Daubert in the Practice Areas

Daubert in Class Action Litigation

A. [§13.49] In General

In Wal-Mart Stores, Inc. v. Dukes, 564 U.S.338, 131 S.Ct. 2541, 180 L.Ed.2d 374 (2011), a high-profile class action suit, the United States Supreme Court dramatically changed class action law. There seems little doubt that Dukes will profoundly affect class action matters, but the Dukes Court largely declined to address the expert testimony issues that have split the federal circuits, albeit while signaling the Court’s leanings in doing so. From the perspective of the Daubert analysis, Dukes does not substantially affect the Daubert class action cases, because it does not really address Daubert.

Some commentators have over-characterized Dukes as resolving the split in the circuits over Daubert and class action litigation, discussed in the following sections of this chapter. In reality, Dukes addresses the Daubert issues in the Hydrogen Peroxide line of cases only in dicta, writing: “[t]he District Court concluded that Daubert did not apply to expert testimony at the certification stage of class-action proceedings. 222 F.R.D., at 191. We doubt that is so.” Dukes at 354. As a result, the cases that controlled the use of the Daubert criteria in class certification before Dukes still control the use of Daubert criteria in class certification after Dukes. To the extent that Dukes does point to how the Court might decide a case in this arena, it points to deciding the matter in the manner this author advocates; that is, it points to requiring Daubert analysis to evaluate the expert testimony used to establish elements of the claim for class certification.

A subsequent line of federal court class action opinions, headlined by In re Hydrogen Peroxide Antitrust Litigation, 552 F.3d 305 (3d Cir. 2009) (Hydrogen Peroxide II), moved Daubert analysis from its traditional place nearer the end of the litigation up, both temporally and strategically, to the class certification stage. This line of cases requires that expert testimony relied on to establish a disputed element of class certification must now pass Daubert muster before a class is certified. This is highly significant because it replaces the longstanding rule that plaintiffs need make only a “threshold showing” of expert testimony at the class certification stage with the new and much stronger rule that “proper analysis under Rule 23 requires rigorous consideration of all the evidence and arguments offered by the parties. . . . A ‘threshold showing’ could signify, incorrectly, that the burden on the party seeking certification is a lenient one.” Id. at 321.

Because a court’s certification of a class typically compels a defendant to settle (irrespective of the merits), while a denial of certification typically spells the end of the litigation, the Daubert challenge on which that certification now depends has been promoted to an early, case-dispositive tool for class action litigators.

The other circuit courts of appeal, with some exceptions, have tended to follow the Third Circuit’s Hydrogen Peroxide II opinion with stricter standards of proof to support requests for class certification. See, e.g., American Honda Motor Co. v. Allen, 600 F.3d 813 (7th Cir. 2010); In re New Motor Vehicles Canadian Export Antitrust Litigation, 522 F.3d 6 (1st Cir. 2008); In re Initial Public Offerings Securities Litigation, 471 F.3d 24 (2d Cir. 2006); Bell Atlantic Corp. v. AT&T Corp., 339 F.3d 294 (5th Cir. 2003). The Eighth Circuit has followed less, opting for a more casual Daubert analysis in In re Zurn Pex Plumbing Products Liability Litigation, 644 F.3d 604 (8th Cir. 2011). The Ninth Circuit, overturned by the Supreme Court in Dukes, seems to have come in line in Ellis v. Costco Wholesale Corp., 657 F.3d 970 (9th Cir. 2011) (district court must determine that expert evidence is both admissible under Daubert and persuasive). In In re Williams Securities Litigation-WCG Subclass, 558 F.3d 1130 (10th Cir. 2009), affirming In re Williams Securities Litigation, 496 F.Supp.2d 1195 (N.D. Okla. 2007), the court found plaintiff’s expert’s testimony to be unreliable “because his theories of loss causation could not distinguish between loss attributable to the alleged fraud and loss attributable to non-fraud related news and events,” 558 F.3d at 1132, and granted summary judgment for the defense; the Tenth Circuit affirmed.

