May 27, 2011

Forest For The Trees

In its Tellabs and Matrixx decisions, the Supreme Court emphasized that whether a plaintiff has adequately plead a strong inference of scienter is subject to a holistic review (i.e., the allegations in the complaint must be considered in their entirety). This approach conflicts with the more traditional judicial approach of reviewing each scienter allegation separately and then coming to an overall conclusion as to whether the plaintiff has met its pleading burden.

In Frank v. Dana Corp., 2011 WL 2020717 (6th Cir. May 25, 2011), the court addressed this issue and held that in light of the Supreme Court's decisions it must adopt a new, more efficient approach to evaluating scienter allegations. Exactly how efficient, however, may have come as a surprise to the parties. In just one page of analysis, the court concluded that in light of such factors as overall industry problems, rising prices for a key commodity, and the quick collapse of the company, it was "difficult to grasp the thought that [the defendants] really had no idea that Dana was on the road to bankruptcy." Accordingly, the court found that the plaintiffs had adequately plead a strong inference of scienter because "the inference that [the defendants] recklessly disregarded the falsity of their extremely optimistic statements is at least as compelling to us as their excuse of failed accounting systems."

Holding: Dismissal reversed. (The 10b-5 Daily has previously posted about an earlier, related appellate decision in the case.)

Quote of note: "[In Matrixx] the Court provided for us a post-Tellabs example of how to consider scienter pleadings 'holistically' in section 10(b) cases. Writing for the Court, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis. This is the only appropriate approach following Tellabs’s mandate to review scienter pleadings based on the collective view of the facts, not the facts individually. Our former method of reviewing each allegation individually before reviewing them holistically risks losing the forest for the trees. Furthermore, after Tellabs, conducting an individual review of myriad allegations is an unnecessary inefficiency."

Posted by Lyle Roberts at 9:03 PM | TrackBack

May 20, 2011

The Loss Causation Loophole

An interesting issue, which has generated a district court split, is whether securities class actions can be brought against a mutual fund based on misstatements about the fund's investment objective and holdings. Mutual funds have argued that it is impossible for plaintiffs to establish loss causation. The price of mutual fund shares is not determined by market securities trading, but rather is based on the fund's net asset value (NAV). The NAV is a statutorily defined formula that depends on the value of the underlying securities held by the fund. Accordingly, the NAV can only decline in response to a change in the value of those securities, not as a result of the disclosure of hidden facts about the fund.

Courts have been reluctant to embrace this argument, with several courts noting that as a matter of public policy mutual funds should not be allowed to escape securities liability. In In re State Street Bank and Trust Co. Fixed Income Funds Investment Litigation, 2011 WL 1206070 (S.D.N.Y. March 31, 2011), however, the court examined claims brought under Section 11 and 12 of the '33 Act and found that this policy rationale cannot trump the required legal analysis.

Under the Lentell (2d Cir.) decision, plaintiffs must show "that the misstatement or omission concealed something from the market that, when disclosed, negatively affected the value of the security." Moreover, the damages provisions in Sections 11 and 12 both "tie the recovery of a potential plaintiff to the value of the security." Given that "the NAV does not react to any misstatements [about the fund's investment objective and holdings], no connection between the alleged material misstatement and a diminution in the security's value had been or could be alleged." The court therefore granted the defendants' motion to dismiss.

Holding: Case dismissed with prejudice.

Quote of note: "In this case, however, the Court is constrained by the plain language of Section 11(e) and 12(a)(2), which requires a connection between the alleged material misstatements and a diminution in the security's value. It seems likely that Congress never considered that it might be creating a loophole for fraudulent misrepresentations by mutual fund managers when enacting these provisions. But if this is so, closing the loophole requires legislative action."

Posted by Lyle Roberts at 9:49 PM | TrackBack

May 13, 2011

Top Rated

Mortgage pass-through certificates entitle the investor to distributions from underlying pools of mortgages. A key aspect of these securities are the credit ratings given to them by the ratings agencies. In In re Lehman Brothers Mortgage-Backed Securities Litigation, 2011 WL 1778726 (2d Cir. May 11, 2010), the court considered whether these ratings agencies, by allegedly helping to "determine the composition of loan pools, the certificates' structures, and the amount and kinds of credit enhancement of particular tranches" could be liable under Section 11 of the '33 Act for misstatements in the certificates' offering documents.

The plaintiffs' argued that the ratings agencies activities made them "underwriters" of the securities and therefore subject to Section 11 liability. The court disagreed, finding that "to qualify as an underwriter under the participation prongs of the statutory definition, a person must participate, directly or indirectly, in purchasing securities from an issuer with a view to distribution, in offering or selling securities for an issuer in connection with a distribution, or in the underwriting of such an offering." The fact that the ratings agencies played a role in "structuring or creating" the securities was insufficient to find that they acted as underwriters. Nor had the plaintiffs adequately alleged that the ratings agencies controlled the primary violators. The court found that "allegations of advice, feedback, and guidance fail to raise a reasonable inference that the Ratings Agencies had the power to direct, rather than merely inform, the banks' ultimate structuring decisions."

Holding: Dismissal of claims against ratings agencies affirmed.

Posted by Lyle Roberts at 10:31 PM | TrackBack

May 6, 2011

When A Plan Comes Together

Can a corporate 401(k) profit-sharing plan claim a share of the settlement proceeds from a securities class action brought against the company? In In re Motorola Securities Litigation, 2011 WL 1662838 (7th Cir. May 4, 2011) the court held that Motorola's plan, despite being a purchaser of Motorola common shares during the relevant period, could not participate in the settlement because it was an "affiliate" of the issuer.

The Motorola 401(k) Profit-Sharing Plan (the "Plan") is "a participant-directed, defined-contribution retirement plan established for the benefit of current and former Motorola employees." The Plan was controlled by a committee appointed by Motorola's board. One of the plan's investment options was a fund that allowed participants to acquire beneficial ownership of Motorola common stock.

In 2007, a securities class action brought against Motorola was settled for $190 million. (The 10b-5 Daily also has posted about the lead plaintiff and motion to dismiss decisions in the case.) The settlement specifically excluded any "affiliate" of Motorola from making a claim. The Plan filed a claim with the claims administrator for the benefit of its participants, which the district court eventually rejected.

On appeal, the Seventh Circuit found that the district court's rejection of the Plan's claim was correct. The key issue was whether, pursuant to the securities-law meaning of "affiliate," the Plan was controlled by or under common control with Motorola. Motorola's board appointed the Plan committee, which in turn had managerial control over the Plan's policies and operations. The court held that "[t]his degree of control is sufficient to make the Plan an affiliate of Motorola, and as an affiliate of Motorola, the Plan is specifically excluded from the class."

Holding: Order disallowing the Plan's claim to a share of the Motorola settlement proceeds affirmed.

Posted by Lyle Roberts at 11:30 PM | TrackBack