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February 2, 2012

Subcommittee Hosts Panel Discussion on Compliance Officer Liability

On January 18, 2012, the ABA Securities Litigation SRO Subcommittee hosted a panel discussion on compliance-officer liability, a subject of great interest for legal and compliance professionals at member firms. The presentation featured Susan Schroeder, FINRA’s deputy chief of enforcement, Gloria R. Greco, managing director and chief compliance officer for Merrill Lynch, Pierce, Fenner & Smith Inc., John Sturc of Gibson Dunn & Crutcher LLP, and was moderated by Ben A. Indek of Morgan, Lewis & Bockius LLP. Susan Merrill of Bingham McCutcheon sat in as a commentator with Andy Sidman and Anne Flannery, cochairs of the subcommittee along with David Boch. The program was available via audio-conferencing and more than 100 attendees participated in person or by telephone.

The panelists discussed the role of compliance officers from the in-house perspective, as well as the expectations of both securities and banking regulators. CLE materials that surveyed SEC and FINRA enforcement actions against compliance officers were distributed and are available here. Some of the highlights are summarized below.

Compliance Officer Responsibilities and Reporting Lines
The panelists discussed the typical duties and responsibilities of compliance officers as well as the variation among firms with respect to reporting lines and the relationships between compliance professionals and their colleagues in the legal, internal-audit, and risk management functions. The panel also addressed the different expectations about the role of compliance held by banking regulators, which focus primarily on the safety and soundness of the institution, and securities regulators such as the SEC and FINRA, which generally focus on investor protection and market integrity. The panel discussed the importance of clearly defining the duties and responsibilities of a compliance officer, and empowering compliance officers to play a visible role within the organization. The panel discussed the expectation that a compliance officer should partner with regulators in assessing a firm’s compliance with applicable laws and regulations.

Participation on Firm Committees and in the Self-Reporting Process
The panel addressed the ongoing debate with respect to whether compliance officers should participate in various firm committees—such as risk management, new-product due diligence, and the self-reporting of violative conduct now embodied by FINRA Rule 4530(b)—balancing the importance that their business partners look to compliance as a committed partner while at the same time recognizing that at least some regulators, including SEC staff, seem to view such participation, especially as a voting member, as bestowing supervisory authority that in turn may lead to individual liability where some violation occurs at the firm or by a person deemed to be subject to supervision by the compliance officer.

Legal Framework for Compliance Officer Liability
Mr. Sturc and Mr. Indek outlined the respective statutory and rule-based framework pursuant to which the SEC and FINRA might bring an action against compliance officers for failure to supervise and the panel discussed several recent cases, described in more detail in the CLE materials, in which FINRA found that a compliance officer should be sanctioned. In several such cases, the duty of the compliance officer to perform some specific tasks, such as establishing and implementing AML policies and procedures, was clear from the relevant written supervisory procedures of the firm where they were employed. The panel discussed the important advisory role compliance officers play, and Ms. Schroeder stated that FINRA takes great care before bringing an action against a compliance officer. Other panelists and commentators pointed out however, the chilling effect that such actions may have on compliance officers and the extent to which self interest may conflict with what is in the best interest of the firms and regulators if compliance officers fear that playing an active role increases the likelihood that they will be deemed to have been a supervisor. Ms. Merrill expressed concern that regulators not presume that someone who simply did a poor job was liable under FINRA rules for failing to supervise.

Ted Urban Appeal on Supervision Issues of Compliance Professionals
The panel held an extensive discussion about the significance of the pending appeal to the SEC of an SEC administrative proceeding involving Theodore W. Urban, formerly general counsel, head of compliance, and member of the board of directors of Ferris, Baker Watts, Inc. (now operating under the name RBC Wealth Management). Mr. Sturc, one of the panelists, represents Mr. Urban in Mr. Urban’s appeal from an initial hearing before an SEC administrative-law judge. The appeal raises important issues concerning whether Mr. Urban could be deemed a supervisor of a registered person who engaged in violations of the securities laws and, if so, whether he failed to exercise that supervision reasonably. The initial decision found that Mr. Urban was a supervisor of a former registered representative who had violated the federal securities laws but that he had reasonably supervised that individual with a view toward preventing any violations. As a result, the proceeding against him was dismissed. On appeal, the SEC will consider the position of its Division of Enforcement that Mr. Urban did not act reasonably as well as consider Mr. Urban’s position that he was not a supervisor. Oral argument is to take place in that appeal on February 7, 2012.

If you are not already a member of the ABA Securities Litigation Committee and the SRO Subcommittee, we urge you to consider joining. 

David C. Boch
Bingham McCutchen, LLP
One Federal Street
Boston, MA 02110-1726
617.951.8485
david.boch@bingham.com 

Anne C. Flannery
Morgan Lewis & Bockius, LLP
101 Park Avenue
New York, NY 10178-0600
212.309.6370
aflannery@morganlewis.com 

Andrew W. Sidman
Bressler, Amery & Ross, P.C.
17 State Street
New York, NY 10017
212.510.6916
asidman@bressler.com

— Anne C. Flannery, Morgan Lewis & Bockius, LLP, New York, NY

January 26, 2012

The Role of Foreign Investor Litigation in View of Morrison

In Morrison v. Natl. Australia Bank Ltd., 130 S Ct. 2869, 177 L. Ed. 2nd 535 (2010), the Supreme Court ruled that securities transactions on non-U.S. exchanges would not give rise to an implied right of action under Rule 10b-5. This reasoning has been extended by courts to ‘33 act claims as well. The decision has spurred additional overseas “litigation opportunities” to institutional investors whose trades would now not be included in a U.S. securities class action.

The trend toward foreign litigation opportunities actually began prior to Morrison. Indeed in the Royal Dutch Shell/Transport Securities Litigation (C.A. No. 04-374 (JAP) (D. N.J.) the district court excluded certain foreign investors from the class and a group of foreign investors opted out and negotiated a Netherlands settlement separate from the class settlement. This settlement was achieved though a Dutch foundation, which entity essentially achieved what resembled a U.S. class settlement. The foundation “class” included non-U.S. citizens who purchased Shell securities on non-U.S. exchanges. The settlement included an opt-out provision and its amount ($340 million) was larger than that in the U.S. class settlement. (Ironically, there was also a parallel Securities and Exchange Commission “Fair Fund” settlement in the United States that allowed all purchasers—without regard to nationality or exchange—to participate.)

The Dutch foundation has now become a vehicle for allowing institutions to join in foreign litigation without actually becoming a party plaintiff. Unlike the typical foreign case where the investor needs to be a party plaintiff, the foundation—at least in its early stages—allows for the identity of its “members” to remain confidential. Once one joins as a member they benefit from any settlement. The foundation’s counsel usually makes arrangements for a funding agent and also for insurance and/or indemnification to protect the foundation members. The most notable Foundation settlement thus far since Shell Netherlands was the EADs case. (In EADs one had to be a foundation member to participate in the settlement whereas in Shell Netherlands all investors were included unless they opted out.)

