As reported in The 10b-5 Daily, last December the South Korean legislature passed a bill establishing a private securities class action system. The bill was subject to a contentious debate and, with the new system scheduled to go into effect in 2005, the debate is not over yet. An article in the Korea Times states that companies are demanding a statutory exception for accounting frauds that occured prior to 2005.
Quote of note: "In a seminar on the prospects of class action lawsuits, hosted by the Federation of Korean Industries (FKI), Moon Tack-kon, vice chairman of the Korean Institute of Certified Public Accountants, said considering the accounting features, it is difficult to clean up past accounting books a year before the 2005 introduction of the class action lawsuit. 'Past accounting frauds tend to be reflected in the next period's financial report,' Moon said."
The Wall Street Journal reports (subscription required) that the Judicial Panel on Multidistrict Litigation will hold a hearing today to consider which court (or courts) should handle the numerous federal class actions that have been brought over mutual fund trading practices. The hearing session order states that motions for centralization will be heard for cases involving the following fund groups: Janus, Strong, Bank One, Bank of America, Putnam, and Alliance Capital.
Quote of note: "The panel could assign the cases to federal court in Manhattan or scatter them to federal courts close to the fund companies' headquarters around the country. Fund firms prefer a home-field approach, while attorneys for fund investors generally favor having cases handled in Manhattan, where courts have extensive experience in securities-fraud cases."
The New Republic Online has a column strongly criticizing Democratic presidential contender Senator John Kerry for his vote in favor of the Private Securities Litigation Reform Act of 1995. Noting that Senator Kerry frequently talks about corporate accountability and has expressed shock over the Enron scandal, the author states: "But Kerry shouldn't be shocked at all. Back in 1995, he backed a controversial measure that severely limited the ability of investors to sue companies engaged in fraudulent accounting practices--a legal change widely believed to have contributed to the accounting scandals of the last few years."
The charge that the PSLRA has made it more difficult to bring securities class actions, and therefore has contributed to recent corporate scandals, is controversial. The New Republic Online column has led to a blog debate on the topic between Mickey Kaus (first item on Jan. 25) and Professor Stephen Bainbridge. What does The 10b-5 Daily think about all of this? As previously posted, the statistics appear to speak for themselves.
NCI Building Systems, Inc. (NYSE: NCI), a Houston-based manufacturer of metal products for the nonresidential building industry, has announced the preliminary settlement of the securities class action pending against the company in the S.D. of Tex. The case was originally filed in April 2001 and is based on alleged misrepresentations related to the company's restatement of its 3Q 1999 to 1Q 2001 financial results. The settlement is for $7 million.
A feature article in today's San Francisco Chronicle discusses the rise in securities class actions brought against biotechnology companies. The article notes that although biotechnology companies make up only 2% of the publicly-traded companies in the U.S., they were served with 17% of all securities class actions filed in 2003 (as compared to 9% in 2002). The 10b-5 Daily has recently posted about biotech disclosure issues.
Quote of note: "Without discussing the merits of any specific case, [Biotechnology Industry Organization President Carl] Feldbaum said the wave of lawsuits is a 'growing, malignant phenomenon' that could hamper the discovery of life-saving remedies. 'The victims of choice seem to be small companies that may be on the verge of success, and that is a potentially crippling development,' he said.
Quote of note II: "Kevin Roddy, president-elect of the National Association of Shareholder and Consumer Attorneys, said biotech advocates shouldn't be seeking special protection from investor suits on grounds that they are working on badly needed medicines. 'They want to be above the law, because they think there's something special about what they do,' Roddy said. 'If they want to go out and raise money from the public, they have to tell the truth.'"
Section 11 and Section 12(a)(2) of the Securities Act of 1933 impose liability, under various circumstances, for untrue or misleading statements in registration statements. The statute does not require a plaintiff to establish that the defendant acted with scienter (i.e., fraudulent intent). Nevertheless, a number of federal circuits (3rd, 5th, 7th, and 9th - with only the 8th disagreeing) have found that Federal Rule of Civil Procedure 9(b)'s particularity pleading requirement applies to these claims if they "sound in fraud."
