He's back. Judge Easterbrook has authored a new securities litigation decision for the U.S. Court of Appeals for the Seventh Circuit and, as always, it is interesting and contentious.
In Schleicher v. Wendt, 2010 WL 3271964 (7th Cir. Aug. 20, 2010), the court considered to what extent plaintiffs must establish the existence of loss causation before a class can be certified. Defendants argued, based in part on Fifth Circuit precedent (Oscar Private Equity), that the plaintiffs needed to demonstrate that the alleged false statements materially affected the company's stock price and therefore caused some loss. The court disagreed and held that when and to what extent the alleged false statements affected the stock price are "merits questions" that cannot be resolved as part of the class certification process. Moreover, the Fifth Circuit's approach would "make certification impossible in many securities suits, because when true and false statements are made together it is often impossible to disentangle the [price] effects with any confidence."
Holding: Certification of class affirmed.
Quote of note: "Unlike the fifth circuit, we do not understand Basic to license each court of appeals to set up its own criteria for certification of securities class actions or to 'tighten' Rule 23's requirements. Rule 23 allows certification of classes that are fated to lose as well as classes that are sure to win. To the extent it holds that class certification is proper only after the representative plaintiffs establish by a preponderance of the evidence everything necessary to prevail, Oscar Private Equity contradicts the decision, made in 1966, to separate class certification from the decision on the merits."
A trio of notable appellate decisions have been issued in the last ten days.
(1) In In re Mercury Interactive Corp. Sec. Litig., 2010 WL 3239460 (9th Cir. Aug. 18, 2010), the court addressed the common settlement practice of requiring attorneys' fees objections to be filed prior to the filing of the actual fees motion and supporting papers. The court found that "the practice borders on a denial of due process because it deprives objecting class members of a full and fair opportunity to contest class counsel's fee motion." Accordingly, courts must set a schedule that allows objections to made after the class has an adequate opportunity to review its counsel's fees motion.
(2) In Malack v. BDO Seidman, 2010 WL 3211088 (3rd Cir. Aug. 16, 2010), the court considered the validity of the fraud-created-the-market theory. Under this theory, a presumption of reliance is established if "the defendants conspired to bring to market securities that were not entitled to be marketed." The plaintiff must allege both that the existence of the security in the marketplace resulted from the successful perpetration of a fraud on the investment community and that he purchased in reliance on the market. In a long and thorough opinion, the court declined to endorse the theory, finding that common sense and a lack of empirical support "calls for rejecting the proposition that a security's availability on the market is an indication of its genuineness and is worthy of an investor's reliance."
(3) In In re Aetna, Inc. Sec. Litig., 2010 WL 3156560 (3rd Cir. Aug. 11, 2010), the court found that the PSLRA's safe harbor for forward-looking statements mandated the dismissal of the case. In particular, the statements were accompanied by meaningful cautionary language and were too vague to be material to investors. The 10b-5 Daily's summary of the lower court decision can be found here.
The scope of the Securities Litigation Uniform Standards Act ("SLUSA"), which precludes certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities, continues to be the subject of litigation. A key issue is to what extent a plaintiff can plead around the preclusive effect of the statute.
In Romano v. Kazacos, 2010 WL 2574143 (2d Cir. June 29, 2010), the Second Circuit considered a pair of state law class actions alleging that Morgan Stanley gave inappropriate retirement advice, which led the plaintiffs to retire early, place their lump sum retirement benefits with Morgan Stanley for investment, and subsequently suffer investment losses. The district court found that SLUSA preempted both actions and dismissed them.
On appeal, the Second Circuit made two key findings.
First, the court held that although a plaintiff is normally the master of his complaint, he "cannot avoid removal by declining to plead 'necessary federal questions.'" Based on this "artful pleading" rule, in a SLUSA case courts can look beyond the face of the complaint to determine whether the plaintiff has "allege[d] securities fraud in connection with the purchase or sale of securities."
Second, SLUSA's "in connection" requirement must be given a broad construction. In the cases at issue, the plaintiffs "in essence, assert that defendants fraudulently induced them to invest in securities with the expectation of achieving future returns that were not realized." Even though the plaintiffs "did not invest in any covered securities for up to eighteen months" after receiving the relevant retirement advice, the court concluded this time lapse was "not determinative here because . . . 'this was a string of events that were all intertwined.'" In sum, the court held that "[b]ecause both the misconduct complained of, and the harm incurred, rests on and arises from securities transactions, SLUSA applies."
Holding: Dismissal based on SLUSA preclusion affirmed.
The U.S. Court of Appeals for the Ninth Circuit has been busy over the past few weeks.
(1) In the Apollo Group case, the court reinstated the $277.5 million verdict obtained by the company's investors. The trial court, in a post-verdict decision, had found that the investors failed to prove loss causation. In particular, the court concluded that the two analyst reports relied upon by the plaintiffs as "corrective disclosures" that led to a stock price decline "did not provide any new, fraud-revealing analysis." Although The 10b-5 Daily suggested that the trial court's decision could lead to an interesting appeal, the actual opinion is quite anticlimactic. In an unpublished memorandum, the court simply held that "the jury could have reasonably found that the [analyst] reports following various newspaper articles were ‘corrective disclosures’ providing additional or more authoritative fraud-related information that deflated the stock price." The D&O Diary has extensive coverage, including a guest commentary.
(2) In In re Cutera Sec. Litig., 2010 WL 2595281 (9th Cir. June 30, 2010), the court joined all of the other circuits that have considered the issue (Fifth, Sixth, and Eleventh) in finding that the PSLRA's safe harbor for forward-looking statements "is written in the disjunctive as to each subpart." As a result, the "defendant's state of mind is not relevant" in determining whether a forward-looking statement is protected from liability because it is accompanied by "sufficient cautionary language." Over the years, The 10b-5 Daily has posted frequently on this issue (most recently here).
(3) Many commentators believed that the U.S. Supreme Court would grant cert in the Trainer Wortham case to address the running of the statute of limitations for securities fraud. As it turned out, the Court took the Merck case instead and issued a decision earlier this year. The Court then remanded the Trainer Wortham case for reconsideration. Back in the Ninth Circuit, in Betz v. Trainer Wortham & Co., Inc., 2010 WL 2674442 (9th Cir. July 7, 2010), the court has decided that it would be better for the district court to consider the statute of limitations issue in the first (or, more accurately, second) instance.
In what is shaping up to be a blockbuster term for securities litigation cases, the U.S. Supreme Court will address the issue of primary liability.
On Monday, the Court granted cert (over the objection of the government) in the Janus Capital Group v. First Derivative Traders case. In Janus, the Fourth Circuit found that to establish primary liability it is sufficient for a plaintiff to adequately allege (a) the defendant "participated" in the making of a false statement, and (b) "interested investors would have known that the defendant was responsible for the statement at the time it was made, even if the statement on its face is not directly attributable to the defendant." The defendants argued in their cert peition, apparently with some success, that both prongs of this holding created or exacerbated circuit splits.
SCOTUSBlog has links to the cert petition papers. The official "questions presented" can be found here.
In the Morrison v. National Australia Bank ("NAB") case, the U.S. Supreme Court has held that Section 10(b) of the Exchange Act applies only to transactions in securities listed on U.S. exchanges and to U.S. transactions in other securities. The 8-0 decision (Justice Sotomayor did not participate) authored by Justice Scalia thus rejects the use of the conduct/effects test to determine the extraterritorial application of the U.S. anti-fraud securities laws.
In NAB, the court considered a so-called "foreign-cubed" securities case - i.e., a securities class action brought against a foreign issuer by foreign investors who purchased their securities on a foreign exchange. The Second Circuit applied its existing "conduct test" for determining the extraterritorial application of Section 10(b) and held that the plaintiffs needed to adequately allege that "activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad." The court found that this test was not met in NAB because the locus of the fraudulent activity, including the issuance of the false statements, was in Australia.
On appeal, the Supreme Court reached the same result, but took a notably different approach.
First, the Court found (contrary to the Second Circuit and other lower federal courts) that the extraterritorial application of Section 10(b) does not "raise a question of subject-matter jurisdiction." Instead, it is an issue of "what conduct Section 10(b) prohibits, which is a merits question."
Second, it is a longstanding principle that Congressional legislation, "unless a contrary intent appears, is meant to apply only within the territorial jurisdiction of the United States." The fact that the "Exchange Act is silent as to the extraterritorial application of Section 10(b)" does not give courts license to speculate as to what Congress would have wanted. In the absence of any "affirmative indication" that Section 10(b) applies extraterritorially, the Court concluded "that it does not."
Finally, the Court addressed the plaintiffs' contention that even if Section 10(b) does not apply extraterritorially, there was sufficient deceptive conduct in the U.S. to make it a "domestic" case. Although the Court agreed that applying the presumption against extraterritorial application may require analysis, the presumption "would be a craven watchdog indeed if it retreated to its kennel whenever some domestic activity is involved in the case." The Court found that the focus should be on the location of the securities transaction, not "the place where the deception originated." Accordingly, it is "only transactions in securities listed on our domestic exchanges, and domestic transactions in other securities, to which Section 10(b) applies."
Holding: Affirmed.
Notes on the Decision
(1) Although technically a unanimous decision, the concurrence written by Justice Stevens (and joined by Justice Ginsburg) effectively acted as a dissent. The justices urged affirmance on the grounds set forth in the Second Circuit's opinion.
(2) The Court's bright-line rule would appear easy to apply. One can envision fact patterns, however, that might make it difficult to assess whether a securities transaction is "domestic" (i.e., has taken place within the United States).
(3) While the decision does not discuss whether it applies to the SEC, there is no principled reason why the Court's construction of Section 10(b) would not extend beyond private plaintiffs. Congress has been considering a codification of the extraterritorial application of Section 10(b). By indirectly limiting the scope of the SEC's authority, the Court may have improved the prospects for such legislation.
(4) The Court showed some sympathy for the argument that the extraterritorial application of Section 10(b) will encourage suits of questionable merit and compromise the ability of foreign countries to regulate their own securities markets. To wit: "While there is no reason to believe that the United States has become the Barbary Coast for those perpetrating frauds on foreign securities markets, some fear that it has become the Shangri-La of class action litigation for lawyers representing those allegedly cheated in foreign securities markets."
The U.S. Supreme Court is going to address the issue of materiality in securities fraud cases, albeit in the limited context of actions based on a drug company's nondisclosure of "adverse event" reports.
Yesterday, the Court granted cert in the Matrixx Initiatives, Inc. v. Siracusano (9th Circuit) case. In Matrixx, the Ninth Circuit found that a drug company can be liable for failing to disclose adverse event reports (i.e., reports by users of a drug that they experienced an adverse event after using the drug) even if those reports were not statistically significant. The First, Second, and Third Circuits, however, have held that statistical significance is required to make the nondisclosure of the reports material. The Court will resolve the circuit split.
SCOTUSBlog has links to the cert petition papers. Although the question presented is narrow, the case may have wider ramifications if the Court offers guidance on its general materiality standard. Matrixx will be heard in the October term.
Surprisingly, the U.S. Court of Appeals for the Second Circuit has never issued an opinion analyzing the PSLRA's safe harbor for forward-looking statements. It filled in that gap this week.
In Slayton v. American Express Co., 2010 WL 1960019 (2d Cir. May 18, 2010), the court considered whether the safe harbor shielded American Express from liability for a statement it made in its May 15, 2001 Form 10-Q. As paraphrased by the court, American Express had disclosed "that while it had lost $182 million from its high-yield debt investments in the first quarter of 2001, it expected futher losses from those investments to be substantially lower for the remainder of 2001." It turned out, however, that in July 2001 the company took a large write-down on those investments.
The court's decision contains a number of interesting holdings.
(1) Plain Language - Contrary to some other courts, the Second Circuit found that the safe harbor is "written in the disjunctive." Therefore, "a defendant is not liable if the forward-looking statement is identified and accompanied by meaningful cautionary language or is immaterial or the plaintiff fails to prove that it was made with actual knowledge that it was false or misleading."
(2) Scope of Financial Statement Exclusion - The safe harbor excludes forward-looking statements "included in a financial statement prepared in accordance with generally accepted accounting principles." The Second Circuit held that the Management's Discussion and Analysis ("MD&A") section of the Form 10-Q, which contained the alleged misstatement, was not part of the financial statement portion of the filing. As a result, the safe harbor could be applied.
(3) Meaningful Cautionary Language - The Second Circuit noted that it was difficult to follow Congress's instructions concerning the application of the safe harbor. To determine whether a defendant has identified the risks that realistically could cause results to differ, "the most sensible reference is the major factors that the defendants faced at the time the statement was made." But it is clear from the relevant Conference Report that Congress did not want courts to inquire into the defendant's knowledge of those risks.
The Second Circuit concluded that it did not have to "decide that thorny issue," however, because American Express's cautionary statement was too vague to satisfy the "meaningful" standard. While the company warned of the possibility of "potential deterioration in the high-yield sector," it did not warn of the risk that rising defaults on the bonds underlying its investments would cause that deterioration. Moreover, American Express's cautionary statement remained the same even as the problems related to its investments changed.
(4) Actual Knowledge - The Second Circuit held that the relevant pleading standard for actual knowledge is whether a reasonable person, based on the facts alleged, would "deem an inference that the defendants (1) did not genuinely believe the May 15 statement, (2) actually knew they had no reasonable basis for making the statement, or (3) were aware of undisclosed facts tending to seriously undermine the accuracy of the statement, 'cogent and at least as compelling as any opposing inference.'" In this case, the plaintiffs failed to allege sufficient facts to meet this standard.
Holding: Dismissal based on PSLRA's safe harbor affirmed.
Quote of note: "Congress may wish to give further direction on how to resolve this tension, and in particular, the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections. May an issuer be protected by the meaningful cautionary language prong of the safe harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement? In this case, however, we need not decide that thorny issue because we conclude that at any rate the cautionary statement the defendants point to here was vague."
The U.S. Court of Appeals for the Second Circuit has rejected creationism, at least when it comes to determining whether a secondary actor has "made" a statement for purposes of securities fraud liability. In Pacific Investment Management Co. LLC v. Mayer Brown LLP, 2010 WL 1659230 (2d Cir. April 27, 2010), the plaintiffs and the SEC urged the court to reconsider its "bright line" test for determining whether a defendant can be liable for a misstatement.
Under the "bright line" test, primary liability (as opposed to aiding and abetting liability, which is not available in private securities fraud actions) only exists if the misstatement is attributable on its face to the defendant. In other words, the defendant must have been identified to investors as the maker of the statement. The plaintiffs and the SEC argued that public attribution is unnecessary. Instead, a court should be able to find primary liability where the defendant "creates" the statement, even if investors are unaware of the defendant's involvement.
The Second Circuit disagreed. First, the panel found that an "attribution requirement is more consistent with the Supreme Court's guidance on the question of secondary actor liability." In particular, the Supreme Court's Stoneridge decision suggests that attribution is necessary to establish the existence of reliance on the defendant's deceptive acts. Second, the panel noted that the Second Circuit has consistently favored a "bright line" test to distinguish "primary violations of Rule 10b-5 from aiding and abetting." The attribution requirement makes it clear that secondary actors "who sign or otherwise allow a statement to be attributed to them expose themselves to liability," while "[t]hose who do not are beyond the reach of Rule 10b-5's private right of action."
As for the case at hand, the panel found that none of the alleged misstatements in Refco's public filings were attributed to Mayer Brown or any of its attorneys. Without this attribution, "plantiffs cannot show reliance on any statements of Mayer Brown." Moreover, plaintiffs' "scheme liability" claims failed because plaintiffs admitted that "they were unaware of defendants' deceptive conduct or 'scheme' at the time they purchased Refco securities."
In an interesting concurrence, one of the judges noted that the Second Circuit's decisions on the "attribution" issue have been somewhat inconsistent (including rejecting an attribution requirement for corporate insiders) and there is a split among the circuits. Accordingly, he opined that it might be appropriate for the full Second Circuit, as well as the Supreme Court, to consider the case.
Holding: Dismissal of the claims against Mayer Brown and its attorney affirmed.
In the Merck case, a unanimous U.S. Supreme Court (with two concurrences) has found that the investors' securities fraud claims are not barred by the statute of limitations. In making that determination, however, the Court has significantly changed the relevant legal landscape.
The statute of limitations for private federal securities fraud claims provides that a case "may be brought not later than the earlier of (1) 2 years after the discovery of the facts constituting the violation; or (2) 5 years after such violation." Under the "discovery" clause, courts frequently have found that the statute of limitations begins to run once a plaintiff is on "inquiry notice" of the possibility (or probability) that a fraud has occurred. At issue in the Merck case was whether, as held by the Third Circuit, a plaintiff needs evidence of scienter (i.e., fraudulent intent) before inquiry notice is triggered.
As a threshold matter, the Court found that the statutory words could be read "as referring to the time a plaintiff actually discovered the relevant facts." Nevertheless, based on longstanding judicial precedent, "'discovery' as used in this statute encompasses not only those facts the plaintiff actually knew, but also those facts a reasonably diligent plaintiff would have known." The facts that must be known to the plaintiff, however, are the "facts constituting the violation." Scienter, as "an important and necessary element" of a securities fraud claim, clearly meets this definition. A plaintiff therefore must have discovered (or have been able to discover) scienter-related facts before the statute of limitations begins to run.
The Court rejected the "inquiry notice" standard, however, as inconsistent with the "discovery" rule. To the extent that the term "'inquiry notice' refers to the point where the facts would lead a reasonably diligent plaintiff to investigate further, that point is not necessarily the point at which the plaintiff would already have discovered facts showing scienter or 'other facts constituting the violation.'" In sum, the "discovery" limitations period "begins to run once the plaintiff did discover or a reasonably diligent plaintiff would have 'discover[ed] the facts constituting the violation' -- whichever comes first." The Court concluded that whether the plaintiff was on "inquiry notice" or failed to undertake "a reasonably diligent investigation" is not relevant to the analysis.
Turning to the case at hand, the Court agreed with the Third Circuit that the publicly-available information related to Merck's alleged fraud did not reveal facts indicating scienter. Therefore, the statute of limitations was not triggered more than two years before the filing of the complaint and the plaintiffs' suit was timely.
Holding: Judgment affirmed.
Notes on the Decision
(1) The Court is vague - perhaps deliberately so - on the question of exactly what quantum of evidence concerning scienter is sufficient to constitute discovery of the necessary facts. In various spots, the decision refers to "facts showing scienter" and "facts indicating scienter," but then also notes that the PSLRA requires a plaintiff to plead facts demonstrating a "strong inference" of scienter.
(2) The Court declined to decide whether there are other facts necessary to support a private securities fraud claim, beyond "facts showing scienter," that a plaintiff must have discovered (or have been able to discover) to trigger the running of the statute of limitations. Are facts concerning a plaintiffs' reliance or loss causation among the facts that constitute "the violation"?
(3) For defense counsel who are concerned about the Court's rejection of the inquiry notice standard, there may be some cold comfort in the fact that the decision could have been even more aggressive. Justice Scalia's concurrence (joined by Justice Thomas) argues that under a proper reading of the statute the limitations period should only start upon the plaintiffs' "actual discovery" of the facts constituting the violation.
In In re Omnicom Group, Inc. Sec. Litig., 597 F.3d 501 (2d Cir. 2010), the company had announced in 2001 that it was placing certain investments into a separate holding company. There was no statistically significant movement in the company's stock price following the disclosure. In June 2002, however, there was a flurry of negative news reports about Omnicom and the transaction, leading to a stock price decline. In particular, a June 12 article reported on the resignation of the Chair of Omnicom's Audit Committee and noted concerns about the company's aggressive accounting strategy.
The lower court granted summary judgment for the defendants based on the plaintiffs' failure to proffer evidence sufficient to support a finding of loss causation. On appeal, the Second Circuit affirmed on two grounds. First, the June 2002 news reports were not a "corrective disclosure" of the fraud because they failed to provide the market with any new facts. Second, the resignation of the director (and the accompanying negative publicity) was not a "materialization of the risk" that was supposedly concealed by the fraudulent statements. A mere concern over the company's accounting practices cannot satisfy that standard.
Holding: Grant of summary judgment affirmed.
Quote of note: "The securities laws require disclosure that is adequate to allow investors to make judgments about a company's intrinsic value. Firms are not require by the securities laws to speculate about distant, ambiguous, and perhaps idiosyncratic reactions by the press or even by directors. To hold otherwise would expose companies and their shareholders to potentially expansive liabilities for events later alleged to be frauds, the facts of which were known to the investing public at the time but did not affect share price, and thus did no damage at that time to investors. A rule of liability leading to such losses would undermine the very investor confidence that the securities laws were intended to support."
Oral argument in the National Australia Bank case took place this morning. By all accounts, it does not appear that the U.S. Supreme Court is likely to embrace the broad extraterritorial application of the antifraud provisions of the federal securities laws.
Already facing a tough battle, the petitioners could not have been happy to learn that in the Court's audience were several justices of the Supreme Court of Canada. And whether it was out of deference to their foreign guests, or genuine concern about the policy ramifications of allowing foreign investors access to the U.S. courts, the Court's questioning was hostile from the start.
A few highlights (based on the official transcript):
(1) The Court appeared uninterested in the petitioners' suggestion that it might be appropriate to remand the case to the Second Circuit without rendering a decision. Justice Scalia's verdict: "There is no reason to send it back."
(2) Justice Ginsburg started out the substantive questioning with what would turn out to be the quote of the day - "[T]his case is Australian plaintiff, Australian defendant, shares purchased in Australia. It has 'Australia' written all over it." The justices pressed this theme repeatedly, with questions about the existence of a United States interest, potential interference with the regulation of foreign securities markets, and the connection between the fraud and the United States.
(3) As for the respondents and the government (which received 10 minutes of argument time), the justices appeared interested in exploring the utility of a bright-line test - i.e., barring any claims based on transactions involving shares of foreign issuers purchased or sold on foreign exchanges. Counsel for the respondents was asked about the effect on Americans who purchased stock on foreign exchanges (J. Stevens) and given a hypothetical wherein the fraudulent conduct took place in the United States and the stock purchase took place overseas (J. Breyer). The government, which advocated a test focusing on whether "significant conduct material to the fraud's success occured in the United States," was asked about whether its test was simply too complicated to be workable (C.J. Roberts).
For coverage of the hearing, see SCOTUSblog, the New York Law Journal, and the Associated Press.
As the U.S. Supreme Court gets ready to hear oral arguments in the National Australia Bank case today, here is all the information necessary to set the stage.
The briefs can be found here. The 10b-5 Daily has previously summarized the arguments made by the petitioners (investors) and respondents (corporate defendants). A couple of additional notes:
(1) There has been late supplemental briefing on the issue of whether the Supreme Court should remand the case back to the Second Circuit. According to the petitioners, all of the parties agree that the Second Circuit should not have decided the case on the basis of subject matter jurisdiction. The Second Circuit therefore should have the opportunity to reconsider its decision based on recent relevant Supreme Court decisions. The respondents disagree, arguing that the "jurisdictional label used by the court of appeals made no difference to the outcome of this case" and the real question before the Court is the substantive extraterritoriality issue.
(2) If amicus filings are a contest, the win goes to the respondents. There are three amicus briefs filed in support of the petitioners and fourteen amicus briefs filed in support of the respondents (including three separate briefs from the governments of France, Australia, and the United Kingdom).
For pre-argument coverage, see The Times (London), National Law Journal, and (most comprehensively) SCOTUSblog.
Supreme Court Justice Sandra Day O'Connor may be retired, but she is not done creating securities law. Last year, she sat with the Fifth Circuit by designation and wrote an opinion on loss causation. In February, it was the Sixth Circuit and her opinion concerns the scope of the Securities Litigation Uniform Standards Act ("SLUSA"), which precludes certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities.
In Demings v. Nationwide Life Ins. Co., 2010 WL 364335 (6th Cir. Feb. 3, 2010), the Sheriff of Orange County Florida brought a class action on behalf of all public employers who sponsor § 457 deferred-compensation plans alleging that Nationwide implemented a scheme under which it improperly received revenue-sharing payments from mutual funds and mutual fund advisors that should have gone to the plan participants. The district court found that the case was precluded by SLUSA because the substance of the sheriff's claim was a covered class action alleging that "Nationwide misrepresented a relationship with mutual fund advisors, or, at a minimum, failed to disclose material facts about the relationship."
On appeal, the sheriff argued that his suit was subject to SLUSA's "state actions" exception, which exempts certain suits brought by states, political subdivisions thereof, and state pensions plans from SLUSA's preclusive effect. By its plain terms, however, the state actions exception only applies to a covered entity that brings an action "on its own behalf." Although the sheriff might be a "political subdivision," his complaint sought to bring an action on behalf of the deferred-compensation plan. In the absence of any allegation that the sheriff had the authority to bring an action as the plan, the district court was entitled not to consider that possibility. Moreover, the "state actions" exception requires the members of the proposed class to be "named plaintiffs . . . that have authorized participation, in such action." The sheriff was attempting to bring a class action on behalf of a prospective class of unnamed sponsors of deferred-compensation plans.
Holding: Affirmed dismissal based on SLUSA preclusion.
The respondents have filed their brief in the National Australia Bank case pending before the U.S. Supreme Court. The case concerns the extraterritorial application of the antifraud provisions of the federal securities laws. Links to all of the briefs filed to date, including the extensive amicus submissions, can be found here.
The respondents argue that the Exchange Act does not contain any language "that clearly expresses an affirmative intention of Congress to apply the statute extraterritorially." In the absence of this language, there is a presumption against extraterritoriality that the Court should apply.