Another foundation case that recently settled on a class basis was Scor-Converium. This was the first time the Dutch courts approved a settlement with respect to a non-Dutch company as to securities not traded on the Dutch exchange. The settlement covers non-U.S. residents who purchased Converium shares on the Swiss exchange or any other non-U.S. exchange during a certain period. Again, the settlement has an opt-out provision.

Both Shell Netherlands and Scor-Converium were actions that had U.S. class counsel involved and the investors greatly benefited from counsel’s insights and discovery taken in parallel U.S. cases. It is still unclear how successful a purely “European case” will be—one that does not have the benefit of the experience of U.S. class counsel and prior U.S. discovery. In addition, there are European “litigation opportunities” where the investors have to be party plaintiffs because the Dutch foundation is not available.

The other jurisdiction that has been very active in investor litigation (other than Canada, whose class actions now closely resemble those in the United States) is Australia. Australia has a long tradition of investor actions brought by experienced plaintiffs’ counsel and financed by funding agents. One must nearly always be a party plaintiff to participate in the recovery. The actions are typically multi-plaintiff actions rather than “class actions.” In addition, the combined fees of the funding agent and counsel have a substantial impact on the eventual recovery. However, recently one Australian case actually settled on a class-action basis—the Oz Minerals settlement (Scott & Taws v. Oz Minerals (Supreme Court of New South Wales, later transferred to the Federal Court of Australia, NSW District Registry). In Oz Minerals, the federal court allowed investors merely to “register” an interest (listing their transactions) to participate. Being a party plaintiff was not necessary. An opt-out opportunity was also provided. Presumably the defendants believed that including the largest group of potential claimants was the most prudent course of action.

The Australia investor actions predate Morrison. There is not much investor overlap with the U.S. class actions. Rather, it is the European “litigation opportunities” that will usually be considered by the investor not included in the U.S. class. Whether these opportunities will be a satisfactory substitute for those foreign investors who previously simply filed a claim in a U.S. class settlement and collected their distributions is unclear. To the extent the foundation vehicle can be used, a satisfactory alternative to the U.S. class action may exist. However, if investors have to become actual plaintiffs, recovery may become much more problematic.

— By Peter M. Saparoff, Mintz Levin, Boston, MA

January 24, 2012

SEC Scrutiny on Proper Valuations of Funds by Investment Advisers

With the creation of its Asset Management Unit in the aftermath of the recent economic crisis, and with the impending registration of hundreds of investment advisers pursuant to the Dodd-Frank Act, the Securities and Exchange Commission (SEC) is now positioned to execute more robust and thorough investigations into asset managers—whether they manage registered funds or hedge funds and other alternative investment vehicles.

One issue that the SEC appears to be approaching with increased scrutiny (and sophistication) is whether managers are properly valuing their funds. Some recent enforcement proceedings in this area have focused on managers of both registered and unregistered funds, and include:

• In the Matter of Lisa B Premo, Admin Proc. No. 3-14697 (Jan. 17, 2012): Premo was the portfolio manager for a registered fund managed by Evergreen Investment Management Co. The SEC alleges that she concealed the fact that one of the sub-prime collateralized debt obligations (CDO) that the fund was invested in was in default, which, in turn, caused the value of the CDO investment (and the fund’s net asset value (NAV)) to be inflated for several months before the fund’s valuation committee learned about the default and wrote the value of the CDO investment down to zero.

• In the Matter of Eric David Wanger, Admin Proc. No. 3-14676 (Dec. 23, 2011): The SEC alleged that an investment adviser inflated the NAV of one of its funds by “marking the close” of certain of the securities held by the fund. “Marking the close” generally consists of placing orders for a thinly traded security at or near the end of the trading day to artificially affect the price of that security. By inflating the price of certain securities held by the fund through this type of alleged conduct, the investment adviser was able to allegedly inflate its NAV and earn higher fees.

• em>In the Matter of Leapdog Capital Markets, LLC, Admin Proc. No. 3-14623 (Nov. 15, 2011): The SEC sued an investment adviser for misrepresenting the fact that a majority of its fund’s investments were illiquid and could not be marked to market on a daily basis.

The fact that these three cases all involve very different types of valuation issues demonstrates that the SEC is prepared to investigate a wide range of conduct that results in inaccurate valuations of funds. 

Another point of interest is that the SEC did not charge Premo with violating any of the anti-fraud provisions of the Securities Act or Exchange Act. Rather, the charges against Premo were based on alleged violations of section 206 of the Advisers Act, and Rule 22c-1(a), promulgated under section 22 of the Investment Company Act. This signals that the SEC is willing to proceed against fund managers for valuation issues even when the alleged conduct is not fraudulent.  

Does this mean that the SEC will be proceeding against fund managers that, in hindsight, it views as being simply negligent on a complex issue relating to fund valuation? On one hand, section 206—and its lenient scienter requirement—could invite such an action, and such actions have been brought before. But on the other hand, the SEC will, not surprisingly, be more willing to proceed (and seek greater sanctions) when there are additional facts suggesting that the conduct went beyond mere negligence. For example, the order in the Premo matter insinuates that Premo was manipulating the prices of some securities in the fund by using inflated quotes supplied by a cooperating broker-dealer. The inclusion of those allegations in the order suggests that the SEC believed Premo was involved in something more than mere negligent conduct, and will probably impact the penalties that the SEC will seek against Premo.

The primary take-away from these actions is that fund managers (especially those that are newly registered) should revisit their valuation procedures and processes to ensure that they are functioning properly, and are reasonably designed to prevent circumvention. Even advisers who primarily manage funds with level-one assets should review whatever procedure or process is in place with the administrator and/or auditors to ensure that the assets are appropriately reviewed and valued. It is not a stretch to imagine that the SEC will view anything short of diligent and regular attention to this issue as potentially constituting a breach of fiduciary duty under section 206, especially if something goes wrong.

— Breton Leone-Quick, Mintz Levin, Boston MA

January 5, 2012

SDNY Rejects SEC-Citigroup Settlement

On November 28, 2011, Judge Jed S. Rakoff of the Southern District of New York  issued an unprecedented and historic opinion and order in SEC v. Citigroup Global Markets Inc., No. 11 Civ. 7387 JSR, ___ F. Supp. ___, 2011 WL 5903733 (S.D.N.Y. Nov. 28, 2011), entirely rejecting the Securities and Exchange Commission’s (SEC) settlement with Citigroup Global Markets as unreasonable, unfair, inadequate, and not in the public interest. Id.at *6. The court ordered both the SEC and Citigroup to prepare for a full trial on the merits beginning July 16, 2012. Id.

On October 19, 2011, the SEC had filed suit against Citigroup, alleging that in the midst of the housing and collateralized-debt-obligation market decline in 2007,

Id.at *1. According to the SEC’s complaint, Citigroup yielded a net profit of $160 million while investors lost more than $700 million. Id.

