The Jackson Clarion Ledger reports that the U.S. Court of Appeals for the Fifth Circuit has upheld the dismissal of a securities class action against WorldCom former executives Bernie Ebbers and Scott Sullivan. The decision can be found here.
It is important to note, however, that this suit was not based on the accounting irregularties that led to WorldCom's recent bankruptcy. Instead, it was based on the failure of WorldCom to write-off certain receivables in 2000.
Quote of note: "In the original complaint, shareholders claimed Ebbers and Sullivan withheld information about $685 million in write-offs of uncollectible receivables. The ruling said, 'the plaintiffs simply ignore evidence that WorldCom frequently took large write-offs and that, indeed, a $768 million write-off had been taken in 1999.'"
Today's Wall Street Journal (subscrip. req.) has a feature article on the rising cost of directors and officers liability insurance (for more on this topic see this post in The 10b-5 Daily). Insurers are both raising premiums and "holding firm on many of their efforts to rein in the generous terms and conditions they adopted during a price war in the late 1990s." A side graph identifies AIG (34% of premiums; 19% of policies) and Chubb (16% of premiums; 21% of policies) as the D&O insurance leaders.
Quote of note: "And while the reforms of the Sarbanes-Oxley corporate-governance act may reduce corporate scandals, in the near future they could prove expensive. For example, the law increases the responsibility of audit-committee members for overseeing the company's audits, potentially raising the stakes for individual committee members if problems are later found. 'There's a general confusion about what Sarbanes-Oxley really means,' says Bill Cotter, chief underwriting officer for National Union Fire Insurance Co., of Pittsburgh, a unit of American International Group Inc., the leading underwriter of D &O insurance. 'The fear is that it will be defined through litigation.'"
Quote of note II: "Companies have a variety of options to mitigate higher costs. These include buying less coverage and retaining more of their risk with higher deductibles or co-insurance, in which the policyholder pays a fixed portion of eventual claims, much as health-insurance often requires patients to pay part of their costs, brokers say. Deductibles, recently $1 million or even lower on even large policies, have risen to as high as $100 million. Co-insurance of 10% to 30% or more has become more commonplace as well."
The Bristol Herald Courier has an article today on the lead plaintiff contest in the King Pharmaceuticals securities class action in the E.D. of Tenn. (Thanks to the SW Virginia Law Blog for the link.) The case is based on allegedly misleading financial statements made by the company.
At least two groups of pensions funds, as well as some individual investors who were shareholders in a company King Pharmaceuticals acquired, have moved for lead plaintiff status. U.S. Magistrate Judge Dennis Inman presided over the hearing.
Quote of note: "Inman said federal law favors the appointment of the stockholder who lost the most money. 'I'd like to know who is the biggest hog at the trough,' Inman said. That question prompted a lively debate among the dozen-plus lawyers, all of whom had a reason that their client should get the nod."
There is an interesting article on the ABA's Business Law eSource (July 2003) entitled "Securities Litigation Against Third Parties: Pre-Central Bank Aiders And Abettors Become Targeted Primary Defendants." The authors, Jay Eisenhofer and Cynthia Calder, offer a comprehensive summary of the post-Central Bank case law on who is a "primary violator" for purposes of Rule 10b-5, including separate sections on cases involving accountants, lawyers, underwriters/investment banks, and ratings agencies.
As noted previously in The 10b-5 Daily, the line between a "primary violator" (liable) and an "aider and abettor" (not liable) is becoming blurred. Eisenhofer and Calder conclude that "accountants, lawyers, and investment bankers ought to be taking a hard look at their relationships with their clients, and their own potential for primary liability under Rule 10b-5 in cases of corporate fraud."
Quote of note: "Although neither has achieved majority acceptance, two different approaches - the 'bright line' and 'substantial participations standards - have emerged from the lower courts. According to those courts that have adopted the 'bright line' standard, only if a defendant actually makes a statement to the plaintiff (or the investing public) which contains a misrepresentation or omission can that defendants be liable. By contrast, under the 'substantial participation' rubric, a defendant that plays a significant role in creating the statement can be held liable."
J.P. Morgan Chase & Co. and Citigroup, Inc have agreed to pay $305 million in fines to the SEC and the Manhatten district attorney's office to settle charges that they helped Enron hide billions of dollars worth of loans. The Washington Post ran this story on the settlement in yesterday's edition.