Moreover, acts of Congress should be interpreted to be in conformity with international choice-of-law provisions absent any contrary statement. Based on the law of nations in 1934 (when the Exchange Act was enacted), "Congress must be presumed to have intended that transactions on foreign exchanges must be governed by foreign law." The extraterritorial application of Section 10(b) to foreign transactions also would improperly supplant the substantive laws and remedies that already exist in foreign countries.
Finally, the Court has previously held that because the private right of action under Section 10(b) is judicially created it should be subject to practical limitations. The threat to the sovereign authority of other nations posed by the extraterritorial application of the statute is significant and warrants the limitation of Section 10(b) actions to persons who purchased or sold securities in the United States.
For a summary of the petitioners' arguments, see this earlier post.
One of the very first posts on this blog, way back in May 2003, was about the Halliburton securities class action settlement. Who knew what was to come? The judge recused himself, the settlement was eventually rejected, the lead plaintiff switched counsel, and the court declined to certify a class.
Now, nearly eight years after the case was originally filed, the U.S. Court of Appeals for the Fifth Circuit has issued an opinion affirming the denial of class certification. In The Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 2010 WL 481407 (5th Cir. Feb. 12, 2010), the court considered whether the plaintiffs had adequately demonstrated the existence of loss causation. Based on Fifth Circuit precedent, the plaintiffs were required to show "(1) that an alleged corrective disclosure causing the decrease in price is related to the false, non-confirmatory positive statement made earlier, and (2) that it is more probable than not that it was this related corrective disclosure, and not any other unrelated negative statement, that caused the stock price decline."
The court found that the plaintiffs had failed to meet this standard based on the corrective disclosures they identified. The corrective disclosures either failed to indicate that any prior statements were misleading or the plaintiffs' expert was unable to adequately demonstrate that a particular corrective disclosure, as opposed to other negative news about the company, more probably affected the stock price.
Holding: Denial of class certification affirmed.
Quote of note: "Plaintiff asks us to draw an inference that the June 28, 2001 press release corrected prior allegedly false estimates of asbestos reserves merely because those reserves changed. But a company is allowed to be proven wrong in its estimates, and we can discern no indication from the June 28, 2001 press release that Halliburton's prior asbestos reserve estimates were misleading or deceptive."
Courts can be skeptical about statements from confidential witnesses. One way to express that skepticism is to wonder why, if the witness knows so much about what went on at the company, he or she is unable to provide details about the alleged fraud.
In Konkol v. Diebold, Inc., 2009 WL 4909110 (6th Cir. Dec. 22, 2009), the defendants allegedly had access to internal financial reports demonstrating the falsity of their public statements. These reports included, as described by confidential witnesses who worked at the company, days sales outstanding reports and revenue scorecards.
In evaluating whether the confidential witness allegations contributed to a strong inference of scienter, the court reiterated its previous holding that statements from confidential witnesses should be “discounted,” especially when there is a lack of information about the witnesses in the complaint. Moreover, the court noted that “because the investors had confidential witnesses who provided generalized statements about the reports, one would reasonably expect those witnesses to be able to provide more details about the reports and to be able to specifically connect them to the Defendants.” In the absence of this specific information, the court declined to credit statements from the confidential witnesses about the fraudulent scheme being “openly known” or taking place at a “high level” within the company.
Holding: Dismissal affirmed.
A couple of items related to the National Australia Bank case. The case is pending before the U.S. Supreme Court and concerns the extraterritorial application of the antifraud provisions of the federal securities laws. Oral argument has been scheduled for March 29, 2010.
(1) The petitioners have filed their merits brief. In their brief, the petitioners argue that the "express terms" of Section 10 of the Exchange Act create subject matter jurisdiction for securities frauds involving the "use of any means or instrumentality of interstate commerce or of the mails" and there is no extraterritorial limitation. Moreover, any issues of foreign relations law or international comity can be addressed by the adoption of the "conduct" test suggested by the SEC and Solicitor General: “the scheme involves significant conduct within the United States that is material to the fraud’s success.”
(2) The National Law Journal has a column (subscrip. req'd) noting that the Supreme Court and Congress are on a "collision course" regarding the question of extraterritorial application. While the Court considers the National Australia Bank case, the House of Representatives has just passed the "Wall Street Reform and Consumer Protection Act" containing a provision similar to the conduct test urged by the petitioners (but arguably even broader because it does not contain the "materiality" requirement). Under Section 7216 of H.R. 4173 - an earlier version of the provision was discussed here - jurisdiction exists if there is "conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors." Whether the Senate will embrace this provision remains to be seen.
(1) Given that the PSLRA has been in effect since 1995, federal courts of appeals have been spending a surprising amount of time lately addressing writs of mandamus on how to interpret the statute's lead plaintiff provisions. Just last month, a Ninth Circuit panel held that a district court cannot reject the lead plaintiff's proposed lead counsel and substitute lead counsel of the court's own choosing. In In re Bard Associates, Inc., 2009 WL 4350780, (10th Cir. Dec. 2, 2009), the Tenth Circuit was asked to consider whether an investment advisor who applied to act as lead plaintiff, but did not obtain assignments of its clients' claims until after its motion was filed, made a valid application. The panel found that the district court did not abuse its discretion when it rejected the investment advisor's application on the grounds that the investment advisor had failed to establish its standing to sue as of the lead plaintiff application deadline.
(2) Settling a securities class action for $40 million is not that unusual. Settling a securities class action for $40 million after obtaining the dismissal of the case (and before any appellate ruling) is quite unusual. The D&O Diary and The American Lawyer have full coverage of Dell's interesting settlement announced last week. It certainly seems hard to argue with lead counsel's conclusion that it was "a very, very good result for the class . . . [p]articularly given the procedural posture of the case."
When it comes to securities litigation, all of today's action was in the U.S. Supreme Court.
First, the Court granted cert in the National Australia Bank case (over the objections of the DOJ and SEC) and will review the extraterritorial application of the U.S. securities laws. Bloomberg and Securities Docket have coverage of the decision. Interestingly, Justice Sotomayor recused herself from considering the cert petition.
Second, the Court heard arguments in the Merck case on when the running of the statute of limitations is triggered in securities fraud cases. According to press reports (which the oral argument transcript would appear to confirm), the justices seemed disinclined to overturn the Third Circuit's ruling and find that the plaintiffs' claims are barred by the statute of limitations. Exactly what the Court will hold is sufficient to begin the two-year "discovery" period, however, remains to be seen. The briefs filed in the case can be found here.
When the U.S. Supreme Court asked for the government's view on the National Australia Bank cert petition, it seemed a safe bet that the government would encourage the Court to take the case. After all, the SEC had filed an unsuccessful amicus brief in the Second Circuit in favor of the plaintiffs. Here was an opportunity to get a second bite at the apple.
Earlier this week, however, the Solicitor General and SEC filed a joint amicus brief arguing that the Supreme Court should deny cert. The government now asserts that the Second Circuit's decision was correct, even if its reasoning was wrong.
First, the government argues that the Second Circuit, along with all of the other circuits that have addressed the issue of the "transnational reach of Section 10(b)," have incorrectly described it as one of subject matter jurisdiction. In fact, the relevant jurisdictional provision has no geographical limitation. The need for a connection to the United States is better understood as being related to the elements of the claim. For a private plaintiff (but not the SEC), this includes the requirement that the plaintiff establish a connection between the defendant's violation and the alleged injury.
Second, the government takes issue with the Second Circuit's examination of where the "heart of the alleged fraud" took place. To the extent this analysis suggested that the conduct of National Australia Bank's U.S. subsidiary did not violate Section 10(b) - because it was not the "heart" of the fraud - the holding was "erroneous." Alternatively, the government proposes the following standard: "it is sufficient if the scheme involves significant conduct within the United States that is material to the fraud's success." The U.S. subsidiary's creation of false information that was incorporated into National Australia Bank's financial statements was sufficient to establish a violation of Section 10(b) and the SEC could have brought an action based on these facts.
For a foreign private plaintiff, however, an additional assessment must be made. According to the government, "the plaintiff should be required to prove that his loss resulted not simply from the fraudulent scheme as a whole, but directly from the component of the scheme that occurred in the United States." As to this assessment, the Second Circuit apparently got it right, concluding that causation was too attenuated given all of the activity that took place in Australia prior to the issuance of the false financial statements.
Finally, the government concedes that there is a circuit split over the "conduct" test, with the D.C. Circuit having adopted the most restrictive version. The D.C. Circuit requires that a defendant's "domestic conduct comprise all the elements . . . necessary to establish a violation of Section 10(b)." Nevertheless, the government argues that National Australia Bank "would not be a suitable vehicle for resolving that division" because the plaintiffs could not prevail under any of the existing conduct tests.
Whatever one makes of the government's arguments, it's overall position on granting cert is puzzling. Appellate court misunderstood fundamental legal question? Check. Appellate court applied wrong legal standard? Check. Appellate court decision caused or confirmed existence of circuit split? Check. The U.S. Supreme Court should resolve these important issues? Pass. Stay tuned for the Court's decision.
Quote of note: "[O]ther nations might perceive affording a private remedy to foreign plaintiffs as circumventing the causes of action and remedies (and the limitations thereon) that those nations provide their own defrauded citizens, particularly if the plaintiff’s principal grievance appears directed at another foreign entity. Absent indications of a contrary congressional intent, the judicially-created private right of action under Section 10(b) should be tailored so as to minimize the likelihood of such international friction."
The U.S. Court of Appeals for the Sixth Circuit issued an opinion this week in Indiana State District Council v. Omnicare, Inc., 2009 WL 3365189 (6th Cir. Oct. 21, 2009) that has a few interesting holdings.
(1) Loss causation - The court held that loss causation was inadequately plead as to certain alleged misstatements premised on non-compliance with GAAP. In the absence of any financial restatement and given the continued willingness of Omnicare's auditors to certify the company's GAAP compliance, the court concluded that "the complaint does not suggest that the alleged GAAP violations were ever recognized or revealed to the market."
(2) Confidential Witnesses - The court reaffirmed its willingness to "steeply discount" the statements of confidential witnesses. In the instant case, the plaintiffs provided no information about a key confidential witness "except the title of his position" and there was a disconnect between what the witness knew and the alleged subject matter of the fraud.
(3) Pleading Standard for Section 11 Claims - The court joined the vast majority of other circuits (with the notable exception of the 8th Circuit) in holding that Section 11 claims that "sound in fraud" must be plead with particularity.
Holding: Dismissal of fraud claims affirmed; Section 11 claim remanded for evaluation of whether it met applicable pleading standard.
Quote of note: "Seizing on a few vague statements from management, the plaintiffs try to turn bad corporate news into a securities class action. Because the Private Securities Litigation Reform Act (“PSLRA”) forbids such alchemy, we generally affirm the district court's dismissal, although we reverse its disposition regarding the claims brought under the Securities Act of 1933."
There have been two recent appellate decisions discussing the scope of the Securities Litigation Uniform Standards Act of 1998 ("SLUSA"), which pre-empts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. The decisions address to what extent the statute requires the dismissal of "claims" as opposed to "actions."
In Proctor v. Vishay Intertechnology Inc., 2009 WL 3260535 (9th Cir. Oct. 9, 2009) the court found that SLUSA only precluded one of the plaintiff's three claims. As to the other two claims, the court (largely following a Third Circuit decision from earlier this year) held that they should not be dismissed but, instead, should be remanded to state court for further proceedings.
But what if the plaintiff does not carefully segregate the claims that may be precluded by SLUSA? In Segal v. Fifth Third Bank, 2009 WL 2958438 (6th Cir. Sept. 17, 2009), the complaint expressly disclaimed that any of its state-law claims were based upon alleged misrepresentations, but the court found that this was just "artful pleading" given the complaint's overall contents. As to the plaintiff's argument that his state-law claims did not "depend upon" any misrepresentations, the court held that even if the misrepresentations were "extraneous" there was no requirement that a misrepresentation be an element of a claim for the claim to be precluded by SLUSA. The court had "no license to draw a line between SLUSA-covered claims that must be dismissed and SLUSA-covered claims that must not be" and dismissed the entire action.
Although it has not received much publicity (perhaps due to the fact that it does not appear on the agency's website), last month the Securities and Exchange Commission filed an amicus brief in the U.S. Court of Appeals for the Second Circuit on the issue of primary vs. aiding-and-abetting liability. The case is the Refco securities class action and the SEC takes dead aim at the Second Circuit's "bright line" test.
Under the "bright line" test, primary liability only exists if the misstatement is attributable on its face to the defendant. In other words, the defendant must have been identified to investors as the maker of the statement. The SEC argues in its amicus brief that public attribution is unnecessary. Instead, a court should be able to find primary liability when the defendant "creates" the statement, even if investors are unaware of the defendant's involvement.
Given the long history of the "bright line" test in the Second Circuit, combined with the Supreme Court's recent emphasis in Stoneridge on the need to establish that investors relied on the defendant's actions, the SEC's legal arguments may not carry the day. The SEC seems prepared for this possibility, arguing that even if the Second Circuit keeps the "bright line" test, it should not be applied to government actions (where a showing of reliance is not required).
Quote of Note: "In the Commission's view, a person makes a false or misleading statement and thus can be liable as a primary violator of Rule 10b-5 when that person creates the statement. A person creates a statement in this context if the statement is written or spoken by him, or if he provides the false or misleading information that another person then puts into the statement, or if he allows the statement to be attributed to him."
Thanks to Securities Docket for the link to the SEC's amicus brief.
The U.S. Court of Appeals for the Eighth Circuit does not issue many securities litigation decisions, but it apparently has decided to resolve the few cases it has all at once. For the second time in a week (see here), the court has affirmed the dismissal of a securities class action, although this opinion comes with an interesting twist.
In Horizon Asset Management Inc. v. H&R Block, Inc., 2009 WL 2870505 (8th Cir. Sept. 9, 2009) the court considered whether the plaintiffs had adequately plead a strong inference of scienter (i.e., fraudulent intent) in a case alleging financial misstatements. The opinion contains a few holdings of note:
Internal Investigation - The plaintiffs alleged that the slow pace of the internal investigation once the accounting errors where discovered strengthened the inference of scienter. The court disagreed, finding that it was "prudent" for the company to closely investigate the issue and consult with its independent auditors. Moreover, while the investigation was ongoing, the company publicly disclosed its corporate accounting control weaknesses.
Confidential Witness - The court discounted a statement by a confidential witness that he had been told that senior management was aware of the need for further financial restatements. First, the witness did not state whether his sources had actually spoken with senior management, including the individual defendants, or "merely conveyed hearsay information that was passed along by others." Second, the reliability of the confidential witness was called into question by another, clearly erroneous statement he had made concerning one of the individual defendants.
Corporate Scienter - The plaintiffs argued that even if their complaint did not raise a strong inference of scienter as to the individual officer defendants, the case should still proceed against the company based on the alleged scienter of another one of the company's officers. The court declined to address whether this imputation was proper because the plaintiffs failed, in any event, to establish a strong inference of scienter as to the officer in question.
The Eighth Circuit affirmed the dismissal of the complaint, but also addressed an unusual procedural issue. The district court had consolidated the various securities class actions and derivative cases brought against H&R Block into one case. It then named a lead plaintiff who declined to assert any derivative fiduciary claims in its consolidated complaint. When the derivative plaintiffs asked for reconsideration of the lead plaintiff decision, the district court denied the motion, finding that the proposed claims were "not really derivative claims."
On appeal, the court found that while it was "debatable" whether it was appropriate to have a single plaintiff bring both direct and derivative claims, it was erroneous for the district court to have named a single lead plaintiff who would not pursue the derivative claims the court had previously consolidated. Accordingly, the court reinstated the separate derivative complaints.
Holding: Dismissal of securities class action affirmed. Derivative complaints reinstated.
In the early days of the Private Securities Litigation Reform Act and its new heightened pleading standards, courts regularly dismissed complaints that engaged in "puzzle pleading" (i.e., failed to specify the exact corporate statements that were false and the basis for their alleged falsity). Although plaintiffs quickly learned to be more careful, puzzle pleadings are still sometimes filed and the consequences can be severe.
In In re 2007 Novastar Financial, Inc. Sec. Litig., 2009 WL 2747281 (8th Cir. Sept. 1, 2009), the court considered a complaint against a subprime lender that "over the course of thirty-six pages . . . reproduced, either in their entirety or lengthy excerpts from, nineteen communications-including press releases, SEC filings, and conference call transcripts-issued by Novastar and the individual defendants during the class period that were allegedly false or misleading." What the complaint did not do, however, is give "any indication as to what specific statements within these communications are alleged to be false or misleading."
Although the lead plaintiff identified some specific false statements in his appellate brief, the court found that this did not "excuse" the "failure to comply with the pleading requirements under the PSLRA." The court also agreed with the district court's decision to deny leave to amend, noting that the lead plaintiff "never submitted a proposed amended complaint to the district court, nor did he proffer the substance of such an amended complaint until he filed his appellate brief."
Holding: Dismissal affirmed.
Quote of Note: "[E]ven after the district court dismissed [the lead plaintiff's] complaint and denied his request to amend the complaint, [the lead plaintiff] failed to file a motion under Federal Rules of Civil Procedure 15(a)(2), 59(e), or 60(b), seeking leave to file an amended complaint. As we have noted before, 'the district court [i]s not required to engage in a guessing game' as a result of the plaintiff's failure to specify proposed new allegations."
Time to catch up on a decision from a couple of weeks ago that might add some incentive for the Supreme Court to take up the issue of foreign-cubed cases. In In re CP Ships Ltd. Sec. Litig., 2009 WL 2462367 (11th Cir. Aug. 13, 2009), a class member objected to the proposed settlement because it covered certain foreign investors, some of whom might be prevented from participating in a related Canadian securities class action brought against the company. CP Ships is a Canadian company whose shares are traded on both the NYSE and Toronto Stock Exchange.
The court found, in contrast to the Second Circuit's decision in the National Australia Bank case, that the "conduct test" for subject matter jurisdiction was satisfied. Although the false financial statements were issued abroad as in the Second Circuit case, "not only did the manipulation and falsification of the numbers occur in Florida, the executives with responsibility for ensuring the accuracy of the accounting data operated from Florida."
Holding: District court properly exercised subject matter jurisdiction over the claims of foreign purchasers.
While it may be relatively easy to plead loss causation in the Fifth Circuit, things become a lot more difficult for plaintiffs when it comes time to offer proof. This week, in Fener v. Belo Corp., 2009 WL 2450674 (5th Cir. Aug. 12, 2009), the court considered a case where the corrective disclosure made by the company attributed a decline in newspaper circulation to three separate sources. Only one of the sources, however, was related to the alleged fraudulent conduct.
On appeal from the lower court's denial of class certification, the Fifth Circuit found that the plaintiff's expert report was inadequate. Notably, the plaintiff's expert failed to distinguish between the three different disclosures in conducting his event study, thereby making it impossible to conclude that the alleged fraud caused a significant amount of the post-disclosure stock price decline.
Holding: Denial of class certification affirmed.
Quote of note: "As the district court correctly held, [plaintiff's expert] testimony was fatally flawed; he wedded himself to the idea that the press release was only one piece of news and conducted his event study based on that belief. We reject any event study that shows only how a 'stock reacted to the entire bundle of negative information,' rather than examining the 'evidence linking the culpable disclosure to the stock-price movement.' Because [plaintiffs' expert] based his study on that incorrect assumption, it cannot be used to support a finding of loss causation."
There have been two recent appellate decisions of note.
(1) In In re HealthSouth Corp. Sec. Litig., 2009 WL 1675398 (11th Cir. June 17, 2009), the court addressed the scope of the judicial bar order contained in the partial settlement between HealthSouth and the plaintiffs. The court found that the contractural claims by HealthSouth's former CEO (a non-settling defendant) against the company for (a) indemnification of any amounts he might pay in settlement of his liability to the plaintiffs, and (b) advancement of fees in connection with the litigation, were properly extinguished. (The D&O Diary has a post on the decision that questions the court's policy rationale for barring the advancement of fees claim.)
Holding: Affirmed.
(2) In Alaska Electrical Pension Fund v. Flowserve Corp., 2009 WL 1740648 (5th Cir. June 19, 2009), the court considered what type of corrective disclosure was necessary to establish loss causation. The defendants argued that "a 'fact-for-fact' disclosure of information that fully corrected prior misstatements" was necessary, while the plaintiffs asserted that it was sufficient to point to disclosures that revealed the "true financial condition" of the company. In a per curiam opinion by a panel that included retired Supreme Court Justice O'Connor, however, the court found that "the true standard lies in the middle." To establish loss causation the "disclosed information must reflect part of the 'relevant truth' - the truth obscured by the fraudulent statements," but the information can leak out over time and a "fact-for-fact" disclosure is not required.
Holding: Reversed and remanded for further proceedings consistent with opinion.
After the U.S. Supreme Court gets done with the statute of limitations, will it turn to the issue of foreign-cubed cases? Bloomberg reports that the Court has asked the Solicitor General to present its views on the National Australia Bank cert petition. At issue in the case is whether a U.S. court should exercise jurisdiction over an action brought against a foreign issuer on behalf of a class of foreign investors who purchased their securities on a foreign exchange (otherwise known as a "foreign-cubed" case).
The 10b-5 Daily's discussion of the lower court decision can be found here. Thanks to John Letteri for the link to the Bloomberg article.
The U.S. Supreme Court is going to address when the running of the statute of limitations is triggered in securities fraud cases, but not in the case many observers expected.
Last year, the Court asked the Solicitor General to weigh in on the cert petition filed in the Trainer Wortham (9th Cir.) case. When the Solicitor General finally did so this spring, however, it suggested that the Merck (3rd Cir.) case would be a clearer test of the statute of limitations issue. The Court apparently agreed and granted cert in the case yesterday.
The official question presented in Merck is:
The Court will hear the case in the term starting October 5, 2009. A summary of the Third Circuit's decision can be found here.
When a district court within the Fourth Circuit dismisses a securities class action, it usually stays dismissed. But past performance is no guarantee of future results. In In re Mutual Funds Investment Litig. 2009 WL 1241574 (4th Cir. May 7, 2009), the U.S. Court of Appeals for the Fourth Circuit has reversed the dismissal of a market timing case brought against Janus Capital Group. Moreover, the decision contains some significant legal holdings.
(1) Pleading of Loss Causation - While the Fifth Circuit recently held that loss causation is only subject to notice pleading, the Fourth Circuit is standing tough. The court reaffirmed that, pursuant to Fed. R. Civ. P. 9(b), loss causation must be plead with particularity.
(2) Making of a Misrepresentation - To satisfy the fraud-on-the-market theory, the defendant must have made "a misrepresentation that is public and attributable to the defendant." There is an ongoing circuit split over how to evaluate whether a statement can be attributed to a particular defendant. Some courts (e.g., the Second and Eleventh Circuits) have adopted a "bright line" rule requiring that the misstatement must be attributable on its face to the defendant. Other courts (e.g., the Ninth Circuit) have concluded that substantial participation in the making of the misstatement is sufficient.
The Fourth Circuit declined to fully adopt either approach, instead offering this compromise: it is sufficient for a plaintiff to "alleg[e] facts from which a court could plausibly infer that interested investors would have known that the defendant was responsible for the statement at the time is was made, even if the statement on its face is not directly attributable to the defendant." Applying its new standard to the instant case, the court found that Janus Funds investors would have attributed to Janus Capital Management, the investment advisor to the funds, "a role in the preparation or approval of the allegedly misleading prospectuses. " Janus Funds investors would have been unlikely to come to the same conclusion about Janus Capital Group, however, which was the parent company of the investment advisor.
(3) Scheme Liability - The court found that it did not have to separately evaluate the possible existence of scheme liability. Under Stoneridge, "the existence of a fraudulent scheme does not permit a plaintiff to avoid proving any of the traditional elements of primary liability, such a scienter and reliance." Since the court had already evaluated these elements in connection with the misrepresentation claims, it did not have to go any further.
Holding: Reversed and remanded.
In Institutional Investors Group v. Ayaya, Inc., 2009 WL 1151943 (3rd Cir. April 30, 2009), the U.S. Court of Appeals for Third Circuit has issued a comprehensive opinion that addresses a number of important pleading topics.
(1) Safe Harbor for Forward-Looking Statements - Whether the first prong of the PSLRA's safe harbor, which states that a defendant shall not be liable with respect to any forward-looking statement if it is accompanied by "meaningful cautionary statements," insulates the defendant from liability for false statements made with actual knowledge of their falsity is an open issue (see this post). The Third Circuit found that Avaya's cautionary language was "extensive and specific." In particular, the company had warned against the adverse effects of "price and product competition," which was exactly what the plaintiffs asserted "was responsible for Avaya's missing its projections." The court declined, however, to decide whether the cautionary language on its own was sufficient to avoid liability, instead finding that the plaintiffs had, in any event, failed to adequately plead actual knowledge of the projections' falsity.
(2) Confidential Witnesses - The Third Circuit considered whether, as some courts have held, the Tellabs decision requires a court to discount allegations attributed to confidential witnesses. The court found that its earlier decision on the issue remained good law. To wit, confidential witness allegations must be evaluated by examining "the detail provided by the confidential sources, the sources' basis of knowledge, the reliability of the sources, the corrobative nature of other facts alleged, including from other sources, the coherence and plausibility of the allegations, and similar indicia." The statements should only be "discounted" if they are "found wanting with respect to these criteria."