According to the court, “simultaneously with the filing of its Complaint against Citigroup, the SEC presented to the Court for its signature” a final judgment consent order for court approval that would require Citigroup to pay the SEC a $95 million dollar penalty, disgorge its profits to the SEC, adopt certain remedial measures, and subject Citigroup to the injunctive enforcement of the court, without Citigroup admitting any wrongdoing. Id.In November 2011, the court issued an order listing numerous probing questions it intended to ask the parties to brief and argue relating to final approval of the proposed settlement. Id. at *2. After full briefing and oral argument on those issues, and after “the Court spent long hours [since then] trying to determine whether, in view of the substantial deference due to the SEC in matters of this kind, the Court can somehow approve this problematic Consent Judgment,” the Court rejected the settlement and ordered the parties to prepare for trial. Id.

In its opinion, the court first ruled on the proper standard of review for final approval, and found that for an SEC settlement, the standard for approval is “whether the Proposed Consent Judgment . . . is fair, reasonable, adequate, and in the public interest.” Id.(internal citations omitted). While the SEC took the position that the “the public interest is not part of [the] applicable standard of judicial review,” even though it had used that standard in prior briefing, the court stated that “this [position] is erroneous,” as “a large part of what the SEC requests, in this, and most other such consent judgments, is injunctive relief . . . [and] the Supreme Court has repeatedly made clear that a court cannot grant the extraordinary remedy of injunctive relief without considering the public interest.” Id. (internal citations omitted).

Furthermore, the court rejected what it described as the SEC’s “fall back position,” namely that “if the public interest must be taken into account, the SEC is the sole determiner of what is in the public interest in regard to Consent Judgment settling SEC cases.” Id. at *3. The court found “that, again, is not the law.” Id.The court cited numerous cases for the proposition that “a court, while giving substantial deference to the views of an administrative body vested with authority over a particular area, must still exercise a modicum of independent judgment, in determining whether the requested deployment of its injunctive powers will serve, or disserve, the public interest.” Id.(internal citations omitted). Additionally, the court found that “the requirement that a consent judgment be in the public interest is not meaningfully severable from the requirements, still acknowledged by the SEC, that the consent judgment be fair, reasonable and adequate; for all these requirements inform each other.” Id.(internal citations omitted).

After adopting that standard for approval, the court “conclud[ed], regretfully, that the proposed settlement is neither fair, nor reasonable, nor adequate, nor in the public interest[,] most fundamentally because it does not provide the Court with a sufficient evidentiary basis to know whether the requested relief is justified under any of these standards.” Id.at *4. The court stated that:

Id.

The court directly criticized and questioned “the SEC’s long standing policy—hallowed by history, but not by reason—of allowing defendants to enter into consent judgments without admitting or denying the underlying allegations[.]” Id.The court noted that “as for common experience, a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than any indication of where the truth lies.” Id. at *5. The court further found that “[i]f the allegations in the Complaint are true, this is a very good deal for Citigroup; and even if they are untrue, it is a mild and modest cost of doing business,” and that it is “harder to discern from the limited information before the Court what the SEC is getting from this settlement other than quick headline.” Id.The court, in essence, stated that the relationship between the business community—the regulated—and the SEC—the regulators—has been altogether too cozy for too long.

In the end, the court found that approval of this settlement was not reasonable, as there were no proven facts to base its reasonableness upon. Id.at *6. Furthermore, the court found it was not fair because penalties are being imposed on the basis of unacknowledged and unproven facts. Id. Additionally, the court found that it was not adequate because there are no facts available for the Court to determine its adequacy, and it was not in the public interest “because it asks the Court to employ its power and assert its authority when it does not know the facts.” Id.

In concluding, the court stated that “an application of judicial power that does not rest on facts is . . . inherently dangerous . . . [and that] in any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth.” Id.The court found that the “SEC, of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges, and if its fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.” Id.

This landmark opinion now calls into question the SEC’s decades-long practice of settling cases without obtaining admissions of wrongdoing or admission of facts, questions whether the SEC has been fulfilling its statutory mandate to ensure transparency in the financial markets, and can be seen as an attempt to foster change in the SEC’s practices. The court has now, in essence, attempted to force the SEC to either change its settlement practices, fight this ruling as it is now doing (it has asked, and been granted, expedited review by the Second Circuit Court of Appeals and a hearing is scheduled for January 17, 2012), or face future uncertainty when it seeks to have such settlements approved in federal court.

Indeed, just on December 20, 2011, in a letter to the SEC, Judge Rudolph T. Randa of the Eastern District of Wisconsin, directly citing this opinion, questioned the agency about its proposed settlement of fraud charges against Koss Corp., and requested a response to those questions by no later than January 24, 2012, just one week after the Second Circuit is set to begin hearing the expedited appeal of the opinion. See Letter from the Court to Plaintiff’s Counsel re: Motion for Entry of Final Judgment at 1, SEC v. Koss Corp., No. 2:11-cv-00991-RTR, DI. No. 5 (E.D. Wis. Dec. 20, 2011) (“The Court requests that the SEC provide a written factual predicate for why it believes the Court should find that the proposed final judgments are fair, reasonable, adequate, and in the public interest.”) (internal citations omitted).

Thus, it seems quite clear that this opinion, should it be upheld by the Second Circuit on the current expedited appeal, will reverberate in the business community, the SEC, and the legal community at large for a long time to come, and in ways that were unimaginable to both the business and legal communities just a short while ago.

— Allen Schwartz, Levi & Korsinsky, LLP, New York, NY

December 21, 2011

New York Court Issues Important Ruling on Martin Act

On December 20, 2011, the New York Court of Appeals issued an important ruling concerning the Martin Act, holding that overlapping common-law claims are not precluded by the statute unless such claims are predicated solely on a violation of the Martin Act or its implementing regulations and would not exist but for the statute.

Plaintiff Assured Guaranty sued J.P. Morgan alleging mismanagement of a third party’s investment portfolio (whose obligations the plaintiff guaranteed) which purportedly caused $533 million in losses. At the heart of the appeal were the plaintiff’s claims for breach of fiduciary duty and gross negligence, which alleged that J.P. Morgan invested the third party’s assets in high-risk securities without adequate diversification or disclosure, and with the best interests of nonparty Scottish Re Group Ltd. in mind. As a result, the investments allegedly failed and th eplaintiff’s obligations under the guarantee were triggered.

In the trial court, J.P. Morgan successfully argued that the plaintiff’s breach of fiduciary duty and gross negligence claims were preempted by the Martin Act—New York’s “blue sky” law—which authorizes the attorney general to investigate and enjoin fraudulent practices in the marketing of stocks, bonds, and other securities within or from New York. In November 2010, the Appellate Division reversed, and, on Tuesday, the court of appeals affirmed, holding that the plaintiff’s claims were not preempted.

On appeal, J.P. Morgan contended that the Martin Act vests the attorney general with exclusive authority over fraudulent securities and investment practices addressed by the statute, such that it would be inconsistent to allow private investors to bring overlapping common-law claims. The plaintiff—who was joined by various amici curiae, including the New York Attorney General Eric Schneiderman—countered that neither the language nor the history of the Martin Act requires preemption.

In agreeing with the plaintiff, the court of appeals focused heavily on the legislative intent, finding “the plain text of the Martin Act, while granting the Attorney General investigatory and enforcement powers and prescribing various penalties, does not expressly mention or otherwise contemplate the elimination of common-law claims.” Writing on behalf of the court, Judge Victoria A. Graffeo noted: “Certainly the Martin Act, as it was originally conceived in 1921 with its limited relief, did not evince any intent to displace all common-law claims in the securities field.”

