class Plaintiffs claimed that Merrill Lynch and its star research analyst, Henry Blodget, artificially inflated the price of stock in order to win investment banking fees from issuers.  As part and parcel of the alleged fraud on the market, Merrill Lynch maintained a skewed three-point rating system.  That system maintained ratings of Strong Buy or Buy for the covered stock, even when the prices fell.  The Class Plaintiffs alleged they would not have purchased had Merrill Lynch disclosed its fraudulent scheme.  As a result, Merrill Lynch caused
the Class Plaintiffs' losses. 

     According to Judge Pollack, the Class Plaintiffs failed to show:

          (1) that Merrill Lynch intended to defraud them;

          (2) that the research reports and rating system were
          actionable misstatements of opinion;

          (3) that the conflicts of interest and the three-point rating
          system were material; and

          (4) that the Class Plaintiffs could prove the alleged
          misrepresentations and omissions caused their losses. 

August Decision at 358 (". . . the federal securities laws at issue here fault those who, with intent to defraud, make a material misrepresentation or omission of fact (not opinion) in connection with the purchase or sale of securities that causes a plaintiff's losses" (emphasis in original)).  In sum, Judge Pollack was "utterly unconvinced" that the facts alleged in the complaints could state a cause of action under 10b-5.  Judge Pollack also concluded that the Class Plaintiffs' complaint
was not timely filed, because they were on inquiry notice more than two years prior to the date of filing.        

Despite Judge Pollack's conclusions in these decisions, his decisions stand apart from other research analyst cases considering similar materials.  Faced with research analyst cases involving different brokerage firms, other judges have held that the plaintiffs did sufficiently allege a cause of action under Rule 10b-5.  See In re WorldCom ("WorldCom"), 294 F.Supp.2d 294 (S.D.N.Y.); In re WorldCom Public Employees Retirement System of Ohio ("WorldCom Ohio"), 2003 WL 22790942 (S.D.N.Y.); Fogarazzo v. Lehman Bros., Goldman Sachs & Morgan Stanley, 2004 WL 1151542 (S.D.N.Y.); DeMarco v. Lehman Bros. et al. ("DeMarco I"), 309 F.Supp.2d 631 (S.D.N.Y.2004); DeMarco v. Robertson Stephens ("DeMarco III"), 318 F.Supp.2d 110(S.D.N.Y. 2004); see also In re Initial Public Offerings ("IPO"), 297 F.Supp.2d 668 (S.D.N.Y. 2003); Norman v. Salomon Smith Barney, 2004 WL 1287310 (S.D.N.Y.)(denying motion to dismiss claim against trading program based on SSB research); La Grasta v. First Union, 358 F.3d 840 (11th Cir. 2004)(reversing motion to dismiss for statute of limitations); but compare Podany v. Robertson Stephens, 318 F.Supp.2d 146 (S.D.N.Y. 2004)(granting motion to dismiss research analyst case).

The Distinct Facts Alleged in the Merrill Lynch Class Actions

Motions to dismiss generally review the sufficiency of the complaint to determine whether the allegations state a cause of action on which relief may be granted.  Judge Pollack dismissed his securities class actions at the pleading stage, but did not rule on the underlying merits.  The cases reviewed by Judge Pollack alleged distinct facts in the pleadings  revealed largely before discovery.    

The Class Plaintiffs faced a tough challenge to allege facts sufficient to survive a motion to dismiss.  The NASD found Merrill Lynch published fraudulent research on Goto.com and InfoSpace.  "As a result, Merrill Lynch effected transactions in, or induced the purchase or sale of, securities by means of acts deemed to be manipulative, deceptive or otherwise fraudulent devices or contrivances."  NASD, Letter of Acceptance, Waiver and Consent ("AWC"), No.CAF030028 at 24 (Apr. 21, 2003). 

The NASD found Merrill Lynch "only" violated NASD Advertising Rules for its coverage of 24/7 Real Media ("24/7"), Lifeminders, and Homestore.com, but did not find violations of federal anti-fraud laws (fn. 1).  The AWC does not mention Interliant, eToys, iVillage, LookSmart, Openwave Systems, Pets.com, or Quokka Sports at all.

Judge Pollack decided the motions to dismiss these securities class actions under 10b-5 where the Class consisted of non-clients who did not allege to have purchased the securities through Merrill Lynch.  Claimants need to distinguish their facts from the allegations in the complaints before Judge Pollack, because respondents are insisting that Judge Pollack's decision protects brokerage firms from liability.  Judge Pollack was hardly the only judge presiding over research
analyst cases in the Southern District of New York ("S.D.N.Y.").  This article details their decisions and demonstrates the facts judges in the S.D.N.Y. have accepted as sufficiently pleading a 10b-5 cause of action. 