The Eleventh Circuit applied the Seventh Circuit’s American Honda holding in Sher v. Raytheon Co., 419 F.App’x 887 (11th Cir. 2011). In Sher, the district court certified a class even though there were substantial differences in the expert testimony proffered by the parties, writing that: “[a]t this stage of the litigation, . . . an inquiry into the admissibility of Plaintiffs’ proposed expert testimony as set forth in Daubert would be inappropriate, because such an analysis delves too far into the merits of Plaintiffs’ case.” Id. at 889 (quoting the district court). The Eleventh Circuit reversed:

The American Honda court found that, if the situation warrants, the district court must perform a full Daubert analysis before certifying the class. A district court is the gatekeeper. It must determine the reliability of the expert’s experience and training as well as the methodology used. The . . . court must also resolve any challenge to the reliability of information provided by an expert if that information is relevant to establishing any of the Rule 23 requirements for class certification. We agree.

Id. at 890 [internal citations omitted]. The Eleventh Circuit held that the “district court erred as a matter of law by not sufficiently evaluating and weighing conflicting expert testimony on class certification.” Id.

The Eighth Circuit is at variance here. In In re Zurn Pex Plumbing Products Liability Litigation, 644 F.3d 604 (8th Cir. 2011), the parties disagreed about the proper application of Daubert at the class certification stage: plaintiffs argued that their expert’s testimony should be excluded at this stage only if it were “so flawed it cannot provide any information as to whether the requisites of class certification have been met.” In re Zurn Pex at 610. The defendant, Zurn, argued that the district court should conduct a full and conclusive Daubert inquiry before certifying a class. The district court plotted a middle course between the parties’ positions, and the Eighth Circuit let that course stand, citing to Eisen v. Carlisle & Jacquelin, 417 U.S. 156, 178, 94 S.Ct. 2140, 40 L.Ed.2d 732 (1974) (which is questionable law on this point, as noted in Dukes at 2552 n.6), and stating that

The district court did not err by conducting a focused Daubert analysis which scrutinized the reliability of the expert testimony in light of the criteria for class certification and the current state of the evidence. In doing so the district court conducted the requisite “rigorous analysis” of the parties’ claims to determine “whether the defendant’s liability to all plaintiffs may be established with common evidence.”

In re Zurn Pex at 614, quoting Avritt v. Reliastar Life Insurance Co., 615 F.3d 1023 (8th Cir. 2010). A vigorous dissent in In re Zurn Pex relied on the reasoning of the Seventh Circuit in American Honda and the Eleventh Circuit in Sher, and said that “a full Daubert analysis would have been particularly apt in this case as the district court relied on . . . questionable expert testimony . . . when it certified the . . . class.” In re Zurn Pex at 630 n.11 (Gruender, J., dissenting).

The Eighth Circuit notwithstanding, the law in the federal courts is that a full Daubert analysis is required at the certification stage of any class action. Indeed, a full Daubert analysis may be only a step along the way to what is really required, which is, after the Daubert hearing, to decide which expert is more persuasive.

Hydrogen Peroxide was an antitrust class action, but its analysis has been quickly imported into toxic tort, securities litigation, and employment litigation, and it will control matters across the class action waterfront. The Hydrogen Peroxide cases have their basis in a line of United States Supreme Court opinions that do not explicitly address Daubert or expert testimony, but set the stage for the Hydrogen Peroxide cases by setting stricter rules for pleadings in general. See the discussion of Dura Pharmaceuticals, Tellabs, Inc., and Twombly at §13.54. Hydrogen Peroxide II and some of its sister cases are the opinions of Third Circuit Court of Appeals Chief Judge Anthony J. Scirica, who oversaw the 2003 Rule 23 revisions as chair of the Standing Committee on Rules of Practice and Procedure. Hydrogen Peroxide II applied those Rule 23 amendments that changed previous language that class certification “may be conditional,” which had been construed to encompass tentative or only promised certifications, to new language requiring more thorough evaluations of the Rule 23 factors and making clear that Rule 23 does not provide for perfunctory certification decisions.