The Court similarly rejected the defendant’s reliance on two of its opinions, CPC International v. McKesson Corp., 70 N.Y.2d 268 (1987]) and Kerusa Co. LLC v w10z/515 Real Estate Ltd. Partnership (12 NY3d 236 [2009]), in support of its contention that the Martin Act abrogated all nonfraud common-law claims. Judge Graffeo explained:

This decision resolves an apparent split in the lower courts regarding preemption of common-law claims if the subject is “covered” by the statute. It bears emphasis that this opinion did not address the merits of the plaintiff’s claims, which J.P. Morgan maintains are without merit.

— Patrick G. Rideout, Skadden, Arps, Slate, Meagher & Flom LLP, New York, NY

November 16, 2011

Second Circuit Affirms Dismissal of ARS Case Against Merrill Lynch

On November 14, 2011, the Second Circuit Court of Appeals affirmed the dismissal of an auction-rates securities (ARS) investor class action, ruling that Merrill Lynch & Co’s disclosures regarding the risks relating to ARS were adequate. In an opinion authored by U.S. Circuit Judge Robert Katzmann, the Second Circuit unanimously rejected the plaintiffs’ claims that Merrill Lynch failed to adequately disclose its practice of placing so-called support bids in auctions or that without such bids the ARS market would fail.

In July 2007, lead plaintiff Colin Wilson purchased $125,000 of the ARS through online brokerage E*Trade Financial Corp. In February 2008, the approximately $330 billion market for ARS failed when major ARS dealers withdrew their support for the auctions and insufficient bidders participated therein. Wilson alleged that many who bought ARS were left holding financial instruments that they were unable to sell.

In rejecting the plaintiffs’ claims, the court noted that when Wilson purchased his ARS in July 2007, the general phenomenon of ARS dealers placing support bids to prevent failed auctions was publicly disclosed. The panel also observed that there were no indications that the ARS market was teetering at that time. Accordingly, the court held that, “[t]aken together, these allegations do not support the inference that Merrill knew, at the time of Wilson’s purchase, that the ARS market was certain to fail in the absence of its intervention.” Moreover, Judge Katzmann held that “Merrill’s particular disclosures sufficiently alerted investors in Merrill ARS of the likelihood that the interest rates and apparent liquidity of these ARS reflected Merrill’s own intervention in these auctions rather than the natural interplay of supply and demand.”

This case was one of nine consolidated cases in multidistrict litigation against Merrill Lynch concerning ARS. It is unclear what the Second Circuit’s opinion will mean for the remaining eight cases, as the court cautioned that its holding “rests in substantial part on the fact that Wilson’s purchase of his securities antedated the time that Merrill was alleged to have learned that the ARS market was no longer viable and to have made statements directed at investors that were at odds with its internal understanding of the liquidity of these securities.”

— Patrick G. Rideout, Skadden, Arps, Slate, Meagher & Flom LLP, New York, NY

November 7, 2011

Delaware Court Dismisses Compensation Case Against Goldman Sachs

On October 12, 2011, the newly appointed Vice Chancellor Glasscock of the Delaware Chancery Court issued a decision in In Re Goldman Sachs Group, Inc. Shareholder Litigation, 2011 WL 4826104 (Del. Ch. Oct. 12, 2011) that ruled in favor of defendant Goldman Sachs’s motion to dismiss pursuant to Chancery Rule 23.1, which requires that a plaintiff plead particularized facts as demand futility in derivative suits.

The plaintiffs had challenged Goldman’s “pay for performance” compensation policies. The plaintiffs had argued, inter alia, that by tying pay to revenue, Goldman was incentivizing its employees to focus on short-term revenue increases at the expense of the very large attendant risks in the longer term. “The Plaintiffs contend that Goldman’s employees would do this by engaging in highly risky trading practices and by over-leveraging the company’s assets. If these practices turned a profit, Goldman’s employees would receive a windfall; however, losses would fall on the stockholders.” Id. at *1.

The Court dismissed these claims on the grounds that the plaintiffs had failed to meet Delaware’s demand-futility requirements—which require that a plaintiff “alleg[e] particularized facts that create a reasonable doubt that either (1) the directors are disinterested and independent or (2) “the challenged transaction was otherwise the product of a valid exercise of business judgment.” Id at *6 (internal citations omitted).

As to the first prong, the court found that the majority of the board was independent and disinterested. As to the second prong, under which “the Plaintiffs must allege “particularized facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision[,]” Id at. *12, the court again held for defendants. The court found that

Id. at *19. Further, the court found that “[a]t most, the Plaintiffs’ allegations suggest that there were other metrics not considered by the board that might have produced better results. The business judgment rule, however, only requires the board to reasonably inform itself; it does not require perfection or the consideration of every conceivable alternative.” Id. at *16.

The plaintiffs’ also claimed that the defendants had abdicated their oversight responsibilities by, among other things, failing to implement procedures to prevent risky and unlawful trades that were a result of Goldman’s compensation structure. As to these claims, the court applied the test articulated in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch.1996), which held that “[p]laintiffs ha[ve] to show that the Board (a) . . . utterly failed to implement any reporting or information system or controls” . . . or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention.” Goldman, 2011 WL 4826104 at *19 (internal citations omitted). The court also applied the demand-futility test for board inaction articulated in Rales v. Blasband. 634 A.2d 927 (Del.1993), requiring plaintiffs to plead particularized facts “creat[ing] a reasonable doubt that, as of the time the complaint [was] filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” Goldman, 2011 WL 4826104 at *6. (emphasis added). Furthermore, “[u]nderRales, defendant directors who face a substantial likelihood of personal liability are deemed interested in the transaction and thus cannot make an impartial decision.” Id. at 18.

The court held that the plaintiffs failed the Rales test because the defendants did not face a substantial likelihood of liability. The plaintiffs pointed to, inter alia, the collateralized debt obligation transaction with the famous investor, John Paulson, as an example of oversight failure. The court, however, found that the “transactions referenced by the Plaintiffs . . . are not sufficient pleadings of wrongdoing or illegality necessary to establish a Caremark claim—the only inferences that can be made are that Goldman had risky assets and that Goldman made a business decision, involving risk, to sell or hedge these assets.” Id. at 20. The court found that that there were no particularized pleadings that suggested that the defendants acted in bad faith or consciously disregarded their oversight risks.

As a result, “[t]he Plaintiffs ha[d] failed to allege facts sufficient to demonstrate that the directors were unable to properly exercise this judgment in deciding whether to bring these claims.” Id. at 23. The court did not have to therefore decide on Goldman’s Chancery Rule 12(b)(6) motion, under which pleading standards are significantly lower, to reach its decision.