(3) Holistic Approach to Scienter Allegations - As predicted by The 10b-5 Daily following the Tellabs decision (see note 3 in this post), the Third Circuit found that it can no longer allow plaintiffs to plead scienter by either alleging facts establishing motive and opportunity or by alleging facts that constitute evidence of reckless or conscious behavior. Instead, all of the plaintiffs' scienter allegations must be considered collectively. (Along the same lines, the court rejected the Ninth Circuit's recent embrace of a dual inquiry in which scienter allegations are evaluated individually and then, if insufficient on their own, collectively.)
Holding: Reversed in part, affirmed in part, and remanded.
Quote of note: "Our conclusion that 'motive and opportunity' may no longer serve as an independent route to scienter follows also from Tellabs's general instruction to weigh culpable and nonculpable inferences. Individuals not infrequently have both strong motive and ample opportunity to commit bad acts-and yet they often forbear, whether from fear of sanction, the dictates of conscience, or some other influence. It cannot be said that, in every conceivable situation in which an individual makes a false or misleading statement and has a strong motive and opportunity to do so, the nonculpable explanations will necessarily not be more compelling than the culpable ones. And if that is true, then allegations of motive and opportunity are not entitled to a special, independent status."
The U.S. Court of Appeals for the Fifth Circuit has offered some guidance on how to analyze allegations of loss causation. In Lormand v. US Unwired, Inc., 2009 WL 941505 (5th Cir. April 9, 2009), the plaintiffs alleged that the truth about the fraud "leaked" to the market in a series of partial disclosures and led to stock price declines.
The Fifth Circuit made two holdings of note.
(1) In contrast to some other courts (including a recent Ninth Circuit decision), the court found that under Supreme Court precedent loss causation is only subject to a notice pleading requirement. In the court's lengthy formulation, a plaintiff must allege either a "facially 'plausible' causal relationship between the fraudulent statements or omissions and plaintiff's economic loss, including allegations of a material misrepresentation or omission, followed by the leaking out of relevant or related truth about the fraud that caused a significant part of the depreciations of the stock and plaintiff's loss" (citing Dura) or "enough facts to give rise to a reasonable hope or expectation that discovery will reveal evidence of the foregoing elements of loss causation" (citing Twombley).
(2) The disclosures that constitute the leaking out of the truth about the fraud may come from third parties.
Applying these legal standards, the Fifth Circuit held the plaintiffs had alleged, at least as to some of their claims, both a "plausible nexus" between the fraud and the cited disclosures and enough factual allegations to raise a reasonable expectation that discovery would reveal evidence of loss causation.
Holding: Affirmed in part, reversed in part, and remanded.
A visit to the U.S. Supreme Court does not necessarily mean the end of a securities class action, even if the defendants win their legal argument. The defendants in the Tellabs case successfully overturned the Seventh Circuit's interpretation of the "strong inference" pleading standard for scienter (i.e., fraudulent intent). On remand, however, the Seventh Circuit found that the plaintiffs had adequately plead scienter even under the Supreme Court's more rigorous interpretation and sent the case back to the district court for further proceedings.
A mere eight years after the case was filed, the issue of class certification has been decided. In Makor Issues & Rights, Ltd. v. Tellabs, Inc., 2009 WL 448895 (N.D. Ill. Feb. 23, 2009), the court rejected the defendants' attempts to limit the class period and class members. Among other rulings, the court found that in-and-out traders, members of the class in a related ERISA class action, and Tellabs employees should not be excluded from the class. However, the court did exclude one of the proposed representative plaintiffs because, under a last-in, first-out ("LIFO") analysis of his stock trading, his gains during the class period outweighed any losses.
Holding: Class certification granted.
In In re Williams Sec. Litig. - WCG Subclass, 2009 WL 388048 (10th Cir. Feb. 18, 2009), the court considered whether the plaintiffs' expert was able to "reliably link the class's losses to the revelation of the alleged misrepresentations." In examining the validity of the expert's methodology, the court also provided its views on the application of the Supreme Court's Dura decision on loss causation.
(1) Although loss causation "is easiest to show when a corrective disclosure reveals the fraud to the public and the price subsequently drops," a "leakage theory that posits a gradual exposure of the fraud rather than a full and immediate disclosure" is permissible under the Dura decision.
(2) To be a corrective disclosure, "the disclosure need not precisely mirror the earlier representation, but it must at least relate back to the misrepresentation and not to some other negative information about the company."
(3) The plaintiffs must be able to demonstrate that the stock price decline was due "to the revelation of the fraud and not to another significant piece of negative information that was released" at the same time.
As to the plaintiffs' expert, the court found that his "leakage theory" failed to adequately identify when the "materialization of the concealed risk" occurred. The expert's alternative theory - that there was a series of corrective disclosures at the end of the class period - was inadequate because he failed to show "that it was the revelation of the fraud, and not other factors, that caused the subsequent declines in price."
Holding: Affirmed district court's exclusion of expert testimony and grant of summary judgment in favor of defendants.
Addition: Note that the plaintiffs did not appeal the district court's rejection of the "constant percentage" method of calculating damages (see here for a discussion of that holding).
Addition: A summary of the case by the defendants' expert can be found here.
There is now an official circuit split over the issue of whether a '33 Act securities class action that is not removable to federal court under the Securities Litigation Uniform Standards Act of 1998 ("SLUSA") is nevertheless subject to the removal provisions of the Class Action Fairness Act of 2005 ("CAFA") (see this post for more background). In Katz v. Gerardi, 2009 WL 18137 (7th Cir. Jan. 5, 2009), the court held, in contrast to the Ninth Circuit, that the '33 Act's general grant of state court jurisdiction is modified by CAFA, which clearly provides for the removal of certain securities class actions not otherwise covered by SLUSA.
Holding: Judgment of district court vacated and remanded for further proceedings.
The U.S. Court of Appeals for the Third Circuit has issued two interesting decisions.
(1) The Securities Litigation Uniform Standards Act of 1998 ("SLUSA") pre-empts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. In In re Lord Abbett Mutual Funds Fee Litig., 2009 WL 117002 (3rd Cir. Jan. 20, 2009), the court considered whether Congress intended SLUSA to pre-empt the entire case or just the offending state-law claim(s). The court found that that nothing in the language or legislative history of SLUSA "mandate[s] dismissal of an action in its entirety where the action includes only some pre-empted claims." Moreover, interpreting SLUSA in this manner would have little practical effect: "plaintiffs could simply bring two or more actions in order to avoid having all of their claims dismissed - one action with the potentially pre-empted state law claims and one or more with the remaining claims."
(2) In Alaska Electrical Pension Fund v. Pharmacia Corp., 2009 WL 213095 (3rd Cir. Jan. 30, 2009), the court had an opportunity to apply its Merck decision on inquiry notice and the statute of limitations. The court found that "investors are not put on inquiry notice of fraud when, in the context of this case, an apparently legitimate scientific dispute arises between the FDA and a pharmaceutical company." Instead, to find the existence of inquiry notice the court required "some reason to suspect that defendants did not genuinely believe the accuracy of their statements."
JP Morgan Chase was willing to settle with Enron's investors over its alleged complicity in the energy company's financial scandal, but not with its own investors. That turned out to be a prudent decision when the U.S. Court of Appeals for the Second Circuit affirmed the dismissal of the JP Morgan Chase investors' securities class action last week.
In ECA v. JP Morgan Chase Co., 2009 WL 129911 (2d Cir. Jan. 21, 2009), the court found that the plaintiffs' scienter allegations suffered "from a basic problem concerning plausibility." The plaintiffs argued that JP Morgan "concealed its transactions with Enron in return for excessive fees." The court held, however, that it was "implausible to have both an intent to earn excessive fees for the corporation and also an intent to defraud Plaintiffs by losing vast sums of money [through loans to Enron that JP Morgan could not recover]."
Holding: Dismissal affirmed (on both scienter and materiality grounds).
Addition: The court considered whether Chase was motivated to artificially inflate its stock price via the Enron fraud so that it could use the stock as currency for its acquisition of JP Morgan. Whether this type of motive allegation can contribute to a strong inference of scienter has been an unsettled question. The court found that "a generalized desire to achieve a lucrative acquisition proposal" is common to all companies seeking to make an acquisition and fails "to establish the requisite scienter."
The U.S. Court of Appeals for the Ninth Circuit issued two decisions this week affirming dismissals based on a failure to adequately plead scienter (i.e., fraudulent intent). The decisions - Zucco Partners, LLC v. Digimarc Corp., 2009 WL 57081 (9th Cir. Jan. 12, 2009) and Rubke v. Capitol Bancorp LTD, 2009 WL 69278 (9th Cir. Jan. 13, 2009) - are notable because they appear to tweak the court's approach to evaluating scienter allegations.
The panels found that the U.S. Supreme Court's decision in Tellabs meant that they could no longer dismiss a complaint because the individual scienter allegations were insufficient. Instead, as the Zucco panel held, the court needed to "conduct a dual inquiry: first, we will determine whether any of the plaintiff's allegations, standing alone, are sufficient to create a strong inference of scienter; second, if no individual allegations are sufficient, we will conduct a 'holistic' review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or deliberate recklessness." The Rubke panel agreed with this two-step approach, finding that it was required to perform a "second holistic analysis to determine whether the complaint contains an inference of scienter that is greater than the sum of its parts."
Whether this dual inquiry, which appears to afford plaintiffs a second bite at the apple, will have any practical effect is difficult to say. Both panels held that scienter was inadequately plead in the respective complaints (even when evaluated holistically), with the Zucco panel noting that "a comprehensive perspective of Zucco's complaint cannot transform a series of inadequate allegations into a viable inference of scienter." To put it another way, can zero plus zero plus zero ever add up to something? Stay tuned.
Last month, the U.S. Court of Appeals for the Fourth Circuit issued its first post-Tellabs decision on the pleading of scienter (i.e., fraudulent intent). The court is back this month with another scienter decision, this time in a case against an accounting firm.
In Public Employees' Retirement Assoc. of Col. v. Deloitte & Touche LLP, 2009 WL 19134 (4th Cir. Jan. 5, 2009), the court considered the alleged role of two Deloitte entities in the Royal Ahold fraud. (The corporate defendants settled for $1.1 billion in 2005.) The court found that "to establish a strong inference of scienter," the plaintiffs needed to "demonstrate that the Deloittes were either knowingly complicit in the fraud, or so reckless in their duties as to be oblivious to malfeasance that was readily apparent." The plaintiffs, however, could not "escape the fact that Ahold . . . went to considerable lengths to conceal the frauds from the accountants and it was the defendants that ultimately uncovered the frauds." The "strong inference to be drawn from this fact" is that the Deloitte entities "lacked the requisite scienter."
Holding: Dismissal affirmed.
Quote of note: "It is not an accountant's fault if its client actively conspires with others in order to deprive the accountant of accurate information about the client's finances. It would be wrong and counter to the purposes of the PSLRA to find an accountant liable in such an instance."
The U.S. Court of Appeals for the Fourth Circuit has issued its first opinion applying the Tellabs decision on the pleading of scienter (i.e., fraudulent intent). Those who follow the Fourth Circuit's jurisprudence in this area will be unsurprised to learn that the decision creates good law for defendants.
In Cozzarelli v. Inspire Pharmaceuticals, Inc., 2008 WL 5194311 (4th Cir. Dec. 12, 2008), the plaintiffs alleged that Inspire made false statements regarding a drug trial. The court found that in defining the PSLRA's "strong inference" pleading standard for scienter, the Supreme Court "gave that standard teeth, using adjectives like 'cogent,' 'compelling,' 'persuasive,' 'effective,' and 'powerful.'" Moreover, an inference of scienter "can only be strong - and compelling, and powerful - when it is weighed against the opposing inferences that may be drawn from the facts in their entirety."
Based on the facts before it, the court found the inference that any allegedly omitted information about the drug trial was withheld "to protect [Inspire's] competitive advantage" more "powerful and compelling than the inference that defendants acted with an intent to deceive." Moreover, the plaintiffs' motive allegations based on the company's need to raise capital, the CEO's performance-based compensation, and a limited amount of stock sales were "conclusory" and "lack[ed] merit."
The court also joined a number of other circuit courts in holding (a) the signing of allegedly false SOX certifications does not contribute to an inference of scienter, and (b) Section 11 and 12(a)(2) claims that "sound in fraud" must be plead with particularity pursuant to Fed R. Civ. P. 9(b).
Holding: Dismissal affirmed.
Quote of note: "All investments carry risk, particularly in a field like biopharmaceuticals. If we inferred scienter from every bullish statement by a pharmaceutical company that was trying to raise funds, we would choke off the lifeblood of innovation in medicine by fueling frivolous litigation-exactly what Congress sought to avoid by enacting the PSLRA. Furthermore, the fact that some analysts relied on defendants' hopeful statements to speculate-as the analysts admitted they were doing-that Study 109 would succeed adds little to an inference of scienter. Speculation by investors and subsequent buyers' remorse cannot support an Exchange Act suit alone."
Disclosure: The author of The 10b-5 Daily has previously represented the defendants in this case.
What triggers the running of the statute of limitations for a securities fraud action is suddenly a hot topic, thanks to a possible Supreme Court case and a recent Second Circuit decision.
In Staehr v. Hartford Financial Services Group, Inc., 2008 WL 4899445 (2d Cir. Nov. 17, 2008), the court considered whether the plaintiffs had been put on inquiry notice of their claims based on the "cumulative effect" of news articles, public filings, and lawsuits referring to an industrywide fraudulent scheme. The court found that the news articles mostly did not mention Hartford and were in specialty publications, the company's public filings did not offer enough information about the subject of the fraud, and the lawsuits either did not mention Hartford or were not sufficiently publicized so as to be "reasonably accessible" to an ordinary investor. The New York Law Journal has a column (Dec. 10 edition - subscrip. req'd) on the decision.
Holding: Dismissal based on statute of limitations vacated.
Quote of note (decision): "Given the objective standard for inquiry notice, there is an inherent sliding scale in assessing whether inquiry notice was triggered by information in the public domain: the more widespread and prominent the public information disclosing the facts underlying the fraud, the more accessible this information is to plaintiffs, and the less company-specific the information must be."
The U.S. Court of Appeals for the Ninth Circuit has issued an opinion on pleading scienter that includes new law (sort of) on the issues of collective scienter, SOX certifications, and profit motive.
In Glazer Capital Management LP v. Magistri, 2008 WL 5003306 (9th Cir. Nov. 26, 2008) the Ninth Circuit considered a case based on alleged misstatements in a merger agreement attached to an SEC filing. The district court found that the complaint failed to adequately plead falsity or scienter. On appeal, the Ninth Circuit made the following rulings (among others) regarding scienter:
(1) Collective scienter - The decision appears to open the door for collective scienter arguments in the Ninth Circuit, but it is far from clear on this point. The collective scienter theory holds that it is possible to raise the required inference of scienter about a corporate defendant without doing so with regard to a specific individual defendant. Although there is a published (and an additional unpublished) Ninth Circuit decision that appear to reject the collective scienter theory, in Glazer the panel found that the earlier published decision had "not foreclose[d] the possibility that, in certain circumstances, some form of collective scienter might be appropriate." In the instant case, however, the alleged misstatements were not susceptible to the theory because they were broad legal warranties contained in a single document. Accordingly, the panel did not need to decide whether the collective scienter theory was viable.
(2) SOX certifications/Profit motive - Following precedent from other circuits, the panel found that neither the signing of SOX certifications nor allegations that the individual defendant "was positioned to profit personally from the proposed merger" were sufficient to raise a strong inference of scienter.
Holding: Dismissal affirmed.
Quote of note: "If the doctrine of collective scienter excuses Glazer from pleading individual scienter with respect to these legal warranties, then it is difficult to imagine what statements would not qualify for an exception to individualized scienter pleadings. In fact, because the merger agreement warranted that the company was in compliance 'with all laws,' then under the collective scienter theory urged by Glazer, so long as any employee at InVision had knowledge of the violation of any law, scienter could be imputed to the company as a whole. This result would be plainly inconsistent with the pleading requirements of the PSLRA. We are thus not faced with whether, in some circumstances, it might be possible to plead scienter under a collective theory."
As discussed in The 10b-5 Daily before, whether the Tellabs decision on pleading scienter (i.e., fraudulent intent) can best be described as a victory for plaintiffs or defendants has to be evaluated on a circuit-by-circuit basis. In the U.S. Court of Appeals for the Sixth Circuit, for example, the pleading standard has been lowered.
In Frank v. Dana Corp., 2008 WL 4923012 (6th Cir. Nov. 19, 2008), the lower court found that it was "required to accept plaintiff's inferences of scienter only if those inference are the most plausible of competing inferences." On appeal, the Sixth Circuit noted that although its earlier decisions applied a "most plausible" standard, that standard was no longer good law. Instead, under Tellabs, the plaintiffs only needed to demonstrate an inference of scienter that was "at least as compelling" as any opposing inference one could draw from the facts alleged.
Holding: Dismissal vacated and case remanded to district court for reconsideration.
When only some of the defendants settle a securities class action, the extent to which they can avoid related litigation with non-settling defendants through the imposition of a judicial bar order is limited. In In re Heritage Bond Litig., 2008 WL 4415172 (9th Cir. Oct. 1, 2008), the court, agreeing with Second Circuit precedent, held that a permissible bar order "may only bar claims for contribution and indemnity and claims where the injury is the non-settling defendant's liability to the plaintiff." Non-settling defendants should still be able to bring "genuinely independent" claims against settling defendants, even if the claims arise out of the same facts as those underlying the securities class action.
Holding: Vacated challenged bar orders and remanded to district court for modification.
Will the next U.S. Supreme Court securities case be about the statute of limitations? It is a strong possibility, given that the Court has asked the Solicitor General to weigh in on the cert petition filed in a Ninth Circuit case.
At issue in Betz v. Trainer Wortham & Co., Inc., 519 F.3d 863 (9th Cir. 2008) is when the two-year statute of limitations for a securities fraud begins to run. It is well-settled that if an investor has sufficient knowledge concerning the possibility or probability of fraud (courts have differed on the exact wording), he is deemed to have "inquiry notice" and must begin an investigation into the underlying facts. There is a conflict between the circuits, however, on whether the statute of limitations begins to run when the investor is put on inquiry notice, or later when a reasonably diligent investigation would have revealed the fraud.
The Ninth Circuit went even further then the existing case law and held that inquiry notice is triggered not by mere evidence of a misrepresentation (as in other circuits), but only by evidence of the defendant's fraudulent intent. It also adopted the more rigorous notice-plus-reasonable-diligence standard and found that even fairly mild reassurances from the defendant in response to a plaintiff's inquiries may require a jury determination as to whether a reasonably diligent investigation would have revealed the fraud. In a vigorous dissent from the denial of en banc review, Judge Kozinski described the court as being "out in left field again" and argued that "the panel effectively writes the statute of limitations off the books."
Stay tuned for whether the Court takes the case. In the interim, the amicus brief filed by the Organization for International Investment and the Chamber of Commerce of the United States of America in support of a cert grant can be found here. Thanks to LawyerLinks for noting the Court's invitation to the Solicitor General's office to express the government's views.
"Foreign-cubed" cases are actions brought against a foreign issuer, on behalf of a class that includes not only investors who purchased the securities in question on a U.S. securities exchange, but also foreign investors who purchased the securities on a foreign securities exchange. These cases raise a number of jurisdictional issues.
In Morrison v. National Australia Bank Ltd., 2008 WL 4660742 (2nd Cir. Oct. 23, 2008), the court considered whether it should exercise subject matter jurisdiction over the claims brought by the foreign purchasers of the bank's ordinary shares (the lower court had dismissed the domestic purchasers' claims on other grounds). The court declined to impose a "bright-line ban" on foreign purchaser claims, expressing concern that "securities cheaters . . . should not be given greater protection from American securities laws because they carry a foreign passport or victimize foreign shareholders."
Instead, the court applied its existing "conduct test" for subject matter jurisdiction. Under the conduct test, the plaintiffs needed to adequately allege that "activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad." The court found that this test was not met: "the fact that the fraudulent statements at issue emanated from NAB's corporate headquarters in Australia, the complete lack of any effect on America or Americans, and the lengthy chain of causation between [the false numbers communicated to NAB by its U.S. subsidiary] and the statements that reached investors - add up to a determination that we lack subject matter jurisdiction."
Holding: Dismissal affirmed (note that the Second Circuit did not address a related issue that was recently raised in a S.D.N.Y. case - whether the fraud-on-the-market theory is applicable to foreign purchasers).
Quote of note: "[W]e are leery of rigid bright-line rules because we cannot anticipate all the circumstances in which the ingenuity of those inclined to violate the securities laws should result in their being subject to American jurisdiction. That being said, we are an American court, not the world's court, and we cannot and should not expend our resources resolving cases that do not affect Americans or involve fraud emanating from America. In our view, the 'conduct test' balances these competing concerns adequately and we decline to place any special limits beyond the 'conduct test' on 'foreign-cubed' securities fraud actions."
The latest application of the Tellabs decision on the pleading of scienter (i.e., fraudulent intent) comes from the U.S. Court of Appeals for the Eleventh Circuit. In Mizzaro v. Home Depot, Inc., 2008 WL 4498940 (11th Cir. Oct. 8, 2008), the court considered two controversial issues.
Confidential Witnesses - The court declined to embrace the Seventh Circuit's position that statements by confidential witnesses should be "heavily discounted." On the other hand, the court acknowledged that there were reasons to be "skeptical of confidential sources cited in securities fraud complaints," including that there are no harsh consequences if a witness lies to a plaintiff's attorney. The court concluded: "Confidentiality . . . should not eviscerate the weight given if the complaint otherwise fully describes the foundation of the confidential witness's knowledge, including the position(s) held, the proximity to the offending conduct, and the relevant time frame."
Collective Scienter - The court agreed with the Fifth Circuit's position that a defendant corporation's scienter is determined by looking "to the state of mind of the individual corporate official or officials who make or issue the statement . . . rather than generally to the collective knowledge of all the corporation's officers and employees acquired in the course of their employment." (For more on the circuit split over collective scienter, see this post.) The plaintiffs did "not argue that any Home Depot officials were responsible for the company's financial statements other than the named individual defendants." Accordingly, the court found that it "need not pursue this issue further."
Holding: Dismissal affirmed.
Quote of note: "To begin with, we indulge at least some skepticism about allegations that hinge entirely on a theory that senior management 'must have known' everything that was happening in a company as large as Home Depot, which operates over 2000 stores. The amended complaint, therefore, must at least allege some facts showing how knowledge of the fraud would or should have percolated up to senior management. The amended complaint does not come close to accomplishing that task. In particular, [plaintiff's] 'must have known' theory fails because the alleged amount of the fraud is wholly speculative, the type of fraud alleged would be very difficult for senior management to detect, [plaintiff] alleges no suspicious stock sales by management, and Home Depot’s 2004 overhaul of its RTV processing system does not suggest knowledge of widespread fraud."
Centene Corporation requires all insider stock transactions by its senior executives to be executed under pre-authorized Rule 10b5-1 stock trading plans. That policy turns out to have been helpful in obtaining the dismissal of a securities class action against the company.
In Elam v. Neidorff, 2008 WL 4587310 (8th Cir. Oct. 16, 2008), the Eighth Circuit reviewed the dismissal of the securities class action against Centene and certain individual officers. The plaintiffs argued that scienter (i.e., fraudulent intent) was demonstrated, among other things, by insider stock sales during the class period. The court, however, found that the stock sales could not support an inference of scienter because they were (a) done pursuant to Rule 10b5-1 trading plans, and (b) represented only a small portion of each seller's overall holdings. Interestingly, the court discussed the terms of the trading plans, suggesting that the trading plans were publicly disclosed. (For more on this issue and related posts, click here.)
Holding: Dismissal affirmed (for failure to adequately plead falsity and scienter).
Does the fraud-on-the-market presumption, pursuant to which reliance by investors on a material misrepresentation is presumed if the company's shares were traded on an efficient market, apply in suits alleging misrepresentations by analysts (and other non-issuers)?
The U.S. Court of Appeals for the Second Circuit was poised to answer that question in 2004, but Citigroup's settlement of the claims against it in the WorldCom litigation rendered its appeal moot. Based on the order granting the appeal, issued a day after the agreement to settle was reached, it appeared that the court was inclined to limit the reach of the fraud-on-the-market presumption. Four years later, before a completely different panel, the plaintiffs' bar has a significant win on the same issue.
In In re Salomon Analyst Metromedia Litigation, No. 06-3225 (2nd Cir. Sept. 30, 2008), the court found that nothing in Basic, the Supreme Court case creating the fraud-on-the-market presumption, limited the presumption's application to misrepresentations by issuers. Indeed, the "logic" of the Basic decision, which is based on the economic theory that share prices reflect all publicly available information in an efficient market, suggests "it does not matter, for purposes of establishing entitlement to the presumption, whether the misinformation was transmitted by an issuer, an analyst, or anyone else."
In the alternative, the defendants argued that to establish the materiality of the misrepresentations, and thereby invoke the fraud-on-the-market presumption, the plaintiffs had the burden of proving that the misrepresentations had a quantifiable effect on the company's stock price. The court disagreed, holding that inherent in the fraud-on-the-market theory is the presumption that material misrepresentations have an effect on stock price. Therefore, it was the defendants' burden to rebut the presumption by demonstrating the absence of a price impact.
A couple of notes on the decision:
(1) The Second Circuit cited the Supreme Court's recent Stoneridge decision in support of its holding. In Stoneridge, however, the Court found that the fraud-on-the-market presumption was inapplicable to the non-issuer defendants based on the fact that their "deceptive acts" were not communicated to the public. The issue of the scope of the fraud-on-the-market presumption was not squarely before the Court. Moreover, the Court expressed grave reservations about expanding securities fraud liability, something the Second Circuit's decision arguably does.