The Third Circuit extended the reasoning of Hydrogen Peroxide II in reversing a district court grant of class certification in an employment discrimination claim brought under the Americans with Disabilities Act. See Hohider v. United Parcel Service, Inc., 574 F.3d 169 (3d Cir. 2009).

B. [§13.50] Daubert’s Enhanced Role In Class Action: In Re
Hydrogen Peroxide And Kindred Opinions

The elements of class certification under Rule 23 require commonality, typicality, and impact on the class that is capable of common proof. This common proof element has always required expert testimony, but with a substantially lax standard of proof. What is new under Hydrogen Peroxide is that now this expert testimony must pass a Daubert analysis, perhaps even an über-Daubert analysis, as a precondition of surviving the class certification stage of the litigation. This is important because surviving the class certification stage is a critical step in the prosecution of class actions. Historically, class certification has permitted a plaintiff a settlement, irrespective of the other merits of the cause of action; surviving the class certification stage is generally profitable for plaintiffs and costly for defendants.

This section assumes the reader is conversant with class action law and does not discuss that law except as it interacts with the Daubert line of cases.

The Third Circuit’s analysis merits close consideration. In Hydrogen Peroxide, the parties proffered contradictory expert testimony on whether antitrust impact could be proven through evidence common to the class. The district court certified a class, stating that “‘[p]laintiffs need only make a threshold showing that the element of impact will predominantly involve generalized issues of proof, rather than questions which are particular to each member of the plaintiff class.’” In re Hydrogen Peroxide Antitrust Litigation, 240 F.R.D. 163, 174 (E.D. Pa. 2007) (Hydrogen Peroxide I), vacated & remanded 552 F.3d 305 (Hydrogen Peroxide II) (quoting Lumco Industries, Inc. v. Jeld-Wen, Inc., 171 F.R.D. 168, 174 (E.D. Pa. 1997)).

The Third Circuit rejected this long-applied rule, specifically addressing the “threshold showing” language, stating that “invoking the phrase ‘threshold showing’ risks misapplying Rule 23” and that “as we have explained, proper analysis under Rule 23 requires rigorous consideration of all the evidence and arguments offered by the parties. . . . A ‘threshold showing’ could signify, incorrectly, that the burden on the party seeking certification is a lenient one.” Hydrogen Peroxide II, 552 F.3d at 321.

The expert testimony is the central interest of this section and the Third Circuit summarized it as follows:

[The parties] presented the opinions of expert economists
[who] disagreed on the key disputed predominance issue — whether antitrust impact was capable of proof at trial through evidence common to the class, as opposed to individualized evidence.

Plaintiffs’ expert . . . offered an opinion purporting to show that “there is common proof that . . . the alleged conspiracy to raise prices, restrict output and allocate customers would have impacted all purchasers of hydrogen peroxide” . . . [and] favored a conspiracy that would have impacted the entire class.

* * *

[Plaintiff’s expert, Dr.] Beyer identified two “potential approaches” to estimating damages on a class-wide basis.
. . . These methods, according to Beyer, could be used to estimate the prices plaintiffs would have faced but for the conspiracy. Beyer stated that “sufficient reliable data” exist to allow him to employ one or both of the potential approaches.

Defendants offered the opinion of their own expert, Dr. Ordover . . . to address “whether, assuming a conspiracy of the kind described in the Complaint, the Plaintiffs will be able to show, through common proof, that all or virtually all of the members of the proposed class suffered economic injury caused by the alleged conspiracy.” [Inter alia, Ordover contends] that the “various grades of hydrogen peroxide . . . have different supply characteristics and face different demand conditions. The existence of supply and demand characteristics that are specific to the various grades and uses requires individualized assessment of the impact of the alleged conspiracy at least across these different grades and uses. Consequently, a finding of class-wide impact from the alleged conspiracy cannot be inferred from the mere fact of the conspiracy and from common evidence.”

* * *

Ordover opined that the statistical methods by which Beyer proposed to demonstrate common impact and damages were not feasible [and this defeated] any reasonable notion of proof common to the class.

In addition to presenting Ordover’s testimony, defendants moved to exclude Beyer’s testimony as unreliable, citing Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 113 S. Ct. 2786, 125 L. Ed. 2d 469 (1993). The District Court denied the Daubert motion in its memorandum and order certifying the class.