Intent to Defraud -- Scienter and the Millions of Dollars in Bonuses

Plaintiffs cannot "second guess" analysts after the fact and conclude that the analyst's statement was fraudulent.  Podany 318 F.Supp.2d at 154.  Analysts could review the same information about an issuer and arrive at different conclusions.  "A statement is objectively misleading. . .simply by virtue of being false. . . . A statement can also be misleading, though not technically false, if it amounts to a half-truth by omitting some material fact."  Fogarazzo at *14.  "But a statement does not become fraudulent simply by virtue of being false (or otherwise misleading) the other elements of fraud, such as scienter and reliance, must also be present."  Id.

A party pleads scienter by "establish[ing] a 'strong inference' of fraudulent intent 'either (a) by alleging facts to show that defendants had both motive and opportunity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness.'"  Suez Equity v. The Toronto-Dominion Bank, 250 F.2d 87, 99-100 (2d Cir. 2001), quoting Shields v. Citytrust Bancorp, 25 F.3d 1124, 1128 (2d Cir. 1994).  "In general, a strong inference of scienter 'may arise where the complaint sufficiently alleges that the defendants: (1) benefitted in a concrete and personal way from the purported
fraud, (2) engaged in deliberately illegal behavior, (3) knew facts or had access to information suggesting that their public statements were not accurate, or (4) failed to check information they had a duty to monitor.'"  Fogarazzo at *15, quoting Novak v. Kasaks, 216 F.3d 300, 310-11 (2d Cir. 2000).

The various, well-documented settlements offer clear evidence of scienter as to the existence of "wide-spread conflicts of interest between the analyst and investment banking departments. . . ."  Fogarazzo at *16.  Many, if not all, of the Research Analyst AWC's have shown that firms compensated analysts based on their ability to generate investment banking fees.  Further, brokerage firms entered AWC's which found the firms were engaged in deliberately illegal behavior.

The plaintiffs in Fogarazzo ". . . certainly alleged scienter by showing that the Banks had both the motive and opportunity to commit the fraud   they were the entities that released the allegedly fraudulent analyst reports."  Id. at *15.  The Banks did not contest opportunity, but did contest motive. 

Judge Scheindlin held that plaintiffs "show[ed] motive by alleging concrete benefits that could be realized by one or more of the false statements and wrongful nondisclosures alleged."  Id. (internal citation omitted).  As in most research analyst cases, ". . . the motive prong is . . .satisfied because the Banks allegedly doctored their analyst reports in order to win investment banking business from RSL."  Id. at 16.  Additionally, the Fogarazzo plaintiffs alleged the Banks exchanged favorable research coverage for investment banking business.  Even where ". . . there
are no explicit allegations of a deal to trade research coverage for business,
. . . there are remarkable coincidences that, viewed in the light most favorable to the plaintiffs, suffice to suggest [a] quid pro quo."  Id., citing WorldCom, 294 F.Supp.2d at 425.

The illicit arrangement need not only to have involved the security covered in the research reports.  In Fogarazzo, for instance, "some of the most specific allegations of scienter in the complaint" pertained to securities other than RSL.  "Taken together," Judge Scheindlin found he could "easily infer that the Banks' relationships with RSL were subject to the same conditions as with other companies."  Id. (emphasis in original).

Judge Rakoff concluded that "the stark difference" between what an analyst recommended to the public and what he recommended to institutional investors "supports a reasonable inference of an intent to mislead and defraud the former."  DeMarco I at 635.

Misrepresentations of Opinion are Actionable under Rule 10b-5

The Supreme Court announced in Virginia Bankshares that statements of opinion may be actionable as fraudulent where the statements are objectively and subjectively false.  Virginia Bankshares v. Sandberg, 501 U.S. 1083, 1095-96 (1991); In re McKesson HBOC, Inc. Sec. Litig., 126 F.Supp.2d 1248 (N.D. Cal. 2000).  "A statement is objectively misleading . . . simply by virtue of being false."  Fogarazzo at *14.  Cases decided under Virginia Bankshares have concluded that "[t]o prove that [ ] statements were subjectively false the plaintiffs must show that, at a minimum, the [speaker] made their statements in reckless disregard as to whether they were false."  In re Reliance Sec. Litig., 135 F.Supp.2d 480, 515 (D.Del. 2001).   
   

"Forward-Looking" Statements

The Class Plaintiffs conceded that the research reports and ratings were opinions, which "necessarily" contained forward-looking statements.  August Decision at 372, 376. "[T]he only challenge that may be made to a statement of opinion is that the speaker did not actually hold theopinion."  August Decision at 372-73, citing Virginia Bankshares v. Sandberg, 501 U.S. 1083, 1095-96 (1991) (fn. 2).   Judge Pollack found that the Class Plaintiffs' allegations relating to conflicts of interest and the ratings were irrelevant to the determination of whether the statements were genuinely held  "undisclosed motivations are not actionable."  Id. at 374.  Without that evidence, "plaintiffs [were] left with just the e-mails."  Id.  The emails, according to Judge Pollack, were not contemporary with the alleged fraudulent reports and concerned other securities.  Therefore, the Class Plaintiffs failed to show Merrill Lynch did not actually hold the opinions contained in the research reports and ratings.