(2) The Second Circuit brushed aside the defendants' arguments concerning the expansion of liability (see full quote below), but offered an interesting codicil in a footnote. The court noted that "the identity of the speaker may be significant, because a court may determine that the reasonable investor would only rely on misrepresentations made by some speakers, but not by others."
Holding: Vacate order of class certification and remand for further proceedings (including providing the defendants with an opportunity to rebut the presumption of a price impact).
Quote of note: "Defendants worry that if no heightened test is applied in suits against non-issuers, any person who posts material misstatements about a company on the internet could end up a defendant in a Rule 10b-5 action. The worry is misplaced. The law guards against a flood of frivolous or vexatious lawsuits against third-party speakers because (1) plaintiffs must show the materiality of the misrepresentation, (2) defendants are allowed to rebut the presumption, prior to class certification, by showing, for example, the absence of a price impact, and (3) statements that are 'predictions or opinions,' and which concern 'uncertain future event[s],' such as most statements made by research analysts, are generally not actionable."
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.
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."
Does the PSLRA require courts to find the attorneys' fees agreed upon by the lead plaintiff presumptively reasonable? In In re Nortel Networks Corp. Sec. Litig., 2008 WL 3840916 (2d Cir. Aug. 19, 2008), the lead counsel made this argument on appeal after the district court reduced its fee request from the negotiated 8.5% of the settlement amount to 3% of the settlement amount. The Second Circuit found that the lead counsel had waived the argument, which was based on Third Circuit precedent, by failing to raise it before the district court. The appellate court nevertheless made it clear that while district courts should give "serious consideration" to negotiated fee arrangements, "the only PSLRA provision related to attorneys' fees places an obligation on district courts to ensure independently that fees are reasonable." As for the 3% fee award (resulting in a 2.04 lodestar multiplier), the appellate court found that it was "toward the lower end of reasonable fee awards," but the district court had not abused its discretion in setting the award at that level.
Holding: Fee award affirmed.
Two recent decisions from the U.S. Court of Appeals for the Ninth Circuit demonstrate that a fair amount of judicial discretion goes into determining whether the inference of loss causation created by a complaint's factual allegations is either "unreasonable" or "facially plausible."
(1) In Metzler Investment GMBH v. Corinthian Colleges, Inc., 2008 WL 2853402 (9th Cir. July 25, 2008), the court examined whether a news story and a press release that lead to stock price declines could "be reasonably read to reveal widespread financial aid manipulation by Corinthian." The court found that the news story only discussed a Department of Education investigation into improper financial aid practices at one of Corinthian's schools and, therefore, could not have revealed the supposed fraud. As for the later press release, the plaintiffs alleged that the announcement of higher than anticipated student attrition was understood by the market as the company's "euphemism for an admission that they had enrolled students who should not have been signed up at all, resulting in a 45% stock price drop." The court was unwilling to credit this inference, holding that although the corrective disclosure does not have to be an admission of fraud, "that does not allow a plaintiff to plead loss causation through 'euphemism.'"
Holding: Dismissal affirmed.
Quote of note: "So long as there is a drop in a stock's price, a plaintiff will always be able to contend that the market 'understood' a defendant's statement precipitating a loss as a coded message revealing the fraud. Enabling a plaintiff to proceed on such a theory would effectively resurrect what Dura discredited - that loss causation is established through an allegation that a stock was purchased at an inflated price. Loss causation requires more."
(2)In In re Gilead Sciences Sec. Litig., 2008 WL 3271039 (9th Cir. Aug. 11, 2008), the court examined whether loss causation was adequately plead where the market was alerted to the company's off-label marketing efforts by an FDA warning letter in August 2003 (no decline in stock price), but the alleged financial impact to the company of the FDA warning letter was not announced until October 2003 (12% decline in stock price). The lower court found that it was unreasonable to infer that the August 2003 revelation caused a stock price decline nearly three months later and that the October 2003 announcement of a slowing increase in demand for the relevant product was too speculative a basis for finding loss causation. On appeal, the court held that "a limited temporal gap between the time a misrepresentation is publicly revealed and the subsequent decline in stock value does not render a plaintiff's theory of loss causation per se implausible." Moreover, the warning letter's effect on product demand may not have been understood by the market until the October 2003 announcement.
Holding: Dismissal reversed.
Quote of note: "It is true that the court need not accept as true conclusory allegations, nor make unwarranted deductions or unreasonable inferences. But so long as the plaintiff alleges facts to support a theory that is not facially implausible, the court's skepticism is best reserved for later stages of the proceedings when the plaintiff's case can be rejected on evidentiary grounds."
The Shaw Group is on a roll. Following the recent dismissal of the securities class action against the company in the S.D.N.Y., it has obtained an unusual victory in an earlier, unrelated securities class action filed in the D. of La. As noted in The 10b-5 Daily nearly two years ago, the D. of La. court denied Shaw's motion to dismiss in the case, but certified its denial for appeal. The court found that "reasonable minds might disagree on the issue of whether the Plaintiffs have satisfied their pleading burden under the heightened standards for securities claims." Apparently so.
In Indiana Electrical Workers' Pension Trust Fund IBEW v. Shaw Group, Inc., 2008 WL 2894793 (5th Cir. July 29, 2008), the court held that the plaintiffs had failed to allege a strong inference of scienter. Interestingly, the court agreed with the Seventh Circuit that "[f]ollowing Tellabs, courts must discount allegations from confidential sources." In the absence of any financial restatement, the court found that the complaint's circumstantial allegations of scienter (based largely on confidential sources) were insufficient and there were plausible, non-fraudulent explanations for the officer stock sales during the class period.
Holding: Reversed and remanded with instructions to dismiss.
In Berson v. Applied Signal Tech., Inc., 527 F.3d 982 (9th Cir. 2008), the company allegedly misled investors into believing it was likely to perform contracted work. According to the plaintiffs, however, the work had actually ceased pursuant to “stop-work” orders and was not likely to be resumed. On appeal, the U.S. Court of Appeals for the Ninth Circuit reversed the dismissal of the case. A couple of interesting holdings in the decision:
(1) Scienter - The plaintiffs did not allege particular facts indicating that the individual defendants knew about the stop-work orders. Instead, they argued that Applied Signal’s CEO and CFO must have known about the stop-work orders because of the devastating effect of the orders on the corporation’s revenue. The court agreed and found that the stop-work orders “were prominent enough that it would be ‘absurd to suggest’ that top management was unaware of them.” The decision continues a recent appellate trend of finding "must have known" allegations sufficient in situations where the underlying events are deemed to be highly important to the corporation.
(2) Loss Causation – The Supreme Court’s Dura decision left open the question of whether loss causation is subject to a heightened pleading standard. A number of courts have held that notice pleading pursuant to F.R.C.P. 8(a)(2) is sufficient (see, e.g., Greater Penn. Carpenters Pension Fund v. Whitehall Jewellers, Inc., 2005 WL 1563206 (N.D. Ill. June 30, 2005)), while a few others have required pleading with particularity pursuant to F.R.C.P. 9(b) (see, e.g., In re The First Union Corp. Sec. Litig., 2006 WL 163616 (W.D.N.C. Jan. 20, 2006)). The Applied Signal court noted that this is still an open question in the Ninth Circuit, but declined to decide it because the loss causation allegations in the case met the more stringent standard.
Whether a plaintiff can establish the scienter of a defendant corporation based on the collective knowledge of the corporation's employees, commonly referred to as the "collective scienter" theory, is a topic that is getting increased attention in the courts. The author of The 10b-5 Daily wrote a New York Law Journal column (with a colleague) on collective scienter earlier this year.
The main case discussed in that column was decided by the Second Circuit last week. In Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital, Inc., 2008 WL 2521676 (2nd Cir. June 26, 2008), the court drew a distinction between the pleading and proving of corporate scienter. Although to prove corporate liability "a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation," the court found that at the pleading stage a plaintiff is only required to create a strong inference that "someone whose intent could be imputed to the corporation acted with the requisite scienter." This pleading burden can be met "with regard to a corporate defendant without doing so with regard to a specific individual defendant." The court went on to hold, however, that the generic allegations of knowledge and motive in the complaint failed to meet this standard.
Practitioners, especially in the defense bar, are likely to find the decision disappointing. First, the court did not address what type of factual allegations would be sufficient to find the existence of a strong inference of corporate scienter (in the absence of sufficient factual allegations concerning an individual defendant). The only hint is a quote from the Seventh Circuit's decision in Tellabs II discussing a hypothetical in which "General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero." Although General Motors now knows one situation to avoid, that fact pattern offers limited guidance for the lower courts. Second, the court provided no legal basis for its announced pleading standard (other than the citation to Tellabs II) and did not address the growing circuit split on this issue.
Disclosure: The author of The 10b-5 Daily submitted an amicus brief in the Dynex Capital case on behalf of the Washington Legal Foundation.
One of the concerns raised by Congress, as part of the PSLRA, was that the application of traditional joint and several liability in securities cases may be unfair, given the enormous potential damages. To combat this problem, the PSLRA replaced joint and several liability with a proportionate liability scheme for defendants who are not found to have knowingly violated the securities laws. An unanswered question, however, is whether this proportionate liability scheme also applies to defendants who are found to have controlling person liability. Section 20(a) of the '34 Act, which creates controlling person liability, specifically states that the controlling person shall be liable "jointly and severally with and to the same extent" as the primary violator.
In Laperriere v. Vesta Ins. Group, Inc., 2008 WL 1883482 (11th Cir. April 30, 2008), the Eleventh Circuit has held that the proportionate liability provisions of the PSLRA also apply to controlling persons. In the comprehensive decision, which discusses the relevant statutory provisions at length, the court found that both the plain language and legislative history suggest that Congress intended to include controlling persons.
Quote of Note: "We ought to avoid any interpretation of the statute that would treat controlling persons more harshly than the primary violator - that would put derivatively liable controlling persons on the hook for all damages, but let primary violators off the hook for any damages that their actions did not cause. That result would be contrary to common sense, to what the committee that drafted the PSLRA said it intended to do, and to what Congress actually did in the plain language of the PSLRA."
The U.S. Court of Appeals for the First Circuit has previously held that the Tellabs decision lowered the pleading standard for scienter in its court. While that determination did not lead to a reversal of the dismissal in the ACA Financial case, the same cannot be said of a new First Circuit decision issued this week.
In Mississippi Public Employees' Retirement System v. Boston Scientific Corp., 2008 WL 1735390 (1st Cir. April 16, 2008), the court specifically noted that its application of Tellabs lead it to conclude that the district court, which "did not have the benefit" of the Supreme Court's opinion, had erroneously dismissed the complaint based on a failure to adequately plead scienter. The court based its holding on allegations suggesting that Boston Scientific may have known of the relevant manufacturing problem during the class period, the closeness in time between alleged misstatements by the company and an announced product recall, and stock sales by the individual defendants.
On the issue of insider trading, the court addressed the defendants' argument that many of the alleged insider stock sales were effectuated pursuant to Rule 10b5-1 trading plans and therefore could not have supplied a motive to engage in fraud. The court concluded, however, that there was insufficient evidence about the nature of the plans to credit this argument. (The author of The 10b-5 Daily has co-written an article on the potential use of Rule 10b5-1 trading plans in defending against securities class actions, including the importance of public disclosure of the nature of the plans. In addition, a discussion of other relevant cases can be found here.)
Quote of note: "It was the defendants' choice to move to dismiss the case on the pleadings without presenting evidence. As a result, there is no evidence of when the [Rule 10b5-1] trading plans went into effect, that such trading plans removed entirely from defendants' discretion the question of when sales would occur, or that they were unable to amend these trading plans."
The Seventh Circuit is determined to be the market leader in interpreting U.S. Supreme Court securities litigation opinions. Following up on its application of Tellabs, last week it issued the first appellate decision utilizing the Stoneridge decision.
In Pugh v. Tribune Co., 2008 WL 867739 (7th Cir. April 2, 2008), the court considered the issue of "scheme liability" in the context of a corporate insider's activities (as opposed to the actions of a third party). One of the individual defendants was a Tribune vice-president, as well as the director of circulation for a subsidiary. In his capacity as an officer of the subsidiary, the individual defendant allegedly signed false circulation audits that inflated the paid circulation figures for two publications. The plaintiffs argued that it was "'forseeable' that this scheme [to defraud the advertisers] would result in improper revenue which, in turn, would be reflected in Tribune's published financial statements."
The Seventh Circuit found that these allegations were insufficient. As in Stoneridge, the individual defendant "participated in a fraudulent scheme but had no role in preparing or disseminating Tribune's financial statements or press releases." Moreover, there was no allegation that Tribune investors had been informed of the false circulation audits. Accordingly, the plaintiffs failed to establish "the requisite proximate relation" between the advertiser fraud and the harm to Tribune's investors.
Interestingly, the Seventh Circuit also addressed the issue of whether the scienter of this individual defendant could be imputed to Tribune on a respondeat superior theory. The court concluded that it could not because: (a) the individual defendant had no primary liability; (b) the misconduct of an employee of a subsidiary is not normally attributable to the corporate parent; and (c) the advertiser fraud was not undertaken to benefit Tribune. (For a discussion of the lower court's decision on corporate scienter, see this post.)
Holding: Dismissal affirmed.
Was the U.S. Supreme Court's Tellabs decision interpreting the "strong inference" pleading standard for scienter a victory for defendants? Not if the defendant is being sued in Boston (or any other locale within the U.S. Court of Appeals for the First Circuit).
In ACA Financial Guaranty Corp. v. Advest, Inc., 512 F.3d 46 (1st Cir. 2008), the First Circuit addressed the effect of Tellabs on its existing law. The court concluded that Tellabs was consistent with the scienter pleading standard previously applied by the court, except in one respect. Whereas the First Circuit had held "that where there were equally strong inferences for and against scienter, this resulted in a win for the defendant," it was now clear under the Supreme Court's "at least as compelling" standard for weighing inferences of scienter that "the draw goes to the plaintiff."
Holding: Dismissal affirmed.
The U.S. Court of Appeals for the Seventh Circuit is making up for lost time. Although it was one of the last circuits to issue an opinion interpreting the PSLRA's heightened pleading standards, the U.S. Supreme Court's decision to review (and reverse) the case has put the Seventh Circuit in the limelight.
In Tellabs, the Supreme Court held that courts must take into account "plausible opposing inferences" when examining whether a plaintiff has adequately plead a strong inference of scienter (i.e., fraudulent intent). A complaint can survive a motion to dismiss "only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged." The Court then remanded the case back to the Seventh Circuit for further proceedings.
The Seventh Circuit's decision on remand - Makor Issues & Rights, Ltd. v. Tellabs, Inc., 2008 WL 151180 (7th Cir. Jan. 17, 2008) (Tellabs II) - may be just as controversial as its first decision. In an opinion by Judge Posner, the court touched on a number of hot button scienter pleading issues that were not addressed by the Supreme Court.
(1) Corporate scienter - In the Seventh Circuit's earlier decision, the court found that the plaintiffs had adequately plead scienter as to Tellabs' CEO and then imputed that scienter to the corporation. Judge Posner, however, decided that Tellabs' scienter should be examined separately. Although the court found that it was inappropriate to consider the collective knowledge of the corporation's employees in assessing Tellabs' scienter, it also declined to look to the state of mind of the CEO who made the allegedly false or misleading statements. Instead, the court appeared to embrace what The 10b-5 Daily has described as the "weak" or "narrow" version of the collective scienter theory, holding that it was "possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud." In this case, the court held that because the the alleged false or misleading statements concerned Tellabs' "most important products" and a significant amount of alleged channel-stuffing, it was much more likely that the statements were the result of an intent to deceive or recklessness on the part of management rather than "merely careless mistakes at the management level based on false information fed it from below." Given that the inference of corporate scienter was much more likely, it was also cogent.
(2) Motive - The court expressed little concern over the fact that the plaintiffs were unable to allege that any of the defendants profited from the fraud, finding that the "argument confused expected with realized profits." Judge Posner speculated that the CEO "may have thought there was a chance the situation regarding the two key products would right itself" and, therefore, wanted to conceal the truth and avoid causing volatility in the company's stock price.
(3) Confidential witnesses - Shortly after the Supreme Court decided Tellabs, the Seventh Circuit applied the holding in a different case. In Baxter, the court found that the failure to name sources cited in the complaint "conceals information that is essential to the sort of comparative evaluation required by Tellabs" because the court is unable to fully evaluate the reliability of the witnesses. Accordingly, allegations from confidential witnesses must be "discounted" in determining whether a plaintiff has plead a strong inference of scienter and that discount will usually be "steep." Although there is nothing in Baxter suggesting that the holding concerning confidential witnesses was limited to the facts of that case, Judge Posner concluded that the steep discount should not be applied to the more numerous and reliable confidential witnesses in the Tellabs complaint.
Holding: Reverse the judgment of the district court dismissing the suit.
Quote of note: "Suppose General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero. There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false."
Here is a roundup of Stoneridge commentary available on the web.
(1) Stoneridge: Pro-Business, Pro-SEC Enforcement, Not The "Decision of the Century"; The Supreme Court’s Ruling in the Enron Litigation and Simpson Help Define Stoneridge - SEC Actions
(3) The Stoneridge opinion; More Stoneridge: Taming the monster, not turning it around; The future of scheme liability; Stoneridge and the Enron zombie; What does the Enron cert denial mean? - Ideoblog
(3) Stoneridge and the Judicial Role - Business Associations Blog
(4) Stoneridge and the Legislative Role of the Supreme Court - HLS Corporate Governance Blog
(5) Stoneridge Securities Fraud Opinion from the Supreme Court - Truth On The Market
(6) Supreme Court Rules in Stoneridge Defendants’ Favor - The D&O Diary
(7) Scheme Liability Survives Stoneridge - Barely - SixthCircuitBlog
(8) Enron: Extortion, Interrupted - The N.Y. Sun (Ted Frank)
(9) Stoneridge and the Rule of Law - Wall Street Journal (Paul Atkins)
The first impact of the Stoneridge decision has been felt. The U.S. Supreme Court issued an order today denying review of California Regents v. Merrill Lynch, the Enron-related case from the Fifth Circuit that raised similar scheme liability issues.
The Court also vacated and remanded a Ninth Circuit case on scheme liability, Avis Budget Group, Inc. v. Ca. State Teachers' Retirement, for further consideration in light of Stoneridge (see here for a summary of the Ninth Circuit opinion). Bloomberg and SCOTUSBlog have reports on the decisions.
Quote of note (Bloomberg): "The court's rejection of the Enron investor appeal came without any published dissent. The rebuff 'further confirms that there is no financial services exception' to the Stoneridge ruling, said [counsel for] the suppliers in last week's case."
In the Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (a.k.a. Charter Communications) case, the U.S. Supreme Court has held that the implied private right of action under Sec. 10(b) for securities fraud does not extend to third parties who neither make alleged misstatements nor engage in deceptive conduct on which investors relied. The 5-3 decision (Justice Breyer did not participate) authored by Justice Kennedy resolves a circuit split over the scope of "scheme liability."
In Stoneridge, the plaintiffs alleged that Charter and two of its suppliers and customers, Scientific-Atlanta and Motorola, knowingly engaged in a business scheme that allowed Charter to artificially inflate its reported revenues and operating cash flow. The plaintiffs sought to hold Scientific-Atlanta and Motorola primarily liable for the misstatements contained in Charter's financial statements. The district court, with an affirmance from the U.S. Court of Appeals for the Eighth Circuit, dismissed these claims. On the issue of scheme liability, the Eighth Circuit found that Scientific-Atlanta and Motorola had not participated in the making of the misstatements and "any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under Sec. 10(b) or any subpart of Rule 10b-5."
On appeal, the Supreme Court took a notably different approach. The Court rejected the Eighth Circuit's decision to the extent that it could be "read to suggest there must be a specific oral or written statement before there could be liability under Sec. 10(b) or Rule 10b-5." The Court found that "[c]onduct itself can be deceptive" and provide the basis for liability. Instead, the Court focused on whether the Charter investors could be said to have relied upon the deceptive acts of Scientific-Atlanta and Motorola in purchasing their securities.
The Court concluded that there was no basis for finding that the investors could be presumed to have relied upon the relevant deceptive acts. First, Scientific-Atlanta and Motorola had no duty to disclose their conduct to Charter's investors. Second, the fraud-on-the-market doctrine was inapplicable because the conduct was "not communicated to the public." Accordingly, the Court held that the investors could not "show reliance upon any of respondents' actions except in an indirect chain that we find too remote for liability."
The rest of the opinion is devoted to various legal and policy defenses of this limitation on the scope of scheme liability. The Court noted that Charter's investors were seeking to apply Section 10(b) "beyond the securities markets - the realm of financing business - to purchase and supply contracts - the realm of ordinary business operations." To do so would "invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees." Moreover, adopting the position advocated by Charter's investors would "revive in substance the implied cause of action against all aiders and abettors except those who committed no deceptive act in the process of facilitating the fraud" and would undermine Congress' determination in the PSLRA that this "class of defendants should be pursued by the SEC and not by private litigants." Finally, the Court expressed concern that "scheme liability" would "raise the cost of being a publicly traded company" and "shift securities offerings away from domestic capital markets."
Holding: Affirmed.
Notes on the Decision
(1) The Court adhered closely to the argument made by the Department of Justice in its amicus brief. Although some commentators predicted that outcome, the Court's focus on reliance is interesting given that Chief Justice Roberts (who joined the majority opinion) expressed skepticism at oral argument over whether the issue was properly before the Court. The dissent (Stevens, J.) agreed that the issue was not ripe and suggested that "the fairest course to petitioner would be for the majority to remand to the Court of Appeals to determine whether petitioner properly alleged reliance, under a correct view of what Section 10(b) covers."
(2) While the media is likely to trumpet the decision as a victory for corporate defendants, it is important to note that the victory was not as sweeping as it could have been. Contrary to the holdings of both the Eighth Circuit and the Fifth Circuit (see here), the Court held that deceptive conduct, even without the existence of an oral or written misstatement, can provide the basis for securities fraud liability if the plaintiffs can establish that they relied on that conduct. Indeed, many courts have defined the distinction between "aider and abettor" and "primary violator" by reference to the level of participation of the individual defendant in making the misstatement at issue and whether the public became aware of the defendant's alleged involvement. Does Stoneridge open the door to a broader view of "participation"?
(3) The Court's references to the possible deterrence of overseas firms from doing business in this country and the shifting of "securities offerings away from domestic capital markets" are going to draw criticism as being excessively policy oriented (see here for an early example).
(4) In support of its holding that the investors could not establish reliance, the Court repeatedly cited the investors' lack of knowledge about the "deceptive acts" in which Scientific-Atlanta and Motorola were alleged to have engaged. Presumably the Court was referring to the failure of the investors to allege that they were aware of the transactions between the companies and Charter, not to a lack of knowledge that the transactions were deceptive. Nevertheless, it struck a discordant note when the Court stated, for example, that the defendants' "deceptive acts were not communicated to the public." If the deceptive acts had been communicated to the public, of course, the defendants would have had a completely different lack of reliance defense.
This month has seen two noteworthy decisions from the U.S. Court of Appeals for the Seventh Circuit.
(1) In Sutton v. Bernard, 2007 WL 2963940 (7th Cir. Oct. 12, 2007), the court addressed an appeal by the lead counsel in a securities class action brought against Marchfirst, Inc. Following the settlement of the case, the district court rejected the lead counsel's fees request, reducing it from 28% of the gross settlement amount to 15% or $2,605,000. On appeal, the court held that the district court had improperly failed to take into account "the market price for legal services" in making its determination, instead focusing only on the results achieved in the case.
Quote of note: "The trouble we have with the district court's methodology is that the fee determination began and ended with the amount actually recovered for the class; the court did not consult the market for legal services for guidance in what constituted, as an abstract matter, a 'reasonable percentage.'"
(2) In Asher v. Baxter Int'l Inc., 2007 WL 3010617 (7th Cir. Oct. 17, 2007), the court considered another appeal in a case that had previously generated a well-known decision on the PSLRA's safe harbor for forward-looking statements. This time the court addressed whether, pursuant to Fed. R. Civ. P. 23(f), a plaintiff is entitled to appeal subsequent denials of class certification if it does not appeal the first denial within the 10-day statutory period. The court found that the "time limit would not be worth anything if it restarted with each new motion" and declined to allow the appeal. The opinion also contains interesting dicta on the representative plaintiff selection process in the case.
Quote of note: "The district court deemed both the Alaska and the Fayetteville funds inadequate because their investments are much smaller than those of other mutual or pension funds. One can't help thinking that the unwillingness of any substantial shareholder to step forward as a representative suggests that the suit may not be in investors' interest. To the district judge, the fact that two modestly sized pools with modest stakes in Baxter had been recruited by the lawyers already trying to represent a plaintiff class implied that they would be subservient to counsel."
Despite all of the fanfare leading up to the oral argument in the Stoneridge (a.k.a. Charter Communications) case on scheme liability, the aftermath has been quite subdued. That may be because the post-argument consensus (at least in the blogosphere) is that the plaintiff investors have no chance of obtaining a reversal. On exactly what basis the court will decide against them, however, is still the subject of debate. Summaries and predictions can be found at BusinessAssociationsBlog, Legal Pad, Securities Law Prof Blog, Business Law Prof Blog, Ideoblog, and The Race to the Bottom.