Quote of note: "'The shareholders' claim is that the various banks, including these two, were doing exactly what the SEC says they were doing in this action,'" [Professor Henry T.C. Hu, a law professor at the University of Texas] said. "'The banks are not paying this amount of money for charity purposes; it is not chump change. It tends to give credence to the shareholder allegations. . . . This settlement, complete with the SEC's harsh language, will be materially helpful to the massive shareholder lawsuit.'"
Quote of note II: "Under today's settlement with the SEC and the district attorney, $236 million will eventually be distributed to 'victims' of Enron's fraud. Exactly who will be eligible for restitution has not been determined."
Apparently, it's a good day to be a defendant. Baxter International, Inc. , a medical products maker, has announced the dismissal of the securities class action filed against it in Illinois federal court. The suit was based on earnings forecasts Baxter had made for FY2002.
Quote of note: "Coffee [Columbia University law professor John Coffee] reckons that Judge Pollack's most important line of reasoning is that the plaintiff has to prove 'loss causation'. 'They can't simply prove that the plaintiff was fraudulently induced to buy the stock by the false inflated and insincere recommendation, but rather he has to prove first, and then later, that the recommendation was causally related to the stock's ultimate fall.' That is a very difficult burden for litigators to have to meet, he adds."
Quote of note: "The bill is largely aimed at boosting the SEC's powers. But one section of it targets state officials, such as New York Attorney General Eliot Spitzer, by proposing barring them from writing securities law exceeding or adding to federal statute. State securities regulators have attacked the bill as a shield meant to protect Wall Street's largest brokerages from state-level investigations like the one Spitzer mounted recently into stock analyst conduct at Merrill Lynch."
The Associated Press has a lengthy interview with Mel Weiss of Milberg Weiss, the leading plaintiffs' securities class action firm.
Quote of note:
Interviewer - "How big was the $1 billion settlement for ordinary investors in the IPO fraud case in your view? How much do you hope to get from the brokerages?"
Weiss - "The billion dollars is an expression of concern that these allegations are real and could give rise to staggering liability. It simplifies the litigation in that we can focus our attention on the conduct of the investment banks. The interesting part here is how much broader our inquiries will be than the government's has been because we're covering 55 banks, not 10. It's going to be far more fascinating to demonstrate that the conduct we allege to be serious violations of the law was widespread throughout the entire industry. ... I would be very disappointed if we don't achieve multiple billions (in recovery)."
As previously posted in The 10b-5 Daily, the South Korean legislature is considering a proposal to permit investors to bring securities class actions. The JooAng Daily reports that the Legislation and Judiciary Committee’s review subcommittee approved the measure yesterday.
Quote of note: "[T]he proposed legislation only allows filing of such suit for financial fraud complaints: book-rigging, stock price manipulation or false disclosures and audits. At least 50 shareholders who collectively owns either 0.01 percent of a firm’s shares or own shares valued at 100 million won would be required for a suit to be filed. The court would have the right to investigate the qualifications of shareholders as plaintiffs. The court could also ask for basic information from financial authorities. If a court rejected the filing of a lawsuit, aggrieved shareholders would have the right to appeal the decision. "
The Associated Press reports that Green Tree Financial Corp. has settled the securities class action against the company that has been ongoing since 1998. The suit alleged that the company and its officers engaged in fradulent accounting practices to artificially inflate its stock price and increase the CEO's compensation. The preliminary settlement is for $12.5 million, which will be paid by the company's D&O insurer.
Note that this suit led to the 8th Circuit's seminal decision interpreting the scienter pleading requirements of the Reform Act: Florida State Board of Admin. v. Green Tree Financial Corp. (8th Cir. 2001).
In case there was any doubt about the Association of Trial Lawyers of America's position on the Class Action Fairness Act.
Quote of note: "Alexander stated that the convention would work 'to strengthen the fight against the Administration's and Congress' anti-consumer actions, especially concerning medical malpractice rights, and class action lawsuits against major malfeasant corporations like Enron and Global Crossing, who are almost unaccountable on issues from pensions to pollution.'"
An interesting column by Michael Carroll in yesterday's Wall Street Journal (subscrip. required) about the potential ramifications of Judge Pollack's decision in the Merrill Lynch cases. The author questions whether private securities class actions, as opposed to regulatory actions by the S.E.C., are the right method for remedying the societal costs of misleading market information.
