OPINION AND ORDER

LECHNER, District Judge.

This is an action brought by holders of common stock of Coated Sales, Inc. ("Coated Sales" or the "Company"). The individual defendants include Bruce M. Bloom, Richard Bober, Ernest Glantz, Michael S. Weinstein, Dennis Lustig, and Philip I. Kagan ("Kagan"). These individuals are or were high level officers of Coated Sales and, in the case of Kagan, an outside director and attorney for the Company. Other defendants include Coated Sales, now in bankruptcy proceedings, and Peat Marwick Main Co. ("PMM"), the former independent auditors for Coated Sales. Separate motions have been filed by PMM and Kagan attacking the sufficiency of plaintiffs' Consolidated Amended Class Action Complaint (the "Amended Complaint").

Count I of the Amended Complaint is asserted pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78j(b) (1982) and 78t(a) (1982), and Rule 10b-5 promulgated under Section 10(b). Count II of the Amended Complaint alleges common law fraud and deceit under the law of the State of New Jersey. Count III of the Amended Complaint asserts a claim of negligent misrepresentation, again based upon New Jersey law.

PMM's motion requests a dismissal of Count I pursuant to Fed.R.Civ.P. 12(b)(6) (for failure to allege necessary elements, or adequate substitutes therefor, of the securities fraud claims) and Fed.R.Civ.P. 9(b) (for failure to allege fraud as to PMM reports with particularity). PMM's motion requests a dismissal of Counts II and III on the grounds that, if Count I is dismissed, there will exist no independent basis for federal jurisdiction, and, as well, pursuant to Fed.R.Civ.P. 9(b); 12(b)(1) and 12(b)(6).

Kagan's motion requests a dismissal of Counts I, II and III pursuant to Fed.R.Civ.P. 12(b) (for failure to allege facts giving rise to controlling person's liability under the federal securities laws) and Fed.R.Civ.P. 9(b) (for failure to allege specific fraud on the part of Kagan).

Facts

Coated Sales, incorporated under the laws of the State of New Jersey in 1974, develops and sells specially treated fabrics to industry and government. Coated Sales became a public company in 1984 when it offered shares of common stock registered on Form S-1 under the Securities Act of 1933 (the "Securities Act"), 15 U.S.C. § 77a et seq., the Securities and Exchange Commission ("SEC") form which relatively new and unseasoned corporate issuers are required to use for securities offerings. The Company's publicly held securities are not listed on a national exchange, but instead are traded in the "over-the-counter" market (a reporting network in which transactions in securities are reported to the National Association of Securities Dealers for publication) and listed on the NASDAQ automated national quotation system ("NASDAQ"). According to the Amended Complaint, during the class period Coated Sales had approximately 19,000,000 shares of stock outstanding which were held by approximately 1200 holders. Amended Complaint ¶ 10. The Amended Complaint contains no other factual allegations indicating the degree to which the Company's stock was traded or followed by investors and analysts; it does not allege in plain words or otherwise the market for Coated Sales stock was efficient or well-developed.

As is sometimes the case with new "growth companies," Coated Sales found itself in a bankruptcy situation (Chapter 11 filing made on June 16, 1988) after learning from PMM that the Company's financial well being had been overstated in the last two years. PMM had been the independent public auditor for Coated Sales until it resigned, as announced by the Board of Directors of the Company on May 23, 1988. Although not overly critical to most aspects of the present motions, a short summary of the Company's troubles is useful.

According to the Amended Complaint, Coated Sales had booked material amounts of revenue in fiscal years 1987 and 1988 pursuant to fictitious "bill and hold" transactions. Under this procedure, the Company would sometimes recognize revenue in advance of shipping goods to customers, an accounting practice which is allegedly acceptable only where there exists a sound business justification, i.e., the customer has yet to instruct the Company as to where and when to ship the goods. The Amended Complaint indicates this accounting practice was accomplished by the creation of phony invoices which were never sent to the purported customer. The invoices were marked with the instruction "Bill and Hold, Do Not Call". Plaintiffs allege this unusual instruction should have revealed the scheme to falsify revenues.

In addition, the Amended Complaint alleges Company officers perpetrated a significant fraud beginning in the Fall of 1987 in connection with a phony equipment acquisition. These officers stated an equipment manufacturer received $6,000,000 from Coated Sales as a deposit on the machinery; this amount was capitalized and classified on the balance sheet as part of the current assets. It is asserted that on May 6, 1988, PMM learned the $6,000,000 deposit for machinery was a sham transaction and reported this to the Company's Board of Directors at its May 20, 1988 meeting. On May 23, 1988 Coated Sales announced PMM had resigned as the Company's auditors because it was dissatisfied with representations regarding the alleged $6,000,000 payment for machinery in October, 1987 and determined it could not rely on the representations of management.

In response to PMM's resignation, the Board appointed an outside director to investigate the $6,000,000 transaction. As a result of the investigation, Coated Sales conceded on May 31, 1988 that the $6,000,000 "deposit" on machinery reportedly made in October, 1987 and the $6,000,000 "receipt" by the supposed equipment manufacturer in May 1988 of a deposit never took place. The Company conceded the net assets reported as of November 30, 1987 and May 17, 1988 were overstated by $6,000,000. The Company also conceded that "material irregularities in the booking of accounts receivable were discovered" and stated that "many of the individual defendants were being terminated from their senior management positions." Amended Complaint ¶ 34(a).

On May 31, 1988 a press release was issued concerning the foregoing events. Following the announcement on May 31, 1988 the market price of Coated Sales common stock dropped 2 1/8 points per share. During the Class Period, the stock reached a high of $12 per share. Amended Complaint ¶ 35. It is not clear from the Amended Complaint how quickly the 2 1/8 point per share drop occurred. Furthermore, while it appears from this allegation that Coated Sales stock declined during the Class Period, it is not possible to determine from the Amended Complaint to what extent various changes in the price occurred in response to specific information released by the Company during the period.

The vast majority of the allegations contained in the Amended Complaint, and indeed all of the allegations relating to the culpable acts referred to above, are made against individual defendants Weinstein, Bober, Bloom, Glantz and Lustig, the top management of Coated Sales. As to PMM, the Amended Complaint alleges Coated Sales' 1987 fiscal year and financial statements were fraudulent and PMM nonetheless issued its unqualified opinion that the financial statements had been audited by PMM in accordance with generally accepted auditing standards ("GAAS") and fairly represented the financial position of Coated Sales under generally accepted accounting principles ("GAAP").

The Amended Complaint recites in detail what auditing steps should have been taken, and what accounting treatment should have occurred, under GAAS and GAAP and further states how various accounting principles and standards were violated in this case. For example, the Amended Complaint alleges PMM violated GAAP by permitting Coated Sales to book material amounts of revenue in fiscal 1987 from the fictitious "bill and hold" transactions. PMM was allegedly required under GAAS to take greater than usual care in auditing these transactions because GAAP does not allow such revenues to be recorded prior to shipment, absent a compelling business purpose, and because of the unusual legend contained on the invoices: "Do Not Call." In addition, the Amended Complaint alleges PMM delayed unreasonably in bringing the financial irregularities to the attention of the Company's Board of Directors at its regular meeting on May 20, 1988, some two weeks after PMM discovered them.

The financial statements, along with PMM's opinion, were contained in Coated Sales' 1987 Annual Report and 10-K Report. PMM's present motion centers on the issue of reliance which, as discussed below, is a necessary element to a securities fraud lawsuit. It is not clearly alleged in the Amended Complaint, however, any of the plaintiffs directly relied on the annual reports in purchasing their shares of Coated Sales stock. The Amended Complaint is ambiguous on this issue. It appears the issue of individual reliance was never taken seriously by plaintiffs in this litigation until very recently in the latest of several rounds of briefing. Although they appeared to rely primarily on the fraud on the market theory (as a substitute for individual reliance) in their "early round submissions," plaintiffs, responding to a recent suggestion that this issue be promptly investigated, belatedly made testimonial and legal submissions which, at least as to some named plaintiffs, purportedly demonstrate direct and indirect reliance on the PMM 1987 audit report.

As discussed later, PMM's motion will be treated under Rule 56 and factual assertions contained in the recent submissions will be taken into account. At the Hearing, plaintiffs' counsel summarized the reliance situation in this litigation as follows: some plaintiffs directly relied upon the PMM report; some plaintiffs relied upon the PMM report, but indirectly through the advice of third parties such as brokers or family members who themselves read it; some plaintiffs relied on the "efficiency of the market" to reflect the content of the PMM report and other data released by the Company in the price of the Coated Sales stock; and some plaintiffs assert a combination of the foregoing forms of reliance. It was suggested at the Hearing multiple classes may well be sought to be certified, perhaps with certain stipulations to be entered into between the parties. It was represented by plaintiffs' counsel at the Hearing that there existed a sufficient number of plaintiffs who directly relied upon the PMM report, so that the numerosity prerequisite to such a class certification could be met.