The Supreme Court has released the transcript of today's oral argument in the Stoneridge case. A few highlights from the justices:
(1) Justice Scalia noted that private actions pursuant to Rule 10b-5 are a judicial creation. He then wondered why they could not also be judicially limited.
"If it's our creation, couldn't we sensibly limit it so that, for example, schemes can be attacked by the SEC, but schemes do not form the basis for private attorney generals' actions? You need actual conveyance of a misrepresentation to the injured party." (p. 5)
(2) Chief Justice Roberts, on the other hand, appeared inclined to defer to Congress given its active legislating in the area of securities litigation.
"My suggestion is that we should get out of the business of expanding [Rule 10b-5 liability], because Congress has taken over and is legislating in the area in the way they weren't back when we implied the right of action under 10(b)." (p. 7)
(3) Justice Kennedy expressed concern over the potentially broad scope of liability under a scheme theory (while painting an unflattering portrait of the corporate world).
"[T]here are any number of kickbacks and mismanagements and petty frauds that go on in business, and business people know that any publicly held company's shares are going to be affected by its profits, so I see no limitation to your - to your proposal []." (p. 18)
(4) Justice Ginsburg wondered whether scheme liability occupied a middle ground between aiding and abetting, which is a claim that can only be brought by the SEC, and a primary violation by the company.
"That's if they are aiders and abettors, which is what Congress covered. And I again go back to, is there another category or is everyone - either Charter, the person whose stock is at stake, the company whose stock is at stake and everyone else is an aider?" (p. 35)
(5) Justice Souter alluded to the public controversy over the Solicitor General's amicus brief by asking the government "whether the SEC has publicly taken a position" on the question of whether there was a violation of Rule 10b-5. Counsel for the government outlined the course of events, but noted that there has not been "any official SEC Commission statement." (pp. 49-50)
(6) Chief Justice Roberts and Justice Ginsburg expressed skepticism over whether the issue of reliance, which the government focused on, was addressed by the appellate court. Counsel for the government replied that "it's not as complete a discussion of the reliance issue as we would have thought appropriate if we had been writing the opinion, but it certainly does touch on the question and we think it's wholly presented." (pp. 56-7)
Early reports from today's Supreme Court oral argument in the Stoneridge case suggest that the court is unlikely to side with the plaintiff investors and adopt a broad definition of "scheme liability." First-hand accounts can be found at SCOTUSBlog and the WSJ Law Blog. (Also worth reading is today's coverage of the case in the Wall Street Journal, including an op-ed by SEC Commissioner Paul Atkins.)
Quote of note (SCOTUSBlog): "'Congress has kind of taken over for us . . . They picked up the ball and are running with it . . . My suggestion is that we should get out of the business of expanding [the key securities fraud section]; Congress has taken over,' the Chief Justice told New York attorney Stanley M. Grossman."
As predicted by some observers, Chief Justice Roberts is rejoining the Stoneridge (a.k.a. Charter Communications) case after initially recusing himself. The speculation is that he has sold the securities that caused the conflict of interest. Justice Breyer remains recused, however, setting up the possibility of a split decision. Coverage can be found in SCOTUSBlog, the Blog of Legal Times, and the WSJ Law Blog.
Quote of note (SCOTUSBlog): "If the Court were to divide evenly, 4-4, on Stoneridge, the result would simply be to affirm the Eighth Circuit decision without an opinion. The Court might then seek another test case in which to address the underlying legal question. A major Enron case, California Regents v. Merrill Lynch, et al. (docket 06-1341), raises the same issue; that case apparently is being held to await the outcome of the Stoneridge case."
Two recent appellate decisions of interest:
(1) In Central Laborers' Pension Fund v. Integrated Electrical Services, Inc., 2007 WL 2367776 (5th Cir. August 21, 2007), the court addressed the pleading of scienter under the Supreme Court's recent Tellabs decision. Notably, the court found that (a) the confidential witness allegations lacked sufficient detail supporting their reliability (although the court stopped short of suggesting that the plaintiffs should provide the names of the witnesses), (b) the argument that the stock trading of one of the defendants was non-suspicious because he traded pursuant to a Rule 10b5-1 plan was "flawed" because the plan was put into effect during the class period, and (c) an inference of scienter cannot be drawn from a Sarbanes-Oxley certification unless the person signing the certification had reason to know or should have suspected that the financial statements contained misrepresentations. The court concluded that the "allegations read in toto do not permit a strong inference of scienter."
(2) In Employers-Teamsters Local Nos. 175 & 505 Pension Trust Fund v. Anchor Capital Advisors, 2007 WL 2325079 (9th Cir. August 16, 2007), the court considered whether a lead plaintiff decision can be appealed following the dismissal of the underlying case. A group of public pension funds had unsuccessfully moved to serve as lead plaintiff. The lower court subsequently granted the defendants' motion to dismiss the case. The appointed lead plaintiff declined to file an amended complaint and instead requested that the individual uncertified actions be dismissed with prejudice. The pension funds moved to appeal the earlier lead plaintiff decision, but the appellate court held that because the pension funds never filed their own complaint or intervened in the pending action, they were merely "potential class members in a potential class action suit" and had no standing to bring an appeal.
Two more items regarding the Stoneridge (a.k.a. Charter Communications) case on scheme liability:
(1) Although Chief Justice Roberts and Justice Breyer initially recused themselves from the case because of personal stockholdings, the New York Law Journal reports that they may be back in time for the argument (scheduled for October 9, 2007). Under a new federal law, the justices could sell their stockholdings and, because the sale was done to resolve a conflict of interest, defer any capital gains tax. The article speculates that Chief Justice Roberts may have rejoined a case earlier this year, the day before oral argument, by resolving a conflict through a stock sale.
Quote of note: "'The justices who recused are - I don't want to use the term - business-friendly,' said Stephen Bainbridge, who participated in a brief that opposed the investors' broad liability theory. But Mr. Bainbridge, a professor at UCLA School of Law, said the Court can be especially unpredictable in securities cases, because the justices and their law clerks are 'institutionally incompetent' to resolve complex securities cases. 'I would never count the chickens before they hatch,' he said."
(2) The WSJ Law Blog has a post on the large number of amicus briefs that have been filed in the case.
Quote of note: "At final count, about 30 'friend of the court' briefs (aka amicus briefs) were filed with the court in Stoneridge, which asks whether shareholders can sue to hold third parties — e.g., investment banks, accountants and law firms — liable for a company’s fraud. It’s a 'startling' number of friend-of-the-court briefs for a securities-law case, says Tom Goldstein, a Supreme Court practitioner at Akin Gump, not involved in the case."
The long wait is over and everyone will be at least slightly disappointed. After significant public and private debate, the Solicitor General has submitted an amicus brief in support of the corporate defendants in the Stoneridge (a.k.a. Charter Communications) case on scheme liability.
The government's legal argument appears to be something of a compromise position. The brief states that the Eighth Circuit erred to the extent it held that "non-verbal deceptive conduct is somehow beyond the reach of Section 10(b)." Instead, the plain language of the statute makes it clear that it reaches "all conduct that is 'manipulative' or 'deceptive,'" in whatever form.
Nevertheless, the government argues that the Eighth Circuit correctly upheld the dismissal of the complaint based on the plaintiffs' failure to adequately plead reliance and loss causation. The plaintiffs allege "only that the backdating of the contracts assisted Charter in mischaracterizing the payments from [its business partners] as revenue (and thus inflating its operating cash flow in its financial statements)." The "critical point" is that it was Charter's misrepresentation of its cash flow, not the allegedly deceptive conduct of its business partners, on which the plaintiffs relied in purchasing their shares. The presumption of reliance created by the fraud-on-the-market theory also is unavailable to the plaintiffs, the government argues, because it applies only to public misrepresentations and the complaint "does not identify any public statements or actions" by the business partners. Finally, the brief states that for "many of the same reasons" the complaint fails to adequately allege that the conduct of the business partners caused the plaintiffs' losses.
A few additional notes: (1) SCOTUSblog has a summary of the filing and additional coverage can be found on the WSJ Law Blog and the Blog of the Legal Times; (2) many (if not all) of the briefs in the case, including the briefs of the corporate defendants filed today, are available on the DU Sturm College of Law Corporate Governance site; and (3) the Stoneridge docket reveals that oral argument in the case has been scheduled for October 9, 2007.
Quote of note (SG's brief - citations omitted): "More fundamentally, Congress’s unwillingness to recognize a private right of action for aiding and abetting suggests that this Court should be loath to create the functional equivalent of such a right of action itself. Such an action would upset the deliberate balance struck by Congress. Insofar as petitioner and its amici advance various policy arguments in favor of broad liability for secondary actors, there are ample policy arguments to the contrary (some of which apparently struck a chord when Congress last expressly addressed the issue). In any event, all of those policy arguments 'are more appropriately addressed to Congress than to this Court.'"
The Wall Street Journal has an editorial (subscrip. req'd) on the amicus brief filed by Congressmen Frank and Conyers in the Stoneridge case. The newspaper is critical of the congressmen's decision to have a law firm that does lobbying work for plaintiffs lawyers write the brief.
Quote of note: "We trust the Supreme Court Justices, who are due to hear Stoneridge arguments as early as October, will notice the provenance of Mr. Frank's legal wisdom."
The first circuit court opinion to extensively apply the Tellabs decision has arrived and it contains a number of interesting holdings. Given that the opinion comes from the U.S. Court of Appeals for the Seventh Circuit and is authored by Judge Easterbrook, that will come as no surprise to any regular reader of this blog.
In Higginbotham v. Baxter Intern., Inc., 2007 WL 2142298 (7th Cir. July 27, 2007), the court addressed the impact of Tellabs on the use of confidential witnesses. Noting that the Supreme Court has required plaintiffs to plead an inference of scienter that is both cogent and at least as compelling as any opposing inference that can be drawn from the alleged facts, the court found that "anonymity frustrates that process." In particular, the failure to name sources "conceals information that is essential to the sort of comparative evaluation required by Tellabs," because the court is unable to fully evaluate the reliability of the witnesses. Accordingly, allegations from confidential witnesses must be "discounted" in determining whether a plaintiff has plead a strong inference of scienter and that discount will usually be "steep."
The court went on to find that the plaintiffs had failed to plead a strong inference of scienter. In addition to discounting the statements of confidential witnesses, the court also poked holes in a number of other alleged inferences of scienter put forward by the plaintiffs. Notably, the court found that allegations of a publicly-announced antitrust investigation, stock sales by two company managers, and the company's failure to disclose a fraud at its Brazilian subsidiary as soon as management was informed of its possible existence were insufficient to meet the plaintiffs' pleading burden.
Holding: Dismissal affirmed.
Quote of note: "It is hard to see how information from anonymous sources could be deemed 'compelling' or how we could take account of plausible opposing inferences. Perhaps these confidential sources have axes to grind. Perhaps they are lying. Perhaps they don't even exist."
Quote of note II: "Prudent managers conduct inquiries rather than jump the gun with half-formed stories as soon as a problem comes to their attention. Baxter might more plausibly have been accused of deceiving investors had managers called a press conference before completing the steps necessary to determine just what had happened in Brazil. Taking the time necessary to get things right is both proper and lawful. Managers cannot tell lies but are entitled to investigate for a reasonable time, until they have a full story to reveal."
The Solicitor General's decision not to support the investor plaintiffs in the Stoneridge (a.k.a. Charter Communications) case has spurred another attempt at a post-deadline amicus brief filing, this time from a pair of prominent congressmen. The Washington Post reports that House Financial Services Committee Chairman Barney Frank (D-Mass.) and House Judiciary Committee Chairman John Conyers Jr. (D-Mich.) have sought permission to file an amicus brief in the case. The effort follows on the heels of a similar request from a group of former high-ranking SEC officials. The congressmen's proposed amicus brief can be found here.
Quote of note (proposed amicus brief): "The interpretation of Section 10(b) and Rule 10b-5 adopted by the Court of Appeals and urged by Respondents ultimately rests on policy considerations at odds with the statutory text that should more appropriately be addressed to Congress than to this Court."
The Washington Post has an article on an unusual effort by three former high-ranking SEC officials to file a post-deadline amicus brief in the Stoneridge (a.k.a. Charter Communications) case. The request evidently is being made in response to the Solicitor General's decision not to file a brief in support of the investor plaintiffs. Professor Arthur Miller, who recently argued the Tellabs case before the U.S. Supreme Court, is representing the officials.
Chairman Christopher Cox of the SEC testified before the House Financial Services Committee this week. CFO.com has an article on a mostly unnoticed part of his testimony where Chairman Cox discussed his participation in the SEC's decision to ask the Solicitor General to support the investor plaintiffs in the Stoneridge (a.k.a. Charter Communications) case. The Solicitor General ultimately decided not to file the requested amicus brief.
Quote of note: "Cox's vote was part of the majority in a 3-2 SEC vote in the so-called StoneRidge case. 'It is my view that precedent matters,' he said during a House Financial Services Committee hearing at which all five commissioners attended. 'The SEC rules and policies should not be so effervescent as to change with one or two people on board.' . . . In 2004 — a year before Cox joined the commission — the SEC weighed in favor of a broad definition of liability for companies indirectly involved in violations of the securities laws."
Addition: In a related story, the WSJ Law Blog had an interesting post this week on the campaign by the American Association of Justice (i.e., the main trial lawyer association) to influence public opinion regarding the government's position in the case.
In the Tellabs v. Makor Issues & Rights case, the U.S. Supreme Court has held that in determining whether the pleaded facts give rise to a "strong inference" of scienter, a court must take into account "plausible opposing inferences." The 8-1 decision authored by Justice Ginsburg addresses the application of the PSLRA's heightened scienter pleading standard.
To survive a motion to dismiss, a securities fraud complaint must contain factual allegations giving rise to a "strong inference" that the defendant acted with scienter (i.e., fraudulent intent). In creating this pleading standard as part of the PLSRA, however, Congress did not define the term "strong inference" and courts subsequently construed it differently. Among the outstanding issues was how courts should address competing inferences in determining whether the standard is met.
In Tellabs, the Court described its task as prescribing "a workable construction of the 'strong inference' standard, a reading geared to the PSLRA's twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors' ability to recover on meritorious claims." To that end, the Court established a three-step evaluation process for lower courts.
First, when faced with a motion to dismiss a securities fraud claim, "courts must, as with any motion to dismiss for failure to plead a claim on which relief may be granted, accept all factual allegations in the complaint as true."
Second, courts should consider complaints in their entirety, as well as other sources of information it is appropriate for courts to consider on a motion to dismiss. The proper inquiry is "whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard."
Finally, courts must take into account "plausible opposing inferences." A complaint can survive a motion to dismiss "only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."
Although the Court evaluated the factual allegations in the Tellabs complaint, it did not reach any conclusions. Instead, the Court merely emphasized that courts must "assess all the allegations holistically." To that end, it found that the mere absence of insider trading allegations or the existence of "omissions or ambiguities" in the allegations of improper channel-stuffing may "count against inferring scienter," but they were not, by themselves, dispositive as to whether the plaintiffs had met the "strong inference" standard. The Court also addressed an issue that attracted a great deal of attention at oral argument: whether the heightened pleading standard for scienter improperly required a court to act as a fact-finder on the merits of the suit in violation of the Seventh Amendment right to jury trial. The Court held that Congress has the power to establish pleading standards for a federal statutory claim and this power did not implicate the Seventh Amendment.
Holding: Judgment vacated and case remanded for further proceedings
Notes on the Decision
(1) Justices Scalia and Alito wrote concurrences. Justice Scalia argued that "the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence." Although he noted that this test is unlikely "to produce results much different from the Court's," Justice Scalia found that it is more in keeping with the "normal meaning" of "strong inference." Justice Alito agreed with the "more plausible" test put forward by his colleague and also argued that a court should not consider "nonparticularized" allegations in evaluating scienter.
(2) Justice Stevens filed a dissent and argued that Congress had "implicitly delegated significant lawmaking authority to the Judiciary in determining how [the scienter] standard should operate in practice." He suggested that applying a "probable cause" standard "would be both easier to apply and more consistent with the statute." Under that standard, Justice Stevens believed it "clear" that the plaintiffs had sufficiently plead scienter.
(3) Although attention is likely to be focused on the Court's "competing inferences" holding, it is worth noting that the Court's "holistic" approach to evaluating scienter also addresses a circuit split. The decision 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 to find that the "strong inference" standard has been met.
(4) The majority opinion contains some ambiguities itself. In two consecutive sentences, for example, it states: (a) the inference of scienter "must be cogent and compelling, thus strong in light of other explanations;" and (b) the inference of scienter must be "cogent and at least as compelling as any opposing inference one could draw from the facts alleged." The second statement (which also appears in the introduction to the opinion) appears to allow for a "tie" to go to the plaintiff. As noted by Justice Scalia in his dissent, this result arguably is not in keeping with Congress' desire to heighten the pleading standard.
The Stoneridge (a.k.a. Charter Communications) case on scheme liability pending before the U.S. Supreme Court may or may not be "the biggest securities litigation case in a generation," but it has certainly generated more pre-argument media coverage than Dura and Tellabs put together. Much of that coverage has focused on whether the SEC/DOJ would submit a brief today in support of the plaintiff investors (see here, here, and here). The Wall Street Journal had an editorial on the topic this past weekend.
Although the SEC apparently recommended that the Solicitor General file the brief - see this Bloomberg article for the details - it does not appear that the recommendation was accepted. Reuters reported earlier today that it was "unlikely" the filing would be made and, as of the time of this post, there is no indication that it has happened. If not, the government has the option of filing a brief in support of the defendants (due in 30 days) or simply remaining silent.
Whatever the government's position, however, the show goes on for the parties. The plaintiff investors filed their brief today and it can be found here.
Quote of note (plaintiffs' brief): "Legitimate business will be unaffected if the Court adopts a test giving effect to the plain text of Section 10(b) and Rule 10b-5, but going no further. One proposed test would be that: a person engages in a deceptive act as part of a scheme to defraud investors, and violates Section 10(b) and Rule 10b-5(a) and/or (c), if the purpose and effect of his conduct is to create a false appearance of material fact in furtherance of that scheme."
Addition: As predicted, the government did not file an amicus brief in support of the investor plaintiffs. Press coverage can be found in Bloomberg and the Washington Post.
Some interesting tidbits from around the web on the Stoneridge (a.k.a. Charter Communications) case on scheme liability set to be heard by the U.S. Supreme Court next term.
Whether, and on which side, the SEC will participate in the case has been a hot issue. SCOTUSblog reports that there are two dates to keep in mind: (1) amicus briefs urging the Supreme Court to hear a similar Enron-related case on scheme liability (maybe in tandem or consolidated with Stoneridge) are due on June 1; and (2) amicus briefs in support of the investor plaintiffs in Stoneridge are due on June 11.
Meanwhile, Point of Law speculates that Justice Alito may be the swing vote in the Stoneridge case. Justices Breyer and Roberts are recused because of stockholdings, leaving seven justices to consider the case.
There has been a fair amount of media and blog coverage of the oral argument in the Tellabs case. Here is a partial roundup:
Media - Articles can be found in the Washington Post, the Associated Press (here and here), and Bloomberg News.
Blogs - Commentary, with some predictions on the outcome of the case, can be found on the Wall Street Journal Law Blog, the Sixth Circuit Blog, and LawMemo.
Click here for the transcript.
Oral argument in the Tellabs v. Makor Issues & Rights case took place in the U.S. Supreme Court this morning (links to most of the briefs can be found here). The question presented was: "Whether, and to what extent, a court must consider or weigh competing inferences in determining whether a complaint asserting a claim of securities fraud has alleged facts sufficient to establish a 'strong inference' that the defendant acted with scienter, as required under the Private Securities Litigation Reform Act of 1995."
All of the justices participated in the hearing. Argument was heard from Carter G. Phillips of Sidley Austin on behalf of petitioners Tellabs and Notebaert; Professor Arthur Miller of Harvard Law School on behalf of the respondent shareholders; and Assistant to the Solicitor General Kannon Shanmugam on behalf of the United States as an amicus in support of Tellabs.
Overall Impressions - Predicting how the Supreme Court will rule based on oral argument, especially where there are multiple possible approaches to the issue, is difficult. That said, the Court appeared likely to reject the Seventh Circuit's "reasonable person" standard as incompatible with the "strong inference" scienter pleading requirement. As noted by Justice Roberts and Justice Breyer, the "reasonable person" standard appears to allow for the possibility that the case will go forward even if the plaintiffs are only able to allege facts establishing a weak inference of scienter. There also appeared to be considerable support for the need to weigh competing inferences.
A few notes on the main issues discussed:
Is There A Seventh Amendment Violation? - Perhaps to the surprise of Tellabs' counsel, who had argued in his briefs that the Court did not have to reach this issue, the justices spent a fair amount of time discussing whether there needed to be uniformity between the pleading and proof standards for scienter. In their brief, the shareholders had argued that the heightened pleading standard for scienter improperly required a court to act as a fact-finder on the merits of the suit. Justice Scalia and Justice Breyer expressed skepticism over the idea that Congress could not create a heightened pleading standard, noting that there are lots of barriers to entry to federal courts (including diversity and amount in controversy requirements). Justice Breyer wondered whether there was really any difference between saying a plaintiff's case has to be "really strong" and saying that a plaintiff has to be "really suffering." That said, a number of justices (Justice Breyer most of all) seemed concerned that the "strong inference" pleading standard was higher than the "preponderance of the evidence" proof standard. Tellabs' counsel and government counsel both argued that if the Court wanted to address this question, it would need to reconsider the standard of proof, as opposed to watering down the PSLRA.
Can You Infer A CEO's Knowledge About Financial Issues Based On His Position? - Justice Kennedy appeared anxious to get an answer to this question, asking it of both parties. Tellabs' counsel responded that the CEO's title was insufficient; plaintiffs needed to provide particularized facts regarding the CEO's scienter. Shareholders' counsel, however, suggested that it was unlikely that a CEO would not know about important financial issues. Moreover, the confidential witnesses cited in the complaint confirmed the existence of scienter for Tellabs' CEO.
Competing Inferences - Justice Alito took center stage on the issue of how to evaluate competing inferences with the following analogy: if you see a person walking down the street toward the Supreme Court, this fact would create a strong inference that the person is going to the Supreme Court if it is the only building around. If there are a lot of other buildings, however, doesn't a court have to consider the inference that the person is going to another location? In response to this analogy and further prodding from Justice Ginsburg and Justice Souter, shareholders' counsel conceded that the court could consider other facts that were subject to judicial notice, but stopped short of agreeing that this constituted an evaluation of competing inferences.
How To Decide This Case - Justice Ginsburg noted that the phrase "strong inference" is not "self-defining" and other justices also appeared to struggle with its meaning. As to how to decide the case in front of them, Justice Scalia expressed a desire to provide lower courts with guidance on what is a "strong inference" of scienter and, during his rebuttal time, Tellabs' counsel urged the same course.
Prof. Miller v. Justice Scalia - By his own admission, Prof. Miller has a more "colloquial" argument style. That got him into some hot water with Justice Scalia, with whom he traded barbs. Justice Stevens asked Prof. Miller if he could translate the "strong inference" standard into a probability percentage. Justice Scalia quipped that he thought it was 66 2/3%, in response to which Prof. Miller asked if that was "because you never met a plaintiff you really liked?" Justice Scalia got his revenge a few minutes later when Prof. Miller stated "don't take me literally" on a certain comment and Justice Scalia replied that he would write that down. At that point, Justice Roberts called it a draw.
A transcript of the argument will be released later today. The 10b-5 Daily reserves the right to edit this post if it turns out that the transcript creates a "competing inference" as to the accuracy of the author's scribbled notes.
The U.S. Supreme Court has turned its gaze to securities litigation and does not appear to like the circuit splits it is seeing. This week features an unprecedented amount of Supreme Court activity on securities issues, with two arguments and a noteworthy grant of certiorari.
An early report on today's argument in the Credit Suisse case suggests that several justices were skeptical about applying antitrust law to the same allegations raised in the IPO allocation cases. Meanwhile, oral argument in the Tellabs case on scienter pleading is scheduled for tomorrow. Previews of the two cases can be found in the Wall Street Journal (subscrip. req'd), Bloomberg, and the Financial Times.
On Monday, the Supreme Court also granted cert in the Charter Communications case from the Eighth Circuit that addresses scheme liability. The timing could hardly have been better. As discussed in this recent post, the circuit split on the issue expanded just last week when the Fifth Circuit declined to grant class certification in the securities fraud case brought against Enron's banks.
The question presented in Charter Communications is: "Whether this Court’s decision in Central Bank [], forecloses claims for deceptive conduct under [Section 10(b) and Rule 10b-5] where Respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where Respondents themselves made no public statements concerning those transactions." Chief Justice Roberts and Justice Breyer will not participate in the case (probably because of stock ownership). The Associated Press has an article and Securities Litigation Watch has a post.
In two decisions issued last year, the Eighth Circuit and the Ninth Circuit split over the extent to which secondary actors (e.g., accountants, lawyers, or bankers) can be held primarily liable under Rules 10b-5(a) and (c) for deceptive devices, schemes, and acts. The Eighth Circuit limited the scope of potential liability, holding that "any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under Sec. 10(b) or any subpart of Rule 10b-5." In contrast, the Ninth Circuit created a broader test, finding that "to be liable as a primary violator of Sec. 10(b) for participation in a 'scheme to defraud,' the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme." In a decision issued yesterday, the Fifth Circuit has sided squarely with the Eighth Circuit and limited the scope of liability.
