The 10b-5 Daily

Shrug, Concur, and Move On

In a famous market manipulation that lead to multiple criminal convictions, the A.R. Baron brokerage engaged in a pump-and-dump scheme to induce customers to purchase the securities of small companies at artificially inflated prices. Among many others, investors sued an individual whose acts allegedly facilitated Baron's frauds in violation of Section 10(b). The district court dismissed the Section 10(b) claim.

On appeal, the Second Circuit addressed this dismissal (Fezzani v. Bear Stearns & Co., Inc., 2013 WL 1876534 (2d Cir. May 7, 2013) (Lohier, J. dissenting). The court found that manipulation violates Section 10(b) "when an artificial or phony price of a security is communicated to persons who, in reliance upon a misrepresentation that the price was set by market forces, purchase the securities." The Supreme Court, in its decisions in Stoneridge and Janus, has held that in a Section 10(b) claim involving a misrepresentation there can only be primary liability for entities or individuals who actually communicated the misrepresentation to the injured investors. Applying that principle in the instant case, the court found that because there was no allegation that the individual defendant actually communicated the artificial price information to the investors (as opposed to assisting Baron in its fraud), there could be no Section 10(b) primary liability.

In a vigorous dissent, however, one of the panel members challenged whether Stoneridge and Janus are applicable in a case alleging market manipulation. The dissent noted that a "market manipulation claim permits the plaintiff to plead that it relied on an assumption of an efficient market free of manipulation, whereas a misrepresentation claim requires the plaintiff to allege reliance upon a misrepresentation or omission." As a result, a plaintiff alleging market manipulation is entitled to use a fraud-on-the-market theory to establish reliance (i.e., the defendant engaged in a transaction that sent a fale pricing signal to the market, which was then communicated by the market to the investor). Accordingly, the dissent concluded, the fact that the individual defendant was a key participant in the transactions that sent a false pricing signal was sufficient to establish Section 10(b) primary liability.

Holding: Dismissal affirmed.

Quote of note (dissent): "I fear that every market manipulator . . . will be cheered by the extra shelter for stock manipulation under the federal securities laws that the majority opinion unnecessarily provides them. If I thought that Stoneridge or Janus required that result, I would shrug, concur, and move on. Because I conclude that neither case forecloses the federal claim of market manipulation against Dweck, I respectfully dissent."

What Next?

Based on the Supreme Court's recent decisions, a plaintiff is not required to prove the existence of loss causation (Halliburton) or materiality (Amgen) to certify an investor class. In the Halliburton case, however, the defendants pursued a related issue on remand. Halliburton argued that it should be allowed to rebut the fraud-on-the-market presumption of reliance by establishing that the alleged misrepresentations did not have a stock price impact. The district court found that price impact evidence did not bear on the critical inquiry of whether common issues predominated under FRCP 23(b)(3) and certified the class. Halliburton appealed.

In Erica P. John Fund, Inc. v. Halliburton Company, 2013 WL 1809760 (5th Cir. April 30, 2013), the Fifth Circuit found that "Halliburton's price impact evidence potentially demonstrates that despite the presence of the necessary conditions for market price incorporation of fraudulent information (fraud-on-the-market reliance), no such incorporation occurred in fact." Although this evidence certainly could be used at trial to refute the presumption of reliance, the court questioned whether it was appropriate to consider it at class certification.

Under Amgen, the court held, price impact evidence should not be considered if it is "common to the class" and if there is no risk "that a later failure of proof on the common question of price impact will result in individual questions predominating." The court found that both criteria were met and the district court did not err in declining to consider Halliburton's price impact evidence. First, "price impact is ordinarily established by expert evaluation of a stock's market price following a specific event and it inherently applies to everyone in the class." Second, although defeating the presumption of reliance would presumably still leave open the possibility of individual claims, "[i]f Halliburton were to successfully show that the price did not drop when the truth was revealed, then no plaintiff could establish loss causation." Accordingly, the claims of all individual plaintiffs would fail.

Holding: Affirming grant of class certification.