Judge Pollack's rulings rest on the insufficiency of evidence alleged in the complaints before him.  Judge Pollack did not dismiss the complaints because an aggrieved party has no legal remedy for a misrepresentation of opinion.  As revealed in other research analyst cases, opinions contained in research reports may well be actionable.

In contrast to Judge Pollack's holding, Judge Scheindlin determined that "[t]here is no question that plaintiffs have identified the allegedly misleading statements: they are the buy recommendations and price targets contained in the Banks' research reports."  Fogarazzo at *14.
As a statement of opinion, Judge Scheindlin held that evidence that the statement was objectively false and that the speaker deliberately misrepresented her actual opinion was sufficient to render a misstatement of opinion actionable. 

Judge Rakoff came to the same conclusion: "The primary statements here alleged to be misleading are the ratings themselves and the accompanying 'bullish' analysis."  DeMarco I, 309 F.Supp.2d at 634.  Contrary to Judge Pollack's decision, the Court held that two e-mails written in July 2000 and January 2001 sufficiently supported a reasonable inference that the analyst did not believe in his Strong Buy rating for RealNetworks "throughout the period that he continued to give RealNetworks his very highest rating (i.e. through July 2001)."  Id.  

Judge Cote denied SSB's argument that the research reports "were simply statements of opinion and expressions of optimism held in good faith."  WorldCom, 294 F.Supp.2d 392 at 427.  In that case, plaintiffs "alleged with particularity that, at a minimum, Grubman was not functioning as an independent analyst, but had been corrupted, and withheld from his readers his serious concerns about the accuracy of the WorldCom financial information that he was conveying to them and about the reliability of his advice to them."  Id.

The mere fact that research analysts produce forward-looking opinions cannot immunize them from liability where they did not actually hold the opinions they published.  "Critical to the value of these reports was that the Banks held them out to be based on accurate information and to contain independent and unbiased recommendations on which the investing public could rely." Fogarazzo at *2.  In reality, many research analysts were not independent, were biased, and passed along inaccurate information.

Materiality of Misrepresentations and Omissions and The Bespeaks Caution Doctrine

In spite of these showings, Banks have argued that the mixture of cautionary language in the research reports and disclosures in newspaper articles successfully warned the public about risks associated with the stocks they recommended.  The bespeakscaution doctrine "is essentially shorthand for the well-established principle that a statement or omission must be considered in context, so that accompanying statements may render it immaterial as a matter of law."  In re Donald Trump Casino Sec. Litig., 7 F.3d 357, 364 (3d Cir. 1993).  In the situation of the Merrill Lynch research analyst cases, Judge Pollack decided that the conflicts of interest and fraudulent rating system were immaterial.  August Decision at 376-78.
                   
"The doctrine of bespeaks caution provides no protection to someone who warns his hiking companion to walk slowly because there might be a ditch ahead when he knows the Grand Canyon lies one foot away."  In re Prudential Securities Inc. Ltd. Partnerships Lit., 930 F.Supp. 69, 72 (S.D.N.Y. 1996)(Pollack, J.).  Judge Pollack concluded that the "[Class] Plaintiffs' 'Grand Canyon' is the bursting of the Internet bubble and the concomitant drop in the stock price of Interliant and 24/7."  August Decision at 376.  In research analyst cases in the S.D.N.Y., Judge Pollack's colleagues have found similar cautionary language and newspaper articles offered no protection in spite of the bursting of the bubble.

Cautionary Language Investment Banks Provided in Research Reports

The bespeaks caution doctrine offers protection only when a forward-looking statement "contain[s] extensive and specific warnings about the riskiness of investments."  In re Prudential Ltd. Partnerships, 930 F.Supp. at 72.  General warnings and boilerplate do not constitute bespeaks caution language; neither are disclaimers which are not "explicit or specific as to the fraud alleged."  La Grasta, 358 F.3d at 851.  Cautionary language cited to justify application of the doctrine must precisely address the substance of the specific statement or omission that is
challenged.  In re Trump Casino, 7 F.3d at 371-72.  Cautionary language does not protect material misrepresentations or omissions when defendants know of their falsity when made.  Huddleston v. Hermon & MacLean, 640 F.2d 534 (5th Cir. 1981), modified on other grounds, 459 U.S. 375 (1983).

The cautionary language must address the misrepresentations and/or omissions alleged to have been fraudulent.  In the Pollack Decisions, as evidenced by excerpts provided by Judge Pollack, Merrill Lynch provided (at least) some warning concerning risk.  As a matter of law, Judge Pollack held that this language rendered any allegation of misrepresentation or omission based on the conflicts and rating system immaterial.