To the extent direct reliance is deemed to have been asserted (by at least some plaintiffs), PMM's motion to dismiss on summary grounds must clearly be denied. The strong impression created in this lawsuit, however, is that, of the several investors who purchased Coated Sales stock during the Class Period, most of them will depend on the availability of the fraud on the market presumption of reliance. If it is available, of course, all plaintiffs can assert fraud on the market and obviate the need to prove individual reliance (at least as to the federal securities law claims ). While there may ultimately exist other issues concerning reliance in this case (some of which may be legal), PMM's motion is treated as a Rule 56 motion to dismiss the fraud on the market theory in this case because it contends, as a matter of law, Coated Sales stock traded in an inefficient market. PMM's motion to dismiss the state law claims, which require direct reliance, is also treated under rule 56.

The Amended Complaint alleges Kagan was Assistant Secretary and Director of the Company. In addition, Kagan derived personal income from Coated Sales as counsel to the company during the Class Period. On June 29, 1987, Kagan sold 2,000 shares of Coated Sales common stock. During the period between April 13, 1988 and April 18, 1988, Kagan sold an additional 10,000 shares of common stock of Coated Sales which yielded approximately $125,000. Amended Complaint at ¶ 6(f). In addition, as part of its allegations against "all defendants," the Complaint basically alleges Kagan had readily available to him the underlying facts concerning the financial misstatements and he either knowingly or wrecklessly participated in the Coated Sales fraud. Complaint ¶ 50.

Discussion

I. Fraud on the Market Theory

Plaintiffs have alleged PMM audited Coated Sales' financial statements for fiscal year 1987 and that PMM issued an unqualified opinion on those financials. Section 10 of the Exchange Act provides that:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange —

(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) to employ any device, scheme, or artifice to defraud,

(b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made in the light of the circumstances under which they were made, not misleading, or

(c) to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

It is settled a plaintiff asserting a claim under Rule 10b-5 can satisfy the reliance element by asserting, in appropriate cases, the fraud on the market theory rather than alleging direct reliance on a defendant's misrepresentations. See Basic v. Levinson, 485 U.S. 224, 108 S.Ct. 978, 989-91, 99 L.Ed.2d 194 (1988); Peil v. Speiser, 806 F.2d at 1160-1161; Blackie v. Barrack, 524 F.2d 891, 907 (9th Cir. 1975), cert. denied, 429 U.S. 816, 97 S.Ct. 57, 50 L.Ed.2d 75 (1976). As the Supreme Court succinctly explained in Basic:

"The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business. . . . Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. . . . The causal connection between the defendants' fraud and the plaintiffs' purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations."

Although Peil makes it clear "the fraud on the market theory rests on the assumption that there is a nearly perfect market of information," id. at 1161 n. 10, the Third Circuit affirmatively declined to specifically define the term "open and developed market." It stated that "[a]s the case at bar involves a widely traded and established stock, we need not consider whether we would apply the fraud on the market theory in other instances." Id. This unanswered question in Peil goes to the heart of PMM's motion.

PMM does not question the validity of the fraud on the market theory in general, but argues it has no application here, because plaintiffs have failed to allege (and cannot prove as a matter of fact) Coated Sales stock trades actively in an "open and developed" securities market, such as the New York or American Stock Exchanges. PMM also points out Coated Sales was not such a seasoned company that it was entitled to register new securities using SEC Form S-3.

As indicated above, the Company's stock traded in the "over-the-counter" market. Although some may concur with PMM's suggestion — which was doubtless unintended — that companies listed on national stock exchanges or companies entitled to issue new securities using SEC Form S-3 would almost by definition involve stocks trading in an "open and developed" market, it is less clear that companies without these distinctions necessarily trade outside of an "open and developed" market.

Plaintiffs have cited in their briefs cases in which the fraud on the market theory was allowed where the stock in question was traded in the over-the-counter market. E.g., Finkel v. Docutel/Olivetti Corp., 817 F.2d 356 (5th Cir. 1987), cert. denied, ___ U.S. ___, 108 S.Ct. 1220, 99 L.Ed.2d 421 (1988); Teichler v. DSC Communications Corp., No. CA3-85-2005-T (N.D.Tex. Apr. 26, 1988); In re Electro-Catheter Secs. Lit., [1987-88] Fed.Sec.L.Rep. (CCH) ¶ 93,643, 1987 WL 47375 (D.N.J. Dec. 3, 1987); Gavron v. Blinder Robinson Co., Inc., 115 F.R.D. 318 (E.D.Pa. 1987); Klein v. A.G. Becker Paribas, Inc., 109 F.R.D. 646 (S.D.N.Y. 1986); Mottoros v. Abrams, 524 F. Supp. 254 (N.D.Ill. 1981). In none of these cases, however, was the question of whether the over-the-counter stock traded in an efficient or developed market squarely addressed.

PMM, on the other hand, has referred in its briefs to at least two cases which contain language suggesting that stocks trading over-the-counter are not ripe for application of the fraud-on-the-market theory. See Epstein v. American Reserve Corp., No. 79 C 4767, 1988 WL 40500 (N.D.Ill. 1988); In re Data Access Systems Securities Litigation, 103 F.R.D. 130, 138 (D.N.J. 1984) (dicta), rev'd on other grounds, 843 F.2d 1537 (3d Cir. 1988). These cases, however, do not provide any analysis of why over-the-counter stocks do not qualify for fraud-on-the-market treatment. They simply conclude such stocks do not trade in "open and developed" markets.

The question of whether the fraud on the market theory can substitute for direct reliance in any given case is both a legal and a factual one: is the market in which a particular company's stock trades efficient and well-developed. See generally Fleming, Securities Fraud — Third Circuit adopts Fraud-On-The-Market Theory of Causation In 10b-5 Actions, 32 Vill. L.Rev. 913, 936 N. 85 (1987) (hereinafter "Fleming") ("term 'developed markets' generally refers to large impersonal, actively traded markets. . . . Such markets can be contrasted with 'undeveloped markets', such as thin markets and markets for new offerings and restricted resale securities" (citing cases)). There must, then, be a factual inquiry made into whether Coated Sales stock was traded on a "thin market."

Before discussing the kinds of facts which suggest the existence of an efficient ("open and developed") market, it is important to address two points. First, it is necessary to state why the Rule 56 standard rather than the Rule 12(b)(6) standard is applied to PMM's motion. Second, it is important to address two bright-line tests for efficiency of the market offered by PMM. In short, PMM submits that listing on a national stock exchange or status as an issuer eligible to register securities on SEC Form S-3 should be considered prerequisites to an efficient market. PMM argues that, because Coated Sales stock fails to meet either of the two bright-line tests, the court should conclude the market in question is inefficient as a matter of law.

Applicable Standard

As indicated, PMM and Kagan have brought their motions as motions to dismiss under Rule 12(b)(6). If PMM's fraud on the market motion were to be treated under Fed.R.Civ.P. 12(b)(6), the question would be whether plaintiffs have alleged in the Amended Complaint that the Company's stock traded in an efficient or "open and developed market," Peil, supra, 806 F.2d at 1161, or whether any of the facts alleged give rise to such an inference. As the Supreme Court stated in Conley v. Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 101-02, 2 L.Ed.2d 80 (1957):

In appraising the sufficiency of the complaint we follow, of course, the accepted rule that a complaint should not be dismissed for failure to state a claim unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.

The Amended Complaint, however, does not contain any specific allegations that Coated Sales stock traded in an efficient or "open and developed" market. Nor does it allege the kinds of facts, discussed below, from which it can be inferred Coated Sales traded in such a market. Plaintiffs' counsel, Milberg Weiss, submitted an amicus brief to the Supreme Court in the Basic litigation on these very issues and are keenly aware of the pleading requirements to invoke the fraud on the market theory.

While the Amended Complaint — which is the product of twenty-nine capable law firms collaborating on essentially the eighteenth draft — is void of facts which would support the invocation of the fraud on the market theory, plaintiffs have belatedly submitted the Poser Affidavit and numerous other submissions which, they argue, amply demonstrate the efficiency of the market. Furthermore, plaintiffs have requested leave to amend the Amended Complaint yet another time to assert the additional facts contained in the Poser Affidavit should it be determined the Amended Complaint, as currently drafted, is insufficient. Plaintiffs' Third Brief, p. 10.

