The recent string of appellate decisions involving securities class actions includes Ley v. Visteon Corp., 2008 WL 3905469 (6th Cir. Aug. 26, 2008), which contains a couple of interesting holdings.
Comparisons to Competition - The plaintiffs alleged that Visteon failed to disclose how high its costs were relative to its competition. The court declined to "advocate a rule that requires companies to draw such comparisons." Quoting from an older Third Circuit opinion, the court found that "it is precisely and uniquely the function of the prudent investor, not the issurer of securities, to make such comparisons among investments."
Discounting Confidential Witnesses - The Seventh Circuit has held that in evaluating the pleading of scienter (i.e. fraudulent intent), allegations from confidential witnesses must be "discounted" and that discount will usually be "steep." Although there is some confusion as to whether that holding remains good law, the Sixth Circuit cited it favorably in concluding that the confidential witness allegations in the Visteon complaint were insufficient to establish any inference of scienter.
Holding: Dismissal affirmed.
(1) The National Law Journal (Sept. 22 edition) has an interesting column on the issue of securities class action damages. Professor Adam Pritchard (U. Mich.) argues that the fundamental flaw in the system is the failure to measure damages by the defendant's gain, rather than the plaintiff's loss.
Quote of note: "Measuring damages by the defendant's gain would accomplish two things. First, it would scale back the stakes in securities class actions. . . . Second, measuring damages by the defendant's benefit would focus deterrence on the executives who actually lied."
(2) The New York Law Journal (Sept. 22 edition) has an article discussing whether the government's role in the credit crisis will limit the scope of private litigation.
Quote of note: "AIG, for instance, was already facing a number of shareholder suits before the government stepped in. The government's acquisition of an 80 percent interest in the insurer through its $85 billion loan then squeezed shareholders further. How a government-controlled AIG will deal with securities class actions remains uncertain."
There is a recent appellate trend of finding "must have known" allegations sufficient to establish a strong inference of scienter in situations where the underlying events are deemed to be highly important to the corporation (e.g., Dynex Capital (2nd Cir.), Tellabs II (7th Cir.), and Applied Signal (9th Cir.)).
In South Ferry LP v. Killinger, 2008 WL 4138237 (9th Cir. Sept. 9, 2008), the court examined exactly when "a scienter theory that infers that facts critical to a business's 'core operations' or an important transaction are known to a company's key officers" establishes a strong inference of scienter. The court found that these allegations may help to satisfy the pleading standard in three circumstances.
(1) "[T]he allegations may be used in any form along with other allegations that, when read together, raise an inference of scienter that is 'cogent and compelling, thus strong in light of other explanations.'" (citing Tellabs)
(2) The "allegations may independently satisfy the [scienter pleading standard] where they are particular and suggest that defendants had actual access to the disputed information."
(3) The "allegations may conceivably satisfy the [scienter pleading] standard in a more bare form, without accompanying particularized allegations, in rare circumstances where the nature of the relevant fact is of such prominence that it would be 'absurd' to suggest that management was without knowledge of the matter."
Although the first two tests are uncontroversial, the "absurdity" test appears difficult to apply in a consistent fashion. The court cited the Applied Signal case, where the defendants allegedly failed to disclose stop-work orders from the company's largest customers even though they had a devastating effect on revenues, as one of the "exceedingly rare" cases where the core operations inference, without more, was sufficient. But whether lower courts will find that the core operations inference is sufficient only in "exceedingly rare" cases remains to be seen.
Holding: Remanded for further proceedings consistent with the opinion.
Can the sheer number of accounting errors negate an inference of fraud? In In re Ceridian Corp. Sec. Litig., 2008 WL 4163782 (8th Cir. Sept. 11, 2008), the U.S. Court of Appeals for the Eighth Circuit had an opportunity to address that question.
Between February 2004 and April 2005, Ceridian announced three financial restatements. The restatements were based on a variety of apparently unrelated accounting errors over a number of years. The district court found that the sheer number of accounting errors, which involved dozens of employees, made it "almost inconceivable that there could have been any unifying intent behind the errors, much less an intent to defraud."
The Eighth Circuit agreed. Even in conjunction with the plaintiffs' other scienter allegations - including insider trades, SOX certifications, confidential witness statements about pre-class period conduct, and an ongoing SEC investigation - the court found that "the opposing inference that Ceridian and the controlling officer defendants should have known about the many accounting errors" was more compelling than the inference that they knew about the errors. The court concluded that the plaintiffs had "a viable claim of negligence, but not of fraud."
Holding: Dismissal affirmed.
