Extending the Fraud on the Market Theory: The Second Circuit's Connection Test for SEC Rule 10b-5
Tonya Smits Rodriguez
University of Iowa College of Law
Journal of Corporation Law, Vol. 25, No. 2, 2000
The Second Circuit recently expanded the protection afforded to investors under Section 10(b) of the Securities Exchange Act of 1934 by holding that drug advertisements in technical medical journals might create Section 10(b) liability. The court concluded that such advertisements might meet the connection requirement of SEC Rule 10b-5, in light of a 1988 Supreme Court decision allowing courts to presume reliance based on a fraud on the market theory. According to this theory, because fraud affects market price on an open market, investors who rely on market price indirectly rely on fraud. The Second Circuit determined that fraud's effect on the market can also sufficiently establish the connection requirement of Section 10(b).
This comment examines the Second Circuit's extension of fraud on the market and concludes that the new connection requirement does not satisfy two primary reasons for applying fraud on the market to the reliance element of Rule 10b-5. First, while fraud on the market eliminates a difficulty of proof when applied to the reliance requirement of 10b-5, the new connection requirement might actually create a difficulty of proof. Second, unlike the reliance requirement of 10b-5, the connection requirement does not pose a class certification problem. In addition, in this particular case, the broader connection requirement might frustrate drug manufacturer's attempts to communicate with the medical community in a way that furthers valid reasons for delayed disclosures. This comment concludes that while drug companies currently have several potential defenses to this problem, a broader bespeaks caution doctrine would provide the best protection.
Accepted Paper Series
Date posted: June 5, 2000
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