2nd Circuit Affirms Dismissal of 10b5 Complaint Against Merrill Lynch for Hyping Internet Stocks

January 20, 2005. The U.S. Court of Appeals (2ndCir) issued its opinion [45 pages in PDF] in Lentell v. Merrill Lynch, a consolidated class action case against Merrill Lynch and one of its research analysts alleging securities fraud for issuing falsely optimistic reports recommending that investors purchase stock of two internet companies. The Court of Appeals affirmed the District Court's dismissal for failure to satisfy the pleading requirements of Section 10b5 and the PSLRA. Basically, the Appeals Court held that the complaint failed to plead loss causation.

The plaintiffs are John Lentell and others. They want to represent the a class of purchasers of stock in 24/7 Real Media, Inc. and Interliant, Inc. Merrill Lynch is a financial institution. Henry Blodget was a research analyst for Merrill Lynch who issued reports recommending that investors purchase stock in 24/7 and Interliant. Merrill Lynch was also a lead underwriter or co-lead underwriter for several securities offerings of 24/7 and Interliant.

The plaintiffs assert that Merrill Lynch both conducted market research and analysis, and underwrote public offerings of securities. They allege that to attract investment banking business, it deliberately published market research that was falsely optimistic, and that this amounts to securities fraud.

This action followed the widely publicized disclosures by the New York Attorney General of internal communications of financial institutions that contradicted their publicly released recommendations.

The plaintiffs filed a complaint in U.S. District Court (SDNY) against Merrill Lynch and Blodget alleging Section 10b5 securities fraud.

The complaint alleges that Merrill Lynch's analysts did not actually believe 24/7 Media or Interliant securities were a good investment when they encouraged the public to buy them; that the analysts' reports failed to disclose that the Firm's true motivation for publishing the fraudulent recommendations was to attract investment banking business; and (iii) that as a result of Merrill's misstatements and omissions, plaintiffs bought the stocks and, when their value plummeted, lost millions of dollars.

The District Court dismissed the complaint.

The Appeals Court affirmed. It held that the plaintiffs failed to plead fraud with the particularity required by the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995.

The Appeals Court held that one of the elements of a securities fraud action is loss causation -- that but for the claimed misrepresentations or omissions, the plaintiff would not have entered into the detrimental securities transaction. Moreover, the Court wrote that the loss must be foreseeable and that the loss be caused by the materialization of the concealed risk.

The Court noted that the complaint does not allege the plaintiffs read the hyped recommendations, or relied upon them in purchasing stock in 24/7 or Interliant. Rather, the complaint alleges that they were relying on the integrity of the market.

The Court continued that "To plead loss causation, the complaints must allege facts that support an inference that Merrill’s misstatements and omissions concealed the circumstances that bear upon the loss suffered such that plaintiffs would have been spared all or an ascertainable portion of that loss absent the fraud. As the district court found, no such allegations are made." It added that "There is no allegation that the market reacted negatively to a corrective disclosure regarding the falsity of Merrill's ``buy´´ and ``accumulate´´ recommendations and no allegation that Merrill misstated or omitted risks that did lead to the loss."

This case is Lentell, et al. v. Merrill Lynchand Henry Blodget, U.S. Court of Appeals for the 2nd Circuit, App. Ct. No. 03-7948, an appeal from the U.S. District Court for the Southern District of New York. Judge Dennis Jacobs wrote the opinion of the Court, in which Judges Sotomayor and B.D. Parker joined.

In April 2003 the Securities and Exchange Commission (SEC) filed and settled civil securities fraud actions in the U.S. District Court (SDNY) against Merrill Lynch and Blodget arising out of the same occurrences. Merrill Lynch agreed to pay $200 Million, and Blodget $2 Million. See, SEC release, complaint against Merrill Lynch, and complaint against Blodget.