How do you know when a judge does not think much of your case? When the quips start flying around in her decision.
In City of Brockton Retirement System v. The Shaw Group Inc., 2008 WL 833943 (S.D.N.Y. March 18, 2008), District Judge Colleen McMahon addressed a securities class action brought after The Shaw Group was forced to restate its 2Q 2006 financials. In particular, the restatement resulted from two accounting errors: (a) an arithmetic error related to the computation of percent complete on one contract; and (b) a failure to account properly for a minority interest in a variable interest entity. The court dismissed the case based on the plaintiffs' failure to adequately plead a strong inference of scienter (i.e., fraudulent intent) and made its overall feelings about the claims quite clear. Here are some of the more quotable lines:
(1) "Calling the failure to catch [the simple arithmetic error] a 'failure of accounting controls' makes it sound sinister, but it does not change the fundamental nature of the 'failure' - somebody forgot to check his/her work. This is not sinister at all. Mistakes like this happen a lot in the third grade, and sometimes they happen in public companies, too. There is no reason to make a federal case out of it."
(2) "It may not be prudent as a business matter to have an accounting department that has a hard time keeping up with new information technology, but it is not a violation of the federal securities laws to do so."
(3) "So none of the matters cited by plaintiffs admits of an inference of fraud. Plaintiffs argue, however, that zero plus zero plus zero plus zero plus zero adds up to something. In this, its arithmetic is as faulty as Shaw Group's was."
Thanks to an alert reader for sending in the decision.
In its Tellabs decision, the U.S. Supreme Court created an "at least as compelling" standard for weighing competing inferences of scienter in securities fraud cases. The fact that a draw goes to the plaintiff was criticized by Justice Scalia in his concurrence, although he noted that his preferred "more plausible" standard would be unlikely to have much of a practical effect because "[h]ow often is it that inferences are precisely in equipoise?" Beware of rhetorical questions.
In In Re Paincare Holdings Sec. Litig., 2008 WL 348781 (M.D. Fla. Feb. 7, 2008), the court considered an amended complaint filed after a dismissal without prejudice. The magistrate judge (whose order was adopted by the court), found that scienter had been adequately plead because "the inference of scienter is equal to the inference of non-fraudulent intent." In support of its holding, the decision noted the sheer magnitude of the financial restatement, the company's ambitious acquisition strategy, and the company's alleged false rationalization for the financial restatement.
Quote of note: "To the extent the reason offered to the public [for the financial restatement] was not true, one can infer that the Company had a reason not to delve too deeply in presenting its mea culpa to the public. While fecklessness is not recklessness, when truly falling on your sword, you aim for the heart."
A couple of notable recent decisions:
(1) In In re Cardinal Health Inc. Sec. Litig., 528 F. Supp. 2d 752 (S.D. Ohio 2007), the court considered a requested attorney fee award of $145 million (24% of the $600 million settlement). The court found that the absence of an ex-ante fee arrangement between the lead plaintiff group and lead counsel required it to "undertake an independent analysis to determine reasonable attorneys' fees." The court ultimately awarded an 18% fee award, with a high lodestar multiplier of 6, based on the "excellent recovery, considerable effort and time, and high quality of lawyering."
Quote of note: "[T]his court would . . . recommend that courts, in addition to the established requirements, look favorably on the presence of an ex-ante fee arrangement in its [sic] decision to approve lead plaintiff and lead counsel. Alternatively, Congress could amend the PSLRA to mandate lead plaintiffs to enter into a fee arrangement with lead counsel before the court formally approves lead counsel. Under this approach, sophisticated parties would be encouraged to negotiate fee arrangements without the bias of hindsight, and they could reach presumptively reasonable results that the court can review."
(2) In In re Pfizer, Inc. Sec. Litig., 2008 WL 540120 (S.D.N.Y. Feb. 28, 2008), the court considered whether an anonymous blog post could provide reliable factual allegations. The plaintiffs asserted that the blogger was actually a former Pfizer officer. The court found that there was insufficient information about the blogger's identity and, even accepting that he had been employed at Pfizer, it was unclear whether the blogger "would have been likely to know the relevant facts."
Quote of note: The blogger's "allegation does not claim to be based on personal knowledge and lacks detail that might suggest personal knowledge. For example, the blog post does not describe when, how, on what basis, by whom, or to whom the alleged warning was communicated."
Motive is in the eye of the beholder. Many courts have found that the sale of stock by corporate insiders just before the announcement of bad news is "suspicious" and can contribute to an inference of scienter (i.e., fraudulent intent). In a decision from earlier this summer, however, a federal district court came to the exact opposite conclusion. The court's apparent theory was that if the defendants had committed a fraud, they surely would have done it better.
In In re Hutchinson Technology Inc. Sec. Litig., 2007 WL 1620805 (D. Minn. June 4, 2007), three of the individual defendants sold stock a month before dramatically lowering the company's finanical projections. The court found that "it would have been in [the defendants] interests to put off the disclosure of that bad news as long as possible, because the closer the release of the bad news followed on the heels of their stock sales, the more suspicious those sales would have appeared." The fact that the defendants did not delay the release of the news, according the the court's reasoning, removed any suspicion from the stock sales.
Holding: Motion to dismiss granted (with prejudice).
There are two prongs to the PSLRA's safe harbor for forward-looking statements. First, a defendant shall not be 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. Second, a defendant shall not be liable with respect to any forward-looking statement, even in the absence of meaningful cautionary statements, if the plaintiff cannot establish that the statement was made with "actual knowledge" that it was false or misleading.
Although the two prongs are written in the alternative, courts frequently have rebelled against the plain language of the statute because it appears to provide defendants with a "license to defraud" investors about a company's future prospects so long as the statement is accompanied by meaningful cautionary language.
In a decision issued this week, In re Nash Finch Co. Sec. Litig., 2007 WL 1266658 (D.Minn. May 1, 2007), the court noted that the Eighth Circuit had not yet addressed the question of "whether allegations of actual knowledge defeat the safe harbor when cautionary language is present." The defendants argued that their knowledge of the truth or falsity of the forward-looking statements was irrelevant under the first prong of the safe harbor. The court held, however, that "cautionary language can not be 'meaningful' when defendants know that the potential risks they have identified have in fact already occurred, and that the positive statements they are making are false." (For a similar holding from the C.D. of Cal., see this post.)
The fee-shifting imposed by the Enron court - related to claims brought against Alliance Capital - continues to make news. At the time of the decision, the Wall Street Journal (subscrip. req'd) published an editorial lauding the result. In today's edition, the plaintiff's attorney fights back with a letter that he challenges the paper to print (a bet he happily loses), while the newspaper's editorial board defends its analysis. The WSJ Law Blog has the blow-by-blow (free content).