Hydrogen Peroxide II at 312–315.

The Third Circuit overturned the district court, writing that:

The District Court concluded the predominance requirement was met. It held that “[e]ither [Beyer’s] market analysis or the pricing structure analysis would likely be independently sufficient at this stage. Plaintiffs and Dr. Beyer have provided us with both. Despite defendants’ claims to the contrary, we should require no more of plaintiffs in a motion for class certification.”

Id. at 315.

Although the District Court properly described the class certification decision as requiring “rigorous analysis,” some statements in its opinion depart from the standards we have articulated. The District Court stated, “So long as plaintiffs demonstrate their intention to prove a significant portion of their case through factual evidence and legal arguments common to all class members, that will now suffice. It will not do here to make judgments about whether plaintiffs have adduced enough evidence or whether their evidence is more or less credible than defendants’.” With respect to predominance, the District Court stated that “[p]laintiffs need only make a threshold showing that the element of impact will predominantly involve generalized issues of proof, rather than questions which are particular to each member of the plaintiff class.” . . . As we have explained, proper analysis under Rule 23 requires rigorous consideration of all the evidence and arguments offered by the parties. It is incorrect to state that a plaintiff need only demonstrate an “intention” to try the case in a manner that satisfies the predominance requirement. Similarly, . . . [a] “threshold showing” . . . is an inadequate and improper standard. “[T]he requirements of Rule 23 must be met, not just supported by some evidence.” IPO, 471 F.3d at 33; see e.g., id. at 40, 42 (rejecting the view that a party seeking certification need only make “some showing” with respect to the Rule 23 requirements).

Id. at 321.

There is additional important language in the Third Circuit’s Hydrogen Peroxide opinion:

Weighing conflicting expert testimony at the certification stage is not only permissible; it may be integral to the rigorous analysis Rule 23 demands. See Blades [v. Monsanto Co., 400 F.3d 562, 575 (8th Cir. 2005)] (“[I]n ruling on class certification, a court may be required to resolve disputes concerning the factual setting of the case,” including “the resolution of expert disputes concerning the import of evidence concerning the factual setting — such as economic evidence as to business operations or market transactions”); West [v. Prudential Securities, Inc., 282 F.3d 935, 938 (7th Cir. 2002)] (cautioning that neglecting to resolve disputes between experts “amounts to a delegation of judicial power to the plaintiffs, who can obtain class certification just by hiring a competent expert”); see also Cordes & Co. Fin. Servs. v. A.G. Edwards & Sons, Inc., 502 F.3d 91, 106-07 (2d Cir.2007) (analyzing the opinions of plaintiffs’ and defendants’ experts); In re PolyMedica Corp. Sec. Litig., 432 F.3d 1, 5-6, 19 (1st Cir.2005) (vacating class certification order but finding no error in the “level of inquiry” the district court applied under Rule 23 when it “went well beyond the four corners of the pleadings, considering both parties’ expert reports and literally hundreds of pages of exhibits focused on market efficiency”).

Id. at 323.

Resolving expert disputes in order to determine whether a class certification requirement has been met is always a task for the court — no matter whether a dispute might appear to implicate the “credibility” of one or more experts, a matter resembling those usually reserved for a trier of fact. Rigorous analysis need not be hampered by a concern for avoiding credibility issues; as noted, findings with respect to class certification do not bind the ultimate fact-finder on the merits. A court’s determination that an expert’s opinion is persuasive or unpersuasive on a Rule 23 requirement does not preclude a different view at the merits stage of the case.

Id. at 324.