Merrill Lynch included allegedly skeptical language which Judge Pollack found should have sufficiently cautioned investors.  This skepticism included statements that:

               potential problems of financial controls "makes
               accurate forecast of results difficult;"
               "the stock is likely to be extremely volatile;"
               "the stock's valuation is aggressive in light of the
               company's relatively early stage of development and
               the risk associated with the consolidation strategy;"
               "we expect [the company] to develop 'in fits and
               starts;'"
               ". . . we continue to have concerns about low revenue
               visibility and volatile margins."

August Decision at 377.  Thus, claims that Merrill Lynch exaggerated their enthusiasm about the stocks were immaterial due to cautionary language contained in the reports.  

Additionally, each security "carried a 'D' rating, which was published on the first page of every report and signified that the stocks have 'high potential for price volatility.'" August Decision at 377 (emphasis in original).  However, as Judge Pollack demonstrated, Merrill Lynch assigned a "D" rating to all Internet companies.  Id. at 361.  The "D" rating offered investors no guidance as
to the riskiness among Internet companies. 

Judge Pollack did not discuss Merrill Lynch's numerical ratings, which provided what Merrill Lynch considered as the potential for appreciation.  A "D-1-1" rating, which Merrill Lynch maintained for InfoSpace during almost all of 2000, meant that Merrill Lynch recommended a stock as appreciating by more than 20% within the first 12 months, another 20% within 12-24 months, but with a high potential for volatility.  Consistency of a single recommendation along with the absence of cautionary language or scant cautionary language may nevertheless render a misrepresentation or omission material. 

Analysis under the bespeaks caution doctrine necessitates a close reading of the context of the statements made.  In re Trump Casino 7 F.3d at 369, passim.  As other judges have shown, contrary to Judge Pollack, inclusion of cautionary language does not end the discussion.  Cautionary language cannot overcome what the analyst knows is false, and an analyst's unwavering support for a security tells investors to throw caution to the wind. 
    
Judge Cote rejected the bespeaks caution doctrine as a defense in her decision in WorldCom, 294 F.Supp.2d 392, 427: "[t]he cautionary language on which the defendants rely does not come close to providing a sufficient warning of Grubman's skepticism about the WorldCom data he was presenting to his readers and his skepticism about his own repeated, forceful recommendations that investors should buy WorldCom securities."  Id. 

Judge Rakoff agreed: "[T]he very fact that, notwithstanding the skeptical language, the reports gave RealNetworks its highest possible 'buy' rating is tantamount to a statment that the reader of the reports should discount the skeptical language."  DeMarco I, 309 F.Supp.2d at 634.  In that case, the bespeaks caution defense "fail[ed] because a reasonable fact-finder could conclude that Lehman, in repeatedly and disingenuously giving RealNetworks its highest 'buy' rating, was effectively representing that it did not believe the risks involved should deter a prudent investor from purchasing RealNetworks . . . ."  Id.

Newspaper Articles Did Not Sufficiently Warn the Public

Merrill Lynch, as other defendant-respondents have done since, pointed to supposedly wide-spread knowledge of conflicts of interest between research and investment banking.  Judge Pollack agreed: "The plethora of public information would have required even a blind, deaf, or indifferent investor to take notice of the purported alleged 'fraud.'" August Decision at 389 (emphasis in original).  Judge Pollack assumed this position by taking judicial notice of newspaper articles.  He justified his decision, because "[t]he Court may take judicial notice of newspaper articles for the fact of their publication without transforming the motion into one for summary judgment."  August Decision at 383, n.3.  However, Judge Pollack
did not take judicial notice for the fact of their publication, but for their contents.

After reviewing these newspaper articles, Judge Pollack stated: "Thus, well before the internet bubble burst in March and April 2000, abundant material was in the public domain regarding the existence of widespread investment banking conflicts of interest and allegedly inflated buy ratings in Wall Street stock research."  Id. at 388.  "Every investor of reasonable intelligence would have been absolutely on inquiry notice.  Plaintiffs overlook the 'uncontroverted evidence [that] irrefutably demonstrates' the inquiry notice."  Id. at 389 (alteration in original).  Judge
Pollack concluded that "[t]he market could not have been defrauded by the alleged failure to disclose the conflicts or the supposed three-point rating system.  Plaintiffs' own allegations and the articles upon which they rely evidence that the market was apprised of the very conflicts and ratings issues raised by them."  Id. at 375. 
 
The courts have disagreed with Judge Pollack.  The Eleventh Circuit recently denied a motion to dismiss in a case similar to Merrill Lynch based on First Union's coverage of Ask Jeeves.  La Grasta, 358 F.3d at 849.  In that case, the Eleventh Circuit determined from the pleadings that the time of inquiry notice started based on a June 2000 Smart Money magazine article.  Id. at 846.  But the Court questioned the propriety of taking judicial notice of a dozen newspaper
articles for the purposes of hearing a motion to dismiss.  Id. at 849-50. 