If the market were aware during the class period of the allegedly omitted information, could the investors later argue that they were defrauded? Some courts have declined to consider a "truth on the market" defense raised as part of a motion to dismiss because it presents factual issues. Other courts, however, have been willing to examine public documents available to investors and conclude that any failure on the part of the defendants to disclose material information was excused by its availability from other sources. Two recent decisions have taken the latter approach and dismissed securities fraud claims.
In Ley v. Visteon Corp., 2006 WL 2559795 (E.D. Mich. Aug. 31, 2006), the court considered whether claims based on "Visteon's Ford-related operational issues" should be dismissed because these issues were discussed in analyst reports and newspaper articles during the class period. Although the plaintiffs argued that a truth on the market defense would be premature at the motion to dismiss stage of the case, the court disagreed, finding that it could "consider publications by market analysts in determining if the market had sufficient knowledge of Defendants' various deficiencies." The court concluded that it was clear from these publications that the market was aware of "Visteon's inability to shed unprofitable business lines inherited from Ford, high labor costs, price reductions owed to Ford, and general reliance upon Ford."
Similarly, in In re Discovery Laboratories Sec. Litig., 2006 WL 3227767 (E.D. Pa. Nov. 1, 2006), the court examined whether certain statements related to the FDA-approval process for a drug product were materially misleading in light of the public information available to the market. The court held that the "'truth on the market' defense does not require that any investor should be capable of finding the information and understanding its significance based on a single click for a simple Web search." Instead, the standard is "reasonable investors, those who we can assume exercise due investment diligence." Based on public reports of facility problems and the widely known fact that the company would need to comply with FDA regulations to obtain approval for the drug, the court found that the alleged misstatements related to those issues were inactionable.
Courts continue to struggle with the question of how to determine the scienter (i.e., fraudulent intent) of a defendant corporation. Should a court examine the collective knowledge of the corporation's employees (collective scienter theory) or should it look to the state of mind of the individual corporate official or officials who made the false or misleading statement (which some courts have found is required under the common law of agency)? As The 10b-5 Daily has noted, between these two positions is a weaker version of the collective scienter theory that allows a plaintiff to establish the scienter of a defendant corporation by showing that a management-level employee of the corporation acted with knowledge or recklessness, even if that employee was not an individual defendant and did not make any alleged false statements.
The weaker version of the collective scienter theory, however, suffers from a lack of judicial uniformity as to exactly which employees can have their state of mind imputed to the corporation. One possible definition can be found in a recent decision - Hill v. The Tribune Co., 2006 WL 2861016 (N.D. Ill. Sept. 29, 2006) - dismissing a securities class action. The court found that a "corporation's scienter is generally limited to being based on knowledge or scienter of a senior officer or director of the corporation, or an employee involved in issuing the alleged misrepresentation." Because the plaintiffs were unable to "adequately allege that those responsible for [Tribune's] SEC filings and press releases recklessly relied on the circulation figures that were provided" by lower-level employees, the court held that the defendant corporation's scienter was not adequately alleged.
Whether a plaintiff can establish the scienter (i.e., fraudulent intent) 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 has been simmering in the courts for a number of years. When The 10b-5 Daily last checked in on the status of the issue back in 2004, the Sixth Circuit had issued an opinion in the Bridgestone securities litigation that appeared to apply a collective scienter theory. Although the opinion did not specifically discuss the issue, the court's holding clearly was incompatible with the Fifth and Ninth Circuits' previous rulings that a defendant corporation only can be deemed to have acted with scienter if the individual officer making the alleged false statement acted with scienter.
Fast forward a couple of years and the collective scienter theory is gaining traction in certain district courts. There are two distinct versions of the theory being applied.
Under the weaker version, it is sufficient for a plaintiff to establish that a management-level employee of the corporation acted with fraudulent intent, even if that employee is not a defendant and did not make any alleged false statement. Two recent decisions from the D. of Mass. and the S.D.N.Y. have adopted this version. In re Sonus Networks, Inc. Sec. Litig., 2006 WL 1308165 (D. Mass. May 10, 2006) (scienter of former controller attributable to corporation); In re Marsh & McLennan Companies, Inc. Sec. Litig., 2006 WL 2057194 (S.D.N.Y. July 20, 2006) (scienter of "particular management-level employees identified in the Complaint" attributable to corporation).
Under the stronger version, a plaintiff can establish that the corporation acted with fraudulent intent without any reference to a particular employee. Not only has this version been adopted by a court in the S.D.N.Y., but that court has certified the issue for interlocutory appeal to the Second Circuit. In re Dynex Capital, Inc. Sec. Litig., 2006 WL 1517580 (S.D.N.Y. June 2, 2006) (finding that relevant prior decisions from Second Circuit do not clearly decide issue).
So stay tuned. The Second Circuit will have the opportunity to decide a question that The 10b-5 Daily posited years ago: if an officer makes the statement and a janitor knows the statement is false, has the corporation acted with fraudulent intent? If the answer is "yes," there will be an open circuit split on corporate scienter.
The New York Law Journal has an article (via law.com) in its August 14 edition discussing the dismissal of the federal securities claims in the Salomon Smith Barney mutual fund fees litigation. The plaintiffs had "accused the investment firm of offering undisclosed incentives to brokers and financial advisers, extracting improper fees from investors in its proprietary funds and encouraging its propriety funds to invest in poorly performing companies because of their status as Smith Barney investment banking clients." In its decision - In re Salomon Smith Barney Mut. Fund Fees Litigation, 2006 WL 2085979 (S.D.N.Y. July 26, 2006) - the court dismissed both the '34 Act (Rule 10b-5) and '33 Act (Sections 11 and 12) claims based on the failure to adequately plead loss causation.
Quote of note (opinion): "Here, Plaintiffs have not only not alleged why they lost money on their purchase of the mutual fund stock, they have not alleged even that they in fact lost money on their purchase of the mutual fund stock (i.e., that the mutual fund share price dropped and that it dropped for the precise reason complained of)."