— Ed Korsinsky and Allen Schwartz, Levi & Korsinsky, LLP, New York, NY

November 7, 2011

SDNY Questions SEC Settlement Practices in Citigroup Settlement

On October 27, 2011, Judge Jed. S. Rakoff, issued an order in SEC v. CitiGroup Global Market, Inc., 1:11-cv-073897-JSR, DI 9 (S.D.N.Y. 2011), in which he continues to question Securities and Exchange Commission (SEC) settlement practices. In the order, Judge Rakoff listed numerous questions he intends to ask the parties when he holds a hearing on November 11, 2011 to finally approve the settlement the SEC reached with CitiGroup. Judge Rakoff, who has made comments critical of the SEC settlement practices in the past, intends to question the SEC as to why the court should approve a settlement where no wrongdoing is admitted, especially in light of the SEC’s “statutory mandate to ensure transparency in the financial marketplace.” Id. at 1. He asks, “[i]s there an overriding public interest in determining whether the S.E.C.’s charges are true? Is the interest even stronger when there is no parallel criminal case?”Id. The SEC has historically not required defendants to admit to any wrongdoing when reaching settlements.

 He also asks “[h]ow was the amount of the proposed judgment determined? In particular what calculations went into the determination of the $95 million dollar penalty? Why, for example, is the penalty in this case less than one fifth of the $535 million dollar penalty assessed in [the recent case of] SEC v. Goldman Sachs & Co.”? Id.at 2. These probing questions are unusual in cases where the SEC is seeking settlement.

Thus, while the SEC has historically faced little difficulty in getting their settlements approved in federal court, and has rarely faced such probing questions from federal judges, it appears this settlement will be different. Judge Rakoff, who has been very critical of the SEC of late, will likely probe the SEC at the November 11, 2011, hearing. What effects it will have on SEC practices going forward remains to be seen.

— Ed Korsinsky and Allen Schwartz, Levi & Korsinsky, LLP, New York, NY

November 1, 2011

Confirmatory Statements Can Prolong Inflation Without Price Increase

An important question arising more and more in securities-fraud class actions is whether a plaintiff must establish that a company’s stock price experienced an immediate increase after the company or its officers made a material misrepresentation to the market so as to evidence the inflationary impact on the security. In recently addressing this issue on an appeal from a summary judgment order, the Eleventh Circuit Court of Appeals held that to be actionable as a false or misleading statement under the securities laws, a plaintiff need not prove that the statement either caused in the first instance or increased artificial inflation of a company’s stock price, but simply that the statement, by confirming prior misstatements, maintained or propped up pre-existing inflation caused by those earlier statements. See Findwhat Investor Group v. Findwhat.com, No. 10-10107, 2011 WL 4506180 (11th Cir. Sept. 30, 2011).

As the court stated, “[t]here is no reason to draw any legal distinction between fraudulent statements that wrongfully prolong the presence of inflation in a stock price and fraudulent statements that initially introduce that inflation” because inflation caused by confirmatory false statements “creates an ongoing risk of harm”—i.e., the investor continues to be deceived about the true value of his or her stock.    

In Findwhat, the plaintiffs’ expert admitted that defendant MIVA’s stock price was inflated before the defendants’ first actionable misrepresentation and remained at that same inflated level after the defendants’ two subsequent misstatements. The district court reasoned that “because the inflation level in MIVA’s stock price did not change as a result of the alleged misrepresentations, these otherwise actionable statements by the [d]efendants could not have ‘caused’ the Plaintiffs’ losses.” The court of appeals found this ruling “constituted legal error” because the defendants “may be held liable for knowingly making materially false statements that continued to prop up the already inflated price of MIVA’s stock and thereby caused losses to investors, regardless of whether MIVA’s stock price was already inflated before the actionable statements were made.” As the court stated, “[i]nvestors who purchased MIVA stock at inflated prices during the Class Period—and, notably, after the purportedly fraudulent statements were made—may have sustained substantial losses that they would not have suffered had the [d]efendants revealed the truth at the start of the Class Period.” Therefore, the Eleventh Circuit vacated the district court’s summary judgment ruling and remanded the action to the district court to apply the proper legal standard.

As the Eleventh Circuit explained, “confirmatory information that wrongfully prolongs a period of inflation—even without increasing the level of inflation—may be actionable under the securities laws.” This means that the defendants can be liable for “causing a stock price to remain inflated by preventing preexisting inflation from dissipating from the stock price.” The court also found that fraudulent misstatements that prolong inflation can be equally as harmful to subsequent investors as statements that cause inflation at the outset. Therefore, the court concluded that the existence of inflation prior to a defendant’s first actionable misstatement is “irrelevant to securities fraud liability” because “[e]very investor who purchases at an inflated price—whether at the beginning, middle, or end of the inflationary period—is at risk of losing the inflationary component of his investment when the truth underlying the misrepresentation comes to light.”

The Eleventh Circuit further posited that due to the high volumes of shares purchased on a daily basis, the longer the stock price remains at an inflated level, the greater the number of shares purchased at inflated prices, and the greater the number of shares that will inevitably lose value when the inflation subsequently dissipates from the stock price. In simple terms, “a falsehood that endures within the marketplace for a longer period of time, all else being equal, will cause greater harm than one that endures for a shorter period of time.” As the appeals court stated in closing, “Defendants who commit fraud to prop up an already inflated stock price do not get an automatic free pass under the securities laws.”

— Matthew L. Mustokoff, Kessler Topaz Meltzer & Check LLP, New York, NY

October 31, 2011

New York Court Dismisses Shareholder Suit Against Goldman Sachs

On September 21, 2011, Judge Bernard J. Fried issued a decision in Central Laborers’ Pension Fund v. Blankenfien, Civ. No. 6000036/2010 D.I. 91 (N.Y. Sup. Ct. Sept. 21, 2011), where the plaintiff had “alleged that certain members of Goldman’s Board of Directors and executive officers breached their fiduciary duties by reserving 50% of Goldman’s net revenues for employee compensation, without consideration as to whether or not such a payout was merited.” After Goldman had to some extent mitigated that problem by lowering the proportional rate of revenue allocated to compensation, the plaintiff sought a fee award for the substantial benefit conferred on shareholders.

The court denied any fee award and also took a position on an issue that remains unresolved in New York: whether a plaintiff’s firm can seek attorney fees for conferring a substantial benefit on a corporation in a derivative suit without the court first determining whether the suit was meritorious when filed, as required in Delaware. In its opinion, the court found that

 Id. at 10.

Goldman argued that regardless of whether the plaintiff’s suit was a cause of the reforms, the court had to look first as to whether the suit was meritorious when filed—that is, whether it would have survived a motion to dismiss. Without adapting the “meritorious when filed” standard, the court did look to whether the suit met the requirements of section 626, which articulates New York’s demand requirements, when filed, and held that “the party seeking relief under subsection (e) must demonstrate that its complaint contains sufficient particularized obligations of pre-suit demand or demand futility as to satisfy subsection (c).” Id. at 11. The court reasoned that “[a]ny other rule would permit, even encourage, the filing of baseless claims, the sole objective of which is to collect attorneys fees.”

Under that standard, the court found that regardless of whether the plaintiffs had caused Goldman Sach’s compensation reforms—which the court did not actually dispute—the suit did not plead demand futility sufficiently, and with enough particularity. Accordingly, the court denied the fee petition. The decision is subject to appeal.