Quote of note: "The judge's ruling draws on ideas which, if they are followed by other courts, could change the world of securities class actions as we know it. As Judge Pollack put it, when plaintiffs are a class of disappointed investors who lost money in trades on the secondary market, there is another class of lucky investors who were on the other side of those trades. In the language of economics, the losses that class plaintiffs were seeking to recover in the Merrill Lynch case were transfer payments that had been made to other investors in the market. Judge Pollack decided that Merrill Lynch did not have to underwrite those transfer payments."
Quote of note II: "Transfer payments among investors based on false or misleading market information impose a cost on society, but it is not a cost that is best measured by the total of all transfer payments or that is best remedied by private lawsuits. The societal cost imposed by bad market information is a lessening of market confidence and the decrease in investment activity that can follow. These are macro results that can be addressed by regulatory agencies such as the Securities and Exchange Commission, whose job it is to protect market confidence by policing information in the market."
Over the weekend, the Associated Press reported that state public employee pension funds in Ohio and California have declined to join the federal securities class action against AOL (postings about the AOL case can be found here and here). Instead, they have sued AOL separately in state court based on the same conduct. Note that this is part of a trend for the Ohio funds, which have also sued Enron and WorldCom in state court.
Quote of note: "'The class-action lawsuit, you get peanuts at the end of it,' Ohio Attorney General Jim Petro said."
The National Law Journal (July 21, 2003 edition) has a breakout of "The Plaintiffs' Hot List" of law firms. A number of plaintiffs firms that focus on securities class actions have made the list.
The conventional wisdom on Judge Pollack's decision in the Merrill Lynch analyst research cases is that he dismissed the cases because the plaintiffs were not Merrill Lynch clients, and therefore could not demonstrate that they reasonably relied on the brokerage's research. Columnists for Forbes and Bloomberg continue to provide a forum for this incorrect reading of the case, which is being promoted vociferously by (surprise) attorneys representing individual Merrill Lynch clients in arbitration claims against the brokerage.
In fact, as discussed in The 10b-5 Daily here and here, Judge Pollack dismissed the cases because plaintiffs failed to establish any connection between the analyst research and the companies' financial troubles or the collapse of the overall market. In Judge Pollack's view, that is what actually caused plaintiffs' losses. But as Chico Marx once said, "who are you going to believe, me or your own eyes?" Here's the opinion again -- whether you agree with Judge Pollack or not, it's fascinating reading.
The May 2003 edition of the Fordham Law Review contains a transcript of an interesting, if slightly dated, panel discussion on the selection of lead plaintiff/lead counsel in securities class actions. See 71 Fordham L. Rev. 2363 (panel discussion took place on Feb. 5, 2002). The panel participants included Judge Edward Becker (3rd Cir.), Judge Milton Shadur (N.D. Ill.), Jill Fisch (Professor - Fordham), Gregory Joseph (private attorney), and Mel Weiss (private attorney).
Quote of note (Judge Becker): "Congress originally thought that institutions in this new client-driven, as opposed to lawyer-driven, regime that it was creating would be the lead plaintiffs, but it really has not turned out that way. The only institutions that have agreed to be lead plaintiffs are public pension funds and a few union-related institutions. By and large, the mutual funds was the group that I think Congress had in mind--because they've got more stock than anybody in any of these corporations that go sour--but the mutual funds won't touch it. Doing a cost/benefit analysis, they think that it just ain't worth it for them to get involved. So the mutual funds have not come forth as lead plaintiffs. The private pension funds have not."
Mark your calendars. The judge in the Enron securities class action has laid out the case schedule. According to an article in the Houston Chronicle, the trial will commence on Oct. 17, 2005, provided, of course, that the case ever gets to that stage.
NERA, an economics consulting firm, has released its latest study on securities class actions entitled "Recent Trends in Securities Class Action Litigation: Will Enron and Sarbanes-Oxley Change The Tides?" The study reached the following conclusions about the trends in securities litigation since the passage of Sarbanes-Oxley in June 2002:
1) Securities class action filings have not increased dramatically (annual rate of 214 filings, compared to average annual rate of 208 filings from 1996-2001).
2) Dismissals have fallen sharply (half as many dismissals as in the previous 11 month period).
3) Average settlement values have fallen modestly ($22.7 million per settled case, compared to $25.5 million from 1996-2002).