PMM, on the other hand, previously argued plaintiffs have already filed eighteen complaints and "enough is enough." PMM contended "while leave to amend is freely granted" under Fed.R.Civ.P. 15, it should not be granted here where, even considering the contents contained in plaintiffs' new submissions, plaintiffs cannot prove Coated Sales (trading in the over-the-counter market) trades in an efficient market. PMM's Third Brief, pp. 46-47. The Amended Complaint, as currently drafted, is woefully deficient as far as the "fraud on the market theory" is concerned (and plaintiffs have had more than ample opportunity to perfect the pleadings); however, it appears genuine factual issues concerning the "character of the market" have been raised by plaintiffs' recent submissions. Plaintiffs' request for leave to further amend the Amended Complaint to set forth the facts, detail and allegation as set forth in the Finkle Ross Complaint is granted. See discussion at footnote 10.

Although leave has been granted to allow plaintiffs to further amend the Amended Complaint, for present purposes consideration will be given to the contents of the Poser Affidavit (along with other recent submissions) and PMM's Rule 12(b)(6) motion will be treated as a motion for summary judgment under Rule 56.

The Federal Rules of Civil Procedure provide that a Rule 12(b)(6) motion to dismiss for failure to state a claim shall be converted to a motion for summary judgment under Rule 56 whenever matters submitted outside the pleading are considered by the court. Fed.R.Civ.P. 12(b). Because of the review and consideration of matters outside the pleading in this case which are sufficient to require a determination of the motion on summary judgment, the summary judgment standard under Fed.R.Civ.P. 56 will be applied.

To prevail on a motion for summary judgment, the moving party must establish "there is no genuine issue as to any material fact and that [it] is entitled to judgment as a matter of law." Fed.R.Civ.P. 56(c). The district court's task is to determine whether disputed issues of fact exist, but the court cannot resolve factual disputes in a motion for summary judgment. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 249-50, 106 S.Ct. 2505, 2510-11, 91 L.Ed.2d 202 (1986). All evidence submitted must be viewed in a light most favorable to the party opposing the motion. See Matsushita Elec. Industrial Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 587, 106 S.Ct. 1348, 1356, 89 L.Ed.2d 538 (1986).

Although the summary judgment hurdle is a difficult one to overcome, it is by no means insurmountable. As the Supreme Court has stated, once the party seeking summary judgment has pointed out to the court the absence of a fact issue,

its opponent must do more than simply show that there is some metaphysical doubt as to the material facts. . . . In the language of the Rule, the non-moving party must come forward with 'specific facts showing that there is a genuine issue for trial.' . . . Where the record taken as a whole could not lead a rational trier of fact to find for the non-moving party, there is no 'genuine issue for trial.'

The Court elaborated on the standard in Anderson v. Liberty Lobby, Inc., 477 U.S. at 249-50, 106 S.Ct. at 2510-11 (citations omitted): "If the evidence [submitted by a party opposing summary judgment] is merely colorable . . . or is not significantly probative . . . summary judgment may be granted." The Supreme Court went on to note in Celotex Corp. v. Catrett, 477 U.S. 317, 323-24, 106 S.Ct. 2548, 2553-54, 91 L.Ed.2d 265 (1986) (footnote omitted): "One of the principal purposes of the summary judgment rule is to isolate and dispose of factually unsupported claims or defenses, and we think it should be interpreted in a way that allows it to accomplish this purpose." Thus, once a case has been made in support of summary judgment, the party opposing the motion has the affirmative burden of coming forward with specific facts evidencing a need for trial. See Fed.R.Civ.P. 56(e).

PMM argues the Amended Complaint should be dismissed as a matter of law because (1) Coated Sales stock was not listed on a national stock exchange and (2) Coated Sales was not eligible to register new stock using SEC form S-3. Although PMM has raised interesting questions by arguing Coated Sales fails to meet either of these bright-line tests for the reasons stated below, neither of the two tests will be adopted. Furthermore, summary judgment is inappropriate because genuine issues of material fact concerning the character of the market for Coated Sales stock have been created by the Poser Affidavit.

The Over-the-Counter Market

It is PMM's position that only stocks trading on either the New York or American stock exchanges should be eligible for fraud on the market treatment. The focus, according to PMM, should be on the broader (or "whole") market in which a security trades (in the case of Coated Sales, the over-the-counter-market), not on an "individual market" for a specific security which happens to trade within the context of a larger, "whole" market.

PMM argues the leading cases discussing the fraud on the market theory, e.g. Basic and Peil, involved defendants which were national stock exchange listed companies and that the decisions in those cases depended entirely upon the empirical market studies referred to therein — which in every case involved national exchanges.

In re LTV Securities Litigation, 88 F.R. D. 134 (N.D.Tex. 1980), explained:

"The reasonableness of a presumption turns either on the empirical validity of the fact presumed or upon a policy sufficient to justify placing the burden of proof where it would not naturally be under our adversary system. Recent economic studies tend to buttress empirically the central assumption of the fraud on the market theory — that the market price reflects all representations concerning the stock. Indeed, economists have now amassed sufficient empirical data to justify a present belief that widely-followed securities of the larger corporations are 'efficiently' priced: the market price of stocks reflects all available public information — and hence necessarily, any material misrepresentations as well." (citations omitted)

PMM emphasized the fact that the four finance theory texts cited by Judge Higginbotham in LTV Securities studied New York Stock Exchange trading. PMM further argues "there has never been a rigorous economic study of the efficiency of the over-the-counter market." PMM's Third Brief, p. 12. While research has not revealed an empirical academic study of the over-the-counter-market (focusing particularly on whether there exists the requisite efficiency for the fraud on the market theory), the absence of such a study is not conclusive on the issue of whether the over-the-counter market is efficient.

As further support for its argument that the focus should be on "whole markets," PMM refers to Fama's article, where it is stated: "the ideal is a market . . . in which . . . investors can choose among . . . securities. . . ." Fama, supra, at 383. PMM also relies on a passage contained in Basic, 108 S.Ct. at 992, which, it is argued, looks not explicitly to the particular company but to whether "the shares were traded on an efficient market". PMM's Second Brief, p. 8 n. 7.

The above citations, however, do not persuasively support the fine distinctions PMM seeks to have made. Examining the above quotations in context, it is not clear the authors were considering the differences between "markets as a whole" and the notion of sub-markets for individual securities within a larger market. The distinction was more squarely addressed in Harman v. Lyphomed, Inc., 122 F.R.D. 522 (N.D.Ill. 1988):

"the question is always whether the stock trades in an efficient market, i.e. one in which material information on the company is widely available and accurately reflected in the value of the stock. Basic, 108 S.Ct. at 991 and n. 24 (citing studies). While some over-the-counter stocks no doubt trade in a less developed market than some New York Stock Exchange issues, the inquiry in an individual case remains the development of the market for that stock, and not the location where the stock trades." (emphasis added).

It would be illogical to apply a presumption of reliance merely because a security is traded within a certain "whole market", without considering the trading characteristics of the individual stock itself. Some well-followed stocks, such as Apple Computer and MCI Telecommunications, have chosen to trade in the over-the-counter market rather than on a national exchange. On the other hand, some companies listed on national stock exchanges are relatively unknown and trade there only because they met the eligibility requirements. While the location of where a stock trades might be relevant, it is not dispositive of whether the "current price reflects all available information."

After holding out relatively unpersuasive authority for the proposition that the focus should be on the over-the-counter market as a whole, not the market for an individual stock, PMM discusses at great length why a stock traded in the over-the-counter market is unworthy of inclusion in a fraud on the market theory cause of action. PMM argues:

The over-the-counter market has been variously described as "an inefficient market," as "thinly traded and very inefficient," "where floats and trading characteristics are so limited that only a tiny portion of investors are comfortable investing," as a "woebegone marketplace" where "investors must twiddle their thumbs for days or weeks, waiting for the chance to buy or sell at a reasonable price," as a "thin and skittish" market — "the financial version of a greasy spoon restaurant, where the prices are cheap and you always end up with heartburn," — "as the Casbah of the securities industry, the haven for insignificant, risky, even shady stocks."

PMM's Third Brief, pp. 15-16 (citations omitted). PMM goes on to explain the differences in the trading environments and mechanics in the context of national exchanges on the one hand, and the over-the-counter market on the other. PMM's argument appears to be that, because the regulations governing traders and "specialist units" at the national exchanges are more rigid, there is greater liquidity and greater maintenance of an orderly market.

The primary impression created by PMM's submission is that, without reference to individual stocks, the national exchanges might be somewhat better equipped to consistently assure investors the ability to execute instantaneous ( i.e. within seconds of seeking bid quotations) trades. Although it may have intended to, PMM has not compelled the conclusion that the over-the-counter market is virtually illiquid or stagnant as is, for example, the market for privately placed securities with only a handful of holders.