In Rombach v. Chang, 2004 WL 77928 (2d Cir. Jan. 20, 2003), the Second Circuit addressed the issue for the first time. The court noted that Rule 9(b) applies to "all averments of fraud" and "is not limited to allegations styled or denominated as fraud or expressed in terms of the constituent elements of a fraud cause of action." Although fraud is not an element of Sections 11 and 12(a)(2) claims, these claims are often predicated on the same course of conduct that would support a Rule 10b-5 claim. Accordingly, "while a plaintiff need allege no more than negligence to proceed under Section 11 and Section 12(a)(2), claims that do rely upon averments of fraud are subject to the test of Rule 9(b)."
The Rombach plaintiffs brought Section 11, Section 12(a)(2), and Rule 10b-5 claims based on the same course of conduct. Although they asserted that their Section 11 claims did not sound in fraud, the court held that "the wording and imputations of the complaint are classically associated with fraud: that the Registration statement was 'inaccurate and misleading;' that it contained 'untrue statements of material facts;' and that 'materially false and misleading written statements' were issued." Having found that the particularity requirement of Rule 9(b) was applicable, the court then affirmed the lower court's decision that the plaintiffs' had failed to adequately plead that the statements at issue were false or misleading.
Holding: Affirm grant of motion to dismiss.
Quote of note: "The particularity requirement of Rule 9(b) serves to 'provide a defendant with fair notice of a plaintiff's claim, to safeguard a defendant's reputation from improvident charges of wrongdoing, and to protect a defendant against the institution of a strike suit.' These considerations apply with equal force to 'averments of fraud' set forth in aid of Section 11 and Section 12(a)(2) claims that are grounded in fraud."
The New York Law Journal has an article (via law.com - free regist. req'd) on the decision.
Over forty individual actions have been brought by WorldCom bondholders pleading '33 Act claims based on alleged misrepresentations. Last November, the WorldCom court dismissed the claims brought by two Alaska plaintiffs involving a $6 billion bond offering in 1998 (Section 11 claim was time-barred) and a $2 billion bond offering in 2000 (no cause of action under Section 12(a)(2) for private placement). The 10b-5 Daily has posts discussing the decision and the solicitation dispute over the individual bondholder actions.
The defendants asked the court to dismiss similar claims brought in thirty-six of the cases. In an opinion issued January 20, Judge Cote granted the motions. The Associated Press has an article on the decision.
The 10b-5 Daily has been following the district court split over whether the new statute of limitations in the Sarbanes-Oxley Act of 2002 revives time-barred claims.
Sarbanes-Oxley extends the statute of limitations for federal securities fraud to the earlier of two years after the discovery of the facts constituting the violation or five years after such violation. Although the legislation clearly provides that it "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 Congress intended to revive claims that had already expired under the earlier one year/three years statute of limitations. District courts have gone both ways on this question and the issue is currently before the U.S. Court of Appeals for the 11th Circuit.
There has been another relevant district court opinion out there for over a year, but it has only recently appeared on Westlaw (and in F. Supp. 2d). The court in In re Heritage Bond Litigation, 289 F. Supp. 2d 1132 (C.D. Cal. 2003) addressed whether the statute of limitations barred the plaintiffs' Section 20(a) claims for control person liability based on statements made more than three years before the initial filing of the suit. The plaintiffs first asserted the claims in a complaint filed on July 24, 2002, a few days before the passage of Sarbanes-Oxley, and then filed a new and separate complaint asserting the same claims on August 30, 2002. In an opinion issued last January, the court held that "while the amended statute of limitations may apply to proceedings filed after passage of the Act, it cannot apply to claims already barred at the time of its enactment, regardless of the filing date." Accordingly, the plaintiffs' Section 20(a) claims were dismissed.
The Chicago Tribune has a feature article (free regist. req'd) on the recent trend of requiring corporate governance reforms as part of the settlement of shareholder litigation. The article contains a list of prominent examples, including the Hanover Compressor settlement. (The 10b-5 Daily most recently posted about this issue here.)