Three unusual recent decisions addressing the PSLRA's discovery stay, appeals from the denial of a motion to dismiss, and prolixity in complaints:
(1) While the primary securities class action against Time Warner was settled last year, a consolidated action consisting of suits by institutional investors that opted out of the main case continues on. Moreover, the plaintiffs in the consolidated action have access to the approximately 14 million documents that Time Warner produced in the primary securities class action and related state court litigation. In re AOL Time Warner, Inc. Sec. Litig., 2006 WL 1997704 (S.D.N.Y. July 13, 2006), the court addressed a "unique" request by the defendants to lift the PSLRA's discovery stay to allow them to obtain discovery from the plaintiffs. Time Warner argued, and the court agreed, that the discovery stay should be lifted because "prohibiting Time Warner's discovery of Plaintiffs while Plaintiffs are able to formulate their litigation and settlement strategy on the basis of the massive discovery Time Warner has already produced constitutes undue prejudice."
(2) The denial of a motion to dismiss is not a final judgment in a securities class action and is normally not subject to appeal. Although a district court might certify an interlocutory appeal based on the existence of a novel and dispositive legal issue, whether the district court correctly found that the plaintiff met the heightened pleading standards of the PSLRA is not usually thought to meet that criteria. In Thompson v. Shaw Group, Inc., 2006 WL 2038025 (E.D. La. July 18, 2006), however, the district court certified its denial of the defendants' motion to dismiss for appeal, finding that "reasonable minds might disagree on the issue of whether the Plaintiffs have satisfied their pleading burden under the heightened standards for securities claims." The court noted that an immediate appeal was justified because "a ruling favorable to Defendants on this issue would render years of discovery, enormous expenses incurred by the parties, and a trial on the merits unnecessary."
(3) The modern securities class action complaint can be a massive tome, primarily because of the need to meet the PSLRA's heightened pleading standards. That said, not every court appreciates getting so much reading material. In In re Leapfrog Enterprises, Inc. Sec. Litig. 2006 WL 2192116 (N.D. Cal. Aug. 1, 2006), the court addressed a 147-page consolidated complaint that it believed was unnecessarily long. After clarifying the issues in the case at oral argument, the court granted leave to amend with the express condition that the amended complaint "not exceed fifty (50) pages in length."
The PSLRA's Safe Harbor for forward-looking statements is designed to encourage companies to provide investors with information about future plans and prospects by limiting their potential liability for these statements. 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.
In the case of oral forward-looking statements, the PSLRA specifically provides that the meaningful cautionary statements can be incorporated by reference in a readily available written document. The statute is silent, however, about whether this is also true for written forward-looking statements. A surprisingly small number of courts have addressed this issue, but the trend appears to be in favor of finding that a company's incorporation by reference is sufficient.
In Yellen v. Hake, 2006 WL 1881205 (S.D. Iowa July 7, 2006), the court addressed a securities class action brought against Maytag Corp. The court found that "[w]hile the Safe Harbor provision does not explicitly provide for incorporation by reference for written forward-looking statements" it is implicit in Congress' direction that courts consider "all information and documents relevant to a determination of whether a defendant has given adequate warnings." Accordingly, the court agreed to consider warnings contained in Maytag's 2004 Annual Report that were incorporated by reference in the press release and investor presentations that allegedly contained false or misleading forward-looking statements.
The role of Rule 10b5-1 stock trading plans in assessing the adequacy of a plaintiff's scienter (i.e., fraudulent intent) allegations is becoming a more frequent issue in securities class actions as the use of these plans increases. A recent decision in the N.D. of Texas - relying on the Netflix opinion discussed in this post - will certainly encourage that trend.
In Fener v. Belo Corp., 425 F.Supp.2d 788 (N.D. Tex. 2006), the court held that at the pleading stage it is the burden of the plaintiff to place any allegedly suspicious stock trading in context. Accordingly, the plaintiffs needed to address "in their complaint whether [the defendant officer] sold his stock pursuant to a Rule 10b-5(1) trading plan formulated before the alleged fraudulent scheme and why, if he did, this does not undercut a strong inference of scienter." (A contradictory decision is discussed here.)
Holding: Motion to dismiss granted with leave to amend.
Whether selling company stock under a Rule 10b5-1 trading plan can help shield corporate executives from securities fraud liability is an open question. Although some courts have considered the existence of a trading plan in finding that an executive's stock sales did not create a strong inference of scienter (i.e., fraudulent intent), a recent decision goes the other way. In In re Cardinal Health Inc. Sec. Litig., 2006 WL 932017 (S.D. Ohio April 12, 2006), the court held that it was "premature" to evaluate the impact of a trading plan at the motion to dismiss stage because it is an affirmative defense to insider trading allegations.
The content of the disclosure that led to a stock price decline is an important part of post-Dura loss causation analyses. One particular fact pattern that has proven difficult for defendants is when a company announces a SEC investigation without specifying exactly what conduct is under investigation.
In In re Bradley Pharmaceuticals, Inc. Sec. Litig., 2006 WL 740793 (D.N.J. March 23, 2006), the company disclosed that the SEC was conducting an informal inquiry and had asked for information "with respect to revenue recognition and capitalization of certain payments." The stock price fell 26%. A subsequent announcement by the company revealed that it would have to restate its financial results for an earlier quarter due to improper revenue recognition on a particular transaction. The stock price went up slightly.
In their motion to dismiss, the defendants argued that the plaintiffs had failed to allege a loss following a "corrective disclosure" because the original press release was "simply a disclosure of a non-specific SEC inquiry" and did not say anything about the particular transaction at issue. The court disagreed, finding that the revelation of the truth "occurred through a series of disclosing events" and that by the time the company announced its restatement "the market had already incorporated that the previously released financial statements could not be relied upon."
Holding: Motion to dismiss denied.
Addition: For a similar holding, see Brumbaugh v. Wave Systems Corp., 2006 WL 52751 (D. Mass. 2006).
In its Dura decision, the Supreme Court left open the question of whether loss causation is subject to a heightened pleading standard. 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," and applied the notice pleading requirements of F.R.C.P. 8(a)(2). Following Dura, several courts have concluded that notice pleading is sufficient (see, e.g., Greater Penn. Carpenters Pension Fund v. Whitehall Jewellers, Inc., 2005 WL 1563206 (N.D. Ill. June 30, 2005)).
A contrary view can be found in the recent decision in In re The First Union Corp. Sec. Litig., 2006 WL 163616 (W.D.N.C. Jan. 20, 2006). The court noted that the Supreme Court had "expressly declined to consider whether loss causation must be pled with particularity." Based on pre-Dura circuit court decisions finding that F.R.C.P. 9(b)'s particularity standard is applicable to loss causation and the fact that "the Fourth Circuit has held that every element of a common law fraud action must be plead with particularity," the court decided that the plaintiffs needed to satisfy the heightened pleading standard.
