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Kaufman v. I-Stat Corporation

324 N.J. Super. 344, 735 A.2d 606 (App. Div. 1999)

SECURITIES; FRAUD—A buyer of securities alleging common law fraud need not have been actually aware of the false statements; reliance on the integrity of the marketplace may be sufficient.

The primary issue presented in this appeal was whether a person who purchases corporate securities for a price which was artificially inflated by deliberately false statements issued by the corporation may maintain an action for common law fraud even though the buyer was not aware of those statements. The lower court held that to maintain a fraud action based upon a corporation’s deliberate false statements about its financial condition, a plaintiff must allege that he or she was aware of, and directly relied upon, those statements. Because the buyer in this case did not allege such direct reliance, the lower court dismissed the complaint. The Appellate Division, however, concluded that a plaintiff may satisfy the reliance element of a cause of action for fraud by showing reliance upon the integrity of the market price for a corporate security. Therefore, it reversed the dismissal of the buyer’s complaint.

Here, the buyer purchased 100 shares of the corporation’s common stock. It was alleged that prior to the purchase, the corporation issued public statements which “reported sales that were not, in fact, true sales, but were, instead, loans on a trial basis.” In addition, it was alleged that the corporation reported sales to certain customers without disclosing that the sales were induced by a major stockholder’s charitable donations to those buyers. The buyer claimed that these practices portrayed an exaggerated picture of the corporation’s sales and the degree of market acceptance of its products. After the nature of these false statements was published in newspapers, which also reported that the Securities and Exchange Commission had commenced an investigation of the company, the market price of the corporation’s stock fell substantially. Before the lower court, the buyer and the corporation entered into a stipulation which stated, among other things, that the buyer did not actually or directly receive or rely on any communication containing any misrepresentation alleged in the complaint nor did the buyer actually receive or rely on any communication which omitted material facts necessary to make any statement alleged in the complaint not false or misleading. In fact, it was stipulated that in purchasing and retaining the securities, the buyer relied exclusively on the integrity of the market price of the corporation’s stock at the time of her purchase. Accordingly, the buyer was relying solely on the complaint’s fraud-on-the-market allegations. The buyer insisted that a presumption of reliance applies because the alleged misrepresentations, in order to satisfy the reliance element of a common law claim for fraud and negligent misrepresentation and/or omissions made by the corporation, caused the common stock to trade at artificially inflated prices during the relevant period. The Appellate Division held that indirect reliance in the form of reliance upon the integrity of the market price for a corporate security which has been artificially inflated in the corporation’s deliberate false statements concerning its financial condition may satisfy the reliance element of a common law fraud action. The Court’s opinion with respect to common law fraud was based on case law which recognized that the reliance element of a cause of action for fraud may be satisfied by indirect reliance. The Restatement of Torts adopts the same rule: “[t]he maker of a fraudulent misrepresentation is subject to liability for pecuniary loss to another who acts in justifiable reliance upon it if the misrepresentation, although not made directly to the other, is made to a third person and the maker intends or has reason to expect that its terms will be repeated or its substance communicated to the other, and that it will influence his conduct in the transaction or type of transaction involved.” An example given by the Restatement is that of a person who provides false information for the purpose of obtaining a favorable credit rating and damage is caused to a person who relies on that credit rating. Here, although, a buyer on the stock exchange may not be aware of a specific false representation or does not directly rely on it, the buyer may purchase a company’s stock because of a favorable price trend, price earnings ratio, or some other factor. The reliance, therefore, is on the supposition that the market price is validly set and that no unsuspected manipulation has artificially inflated the price, and thus indirectly on the truth of the representations underlying the stock price. The corporation suggested that the Court should decline to apply the fraud-on-the-market theory of indirect reliance in a securities fraud case because the buyer already had an adequate remedy under federal securities law. This was rejected by the Court based upon language within the Securities Exchange Act of 1934 to the effect that “the rights and remedies provided by this chapter shall be in addition to any and all remedies that may exist at law or in equity.” With respect to the negligent misrepresentation claims, however, the Court held that a determination of the scope of liability “involves a weighing of the relationship of the parties, the nature of the risk, and the public interest in the proposed solution.” Although the New Jersey Supreme Court has held that an independent auditor generally “has a duty to all those whom that auditor should reasonably foresee as recipients from the company of the statements for its proper business purposes,” it stopped short of imposing liability for claims by persons who do not receive audited statements from the company, such as buyers of the company’s stock. In reaching the view that to prevail in a claim for fraudulent misrepresentation, the claimant must show direct reliance, the Court looked to a comment within the Restatement of Torts, to wit: “[w]hen there is no intent to deceive but only good faith coupled with negligence, the fault of the maker of the misrepresentation is sufficiently less to justify a narrower responsibility for its consequences.” By analogy to federal securities law, where liability cannot be imposed for mere negligence, the Court declined to adopt a rule of liability which would create expansive potential liability for negligent misrepresentations that may affect the price of securities.


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