Quote of note: "Experts said companies' willingness to make governance changes often depends on the situation. Firms dominated by a controlling shareholder or founding family, they said, are more likely to resist what they deem to be interference. Plaintiffs are more likely to succeed, experts said, in the worst cases of inattentive boards and companies that have cooked the books."
A court in the E.D. of Tex. has denied the motion to dismiss in the securities class action against Electronic Data Systems Corp. ("EDS"). The suit alleges that EDS misrepresented company earnings and facts related to its multibillion-dollar Navy/Marine Corps Intranet contract. According to an article in Computerworld, the court found that the plaintiffs had established a "strong inference that defendants were extremely reckless in continuing to recognize any revenue on the project when they were allegedly pursuing a tactic of intentionally providing goods that did not meet contract specifications."
Quote of note: "Lawyers for the shareholders presented a significant number of documents that the court upheld as evidence supporting the allegations against EDS. Among the documents was a May 6, 2002, e-mail from the N/MCI transition manager at the Naval Air Systems Command that outlined various software problems, a failure to provide remote access for 61% of the users that were testing the new intranet, and a lack of secure Web access and help desk support."
Addition: The opinion is now available on Westlaw - In re Electronic Data Systems Corp. Securities and "ERISA" Litigation, 2004 WL 52088 (E.D. Tex. Jan. 13, 2004).
PricewaterhouseCoopers has released a study on the role of public pension funds in securities class actions. Notable results:
(1) The number of cases with public pension funds as lead plaintiff has steadily increased since the passage of the PSLRA in 1995 - from 4 cases filed in 1996 to 56 cases filed in 2002.
(2) Of the more than 100 active cases where a public pension fund is acting as lead plaintiff, 80% allege accounting issues.
(3) In 2003, 15 settlements averaging over $120 million were reached in cases where a public pension fund served as lead plaintiff -- sixteen times the average value of the remaining 85 cases settled last year.
There are a lot of conclusions that could be drawn from this data, but it is certainly clear that public pension funds are taking the lead in large accounting fraud cases.
What is necessary to adequately plead loss causation in a securities fraud case continues to be the subject of contention in the S.D.N.Y., with a number of decisions addressing the issue over the past year. (The 10b-5 Daily discusses the recent loss causation decision in the IPO Allocation cases here.) The New York Law Journal has an article (via law.com - free regist. req'd) on yet another loss causation decision in DeMarco v. Robertson Stephens, Inc., 2004 WL 512232 (S.D.N.Y. Jan. 9, 2004), the securities class action against Robertson Stephens over its Corvis Corp. stock recommendations.
The suit alleges that Robertson Stephens' analysts made buy recommendations for Corvis stock to prop up the price until the firm and some of its executives could sell off their pre-IPO shares in the company (i.e., a variation on a "pump-and-dump" stock manipulation). The alleged scheme was revealed to the market when a May 2001 article in the New York Times reported the discrepancy between Robertson Stephens' public recommendations and the sales by its executives. In his opinion, District Judge Lynch notes that the price of Corvis stock dropped 16% within a few days of the article.
On the issue of loss causation, the defendants argued that the plaintiffs' loss was due to the general market downturn in telecommunications stock, not any alleged misrepresentations. The court agreed that the plaintiffs could not merely allege that the price of Corvis shares had been inflated to establish loss causation (there is a circuit split on this issue, see this post), holding that "it is unlikely that loss causation could be adequately alleged in every fraud-on-the-market case that successfully pleads transaction causation because in cases where an unforseeable intervening event causes the plaintiffs' loss, there is no causal nexus between the loss and the misrepresentation." In the instant case, however, the court found that "the bursting of the Corvis stock bubble could reasonable be construed, at least in part, as the market's correction of an inflated stock price, pumped up in part by defendants' false statements about its opinions."