— Ed Korsinsky and Allen Schwartz, Levi & Korsinsky, LLP, New York, NY

October 27, 2011

SEC Files Charges Against Former Goldman Sachs Board Member

In a complaint filed October 26, 2011, in the federal district court in the Southern District of New York, the Securities and Exchange Commission (SEC) charged Rajat Gupta with insider trading during the height of the 2008 financial crisis. Specifically, the complaint alleges that Gupta, who served on the board of directors for Goldman Sachs and Procter & Gamble during the time which the charges are alleged to have occurred, illegally tipped Raj Rajaratnam on the quarterly financial results of Goldman Sachs and Procter & Gamble, and on a $5 billion investment in Goldman Sachs by Berkshire Hathaway before the information became public. Rajaratnam, the founder and managing general partner of Galleon, allegedly used the inside information as the basis for trading in Galleon hedge funds, resulting in illegal profits and loss avoidance of more than $23 million. The complaint alleges that Gupta had various business dealings with Rajaratnam during this time and gave the inside information with the expectation of receiving a benefit.

The SEC seeks relief including disgorgement, civil monetary penalties, a permanent injunction enjoining Gupta and Rajaratnam from further violations of the securities laws, as well as an order barring Gupta from acting as an officer or director of any registered public company and permanently enjoining him from associating with any broker, dealer, or investment adviser. The SEC has now charged 29 defendants in Galleon-related enforcement actions, whose insider trading is said to have generated illegal profits totaling more than $90 million.

— Julie H. Firestone and Christine J. Kim, Briggs and Morgan, Minneapolis, Minnesota

June 21, 2011

The Supreme Court Curtails Rule 10b-5's Reach

In Janus Capital Group, Inc. v. First Derivative Traders, issued June 13, 2011, the Supreme Court held that a person makes a statement within the meaning of section 10(b) and Rule 10b-5 only if the person has “ultimate authority over the statement.” A person who lacks ultimate authority—even a person “significantly involved” in preparing a statement or who publishes a statement on behalf of another—does not make the statement. The decision confirms that no private right of action exists under Rule 10b-5 against secondary actors (advisors, auditors, bankers, lawyers) who only help to draft or disseminate a statement made by another.

The plaintiffs alleged that Janus Capital Management, an advisor to Janus mutual funds, violated Rule 10b-5 by causing the funds to issue prospectuses containing misstatements. The district court dismissed. But the Fourth Circuit reversed, holding that Janus Capital Management made the alleged misstatements “by participating in the writing and dissemination of the prospectuses.”

Reversing, the Supreme Court held that “the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not ‘make’ a statement in its own right.” Drawing a “clean line” between those who are potentially liable under Rule 10b-5 and those who are not, the Court held that a person who “creates” or “prepares or publishes a statement on behalf of another” does not “make” the statement.

The “ultimate authority” rule follows from Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), where the Court held that no private right of action exists against those who aid and abet a violation of section 10(b). Central Bank’s holding would be “substantially undermine[d]” if a person without ultimate authority could be liable for a statement. If those persons were “primary violators . . . then aiders and abettors would be almost nonexistent.”

Janus Capital Management lacked ultimate authority over the statements in the prospectuses because it was legally separate and independent from the funds it advised. The funds, not Janus Capital Management, were legally obligated to, and did, issue the prospectuses. Further, the prospectuses did not attribute to Janus Capital Management any alleged misstatement. Therefore, Janus Capital Management did not make the alleged misstatements for Rule 10b-5 purposes.

Following Central Bank and Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) (holding that no private right of action exists against a person whose undisclosed, deceptive acts facilitated another’s fraud), Janus affirms the Court’s commitment to construing narrowly the implied private right of action under Rule 10b-5.

The decision was written by Justice Thomas for a five-justice majority.

— Hannah Berkowitz and James Goldfarb, Murphy & McGonigle, New York, NY

June 21, 2011

Supreme Court: “Loss Causation” Not Required at Class Certification

A unanimous U.S. Supreme Court has held that plaintiffs do not have to prove loss causation to obtain class certification in federal securities-fraud cases. The decision, Erica P. John Fund, Inc. v. Halliburton Co., issued June 6, 2010, overturns a unique Fifth Circuit rule requiring plaintiffs to prove loss causation at the class-certification stage to invoke the rebuttable presumption of reliance that the Supreme Court adopted in Basic v. Levinson, 485 U.S. 224 (1988). The decision does not address and, therefore, leaves intact, a defendant’s ability to rebut Basic’s presumption of reliance by showing that a misrepresentation did not inflate the share price at the time of the relevant transaction.

In Basic, the Supreme Court held that because “the market price of shares traded on well-developed markets reflects all publicly available information,” plaintiffs may raise a rebuttable presumption that they relied on a misrepresentation when they bought or sold shares at the price set by the market. To invoke the rebuttable presumption, plaintiffs must show that the market for the shares was efficient. Before Halliburton, the Fifth Circuit also required plaintiffs who sought to invoke the presumption to prove loss causation at the class-certification stage. Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261 (5th Cir. 2007).

In Halliburton, plaintiffs tried to invoke the presumption of reliance not by showing that the fraud inflated Halliburton’s share price, but by showing that the share price corrected because the fraud was revealed. The court declined to certify a class. Applying Oscar, the court held that plaintiffs could not invoke Basic’s presumption of reliance because they failed to prove loss causation. The Fifth Circuit affirmed.

Vacating the Fifth Circuit’s ruling, the Supreme Court held that reliance and loss causation are distinct elements, and the facts necessary to establish loss causation have “no logical connection to the facts necessary to establish” the rebuttable presumption of reliance. Reliance focuses on “facts surrounding the investor’s decision to engage in a transaction,” whereas loss causation “requires a plaintiff to show that a misrepresentation that affected the integrity of the market price also caused a subsequent economic loss.” Defendants might show that facts other than the revelation of the fraud caused economic loss, thereby undercutting loss causation. But those facts have “nothing to do with whether an investor relied on the misrepresentation in the first place.”

By conflating reliance and loss causation at the class-certification stage, the Fifth Circuit imposed a condition on class certification that was inconsistent with Basic. The Court declined to address other aspects of Basic, its presumption, or when and how defendants may rebut the presumption. These issues remain for further development by the lower courts.

— Hannah Berkowitz and James Goldfarb, Murphy & McGonigle, New York, NY

May 31, 2011

Concurrent State Jurisdiction for ’33 Act Claims Survives SLUSA

In a May 18, 2011, decision, the California Court of Appeal allowed claims under sections 11, 12, and 15 of the Securities Act of 1933 alleging misstatements in connection with mortgage pass-through certificates to proceed in California state court, rejecting defendant Countrywide’s argument that the Securities Litigation Uniform Standards Act (SLUSA) requires removal of claims under the 1933 Securities Act to federal court. See Luther v. Countrywide Fin. Corp., --- Cal.Rptr.3d ---, 2011 WL 1879242 (Cal. App. 2 Dist. May 18, 2011). The decision was the latest chapter in a three-and-one-half-year litigation saga that still has not gotten beyond the threshold procedural question of which court has jurisdiction.

