Citigroup Inc. (NYSE: C), a leading global bank, has agreed to settle a securities class action pending against the company in the S.D.N.Y. The case, which was originally filed in 2008, alleges that Citibank misrepresented its exposure to collaterialized debt obligations. The court preliminarily approved the settlement on August 29, 2012, and has scheduled a hearing for final approval on January 13, 2013.
The settlement is for $590 million, which the company says will be covered by existing legal reserves. It is the third-largest settlement of a credit crisis case, trailing only Wachovia ($627 million) and Countrywide ($624 million). Bloomberg and Reuters have articles on the settlement.
The New York Law Journal has a column (Aug. 17 edition - subscrip. req'd) on the application of the Morrison decision. In Morrison, the Supreme Court held that Section 10(b) liability for securities fraud is limited to "transactions in securities listed on our domestic exchanges, and domestic transactions in other securities." What constitutes a "domestic transaction," however, was not clarified.
As a result, the authors note, lower courts have adopted at least three different approaches for determining whether a non-exchange transaction is "domestic." Some courts have looked at whether the "critical steps of the transaction," including the offer and acceptance, occurred in the United States. Other courts limit potential liability to transactions in which the parties agreed to be bound to each other in the United States. The strictest approach is to insist that the actual transfer of the securities must have taken place in the United States. The authors argue that all of these approaches are broader than what the Supreme Court intended.
Quote of note: "When any of these approaches is applied to Morrison, it becomes clear that the lower courts' applications of Morrison are inconsistent with the Supreme Court's ruling and do not end extraterritorial application of the 34 Act. If [the Morrison corporate defendant] had hypothetically transferred its stocks to the investors in New York, for example, the 34 Act arguably would have applied under all three approaches. Ironically, under the prior conduct and effects tests, the same hypothetical would likely not have triggered the application of the 34 Act."
While the Morrison decision limits Section 10(b) liability to securities transactions that take place in the United States, the complexity of the global securities market can lead to transactions that are difficult to define geographically. As a result, lower courts have struggled to consistently apply Morrison to different fact patterns.
In Phelps v. Stomber, 2012 WL 3276969 (D.D.C. Aug. 13, 2012), the court addressed whether there could be Section 10(b) liability for "Class B Shares" and "Restricted Depositary Shares (RDS)" issued by a closed-end investment fund. The Class B Shares were sold only outside the U.S. to foreign investors. The RDSs were sold to investors in the U.S.
As to the Class B Shares, the court held it was of no significance that Euronext, the exchange upon which the shares were traded, is owned by a Delaware company. Euronext was still a "foreign exchange" for purposes of the Morrison analysis and there could be no Section 10(b) liability. In contrast, the RDSs were clearly bought and sold in the U.S., but the defendants argued that the purchase of a RDS also should be considered a foreign transaction because it represented the shareholder's ownership of a Class B Share traded on Euronext. Among other precedent, the defendants cited the Societe Generale decision, which held that American Depository Receipts were the "functional equivalent" of trading a company's shares on a foreign exchange. The court rejected this view, finding that while the contention that "an investor could not purchase an RDS in the United States without a corresponding overseas transaction may be true, it does not change the fact that a purchase in the United States still took place." Accordingly, Morrison did not bar the RDS claims.
Holding: Motion to dismiss granted (on other grounds as to the RDS claims).
Quote of note: "[P]laintiffs' efforts to label everything "Made in America" to get around Morrison requires the Court to ignore allegations in the complaint and information contained in the Offering documents referenced in the complaint."
In its Tellabs decision, the U.S. Supreme Court held that a court must assess a plaintiff's scienter (i.e., fraudulent intent) allegations "holistically" in determining whether the plaintiff has met the requisite "strong inference" pleading standard. The 10b-5 Daily noted that this holding "would appear to alter the evaluation of scienter in the Second Circuit and Third Circuit, both of which have held that a court can examine allegations of motive or knowledge/recklessness separately." In the intervening years, however, the Second Circuit has not directly addressed this inconsistency, to the benefit of plaintiffs.