Unlike the articles of which Judge Pollack took judicial notice, the June 2000 Smart Money article "featured [the First Union analyst] and her coverage of Ask Jeeves, and disclosed that, since January of 2000, First Union had been 'in the running'
to be selected as the underwriter for Ask Jeeves' secondary stock offering, with a 'potential seven-figure payday.'" Id. at 844.  By contrast, the "Merrill Lynch" newspaper articles barely mentioned either Merrill Lynch or Henry Blodget.  The articles also did not discuss the specific securities the plaintiffs purchased.  August Decision at 383-88.            

Judge Cote rejected the same newspaper article argument.  The articles presented by the SSB Defendants in that case detailed a "friendship" between SSB analyst, Grubman, and WorldCom's CEO, Ebbers.  Another discussed "Grubman's 'dual role' as an analyst and deal broker.'" WorldCom Ohio at *6.  Yet another revealed how research analysts derived their compensation based on the amount of investment banking fees generated.  Id.  Nonetheless, Judge Cote held that "the press reports on which the SSB Defendants rely are simply too vague to support a conclusion that, as a matter of law, plaintiffs were on notice as early as September 2000, of their potential claims that an illicit relationship between the SSB Defendants and WorldCom had tainted financial reporting about WorldCom in the analyst reports."  Id.

Similarly, Judge Scheindlin has held that such newspaper articles failed to disclose "allegations that investment bankers were requiring analysts to issue certain recommendations, that analysts' compensation was derived from the amount of
investment banking revenue that they generated, or that the analysts' views of the securities they covered were the exact opposite of what they recommended to the public."  Fogarazzo at *18.

Judge Lynch distinguished the case before him from the August Decision: "It is one thing to be aware that an analyst might have a conflict of interest that could cloud his judgment, and quite another to be aware that the analyst believes the exact opposite of what he is saying, and that he is saying it precisely in order to induce the unwary to buy the very stock the analyst is trying to unload before others realize, as he has, that the stock is wildly overvalued."  DeMarco III, 318
F.Supp.2d at 122.

Judge Cote also disagreed with Judge Pollack as to what legally constituted inquiry notice.  According to Judge Pollack, the newspaper articles placed the Class Plaintiffs on inquiry notice, because they disclosed the "potential for the conflicts."  August Decision at 379.  Judge Pollack cited this as "the language used by the Second Circuit in" LC Capital Partners v. Frontier Ins. Group, 318 F.3d 148 at 153-54, 157 (2d Cir. 2003).  Judge Pollack's summary rejection of the Class Plaintiffs' insistence on "probability of the fraud" is unfounded. 

In LC Capital, the Second Circuit stated that the district court determined inquiry notice based on the potential of the fraud.  The Second Circuit's discussion upheld prior Second Circuit language: "As we have explained, '[w]hen the circumstances suggest to an investor of ordinary intelligence the probability that she has been defrauded, a duty of inquiry arises.'" Id. at 154, quoting Dodds v. Cigna Securities, 12 F.3d 346, 350 (2d Cir. 1993); see also Newman v. Warnaco Group, 335 F.3d 187, 193 (2d Cir. 2003)(storm warnings "must be probable, not merely possible").  In contrast to Judge Pollack, Judge Cote held: "[Press reports] must be sufficiently revealing to make the existence of the fraud probable."  WorldCom Ohio at *6.

These newspaper articles could not have apprised the investing public of the conflicts of interest and the fraudulent rating system, because the articles were not specific or explicit to the actual fraud alleged.  General statements about the possibility of conflicts, for instance, would not have warned investors that a particular research report was false.   

The Individual Claimant and What the Investing Public Knew

The newspaper article defense is a variation of the "truth on the market" defense. See Demarco I, 309 F.3d at 634-35.  Individual investors who were clients of the publishing brokerage firm need not plead fraud on the market.  The individual claimant may prove direct reliance on the broker's statements.  In this situation, the truth on the market defense is inapplicable.  Evidence of what a newspaper might have written concerning general conflicts is irrelevant unless a respondent can show the claimant knew or should have known of the article.  General articles about conflicts cannot apprise a claimant of the specifics of a respondent's fraud, because they do not warn the investor of the probability their broker is defrauding them.  See WorldCom Ohio at *6; Fogarazzo at *17 ("Available information must establish 'a probability, not a possibility' of fraud to trigger inquiry notice"), quoting Newman, 335 F.3d at 193. 

Side Note: The Duty to Speak Doctrine

Respondents have also presented a defense related to the bespeaks caution argument in the Pollack Decisions.  They contend "that the analyst reports disclosed [the conflicts] to the extent required by NASD and NYSE regulations, and Section 10(b) does not require anything beyond such compliance."  WorldCom at 429-30 ("Where the SEC has decided what type of disclosure is necessary to reveal to the public a particular conflict of interest, and has enacted regulations to enforce that decision, courts will not impose greater disclosure obligations under the rubric of
Secion 10(b) or Rule 10b-5").  They have also argued that Claimants cannot hold brokers to present regulations retroactively and that imposing liability on anything beyond what was required would constitute an ex post facto taking.