Motions for reconsideration are rarely successful, but loss causation issues may be an exception given the need to interpret the Supreme Court's recent Dura decision. In In re Royal Dutch/Shell Transport Sec. Litig., 2005 WL 3359695 (D.N.J. Dec. 12, 2005), the court had held, based on Dura, that investors who purchased securities during the class period, but did not subsequently sell the securities, could not adequately plead loss causation. Therefore, those investors could not join the putative class.
On reconsideration (and after the case was reassigned to another judge), the court found that Dura "neither expressly nor implicitly mandates that the subject securities be sold in order for a plaintiff to have suffered cognizable loss." The court also found that the PSLRA did not require such a sale to bring a securities fraud action and that it would be against public policy to judicially create this requirement.
Holding: Motion for reconsideration granted.
Quote of note: "Nothing in Dura indicates that the Supreme Court intended to overrule the established precedent permitting holding plaintiffs to maintain actions for securities fraud, to call into question the statutory scheme by creating a sell- to-sue requirement, or to undermine relevant policy concerns without any analysis. Moreover, Dura's holding was limited to rejecting the Court of Appeals for the Ninth Circuit's standard for pleading loss causation and economic loss in a securities fraud action, which had required only an allegation of inflated purchase price because of a misrepresentation; the Supreme Court expressly stated that it did not 'consider other proximate cause or loss-related questions.' Accordingly, Dura cannot be read to require both purchase and sale of the subject securities."
Section 304 of the Sarbanes-Oxley Act of 2002 provides that a company's CEO and CFO must disgorge certain bonuses, equity-based compensation, and trading profits if the company is required "to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws." Although Congress did not create an express private right of action in the statute, recent securities class actions and derivative suits often include a tag-along Section 304 claim.
As reported by The 10b-5 Daily, at least one court has found in a derivative case that the legislation did not create a private right of action and dismissed the claim. Courts that are inclined to do the same thing in a securities class action, however, may choose to rely on the plain language of the statute. In In re Qwest Communications Int'l, Inc. Sec. Litig., 387 F. Supp. 2d 1130 (D. Col. 2005), the court found that Section 304 expressly requires an officer to "reimburse the issuer." Under these circumstances, Qwest's investors did not have standing to bring the claim because they were "not entitled to the relief authorized by the statute."
Holding: Motion to dismiss Section 304 claim granted.
Section 304 of the Sarbanes-Oxley Act of 2002 provides that a company's CEO and CFO must disgorge certain bonuses, equity-based compensation, and trading profits if the company is required "to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws." Although Congress did not create an express private right of action in the statute, recent securities class actions and derivative suits often include a tag-along Section 304 claim.
The Legal Intelligencer reports (via law.com - free regist. req'd) that a federal judge finally has had the opportunity to address whether private litigants, as opposed to the SEC, can bring a Section 304 claim. In a derivative suit brought against Stonepath Group in the E.D. of Pa., Judge Dalzell has ruled that Congress did not intend to create an implied private right of action. The court found that another Sarbanes-Oxley provision expressly creates a private right of action, leading to the conclusion that Section 304's silence should be interpreted as restricting enforcement of the statute to the SEC. The case is Neer v. Pelino - a Westlaw cite will be added to this post when available.
Addition: Neer v. Pelino, 389 F.Supp.2d 648 (E.D.Pa. 2005).
The content of the disclosure that led to a stock price drop continues to be the focal point of post-Dura loss causation analyses. In Sekuk Global Enterprises v. KVH Industries, Inc., 2005 WL 1924202 (D.R.I. Aug. 11, 2005), the plaintiffs claimed that the company engaged in improper accounting practices related to the sales of a key product. The plaintiffs' alleged losses occurred after the company issued a press release announcing reduced quarterly revenue based on lower than expected sales.
In their motion to dismiss, the defendants argued that "the press release and the resulting drop in the price of KVH common stock fails to establish loss caustion because the press release does not attribute the declining revenue to the sales of the [key product]." The court found, however, that the key product was a possible contributor to the lower than expected sales, even if it was not expressly discussed in the press release. Accordingly, the plaintiffs adequately plead loss causation.
Holding: Motion to dismiss denied (except for the claims based on a limited number of inactionable statements).
Following the Dura decision by the Supreme Court, lower courts continue to grapple with what constitutes a sufficient pleading of loss causation. In In re Cree, Inc. Sec. Litig., 2005 WL 1847004 (M.D.N.C. Aug. 2, 2005), Cree's stock price dropped after its former CEO filed an individual lawsuit generally alleging that the company had engaged in securities fraud. The court found: (a) the individual lawsuit "did not disclose anything about transactions with five of the six companies Plaintiffs now claim were the subject of numerous misstatements and omissions;" and (b) as to the one transaction it did address, the complaint "merely attribute[d] an improper purpose to the previously disclosed facts." In the absence of the disclosure of new facts, the court found that the transaction could not be the "proximate cause of the complained-of loss."
Holding: Dismissed with prejudice. (The court also adopted the rigorous First Circuit standard for evaluating confidential witness statements and held that the plaintiffs failed to plead falsity with sufficient particularity.)
Quote of note: "It is doubtful that a general averment of fraud with no specific factual allegations could be deemed a 'disclosure' for purposes of determining whether some act or omission, previously concealed by a false representation, caused, upon revelation, a shareholder's loss. While it is clear that a disclosure need not conform to any prescribed format, in must nevertheless satisfy at least a minimum standard of content. A disclosure must reveal new facts; a bald assertion of fraud is not sufficient."
Disclosure: The author of The 10b-5 Daily represents the defendants in the Cree securities litigation.
Everything a CEO does can effect his company's public disclosures. Regular readers will recall the case of the company that was forced to restate its CEO's resume. A similar type of case was decided earlier this year.
In In re Ariba, Inc. Sec. Litig., 2005 WL 608278 (N.D. Cal. March 16, 2005), the company failed to disclose that its outgoing CEO had personally, out of his own funds, paid another officer $10 million (plus $1.2 million in travel benefits and expenses) to assume the CEO position. Ariba was eventually forced to restate its financial statements to record the payments as capital contributions. In the resulting securities class action, the plaintiffs alleged that the payments were made to "create the false impression that Ariba was doing better than it was" and that "confidence in Ariba's management would have eroded completely" had it been disclosed that the new CEO had only agreed to accept the position after receiving the payments.
The court found that the plaintiffs had failed to adequately plead that the defendants acted with a fraudulent intent (i.e., scienter). The complaint relied heavily on statements from a confidential witness identified as an "executive assistant," the existence of GAAP violations, and the individual defendants' positions at the company. The court held that these allegations did not "constitute the strong circumstantial evidence of deliberately reckless or conscious misconduct with respect to each omission required for Plaintiff to overcome Moving Defendants' motion to dismiss."