C. [§13.51] District Court Should Not Err In Favor Of
Certifying Class

The Hydrogen Peroxide district court found that “‘when a court is in doubt as to whether or not to certify a class action, the court should err in favor of allowing the class.’” In re Hydrogen Peroxide Antitrust Litigation, 240 F.R.D. 163, 168 (E.D. Pa. 2007) (Hydrogen Peroxide I), quoting Cumberland Farms, Inc. v. Browning-Ferris Industries, Inc., 120 F.R.D. 642, 645 (E.D. Pa. 1988). The Third Circuit Court of Appeals disagreed, remanding and instructing that:

These statements invite error. Although the trial court has discretion to grant or deny class certification, the court should not suppress “doubt” as to whether a Rule 23 requirement is met — no matter the area of substantive law. . . . [T]he recent amendments to Rule 23 . . . reject tentative decisions on certification and encourage development of a record sufficient for informed analysis. See Fed. R. Civ. P. 23 advisory committee’s note, 2003 Amendments (“A court that is not satisfied that the requirements of Rule 23 have been met should refuse certification until they have been met”).

In re Hydrogen Peroxide Antitrust Litigation, 552 F.3d 305, 321 (3d Cir. 2009) (Hydrogen Peroxide II).

D. [§13.52] Über-Daubert?

Finally, while considering a Daubert motion, the judge must determine that the expert is qualified and proffering relevant and reliable testimony, as defined throughout this chapter. Furthermore, it seems that In re Hydrogen Peroxide Antitrust Litigation, 552 F.3d 305 (3d Cir. 2009) (Hydrogen Peroxide II), and In re Initial Public Offering Securities Litigation, 471 F.3d 24 (2d Cir. 2006) (IPO), instruct the class action district court to go well beyond that and decide if the expert is persuasive. Concerning the testimony of expert economists Beyer and Ordover, Judge Scirica in Hydrogen Peroxide II said, at 322:

In addressing defendants’ Daubert motion to exclude Beyer’s opinion, the court discussed whether it should consider Ordover’s opinion in deciding whether Beyer’s opinion was admissible. The court stated it would be improper to “weigh the relative credibility of the parties’ experts” — in other words, to weigh Ordover’s opinion against Beyer’s — for the purpose of deciding whether to admit or exclude Beyer’s opinion. . . . The court appears to have assumed it was barred from weighing Ordover’s opinion against Beyer’s for the purpose of deciding whether the requirements of Rule 23 had been met. This was erroneous.

This seems to have broad implications. Courts routinely seek the parties’ consent to decide Daubert issues on the papers (or do it by quasi-fiat: “Counsel, is there any reason that we cannot decide this matter on the papers?”). If the trial court is now charged with making a determination of the “relative credibility” of the experts at the pleading stage, this will tend to require full blown Daubert hearings with testimony by experts and so forth. Thus, passing a traditional Daubert analysis is necessary to establishing the class, but is perhaps not sufficient: much of Hydrogen Peroxide and the kindred cases are devoted to establishing the proposition that unless expert testimony to the Rule 23 requirements passes Daubert, no certification will be forthcoming; most commentators see only that. However, Hydrogen Peroxide II goes on to say, at 323, “Expert opinion with respect to class certification, like any matter relevant to a Rule 23 requirement, calls for rigorous analysis. . . . It follows that opinion testimony should not be uncritically accepted as establishing a Rule 23 requirement merely because the court holds the testimony should not be excluded, under Daubert or for any other reason.”

The extra-Daubert analysis can apparently require the court to actually pick one expert over the other, a burden specifically not allocated to the district court under Daubert:

Under Rule 23 the district court must be “satisfied,” [General Telephone Co. of Southwest v. Falcon, 457 U.S. 147, 161, 102 S.Ct. 2364, 72 L.Ed.2d 740 (1982)], or “persuaded,” IPO, 471 F.3d at 41, that each requirement is met before certifying a class. Like any evidence, admissible expert opinion may persuade its audience, or it may not. This point is especially important to bear in mind when a party opposing certification offers expert opinion. The district court may be persuaded by the testimony of either (or neither) party’s expert with respect to whether a certification requirement is met. Weighing conflicting expert testimony at the certification stage is not only permissible; it may be integral to the rigorous analysis Rule 23 demands.

Hydrogen Peroxide II at 323.

This arguably requires a more substantial showing than surviving a Daubert motion, because in ruling on a Daubert motion, the judge specifically does not enter into the fact-finder’s preserve of determining whether an expert is persuasive, or more persuasive than another expert.