The case was originally filed by the plaintiffs in California state court in November 2007. The defendants removed the case to federal district court pursuant to the Class Action Fairness Act of 2005 (CAFA). The plaintiffs then moved to remand the case to state court pursuant to the concurrent state-court jurisdiction provision of the Securities Act, section 22(a), arguing that CAFA does not trump section 22(a)’s explicit non-removal language for Securities Act claims. Following the district court’s grant of the plaintiffs’ motion to remand, the Ninth Circuit Court of Appeals affirmed, holding that “CAFA’s general grant of the right of removal of 22(a)’s specific bar to removal of high-dollar class actions does not trump § cases arising under the Securities Act of 1933.” According to the court, “the Securities Act of 1933 is the more specific statute; it applies to the narrow subject of securities cases and §22(a) more precisely applies only to claims arising under the Securities Act of 1933. CAFA, on the other hand, applies to a ‘generalized spectrum’ of class actions.” Luther v. Countrywide Home Loans Servicing L.P., 533 F.3d 1031, 1034 (9th Cir. 2008).

After being remanded to state court by the Ninth Circuit, the defendants filed a demurrer, claiming that SLUSA superseded concurrent state-court jurisdiction for ‘33 Act claims. The California Court of Appeal rejected the defendants’ argument, declining to endorse the defendants’ “limited reading” of SLUSA, and holding that “concurrent jurisdiction of this case survived the amendments to the 1933 Act,” stating, “the fact that the case is not precluded and can be maintained, but cannot be removed to federal court if it is filed in state court, tells us that the state court has jurisdiction to hear this action.” Luther, 2011 WL 1879242, at *3. Thus, after three-and-one-half years, it appears that the case will finally proceed in state court where it was originally filed.

While both the state and federal appellate courts of California appear to endorse the concept of concurrent jurisdiction as inscribed in the Securities Act, other courts have concluded that the removal provisions of SLUSA and CAFA trump a plaintiff’s traditional right to pursue ‘33 Act claims in the forum of his or her choosing, even in the case on “non-covered” securities that do not trade on a national exchange. See, e.g., Katz v. Gerardi, 552 F.3d 558 (7th Cir. 2009). The divergence in the courts’ interpretation of these interconnected statutes is likely to spur further litigation—and perhaps an eventual petition of certiorari to the U.S. Supreme Court—particularly as mortgage-backed and asset-backed instruments and other non-traditional securities not traded on a national exchange increasingly become the subject of class-action litigation.

—By Matthew L. Mustokoff and John Gross, Kessler Topaz Meltzer & Check, LLP

May 3, 2011

High Court: States May Not Mandate Availability of Class Arbitration

In a 5–4 majority opinion by Justice Antonin Scalia, the U.S. Supreme Court held on April 27, 2011 that California’s Discover Bank decision—which, essentially stated, said that class-action waivers in arbitration agreements of adhesion were unconscionable—is preempted by section 2 of the Federal Arbitration Act (FAA). AT&T Mobility LLC v. Concepcion, No. 09-893, 563 U.S. ---- (2011). Under Discover Bank, California courts had refused to enforce class-action waivers in adhesion consumer contracts.

Section 2 of the FAA provides that arbitration agreements are enforceable, “save upon such grounds as exist at law or in equity for the revocation of any contract”—in other words, that an arbitration agreement need not be enforced if it is subject to a generally applicable contract defense, such as fraud, duress, or unconscionability. But, if the arbitration agreement is not subject to a generally applicable contract defense, the Court explains that section 2 requires that the arbitration agreement be enforced according to its terms. To the Court, class arbitration is slower than regular arbitration, it requires more formal procedures to bind absent class members, and it increases the risk (in terms of damages after judgment) to defendants faced with class arbitration, which lacks an effective means of review for errors by the arbitrators. Consequently, the Court concludes that the Discover Bank rule interferes with and is inconsistent with section 2 of the FAA by requiring the availability of class-wide arbitration regardless of the parties’ agreement. (The Court acknowledges that the parties could agree to class arbitration as a matter of contract, but explains that does not mean it can be required by state law.)

Justice Thomas, who “reluctantly” joins in the five-vote majority opinion, argues in a separate concurrence that only doctrines that address contract formation, “such as by proving fraud or duress,” may be used to prevent enforcement of an arbitration agreement under section 2 of the FAA. He reaches that conclusion by reading sections 2 and 4 of the FAA together; where section 2 requires that arbitration agreements be enforced unless there is a ground for “revocation” of the contract, section 4 provides that a court must enforce an arbitration agreement once “satisfied that the making of the agreement . . . is not an issue.” Consequently, to Justice Thomas, the “grounds . . . for the revocation of any contract” refers to grounds related to making the agreement, and because the Discover Bank rule does not relate to the making of an agreement—he notes that the California Supreme Court made the rule in concluding that class-action waivers in adhesion contracts were in effect exculpatory—it is preempted by the FAA.

—Matthew M.K. Stein, Skadden, Arps, Slate, Meagher & Flom LLP, Boston, MA

The opinions expressed in this summary are those of the author, and not necessarily those of Skadden Arps or its clients.

May 3, 2011

Supreme Court Hears Oral Argument in Halliburton

On April 25, 2011, the U.S. Supreme Court heard argument in Erica P. John Fund v. Halliburton, a securities class action alleging a violation of Rule 10(b)-5. Petitioner Erica P. John Fund, an investor in Halliburton, appealed the Fifth Circuit’s affirmance of the district court’s denial of its motion for class certification. The Court considered whether securities plaintiffs must prove loss causation by a preponderance of the evidence as a requirement for class certification, or whether that proof is a merits-based question reserved for trial.

Based on the argument, the Court appears to be inclined to accept the petitioner’s position and reverse the Fifth Circuit’s holding that plaintiffs must prove loss causation at the class-certification stage. The Court acknowledged that the Fifth Circuit’s opinion was an outlier, but left open the possibility of remanding the case for consideration of whether reliance had been shown for purposes of class certification.

The petitioner brought a section 10(b)-5 action against Halliburton alleging that it made material misstatements regarding: (1) the company’s liability for asbestos claims; (2) its accounting of revenue in its engineering and construction business; and (3) the benefits of its merger with Dresser Industries. The petitioner alleged that Halliburton’s share price declined when it subsequently made corrective disclosures. The respondents argued that the alleged misrepresentations had no impact on the company’s stock price.

The Fifth Circuit, relying on the Supreme Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988), denied class certification, holding that because the plaintiffs did not show loss causation, they did not trigger the “fraud-on-the-market” presumption of reliance. Class reliance is presumed if a plaintiff can show that a defendant made a misrepresentation, that the defendant’s stock traded in an efficient market, and that the plaintiff traded shares between the misrepresentation and the corrective disclosure. Relying on Basic and its own precedents, the Fifth Circuit held that a misrepresentation’s effect on market price must be assessed at the class-certification stage. The plaintiff may demonstrate reliance with proof of either “an increase in stock price immediately following the release of positive information, or by showing negative movement in the stock price after release of the alleged ‘truth’ of the earlier falsehood.” The petitioner “relie[d] only on stock price decreases following allegedly corrective disclosures by Halliburton.” The Fifth Circuit held that such proof was insufficient. 