Holding: Dismissed with prejudice.
Judge Scheindlin (S.D.N.Y.) has issued two loss causation decisions in an offshoot of the IPO allocation cases.
In the case in question, the plaintiffs alleged a scheme by an investment bank and several issuers to systematically set the issuers' announced earnings forecasts below internal forecasts. When earnings consistently beat the announced forecasts, the resulting excitement in the market allegedly drove the issuers’ stock prices up. According to the complaint, the scheme was ultimately revealed to the market through a series of announcements disclosing that earnings were below expectations or warning that future earnings would not meet expectations. These announcements allegedly ended "the fraudulently induced expectation of continuing upside surprises."
In In re Initial Public Offering Sec. Litig., No. MDL 1554(SAS), 2005 WL 1162445 (S.D.N.Y. May 13, 2005), the court responded to a motion for reconsideration of an earlier dismissal of the claims by rejecting the plaintiffs' reliance on the announcements because they were not "corrective disclosures." The court explained that "[t]o allege loss causation, plaintiffs must allege that, at some point, the concealed scheme was disclosed to the market." None of the disclosures relied on by the plaintiffs, however, implied that there had been a fraudulent scheme.
In response to a second motion for reconsideration, Judge Scheindlin issued another decision. In In re Initial Public Offering Sec. Litig., 2005 WL 1529659 (S.D.N.Y. June 28, 2005), the court noted that the Supreme Court's Dura opinion "did not disturb Second Circuit precedent regarding loss causation." After a lengthy discussion of how to reconcile this sometimes contradictory Second Circuit precedent, the court again found that loss causation had not been adequately plead.
The June 28 decision is the subject of a New York Law Journal article (via law.com - free regist. req'd).
Whether trading under a Rule 10b5-1 trading plan can help shield corporate executives from securities fraud liability is a topic that courts continue to explore.
Rule 10b5-1, put into place in 2000, establishes that a person's purchase or sale of securities is not "on the basis of" material nonpublic information if, before becoming aware of the information, the person enters into a binding contract, instruction, or trading plan (as defined in the rule) covering the securities transaction at issue. To take advantage of this potential affirmative defense, many executives have implemented trading plans for their sales of company stock.
Insider trading, of course, is often used by plaintiffs in securities class actions to create an inference of scienter (i.e., fraudulent intent). The plaintiffs allege that the individual corporate defendants profited from the alleged fraud by selling their company stock at an artificially inflated price. In the latest decision to consider the impact of Rule 10b5-1 trading plans on insider trading scienter allegations, the court in In re Netflix, Inc. Sec. Litig., 2005 WL 1562858 (N.D. Cal. June 28, 2005) found that the fact that the trading in question took place pursuant to a trading plan mitigated against a finding of an inference of scienter.
The author of The 10b-5 Daily has written an article (with one of his colleagues) on this topic.
In an interesting opinion released yesterday in the Parmalat securities class action, Judge Kaplan (S.D.N.Y.) addresses some important topics.
(1) Parmalat's primary auditors were the Italian affiliates of two multinational accounting firms - Grant Thornton and Deloitte & Touche. The court found that the plaintiffs sufficiently alleged an agency relationship between the global umbrella organizations, Grant Thornton International ("GTI") and Deloitte Touche Tohmatsu ("DTT"), and their Italian member firms so as to allow the claims against the global entities to go forward.
(2) GTI and DTT argued that the plaintiffs had failed to adequately plead loss causation "because they do not allege that any misrepresentation by them was the proximate cause of the decline in the value of the price of Parmalat securities or that a corrective disclosure about their prior misrepresentations caused the company's collapse." The court disagreed, holding that under Second Circuit precedent the plaintiffs' allegations that the risks concealed by Parmalat and its auditors caused the decline in investor value were sufficient.
(3) Section 20(a) of the '34 Act creates a cause of action against defendants alleged to have been "control persons" of those who engaged in securities fraud. There is a split within the Second Circuit over whether a plaintiff must allege culpable participation to state a legally sufficient claim under this provision. The court found that allegations of culpable participation are not necessary.
(4) The defendants evidently also moved to dismiss the 368-page complaint as failing to comply with F.R.C.P. 8 ("short and plain statement" of the claim). The court noted that it was in "substantial sympathy" with this position: "The requirement of pleading fraud with particularity does not justify a complaint longer than some of the greatest works of literature." Nevertheless, the court declined to dismiss the complaint on this basis.
Speaking of confidential sources, it has not taken long for the Third Circuit's decision in Chubb to have an effect in the lower courts. In Freed v. Universal Health Services, Inc., 2005 WL 1030195 (E.D.Pa. May 3, 2005), the plaintiffs relied on confidential sources in alleging that UHS improperly accounted for its receivables and deliberately understated its bad debt reserves.
The confidential sources included numerous unnamed former employees of UHS, but all of them worked in individual hospitals owned by the corporation. The court, citing the Chubb decision, found that the statements could not be relied upon because "the Amended Complaint fails to allege how [the confidential sources] would have access to information regarding UHS's operations nationwide." The Legal Intelligencer has an article (via law.com - free regist. req'd) on the decision.
Holding: Dismissed with leave to amend.
Quote of note: "[C]omplaints that rely heavily on confidential sources to establish the 'true facts' must contain information describing the time period during which the confidential sources were employed by the defendant corporation, the dates on which they acquired the information they purportedly possess, and the manner in which they had access to such information."
Is it fraudulent to pay analysts to promote your company's stock? In a break from the run-of-the-mill securities class action, investors in Diomed Holdings, Inc. alleged that, in 2002, the company and its chairman "devised a plan to artificially inflate the price of Diomed's stock by secretly paying stock analysts to tout Diomed to unsuspecting investors." The plaintiffs argued that this was part of a "pump and dump" scheme and and unlawful pursuant to Rule 10b-5.
The court disagreed. In Garvey v. Arkoosh, 2005 WL 273135 (D. Mass. Feb. 4, 2005), the court held that "nothing in the securities laws bars the issuer of a regulated security from paying an analyst for a stock recommendation." While the applicable regulatory scheme requires the person who publishes the report to disclose a conflict of interest (see Section 17(b) of the '33 Act), there is no similar duty imposed on the issuer who paid for the promotion. Moreover, the analysts had clearly stated in their reports that they were being paid to tout the stock, even if the disclosures did not directly connect Diomed to the payments.
Holding: Motion to dismiss granted.