The U.S. Court of Appeals for the Third Circuit has issued a notable decision on the application of the statute of limitations in securities cases. In In re Merck & Co., Inc. Sec., Derivative & ERISA Lit., Nos. 07-2431, 07-2432 (3rd Cir. Sept. 9, 2008), the court considered whether Merck investors were on inquiry notice of their securities claims relating to Vioxx disclosures more than two years before the case was filed. If so, the plaintiffs' claims would be barred by the statute of limitations. The decision has a number of interesting holdings:
(1) There has been some ambiguity in the Third Circuit over whether inquiry notice is triggered by evidence alerting an investor to the "possibility" or the "probability" of wrongdoing. The decision clarified that the Third Circuit's standard is: "whether the plaintiffs, in the exercise of reasonable diligence, should have knows of the basis for their claims depends on whether they had sufficient information of possible wrongdoing to place them on inquiry notice or to excite storm warnings of culpable activity." Although the court adopted the lower "possibility" standard, it emphasized that the evidence must be substantial, especially in light of the PSLRA's heightened pleading standards.
(2) The district court found the existence of inquiry notice based upon a public FDA warning letter stating that Merck was misrepresenting the safety profile of Vioxx, press and scholarly articles about the risk of heart attack associated with the drug, and various lawsuits filed against Merck over Vioxx safety issues. On appeal, however, the court found that these "storm warnings" were dissipated by Merck's reassuring statements to the market or undermined by the failure of the disclosures to have any significant impact on Merck's stock price or projections by analysts. In particular, the court focused on the fact that Merck put forward an alternative hypothesis as to why the relevant clinical study showed increased heart attack risks associated with Vioxx that may have led to the limited stock price reaction. Also, none of the lawsuits alleged securities fraud.
(3) In a vigorous dissent, Judge Roth argued that the FDA warning letter, by itself, was a sufficient storm warning that Merck had engaged in misrepresentations concerning Vioxx. Moreover, the subsequent press coverage and consumer lawsuits should have led investors to an awareness "of the possibility that Merck had been fraudulently misrepresenting the cardiovascular safety of Vioxx."
(4) The majority's footnote response to the dissent appears ill-considered: "It is ironic that the dissent, although noting what might be viewed as Merck's misrepresentations, would apply the statute of limitations to deprive plaintiffs of the opportunity to prove a viable case against Merck for such misrepresentations." Bad facts make for bad law? After all, as The 10b-5 Daily has noted before, an inquiry notice argument presupposes the possibility of misrepresentations and the statute of limitations can limit liability even where misconduct has occurred.
Holding: Reversed and remanded.
Quote of note (majority opinion): "Merck’s stock price dipped slightly following the disclosure of the FDA warning letter before closing higher than it did before that disclosure just a week and a half later. Although the lack of significant movement in Merck’s stock price following the FDA warning letter is not conclusive, it supports a conclusion that the letter did not constitute a sufficient suggestion of securities fraud to trigger a storm warning of culpable activity under the securities laws. This conclusion is also supported by the fact that more than a half-dozen securities analysts continued to maintain their ratings for Merck stock and/or project increased future revenues for Vioxx after the warning letter was made public."
Quote of note (dissent): "In applying the above inquiry notice standard to the instant case, I am reminded of a classic fairytale: The Emperor’s New Clothes, by Danish author and poet, Hans Christian Anderson. As the child in The Emperor’s New Clothes saw – that the Emperor walked naked down the street – any reasonable investor reading the FDA’s September 17, 2001, warning letter could see the problem with Vioxx – the misrepresentation of its safety profile and the 'possibility' that Merck had fraudulently misrepresented the cardiovascular safety of its 'blockbuster' product."
A few items of interest from around the web:
(1) Bruce Carton, a longtime securities law blogger, has launched Securities Docket a "global securities litigation and enforcement report." The site provides one-stop shopping for the latest news, blog posts, filings, etc.
(2) The New York Law Journal has a column (subscrip. req'd) on recent Ninth Circuit loss causation decisions. In particular, the authors discuss the Apollo Group, Corinthian Colleges, and Gilead decisions and conclude that they have not made it more difficult to successfully plead loss causation.
(3) The WSJ Law Blog has coverage of a recent decision in the Oracle securities class action. The court found that the defendants engaged in discovery abuses, including failing to preserve audio recordings of an author's interviews with Oracle's CEO (even though the recordings were in the possession of the author).
Following the Stoneridge decision on scheme liability, the lower courts continue to explore what conduct is sufficient to induce reliance by investors. In In re Bristol Myers Squib Co. Sec. Litig., 2008 WL 3884384 (S.D.N.Y. Aug. 20, 2008), a corporate officer negotiated a settlement agreement in a patent infringement case, the terms of which were misstated by the company in its disclosures. Even though the corporate officer did not participate in the making of the disclosures, the court considered whether investors relied on his allegedly deceptive conduct in failing to correct the misstatements. In determining that reliance was adequately plead, the court found that the "investors relied on [the corporate officer's] good faith in negotiating the Apotex settlement agreement and committing the Company to its terms." In addition, unlike in Stoneridge, the corporate officer's deceptive conduct was communicated to the public.
Holding: Motion to dismiss denied.