Addition: As detailed in a February 2010 post, the Halliburton case has a remarkable procedural history that now includes a Supreme Court decision and two Fifth Circuit decisions on class certification. What next?

Cornerstone Report On Accounting Cases

Cornerstone Research has issued a study of 2012 securities class actions involving accounting allegations. The notable findings include:

(1) The number of accounting filings fell from 78 in 2011 to 45 in 2012. Two factors that contributed to this decline were the overall decrease in filings and the specific decrease in Chinese reverse merger cases (which frequently include accounting allegations).

(2) The proportion of accounting filings involving restatements (36%) and internal control weaknesses (67%) remained relatively constant.

(3) Accounting cases are less likely to be dismissed and more likely to settle than non-accounting cases. In 2012, accounting cases were less than 70% of the settled cases, but represented more than 90% of the total value of settlements.

All The CLE You Could Possibly Want

It is not too late to sign up for PLI's Handling a Securities Case 2013: From Investigation to Trial and Everything in Between. The program takes place on Thursday, April 25 in New York and via webcast. The details can be found here.

Lyle Roberts of Cooley LLP (the author of The 10b-5 Daily) is co-chairing the program. The outstanding faculty will cover a wide range of topics, all while following a hypothetical case from the initial investigation through trial. There even will be a panel on ethical issues, for those in need of ethics credits.

Hope to see you there.

Draining the Safe Harbor

Securities class actions alleging that a company issued false or misleading earnings guidance are frequently dismissed. Among other things, to overcome the PLSRA's safe harbor for forward-looking statements a plaintiff must adequately plead (a) the guidance was not accompanied by "meaningful cautionary statements" and (b) the company had "actual knowledge" of its falsity. Given the vagaries of business performance, courts generally find that one or the other pleading burden has not been met.

With that background, the decision in City of Providence v. Aeropostale, Inc., 2013 WL 1197755 (S.D.N.Y. March 25, 2013) is interesting because the court found that the plaintiffs successfully plead an "earnings guidance" claim, albeit with the help of a unique fact pattern and (arguably) a misreading of the law. Aeropostale is a clothing retailer. In the second half of 2010, the company decided to change the design of its women's fashion line and placed orders for the new styles that would provide inventory through the fall of 2011. The new styles sold poorly and, in December 2010, the company fired the officer who led the change.

In response to the poor sales, Aeropostale provided 2011 earnings guidance that was below its 2010 results. According to the complaint, however, this guidance still understated the sales and inventory problems and failed to disclose that the unpopular new styles had been pre-ordered and would continue to be stocked for the next several quarters. The defendants argued that its earnings guidance (and other statements about the company's future performance) were protected by the PSLRA's safe harbor, but the court disagreed.

First, the court found that Aeropostale had failed to provide "meaningful cautionary statements." While the company disclosed risks concerning "consumer spending patterns," "fashion preferences," and "inventory management," its failure to disclose that the new styles would continue to be sold throughout most of 2011 meant that these risks were not hypothetical. Accordingly, the cautionary statements were inadequate because they did not "disclose hard facts critical to appreciating the magnitude of the risks described."

Second, the court found that the "safe harbor does not apply to material omissions" and, as a result, the failure to dislose the pre-ordering of the unpopular new styles was "unprotected by the safe harbor, regardless of whether the statements thereby rendered misleading were forward-looking." Because the court "declined to find that the misleading nature of the statements rests on the forward-looking aspects of the statements," it also declined to find that the safe harbor's "actual knowledge" requirement was applicable.

The court's interpretation of the scope of the safe harbor is questionable (and perhaps unnecessary, given the court's general view of the strength of the complaint's allegations). The PSLRA expressly states that the safe harbor applies "in any private action that is based on an . . . omission of a material fact necessary to make the statement not misleading." While the safe harbor does not apply to statements of current fact (whether they are alleged to be misstatements or rendered misleading by a material omission), that is different than concluding that the safe harbor does not apply to forward-looking statements that are alleged to be misleading because of the omission of a current fact. Indeed, reading the statute in this manner would severely limit its application. Plaintiffs routinely allege that a company's projections were misleading based on its failure to disclose certain current facts.