Quote of note: "Any reasonable investor told that the publisher of an investment report had received $700,000, $100,000, or even $50,000 to tout a particular stock would give the analyst's recommendation the proverbial grain of salt regardless of the source of the funds."
The 11th Circuit and 2nd Circuit are continuing to ponder whether the Sarbanes-Oxley Act of 2002, which extended the statute of limitations for securities fraud claims, revived claims that were time-barred prior to the Act's passage. Meanwhile, a growing majority of district courts are holding that these time-barred claims must be dismissed. In the past two months, three courts have come to this conclusion: Zurich Capital Mkts. v. Coglianese, 2004 WL 2191596 (N.D. Ill. Sept. 23, 2004); Zouras v. Hallman, 2004 WL 2191031 (D.N.H. Sept. 30, 2004); Milano v. Perot Systems Corp., 2004 WL 2360031 (N.D. Tex. Oct. 19, 2004). Given that the frequency of these cases is bound to decrease over time, the appellate courts better act quickly if they plan to reverse the tide.
As the U.S. Supreme Court prepares to take on the issue of loss causation in securities fraud cases, the lower court split continues. In Swack v. Credit Suisse First Boston, 2004 WL 2203482 (D. Mass. Sept. 21, 2004), a case alleging that the defendants committed fraud by disseminating research reports that they knew to be overly optimistic, the court held that loss causation could be adequately plead even though the corrective disclosure did not lead to a stock price decline.
The court noted that "stock prices sometimes self-correct in advance of the final overt disclosure." In the case of a misleading analyst report, data that is inconsistent with the rating may lead the market to devalue the rating to the point that the corrective disclosure fails to move the stock price. As a result, the court found that it could not resolve the issue of loss causation on a motion to dismiss. (Note that the court's decision is similar to the Fogarazzo opinion from earlier this year, which is discussed here.)
Holding: Motion to dismiss denied.
Note to companies headquartered in Kansas: be careful when telling investors that you are eager to retain your senior officers.
In a securities class action against Sprint Corp., the plaintiffs based their claims on Sprint's March 26, 2001 statement that it had entered into new employment contracts with its CEO and COO that were "designed to insure their long-term employment with Sprint." According to the plaintiffs, this statement was misleading because Sprint knew that it might have to fire these officers as the result of a tax avoidance issue. In its motion to dismiss, Sprint argued that it had no duty to disclose this information because its statement did not "foreclose the possibility" that the CEO and COO might later be terminated.
The court disagreed with this characterization of the statement. See State of New Jersey and its Division of Investment v. Sprint Corp., 2004 WL 1960130 (D. Kan. Sept. 3, 2004). In finding that a duty to disclose existed, the court held that "Sprint's statements that the contracts were 'designed to insure' the long-term employment of [the CEO and COO] could reasonably have led an investor to conclude that the termination of [their] employment (at least in the near future) was simply not an option from Sprint's perspective."
Although the court may have correctly found that a duty to disclose existed, the rationale it used is curious. Did Sprint really need to say, "then again, we might fire them," for a reasonable investor to realize that it is always possible for the employment of a CEO or COO of a corporation to be terminated? Guess so.
Whether a defendant corporation has acted with scienter (i.e., fraudulent intent) 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." Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353 (5th Cir. 2004). In other words, courts reject a "collective scienter" theory.
Eager to get at corporate wrongdoing, however, some courts have been ignoring this principle. In In re NUI Sec. Litig., 314 F.Supp.2d 388 (D.N.J. 2004), the court found that the plaintiffs had adequately alleged a strong inference of scienter for the corporate defendant because NUI's associate general counsel (who was not a defendant in the case and made none of the alleged misstatements) was alleged to have actual knowledge of the company's fraudulent conduct. As to the individual defendants (the CEO and CFO of NUI), however, the court held that there were insufficient allegations concerning their motive to commit fraud and knowledge of the alleged fraudulent conduct. (See this post for a discussion of the case.)
Similarly, in the recent decision in In re Motorola Sec. Litig., 2004 WL 2032769 (N.D. Ill. Sept. 9, 2004), the court held that the plaintiffs had alleged a strong inference that Motorola "through its various officials, sought to mislead the investing public" about its vendor financing to a Turkish company. The direct fraud claims against the individual defendants (the CEO, CFO, and COO of Motorola) were dismissed, however, because the plaintiffs made no allegations that the individual defendants "had specific knowledge of the details concerning Motorola's loan" and the plaintiffs' motive allegations were insufficient.
In both cases, the claims against the individual defendants were not fully dismissed. Since the individual defendants controlled NUI and Motorola, and the courts found that a Rule 10b-5 claim was adequately pled against these companies, the Section 20(a) claims against the individual defendants based on control person liability for fraud still remained. By analyzing the scienter of NIU and Motorola separately, the courts, in essence, held that the companies acted with fraudulent intent, but their controlling officers or directors did not. This result both defies common sense (after all, a corporation can only act through its officers and directors) and, given that the individual defendants still have potential Section 20(a) liability, provides an end run around the PSLRA's requirement that scienter be adequately plead as to each defendant.
Following its enormous settlement in the WorldCom case, Citigroup received a bit of relief last week when Judge Swain (S.D.N.Y.) dismissed a related securities class action against the company. In In re Citigroup, Inc. Sec. Litig., 2004 WL 1794465 (S.D.N.Y. August 10, 2004), the court addressed claims that Citigroup had failed, with respect to transactions with Enron, Dynegy, and WorldCom, to conduct its business in accordance with its risk management policies. The plaintiffs also alleged that Citigroup had permitted Solomon Smith Barney (a Citigroup subsidiary) analysts to color their public assessments of those companies to aid Citigroup's investment banking business.
In its decision, the court found that the claims regarding the transactions with Enron, Dynegy, and WorldCom merely alleged "that Citigroup's business would have been conducted differently had the company adhered to the management principles disclosed in its public filings." The court held that under established law, "allegations of mismanagement, even where a plaintiff claims that it would not have invested in the an entity had it known of the management issues, are insufficient to support a securities fraud claim under section 10(b)."
As to the claims based on analyst statements, the court noted that the plaintiffs had failed to allege that any misleading statements were made "in connection with the market for Citigroup's own securities." The allegation that Citigroup's failure to disclose the false nature of the analyst statements had the effect of misleading investors concerning the profitability of Citigroup's investment banking activities was summarily rejected. First, the court found the "securities laws do not require a company to accuse itself of wrongdoing." Second, the court found that to the extent the claims were "premised on the assertion that Citigroup breached a duty to disclose that its revenues were 'unsustainable," no such duty existed in the absence of any projections concerning those revenues.