In Regents of the Univ. of California., et al. v. Credit Suisse First Boston (USA), Inc., et al., 2007 WL 816518 (5th Cir. March 19, 2007), the issue presented was whether the district court had properly granted class certification for Rule 10b-5 claims brought against three banks that had entered into transactions with Enron. The "common feature of these transactions is that they allowed Enron to misstate its financial condition; there is no allegation that the banks were fiduciaries of the plaintiffs [Enron investors], that they improperly filed financial reports on Enron's behalf, or that they engaged in wash sales or other manipulative activities directly in the market for Enron securities." Nevertheless, the district court held that class certification was appropriate because a "deceptive act" included participation in a transaction whose principal purpose and effect was to create a false appearance of revenues. Because the banks had failed in their duty not to engage in a fraudulent scheme, the district court found that plaintiffs were "entitled to rely on the classwide presumption of reliance for omissions and fraud on the market." On appeal, the Fifth Circuit disagreed.
As an initial matter, the court found that it could address the district court's definition of "deceptive act" because it was the basis for the district court's determination that the plaintiffs were entitled to a presumption of reliance. Without that presumption, class certification would fail.
The court then turned to whether plaintiffs could properly rely on a presumption of reliance created by either the existence of actionable omissions or a fraud on the market. First, the court held that the banks had not made any actionable omissions because they "did not owe plaintiffs any duty to disclose the nature of the alleged transactions." Second, the court found that the district court's definition of "deceptive act" was "inconsistent with the Supreme Court's decision that Sec. 10 does not give rise to aiding and abetting liability." After examining relevant Supreme Court precedent, the court held that the Eighth Circuit's definition of "deceptive act" (i.e., conduct involving "either a misstatement or a failure to disclose by one who has a duty to disclose") was correct. In contrast, the banks' acts "at most aided and abetted Enron's deceit by making its misrepresentations more plausible." Finally, the court concluded that the transactions did not constitute market manipulation because the banks "did not act directly in the market for Enron securities." Because the banks' transactions with Enron were not deceptive acts and did not constitute market manipulation, there could be no fraud on the market presumption of reliance and class certification failed.
A few additional notes on the panel's decision:
(1) There is a "concurrence" that, in fact, is a vigorous dissent from the primary legal holdings in the majority opinion. In particular, the concurring judge found that the majority had overreached in deciding the substantive scope of Rule 10b-5 on an appeal from class certification and that its definition of "deceptive act" was too narrow.
(2) There has been a significant amount of commentary on the decision already. For an internet roundup, see this Point of Law post.
(3) One obvious question is whether this ruling will have any effect on the previous bank settlements in the Enron securities litigation totaling over $7 billion. According to a Wall Street Journal article in today's edition, the answer is "no," because the settlements are already final.
Quote of note (opinion): "We recognize, however, that our ruling on legal merit may not coincide, particularly in the minds of aggrieved former Enron shareholders who have lost billions of dollars in a fraud they allege was aided and abetted by the defendants at bar, with notions of justice and fair play. We acknowledge that the courts' interpretation of § 10(b) could have gone in a different direction and might have established liability for the actions the banks are alleged to have undertaken. Indeed, one of our sister circuits - the Ninth - believes that it did. We have applied the Supreme Court's guidance in ascribing a limited interpretation to the words of § 10, viewing the statute as the result of Congress's balancing of competing desires to provide for some remedy for securities fraud without opening the floodgates for nearly unlimited and frequently unpredictable liability for secondary actors in the securities markets."
The briefing is complete in Tellabs, Inc. v. Makor Issues & Rights, Ltd., the scienter pleading case currently before the U.S. Supreme Court. The extensive list of amicus briefs can be found on the court docket. The briefs available via public link include:
Petitioners (Tellabs, Inc. and Richard Notebaert)
Respondents (Makor Issue & Rights, Ltd., et al.)
Securities Industry and Financial Markets Association and Chamber of Commerce of the United States of America (Amicus/Petitioners)
American Institute of Certified Public Accountants, et al. (Amicus/Petitioners)
Washington Legal Foundation (Amicus/Petitioners)
SEC and DOJ (Amicus/Petitioners)
North American Securities Administrators Association (Amicus/Respondents)
Ohio and 23 Other States, Territories and Commonwealths (Amicus/Respondents)
Council of Institutional Investors (Amicus/Respondents)
National Conference on Public Employee Retirement Systems and National Association of Shareholder and Consumer Attorneys (Amicus/Respondents)
Arkansas, Seven Other States, and Two Public Pension Funds (Amicus/Respondents)
Oral argument is set for March 28, 2007. The question presented is: "Whether, and to what extent, a court must consider or weigh competing inferences in determining whether a complaint asserting a claim of securities fraud has alleged facts sufficient to establish a 'strong inference' that the defendant acted with scienter, as required under the Private Securities Litigation Reform Act of 1995."
Readers are encouraged to send in public links to any Tellabs briefs not listed here.
Addition: Thanks to Adam Savett for links to the Petitioners' brief and a few of the amicus briefs (added above).
The U.S. Court of Appeals for the Fourth Circuit has issued a decision that addresses two pressing securities litigation issues. In Teachers' Retirement System of Louisiana v. Hunter, 2007 WL 509787 (4th Cir. Feb. 20, 2007), the court considered: (a) whether the plaintiffs could establish the scienter of the corporate defendant using a collective scienter theory; and (b) what is the proper pleading standard for loss causation. (For a discussion of the lower court decision, see this post.)
Collective scienter - The court rejected the idea that a corporate defendant's scienter can be established based on the collective knowledge of its employees. Specifically, the court held that "if the defendant is a corporation, the plaintiff must allege facts that support a strong inference of scienter with respect to at least one authorized agent of the corporation, since corporate liability derives from the actions of its agents." Although the court did not expressly determine whether the agent also must be alleged to have made a misstatement, the court's citation to the Southland decision (5th Cir.) offers some support for that interpretation.
Loss causation - The court noted that in Dura the U.S. Supreme Court expressly did not decide whether the pleading of loss causation is governed by Fed. R. Civ. P. 9(b). In examining the issue, the court found that a "strong case can be made that because loss causation is among the 'circumstances constituting fraud' for which Rule 9(b) demands particularity, loss causation should be pleaded with particularity." Based on this observation and the public policy concerns outlined in Dura, the court concluded that loss causation must be plead "with sufficient specificity to enable the court to evaluate whether the necessary causal link exists." In the instant case, the court found that the plaintiffs did not adequately plead loss causation. Although the disclosure that caused the stock price decline accused the corporate defendant of fraud, it did not provide any "new facts" that "revealed [the corporate defendant's] previous representations to have been fraudulent."
Holding: Dismissal affirmed (based on the failure to adequately plead falsity, scienter, and loss causation).
Disclosure: The author of The 10b-5 Daily represented the defendants in this litigation.
A recent decision by the U.S. Court of Appeals for the Second Circuit offers some interesting clarifications on the scope of accountant liability for securities fraud. In Lattanzio v. Deloitte & Touche LLP, 2007 WL 259877 (2d Cir. Jan. 31, 2007), the court addressed whether Deloitte could be held liable for statements in audited and unaudited financial filings.
As to the company's unaudited financial filings, the court found that Deloitte's regulatory obligation to review the company's quarterly statements did not turn those statements into accountant's statements. Even if the public understood that Deloitte was engaging in these reviews, the accountant's "assurances were never communicated to the public." The court also rejected plaintiffs' argument that the reviews created a duty to correct the quarterly financial statements if false and that a breach of this duty amounted to a misstatement by Deloitte. The court noted that there is a distinct difference between the duties and liabilities created by a review of interim financial statements and those created by an audit of annual financials.
As to the company's audited financial filings, the court dismissed the relevant claims based on a failure to adequately plead loss causation. The court held that the "plaintiffs had to allege that Deloitte's misstatements [in the company's annual reports concerning accounts payable and inventories] concealed the risk of [the company's] bankruptcy." Given that Deloitte had issued a going concern warning - along with the disclosed (if understated) collapse in the company's value - the risk of bankruptcy was apparent. Accordingly, the court found that the plaintiffs had not alleged facts showing that Deloitte's misstatements were the "proximate cause of plaintiffs' loss; nor have they alleged facts that would allow a factfinder to ascribe some rough proportion of the whole loss to Deloitte's misstatements."
Holding: Dismissal affirmed.
Quote of note: "Public understanding that an accountant is at work behind the scenes does not create an exception to the requirement that an actionable misstatement be made by the accountant. Unless the public's understanding is based on the accountant's articulated statement, the source for that understanding - whether it be a regulation, an accounting practice, or something else - does not matter."
Addition: Retired Supreme Court Justice Sandra Day O'Connor sat on the panel.
The U.S. Supreme Court's decision to hear a case on the pleading standards for scienter (i.e., fraudulent intent) has received little media attention . . . until today. The New York Times has an article on the SEC's recent activities related to private securities litigation, including the agency's decision to file an amicus brief in the Tellabs case in support of the defendants.
In their brief, the SEC/DOJ rejected the "reasonable person" test applied by the U.S. Court of Appeals for the Seventh Circuit in evaluating whether the "strong inference" of scienter pleading standard was met (see this post under "Competing Inferences"). Instead, "a court should determine whether, taking the alleged facts as true, there is a high likelihood that the conclusion that the defendant possessed scienter follows from those facts." If the same facts both support and negate an inference of scienter, "the court should consider the relative strength of both inferences, because, where there is a substantial possibility that the defendant acted without scienter, the inference of scienter will not be 'strong.'"
Quote of note (New York Times): "Critics said that the moves signaled a major retrenchment from the post-Enron changes and showed that a lobbying push by big companies, Wall Street firms and the accounting industry was gaining traction as they seek to roll back what they see as onerous regulation and excessive investor litigation. But Christopher Cox, the chairman of the commission, said in an interview Monday that both efforts were in the best interests of investors because they aimed at preventing the accounting industry from further consolidation and at limiting what he called 'fraudulent lawsuits,' including some he said were filed by 'professional plaintiffs.'"
After eleven years, the PSLRA's scienter pleading standard finally will be addressed by the U.S. Supreme Court. On Friday, the court granted certiorari in Tellabs, Inc. v. Makor Issues & Rights, Ltd. on appeal from the U.S. Court of Appeals for the Seventh Circuit. (The 10b-5 Daily's summary of the lower court decision can be found here.)
The question presented on appeal is whether, and to what extent, a court must consider or weigh competing inferences in determining whether a complaint has alleged sufficient facts to establish a strong inference of scienter. The Seventh Circuit held that the plaintiff was entitled to more than the most plausible of competing inferences. Instead, a court should "allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent." In their cert petition (via SCOTUSblog), defendants argued that this is the most lenient of the "four meaningfully different interpretations of the strong inference standard" that have been adopted by federal circuit courts and urged the Supreme Court to resolve the circuit split.
Links to the various cert petition briefs can be found on SCOTUSblog, which also notes that the Supreme Court has ordered expedited briefing in the case and may be planning to hear it during the March 2007 session. Thanks to Greg Harris for the tip.
In an opinion issued in the IPO allocation cases, the Second Circuit has held that in evaluating a motion for class certification under Federal Rule of Civil Procedure 23, district judges must receive and review enough evidence to be satisfied that each requirement of Rule 23 is met, even if there is some overlap between class certification and the merits of a case. The court cautioned that while district judges must reach a full "determination" (but not a finding) regarding fulfillment of the class certification requirements, they should avoid reviewing any aspects of case merits that are unrelated to those requirements. The decision brings the Second Circuit's jurisprudence on class certification into line with the majority of federal appellate courts (including the Fourth, Fifth, Seventh, Eighth and Eleventh Circuits).
More importantly (at least for securities litigators), the court went on to decide whether class certification could be granted in the representative IPO allocation cases at issue. The Second Circuit held that, under the new, stronger standard, the plaintiffs were unable to satisfy the predominance of common questions over individual questions requirement for a Rule 23(b)(3) class action. Accordingly, the court vacated the district court's order granting class certifications and remanded the case for further proceedings.
Although the court's class certification analysis is short, it contains two interesting holdings.
Reliance: The court held that the "fraud on the market" presumption could not be applied because the market for IPO shares cannot be efficient under any circumstances. Interestingly, the court cited the Sixth Circuit's decision in Freeman v. Laventhol & Horwath, 915 F.2d 193, 199 (6th Cir. 1990) in support of this position, even though Freeman is a case about newly traded municipal bonds, not securities traded on a national exchange. The court went on to find that an efficient market cannot be established, for example, because during the 25-day "quiet period" analysts cannot report publicly concerning securities in an IPO and a “significant number of reports by securities analysts” is a "characteristic of an efficient market." Finally, the court reiterated its skepticism (also found in an earlier Second Circuit decision related to the WorldCom securities litigation) that the fraud on the market presumption can be applied in cases based on anything other than statements by an issuer or its agents.
Knowledge: For both Rule 10b-5 and Section 11 claims, plaintiffs must show that they traded without knowing that the stock price was affected by the alleged false or misleading statements. The Court held that lack of knowledge could not be established in the IPO allocation cases because many of the investors were fully aware of the alleged fraudulent scheme (due in large part to the unusual facts of the case). Thus, the court held that the plaintiffs were unable to fulfill the predominance requirement because lack of knowledge was not common throughout the class.
Reports on the decision and its potential impact on the proposed settlement by the issuer defendants can be found in the American Lawyer, Wall Street Journal (subscrip. req'd), and WSJ Law Blog. There is also a Bloomberg article on dissension among the plaintiffs' firms handling the litigation.
In a decision issued earlier this year in the Qwest securities litigation, the U.S. Court of Appeals for the Tenth Circuit declined to adopt the selective waiver doctrine. Specifically, the court found that Qwest could not withhold documents from the plaintiffs on the grounds of attorney-client privilege or the work-product doctrine if those documents were previously produced to the SEC. On Monday, the U.S. Supreme Court denied cert in the case.
The Denver Business Journal has an article on the decision. Most of the defendants have settled (including Qwest), but the case is continuing against two former officers. The 10b-5 Daily has posted frequently about the settlement - for the latest post, click here.
The Sarbanes-Oxley Act of 2002 ("SOX") requires the chief executive officer and chief financial officer of a company to certify the accuracy of each periodic report containing financial statements. Plaintiffs often argue that these certifications can support the pleading of scienter (i.e., fraudulent intent) in cases alleging accounting misrepresentations.
In what appears to be the first circuit court opinion to address the issue, the U.S. Court of Appeals for the Eleventh Circuit has held that SOX certifications, by themselves, are not indicative of scienter. In Garfield v. NDC Health Corp., 2006 WL 2883238 (11th Cir. Oct. 12, 2006), the court found that SOX "does not indicate any intent to change the requirements for pleading scienter set forth in the PSLRA [Private Securities Litigation Reform Act of 1995]." Accordingly, a SOX certification "is only probative of scienter if the person signing the certification was severely reckless in certifying the accuracy of the financial statements."
Quote of note: "If we were to accept [plaintiff's] proferred interpretation of Sarbanes-Oxley, scienter would be established in every case were there was an accounting error or auditing mistake made by a publicly traded company, thereby eviscerating the pleading requirements for scienter set forth in the PSLRA."
The U.S. Court of Appeals for the Fourth Circuit has issued its first post-Dura decision on loss causation. In Glaser v. Enzo Biochem, Inc., 2006 WL 2692848 (4th Cir. Sept. 21, 2006), the court examined whether the plaintiffs had adequately alleged a Virginia common law fraud claim related to the sale of securities. (The federal securities claims had previously been dismissed on statute of limitations grounds.)
The court found that it "is only after the fraudulent conduct is disclosed to the investing public, followed by a drop in the value of the stock, that the . . . investor has suffered a 'loss' that is actionable after the Supreme Court's decision in Dura." Because the complaint appeared to concede that the plaintiffs had sold their shares before the "alleged truth about Enzo's science" was "publicly revealed," any losses they suffered "must have been the result of market factors or other factors, not the revelation of the alleged truth."
Whether plaintiffs who combine nonfraud and fraud securities claims in the same complaint are subject to the particularity pleading requirement of Fed. R. of Civ. P. 9(b) has been an open issue. Although claims under Section 11 and Section 12(a)(2) of the Securities Act of 1933 do not require the plaintiff to establish fraudulent intent, a number of federal circuits (2nd, 3rd, 5th, 7th, and 9th - with only the 8th disagreeing) have held that these claims must be plead with particularity if they "sound in fraud" based on the existence of a related securities fraud claim.
The U.S. Court of Appeals for the Eleventh Circuit has joined the majority position this week. In Jacobson v. First Horizon Pharm. Corp., 2006 WL 2661652 (11th Cir. Sept. 18, 2006), the court found that a Section 11 or Section 12(a) claim "must be pled with particularity when the facts underlying the misrepresentation at stake in the claim are said to be part of a fraud claim, as alleged elsewhere in the complaint."
The court also addressed whether the complaint was improperly dismissed pursuant to Fed. R. Civ. P. 12(b)(6) on the basis that it was a "shotgun pleading" that did not clearly link its alleged facts to the causes of action. Interestingly, the district court had granted the dismissal and conditioned any amendment of the complaint "on the [plaintiffs'] payment of the defendants' costs and fees associated with the motion to dismiss." On appeal, the court avoided that issue by holding that instead of dismissing the complaint, the district court should have sua sponte ordered a repleading for a more definitive statement of the claim pursuant to Fed. R. Civ. P. 12(e).
Quote of note: "It is not enough to claim that alternative pleading saves the nonfraud claims from making an allegation of fraud because the risk to the defendant's reputation is not protected. It would strain credulity to claim that Rule 9(b) should not apply in this allegation: The defendant is a no good defrauder, but, even if he is not, the plaintiff can still recover based on the simple untruth of the otherwise fraudulent statement."
The Sarbanes-Oxley Act of 2002 ("SOX") 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 the 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.
In an opinion issued this week - Margolies v. Deason, 2006 WL 259788 (5th Cir. Sept. 11, 2006) - the Fifth Circuit has joined the clear majority of federal appellate courts (including the Second, Third, Fourth, Seventh, and Eighth Circuits) in holding that the new statute of limitations should not be applied retroactively. The Eleventh Circuit remains the only dissenter (see this post).
The Securities Litigation Uniform Standards Act of 1998 ("SLUSA") pre-empts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. The "in connection with" requirement has been a continuous source of litigation and was the subject of the Dabit decision by the U.S. Supreme Court earlier this year.
Not to be outdone, the U.S. Court of Appeals for the Seventh Circuit has issued its own opinion discussing the scope of the "in connection with" requirement. In Gavin v. AT&T Corp., 2006 WL 2548238 (7th Cir. Sept. 6, 2006), the court addressed a class action arising out of the merger between MediaOne and AT&T in 2000. The terms of the merger entitled shareholders of MediaOne to obtain, in exchange for their MediaOne shares, a certain amount of AT&T stock plus cash and any accrued but unpaid dividends. After AT&T solicited MediaOne shareholders twice to make this exchange, it hired a shareholder communications company to "clean up" any MediaOne shareholders who had not yet responded. The letter from the shareholder communications company specified a fee of $7 per MediaOne share for the exchange service, without mentioning that MediaOne shareholders could still do the exchange at no cost through AT&T's exchange agent. The failure to mention the "no cost" option is the fraud charged in the complaint.
In an opinion by Judge Posner, the court was highly critical of the defendants' position that the case should be pre-empted by SLUSA because the alleged fraud was in connection with the purchase or sale of MediaOne stock. Noting that MediaOne's shareholders "became the beneficial owners of AT&T stock" when the merger was consummated, the court found that the alleged fraud "happened afterwards and had nothing more to do with the federal securities law than if [the shareholder communication company] had asked the MediaOne shareholders 'do you want your AT&T shares sent to you by regular mail or by courier?' and had charged an inflated fee for the courier service." Accordingly, the court reversed the pre-emption decision and instructed the district court to remand the case back to state court.
Quote of note: "Of course there is a literal sense in which anything that happens that would not have happened but for some prior event is connected to that event. In that sense the fraud of which the plaintiff complains is connected to the merger, without which there would not have been such a fraud against the plaintiff and her class. But in the same sense the fraud is connected to the Big Bang, without which there would never have been a MediaOne or even an AT&T."
Today's edition of the New Jersey Law Journal has an interesting article (subscrip. req'd) on an appellate decision upholding an attorneys' fees award. In In re AT&T Corp. Sec. Litig., 2006 WL 2021033 (3d Cir. July 20, 2006), the Third Circuit found that the upward sliding fee scale (i.e., the fee percentage increased as the size of the settlement increased) agreed to by the lead plaintiff was permissible. Notably, the total fee of $21.25 million was only 1.28 times the lodestar calculation of the reasonable attorney hours expended times their hourly rates. (An earlier post on the AT&T settlement can be found here.)
Quote of note: "St. John's University Law Professor Michael Perino says, 'It is a matter of dispute among academics as to whether an upward sliding scale or a downward sliding scale creates the best set of incentives for plaintiffs. Downward is more common.'"
Disclosure: The author of The 10b-5 Daily is quoted in the article.
Whether secondary actors who did not prepare or substantially participate in preparing corporate financial misstatements can still be held liable for them under Rule 10b-5 as scheme participants is a hot topic in the courts. In Simpson v. AOL Time Warner, Inc., 2006 WL 1791042 (9th Cir. June 30, 2006), the U.S. Court of Appeals for the Ninth Circuit has issued an opinion in the Homestore securities litigation that addresses the issue. (A discussion of the lower court decision and SEC amicus brief on appeal can be found here.)
In Simpson, the court held that "to be liable as a primary violator of Sec. 10(b) for participation in a 'scheme to defraud,' the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme." It is not sufficient, the court concluded, "that a transaction in which a defendant was involved has a deceptive purpose and effect; the defendant's own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect." The court rejected the defendants' argument that Sec. 10(b) liability is limited to those who make material misstatements or omissions, but ultimately found that the district court had correctly dismissed the claims against them.
Held: Dismissal affirmed.
The U.S. Court of Appeals for the Tenth Circuit has issued an opinion in the Qwest securities litigation on the issue of selective waiver. See In re Qwest Communications Int'l Inc. Sec. Litig., 2006 WL 1668246 (10th Cir. June 19, 2006). In particular, the court considered whether the company could withhold documents from the plaintiffs on the grounds of attorney-client privilege or the work-product doctrine even though those documents had previously been produced to the SEC.
After an exhaustive survey of related decisions, revealing that circuit courts generally have rejected the concept of selective waiver, the court held that the record in the case did "not establish a need for a rule of selective waiver to assure cooperation with law enforcement, to further the purposes of the attorney-client privilege or work-product doctine, or to avoid unfairness to the disclosing party." In the court's view, Qwest was seeking "the substantial equivalent of an entirely new privilege, i.e., a government-investigation privilege," which the court was disinclined to create. (Note that the production of opinion work product was not an issue in the case.)
The Rocky Mountain News has an article on the decision.
Quote of note: "At least to the degree exhorted by amici, 'the culture of waiver' appears to be of relatively recent vintage. Whether the pressures facing corporations in federal investigations present a hardened, entrenched problem suitable for common-law intervention or merely a passing phenomenon that may soon be addressed in other venues is unclear."
In the Kircher v. Putnam Funds case, the U.S. Supreme Court has held that a district court's decision to remand a case to state court pursuant to the Securities Litigation Uniform Standards Act of 1998 ("SLUSA") is not subject to appellate review. The 9-0 decision authored by Justice Souter (with a separate concurrence by Justice Scalia) resolves a circuit split between the Second Circuit (not appealable) and the Seventh Circuit (appealable) on the issue.
SLUSA generally prohibits the bringing of a securities class action based on state law in state court. The defendants are permitted to remove the case to federal district court for a determination on whether the case is precluded by the statute. If so, the district court must dismiss the case; if not, the district court must remand the case back to state court.
As a matter of federal procedural law, a remand based on a district court's decision that it does not have subject-matter jurisdiction over a case cannot be reviewed on appeal. In Kircher, however, the Seventh Circuit found that this general proposition is inapplicable to a case removed and remanded under SLUSA because the district court is making a substantive decision of no preclusion, as opposed to a procedural decision of no subject-matter jurisdiction.
The Supreme Court disagreed. Based on SLUSA's text, the Court found that "removal and jurisdiction to deal with removed cases is limited to those precluded" by the statute. Under these circumstances, "a motion to remand claiming the action is not precluded must be seen as posing a jurisdictional issue." The district court's exercise of its "adjudicatory power" is "jurisdictional, as is the conclusion reached and the order implementing it." Accordingly, the remand decision is not subject to appellate review.
Interestingly, the Supreme Court also addressed the Seventh Circuit's assumption that SLUSA gives federal courts exclusive jurisdiction to decide the preclusion issue, so that "a remand order based on a finding that the action is not precluded would arguably be immune from review." The Court found that nothing in SLUSA creates this exclusive jurisdiction and on remand the state court would be "perfectly free to reject the remanding court's reasoning" and make its own determination as to preclusion. Moreover, any error in that decision could "be considered on review by this Court." The issue was of particular importance in the instant case, because the Court had recently held that holder claims, arguably like those brought by Kircher, are precluded under SLUSA.
Holding: Judgment vacated and case remanded with instructions to dismiss the appeal for lack of jurisdiction.
There is a district court split over whether secondary actors who did not prepare or substantially participate in preparing corporate financial misstatements can still be held liable for them under Rule 10b-5 as scheme participants. Last week, the U.S. Court of Appeals for the Eighth Circuit weighed in on the issue and flatly rejected this theory of liability.