George v. China Automotive Systems, Inc., 2012 WL 3205062 (S.D.N.Y. Aug. 8, 2010) is a "Chinese reverse merger" case alleging that the company engaged in accounting fraud. In their motion to dismiss, the defendants argued that the plaintiffs had failed to adequately plead scienter. The court, citing Second Circuit precedent, noted that the "requisite 'strong inference' of scienter can be established by alleging facts showing (a) defendants' 'motive and opportunity' to commit the alleged fraud, or (b) strong circumstantial evidence of conscious misbehavior or recklessness." After examining the complaint, the court held that the plaintiffs' insider trading allegations, by themselves, were sufficient to establish motive and opportunity. In particular, four of the seven individual defendants "sold over 50% of their CAAS stock during the class period" and the individual defendants collectively made a net profit of nearly $42 million on their class period sales.
The defendants offered two counterarguments, both of which were rejected by the court. First, the defendants noted that the individual defendants had entered into Rule 10b5-1 stock trading plans. As a result "more than two-thirds of [their] sales were made pursuant to the 10b5-1 plans and the remaining sales are too small a fraction of total sales to establish 'unusual' trading." The court held that because the 10b5-1 trading plans were entered into during the class period, they could not be invoked "to disarm any inference of scienter raised by the Individual Defendants' sales of CAAS stock." Second, the defendants asserted that "the alleged accounting errors and misstatements regarding internal controls are insufficient to sustain a securities fraud claim." The court found that this assertion was "immaterial at this stage" because the plaintiffs had "sufficiently plead motive and opportunity."
It is difficult, in the wake of Tellabs, to see how a lower court can engage in the required weighing of competing inferences of scienter if it stops the exercise after finding that there has been "unusual" insider trading. The Second Circuit needs to sort this out.
Holding: Motion to dismiss denied (except as to an auditor defendant).
What evidence is necessary to establish loss causation and economic damages? Two recent circuit court decisions address this issue, albeit at different stages of a securities fraud case.
(1) In Aciticon AG v. China North East Petroleum Holdings, Ltd., 2012 WL 3104589 (2d Cir. Aug. 1, 2012), the lower court dismissed the case based on the plaintiffs' failure to adequately plead economic damages. Within a couple of months after the "final allegedly corrective disclosure" was made, the company's stock price rose above the lead plaintiff's average purchase price. The lower court held that a "plaintiff who foregoes a chance to sell at a profit following a corrective disclosure cannot logically ascribe a later loss to devaluation caused by the disclosure."
On appeal, the Second Circuit rejected this economic-loss rule as "inconsistent with the traditional out-of-pocket measure of damages, which calculates economic loss based on the value of the time of the security at the time that the fraud became known." The court noted that "a share of stock that has regained its value after a period of decline is not functionally equivalent to an inflated share that has never lost value." To hold otherwise, would allow defendants to improperly "offset gains that that plaintiff recovers after the fraud becomes known against losses caused by the revelation of the fraud if the stock recovers value for completely unrelated reasons." Accordingly, the court held, "the [stock price] recovery does not negate the inference that [the lead plaintiff] has suffered an economic loss."
Holding: Dismissal reversed and case remanded.
(2) In Hubbard v. BankAtlantic Bancorp, Inc., 2012 WL 2985112 (11th Cir. July 23, 2012), the plaintiffs alleged that BankAtlantic fraudulently concealed the poor credit quality of its commercial real estate portfolio. The plaintiff’s only evidence of loss causation was the testimony of its expert. After a trial, the court granted judgment as a matter of law to the defendants based on the plaintiffs' failure to establish loss causation.
On appeal, the Eleventh Circuit agreed with the lower court (albeit on a slightly different basis). The court found that a plaintiff must "offer evidence sufficient to allow the jury to separate portions of the price decline attributable to causes unrelated to the fraud, leaving only the part of the price decline attributed to the dissipation of the fraud-induced inflation." The study conducted by the plaintiffs’ expert was supposed to isolate which part of the stock price drop was caused by the materialization of the risk concealed by BankAtlantic. But it failed to adequately take into account that BankAtlantic’s assets were concentrated in loans tied to Florida real estate. The court noted that there was a general downturn in the Florida real estate market at the relevant time, which may have been a substantial cause of the stock price drop. Because the plaintiffs' evidence failed to exclude this possibility, the court affirmed the lower court's decision.
Holding: Judgment affirmed.