These short-term trends are not nearly as interesting, however, as NERA's findings suggesting that the PSLRA (enacted in 1995) has not achieved Congress' goal of reducing meritless securities litigation. Indeed, the chances of a publicly-traded company being sued in a securities class action has increased (by 40.5%), while the percentage of cases dismissed (12-13%) or settled for nuisance value (24%) have remained roughly the same. These results lead to one question: has all of the controversy over the PLSRA (presidential veto, periodic calls for its repeal, etc.) been much ado about nothing?
Congress may want to take a hard look at the lessons of the PSLRA as it considers the Class Action Fairness Act and other tort reforms.
The New York Times is keeping on top of the AOL Time Warner securities class action. In a followup to its July 7 overview of the case (posted on The 10b-5 Daily), the paper has an article on the recently filed motion to dismiss. Among other things, AOL Time Warner argues that its restatement of $190 million is just 1% of its revenue over the period in question and that it disclosed all of its two-way deals with customers.
Quote of note: "The company's motion to dismiss the suit is an expected part of the proceedings, and legal scholars consider it unlikely to succeed. But the relative strength of AOL Time Warner's legal defense will help determine how costly it is for the company to resolve the suit, most likely through a settlement payment."
The July 11, 2003 edition of the New York Law Journal contains an article (via law.com - regist. required) on the potential impact of the Sarbanes-Oxley Act of 2002 on securities litigation. The authors, Robert Jossen and Neil Steiner, discuss three issues: (1) the statute of limitations; (2) the advancement of legal fees for individual defendants; and (3) possible attempts to bootstrap violations of the act into Rule 10b-5 claims.
Quote of note: "One area that can be anticipated to be a field for imaginative claims concerns the new certification requirements of the act. Indeed, class action plaintiffs in at least two recent cases have included allegations that the company and its top executives filed the certifications required by Sarbanes-Oxley, but the underlying financial data nevertheless was incorrect. While those complaints do not take the next step and allege that the incorrect certification itself constituted a violation of the securities laws, it may be only a matter of time before defendants see class action complaints make such allegations."
Gary Winnick, the former Global Crossing executive, was not amused to find that his likeness appears on the "Shareholders' Most Wanted" playing cards and sent a cease-and-desist letter directly to the distributers. The distributers, however, claim in this Reuters article that the letter was inappropriate because they are plaintiffs in the Global Crossing securities class action.
The San Jose Mercury News ran a story yesterday on the proposed settlement by the issuer defendants in the IPO allocation cases. The author states that investors should not expect a quick or large recovery. The 10b-5 Daily has an earlier post on the settlement terms.
Quote of note: "Like many average IPO investors, Gallagher is hazy on exactly what iBeam or its investment bank was alleged to have done wrong. But he feels he deserves a cut of the settlement anyway. 'I feel I deserve it because, well, I'm not certain why,' Gallagher said sheepishly. 'Nobody talked me into it, that's for sure. The opportunity was there, and I decided to go for it.'"
The Atlanta Business Chronicle (via MSNBC News) has an article on the proliferation of ERISA class actions by employees being filed in the wake of similar securities class actions by shareholders. BellSouth and Scientific-Atlanta are two companies facing this situation. The 10b-5 Daily has commented on the issues raised by these parallel ERISA suits.
Quote of note: "The lawsuits are among the first in what could be many by members of company retirement plans, who, under federal law, can sue their employers more easily than average shareholders. Such lawsuits have already prompted some companies to extricate themselves from the process of overseeing their retirement plans."
According to a Reuters article, the trial in the securities class action against Enron is now scheduled to begin in October 2005 (nearly four years after the company's bankruptcy).
Quote of note: "Kathy Patrick, a lawyer who represents Enron's outside directors, told the judge that discovery could produce more than 100 million pages of documents. She likened the case to 'the Bataan death march.'"
The June 27, 2003 edition of the National Law Journal contains a column (via law.com - subscrip. required) analyzing the case law on the statute of limitations for securities fraud cases. Sarbanes-Oxley has extended the statute of limitations "to the earlier of two years after the discovery of the facts constituting the violation or five years after such violation."
Quote of note: Sarbanes-Oxley "clearly provides that this amendment 'shall apply to all proceedings addressed by this section that are commenced on or after the date of enactment of this Act [July 30, 2002].' Left unresolved is whether the amendment salvages expired claims or extends the limitations period for pending claims. Compare Roberts v. Dean Witter Reynolds Inc., 2003 WL 1936116 (M.D. Fla. March 31, 2003) (holding that the amendment revives expired claims) with De La Fuente v. DCI Telecommunications Inc., 2003 WL 832009 (S.D.N.Y. March 4, 2003) (holding that the amendment does not apply to claims pending at time of enactment)."