For example, in In re HealthSouth Corp. Securities Litigation, 261 F.R.D. 616 (N.D. Ala. 2009), the court determined that the market efficiency and fraud-on-the-market (FOTM) testimony of plaintiffs’ experts, Dr. Tavy Ronen of Rutgers University; Dr. Nejat Syehun of the University of Michigan; and Timothy A. O’Neill, formerly of Bear Stearns, was due more weight than the testimony of defendant’s experts, Dr. Michael Gibbons of the University of Pennsylvania; dr. Kenneth Lehn of the University of Pittsburgh; and Dr. Chris James of the University of Florida, who sought to testify that the market for HealthSouth bonds was inefficient. The court gave more weight to the testimony of plaintiffs’ experts than it gave to the testimony of defendant’s experts and found that the plaintiffs had met the requirements of Rule 23 for certification of a class.

This is in substantial contrast to the inquiry allocated to the trial court in Daubert, which is limited to qualifications, relevance, and reliability. In the Rule 23 circumstance, the court takes on the role of finder of fact and goes well beyond the parameters usually thought of as being the province of the court.

The other circuits have largely followed the central holding of Hydrogen Peroxide. Judge Scirica’s citations to IPO are important, for that Second Circuit opinion is another of the core opinions in the Hydrogen Peroxide line of cases. In IPO, the Second Circuit said that the trial court may certify a class only after determining that each of the Rule 23 requirements has been met. The trial court must resolve any factual disputes with respect to those requirements and this responsibility is not lessened by any possible overlap between the establishment of the Rule 23 requirements and the subsequent inquiry into the requirements. The Second Circuit changed the rules of proof in IPO just as the Third Circuit did in Hydrogen Peroxide II.

E. [§13.53] Wal-Mart Stores, Inc. v. Dukes

Although the Wal-Mart Stores, Inc. v. Dukes, 564 U.S.338, 131 S.Ct. 2541, 180 L.Ed.2d 374 (2011), Court declined to decide the circuit split over the level of Daubert analysis required at the class certification stage, it is still the opinion of the United States Supreme Court, and requires analysis. In Dukes v. Wal-Mart Stores, Inc., 222 F.R.D. 189, 191 (N.D. Cal. 2004), the district court wrote that “courts should avoid resolving ‘the battle of the experts.’ . . . Indeed, courts should not even apply the full Daubert ‘gatekeeper’ standard at this stage. . . . Rather, ‘[i]t is clear to the Court that a lower Daubert standard should be employed at this [class certification] stage of the proceedings’” [internal citations omitted]. The Ninth Circuit found no abuse of discretion and declined to reach the issue of whether Daubert applied “fully” at the class certification stage. As noted at §13.49, the Supreme Court in Dukes also declined to reach the issue of whether Daubert applied fully at the class certification stage, stating, in dicta only, that “[t]he District Court concluded that Daubert did not apply to expert testimony at the certification stage of class-action proceedings. 222 F.R.D., at 191. We doubt that is so.” Dukes, 564 U.S. at 354.

It seems that the Court did not reach the issue of Daubert at the class certification stage because the expert testimony that Dukes relied on was so flawed as to be disregarded without venturing into the Daubert analysis. Among Daubert’s factors for analyzing the reliability of an expert’s proffered testimony is whether the expert’s method has been published in peer-reviewed journals and whether there are established standards for the use of the technique. As it turns out, Dukes’ expert, Dr. Bielby, used techniques that are at sharp odds with the peer-reviewed research in the area. While the case was pending, the University of Virginia Law School professors, who are credited with pioneering the research upon which Bielby relied, published a series of papers that explained how Bielby misapplied the “social framework” analysis in Dukes. The Supreme Court relied on one of these papers in its opinion. See Monahan, Walker, & Mitchell, Contextual Evidence of Gender Discrimination: The Ascendance of “Social Frameworks,” 94 Va.L.Rev. 1715, 1747–1748 (2008) (“[Bielby’s] research into conditions and behavior at Wal-Mart did not meet the standards expected of social scientific research into stereotyping and discrimination. . . . [A] social framework necessarily contains only general statements about reliable patterns of relations among variables . . . and goes no further. . . . Dr. Bielby claimed to present a social framework, but he testified about social facts specific to Wal-Mart. . . . Dr. Bielby’s report provides no verifiable method for measuring and testing any of the variables that were crucial to his conclusions and reflects nothing more than Dr. Bielby’s ‘expert judgment.’”).