In In re Charter Communications, Inc. Sec. Litig., 2006 WL 925354 (8th Cir. April 11, 2006), the court addressed allegations that the vendor defendants entered into sham transactions with Charter knowing that the company "intended to account for them improperly and that analysts would rely on the inflated revenues and operating cash flow in making stock recommendations." The plaintiffs argued (relying primarily on a district court decision in the Parmalat case) that the vendors violated Rule 10b-5(a) and (c) by participating in a fraudulent scheme or course of business.
The court found, however, that "any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under Sec. 10(b) or any subpart of Rule 10b-5." Since the plaintiffs did not allege that the vendor defendants made or approved Charter's financial misrepresentations, the claims against them were properly dismissed.
Holding: Dismissal affirmed.
Quote of note: "To impose liability for securities fraud on one party to an arm's length business transaction in goods or services other than securities because that party knew or should have known that the other party would use the transaction to mislead investors in its stock would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings. Decisions of this magnitude should be made by Congress."
The respondents' brief in the Kircher case before the U.S. Supreme Court is now available online. The docket reveals that an amicus brief in support of Kircher has been filed by four law professors. Putnam Funds, in turn, is supported by amicus briefs from the Washington Legal Foundation, the Securities Industry Association and the Bond Market Association, and the U.S. Chamber of Commerce. Oral argument is scheduled for April 24.
It turns out that sometimes you can tell what the justices are thinking by the questions they ask. As was predicted by some observers following oral argument in the Dabit case, the U.S. Supreme Court has held that the Securities Litigation Uniform Standards Act ("SLUSA") pre-empts state-law class actions brought on behalf of persons who were induced to hold (but not purchase or sell) securities. The 8-0 decision authored by Justice Stevens resolves a circuit split between the Second Circuit and the Seventh Circuit on the issue.
SLUSA preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. The primary goal of SLUSA was to prevent plaintiffs from using state law claims to avoid the heightened pleading standards imposed on federal securities class actions. The issue before the Supreme Court in Dabit was the meaning of SLUSA's "in connection with" requirement.
Dabit is a former Merrill Lynch broker who filed a class action in federal court claiming, under Oklahoma state law, that Merrill Lynch breached its fiduciary duty to its brokers by disseminating misleading analyst research. Dabit asserted that this practice caused the brokers to hold onto overvalued securities too long and lose commission fees when their clients took their business elsewhere. The Second Circuit found that Dabit's claims were not pre-empted by SLUSA to the extent that he "alleged that brokers were fraudulently induced, not to sell or purchase, but to retain or delay selling their securities."
The Supreme Court previously had held that only purchasers and sellers of securities have standing to bring a private securities fraud action pursuant to Rule 10b-5. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). In Dabit, however, the Court clarified that its earlier decision to limit the potential plaintiffs in Rule 10b-5 cases was based on policy considerations, not on an attempt to define the phrase "in connection with the purchase or sale." Indeed, the Court has generally "espoused a broad interpretation" of that phrase, holding that "it is enough that the fraud alleged 'coincide' with a securities transaction - whether by the plaintiff or by someone else."
The Court found that this broad interpretation must have been known to Congress when it drafted SLUSA and used the "in connection with" language. Given that "class actions brought by holders pose a special risk of vexatious litigation," it would be "odd, to say the least, if SLUSA exempted that particularly troublesome subset of class actions from its pre-emptive sweep." Moreover, allowing state class actions brought by holders "would give rise to wasteful, duplicative litigation" if parallel state court (holders) and federal court (purchasers) class actions were brought based on the same facts.
Holding: Judgment vacated and case remanded for further proceedings consistent with opinion.
Quote of note: "The holder class action that respondent tried to plead, and that the Second Circuit envisioned, is distinguishable from a typical Rule 10b–5 class action in only one respect: It is brought by holders instead of purchasers or sellers. For purposes of SLUSA pre-emption, that distinction is irrelevant; the identity of the plaintiffs does not determine whether the complaint alleges fraud 'in connection with the purchase or sale' of securities. The misconduct of which respondent complains here—fraudulent manipulation of stock prices—unquestionably qualifies as fraud 'in connection with the purchase or sale' of securities as the phrase is defined in Zandford, 535 U. S., at 820, 822, and O’Hagan, 521 U. S., at 651."
Oral argument in the Kircher case before the U.S. Supreme Court will be held on April 24. The case addresses whether a party may appeal a district court's decision to remand a case to state court pursuant to the Securities Litigation Uniform Standards Act of 1998. The official question presented can be found here and the petitioner's brief can be found here. Thanks to Adam Savett for the links.
An interesting appellate decision from late last year illustrates the double-edged nature of the efficient market hypothesis for securities fraud litigants. In In re Merck & Co. Sec. Litig., 432 F.3d 261 (3rd Cir. 2005), the Third Circuit addressed whether Merck's failure to disclose certain accounting practices of a wholly-owned subsidiary was a material omission.
On April 17, 2002, in connection with the initial public offering of the subsidiary, Merck filed a Form S-1 that disclosed for the first time that the subsidiary had recognized as revenue the co-payments paid by consumers. The Form S-1 did not disclose, however, the total amount of co-payments recognized. On the day the Form S-1 was filed, Merck's stock price went up. Two months later, the Wall Street Journal reported that the subsidiary had been recognizing the co-payments as revenue and estimated the total amount of this revenue in 2001 at over $4 billion. Merck's stock price dropped two dollars.
On appeal, the Third Circuit held that in an efficient market the materiality of disclosed information may be measured by looking at the movement of the company's stock price immediately following the disclosure. Since Merck's stock price did not decline when the Form S-1 was filed, the court found that the revenue recognition information was immaterial as a matter of law. In response to the plaintiffs' argument that the real disclosure took place when the Wall Street Journal made public the estimated magnitude of the co-payment recognition, the court found that the "minimal, arithmetic complexity of the calculation" made by the reporter "hardly undermines faith in an efficient market." The court noted that this was especially true given how closely Merck was followed by analysts.
Holding: Dismissal affirmed.
Quote of note: "[Plaintiff] is trying to have it both ways: the market understood all the good news that Merck said about its revenue but was not smart enough to understand the co-payment disclosure. An efficient market for good news is an efficient market for bad news. The Journal reporter simply did the math on June 21; the efficient market hypothesis suggests that the market made these basic calculations months earlier."
Addition: One of the panel judges was Samuel Alito, who has since become Justice Alito.
For readers interested in more analysis of the Securities Litigation Uniform Standards Act (SLUSA) issues before the U.S. Supreme Court this term, the New York Law Journal (via law.com - regist. req'd) has two recent columns on the cases. The column on Dabit (Feb. 15) can be found here; the column on Kircher (Feb. 8) can be found here.
It took ten years, but the U.S. Court of Appeals for the Seventh Circuit has finally issued an opinion that comprehensively interprets the PSLRA's heightened pleading standards. In Makor Issues & Rights, Ltd. v. Tellabs, Inc., 2006 WL 172142 (7th Cir. Jan. 25, 2006) (Wood, J.), the court addressed the following issues:
(1) Pleading of all facts - Although the PLSRA requires a complaint based on information and belief to state "all facts on which that belief is formed," courts generally have held that this requirement should not be applied literally. The Seventh Circuit agreed with the Second Circuit that the relevant question is "whether the facts alleged are sufficient to support a reasonable belief as to the misleading nature of the statement or omission."
(2) Confidential witnesses - In accord with a number of other circuit courts, the Seventh Circuit found that plaintiffs are not required to provide the identify of their confidential sources. It is enough for plaintiffs to describe the sources with sufficient particularity to support the probability that the person would "have access to, or knowledge of, the facts underlying the allegations."
(3) Substantive scienter standard - The Seventh Circuit found that the PSLRA did not raise the substantive scienter standard for securities fraud, which continues to be knowledge or recklessness. (Only the Ninth Circuit has reached a different conclusion.)
(4) Pleading scienter - Under the PSLRA, a plaintiff must plead sufficient facts to create a "strong inference" of scienter or the complaint shall be dismissed. The key issue has been whether motive and opportunity allegations (e.g., insider stock trading), by themselves, can meet this pleading burden. The Second and Third Circuits say yes. The Ninth and Eleventh Circuits disagree. A number of other circuit courts, however, have taken a more holistic approach and require that all of the allegations in the complaint be collectively examined to determine whether the requisite strong inference of scienter is demonstrated. The Seventh Circuit adopted this middle ground, finding that motive and opportunity allegations may be "useful indicators."
(5) Competing inferences - Although the Sixth Circuit has found that the "strong inference" requirement creates a situation in which plaintiffs are only entitled to the most plausible of competing inferences when a court evaluates their scienter allegations, the Seventh Circuit disagreed. Instead, the Seventh Circuit stated that it "will allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent."
(6) Group pleading for scienter - The Seventh Circuit found that the PSLRA requires a strong inference of scienter to be pled for each defendant. Accordingly, scienter allegations made against one defendant cannot be imputed to other defendants on the theory that the officers of the company acted collectively.
For all of the legal windup, the application of the law to the facts in Makor is surprisingly brief. The district court had found that the plaintiffs failed to adequately allege scienter for any of the defendants. On appeal, the Seventh Circuit held that the allegations concerning marketing, sales, and production information available to the CEO were sufficient to establish a strong inference that he acted with fraudulent intent. The CEO's scienter could then be imputed to the company. As for the other individual defendant, the company's Chairman, the scienter allegations appeared to be of the "must have known" variety, and he only sold 1% of his stock holdings during the class period. Accordingly, the Rule 10b-5 claim against the Chairman was dismissed.
Holding: Affirmed in part, reversed in part. (The court also evaluated whether falsity and materiality was adequately pled for all of the statements and whether the forward-looking statements were protected by the PSLRA's safe harbor, but its holdings on these issues were not dispositive of the overall claims against any of the defendants.) The oral argument in the case can be listened to here - thanks to The PSLRA Nugget for the link.
Early reports from today's Supreme Court oral argument in Merrill Lynch v. Dabit (see post below) suggest that the Second Circuit may be reversed. The justices evidently were skeptical that Congress, in passing SLUSA, meant to allow holders to bring a securities class action in state court, while forcing purchasers and sellers to bring the same case in federal court. Dow Jones Newswires (via wsj.com - subscrip. req'd) and the Financial Times (via MSNBC.com) have articles, while the Wall Street Journal's Law Blog gets a first-hand report from a law professor who attended the hearing.
Quote of note (Financial Times): "Justice Stephen Breyer said he was worried that permitting such suits in state court would allow investors to circumvent the limits imposed by federal securities laws on purchaser and seller suits. Mr. Breyer said nothing would stop them from proceeding in state court, simply by filing their suits as holders rather than sellers. Justice Ruth Bader Ginsburg asked: 'Why would Congress with respect to this category want there to be a more plaintiff-friendly rule than it put in place for the purchaser-seller?'"
Media interest in Merrill Lynch v. Dabit, the SLUSA case being heard by the U.S. Supreme Court today, has been muted. Nevertheless, there are some good Internet sources on the case. Scotusblog provides an in-depth preview of the oral argument. The Wall Street Journal's new Law Blog also has a post.
The respondent's brief in Merrill Lynch v. Dabit, the first of two SLUSA cases that will be heard by the Supreme Court this term (see post below), can be found here. The following entities have filed amicus briefs in support of Dabit's position: the National Association of Shareholders and Consumer Attorneys and AARP, IJG Investments Limited Partnership and Iriys Guy, Phillip Goldstein and Bulldog Investors, and New York. Oral argument is scheduled for next Wednesday.
When you're hot, you're hot. The Securities Litigation Uniform Standards Act of 1998 (SLUSA) will be the subject of a second U.S. Supreme Court argument this year following the granting of certiorari in the Kircher v. Putnam Funds Trust case. The question presented is whether a party may appeal a district court's decision to remand a case to state court pursuant to SLUSA. There is currently a circuit split between the Second and Ninth Circuits (not appealable) and the Seventh Circuit (appealable) on this issue. Scotusblog reports that the case will be heard in April. (The 10b-5 Daily's discussion of the underlying Seventh Circuit opinion can be found here.)
The U.S. Court of Appeals for the First Circuit has issued an interesting opinion in a research analyst case. The decision - Brown v. Credit Suisse First Boston LLC, 2005 WL 3359728 (1st Cir. Dec. 12, 2005) - affirms the dismissal of securities fraud claims based on alleged false "buy" recommendations made by CSFB's analysts with respect to the stock of Agilent Technologies.
The court held that the plaintiffs needed to plead facts "sufficient to indicate that the speaker did not actually hold the opinion expressed." In examining the existence of this "subjective falsity," the analysis of the falsity of the statement and the defendants' fraudulent intent (i.e., scienter) cannot be separated. Accordingly, the PSLRA's heightened pleading standard for scienter should be applied and the plaintiffs must "plead provable facts strongly suggesting that the speaker did not believe [a] particular opinion to be true when uttered."
Turning to the complaint, the court found that "while the plaintiffs' allegations regarding the obvious conflicts of interest and general state of corruption within CSFB's analyst ranks may be enough to turn the stomach of an ethically sensitive observer, they are insufficient, on their own, to support a fraud pleading with respect to the subjective falsity of the eight 'buy' recommendations issued on Agilent stock." In particular, the court rejected a series of CSFB e-mails that suggested its analysts engaged in "sharp practice," but fell short of creating a strong inference that any particular "buy" rating did not reflect the personal belief of the analyst in question.
Holding: Dismissal affirmed.
Quote of note: "The plaintiffs' allegations, if true, show beyond hope of contradiction that the defendants operated without much concern for ethical standards. But the fact that an organization is ethically challenged does not impugn every action that it takes. In a securities fraud case, the plaintiffs still must carry the burden, imposed by the PSLRA, of pleading facts sufficient to show that the particular statements sued upon were false or misleading when made. This is as it should be: the securities laws - and section 10(b) in particular - were designed to provide a damages remedy for losses incurred as a result of false or misleading statements, not to punish defendants for bad behavior in a vacuum."
There is no lack of amici curiae who have filed briefs on behalf of Merrill Lynch in Merrill Lynch v. Dabit, the SLUSA case before the Supreme Court. The list includes (with hyperlink to the brief where available) the Department of Justice/SEC, the U.S. Chamber of Commerce, the Investment Company Institute, Lord Abbett & Co./Vance Management, the Washington Legal Foundation, the Securities Industry Association/Bond Market Association, and Pacific Life Insurance.
Oral argument in Merrill Lynch v. Dabit, the SLUSA case before the Supreme Court, has been scheduled for Wednesday, January 18. The petitioner's brief can be found here.
The official question presented in the Dabit case before the U.S. Supreme Court is:
"Whether, as the Seventh Circuit held earlier this month and in direct conflict with the decision below, SLUSA preempts state law class action claims based upon allegedly fraudulent statements or omissions brought solely on behalf of persons who were induced thereby to hold or retain (and not purchase or sell) securities?"
For more on the decision below, see this post.
The Associated Press reports that the U.S. Supreme Court has declined to grant cert in the Lentell v. Merrill Lynch case. In Lentell, the U.S. Court of Appeals for the Second Circuit affirmed the dismissal of two research analyst cases based on the plaintiffs' failure to adequately plead loss causation. The 10b-5 Daily's summary of the Second Circuit decision can be found here.
In a typical securities class action, the dismissal of the claims against the individual defendants leads to the dismissal of the claims against the company. In the absence of an underlying Rule 10b-5 violation, there also can be no control person liability. But consider this scenario: the suit is stayed against the controlled entity because it is in bankruptcy. Can the control person claims continue against the individual defendants even if the Rule 10b-5 claims against them have been dismissed? The U.S. Court of Appeals for the First Circuit says yes, but how the district court is supposed to implement the decision is unclear.
In In re Stone & Webster, Inc. Sec. Litig., 414 F.3d 187 (1st Cir. 2005), the court affirmed the dismissal of the Rule 10b-5 claims against the CEO and CFO of Stone & Webster (the only individual defendants in the case) based on the failure to adequately plead scienter (i.e., fraudulent intent). The Section 20(a) claims for control person liability against the CEO and CFO, however, were allowed to continue. The CEO and CFO petitioned for rehearing on this issue, arguing that the dismissal of the underlying Rule 10b-5 claims necessitated the dismissal of the Section 20(a) claims.
In a separate opinion, the court denied the petition. See In re Stone & Webster, Inc. Sec. Litig., 2005 WL 2216319 (Sept. 13, 2005). The claims against the company had not been dismissed. Instead, they had been stayed when the company filed for bankruptcy protection. The court held that the dismissal of the Rule 10b-5 claims against the CEO and CFO "is in no way incompatible with the establishment of their secondary liability under Sec. 20(a) as controlling persons of Stone & Webster, predicated on Stone & Webster having violated Rule 10b-5."
On remand, however, the district court appears to be presented with a difficult puzzle. Whether a defendant corporation has acted with scienter is normally determined by looking "to the state of mind of the individual corporate official or officials who make or issue the statement . . . rather than generally to the collective knowledge of all the corporation's officers and employees acquired in the course of their employment." Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353 (5th Cir. 2004). The CEO and CFO were the only individual defendants in the case. If the case is not going to proceed against them, how can the corporation be found to have acted with scienter? The opinion refers to the possibility that "the acts of other agents might also serve as predicates for the Sec. 20(a) liability," but this seems like merely a theoretical assertion if all of the individual defendants have been dismissed. Stay tuned.
The Supreme Court has granted cert in the Dabit case (2d. Cir.) and will address the scope of the Securities Litigation Uniform Standards Act of 1998 ("SLUSA").
SLUSA preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. The issue before the Supreme Court is the application of the "in connection with" requirement. In particular, the court will resolve the circuit split between the Second and Seventh Circuits over whether SLUSA preemption applies to claims brought solely on behalf of persons who were induced to hold (but not purchase or sell) securities.
The 10b-5 Daily has posted frequently on this issue, including posts on the underlying Second Circuit opinion in the Dabit case finding that SLUSA only applies to purchaser/seller claims and the Seventh Circuit's opinion in the Putnam Funds II case reaching the opposite conclusion. For a cite to an article discussing the circuit split and its ramifications, see this post.
The Securities Litigation Uniform Standards Act of 1998 ("SLUSA") preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. The defendants are permitted to remove the case to federal district court for a determination on whether the case is preempted by the statute. If so, the district court must dismiss the case; if not, the district court must remand the case back to state court.
Earlier this year, the U.S. Court of Appeals for the Seventh Circuit held in the Putnam Funds cases that the "in connection with" language in SLUSA merely "ensures that the fraud occurs in securities transactions rather than some other activity." Accordingly, plaintiffs could not avoid SLUSA by limiting their proposed class to investors in the funds who merely held their shares, rather than purchased or sold them, during the class period.
The Seventh Circuit has now confirmed that holding under slightly different factual circumstances. In Disher v. Citigroup Global Markets Inc., 2005 WL 1962942 (7th Cir. Aug. 17, 2005), the court found that a class action suit brought in state court on behalf of customers of Salomon Smith Barney alleging that they were mislead by false stock ratings was subject to preemption. The proposed class definition "of all SSB customers who retained certain securities in reliance on SSB's misrepresentations is no more narrowly drawn than the class definitions discussed in [the Putnam Funds decision]." Accordingly, the court ordered that the case be dismissed.
Holding: Reversed and remanded with instructions to vacate the remand order and dismiss the claims.
The U.S. Court of Appeals for the Fourth Circuit has decided to publish its opinion in the PEC Solutions securities class action. As discussed in this post from last March, the opinion is the first post-PSLRA decision by the Fourth Circuit to address the common scienter allegations of insider stock sales and violations of generally accepted accounting principles ("GAAP").
Disclosure: The author of The 10b-5 Daily argued the case before the appellate court on behalf of the defendants.
The PSLRA created a safe harbor for forward-looking statements to encourage companies to provide investors with information about future plans and prospects. Under the first prong of the safe harbor, a defendant is not liable with respect to any forward-looking statement if it is identified as forward-looking and is accompanied by "meaningful cautionary statements" that alert investors to the factors that could cause actual results to differ.
Some commentators have described this provision as a "license to lie," because it arguably protects companies from liability based on even deliberately false forward-looking statements. The U.S. Court of Appeals for the First Circuit agrees. In In re Stone & Webster, Inc., Sec. Litig., 2005 WL 1654040 (1st Cir. July 14, 2005), the court evaluated an allegedly misleading statement that the company "has on hand . . . sufficient sources of funds to meet its anticipated [needs]." The district court found the statement to be forward-looking based on its reference to an anticipated futher need for funds and dismissed the claim based on the PSLRA's safe harbor. On appeal, the First Circuit found "that the meaning of this curious statute, which grants (within limits) a license to defraud, must be somewhat more complex and restricted."
In the instant case, the statement was "composed of elements that refer to estimates of future possibilities and elements that refer to present facts." The court found that the specific claim of fraud related to whether the defendants were "lying about the Company's present access to funds," not whether the defendants "were underestimating the amount of their future cash needs." Under these circumstances, the "mere fact that a statement contains some reference to a projection of future events cannot sensibly bring the statement within the safe harbor."
Holding: Judgment affirmed in part and vacated in part. (The decision contains holdings on a number of other pleading issues. It also creates an interesting bit of nomenclature, referring to the PSLRA's heightened pleading standards for false statements as the "clarity-and-basis" requirement.)
Why has the Supreme Court declined to hear cases that would clarify the PSLRA? Business Week has a "news analysis" on the Supreme Court's reluctance to take cases in "vital areas such as antitrust, environmental, intellectual-property, securities, and tax law." In particular, the article cites the varied application of the PSLRA's heightened pleading standards as a "prime example of the legal confusion that the Supreme Court has allowed to fester."
The article does not state how many cert petitions involving interpretations of the PSLRA the Supreme Court has rejected. That said, anecdotal evidence abounds. A recent example is the Supreme Court's decision not to hear the Baxter case, an appeal from a Seventh Circuit decision that created a circuit split over the PSLRA's safe harbor for forward-looking statements.
The IPO allocation cases (brought against the underwriters of over 300 initial public offerings) generally allege that the defendants ramped up trading commissions in exchange for providing access to IPO shares and required investors allocated IPO shares to buy additional shares in the after-market to help push up the share price. Last year, Judge Scheindlin (S.D.N.Y.) granted class certification in six "focus" cases that have been used to test the sufficiency of the overall allegations.
A reader points out that the Second Circuit has agreed to hear an appeal from that grant (by order dated June 30, 2005). Moreover, the court has specifically asked for briefing on two hot-button issues:
(1) Whether the Second Circuit's previous position that plaintiffs are only required to make "some showing" that the proposed class comports with all of the elements of Federal Rule of Civil Procedure 23 is consistent with the 2003 amendments to that rule.
(2) Whether the presumption of reliance established in Basic v. Levinson, 485 U.S. 224 (1988) (i.e., the fraud-on-the-market theory) was properly extended to plaintiffs' claims against the non-issuer defendants and to the market manipulation claims.
The Second Circuit has come close to addressing the scope of the fraud-on-the-market theory before, but was thwarted by a settlement. The resolution of this issue has wide-ranging implications for securities fraud litigation. Take a look, for example, at The 10b-5 Daily's discussion of two opposing district court decisions in cases brought against research analysts. Stay tuned.
In the first circuit court decision to apply the Supreme Court's holding in the Dura case, the Sixth Circuit has affirmed the dismissal of a securities class action based on the plaintiffs' failure to adequately plead loss causation. The case was brought against several former Kmart executives and PricewaterhouseCoopers. The plaintiffs alleged that the defendants misled Kmart's investors in 2000 and 2001 prior to the company's bankruptcy.
In D.E. & J. Limited Partnership v. Conaway, 2005 WL 1386448 (6th Cir. June 10, 2005) (unpublished), the Sixth Circuit found that the plaintiffs "did not plead that the alleged fraud became known to the market on any particular day, did not estimate the damages that the alleged fraud caused, and did not connect the alleged fraud with the ultimate disclosure or loss." In the end, the plaintiffs relied entirely on allegations that they had paid artificially inflated prices for their Kmart stock and that Kmart's stock price declined after the company announced its bankruptcy. The Sixth Circuit held that price inflation had been expressly rejected by the Supreme Court as an adequate basis for pleading loss causation. As for the bankruptcy filing, the plaintiffs "never alleged that Kmart's bankruptcy announcement disclosed any prior misrepresentations to the market."
Holding: Dismissal affirmed.
The National Law Journal has a review (via law.com - free regist. req'd) of the Second Circuit's major securities law cases over the past year. Click on the case name for The 10b-5 Daily's take on the featured decisions - Dabit, Rombach, and Enterprise Mortgage.
The Sarbanes-Oxley Act of 2002 ("SOX") 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 the 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.
Two circuit courts (the 2nd and 7th) have declined to apply the new statute of limitations to revive time-barred claims. In the past week, the Eleventh and Eighth Circuits have also issued opinions addressing the question.
In its long-awaited decision in Tello v. Dean Witter Reynolds, Inc., 2005 WL 1279130 (11th Cir. June 1, 2005), the Eleventh Circuit held that it could not decide "the statutory-interpretation issue of whether previously time-barred claims are revived by the [SOX] statute of limitations" until the district court determined if the plaintiffs were on inquiry notice of their claims prior to the passage of the legislation.
In contrast, the Eight Circuit's opinion in In re ADC Telecommunications, Inc. Sec. Litig., 2005 WL 1322576 (8th Cir. June 6, 2005) simply follows the earlier appellate holdings in finding that SOX did not revive time-barred claims. The opinion (in a footnote) and concurrence clarify that the issue of the retroactivity of the new statute of limitations (i.e., its application to "causes of action that had already accrued at the time of the change in law") is separate from the issue of whether Congress intended to revive time-barred claims.