The court took pains to distinguish the case from the facially similar cases against Merrill Lynch that have been dismissed by Judge Pollack. (The 10b-5 Daily's summary of the initial Merrill Lynch decision can be found here.) On the issue of loss causation, Judge Lynch noted that, in contrast to the Merrill Lynch cases, "in this case there is evidence that disclosure of defendants' scheme caused a further decline in the price of Corvis stock, even after the overall bubble had burst."
Holding: Motion to dismiss Rule 10b-5 claim denied. A motion to dismiss the insider trading claim against a Robertson Stephens executive, however, was granted.
Quote of note: "On the facts in this case, the Court must conclude that plaintiffs have adequately alleged loss causation because the decline in stock price was a forseeable consequence of defendants' fraudulent statements that allegedly inflated the price, because in an efficient market, revelation of the misrepresentations will lead inexorably to a price correction."
Biotechnology companies are frequent defendants in securities class actions, with the plaintiffs' allegations often focusing on statements related to the new drug approval process. An article in today's Boston Globe notes that the Food and Drug Administration ("FDA") and the SEC "are in talks to develop new guidelines on cooperation" concerning disclosure issues. Last summer, the FDA announced that it has begun making referrals to the SEC when it believes its discussions with a company are being misrepresented to the public markets.
Quote of note: "Just how the FDA and SEC should interact is among the most sensitive issues for biotechnology companies. Their fortunes depend largely on showing investors they are making progress getting approvals for drugs that can cost hundreds of millions of dollars to research. Yet many executives believe that the two agencies work at cross-purposes. While securities rules require wide disclosure, repeating all of the technical detail the FDA conveys about an experimental drug can make a stock extremely volatile, said Carl B. Feldbaum, president of the Biotechnology Industry Organization, a trade group in Washington. 'I think we need to come up with a coherent system where biotech CEOs aren't cross-cut, like logs, between the FDA and the SEC,' Feldbaum said."
The Atlanta Journal-Constitution has a feature article on securities class actions. The article profiles the viewpoints of two prominent local securities litigators.
Quote of note: "A fraction of the 200-plus public companies in Georgia have been sued by shareholders in recent years. But the list includes names like Coca-Cola, BellSouth, Mirant, WestPoint Stevens, and most recently, Amvescap's Invesco Funds Group, and Friedman's, one of the largest retail jewelry chains in the country. All are defendants in pending cases."
The Ninth Circuit has issued an opinion in Employee Teamsters Local Nos. 175 and 505 Pension Trust Fund v. Clorox Co., 2004 WL 32963 (9th Cir. Jan. 7, 2004) that addresses discovery, the PSLRA's safe harbor for forward-looking statements, and scienter issues.
An interesting part of the opinion deals with the plaintiff's contention that the lower court "incorrectly held that knowingly false statements made by [an officer defendant] during her April 22 conference call are not actionable as long as they are short, and that it improperly relied on limited and general cautions to protect Clorox under the PSLRA's safe harbor and the 'bespeaks caution' doctrine." The Ninth Circuit disagreed, finding the basis for the district judge's holding was that the forward-looking statements were accompanied by meaningful cautionary language, not the relative length of the statements. Although plaintiffs argued that the lower court should not have considered cautionary language contained in Clorox's Form 10-K filing in making this determination, the appellate court found that the officer defendant had referenced the risk factors in the Form 10-K during the call and "the PSLRA does not require that the cautions physically accompany oral statements."
Holding: Affirming grant of partial summary judgment and judgment on the pleadings.
Quote of note: "It is with respect to these statements that the court observed that [the officer defendant] 'spoke only a couple of sentences and provided an approximate timetable.' Investors submit that the court's holding that 'short whoppers don't count' is error, but we read its decision as turning on context rather than word count."
The New York Lawyer has an article (via law.com - free regist. req'd) on the Class Action Fairness Act, which looks like it has a chance of passing in the Senate this year. (See this post in The 10b-5 Daily). The legislation applies some of the reform concepts in the PSLRA and SLUSA to all class actions. Notably, class actions meeting certain jurisdictional criteria would have to be heard in federal court. As in the field of securities class actions, one of the beneficiaries of the legislation will be large, national plaintiffs' firms that have the resources to bring these cases.