Holding: Motion to dismiss denied.

Addition: The complaint also contained "opinion evidence from an expert in the retail and wholesale industry," who concluded that the "Defendants had no reasonable basis to believe that Aeropostale could meet the guidance they issued." Although the court summarized this opinion evidence in its decision, it also stated that it "did not consider any of the 'expert testimony' that was included - inappropriately in the Court's view - in the pleading."

The Sun May Not Rise Tomorrow

The Boeing securities class action related to its development of its 787-8 Dreamliner plane continues to provide some drama. In 2011, as noted on this blog, the district court granted the company's motion to dismiss (on a motion for reconsideration) after it was determined that a key confidential witness denied being the source of the allegations attributed to him in the complaint, denied having worked for Boeing, and claimed to have never met plaintiffs' counsel until his deposition. The plaintiffs appealed this decision to the U.S. Court of Appeals for the Seventh Circuit.

In City of Livonia Employees' Retirement System and Local 295/Local 851, IBT v. Boeing Company, 2013 WL 1197791 (7th Cir. March 26, 2013), the court affirmed the dismissal based on the complaint's failure to establish a strong inference of scienter. The opinion, authored by Judge Posner, contains some interesting commentary.

(1) Motive - The plaintiffs alleged Boeing had failed to disclose in a timely manner that the Dreamliner's first test flight would be cancelled. The court noted that the law does not require the disclosure of the mere risk of failure. Indeed, "[n]o prediction - even a prediction that the sun will rise tomorrow - has a 100 percent probability of being correct . . . If a mistaken prediction is deemed a fraud, there will be few predictions, including ones that are well-grounded, as no one wants to be held hostage to an unknown future." Moreover, it was unclear what motive Boeing would have had to put off the announcement, with the court wryly concluding that the main effect would be to "undermine Boeing's credibility with its customers and expose the company to a multi-hundred million dollar lawsuit for securities fraud."

(2) Confidential Witness - The court found that the recantation of the key confidential witness was fatal to the plaintiffs' claims, because his supposed evidence provided the only basis for concluding that the company knew (at an earlier date) that the first flight test would be cancelled. Moreover, the confidential witness would no longer be useful because "[e]ither he had told the investigator the same thing he said in his deposition, which would be of no help to the plaintiffs and would expose the investigator as a liar, or he had had made the opposite assertions on the two occasions, in which event he was the liar, which wouldn't help the plaintiffs either."

(3) Sanctions - The defendants had cross-appealed for sanctions. The court strongly suggested that sanctions were appropriate in the case, noting that the plaintiffs' lawyers "failure to inquire further [about the supposed evidence from the confidential witness] puts one in mind of ostrich tactics - of failing to inquire for fear that the inquiry might reveal stronger evidence of their scienter regarding the authenticity of the confidential source than the flimsy evidence of scienter they were able to marshal against Boeing." Nevertheless, the court remanded the case to the lower court to determine whether sanctions should be imposed.

Holding: Dismissal affirmed, but case remanded for consideration of whether to impose Rule 11 sanctions.

Cornerstone Releases Report on Settlements

Cornerstone Research has released its annual report on securities class action settlements. The notable findings include:

(1) There were 53 settlements in 2012, involving $2.9 billion in total settlement funds. While the overall number of settlements represents a 14-year low, the total settlement funds increased by more than 100% from 2011. The increase in total settlement funds was due in large part to an increase in $100m+ settlements (accounting for nearly 75 percent of all settlement funds in 2012).

(2) The average reported settlement amount increased from $21.6 million (2011) to $54.7 million (2012). There also was a sharp increase in the median settlement amount from $5.9 million (2011) to $10.2 million (2012). The key factor identified by Cornerstone as responsible for the increase in settlement values was a spike in the median "estimated damages" associated with the settled cases (a significant portion of which were related to the credit crisis).

(3) More than 50% of the settled cases were accompanied by a derivative action filing, compared with a post-Reform Act average of 30%. The presence of a derivative action historically coincides with a higher settlement value for the related securities class action.