Judge Cote found this argument "unavailing" and "wrong."  Id. at 430.  "Having chosen to speak to the investing public through the issuance of the analyst reports, they had an obligation to communicate in good faith and to disclose material information."  Id. at 431.  "Those who choose to speak . . . must speak honestly   not in half-truths, in bad faith, or without a reasonable basis for their statements.  When a person speaks, but chooses to omit information, the liability for that omission will be judged by its materiality.  The SSB Defendants were in the business of speaking to the public about stock values.  They spoke forcefully and frequently about the value of WorldCom.  Having spoken, the SSB Defendants may be held accountable for any material omissions in those statements."  Id. at 428.

                         
Transaction Causation

"Transaction causation is generally understood as reliance."  Castellano v. Young & Rubicam, 257 F.3d 171, 186 (2d Cir. 2001).  "Pleading that defendants perpetrated a fraud on the market . . . fulfills a plaintiff's transaction causation pleading requirement."  Fogarazzo at *8.  Under the fraud on the market doctrine, "misleading statements defraud purchasers of stock even if the purchasers do not directly rely on the misstatements."  Basic v. Levenson, 485 U.S. 224, 241-42
(1988).  Reliance is presumed under the fraud on the market doctrine.  "In such a case, individual investors are relieved of the burden of showing direct reliance on the fraudulent statement because it is assumed that in an efficient market, all public information is reflected in share price, including any misrepresentations concerning the value of the company or its stock. . . ." DeMarco III, 318 F.Supp.2d at 119.

The Class Plaintiffs had no choice but to argue fraud on the market, because they had not seen or read the research reports.  August Decision at 359.  Judge Pollack ruled that the Class Plaintiffs had failed to allege any misleading statements on which the Class Plaintiffs could have relied or which could have artificially inflated the price; thus, "[t]he market could not have been defrauded by the alleged failure to disclose the conflicts or the supposed three-point rating system."  Id. at 375. (Fn 3).

Plaintiffs in similar research analyst cases have sufficiently alleged transaction causation solely on the fraud on the market doctrine.  "An underwriter . . . that has a research department engaged in the business of analyzing companies in order to disseminate to the public information and opinions about specific securities clearly intends that the market take into account its recommendations to buy or sell such securities."  DeMarco III, 318 F.Supp.2d at 120. 

The SSB Defendants claimed in WorldCom that it would be inappropriate to apply the fraud on the market presumption in a research analyst case.  However, Judge Cote rejected SSB's argument:

          At no point in their briefs do [the SSB Defendants]
          acknowledge Grubman's alleged role as the premier analyst
          in the telecommunications industry.  Nothing in the
          defendants' briefs address why Grubman was paid
          approximately $20 million a year in compensation by SSB to
          be its telecommunications analyst if his analyst reports were
          irrelevant to the market.  Nothing in the defendants' briefs
          addresses why Grubman issued reports announcing that
          WorldCom was his favorite stock, offering the opinion that
          'we would be aggressive buyers at these prices,' and
          'strongly' reiterating his 'Buy rating on WorldCom, if his
          views were not likely to affect the decisions made by
          WorldCom investors.  The plaintiffs have shown that it
          comports with both common sense and probability to apply
          the presumption here. 

In re WorldCom, 219 F.R.D. 267, 299 (S.D.N.Y. 2003)(internal citations omitted).

Judge Rakoff agreed with Judge Cote in rejecting Lehman's argument that the Basic presumption does not apply to research reports.  DeMarco I, 309 F.Supp.2d at 635-6.  Judge Rakoff also did not follow Judge Pollack's conclusion that general market
awareness rebuts the Basic presumption: "Simply establishing the media had reported on some generalized conflicts between investment banking and research departments in a variety of investment banks is not the equivalent to market awareness of Stanek's misrepresentations."  Id. at 636.

As mentioned above, individual claimants need not plead fraud on the market to prove reliance. Investment banks "widely distributed" research reports "directly to the Banks' clients" and represented them as accurate, independent, and unbiased.  Fogarazzo at *2.  Claimants relied on this research when choosing to purchase or sell securities covered by the brokerage firm.
Brokerage firms failed to disclose conflicts of interest and misrepresented their true opinions about stock values.   
   

Loss Causation

Loss causation poses one of the most ellusive elements of securities fraud for the practitioner, often because of the confusion with transaction causation.  See Emergent Capital v. Stonepath Group, 343 F.3d 189, 198-99 (2d Cir. Sept. 4, 2003).  Following the Second Circuit decision in Emergent Capital, "[i]t is now clear that allegations of artificial inflation, without more, do not suffice to plead loss causation in securities fraud cases involving material misrepresentations and
omissions."  IPO, 297 F.Supp.2d at 672 (emphasis in original) (fn 4).  "The inference to be drawn [from Emergent Capital] is that allegations of artificial inflation plus something else (described only as a 'second, related loss') suffice."  Fogarazzo at *9.