Quote of note: "The burden on federal judges arising from any legislation that moves class actions to the federal courts has raised concerns among judicial administrators who express concern about the additional caseloads. Because of the added delays and expenses, the cumulative effect of the legislation may cultivate a new generation of stronger plaintiffs' firms that can match their counterparts in size and expertise."
Tut Systems, Inc. (Nasdaq: TUTS) has announced the preliminary settlement of the securities class action pending against the company in the N.D. of California (the company is also settling a related derivative case brought in California state court). According to an article on the settlement in the Oakland Tribune, Plaintiffs had alleged that the company's financial results for the second and third quarters of 2000 "were false and misleading because the company failed to report a major recall of one of its products in the summer of 2000 that resulted in improperly recognized revenues on sales of defective products that were returned during the recall."
The settlement of the securities class action, which is still subject to court approval, is for $10 million. The settlement of the derivative case involves Tutís adoption of certain corporate governance measures and the payment of plaintiff's legal fees and expenses. Both payments will be made by Tut's insurance carrier.
As previously reported in The 10b-5 Daily, the number of securities class actions filed against foreign issuers has been on the rise. The Recorder has an article (via law.com - free regist. req'd) discussing this trend and the challenges posed by the cases.
Quote of note: "The suits represent a clash of business cultures. Few nations have financial regulations as stringent as those of the United States, and none has a plaintiffs bar as active. While American companies have grown used to investor class actions, viewing them as a cost of doing business, European executives see them differently."
The WorldCom and Initial Public Offering securities litigations in the S.D.N.Y. are generating judicial opinions on a wide variety of topics, with the plaintiffs frequently getting the better of the argument. Two more opinions have come down from Judge Scheindlin in the IPO allocation cases over the holidays.
Discovery of Wells Submissions
On December 24, the court issued an opinion and order addressing whether "Wells submissions" to the SEC are discoverable in subsequent litigations. The target of a SEC investigation is permitted to file a written submission, known as a Wells submission, with the agency to respond to contemplated charges. The plaintiffs were seeking discovery of Wells submissions made by the underwriter defendants in connection with the SEC's investigation of the same IPO allocation practices at issue in the current litigation. Although the Wells submissions contained offers of settlement, the court found that they are not "settlement material" and, in any event, they are relevant to the current litigation and therefore discoverable.
Quote of note: "Offers of settlement, however, are not intrinsically part of Wells submissions, which were intended to be 'memoranda to the SEC presenting arguments why an enforcement proceeding should not be brought.' To the extent that a respondent may make a settlement offer, that offer is typically clearly identified and thus easily severable from the remainder of the submission."
Holding: The underwriter defendants are ordered to produce their Wells submissions to plaintiffs on or before January 20, 2004.
On December 31, the court issued an order and opinion addressing a motion for judgment on the pleadings by the underwriter defendants. The underwriter defendants argued that the Rule 10b-5 claims against them should be dismissed in light of the Second Circuit's recent decision on the pleading of loss causation in securities fraud cases. In Emergent Capital, the Second Circuit held that allegations of artificial price inflation, without more, do not suffice to plead loss causation. (The 10b-5 Daily has posted about the decision and the current circuit split on this issue.)
In the IPO allocation cases, the underwriter defendants "allegedly required or induced their customers to buy shares of stock in the aftermarket as a condition of receiving initial public offerings stock allocations." This conduct allegedly caused the plaintiffs to purchase the stock at an artificially inflated price. The plaintiffs have brought claims, based on different provisions of Rule 10b-5, for (1) market manipulation and (2) material misstatements and omissions.
Although the Emergent Capital decision requires more than price inflation to adequately plead loss causation (e.g., a corrective disclosure revealing the fraud and causing a stock price decline), the court noted that it is a material misstatements and omissions case. Market manipulation, the court argued, is simply different.