The distinctions between the trading atmospheres (at the national exchanges vs. the over-the-counter market) appear to have been over-emphasized by PMM in its effort to discount the importance of the market for a particular stock. The central question under the fraud on the market theory is whether the stock price, at the time a plaintiff effected a trade, reflected the "misinformation" alleged to have been disseminated. If PMM's submissions suggest anything, it is the possibility that the inflated financial statements contained in the financial reports at issue (to the extent they may have induced trading) might have been reflected in the stock price somewhat more quickly if Coated Sales had been listed on a national stock exchange rather than traded over-the-counter.

There has been no suggestion, however, that this case, as far as most plaintiffs are concerned, boils down to a "matter of seconds." It appears the individual plaintiffs acquired their Coated Sales stock over a fairly broad period of time. Thus, on the issue of whether the stock price already reflected the import of the financial reports by the time particular investors made their purchases, the fine distinctions PMM seeks to have made do not appear relevant.

The issue here is whether market makers in the over-the-counter market, specifically the market for Coated Sales stock, provided a sufficiently fluid and informed trading environment so that when material information about Coated Sales was disseminated, investors had available to them an opportunity to trade at informed, and therefore appropriate, bid and asked prices.

There are several different characteristics pertaining to the markets for individual stocks which are probative of the degree to which the purchase price of a stock should reflect material company disclosures. PMM seeks to have important distinctions drawn based upon subtle differences between the trading atmospheres at the national exchanges and the over-the-counter market. There appears to be, as of yet, no reasoned precedent for such distinctions. Furthermore, it has been said federal courts lack the expertise to evaluate securities markets and formulate substantive rules of law based on such evaluation and that Congress is better equipped for such tasks.

Plaintiffs, in response to PMM's condemnation of the over-the-counter market generally, have focused on Coated Sales and the particular sub-market in which it trades. First, plaintiffs stress Coated Sales traded on NASDAQ's premier "National Market System," a grouping of the largest and most widely followed over the counter stocks. Plaintiffs' Second Brief, p. 6. Second, plaintiffs submitted the Poser Affidavit which contains a detailed analysis of the characteristics pertaining specifically to the stock of Coated Sales. In addition, plaintiffs have constructed comparisons of the relevant characteristics of Coated Sales stock with those of the stocks at issue in Peil and Basic. As indicated above, the more persuasive reasoning indicates the proper inquiry involves the market for the specific security at issue. Status As An Issuer Eligible to Use SEC Form S-3

In Lyphomed, supra, a recent decision specifically rejecting the argument that an over-the-counter stock is ineligible for fraud on the market treatment, the district court placed particular emphasis on the fact that the company was a registrant using SEC Form S-3. The court stated the SEC's explicit rational for the integrated disclosure system is that information on companies which file on Form S-3 is widely available in the market and therefore need not be disseminated in the prospectus. 122 F.R.D. at 525 n. 1. See Black, Fraud on the Market: A Criticism of Dispensing with Reliance Requirements in Certain Open Market Transactions, 62 N.C.L. Rev. 455, 468 (1984). According to the court in Lyphomed, "the SEC established reporting requirements for LyphoMed on the premise that the stock traded in an open and efficient market." Id. PMM argues that because Coated Sales was not eligible throughout the Class Period to issue new securities on SEC Form S-3, the fraud on the market theory should be held inapplicable as a matter of law.

The following SEC releases explain the rationale for allowing older, "more seasoned," companies to fulfill disclosure obligations through integration (i.e., incorporation of old SEC documents into registration statements by reference).

The concept of integration also proceeds from the observation that information is regularly being furnished to the market through periodic reports under the Exchange Act. This information is evaluated by professional analysts and other sophisticated users, is available to the financial press and is obtainable by any other person who seeks it for free or at nominal cost. To the extent that the market accordingly acts efficiently, and this information is adequately reflected in the price of a registrant's outstanding securities, there seems little need to reiterate this information in a prospectus in the context of a distribution.

SEC Securities Act Release No. 6235, 45 Fed.Reg. 63,693 (1980), reprinted in Fed. Sec.L.Rep. (CCH) Spec.Regs. No. 875, second extra ed. (Sept. 10, 1980). As stated by the SEC:

Under the proposed registration statement framework, registrants would be classified into three categories: (1) companies which are widely followed by professional analysts; (2) companies which have been subject to the periodic reporting system of the Exchange Act for three or more years, but which are not widely followed; and (3) companies which have been in the Exchange Act reporting system for less than three years. The first category would be eligible to use proposed Form S-3, which relies on incorporation by reference of Exchange Act reports and contains minimal disclosure in the prospectus. This form is predicated on the Commission's belief that the market operates efficiently for these companies, i.e., that the disclosure in Exchange Act reports and other communications by the registrant, such as press releases, has already been disseminated and accounted for by the market place.

* * * * * *

Proposed Form S-3 recognizes the applicability of the efficient market theory to the registration statement framework with respect to those registrants which usually provide high quality corporate reports, including Exchange Act reports, and whose corporate information is broadly disseminated, because such companies are widely followed by professional analysts and investors in the market place.

SEC Securities Act Release No. 6331, 46 Fed.Reg. 41,902, reprinted in Fed.Sec.L. Rep. (CCH) Spec.Regs. No. 926, extra ed. (Aug. 13, 1981) (emphasis added).

Because of the foregoing observations made by the SEC, the existence of Form S-3 status is an important factor weighing in favor of a finding that a market is efficient. Unlike in Lyphomed where the company was eligible to use Form S-3, however, the question in this case is how devastating is the absence of Form S-3 status to plaintiffs' Amended Complaint. Furthermore, as noted above, Coated Sales was on the verge of being able to register securities on Form S-3. Such entitlement comes from issuing Exchange Act reports for 36 months (Coated Sales fell three months short) and from having a sufficient "float."

As far as the SEC is concerned, the three year reporting history is important to the decision to allow integrated disclosure because there is no need to restate in a prospectus what has already been recently disclosed in public documents. The "public float" aspect of the Form S-3 requirements ensures that enough investors have in fact read the previously filed document. In short, therefore, in assessing the importance of the status (or lack of it) as a Form S-3 issuer, focus is directed to the number of shareholders and market capitalization.

With the rejection, in the context of its current motion, of the two bright-line tests offered by PMM, attention now shifts to a summary of the facts which could have been alleged to justify invocation of the fraud on the market theory, many of which were belatedly stated in the Poser Affidavit.

The Supreme Court in Basic seemingly approved of the elements set forth by Peil as those necessary before a plaintiff can invoke the fraud on the market theory. Included among the elements, Peil and Basic unambiguously require a plaintiff to allege: "(3) that the shares were traded on an efficient market." Basic, 108 S.Ct. at 992 n. 27. From a close examination of the Amended Complaint, however, all that can be gleaned is that Coated Sales traded in the "over-the-counter" market and had approximately 19,000,000 shares of stock outstanding, which are held by approximately 1200 holders. In addition, the Complaint states: "Without knowing of the falsity of the reports and statements described above, plaintiffs and class relied, to their damage, on those reports and statements and/or on the integrity of the market of Coated Sales stock." Amended Complaint ¶ 55. Although the number of shares outstanding and number of holders may be relevant to the character of the market for Coated Sales stock, the allegation contained in ¶ 55 of the Amended Complaint, that plaintiffs relied upon the "integrity of the market," merely begs the question of whether the market was "open and well developed."

There are several types of facts which, if alleged, might give rise to an inference that Coated Sales traded in an efficient market. It is useful to set forth an explanation of how the existence of such facts would cause the understanding that disclosed company information (or misinformation) would be reflected in the company's stock price, the underpinning of the fraud on the market theory. Peil, supra, 806 F.2d at 1160.

First, plaintiffs could have alleged there existed an average weekly trading volume during the class period in excess of a certain number of shares. Abell v. Potomac Ins. Co., 858 F.2d 1104, 1121 (5th Cir. 1988). See also Finkel v. Docutel/Olivetti Corp., 817 F.2d 356, 360 n. 8 (5th Cir. 1987) ("The efficient market model is thought to operate in open or 'developed' market transactions, which simply refers to some large, impersonal actively traded market") (emphasis supplied); Bromberg, supra at § 8.6 (Turnover measured by average weekly trading of two percent or more of the outstanding shares would justify a strong presumption that the market for the security is an efficient one; one percent would justify a substantial presumption). The reason the existence of an actively traded market, as evidenced by a large weekly volume of stock trades, suggests there is an efficient market is because it implies significant investor interest in the company. Such interest, in turn, implies a likelihood that many investors are executing trades on the basis of newly available or disseminated corporate information.

Second, it would be persuasive to allege a significant number of securities analysts followed and reported on a company's stock during the class period. The existence of such analysts would imply, for example, the PMM reports were closely reviewed by investment professionals, who would in turn make buy/sell recommendations to client investors. In this way the market price of the stock would be bid up or down to reflect the financial information contained in the PMM reports, as interpreted by the securities analysts.