Holding: Motion to dismiss granted with leave to amend.
The New York Law Journal has an article (via law.com - free regist. req'd) on the decision.
One way to rebut the fraud-on-the-market theory is to demonstrate that the alleged misrepresentations could not have affected the market price of the stock because the truth of the matter was already known to investors. The "truth-on-the-market" defense is fact-specific, and courts have only rarely found it to be an appropriate basis for dismissing a securities fraud complaint for failure to adequately plead that the alleged misrepresentations were material.
As the court in White v. H.R. Block, Inc., 2004 WL 1698628 (S.D.N.Y. July 28, 2004) recently noted, however, "'rarely appropriate' is not the same as 'never appropriate.'" In that case, the plaintiffs alleged that H.R. Block had concealed important facts about more than 20 class action lawsuits filed against the company over its refund anticipation loan program. The court found that the "litigation involved public lawsuits brought by public filings in public courts, and the litigation was the subject of extensive press coverage . . . as well as press releases and SEC filings from Block itself." Not surprisingly, the court rejected the plaintiffs' argument that this information did not enter the market with sufficient intensity to counter-balance any alleged misrepresentations. "In short, the truth was all over the market."
Holding: Motion to dismiss granted with prejudice.
Quote of note: "Plaintiffs claim that investors should not be obligated to 'scour county court houses across the country.' But, as defendants point out, the market is comprised of more than ordinary investors; it is also comprised of market professionals, such as Avalon, and Avalon apparently had little trouble scouring those courthouses to gather information for its report on the RAL litigation which sparked this lawsuit against Block."
While the U.S. Court of Appeals for the Eleventh Circuit continues to consider whether the new statute of limitations in the Sarbanes-Oxley Act of 2002 revives time-barred claims, the district court split on the issue remains unresolved. Two recent decisions from the S.D.N.Y., in prominent cases, come to different conclusions.
In In re Worldcom, Inc. Sec. Litig., 2004 WL 1435356 (S.D.N.Y. June 28, 2004), Judge Cote found that "there is no explicit language in the statute" that would operate to revive time-barred claims and lengthening the statute of limitations in this manner "would affect the substantive rights of the defendants by depriving them of a defense on which they were entitled to rely." Accordingly, the court held that "Sarbanes-Oxley does not revive previously time-barred private securities fraud claims" and dismissed certain claims in the case that had expired in June 2002 (a month before Sarbanes-Oxley was passed).
In In re AOL Time Warner, Inc. Sec. and "ERISA" Litig., 2004 WL 992991 (S.D.N.Y. May 5, 2004), Judge Kram went in another direction. In that case, the first class action was filed on July 18, 2002 (two weeks before Sarbanes-Oxley was passed). The court held that the plaintiffs' otherwise time-barred claims would have been revived if the plaintiffs had filed after the passage of Sarbanes-Oxley. Although "in most cases, class actions or otherwise, the date of the first filing is the operative one for statute of limitations purposes," the court decided that the filing date of the consolidated complaint, September 16, 2002, should be the operative date in the instant case. As a result, the longer statute of limitations in Sarbanes-Oxley applied and the otherwise time-barred claims could proceed. The court justified this rather extraordinary decision by arguing that any other result would punish the plaintiffs for filing too early and lead to a mass opt-out from the class.
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.
In the case of oral forward-looking statements, the PSLRA specifically provides that the meaningful cautionary statements can be incorporated by reference in a readily available written document. The statute is silent, however, about whether this is also true for written forward-looking statements. Surprisingly, only a few courts have addressed this issue.
In In re Blockbuster Inc., Sec. Litig., 2004 WL 884308 (N.D. Tex. April 24, 2004), the court noted that the PSLRA's safe harbor is based on the judicially-created bespeaks caution doctrine, which provides that statements must be analyzed in context. The court therefore concluded that "as long as the reference is clear and explicit so that the referenced cautionary language can fairly be viewed as part of the 'context' surrounding the written forward-looking statement, the PSLRA safe harbor for written forward-looking statements can be satisfied by meaningful cautionary language that is incorporated by reference." The court found that its holding was supported by the "illogic" of allowing incorporation by reference for oral statements, where the location of the cautionary statements is likely to be misheard or forgotten, but not allowing it for easily followed written statements.
Holding: Motion to dismiss granted.
Matria Healthcare has announced the dismissal of the securities class action pending against the company in the N.D. of Ga. The court's opinion addresses the issue of whether in-and-out traders (i.e., investors who both bought and sold their shares during the class period) can be effective lead plaintiffs.
Only one person filed suit against Matria on a class action basis and he was subsequently named lead plaintiff. The proposed class period extended from October 24, 2000 to June 25, 2002, when the company disclosed problems with its information technology capabilities, but the lead plaintiff had sold all of his Matria shares on February 6, 2002.
In its opinion (Barr v. Matria Healthcare, Inc., 2004 WL 1551566 (N.D. Ga. July 7, 2004)), the court found that it was "undisputed that the Plaintiff sold his stock in response to an adverse market reaction to the Defendants' January 30, 2002 press release." The January 30 press release, however, made no mention of Matria's information technology problems. As a result, the court found that the lead plaintiff could not demonstrate loss causation because the relevant misrepresentations "were not disclosed until well after the Plaintiff had sold his stock at the still artificially inflated price."
Holding: Motion to dismiss granted with prejudice (also on other grounds).
Whether and how to apply the fraud-on-the-market theory (i.e., reliance by investors on an alleged misrepresentation is presumed if the company's shares were traded on an efficient market) to research analyst statements is a controversial issue. It was the subject of a recent appeal by Citigroup in the WorldCom litigation, but the appeal was mooted by the settlement of the case just before the scheduled oral argument.
The 10b-5 Daily has argued that the Second Circuit, in its opinion granting Citigroup's request for interlocutory appeal, appeared favorably disposed to finding that the fraud-on-the-market theory was not generally applicable to research analyst statements. Judge Rakoff of the S.D.N.Y. apparently agrees with this reading of the opinion.
In DeMarco v. Lehman Brothers, 2004 WL 1506242 (S.D.N.Y. July 6, 2004), a case alleging that a Lehman analyst made buy recommendations for RealNetworks, Inc. stock while secretly holding negative views of the stock, the court has denied the motion for class certification. The court noted that there is a "qualitative difference" between a statement of fact from an issuer and a statement of opinion by a research analyst. In particular, a "well-developed efficient market can reasonably be presumed to translate the former into an effect on price, whereas no such presumption attaches to the latter." As a result, the court held that the fraud-on-the-market doctrine can apply to a case based on research analyst statements "only where the plaintiff can make a prima facie showing that the analyst's statements materially impacted the market price in a reasonably quantifiable respect."