"A market manipulation is a discrete act that influences stock price. Once the manipulation ceases, however, the information available to the market is the same as before, and the stock price gradually returns to its true value. . . In market manipulation cases, therefore, it may be permissible to infer that the artificial inflation will inevitably dissipate. That being so, plaintiffs' allegations of artificial inflation are sufficient to plead loss causation because it is fair to infer that the inflationary effect must inevitably diminish over time. It is that dissipation -- and not the inflation itself -- that caused plaintiffs' loss."
The court offers no citations for this analysis and it certainly reaches some broad (and potentially controversial) conclusions. As for the remaining misstatements and omission claims, the court concedes that Emergent Capital is directly on point, but simply bootstraps the claims into its earlier loss causation analysis: "The content of Underwriters' misstatements was, in essence: 'this is a fair, efficient market, unaffected by manipulation.' In fact (according to plaintiffs), the market was manipulated. For the reasons discussed  above, that market manipulation was a cause of plaintiffs' loss. Therefore, the misstatements that concealed that manipulation also were a cause of plaintiffs' loss." But if the plaintiffs have brought separate fraud claims based on alleged misstatements, don't they need to establish that the alleged misstatements, separate and apart from the market manipulation, caused a loss? Apparently not.
Holding: Motion for judgment on the pleadings denied.
To survive a motion to dismiss, the PSLRA requires plaintiffs bringing a securities fraud claim to plead facts establishing a "strong inference" that the defendants acted with scienter (i.e., fraudulent intent). There are two components to this analysis: (1) what is the substantive standard for scienter; and (2) what must a plaintiff allege to meet the "strong inference" pleading requirement. Until last week, the U.S. Court of Appeals for the Fourth Circuit had declined to take a position on either of these issues. Not anymore.
In Ottmann v. Hanger Orthopedic Group, 2003 WL 22992292 (4th Cir. Dec. 22, 2003), the court joined every other circuit in holding that scienter may be established by pleading not only intentional misconduct, but also recklessness (although it must be "severe recklessness [that] is, in essence, a slightly lesser species of intentional misconduct"). Having established the substantive standard, the court turned to what a plaintiff must plead to meet the PSLRA's "strong inference" pleading requirement.
The court found that "Congress ultimately chose not to specify particular types of facts that would or would not show a strong inference of scienter [as part of the PSLRA]." As a result, the court concluded that a "flexible, case-specific analysis is appropriate in examining scienter pleadings." Although facts establishing "motive and opportunity to commit fraud (or lack of such facts) may be relevant to the scienter inquiry, the weight accorded to those facts should depend on the circumstances of each case."
In applying this flexible analysis to the instant case, the court found that there were insufficient facts demonstrating that any of the alleged misstatements were the product of reckless or intentional conduct (as opposed to negligence). Moreover, the court noted that the plaintiffs failed to allege that the individual defendants had any personal motive to make the alleged misstatements, "such as to facilitate personal sales of Hanger stock." Instead, plaintiffs argued that the defendants were motivated to misrepresent Hanger's financial situation so as to maintain the company's positive relationships with its creditors, avoid additional interest payments, and promote future acquisitions. The court concluded that other courts "have repeatedly rejected these types of generalized motives -- which are shared by all companies -- as insufficient to plead scienter under the PSLRA."
Holding: Affirm the dismissal of complaint.
Quote of note: "We therefore conclude that courts should not restrict their scienter inquiry by focusing on specific categories of facts, such as those relating to motive and opportunity, but instead should examine all of the allegations in each case to determine whether they collectively establish a strong inference of scienter."
Addition: Note that the facts of the case do not allow the Fourth Circuit to address an important issue. Based on the analysis in the opinion, it appears clear that the court could have affirmed the dismissal of the complaint based on the lenient Second Circuit pleading standard, as it has in other cases. See Phillips v. LCI Int., Inc. 190 F.3d 609 (4th Cir. 1999). Instead, the court chose to adopt and apply a new pleading standard in a case where the plaintiffs did not allege any personal motive to commit securities fraud (e.g., stock sales by the individual defendants). District courts in the Fourth Circuit are left with no practical guidance on what "weight" the appellate court thinks should be given to those types of allegations in determining whether a strong inference of scienter has been plead.