As a result, there was no reason for the Court to reach the issue of how deep a Daubert analysis is appropriate at the class certification stage of a class action suit.

F. [§13.54] The Foundations Of Hydrogen Peroxide

Background for the Hydrogen Peroxide line of cases includes three United States Supreme Court cases, beginning with Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 125 S.Ct. 1627, 161 L.Ed.2d 577 (2005), that are reshaping commercial litigation at the pleading stage. They are not specifically Daubert cases but are included here both because they set the stage for the Hydrogen Peroxide cases and because of their broader impact on commercial litigation.

Dura Pharmaceuticals was a fraud-on-the-market (FOTM) securities matter. In briefest summary, FOTM requires that a fraudulent statement be made regarding a security and the statement then be incorporated into the securities price by an efficient market. The fraud is “on the market” because the market believes the fraudulent statement and adjusts the price of the security in response to the fraudulent statement. A plaintiff who buys this stock at its inflated price is injured in much the same way as a purchaser of a used car with a bad transmission is injured by relying on the statement of the owner of the car that the car has a good transmission. When the truth comes out about the true (and lower) value of the security, the injury is realized, and the purchaser loses money.

This “fraud-on-the-market” theory, a staple in the academic finance literature, was incorporated into American securities law by the United States Supreme Court in the seminal opinion, Basic Inc. v. Levinson, 485 U.S. 224, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988). A key requirement of the “fraud on the market” is that the security is traded in an efficient market.

In Dura Pharmaceuticals, alleged misrepresentations about Dura’s product led plaintiffs to purchase the stock at inflated prices. When the truth got out that the product was not as good as Dura had represented, the market price for the firm’s stock fell by some 50%. Plaintiffs relied on FOTM arguments to establish loss causation elements of the securities fraud matter. The Court rejected this argument and held:

The basic elements of a private securities fraud action . . . include, as relevant here, economic loss and “loss causation.” The Ninth Circuit erred in following an inflated purchase price approach to showing causation and loss. First, . . . , the moment the transaction takes place, the plaintiff has suffered no loss because the inflated purchase price is offset by ownership of a share that possesses equivalent value at that instant. And the logical link between the inflated purchase price and any later economic loss is not invariably strong, since other factors may affect the price.

Dura Pharmaceuticals, 544 U.S. at 336.

The Court required proof of loss at the pleadings stage that plaintiff’s FOTM arguments were insufficient to meet:

Our holding about plaintiffs’ need to prove proximate causation and economic loss leads us also to conclude that the plaintiffs’ complaint here failed adequately to allege these requirements. We concede that the Federal Rules of Civil Procedure require only “a short and plain statement of the claim showing that the pleader is entitled to relief.” Fed. Rule Civ. Proc. 8(a)(2). And we assume, at least for argument’s sake, that neither the Rules nor the securities statutes impose any special further requirement in respect to the pleading of proximate causation or economic loss. But, even so, the “short and plain statement” must provide the defendant with “fair notice of what the plaintiff’s claim is and the grounds upon which it rests.” The complaint before us fails this simple test.

Id. at 346.

Dura Pharmaceuticals and its companion opinions set new standards for rigor in pleading under the Federal Rules of Civil Procedure.

Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007), is a class action FOTM securities fraud matter, this time focusing on pleading-stage proof of scienter. The district court had dismissed, writing that plaintiff shareholders “had insufficiently alleged that [defendant] acted with scienter.” Id. at 317. The Seventh Circuit reversed, “conclud[ing] that the Shareholders had sufficiently alleged that [the defendant] acted with the requisite state of mind.” Id. The Supreme Court noted that “[i]n adopting its standard for survival of a complaint, the Seventh Circuit explicitly rejected a stiffer standard, adopted by the Sixth Circuit [in Fidel v. Farley, 392 F.3d 220, 227 (6th Cir. 2004)], i.e., that “plaintiffs are entitled only to the most plausible of competing inferences.” Id.