The securities class action (along with another securities fraud case) against the former executives of Suprema Specialties, a bankrupt cheese manufacturer, have been dismissed by Judge William Walls of the D. of N.J. The Newark Star-Ledger reports that testimony and evidence in the related bankruptcy case raised questions about the validity of the company's "hard cheese" sales, but Judge Walls held that the allegations of fictitious sales in the securities fraud cases lacked details and failed to meet the applicable pleading standards.
Quote of note: "'The complaints certainly paint a picture of a company which was troubled and ultimately failed, a picture where, perhaps, something smelled a little funny,' Walls wrote in his June 25 decision. 'But the complaints lack the factual specificity demanded by (securities fraud law) and may not be so maintained.'"
Quote of note: "Rakoff said killing the company 'would unfairly penalize its 50,000 employees, remove a major competitor from a market that involves significant barriers to entry, and set at naught the company's extraordinary efforts to become a model corporate citizen.'"
CorpLawBlog has posted a persuasive critique of the settlement. No word on how the settlement will effect the pending securities class actions.
The The New York Times has a lengthy article in today's edition on the securities class action against AOL Time Warner. The author concludes that a dismissal of the case appears unlikely.
Quote of note: "In what one legal scholar called 'the judicial equivalent of a Freudian slip,' Judge Shirley Wohl Kram of United States District Court in Manhattan responded to a preliminary letter from shareholders' lawyers by ordering AOL Time Warner to turn over millions of pages of documents before the lawyers filed a formal motion or the company had a chance to respond. When AOL Time Warner's lawyers complained, she quickly rescinded the order."
Quote of note II: "[L]egal experts say that the settlement in this case may well exceed previous benchmarks and formulas because of the political impetus among judges and regulators these days to crack down on corporate fraud. 'There has been a regime change,' said Joseph A. Grundfest, a law professor at Stanford and a former member of the S.E.C., adding that 'settlements are more difficult for companies to negotiate in the post- Enron environment.'"
On Friday, the New York Times ran a news analysis on Judge Pollack's decision in the Merrill Lynch case. Unfortunately, the author misstates the central holding in the case, leading to a number of erroneous conclusions. In support of the proposition that the decision has little precedential value, the article conflates two elements of a Rule 10b-5 claim that Judge Pollack took great pains to separate: reasonable reliance and loss causation. The article states: "The judge's point, instead, was that even if the research was fraudulent, the plaintiffs could not prove that their losses were tied to the research because they were not Merrill Lynch clients."
Wrong. Instead, as discussed in The 10b-5 Daily here, Judge Pollack held that the plaintiffs must "allege facts which, if accepted as true, would establish that the decline in the prices of 24/7 and Interliant stock (their claimed losses) was caused by any or all of the alleged omissions from the analyst reports." Finding that there was no alleged connection between the analyst reports and the companies' financial troubles or the collapse of the overall market, the court held that the plaintiffs failed to meet their pleading burden.
In other words, Judge Pollack's ruling is much broader than the New York Times suggests. The key was not whether the plaintiffs were Merrill Lynch clients and therefore could establish that they reasonably relied on Merrill Lynch's research. Judge Pollack notes in his decision that in a fraud-on-the-market class action, price inflation is typically used as a surrogate for reliance. Instead, the court focused on loss causation and whether the plaintiffs, presumably regardless of their status as Merrill Lynch clients, had adequately alleged that their investment losses were caused by the analyst reports. And that, as they say, is a bird of a different feather.
Addition: The 10b-5 Daily should note that the article's overall theme, that Judge Pollack's decision does not necessarily prevent Merrill Lynch clients from successfully bringing individual arbitration claims against the brokerage, is correct. It's simply correct for a different reason. Judge Pollack's decision addresses a fraud-on-the-market class action based on Rule 10b-5, it does not address every type of individual claim that might be brought against Merrill Lynch by a client (including breach of fiduciary duty, breach of contract, etc.).
The Washington Post reports that WorldCom has sweetened its settlement with the SEC, offering $500 million in cash and $250 million in company stock. The 10b-5 Daily has commented on the proposed settlement here.