In an interesting decision from earlier this month, the U.S. Court of Appeals for the Third Circuit has held that deference should be given to a lead plaintiff's decision not to compensate non-lead counsel. The case stems from the $3.2 billion settlement in the Cendant Corp. securities litigation. Lead counsel for the plaintiffs obtained $52 million in legal fees, which it shared with twelve other law firms that had been authorized to work on the case. An additional forty-five firms that represented individual plaintiffs, however, were frozen out of any fees. Three of these firms appealed the lower court's rejection of their fee applications.
In In re Cendant Corp. Sec. Litig., 2005 WL 820592 (3rd Cir. April 11, 2005), the Third Circuit held that the PSLRA "significantly restricts the ability of plaintiffs' attorneys to interpose themselves as representatives of a class and expect compensation for their work on behalf of that class." As a result, the lead plaintiff's "refusal to compensate non-lead counsel will generally be entitled to a presumption of correctness." The court did find that non-lead counsel can ask the court to compensate them for work done before the appointment of a lead plaintiff, but they must "demonstrate that their work actually benefited the class."
The Legal Intelligencer has an article (via law.com - free regist. req'd) on the decision.
Quote of note: "After the lead plaintiff is appointed, however, the PSLRA grants that lead plaintiff primary responsibility for selecting and supervising the attorneys who work on behalf of the class. We conclude that this mandate should be put into effect by granting a presumption of correctness to the lead plaintiff's decision not to compensate non-lead counsel for work done after the appointment of the lead plaintiff. Non-lead counsel may refute the presumption of correctness only by showing that lead plaintiff violated its fiduciary duties by refusing compensation, or by clearly demonstrating that counsel reasonably performed work that independently increased the recovery of the class."
The U.S. Supreme Court has issued an opinion in the Dura Pharmaceuticals v. Broudo case. It is a unanimous decision authored by Justice Breyer. As predicted, the court rejected the Ninth Circuit's price inflation theory of loss causation. Instead, the court held that a plaintiff must prove that there was a causal connection between the alleged misrepresentations and the subsequent decline in the stock price.
Loss causation (i.e., a causal connection between the material misrepresentation and the loss) is an element of a securities fraud claim. In the Dura case, the Ninth Circuit had held that to satisfy this element a plaintiff only need prove that "the price at the time of purchase was inflated because of the misrepresentation." (See this post for a full summary of the Ninth Circuit's decision.)
On appeal, the Supreme Court made three key findings in rejecting the price inflation theory of loss causation. First, the court dismissed the idea that price inflation is the equivalent of an economic loss. The court noted that "as a matter of pure logic, at the moment the transaction takes place, the plaintiff has suffered no loss; the inflated purchase payment is offset by ownership of a share that at that instant possesses equivalent value." Moreover, it is not inevitable that an initially inflated purchase price will lead to a later loss. A subsequent resale of the stock at a lower price may result from "changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events, which taken separately or together account for some or all of that lower price."
Second, the court found that the price inflation theory of loss causation has no support in the common law. The common law has "long insisted" that a plaintiff in a deceit or misrepresentation action "show not only that if had he known the truth he would not have acted but also that he suffered actual economic loss." Accordingly, it was "not surprising that other courts of appeals have rejected the Ninth Circuit's 'inflated purchase price' approach."
Finally, the court noted that the price inflation theory of loss causation was arguably at odds with the objectives of the securities statutes, including the PSLRA. The statutes make private securities fraud actions available "not to provide investors with broad insurance against market losses, but to protect them against those economic losses that misrepresentations actually cause." In particular, the PSLRA "makes clear Congress' intent to permit private securities fraud actions for recovery where, but only where, plaintiffs adequately allege and prove the traditional elements of causation and loss."
As clear as the opinion is on the issue of the price inflation theory, it fails to provide much guidance on what a plaintiff must allege on loss causation to survive a motion to dismiss. The court assumed, without deciding, "that neither the [Federal Rules of Civil Procedure] nor the securities statutes impose any special further requirements in respect to the pleading of proximate causation or economic loss." Even under the notice pleading requirements, however, the complaint's bare allegation of price inflation was deemed insufficient. As stated by the court, "it should not prove burdensome for a plaintiff who has suffered an economic loss to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind."
Holding: Reversed and remanded for proceedings consistent with opinion.
Addition: A few initial thoughts on the Dura opinion:
(1) The case is a significant victory for defendants in the Eighth and Ninth Circuits, which were the only two courts to adopt the price inflation theory of loss causation.
(2) Although the Supreme Court has put the price inflation theory to rest, its opinion raises some complicated questions about recoverable loss. For example, the Supreme Court notes that many factors other than misrepresentations can cause a stock price decline, but does not provide any guidance on how plaintiffs can meet their burden of proof for loss causation in cases where some or all of these other factors are present.
(3) The opinion is unclear on an issue that was raised on appeal: does the stock price decline need to be the result of a corrective disclosure that reveals the "truth" to the market? The Supreme Court makes some opaque references to when "the relevant truth begins to leak out" and "when the truth makes its way into the market place," but does not squarely address whether there is any need for plaintiffs to establish the existence of a corrective disclosure.
(4) Finally, as noted above, the Supreme Court expressly leaves open the question of whether F.R.C.P. 9(b) or the PSLRA requires plaintiffs to plead loss causation with particularity. The lower courts will need to decide whether these statutes are applicable.
News reports on the Dura opinion can be found in the New York Times, the Washington Post , and Reuters.
When Judge Easterbrook of the U.S. Court of Appeals for the Seventh Circuit writes a securities law opinion, it is invariably going to be worth talking about. His latest is no exception.
The Securities Litigation Uniform Standards Act of 1998 ("SLUSA") preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. The defendants are permitted to remove the case to federal district court for a determination on whether the case is preempted by the statute. If so, the district court must dismiss the case; if not, the district court must remand the case back to state court.
In an earlier opinion in the Putnam Fund cases, Judge Easterbrook found that the district court's decision to remand the actions back to state court was appealable. This week's opinion, Kircher v. Putnam Funds Trust, 2005 WL 757255 (7th Cir. April 5, 2005), addressed the merits of that remand decision. In particular, Judge Easterbrook grappled with the question that has confronted the Second and Third Circuits recently (see this post): what is the scope of SLUSA's "in connection with the purchase or sale of securities" requirement?
In contrast to the Second Circuit, the Seventh Circuit found that SLUSA preemption is not limited to actions where the plaintiffs are purchasers or sellers of securities. One of the complaints filed in the Putnam Fund cases defined its class as "all investors who held the fund's securities during a defined period and neither purchased or sold shares during that period." The court held that the "in connection with" language in SLUSA merely "ensures that the fraud occurs in securities transactions rather than some other activity." Although private actions under Rule 10b-5 (from which SLUSA adopted the "in connection with" requirement) can only be brought by purchasers or sellers, it "would be more than a little strange" if this judicially-created limitation on private actions "became the opening by which that very litigation could be pursued under state law, despite the judgment of Congress (reflected in SLUSA) that securities class actions must proceed under federal securities laws or not at all." Accordingly, the complaint was subject to dismissal under SLUSA.
Holding: Cases remanded with instructions to undo the remand orders and dismiss plaintiffs' state-law claims.
Quote of note: "[M]ost of the approximately 200 suits filed against mutual funds in the last two years alleging that the home-exchange-valuation rule can be exploited by arbitrageurs have been filed in federal court under Rule 10b-5. Our plaintiffs’ effort to define non-purchaser-non-seller classes is designed to evade PSLRA in order to litigate a securities class action in state court in the hope that a local judge or jury may produce an idiosyncratic award. It is the very sort of maneuver that SLUSA is designed to prevent."
Two appellate decisions from earlier this year that are worth noting:
(1) In Barrie v. Intervoice-Brite, Inc., 2005 WL 57928 (5th Cir. Jan. 12, 2005), the Fifth Circuit considered a securities fraud claim based on revenue recognition issues at a software company. The defendants argued that a charge the company took against its revenues was caused by the SEC's issuance of new revenue recognition guidance. To counter this argument, the plaintiffs apparently attached a sworn expert analysis to their amended complaint stating that "Intervoice's reversal of revenue in the first quarter fiscal 2001 was not a result of SAB 101, but rather was required because Intervoice's prior revenue recognition practice did not comply with GAAP, specifically SOP 97-2." The Fifth Circuit reversed the dismissal of the revenue recognition claims, finding that the "accounting questions in this case are disputed" and that plaintiffs' position "was adequately supported by expert opinion."
(2) In In re Daou Systems, Inc. Sec. Litig., 2005 WL 237645 (9th Cir. Feb. 2, 2005), the Ninth Circuit clarified its position on confidential witnesses (by adopting the pleading standard used in the First and Second Circuits) and muddied its position on loss causation.
Confidential witnesses - The court held that "[n]aming sources is unnecessary so long as the sources are described 'with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged' and the complaint contained 'adequate corroborating details.'"
Loss causation - The court found that "if the improper accounting did not lead to the decrease in Daou's stock price, plaintiffs' reliance on the improper accounting in acquiring the stock would not be sufficiently linked to their damages." This position is the exact opposite of the one adopted by the Ninth Circuit in the Dura case and recently reviewed by the U.S. Supreme Court. Curious.
Although the U.S. Court of Appeals for the Fourth Circuit established its pleading standards for scienter (i.e., fraudulent intent) in securities fraud cases over a year ago, it has not had a subsequent opportunity to apply these standards. Moreover, the Hanger Orthopedic decision did not address the common scienter allegations of insider stock sales and violations of generally accepted accounting principles ("GAAP").
The Fourth Circuit's decision in In re PEC Solutions, Inc. Sec. Litig., 2005 WL 646070 (March 18, 2005), although unpublished, offers some guidance on how the court will evaluate the existence of a "strong inference" of scienter as required under the PSLRA. In PEC Solutions, plaintiffs alleged that scienter was demonstrated by, among other things, the stock trading of the individual defendants and a failure of the company to take a reserve against non-payment of a contract in violation of GAAP.
As to the stock sales, the court found that they were "nearly de minimus" given that the individual defendants only sold between 1.17% and 13% of their holdings during the class period. Moreover, the individual defendants exercised stock options during the class period, but did not sell the underlying stock, and actually lost hundreds of millions of dollars in stock value due to the price drop. The court concluded that "[i]f this all give rise to a 'strong inference' of anything, it is that no scienter exists."
Turning to the alleged GAAP violation, the court noted that "it is certainly possible that some egregious GAAP violations may help support an inference of scienter for pleading purposes." The supposed lack of a reserve, however, added "nothing new" to the scienter allegations because the complaint had failed to plead facts establishing that PEC believed it would not be paid for its work.
Holding: Dismissal affirmed.
Quote of note: ""But this alleged GAAP violation adds nothing new; rather it simply rides around in circles on the inadequate coattails of the scienter pleading. For if PEC was to take a reserve only when it believed non-payment was 'probable' . . . and that 'the amount of the loss can be reasonably estimated,' we are brought back to Appellants' previous problem that they have not pled facts that give rise to a strong inference that PEC ever believed it would not get paid by Pearson while making the public statements that the [Complaint] challenges."
Disclosure: The author of The 10b-5 Daily argued the case before the appellate court on behalf of the defendants. Note that the case has also received some attention for the results of the court's spell-checking.
It may have been too much to expect that the U.S. Supreme Court would grant cert in two securities litigation cases within the span of a year. Having just addressed the issue of loss causation, the court has passed on the opportunity to interpret the PSLRA's safe harbor for forward-looking statements.
The PSLRA created the safe harbor to encourage companies to provide investors with information about future plans and prospects. Under the first prong of the safe harbor, a defendant is not liable with respect to any forward-looking statement if it is identified as forward-looking and is accompanied by "meaningful cautionary statements" that alert investors to the factors that could cause actual results to differ.
As discussed in a post in The 10b-5 Daily from last August, entitled "The Safe Harbor May Just Be A Safe Puddle," the U.S. Court of Appeals for the Seventh Circuit has weakened the protection afforded by the safe harbor. In Asher v. Baxter Int'l, the court found that it may be impossible, on a motion to dismiss, to determine whether a company's cautionary statements are "meaningful." Prior to this decision, however, numerous courts had dismissed cases pursuant to the first prong of the safe harbor. The defendants petitioned for a writ of certiorari to the Supreme Court to address the circuit split.
On Monday, however, the Supreme Court denied the cert petition. The Chicago Tribune has an article on the decision.
Quote of note: "Numerous business groups filed legal briefs in support of Baxter with the Supreme Court urging review of the case. The Business Roundtable, in its brief, argued that the 7th Circuit decision could affect how public companies across the country handle disclosures. 'The ramifications of the decision below could be enormous,' it wrote, adding that companies 'may choose to avoid making forward-looking disclosures rather than risk lawsuits like this one.'"
Section 11 of the '33 Act creates civil liability for misstatements in a registration statement. The class of persons who can sue under the statute, however, is limited to those who purchased shares issued pursuant to the registration statement in question. To have standing, an investor must have either acquired his shares in the offering or, if he purchased them in the aftermarket, be able to "trace" them back to the offering. As a general matter, the later introduction of non-offering shares into the market (e.g., via the sale of shares by insiders) generally defeats the ability of subsequent investors to trace their shares back to the offering because the intermingling of the shares makes it virtually impossible to establish that the purchased shares are offering shares.
In Krim v. pcOrder.com, 2005 WL 469618 (5th Cir. March 1, 2005), the plaintiffs tried a statistical approach to solving the problem of aftermarket standing for Section 11 claims. Although the plaintiffs conceded that they could not demonstrate that their shares were issued pursuant to the registration statement, they asserted the existence of standing based on expert testimony indicating that given the number of shares they owned and the percentage of offering stock in the market, the probability that they owned at least one share of offering stock was nearly 100%. The court rejected this statistical tracing theory, finding that "Congress conferred standing on those who actually purchased the tainted stock, not on the whole class of those who possibly purchased tainted shares - or, to put it another way, are at risk of having purchased tainted shares."
Holding: Dismissal affirmed.
Quote of note: "The fallacy of Appellants position is demonstrated with the following analogy. Taking a United States resident at random, there is a 99.83% chance that she will be from somewhere other than Wyoming. Does this high statistical likelihood alone, assuming for whatever reason there is no other information available, mean that she can avail herself of diversity jurisdiction in a suit against a Wyoming resident? Surely not."
The litigation arising out of the “research analyst” scandals (where major investment banks have been accused of disseminating overly optimistic research and investment recommendations to garner investment banking business) continues to raise interesting legal issues. Both the Second and Third Circuits, for example, have recently addressed whether the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) mandates the dismissal of class actions based upon state law seeking to recover various types of damages related to the allegedly biased research.
SLUSA preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. In Dabit v. Merrill Lynch, 2005 WL 44434 (2d Cir. Jan. 11, 2005), the Second Circuit addressed two state class actions (brought on behalf of Merrill Lynch brokers and brokerage customers respectively) alleging losses based on biased research. In both cases, the plaintiffs generally did not dispute that the lawsuits were “covered class actions” and concerned “covered securities.” The issue was whether Merrill Lynch’s alleged misrepresentations were “in connection with the purchase or sale” of those securities. The court held that to be prohibited under SLUSA “an action must allege a purchase or sale of covered securities made by the plaintiff or members of the alleged class.” As for the brokers, the court found that the proposed class of brokers who were injured by holding the recommended stocks included purchasers and therefore, in part, satisfied the “in connection with requirement.” Because the court could not “distinguish any non-preempted subclass, SLUSA requires that the claim be dismissed.” A separate claim regarding commissions lost by the brokers when their customers left Merrill Lynch due to the scandal, however, was allowed to proceed in state court.
The brokerage customers also received a mixed decision. The Second Circuit followed a number of other circuits in finding that the claims based on commissions paid to Merrill Lynch in reliance on the research were “preempted because they necessarily involve allegations of a purchase or sale ‘in connection with’ this alleged misconduct.” In contrast, the claims related to the annual fees paid by the customers were not preempted because the fees were “paid whether or not the customer transacts in the account, and the misrepresentations inherent in the alleged nonperformance and statutory violations therefore do not necessarily ‘coincide with’ a securities transaction.”
Last week, the Third Circuit addressed the same issues and came to similar conclusions. In Rowinski v. Salomon Smith Barney, Inc., 2005 WL 356810 (3rd Cir. Feb. 16, 2005) a putative class of Salomon brokerage customers brought a class action in Pennsylvania state court alleging that the company’s dissemination of biased investment research breached the parties’ service contract, unjustly enriched Salomon, and violated state consumer protection law. The plaintiffs sought “an amount equal to the amount of any and all fees and charges collected” from the class by Salomon. The court held that the “in connection with the purchase or sale” requirement under SLUSA must, as it is in the context of Rule 10b-5 actions, be broadly interpreted. Looking at a number of factors, including whether the fraudulent scheme coincided with the purchase or sale of securities and whether the nature of the parties’ relationship was such that it necessarily involved the purchase or sale of securities, the court found that the class action fell “well within the bounds of SLUSA” and upheld its dismissal.
Quote of note (Rowinski): “Plaintiff also contends that as master of his own complaint, he is entitled to plead around SLUSA. But SLUSA stands as an express exception to the well-pleaded complaint rule, and its preemptive force cannot be circumvented by artful drafting. In this context – where Congress had expressly preempted a particular class of state law claims – the question is not whether a plaintiff pleads or omits certain key words or legal theories, but rather whether a reasonable reading of the complaint evidences allegations of ‘a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.’”
Under the PSLRA, plaintiffs must plead facts creating a strong inference that the defendants acted with scienter (i.e., fraudulent intent) to survive a motion to dismiss. Several courts have found that the sheer size of an alleged financial fraud can support a finding of fraudulent intent. In a recent decision, however, the U.S. Court of Appeals for the Sixth Circuit has disagreed.
In Fidel v. Farley, 2004 WL 2901274 (6th Cir. Dec. 16, 2004), the plaintiffs argued that the magnitude of the financial fraud allegedly perpetrated by Fruit of the Loom, including a write-down of over $220 million of inventory in 1999, supported an inference that the company's auditors had acted with scienter. The court found that "[a]llowing an inference of scienter based on the magnitude of fraud 'would eviscerate the principle that accounting errors alone cannot justify a finding of scienter.'" Moreover, the fact that Fruit of the Loom took the write-offs in 1999, "in no way implied that [the auditors] acted with scienter while auditing the 1998 financial data."
Holding: Dismissal affirmed.
Did The 10b-5 Daily's summary of the Dura Pharmaceuticals v. Broudo oral argument get it right? Here's a chance to find out: the U.S. Supreme Court has posted the transcript. Thanks to Richard Zelichov for pointing out the link.
The general theme of the research analyst cases is straightforward: the defendants allegedly committed fraud by disseminating research reports that they knew to be overly optimistic. A key question, however, has been whether the subsequent decline in the company's stock price was caused by the research reports. In an important decision, the U.S. Court of Appeals for the Second Circuit has affirmed the dismissal of two research analyst cases based on the plaintiffs' failure to adequately plead loss causation.
The appeal was from Judge Pollack's seminal decision in June 2003 dismissing the securities class actions brought against Merrill Lynch based on allegedly biased research reports concerning 24/7 Real Media, Inc. and Interliant, Inc. Judge Pollack found that the plaintiffs had failed to adequately allege loss causation because there was no alleged connection between the analyst reports and the companies' financial troubles or the collapse of the overall market. (See this post, among others, for a discussion of the decision.)
In Lentell v. Merrill Lynch & Co., 2005 WL 107044 (2d Cir. Jan. 20, 2005), the Second Circuit affirmed Judge Pollack's ruling. The court held that to establish loss causation, a plaintiff must allege that the subject of the misrepresentation was the cause of the actual loss suffered. In other words, the misrepresentation must have "concealed something from the market that, when disclosed, negatively affected the value of the security." In these cases, however, the court found there was "no allegation that the market reacted negatively to a corrective disclosure regarding the falsity of Merrill's 'buy' and 'accumulate' recommendations and no allegation that Merrill misstated or omitted risks that did lead to the loss." Accordingly, the plaintiffs failed to adequately plead loss causation.
The Second Circuit's decision would appear to have two potential impacts. First, it will make it difficult for the numerous other research analyst cases to go forward. The plaintiffs will need to adequately allege that either: (1) the disclosure of the false recommendations caused a stock price decline; or (2) the recommendations concealed risks about the stocks that later lead to a loss. Certain complaints, however, may satisfy these requirements (see the roundup of cases in this post). Second, the decision could affect the Supreme Court's pending ruling in the Dura loss causation case. Although the Second Circuit does not alter its previous position on loss causation (rejecting the price inflation theory), the case illustrates the serious impact that loss causation standards can have on securities fraud litigation.
Quote of note: "We are told that Merrill's 'buy' and 'accumulate' recommendations were false and misleading, and that the Firm failed to disclose conflicts of interest, salary arrangements, and collusive agreements among analysts, bankers, and 24/7 Media and Interliant. But plaintiffs nowhere explain how or to what extent those misrepresentations and omissions concealed the risk of a significant devaluation of 24/7 Media and Interliant securities. The reports indicate that 24/7 Media and Interliant were high-risk investments, a designation that specifies, inter alia, a 'high potential for price volatility,' and 'no proven track record of earnings.' And the unchallenged financial analyses presented (e.g., negative EPS ratios and consistent quarterly losses) certainly indicate weakness."
Addition: The New York Law Journal has an article (via law.com - free regist. req'd) on the decision. Thanks to all of the The 10b-5 Daily's readers who sent in the opinion.
Barred from taking discovery until after a motion to dismiss has been decided, plaintiffs frequently attempt to meet the PSLRA's heightened pleading standards for securities fraud by citing statements from confidential sources (often former or current employees of the defendant corporation). In its seminal decision in Novak v. Kasaks, the Second Circuit found that it was not necessary to name these confidential sources "provided that they are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged."
The Third Circuit has now weighed in on the issue. In California Public Employees' Retirement System v. The Chubb Corp., 2004 WL 3015578 (3rd Cir. Dec. 30, 2004), the court adopted the Novak standard, but also stated that this standard requires "an examination of the detail provided by the confidential sources, the sources' basis of knowledge, the reliability of the sources, the corrobative nature of other facts alleged, including from other sources, the coherence and plausibility of the allegations, and similar indicia." After engaging in this rigorous examination, the court rejected most of the allegations based on confidential sources contained in the complaint. The opinion is notable for its in-depth discussion of different types of confidential sources, including former employees at various levels within Chubb's corporate organization, and what knowledge reasonably can be imputed to them.
Holding: Dismissal affirmed.
Quote of note: "Citing to a large number of varied sources may in some instance help provide particularity, as when the accounts supplied by the sources corroborate and reinforce one another. In this case, however, the underlying prerequisite - that each source is described sufficiently to support the probability that the source possesses the information alleged - is not met with respect to the overwhelming majority of Plaintiffs' sources. Cobbling together a litany of inadequate allegations does not render those allegations particularized in accordance with Rule 9(b) or the PSLRA."
The U.S. Court of Appeals for the Seventh Circuit is the latest court to hold that the Sarbanes-Oxley Act of 2002, which extended the statute of limitations for federal securities fraud actions, did not revive previously time-barred claims. In Foss v. Bear, Stearns & Co., Inc., 2005 WL 43724 (7th Cir. Jan 11, 2005), the court found the Second Circuit's recent decision in the Enterprise Mortgage case (posted about here) "persuasive" on this issue and noted that it had "nothing to add."
Oral argument in the Dura Pharmaceuticals v. Broudo case took place in the U.S. Supreme Court this morning (links to all of the main briefs can be found here). The question presented was: "Whether a securities fraud plaintiff invoking the fraud-on-the-market theory must demonstrate loss causation by pleading and proving a causal connection between the alleged fraud and the investment's subsequent decline in price."
Chief Justice Rehnquist did not attend the hearing, but reserved his right to participate in the decision. Argument was heard from counsel for Dura Pharmaceuticals, the U.S. government (in support of Dura's position), and Broudo. Here are a few notes on the main issues that were discussed:
Overall Impressions - Predicting how the Supreme Court will rule based on oral argument is a tricky business. That said, the Court appeared likely to reject the 9th Circuit's price inflation theory of loss causation. Whether the Court will attempt to lay out what a plaintiff in a fraud-on-the-market case must plead as to loss causation to survive a motion to dismiss, however, was unclear.
Dura's Position - Consistent with their briefs, Dura's counsel argued that a loss only occurs when a corrective disclosure is made. Justice Breyer posed the following hypothetical - a company says it has found gold and its stock price is $60; the company later discloses that no gold has been discovered and the stock price declines to $10; the loss is clearly $50. But what if the gold never existed but the company finds platinum and the stock price rises to $200? Are plaintiffs permitted to show that the stock price would have been $250 if the company had also found gold? Dura's counsel did not disagree that it might be possible to demonstrate loss causation under these circumstances, but argued that there would need to be a disclosure about the absence of gold.
Difference Between Dura And Government? - Justice Ginsburg, in particular, noted that there appeared to be a difference between Dura's position and the one put forward by the government, because the government allowed for the possibility that something other than a corrective disclosure might be sufficient to establish loss causation. Justice Scalia emphasized that plaintiffs simply need to show that the market knows the truth, however that truth comes to be revealed.
Government's Position - The government's counsel then argued that to establish loss causation, plaintiffs must demonstrate that the pri