Quote of Note (press release): "Class action securities fraud litigation is, like many other lines of business, ‘hit driven,’ in that a small number of settlements often account for a large percentage of the dollar flow. That fact of life can make annual settlement data quite lumpy. Settlement trends are often best viewed over time periods longer than a year, and by carefully analyzing settlement data to reflect the underlying characteristics of the cases being settled. So, just as a lull in last year’s data suggested a pickup for this year in the aggregate statistics, it is always possible that this year’s bump could cause total settlement dollars to tick downward next year."

The Bitter With The Sweet

The Eleventh Circuit has issued an opinion that provides some clear exposition on the issue of loss causation. In Meyer v. Greene, 2013 WL 656500 (11th Cir. Feb. 25, 2013), the court considered whether the plaintiffs had adequately plead loss causation in a securities class action brought against St. Joe Company (a Florida real estate development corporation). The two key disclosures cited by the plaintiffs were (1) a presentation by a prominent short seller, and (2) the company's announcement of an SEC investigation. The district court found that neither disclosure revealed to the market the supposed falsity of the company's prior statements and dismissed the complaint.

On appeal, the Eleventh Circuit examined the two key disclosures:

(1) Short Seller Presentation - The court found that the presentation was based (by its own admission) on "publicly available sources." As a result, it did not provide any new facts to the market that could act as a corrective disclosure. Indeed, the plaintiffs "cannot contend that the market is efficient for purposes of reliance and then cast the theory aside when it no longer suits their needs for purposes of loss causation." Having conceded that the market was efficient and St. Joe's stock price reflected all public information, the plaintiffs "must take the bitter with the sweet."

Nor could the plaintiffs claim that that the presentation qualified as a corrective disclosure because it provided "expert analysis of the source material." The court held that "the mere repackaging of already-public information by an analyst or short-seller is simply insufficient" because "the only thing actually disclosed to the market when the opinion is released is the opinion itself, and such opinion, standing alone, cannot reveal to the market the falsity of a company's prior factual representations."

(2) SEC Investigation - Although the company's disclosure of an SEC investigation lead to a decline in its stock price, the court noted that "the SEC never issued any finding of wrongdoing or in any way indicated that the Company had violated the federal securities laws." Under these circumstances, an "investigation can be seen to portend an added risk of future corrective action" but it does not mean that SEC investigations "in and of themselves, reveal[] to the market that a company's previous statements were false or fraudulent."

Holding: Dismissal affirmed.

Quote of Note: "Put another way, though Sec. 10(b) is designed to protect against fraud, it is not a prophylaxis against the normal risks attendant to speculation and investment in the financial markets, and loss causation therefore ensures that private securities actions remain a scalpel for defending against the former, while not becoming a meat axe exploited to achieve the latter."

Amgen Decided

The U.S. Supreme Court has issued a decision in the Amgen case holding that proof of materiality is not a prerequisite to certification of a securities fraud class action. It is a 6-3 decision authored by Justice Ginsburg, with dissents from Justice Thomas (main) and Justice Scalia.

Under the fraud-on-the-market presumption, reliance by investors on a misrepresentation is presumed if the misrepresentation is material and the company's shares were traded on an efficient market that would have incorporated the information into the stock price. At issue in Amgen was whether a class action plaintiff, to take advantage of this presumption for purposes of class certification, is required to prove that the misrepresentation was material. As foreshadowed by the oral argument, the key issue for the Court was whether the fact that materiality is both a predicate for the use of the fraud-on-the-market presumption and a substantive element of the securities fraud claim means that it should be treated differently than the other fraud-on-the-market predicates (market efficiency, misrepresentation was public, transaction took place between time when misrepresentation was made and truth was revealed).

The majority opinion held that proof of materiality is not needed to ensure, as required by FRCP 23(b), that the questions of law or fact common to the class will predominate over any questions affecting only individual members. First, materiality is determined using an objective test and is therefore a common question as to every class member. Second, if the plaintiff were unable to establish materiality at summary judgment or trial, that failure would end the case for every class member leaving no individual reliance questions. This result is in contrast to the other fraud-on-the-market predicates - e.g., market efficiency - where a failure to prove that the market was efficient would still leave an individual plaintiff capable of establishing reliance by other means and proceeding with his case. The Court also rejected the notion that policy considerations militated in favor of requiring precertification proof of materiality. Notably, the Court found that Congress had previously "rejected calls to undo the fraud-on-the-market presumption of classwide reliance" and had not decreed "that securities-fraud plaintiffs prove each element of their claim before obtaining class certification."