Third, it could be alleged the stock had numerous market makers. The existence of market makers and arbitrageurs would ensure completion of the market mechanism; these individuals would react swiftly to company news and reported financial results by buying or selling stock and driving it to a changed price level.

Fourth, as discussed, it would be helpful to allege the Company was entitled to file an S-3 Registration Statement in connection with public offerings or, if ineligible, such ineligibility was only because of timing factors rather than because the minimum stock requirements set forth in the instructions to Form S-3 were not met. Again, it is the number of shares traded and value of shares outstanding that involve the facts which imply efficiency.

Finally, it would be helpful to a plaintiff seeking to allege an efficient market to allege empirical facts showing a cause and effect relationship between unexpected corporate events or financial releases and an immediate response in the stock price. This, after all, is the essence of an efficient market and the foundation for the fraud on the market theory.

The law in the Third Circuit is that reliance is presumed "only 'where it is logical' to do so." Peil v. Speiser, supra, 806 F.2d at 1161 n. 11 and Zlotnick v. TIE Communications, 836 F.2d 818, 822 (3d Cir. 1988), both quoting Sharp v. Coopers Lybrand, 649 F.2d 175, 188 (3d Cir. 1981), cert. denied, 455 U.S. 938, 102 S.Ct. 1427, 71 L.Ed.2d 648 (1982). It is not logical to draw bright line tests — such as whether a company is listed on a national exchange or is entitled to register securities on SEC Form S-3 — to assist fact finders in determining whether a stock trades in an "open and efficient market." A well established and widely followed company may choose for any number of unrelated reasons not to list itself on a national exchange. Furthermore, there may be a company whose stock trades in an efficient market, but which just missed or recently failed to meet the qualifications for Form S-3 registrants.

While the Amended Complaint does not contain most of the foregoing types of allegations, the Poser Affidavit does. It is curious why, in light of the apparent knowledge of Milberg Weiss that efficiency must be alleged in the Amended Complaint, plaintiffs failed to make these allegations in their early pleadings. For the reasons discussed above, however, this motion is to be treated under the Rule 56 standard with the content of the Poser Affidavit taken into account. The Poser Affidavit has created a genuine issue of material fact concerning the character of the market for Coated Sales stock. Accordingly, PMM's motion for dismissal of the Rule 10b-5 claims must be denied at this time.

II. Pretrial Evidentiary Hearing on the Character of the Market for Coated Sales Stock

The present posture of this litigation raises interesting procedural questions about the types of hurdles a plaintiff should be required to overcome at various stages of a "fraud on the market" lawsuit. In fairness to the parties, a preliminary evidentiary hearing was suggested to examine the availability of the fraud on the market presumption in this case. This approach attempted to avoid the harsh result of dismissing the Amended Complaint. Furthermore, to the extent the fraud on the market theory was inapplicable and plaintiffs could not establish alternative forms of reliance, an early hearing would allow PMM to confront some of the ultimate issues in this case.

It was suggested the parties brief the issue of the appropriateness of a hearing in this context. Research has turned up little direct authority on point. Nevertheless, counsel for the parties have made several arguments on the issue, each of which is discussed below. Without attempting to conclusively resolve the questions concerning the types of burdens to be imposed at various stages of litigation on plaintiffs seeking to proceed under the fraud on the market theory, it appears in this case an evidentiary hearing would not be in the interests of fairness to the parties and judicial economy.

While plaintiffs may be correct that an evidentiary hearing may not be appropriate in this case (at least at this stage), however, their argument that district courts lack the power to pretest the availability of the fraud on the market theory (a judicially created presumption of reliance) in all cases is rejected. As discussed below, it is suggested the inclination of a court to examine, on a preliminary basis, the character of the market for a particular stock should depend in large part on the strength of the plaintiffs' prima facie showing that the market is efficient. If there has been a strong showing that the market is efficient, based upon the factors discussed above, a preliminary hearing would probably be unnecessary. If, on the other hand, it is substantially uncertain from the submissions whether a market is efficient (and therefore whether the fraud on the market theory and its presumption of reliance are available to plaintiffs), an early indication from the court on the availability of the fraud on the market theory is in the interest of all parties, whose subsequent needs for discovery can be tailored to the possible need to develop, or rebut, alternative theories of reliance.

In support of a preliminary hearing concerning the availability of a presumption of reliance based upon the fraud on the market in this case, PMM argues section 33.32 of the Manual for Complex Litigation 2d (1985) ("MCL 2d") urges trial courts to define and clarify issues such as "whether the plaintiffs may proceed on the theory of a 'fraud on the market'" using techniques such as those described in section 21.33. Section 21.33 of the MCL 2d, in turn, lists "conducting a separate trial under Fed.R.Civ.P. 42(b) of issues which may render unnecessary or substantially alter the scope of further discovery or trial." Id. The MCL 2d states: "[I]ssues that affect the scope or extent of discovery or trial . . . should be determined as soon as possible." Id. Section 21.632 of the MCL 2d encourages the use of Rule 42(b) separate trials: "[S]everance of certain issues for separate trials under Fed.R.Civ.P. 42(b) is often useful . . . the results of the first trial may eliminate the need for further proceedings. . . ."

"[I]f a single issue could be dispositive of the case and resolution of it might make it unnecessary to try the other issues, separate trial of the issue may be desirable to save the time of the court and reduce the expense of the parties." 9 C. Wright A. Miller, Federal Practice and Procedure: Civil § 2388 at 280-81 (1971). While the foregoing citations perhaps contemplate a separate trial in the sense that the "facts" concerning the character of the market would be found conclusively in advance of empaneling a jury, that was not what was necessarily contemplated here. As discussed, the proposed hearing here was merely intended to pretest the availability of a rebuttable presumption of reliance.

Plaintiffs strenuously oppose a hearing, arguing that significant constitutional and other issues may arise if plaintiffs are required to prove, "in a separate trial," that Coated Sales stock trades in an efficient market. Specifically, plaintiffs argue the Seventh Amendment prohibits a partial jury trial on the applicability of the fraud on the market presumption because the issues involved are not separate, independent and distinct from all other issues in the case. Plaintiffs' Second Brief, pp. 25-28.

Plaintiffs stress the evidence relating to the existence of an "open and developed" or efficient market — the focus of the proposed pretrial hearing — would have to be reexamined by a second jury because the evidence relating to these factors is appropriate to a determination of materiality, causation and damages (elements required to be proved in a securities fraud suit under Rule 10b-5). Plaintiffs appear to argue they are entitled, under the Seventh Amendment, to have all of the factual issues in this case addressed only once and by the same jury. Several cases have been cited for the proposition that partial trials should not occur where the issues to be resolved may be relevant to other issues in the case. Plaintiffs rely on Gasoline Products Co. v. Champlin Refining Co., 283 U.S. 494, 51 S.Ct. 513, 75 L.Ed. 1188 (1931) where the Court ruled that a partial trial

may not properly be resorted to unless it clearly appears that the issue to be retried is so distinct and separable from the others that a trial of it alone may be had without injustice. . . . Here the question of damages on the counterclaim is so interwoven with that of liability that the former cannot be submitted to the jury independently of the latter without confusion and uncertainty, which would amount to the denial of a fair trial.

In Smith v. Alyeska Pipeline Service Co., 538 F. Supp. 977 (D.Del. 1982), aff'd 758 F.2d 668 (Fed. Cir. 1984), cert. denied, 471 U.S. 1066, 105 S.Ct. 2142, 85 L.Ed.2d 499 (1985) the court explained:

The central inquiry is whether the issues heard by the second jury . . . will be so distinct and independent from those issues heard by the first jury. . . . Two juries cannot decide factual issues that are common to both trials and which are essential to a verdict or an award. Factual questions resolved by one jury which could be reexamined by another jury, either directly or indirectly, violates (sic) the Seventh Amendment.

In these cases, however, the issue was whether a jury trial could be bifurcated, such that a litigant would be forced to try factual issues, concerning substantive elements of the case, in front of different juries — with the possible risk of conflicting verdicts. That is not a problem raised by the proposed pretrial evidentiary hearing in this case. Plaintiffs' right to a jury trial on the merits of each element to their securities fraud lawsuit would be preserved. In the proposed pretrial hearing, plaintiffs would merely be provided an opportunity to demonstrate they are entitled to a judicial presumption of reliance. At such a hearing, consideration would be given to factual data in determining whether Coated Sales stock traded in an efficient market and whether plaintiffs therefore should enjoy a rebuttable presumption of reliance in this lawsuit.

The parties appear to agree that the availability of the fraud on the market theory, as a substitute for actual reliance, is a determination to be made by the trial judge. In Basic, supra, 108 S.Ct. 978, the question was framed as follows: "whether it was proper for the courts below to apply a rebuttable presumption of reliance, supported in part by the fraud-on-the-market theory." Id. at 989. The Supreme Court adopted the lower court's holding that the plaintiff "must allege and prove . . . that the shares were traded on an efficient market" before a trial court may invoke the presumption. Id. at 992 n. 27.