The Class Plaintiffs failed to allege that Merrill Lynch's coverage of 24/7, Interliant and other companies caused their losses.  They claimed that "the so-called 'disparity of investment quality' or 'price inflation' theory" sufficed to plead loss causation.  August Decision at 363.  "[I]n a fraud on the market putative class action, price inflation is typically used as a surrogate for reliance and the closely related concept of transaction causation."  Id., citing Robbins v. Koger Props.,
Inc., 116 F.3d 1441 (11th Cir. 1997).  According to Judge Pollack, fraud-on-the-market is not a surrogate for loss causation. 
         

Intervening Cause: The Market Bubble

Loss causation is comparable "to the tort concept of proximate cause, meaning that in order for the plaintiff to recover it must prove the damages it suffered were a foreseeable consequence of the misrepresentation."  Suez Equity at 96.  As such,
"when factors other than the defendant's fraud are an intervening direct cause of a plaintiff's injury, that same injury cannot be said to have occurred by reason of the defendant's actions." Castellano, 257 F.3d at 189. 

In the case of the Pollack Decisions, Judge Pollack pointed to the bursting of the bubble as an intervening cause.  In other words, despite omissions of conflicts of interest and fraudulent rating systems, the collapse of the Internet market served as an intervening cause.  The Class Plaintiffs did not "allege a factual link between that decline and defendants' conduct."  August Decision at 365.  The absence of evidence of such a cause for the losses as a result of defendants' conduct
necessitated the legal conclusion that the conduct could not have caused the Class Plaintiffs' losses.

As stressed elsewhere, the Class Plaintiffs' complaints suffered from a lack of evidence.  The legal conclusion Judge Pollack reached is limited to the complaints before him.  "Of course, if the loss was caused by an intervening event, like a general fall in the price of Internet stocks, the chain of causation will not have been established.  But such is a matter of proof at trial and not to be decided on a Rule 12(b)(6) motion to dismiss."  Emergent Capital, 343 F.3d at 197.  If a plaintiff shows that defendant caused at least a portion of its losses, the intervening extraneous market forces serve only to limit damages.

Direct Relation to the Stock's Intrinsic Investment Characteristics

In order to plead loss causation, a plaintiff must show that the misrepresentation and/or omission relied upon caused the plaintiff's losses.  This is the "something more" beyond price inflation required to prove loss causation.  In the Pollack Decisions, the Class Plaintiffs based their complaint, in large part, on Merrill Lynch's conflicts of interest and rating system. The conflicts of interest and rating system the Class Plaintiffs alleged to have caused their losses were misrepresentations and/or omissions extraneous to the intrinsic value of 24/7 and Interliant.
August Decision at 364-66.   Without "something more," the Class Plaintiffs could not prove loss causation as a matter of law.

The problem arises as to the meaning of "something more."  "The loss causation inquiry typically examines how directly the subject of the fraudulent statement caused the loss, and whether the resulting loss was a foreseeable outcome of the fraudulent statement."  Suez Equity, 250 F.3d at 96.  A plaintiff must show that the alleged misrepresentation or omission "was 'directly related to the stock's intrinsic investment characteristics.'"  Fogarazzo at *10.  "It [is] enough that (1) the misrepresentation artificially inflated the value of the security, or otherwise
misrepresented its investment quality, and (2) the subject of the misrepresentation caused the decline in the value of the security."  Id. (emphasis in original).

In Suez Equity, "the misrepresentation . . . led plaintiffs to appraise the value of [the] securities incorrectly by assuming the competency of . . . the [company's] principal."  Suez Equity,  250 F.3d at 96. Defendants' omission related directly to the intrinsic value of the stock:  "Under this chain of factual allegations, it would have been foreseeable to defendants that facts concealed in the Modified Report would have indicated Mallick's inability to run the Group, and would have forecast its (eventual fatal) liquidity problems."  Id. at 97.  Similarly, in Emergent Capital,
the Second Circuit found plaintiffs adequately alleged transaction and loss causation, where company insiders engaged in a "pump and dump."  Emergent Capital, 343 F.3d at 197.  The allegation of the scheme showed that the value was driven up in order for corporate insiders to sell at inflated prices.  It was reasonably foreseeable that investors who purchased unaware of the scheme would lose money when defendants sold.  Id. at 197-98.

In Fogarazzo, defendants Lehman, Goldman Sachs, and Morgan Stanley moved to dismiss based, in part, on failure to plead loss causation adequately. 

          "Applying the standard of Emergent Capital, there is no doubt that
          plaintiffs here have adequately alleged that the Banks'
          misrepresentations caused their loss. . . . RSL ultimately failed
          because of the very facts that the Banks misrepresented: that RSL
          was in financial trouble and that the entire 'internet telephony
          sector' was collapsing.
         