Having gone three-for-three in front of Judge Pollack of the S.D.N.Y. this week, Merrill Lynch is apparently optimistic that the remaining 24 securities class actions against the company based on allegedly biased research reports will be dismissed. According to a Reuters article, the general counsel of Merrill Lynch sent an e-mail to employees stating: "Although the dismissals apply only to these three class actions, we believe the reasoning of the decisions is equally applicable to other research-related class actions as well."
The Securities Law Beacon reports that the Ninth Circuit has affirmed the dismissal of the securities class action against Read-Rite Corp. The court agreed with the lower court's determination that the plaintiffs failed to adequately plead scienter. The opinion can be found here.
In the wake of his recent opinions, Judge Pollack of the S.D.N.Y. is profiled in today's Wall Street Journal (suscrip. required).
Quote of note: "Judge Pollack was just as brassy in his days as a plaintiffs' lawyer, said Michael Mukasey, chief judge of the Southern District where Judge Pollack sits. As Judge Mukasey tells the story, one day when taking a deposition from Spyros Skouras, then head of the 20th Century Fox movie studio, in Mr. Skouras's wood- paneled office, Mr. Pollack calmly selected a cigar from a humidor, bit off the end and lit up. Visibly reddening, Mr. Skouras said: 'Mr. Pollack, I don't remember offering you a cigar.' Mr. Pollack replied, 'Those aren't your cigars, those are the stockholders' cigars.'"
For the second time in as many days, Judge Pollack of the S.D.N.Y. has dismissed a securities class action against Merrill Lynch. According to Reuters, the plaintiffs, investors in Merrill Lynch's Global Technology Fund, had alleged "they were duped in part because the fund invested in the stock of companies that Merrill Lynch investment bankers were doing business with."
Quote of note: "'She (the lead plaintiff) was suing on the same general theme of having bought some shares in a fund and that Merrill Lynch was responsible for the decline in the value of the funds,' Pollack told Reuters. 'I tossed her out.'"
The Washington Post has a comprehensive article on the decisions by Judges Pollack and Baer of the S.D.N.Y. dismissing securities class actions against Merrill Lynch and other brokerages that were based on the dissemination of allegedly biased research reports about 24/7 Real Media Inc., Interliant Inc., and Covad Communications Group. The cases are part of 27 similar consolidated actions involving different stocks.
Judge Pollack's decision in the Merrill Lynch case is sweeping in its scope, with the court finding that "plaintiffs were among the high-risk speculators who, knowing full well or being properly chargeable with appreciation of the unjustifiable risks they were undertaking in the extremely volatile and highly untested stocks at issue, now hope to twist the federal securities laws into a scheme of cost-free speculators' insurance." (CorpLawBlog has a post discussing the rhetoric in the decision.) The court held that the plaintiffs had failed to adequately plead their Section 10(b) claims and that the claims were, in any event, barred by the statute of limitations.
Note that when it rains loss causation cases, it pours loss causation cases. In direct contrast to the Eighth Circuit's holding in ConAgra (discussed below), Judge Pollack found that merely alleging that the stock price was artificially inflated is not sufficient to satisfy loss causation. (Indeed, he states that to allow this "would undoubtedly lead to speculative claims and procedural intractability.") The plaintiffs needed "to allege facts which, if accepted as true, would establish that the decline in the prices of 24/7 and Interliant stock (their claimed losses) was caused by any or all of the alleged omissions from the analyst reports." Finding that there was no alleged connection between the analyst reports and the companies' financial troubles or the collapse of the overall market, the court held that the plaintiffs failed to meet their pleading burden.
Quote of note (Washington Post): "'This was something of a test case for [lawsuits] involving similar facts,' Pollack said. 'The question is, are the facts similar?" Pollack said he did not believe the case was a close one. "Anybody who goes out to Las Vegas and loses can't sue the croupier,' he said."
Quote of note II (Washington Post): "Columbia University law professor John C. Coffee Jr. called Pollack's decision 'a huge victory for Merrill Lynch' because the judge ruled that the losses were caused by the bursting of a bubble rather than the allegedly false research. 'That's the part of his decision that has the greatest application to other cases. It's [also] the most debatable. He doesn't have much factual evidence.'"
The Eighth Circuit's decision in the ConAgra case (Gebhardt v. ConAgra Foods, Inc., (8th Cir. June 30, 2003)) highlights how difficult it can be to establish the immateriality of alleged fraudulent statements at the motion to dismiss stage of a securities class action.