No issues under the Seventh Amendment are presented here because a court can consider factual data presented by the parties which consideration is necessary to determine whether plaintiffs should be allowed to proceed under a judicially created method of satisfying an element of a cause of action. Plaintiffs' Seventh Amendment arguments (to the effect the court would be usurping the fact finding role of the jury) are something of a red herring because the trial court would not be making factual findings binding on the jury. For example, if it were concluded after a hearing the market appeared efficient, and plaintiffs could proceed under the rebuttable presumption, PMM would be entitled to prove to a jury that the market was inefficient, thereby rebutting the presumption. Furthermore, plaintiffs' counsel reaffirmed at oral argument the Poser Affidavit should be considered in connection with a determination as to the applicability of the fraud on the market presumption. No plausible explanation was given (nor does one exist) why more data — presented either in document or testimonial form — could not be requested by a court to assist in deciding whether to permit the presumption at this stage.

By adopting the fraud on the market theory, the courts have simply created a method of allowing plaintiffs to more easily satisfy the reliance element; the predicate to invocation of the fraud on the market theory, an efficient market, is not a necessary element to a securities fraud suit, as such. The language in Basic makes it clear the court, not a jury, is to determine the appropriateness of applying "a rebuttable presumption of reliance." 108 S.Ct. at 989.

Plaintiffs have more persuasively argued, as a matter of judicial economy, there should only be one presentation of factual evidence in this case. A court can await the merits trial and base its determination of the "character of market" upon the same evidence simultaneously considered by the jury in connection with the other elements of a Rule 10b-5 litigation. Although PMM has indicated a pretrial evidentiary hearing should last no more than two days, ( see letter from counsel to PMM, dated December 20, 1988, p. 2), counsel to the plaintiffs, in their opposition to the pretrial hearing, suggest "the trial would require at least two weeks, and quite possibly longer." Plaintiffs' Second Brief, p. 30.

All that is in issue, as discussed above, is whether to apply a rebuttable presumption at this stage. At this stage, PMM would be able to submit at the most an equally credible case at the evidentiary hearing to the effect the market for Coated Sales stock is inefficient, the only point being that reasonable experts can differ on such an abstract issue. Because of the significant number of objective characteristics contained in the Poser Affidavit, the outcome of a hearing would almost inevitably be to allow the presumption to stand, and to submit the question of efficiency for ultimate determination by the jury.

While there is no present need to pretest the efficiency of the market for Coated Sales stock, it is possible a pretrial hearing on this issue may become appropriate at a later stage. For example, after the facts are developed during discovery in this case, PMM may be able to prove empirically that the market is inefficient. As previously noted, one of the most convincing ways to demonstrate efficiency would be to illustrate, over time, a cause and effect relationship between company disclosures and resulting movements in stock price. However, as mentioned, such a showing (or, in the case of PMM, the absence of it) would be difficult because it would require exploration of materiality and causation issues. In light of the apparent substance of the Poser Affidavit, plaintiffs will not be required to delve into such issues at this early stage.

In cases where no substantial showing of an efficient market has been made, it is important to note that even if the pretrial evidentiary hearing lasted as long as two weeks, such a period is most probably considerably less time than a full trial of all aspects of a significant securities fraud matter. If it were straightforward that Coated Sales did not trade in an efficient market, the trial could be simplified. Plaintiffs' counsel dispute the existence of such potential efficiency in this case, arguing that there are at least some plaintiffs who can establish alternative theories of reliance (i.e., need not rely on the fraud on the market theory) and the auditing issues will have to be explored in any event.

It is recognized that ordering a pretrial hearing would place an unanticipated, indeed unprecedented, obstacle in front of the plaintiffs, and that significant issues may be involved concerning the purposes of the securities laws and of class action litigations. This procedural issue has been addressed by certain commentators:

It is important to have a fairly simple way of resolving — at least tentatively — at an early state in a case whether the market for a particular security is open, developed and efficient, since this affects whether a claim has been stated and whether a class may be certified. For statement of a claim, the allegations of the complaint are normally sufficient. But their sufficiency for class determination is open to question since the ruling for or against the class in practice often determines the fate of the case. Thus some sort of evidentiary base is appropriate for class determination.

Bromberg, supra, at § 8.6. Bromberg noted that "ultimately, one must decide what degree of responsiveness suffices for an efficient market. Expensive experts with complex equations and long computer printouts are highly likely to reach opposite conclusions on efficiency of the market." Id. Without citing any cases where the issue had been specifically addressed by a court, Bromberg offered:

We think that, at a minimum, there should be a presumption — probably conditional for class determination — that certain markets are developed and efficient for virtually all the securities traded there: the New York and American Stock Exchanges, the Chicago Board Options Exchange and the NASDAQ National Market System. The presumption would be rebuttable on a showing that the specific security in question is inactively traded on the market or unresponsive to new information. For other markets a presumption is harder to frame. Whether the trier of fact is allowed or required to engage in a presumption, the most practical — and therefore probably the best — base for the presumption is average trading volume over a period of several months surrounding the time of the alleged violations. Turnover measured by average weekly trading of 2% or more of the outstanding shares would justify a strong presumption that the market for the security is an efficient one; 1% would justify a substantial presumption. For over the counter markets without volume reporting, the number of market makers is probably the best single criterion. Ten market makers for a security would justify a substantial presumption that the market for the security is an efficient one; five market makers would justify a more modest presumption.

"[I]t is important to have a fairly simple way of resolving . . . at an early stage . . . whether the market is . . . efficient." Id. at § 8.6. PMM's arguments that the absence of New York or American stock exchange listing, or the status of a Form S-3 registrant, should per se preclude application of the fraud on the market theory were previously rejected. Similarly, a rule which per se subjects a party to protracted litigation merely because a company's stock trades within a certain NASDAQ grouping (i.e., the National Market System) is also rejected. Because there appears to be a significant prima facie showing by plaintiffs concerning the character of the market in this case, an evidentiary hearing at this time is unnecessary.

III. Controlling Persons Doctrine: Control

Plaintiffs have alleged that Kagan, as a director, assistant secretary and attorney for Coated Sales, was a "controlling person" of the Company, and therefore secondarily liable for the securities fraud allegedly committed by Coated Sales and other defendants. It is also alleged Kagan sold significant amounts of Coated Sales stock immediately prior to the Company's announcement of the alleged financial irregularities. Finally, although perhaps without particularity, the Amended Complaint basically alleges Kagan either knowingly or recklessly participated in the dissemination of misleading information about the Company. Amended Complaint ¶ 50. Kagan has moved to dismiss this federal securities law claim on the grounds that plaintiffs have failed to allege sufficient facts indicating that Kagan exercised actual control of the Company's operations.

Section 20(a) of the Securities Exchange Act, 15 U.S.C. § 78t, provides:

Every person who, directly or indirectly controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.

The case law is inconsistent on what facts must be alleged in order to survive a defendant's motion to dismiss for failure to assert "controlling person" status. It is clear, however, even if defendant is found to be a "controlling person," no liability will attach if he can make out the good faith statutory defense. See Harriman v. E.I. Dupont De NeMours and Co., 372 F. Supp. 101, 105 (D.Del. 1974) ("defendant may demonstrate, by way of defense, that he did not, directly or indirectly induce [the fraudulent] transaction").

The inconsistency in the case law appears to be caused, at least in part, by the fact that some courts separately analyze whether a person is a controlling person and, if so, whether they can establish the good faith defense. Other courts seem to collapse the analysis by focusing immediately on the bottom line: whether a defendant can be held liable as a controlling person, without a reasoned threshold determination of whether he was a controlling person.

The practical effect of these differing approaches is critical to Kagan's motion to dismiss. Courts applying the first approach appear inclined to hold directors to be controlling persons based on status, which would defeat a motion to dismiss, and then to shift the burden to the defendant to establish his good faith. See Savino v. E.F. Hutton Co., Inc., 507 F. Supp. 1225, 1242-43 (S.D.N.Y. 1981) (discussing the inconsistency in the case law and noting that "[t]oday, however, it is fairly well agreed that proof of 'control by status,' as distinct from 'actual control,' is all that is required to make out a prima facie case under Section 20(a); . . . proof of control by status creates a presumption of 'control', which presumption can be rebutted if the alleged controlling person proves and absence of actual control").

Plaintiffs have cited considerable authority for the proposition that, if a defendant is alleged to be a director of a corporation, he is presumptively a controlling person and the burden shifts to him to demonstrate good faith and noninvolvement in the underlying fraud. On the other hand, defendant Kagan has cited impressive authority to the effect that a plaintiff must allege the director exercised some form of actual control over the company, such as day-to-day involvement in the company's affairs.