The main dissent presented a starkly different view of the importance of addressing materiality at the class certification stage. According to the dissent, "nothing in logic or precedent justifies ignoring at certification whether reliance is susceptible to Rule 23(b)(3) classwide proof simply because one predicate of reliance - materiality - will be resolved, if at all, much later in the litigation on an independent merits element." Indeed, a recent Court decision (Wal-Mart) "expressly held that a court at certification may inquire into questions that also have later relevance on the merits." The judicial history of the fraud-on-the-market presumption also shows that materiality "has been the driving force behind the theory from the outset" and "further supports the need to prove materiality at the time the fraud-on-the-market theory is invoked."

Holding: Judgment of Ninth Circuit upholding grant of class certification affirmed.

Notes on the Decision:

(1) The decision does not "revisit" the fraud-on-the-market presumption. That said, it would appear that at least four justices have some concerns about its continuing validity. The dissent notes that the Court is not well-equipped to apply economic concepts and there is some disagreement about how market efficiency works. In a separate concurrence, Justice Alito references that part of the dissent and suggests reconsideration could be appropriate because the presumption "may rest on a faulty economic premise."

(2) The majority's eagerness to establish there can be no individual questions of reliance if a class action plaintiff fails to prove materiality leads to some interesting language. Notably, the Court states that "there can be no actionable reliance, individually or collectively, on immaterial information." The Court also concludes that an individual's reliance on immaterial information would be "objectively unreasonable." In the context of the entire opinion, it is not clear whether the Court is suggesting that (a) any class member's claim will fail in the absence of materiality (therefore rendering the question of reliance moot), or (b) materiality is a necessary predicate for a finding of reliance under any circumstances. There is no doubt that there is close relationship between the concepts of materiality and reliance, but for an individual investor the reliance question is typically whether he actually saw the misrepresentation and acted upon it (i.e., transaction causation), with materiality as a separate inquiry.

The Continuing Omission Theory

Pursuant to 28 U.S.C. Sec. 1658(b), a private securities fraud action "may be brought not later than the earlier of (1) 2 years after the discovery of the facts constituting the violation; or (2) 5 years after such violation." While there are a number of cases that have explored what triggers the 2-year period (the statue of limitations), fewer courts have examined what triggers the 5-year period (the statute of repose).

In Intesa Sanpaolo, S.p.A. v. Credit Agricole Corporate and Investment Bank, 2013 WL 525000 (S.D.N.Y. Feb. 13, 2013), the plaintiff argued that its securities fraud claim was not time-barred under the 5-year deadline "because a 'violation' for 1658(b) purposes is the transaction that forms the basis of the Sec. 10(b) claim at issue (rather than the alleged misrepresentation)." Alternatively, the plaintiff argued that even if the misrepresentation triggered the time period, its claim was still timely because the defendants had concealed the truth until less than five years before the complaint was filed. The court rejected both arguments.

First, the court found that the majority of courts have held that the "violation" is the misrepresentation, not the securities transaction, and there was no dispute that the last alleged misrepresentation took place more than five years before the plaintiff brought its suit. Second, the court rejected the "continuing omission" theory proposed by the plaintiff. The court noted that "applying the concept of a continuing omission to the five-year deadline would essentially render that element of 1658(b) a nullity with respect to any securities fraud case that does not involve a corrective disclosure."

Holding: Federal claims time-barred.

Quote of note: "For example, if it is assumed that an individual purchased a company's stock in February 2007 in reliance upon an offering memorandum that contained a material omission that was never subsequently acknowledged or corrected, under the continuing omission theory urged by Inesta, not only would a claim based on that omission be timely even today, six years after the omission, despite 1658(b)'s five-year deadline, but the five-year deadline would not have even begun running on the claim."