The plaintiffs relied on Lehman Brothers' promotional materials touting its analyst's abilities and influence and an expert report (largely based on general studies of the effect of analyst recommendations on stock prices) in arguing that the analyst's statements inflated the market price for RealNetworks' stock. The court found that this evidence was insufficient to "warrant invocation of the fraud-on-the-market presumption."
Holding: Motion for class certification denied.
Quote of note: "[A] statement of opinion emanating from a research analyst is far more subjective and far less certain, and often appears in tandem with conflicting opinions from other analysts as well as new statements from the issuer. As a result, no automatic impact on the price of a security can be presumed and instead must be proven and measured before the statement can be said to have 'defrauded the market' in any material way that is not simply speculative."
The New York Law Journal has an article (via law.com - free regist. req'd) on the decision. Thanks to Adam Savett for sending in a copy of Judge Rakoff's opinion.
The decision in the Fogarazzo research analyst case in the S.D.N.Y. (previously posted about in The 10b-5 Daily here) is controversial on a number of pleading issues. Not only does the court apply a loss causation standard that, in contravention of the Second Circuit, appears to remove the need to draw any actual connection between the misrepresentations and the loss, it also runs roughshod over other S.D.N.Y. decisions on how to analyze the falsity and scienter (i.e., fraudulent intent) requirements for securities fraud claims based on statements of opinion.
In the research analyst cases, the issue is whether the defendants deliberately misrepresented their truly held opinion that the stock was not a good investment. Judges in the S.D.N.Y. (e.g., Judge Lynch in the Podany decision discussed here) have found that under these circumstances the falsity and scienter requirements are essentially identical. Since the statement (unlike a statement of fact) cannot be false at all unless the speaker is knowingly misstating his truly held opinion, the plaintiffs must allege inconsistent statements or actions by the defendants from which a factfinder could infer that a knowing misstatement was made. For example, the plaintiffs might allege that the defendants' made statements to others that the stock was overvalued or engaged in personal sales of the stock.
In Forgarazzo, Judge Scheindlin rejected this approach. After finding that falsity must be examined separately from scienter, the court held that the falsity of the analysts' buy recommendations was adequately plead based on allegations that the defendants: (1) wanted to obtain investment banking business from the underlying company; (2) had analysts that were subject to financial conflicts of interest; and (3) failed to maintain adequate controls to protect the objectivity of their public research. None of these allegations, however, suggests that the analyst reports were false (i.e., that the defendants actually regarded the underlying stock as a poor investment). In essence, the court found that the existence of a motive to commit fraud is enough to demonstrate that the opinions were false.
Holding: Motion to dismiss denied.
The argument that loss causation must be plead by showing a stock price decline related to the alleged fraud, articulated in the Second Circuit by the Emergent Capital decision, is meeting with increased resistance by the S.D.N.Y. judges handling the research analyst cases. Judges have argued that the stock market crash that occured between the issuance of the allegedly biased research and the revelation of the analysts' conflicts of interest (and, therefore, arguably caused any loss) was irrelevant, either because of allegations that the research analyst directly participated in a fraudulent scheme perpetrated by the issuer of the underlying stock or because the revelation of the analysts' conduct caused a subsequent stock price drop. (See these posts on the WorldCom and Robertson Stephens cases).
In Fogarazzo v. Lehman Brothers, Inc., 2004 WL 1151542 (S.D.N.Y. May 21, 2004), however, the entire concept of the price decline approach to pleading loss causation comes under attack. The complaint, brought by shareholders of RSL Communications, Inc. (“RSL”), alleged that analysts at three firms had falsified their opinions of RSL. Specifically, while RSL issued a series of negative announcements in 1999 and 2000 – and its stock price dropped – the analysts continued to provide RSL with positive ratings. Ultimately, RSL’s stock declined to the point that it was delisted, and each of the three firms then dropped analyst coverage. The court was careful to note that there were no allegations that the defendants concealed any facts concerning RSL. Instead, the plaintiffs merely alleged that despite publicly available negative information, the analysts expressed falsely positive opinions.
Although the facts are similar to those in the Merrill Lynch cases, Judge Scheindlin appears to create a new loss causation standard and concludes that loss causation was adequately plead. The court explained that loss causation is shown when "(1) the misrepresentation artificially inflated the value of the security, or otherwise misrepresented its investment quality, and (2) the subject of the misrepresentation caused the decline in the value of the security." Here, the subject of the misrepresentations was "the financial health and future prospects of RSL," and though no facts were concealed, that subject still caused plaintiffs' losses. "[E]ven though the true facts were available to the world to see, by affirmatively opining on the meaning of those facts, the Banks obscured the logical conclusion that RSL was failing." This standard would appear to remove the need to draw any actual connection between the misrepresentations and the loss; the mere fact that the company's stock price declined creates liability for anyone who issued false statements about the company into the market.
Moreover, although Judge Scheindlin expressed uncertainty as to whether the Second Circuit’s price decline approach requires a corrective disclosure, the court concluded that dropping analyst coverage of RSL was a corrective disclosure. "[W]hen the Banks dropped coverage, they essentially conceded (in the eyes of the investing public) that their previous recommendations were mistaken." Even accepting this characterization of the banks' actions (and it is hard to see how dropping coverage can be equated with a disclosure about the previous recommendations), the court did not find that there was a price decline after coverage was dropped.
As noted previously, clarification of these issues may come in the near future. The Second Circuit is scheduled to hear the appeal of the first few Merrill Lynch decisions on August 12, 2004.
Holding: Motion to dismiss denied. (The 10b-5 Daily may do an additional post about the other holdings in the opinion.)
As noted in The 10b-5 Daily's discussions of the Intergroup and NUI decisions, the idea that corporate acquisitions for stock are a sufficient motive for securities fraud is controversial. A contrary view can be found in the recent decision in In re Corning Sec. Litig., 2004 WL 1056063 (W.D.N.Y. April 9, 2004).
In the Corning case, the plaintiffs alleged that the defendants were motivated to artificially inflate the company's stock price so that they could use it as currency for the acquisition of Tropel Corporation. The court found that "[p]aying a smaller price for the acquisition of Tropel [by using inflated stock] benefited Corning's common shareholders." Moreover, the desire to have a high stock price to be used in the purchase of Tropel "is a motive that could be attributed to virtually every company seeking to acquire another through the use of its own stock as part of the purchase." As a result, the court held that the acquisition failed to create a strong inference of scienter.
Holding: Motion to dismiss granted.