Neither Kagan nor the plaintiffs have cited to Third Circuit precedent on this question. In addition, it appears the Supreme Court has not resolved this question of control based on status. In resolving this issue, a passage Rochez Brothers, Inc. v. Rhoades, 527 F.2d 880 (3d Cir. 1975), is instructive:

Our next inquiry is to the meaning of "control" under Section 20(a). There is no statutory definition of "control"; however, the SEC has defined "control" as "the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise," 17 C.F.R. Section 240.12(b)-2(f). Congress deliberately did not define "control," thus indicating its desire to have the courts construe the applicable provisions of the statute along with the evidence adduced at trial.

Many factors are involved in determining if one is a "controlling person." In making this determination, the courts have given heavy consideration to the power or potential power to influence and control the activities of a person, as opposed to the actual exercise thereof. (emphasis supplied)

In Gould v. American-Hawaiian S.S. Co., 535 F.2d 761, 779 (3d Cir. 1976), the Third Circuit again indicated a defendant could be a "controlling person" under Section 20(a) of the Exchange Act based upon "influence short of actual direction." (citing Myzel v. Fields, 386 F.2d 718, 738 (8th Cir. 1967)). See also Harriman v. E.I. DuPont De Nemours and Co., 372 F. Supp. 101, 105 (D.Del. 1974) ("a plaintiff can state a cause of action under Sections 10b-5 and 20(a) of the Exchange Act without alleging any affirmative action on the part of the defendant. . . . '[S]tatus' may suffice if that status is such that it involves the potential for control").

The plaintiffs have alleged Kagan was a director, assistant secretary and legal counsel of Coated Sales. For its legal services, Kagan's law firm received $326,665 in fees in fiscal 1986. Plaintiffs also allege Kagan signed the Coated Sales reports which contained the alleged misstatements. If these are not sufficient factual allegations under the foregoing authority, the Amended Complaint also alleges the defendants (which, it is assumed, includes Kagan) knowingly or recklessly participated in the fraud.

Kagan specifically attacks the allegation he knowingly or recklessly participated in the fraud as lacking the particularity required under Fed.R.Civ.P. 9(b). While it might be concluded this allegation of knowing or reckless participation might not meet the pleading standard of the Third Circuit — liberal though it may be —, see Seville Industrial Machines Corp. v. Southmost Machinery Corp., 742 F.2d 786 (3d Cir. 1984), cert. denied, 469 U.S. 1211, 105 S.Ct. 1179, 84 L.Ed.2d 327 (1985); Kronfeld v. First Jersey Nat. Bank, 638 F. Supp. 1454 (D.N.J. 1986), it appears that the specific allegations that Kagan was a director, assistant secretary and attorney for Coated Sales are sufficient to survive a motion to dismiss the Section 20(a) claim. As discussed, however, these boilerplate allegations concerning Kagan's participation in the fraud are not sufficient under Seville to survive Kagan's motion to dismiss the state law claims contained in Count II and Count III of the Complaint.

Without necessarily endorsing on a wholesale basis the "control by status" approach to all Section 20(a) cases, pursuant to the applicable standards governing Rule 12(b)(6) motions, Kagan's motion to dismiss the Section 20(a) claim is denied. Coated Sales is a small company and Kagan apparently had considerable holdings in it, until he made his decision to sell in April, 1988. It may be presumed for pleading purposes a director, who was also corporate counsel and assistant secretary, in such a company would have at least some global responsibilities for, and interest in, corporate affairs. Although plaintiffs have not alleged with particularity any specific facts which would seem to tie Kagan to the fraud itself, plaintiffs have met their liberal pleading requirements as to the Section 20(a) claim. To the extent that plaintiffs fail to establish any actual culpability on the part of Kagan, he will of course be entitled to assert his statutory good faith defense.

IV. Common Law and Other Claims PMM

In addition to alleging PMM violated Rule 10b-5 in connection with its certification of Coated Sales' 1987 financial statements, plaintiffs claim PMM is liable under other theories (primarily under state law) for its involvement in both the 1987 and 1988 financial reports. As to the 1988 financial reports, plaintiffs have alleged PMM was aware of accounting irregularities at Coated Sales just prior to the Company's release of preliminary results for 1988, but that PMM delayed for two weeks before approaching the Board of Directors. As a distinct species of a federal securities law claim, plaintiffs argue PMM's alleged failure to timely notify the Board of Directors of its May 1988 discovery renders PMM "liable as aider and abettor for violating [various accounting professional standards or guidelines]." Complaint ¶ 54. In this Circuit, a party may be held liable as an aider and abettor to a fraud where: (1) there has been a commission of a wrongful act — an underlying securities violation; (2) the alleged aider and abettor had knowledge of the act; and (3) the aider and abettor knowingly and substantially participated in the wrongdoing. Monsen v. Consol. Dressed Beef Co., Inc., 579 F.2d 793, 799 (3d Cir.), cert. denied, 439 U.S. 930, 99 S.Ct. 318, 58 L.Ed.2d 323 (1978). Plaintiffs seek to satisfy the third element of an aiding and abetting claim — knowing and substantial participation in the wrongdoing — by arguing in their brief PMM intended by its inaction in 1988 to avoid both a full-scale inquiry into the 1987 financial audit and the embarrassment of blowing the whistle on a client, which is in fact exactly what PMM did in May, 1988.

Although it has been held that "the 'substantial assistance' element of aider and abettor liability may be satisfied by 'inaction . . . where the plaintiff demonstrates that the aider-abettor consciously intended to assist in the perpetration of a wrongful act,'" Kronfeld, supra, 638 F. Supp. at 1470, plaintiffs have asserted nothing in the Amended Complaint from which a reasonable inference could be drawn that PMM had "thrown in" with the individual defendants to assist them in the commission of securities fraud. See Barker v. Henderson, Franklin, Starnes Holt, 797 F.2d 490, 497 (7th Cir. 1986); Segal v. Coburn Corp. of America, CCH Fed. Sec.L.Rep.] 94,002 at p. 94,021 (E.D.N.Y. 1973), accord, Jacobson v. Peat, Marwick, Mitchell Co., 445 F. Supp. 518, 522 (S.D. N.Y. 1977); Weinberger v. Kendrick, 432 F. Supp. 316, 321 (S.D.N.Y. 1977). Plaintiffs may speculate PMM would benefit by remaining silent — to avoid reopening the 1987 audit — but nothing has been alleged which reasonably suggests PMM stood to gain from the commission of the accounting fraud itself (the act with respect to which there must be "knowing and substantial participation"). Moreover, it is not clear how delaying two weeks eliminated the potential need (if it ever existed) to revisit the 1987 audit.

In Merkel v. Livestock Breeders International of New Jersey, No. 86-4003, 1988 WL 66864, 1988 U.S. Dist. LEXIS 5772 at 11 (D.N.J. June 21, 1988) the court dismissed plaintiffs' Section 10(b) claim, holding:

"'an accounting firm has no duty to disclose fraudulent conduct and may not be judged as an aider and abettor under Section 10(b) where it has not given some representation or certification, such as an opinion or certified statement, or has not invited the public to rely on the firm's financial judgment at the time.'"

"The securities laws do not require every participant in the commercial marketplace to become a whistleblower. The courts have held that an accountant cannot be held liable on the basis of its business relations with any primary wrongdoer where there is no evidence that the accountant took any actions to defraud."

If the federal securities law claims were dismissed in all respects, for failure to demonstrate an efficient market in Coated Sales stock, plaintiffs' state law claims would be dismissed as well. The assertion of pendent jurisdiction is without merit if plaintiffs' purported federal claims are dismissed. United Mine Workers of America v. Gibbs, 383 U.S. 715, 726, 86 S.Ct. 1130, 1139, 16 L.Ed.2d 218 (1966). Without diversity, there exists no separate basis for jurisdiction to hear the state law claims. To the extent plaintiffs have survived PMM's current motion to dismiss the Rule 10b-5 claim, however, it becomes necessary to consider PMM's other arguments for dismissing plaintiffs' common law claims.

The facts concerning reliance in this case, which are subject to repleading, are far from straightforward. As indicated below, however, they are critical to many aspects of the state law claims. It has been discussed at length that individual reliance has been an elusive concept so far in this litigation. The validity of certain of the state law claims depends, moreover, upon the existence of direct reliance by individual plaintiffs. It is anticipated the plaintiffs will further amend the Amended Complaint to allege some plaintiffs directly relied on the PMM financial reports, some plaintiffs indirectly relied on the PMM financial reports, some plaintiffs relied solely on the "efficiency of the market" to reflect the content of the PMM reports, and some plaintiffs can demonstrate aspects of all or some of these forms of reliance. It is against this backdrop that plaintiffs' state law claims must be reviewed.