The Supreme Court “granted certiorari to resolve the disagreement among the Circuits on whether, and to what extent, a court must consider competing inferences in determining whether a securities fraud complaint gives rise to a ‘strong inference’ of scienter.” Id. at 317–318.

The Court’s opinion in Tellabs, Inc. begins by citing Dura Pharmaceuticals for the proposition that “[t]his Court has long recognized that meritorious private actions to enforce federal antifraud securities laws are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by the Department of Justice and the Securities and Exchange Commission (SEC).” Id. at 313. The Court balanced this with the fact that “[p]rivate securities fraud actions, however, if not adequately contained, can be abused to impose substantial costs on companies and individuals whose conduct conforms to the law. . . . As a check against abusive litigation by private parties, Congress enacted the Private Securities Litigation Reform Act of 1995 (PSLRA).” Id. The Court further noted that

[e]xacting pleading requirements are among the control measures Congress included in the PSLRA[, and the Act] requires plaintiffs to state with particularity both the facts constituting the alleged violation, and the facts evidencing scienter, i.e., the defendant’s intention “to deceive, manipulate, or defraud.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194, and n. 12, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976); see 15 U.S.C. §78u-4(b)(1), (2). [Tellabs, Inc.] concerns the latter requirement.”

Id. The Court remanded, writing that “[a] plaintiff alleging fraud in a §10(b) action, we hold today, must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference. At trial, she must then prove her case by a ‘preponderance of the evidence.’ Stated otherwise, she must demonstrate that it is more likely than not that the defendant acted with scienter.” Id. at 328‑329.

The Court implied that this showing would demonstrate a strong inference of a defendant’s required state of mind, and “[t]o qualify as ‘strong’ . . . an inference of scienter must be more than merely plausible or reasonable — it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.” Id. at 314.

This strong inference language has found its way into other opinions. In Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 564, 127 S.Ct. 1955, 167 L.Ed.2d 929 (2007), an antitrust matter, the Court found the complaint’s “claim of conspiracy in restraint of trade” implausible and noted that “nothing contained in the complaint invests either the action or inaction alleged with a plausible suggestion of conspiracy.” Id. at 566.

A plaintiff claiming a violation of §1 of the Sherman Act must allege facts that, if true, would suggest an inference of a conspiratorial agreement, not merely parallel conduct.

The need at the pleading stage for allegations plausibly suggesting (not merely consistent with) agreement reflects the threshold requirement of Rule 8(a)(2) that the “plain statement” possess enough heft to “sho[w] that the pleader is entitled to relief.” A statement of parallel conduct, even conduct consciously undertaken, needs some setting suggesting the agreement necessary to make out a §1 claim; without that further circumstance pointing toward a meeting of the minds, an account of a defendant’s commercial efforts stays in neutral territory.

Id. at 557.

Such a pleading does not make out a claim for relief. The Court dismissed Twombly’s claim because he failed to identify any facts that suggested illegal conspiracy as more likely than alternate explanations for the defendant’s actions.

G. [§13.55] Summary Of Daubert In Class Action Litigation

While the stakes are sufficiently high that there will continue to be litigation over these issues, the Hydrogen Peroxide line of cases continues to control issues of admissibility of expert testimony at the class certification stage of class action matters. Dukes, as important as it is, declined to decide the level of Daubert analysis appropriate for district courts in such matters.

This line of cases requires that expert testimony relied on to establish a disputed element of class certification must now at least pass Daubert muster before a class is certified, and seems to require that the expert testimony not only be reliable, as required by Daubert, but also that the district court examine the expert testimony to assure that it is convincing as well. This is highly significant because it displaces the longstanding rule that plaintiffs need make only a “threshold showing” of expert testimony at the class certification stage and replaces it with the much stronger rule that “proper analysis under Rule 23 requires rigorous consideration of all the evidence and arguments offered by the parties.” Threshold showings are no longer sufficient. Daubert is now an important part of class action litigation.