In ConAgra, plaintiffs alleged that the company had engaged in fraud by permitting its United Agri Products subsidiary to prematurely recognize revenue from sales where the delivery of the goods had not yet taken place. The Eighth Circuit found that "the problem was mostly one of having the money attributed to the wrong year, as opposed to not having ever made the money at all." As a result, "ConAgra's income, before taxes, was reduced by $111 million for the years 1998 through 2000, while its income for 2001 was increased by $127 million." When the restatement was announced in May 2001, the stock price dropped from $20.61 to $20.07. It quickly recovered, however, and began to trend higher.
The district court dismissed the case on two bases. First, the lower court noted that the amount of earnings misrepresented was merely .4% of ConAgra's total revenues during the years in question. The lower court concluded that "[a] reasonable investor with complete knowledge of the UAP accounting issues would have realized that ConAgra's overall earnings were basically unaffected by any of those issues." Second, the lower court held that the plaintiffs' pleadings failed to allege loss causation. The alleged misrepresentations were immaterial and the company's stock price was barely affected by the announcement of the restatement.
The Eighth Circuit disagreed with both conclusions. On the issue of materiality, the appellate court found that focusing on the percentage of total revenues misstated was insufficient. As a result of its revenue recognition problems, ConAgra overstated its net income for 1999 and 2000 by 8%. A discrepancy of that magnitude is not immaterial as a matter of law. The appellate court also found that it was inappropriate for the lower court to rely on the fact that ConAgra was eventually able to receive the revenues it prematurely recognized. The company "could not know for certain it would receive the profits it had booked." Accordingly, a reasonable investor, at the time of the misrepresentation, may have found information about the premature revenue recognition to be material.
As for loss causation, the Eighth Circuit found that because the alleged misrepresentations were material, the plaintiffs can "invoke the fraud-on-the-market theory and assume that the misrepresentations inflated the stock's price." Even though the stock price did not decline when the restatement was announced, the appellate court declined "to attach dispositive significance to the stock's price movements absent sufficient facts and expert testimony, which cannot be considered at this procedural juncture, to put this information in its proper context."
The Eighth Circuit's opinion leaves little room for a materiality argument to succeed on a motion to dismiss. Here, the amount of the restatement was relatively small (even for net income), the company's overall finances were unaffected, and the stock market had virtually no reaction upon being told of the problem. Nevertheless, the appellate court goes out of its way to justify a finding that materiality and loss causation were adequately plead, including dismissing the lack of a negative stock market reaction by holding that "stockholders can be damaged in ways other than seeing their stocks decline. If a stock does not appreciate as it would have absent the fraudulent conduct, investors have suffered harm." The allegations in the case, however, were that the company's stock price was artificially inflated, not lowered, as a result of the misrepresentations.
Holding: Judgment of the district court reversed.
Quote of note: "A reasonable investor might be concerned about one of ConAgra's subsidiaries reporting earnings not yet received, especially if this was done under orders from ConAgra's senior management. The fraud-on-the-market theory then would allow the fact finder to presume that the stock's price reflected the inflated earnings, and it makes sense to conclude that the plaintiffs were harmed when they paid more for the stock than it was worth."
Addition: Note that the Eighth Circuit comes to virtually the opposite conclusion on materiality as the S.D.N.Y in the Allied Capital case. A discussion of Allied Capital can be found here.
Addition: Note also that other courts have expressly rejected the idea that the fraud on the market theory supports a presumption of loss causation. See, e.g., Robbins v. Koger Props, Inc., 116 F.3d 1441, 1448 (11th Cir. 1997).
The Baltimore Business Journal has an article on the litigation pending against Ahold NV based on alleged accounting fraud at U.S. Foodservice, its Columbia, MD subsidiary. The Judicial Panel on Multidistrict Litigation has consolidated the shareholder and employee suits in the D. of Md. before Judge Catherine C. Blake. The 10b-5 Daily has previously posted about the large number of suits that have been filed in this case.
The Associated Press reports that the 8th Circuit has overturned the district court's dismissal of the securities class action against ConAgra Foods, Inc. Plaintiffs allege that ConAgra overstated the earnings of its subsidiary, UAP, by recognizing sales when the delivery of the goods had not yet taken place. As a result, ConAgra prematurely recognized revenue in the years 1998 through 2000. The case was originally filed in the D. of Neb.
The court's opinion can be found here and contains an interesting discussion of materiality. More to follow.