Plaintiffs have alleged in Count II of the Amended Complaint that PMM is liable for common law fraud and deceit. In order to state a cause of action for common law fraud and deceit against PMM it is well settled in this Circuit that no judicial presumption of reliance may be interposed on pendent state law claims. As stated by the Court of Appeals in Peil v. Speiser, 806 F.2d 1154 (3d Cir. 1986):

While the fraud on the market theory is good law with respect to the Securities Acts, no state courts have adopted the theory, and thus direct reliance remains a requirement of a common law securities fraud claim. . . . The district court was therefore correct to direct a verdict against [plaintiff] on the common law claims. (emphasis added).

Plaintiffs claim in Count III of the Amended Complaint that PMM is liable to them for negligent misrepresentations contained in Coated Sales financial statement. Of course, plaintiffs can only be talking about the 1987 financial statements; PMM resigned and made no representations as to the Fiscal 1988 reports. The plaintiffs' claim of negligent misrepresentation must be dismissed as to all plaintiffs who do not fit within a narrow category of investors. As the Supreme Court of New Jersey held in Rosenblum v. Adler, 93 N.J. 324, 461 A.2d 138 (1983):

The principle that we have adopted applies by its terms only to those foreseeable users who receive the audited statements from the business entity for a proper business purpose to influence a business decision of the user, the audit having been made for that business entity. Thus, for example, an institutional investor or portfolio manager who does not obtain audited statements from the company would not come within the stated principle. Nor would stockholders who purchased the stock after a negligence audit be covered in the absence of demonstrating the necessary conditions precedent. (emphasis added).

While the language in Rosenblum, the only New Jersey case cited by the parties on this point, appears to afford a negligence cause of action to certain "foreseeable users" which rely on an accountants' audit report, the class of plaintiffs seems to be very narrowly circumscribed. Rosenblum refers to people who use the audit to influence a business decision. Furthermore, potential plaintiffs must "obtain audited statements from the company."

The argument might be made by plaintiffs that their decision to invest was a "business decision," and that the audit was performed for them in the sense that accountants' audit reports are prepared, and filed under the Exchange Act, with the purpose of, among other things, keeping investors informed. To conclude on that basis alone there is a negligence cause of action for the investing public generally, however, would be a liberal reading of Rosenblum. If that was the holding in Rosenblum, it could have been more clearly stated. Count III of the Amended Complaint must be dismissed as to all plaintiffs who cannot prove they received the PMM report " from the Company" for the purpose of making a business decision. Even if individual plaintiffs can establish their investments were made along the lines suggested above, Rosenblum made it clear throughout the decision that plaintiffs can only recover against an accountant for negligent misrepresentation if they "do in fact place reliance on the [accountant's] audit to their detriment." Id. at 341, 461 A.2d 138. As discussed above, plaintiffs herein have not adequately pled reliance on any reports issued by PMM. The judicially-created presumption of reliance does not apply to common law claims of negligent misrepresentation. See Snider v. Upjohn Co., 115 F.R.D. 536, 541-42 (E.D.Pa. 1987) (dismissing class action claims of state law negligent misrepresentation). Accordingly, Count III is further dismissed as to all plaintiffs who cannot demonstrate individual reliance.

Kagan

In addition to the derivative liability asserted under Section 20(a), plaintiffs also allege Kagan is liable under SEC Rule 10b-5 as an aider and abettor. Kagan contends that no fraud on his part has been stated with the requisite particularity, and that this claim should be dismissed. In a securities fraud action, the burden is on the plaintiff to

allege facts indicating an intent to deceive, manipulate, or defraud, Ernst Ernst v. Hochfelder, 425 U.S. 185, 192 n. 7, 96 S.Ct. 1375, 1380 n. 7, 47 L.Ed.2d 668 (1976), and Rule 9(b) requires that the circumstances constituting such fraud be stated with particularity.

Plaintiffs correctly point out that the courts have moved toward a more lenient application of Rule 9(b). Kronfeld v. First Jersey Nat. Bank, 638 F. Supp. 1454, 1463 (D.N.J. 1986). Allegations of "date, place or time" of the alleged deception fulfill 9(b)'s requirements, but are not required as "plaintiffs are free to use alternative means of injecting precision and some measure of substantiation into their allegations of fraud." See Seville Industrial Machines Corp. v. Southmost Machinery Corp., 742 F.2d 786 (3d Cir. 1984), cert. denied, 469 U.S. 1211, 105 S.Ct. 1179, 84 L.Ed.2d 327 (1985).

Having stated the liberal standard, however, plaintiffs fail in the Amended Complaint to inject any "form of precision or measure of substantiation" to their allegations of fraud on the part of Kagan. As discussed above, aiding and abetting requires knowing participation on the part of the defendant. All that plaintiffs allege is that Kagan was a director and outside attorney for the Company and that he sold certain amounts of Coated Sales stock during the Class Period. As to any direct knowledge of the fictitious "bill and hold" transactions or the phony machinery deposit, the Amended Complaint merely sets forth a broad conclusory allegation. Quite apart from the issue of whether plaintiffs had Kagan in mind when they drafted paragraph 50 — which is presumed under the rule of liberal construction — there is no particularity demonstrating Kagan either knowingly or recklessly participated in the fraud. There are no allegations, for example, that Kagan, as part of his duties as a director, was on the audit committee of the Board of Directors. There are no allegations that he exercised any responsibility for the Company's day to day operations. Indeed nothing at all is alleged in the Amended Complaint from which it can be inferred that Kagan knew of or participated in the fraud.

There is really no way for Kagan to answer the Amended Complaint other than to admit he is a director but deny that he conspired with Coated Sales executives to defraud the shareholders. Even if Kagan is able to answer the boilerplate allegations in this way, Rule 9(b) has the additional important purpose of requiring specific allegations to "demonstrate plaintiffs have investigated the alleged fraud and reasonably believe a wrong has occurred." Kronfeld, supra, 638 F. Supp. at 1463.

Rule 9(b) may not require a plaintiff to identify specific documents that a director read or business meetings which he attended. In order to demonstrate the alleged fraud was duly investigated, however, some specific facts must be alleged. There is no authority which supports a presumption that Kagan, an outside director, was intimately acquainted with Coated Sales' accounting practices. Certified public accounting firms fulfill the role of independent evaluator of the adequacy and fairness of financial statements issued by management to stockholders, creditors, and others. Broad, "The Progress of Auditing," 100 J. Accountancy 38, 38-39 (1955); Hallett Collins, "Auditors' Responsibility for Misrepresentation," 44 Wash.L.Rev. 139, 178 (1968). While it is possible that a director may serve as a liaison between the company and its auditors, or may otherwise be in a position to oversee the revenue recognition and asset capitalization accounting procedures, these are things which must reasonably be alleged.

Plaintiffs' allegations Kagan sold shares of Coated Sales stock do not alone support a claim of aiding and abetting. For the foregoing reasons, plaintiffs' claim of common law fraud against Kagan is dismissed at this time, although plaintiffs are granted leave to replead with particularity any facts which would suggest Kagan had knowledge of, or involvement in, the accounting and reporting practices at Coated Sales. Clinton Hudson Sons v. Lehigh Valley Coop. Farms, Inc., 73 F.R.D. 420 (D.C.Pa.), aff'd, 586 F.2d 834 (3d Cir. 1978) ("whether the action be under federal, state or even common law, any allegation of fraud must be plead with the requisite specificity according to the dictates of Fed.R.Civ.P. Rule 9(b) and efforts to characterize the activity as fraudulent, conspiratorial and deceitful simply do not suffice").

Finally, the Amended Complaint contains a claim of common law negligence against Kagan. Kagan argues the common law negligence cause of action must be dismissed because of an amendment to the Coated Sales, Inc. Certificate of Incorporation, which provides:

TENTH: The Corporation's directors and officers shall not be personally liable, except to the extent herein provided to the corporation or its shareholders for damages for breach of any duty owed to the corporation or its shareholders, except that the corporation's directors and officers will not be relieved from liability for any breach of duty based upon an act or omission (a) in breach of such person's duty of loyalty to the corporation or its shareholders, (b) not in good faith or involving a knowing violation of law or (c) resulting in receipt by such of an improper personal benefit.

Plaintiffs counterargue that, by the very terms of the amendment, Kagan is not relieved of liability for the acts specified in (a), (b) and (c). In the same way that plaintiffs have failed to allege basic facts necessary to support their claims of aiding and abetting and of common law fraud, they have failed to allege facts from which it can be inferred Kagan violated the above terms of the charter amendment. The negligence claim against Kagan is accordingly dismissed, with leave granted to further amend the Amended Complaint.

SO ORDERED.