          "It is true that the Banks did not conceal any facts regarding RSL. .
          . . Nor did they conceal it when RSL earnings came in below
          estimates.  What the banks did do, however, was manipulate these
          objective facts by misstating the Banks' true opinions of the impact
          of these events on the investment quality of RSL securities.  Rather
          than identify these events for what they really were   the first
          warning[ ] signs of the demise of RSL   the Banks instead injected
          bullish reports into the market suggesting that RSL was being
          drastically underpriced, that events such as the restructuring
          charge were aberrations, and that this was the perfect time to buy
          RSL stock because it was far cheaper than it ought to have been.
          The Banks' purportedly expert opinions thus concealed the actual
          financial state of RSL.  In other words, even though the true facts
          were available for the world to see, by affirmatively opining on the
          meaning of those facts the Banks obscured the logical conclusion
          that RSL was failing.
         
Fogarazzo at *11.

The facts of Fogarazzo are not isolated.  Similar misrepresentations and omissions appear in WorldCom (undisclosed loans collateralized by WorldCom stock, subject to massive margin calls), InfoSpace (misrepresenting the value of contracts and the
"reach" of InfoSpace in the marketplace), and others.  In this regard, contrary to Judge Pollack, there were factual predicates to show that these defendants artificially inflated the price through fraud and that these misrepresentations and omissions caused losses when the market became aware with corrective disclosure.

Conclusion
                               
Judge Pollack's Merrill Lynch Decisions represent an extreme viewpoint that has not become the majority view.  Other federal judges have provided common sense answers to Judge Pollack's arguments.  Judge Pollack's decisions should have very little precedential value.  At best, Judge Pollack's decisions are limited to their facts.  Realistically, they have been discredited by the decisions of other Federal District Courts who intentionally chose not to follow Judge Pollack.  His narrow view of the federal securities laws contradicts the plain intent of the federal securities laws  investor protection.  At law, caveat emptor ended with the passage of the Securities Exchange Act of 1934.  It is unfortunate that a distinguished jurist
lost sight of those basic principles.
                   

______________________________________________________________________________

1.   Contrary to Judge Pollack's decisions, Merrill Lynch accepted findings that its coverage of 24/7, Lifeminders, and Homestore.com "were not based on principles of fair dealing and good faith and did not provide a sound basis for evaluating facts, contained exaggerated or unwarranted claims about these companies, and/or contained opinions for which there was no reasonable basis." 
AWC at 24-25.  In light of this AWC entered into prior to Judge Pollack's granting dismissal, Judge Pollack's holding that these Class Plaintiffs could not prove what Merrill Lynch admitted is inexplicable.

2.   Courts have demonstrated confusion as to the proof required to show a speaker does not "actually" hold the opinion stated.  Under Virginia Bankshares, to prove a misstatement of opinion, a plaintiff must show that the misstatement was both objectively and subjectively false.
"Statements regarding projections of future performance may be actionable under Section 10(b) or Rule 10b-5 . . . if the speaker does not genuinely or reasonably believe them."  In re International Business
Machines, 163 F.3d 102, 107 (2d Cir. 1998).  Yet, Judge Lynch held that proving unreasonableness of an opinion could not satisfy the requirement that the speaker did not actually believe in what she said. 
Podany, 318 F.Supp.2d at 155-56.  "A securities fraud action may not rest on allegations that amount to second- guesses of defendants' opinions about the future value of issuers' stock   second-guesses made all
too easy with the benefit of hindsight."  Id. at 154.     
     In Podany, Judge Lynch also stated that ". . . proving the falsity of the statement 'I believe this investment is sound' is the same as proving scienter, since the statement (unlike a statement of fact) cannot be false at all unless the speaker is knowingly misstating his truly held opinion."  Id.  On the other hand, Judge Pollack
claimed "the pleading of a false statement [of opinion] does not 'dovetail' with scienter."  August Decision at 373.
"These are independent pleading requirements and the pleading of a motive to issue false statements does not establish that defendants made materially false statements."  Id.
     In Fogarazzo, Judge Scheindlin stated: "[T]he Supreme Court has confirmed that misstatements of opinion are actionable, so long as the speaker deliberately misrepresented her actual opinion.
Whether a misrepresentation is deliberate is, of course, a question of scienter, not of whether the plaintiffs have identified the alleged misstatements and explained why they are misleading."
Fogarazzo at *14 n.123.

3.   Failure to disclose compensation arrangements is fraudulent conduct under Securities Act 17(b): "It shall be unlawful for any person . . . to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication, which, though not purporting to offer a security for sale, describes such security for a consideration received or to
be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof."

4.   Judge Scheindlin determined a plaintiff need not plead loss causation for a claim based on market manipulation.  Market manipulation is "virtually a term of art when used in connection with securities markets. . . . Market manipulation refers generally to practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting market activity."
IPO, 297 F.Supp.2d at 674 n.30.  These activities are distinct from the misconduct in the research analyst cases.