 David Boies of Boies, Schiller and Flexner, LLP, argued for the petitioner. He contended that class certification should have been granted because Basic established a presumption of class reliance under its “fraud-on-the-market” theory. He asserted that the presumption was met because the parties conceded the existence of an efficient market. He distinguished between the element of reliance which, under Basic, may be considered at the class-certification stage, and the element of loss causation, which cannot.

Justice Scalia questioned Boies as to why the Court should not hold that a showing of loss causation at the class-certification stage is not required and remand to the Fifth Circuit to determine whether to accept the respondents’ argument that the petitioner failed to satisfy Basic’s presumption of reliance. Boies responded that loss causation and reliance are separate issues. Only reliance is a predicate for class certification. He re-emphasized that the petitioner satisfied the reliance predicate because the parties conceded there was an efficient market.

Boies struggled, however, when Justice Alito asked about other economists’ positions that “even in a market that is generally efficient, there can be instances in which the market does not incorporate statements into the price of a stock.” If this were so, queried Alito, then defendants should be able to show at the class-certification stage that the fraudulent statements had no price impact, thus destroying the plaintiff’s theory of reliance. Boies responded by stating that price impact should be addressed at trial, summary judgment, or the pleading stage.

Nicole A. Saharsky, assistant to the U.S. solicitor general, argued for the United States as an amicus curiae supporting the petitioner. Saharsky argued that the Fifth Circuit improperly required the petitioner to prove elements going to the merits at the class-certification stage, specifically, loss causation. She asserted that the Fifth Circuit’s opinion was inconsistent with Basic. Relying on Fed. R. Civ. P. 23, she argued that the focus at the class-certification stage should be whether common issues predominate over individual ones, and not whether a putative class can prove its case. The Court had few questions for the government’s attorney.

David Sterling of Baker Botts LLP argued for the respondent. In response to questioning by Justices Sotomayor and Kagan, Sterling agreed that the petitioner did not bear the burden of proving loss causation at the class-certification stage, which he conceded had been placed on the petitioner by the Fifth Circuit, “contrary to Basic.” Noting Basic’s holding that a defendant may rebut a presumption of reliance by “any showing that severs the link between the misrepresentation and the stock price . . . ,” Sterling argued that the respondent effectively rebutted the “fraud-on-the-market” presumption of class-wide reliance by showing that the alleged misrepresentations did not have an impact on stock price. This then shifted the burden to the petitioner. Thus, he said, the case turned on an application of Basic’s rebuttable presumption, not on a question of loss causation.

When the justices questioned Sterling about examining the merits at the class-certification stage, Sterling asserted that Basic’s purpose in creating the reliance presumption was “to make a judicially created cause of action easier to be maintained as a class action.” However, this presumption was not intended to lead to automatic class certifications because the presumption remains rebuttable. Sterling argued that “Basic itself says if the stock price was not distorted by the misrepresentation, you can’t say the entire class relied upon the misrepresentation to the stock price.” He characterized the petitioner’s position as seeking to “extend Basic . . . to make that rebuttable presumption of reliance irrebuttable at the class certification stage.”

The Court’s questions strongly suggested that it disagreed with the Fifth Circuit’s holding that plaintiffs prove loss causation at the class certification stage. Justices Ginsburg and Kagan expressed concerns in requiring merits-based issues to be argued at class certification. Chief Justice Roberts additionally noted the absence of formal discovery at that stage. Whether the Court will decide the issue narrowly, rejecting the Fifth Circuit’s decision, or remand for further consideration, remains to be seen.

—Joseph Zwicker, Choate, Hall & Stewart LLP, Boston, MA

March 28, 2011

SDNY Judge Unsettled by SEC Settlements

Judge Jed S. Rakoff of the Southern District of New York has been skeptical of settlement agreements executed by the Securities and Exchange Commission (SEC). In the recent Bank of America-Merrill Lynch case, the judge said that the commission’s proposed settlement did not “comport with the most elementary notions of justice and morality.” Now Judge Rakoff had the opportunity to comment on the SEC’s practice of accepting settlements in which the defendants neither admit nor deny the agency’s allegations. The case, SEC v. Vitesse Semiconductor Corp., 10-cv-9239 (Mar. 21, 2011), involved allegedly fraudulent revenue recognition and options-backdating practices. The SEC reached settlement agreements with three defendants and submitted the arrangements for the district court for approval. Judge Rakoff wrote that the “neither admit nor deny” practice was “troubling.” According to the judge, the practice creates “stew of confusion and hypocrisy unworthy of such a proud agency as the SEC.” Judge Rakoff characterized the situation as “an agency of the United States is saying, in effect, ‘although we claim that these defendants have done terrible things, they refuse to admit it and we do not propose to prove it, but will simply resort to gagging their right to deny it.’” He concluded that “only one thing is left certain: the public will never know whether the SEC’s charges are true.” In his words, “the disservice to the public inherent in such a practice is palpable.”

The judge recognized, however, that in this case, the issue was less important because two of the individual defendants had admitted guilt in parallel proceedings and the company had let its “money do the talking” by contributing large sums of cash and stock to the settlement fund. Under these “unusual circumstances,” the judge approved the settlements. He cautioned, however, that he reserved “for the future substantial questions of whether the court can approve other settlements” that involve the practice of defendants who neither admit nor deny the charges against them.

— Mor Wetzler and Sean Haran, Paul Hastings, New York, NY

March 23, 2011

Supreme Court Rejects Test of "Statistical Significance" for Materiality

On March 22, 2011, the U.S. Supreme Court issued a decision in the matter of Matrixx Initiatives, Inc., et al. v. Siracusano, et al., No. 09-1156. The unanimous decision, written by Justice Sotomayor, rejected a bright-line test of statistical significance to determine when information must be disclosed to investors under the securities laws.

The underlying securities-fraud complaint alleged that Matrixx, the maker of Zicam Cold Remedy, an over-the-counter product, failed to disclose “adverse event reports” indicating that some users suffered from a loss of smell (anosmia). Matrixx moved to dismiss, arguing that the investors had failed to plead materiality adequately under section 10(b) of the Securities Exchange Act because they did not allege that the undisclosed reports reflected statistically significant evidence that Zicam caused anosmia. Matrixx argued that because the number of users suffering from anosmia was statistically insignificant, the information was immaterial as a matter of law and the company had no duty to disclose it. The district court granted Matrixx’s motion to dismiss, and the Court of Appeals for the Ninth Circuit reversed.  

Writing for the Court, Justice Sotomayor held that the materiality of adverse-event reports cannot be reduced to a bright-line rule based on statistical significance. The Court reaffirmed the traditional test of Basic, Inc v. Levinson, 485 U.S. 224, 231–32 (1988) and TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976), that the materiality requirement under section 10(b) of the Exchange Act is satisfied when there is “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” In Basic, the Court had rejected a bright-line test for determining materiality, observing that “[a]ny approach that designates a single fact or occurrence as always determinative of an inherently fact-specific finding such as materiality, must necessarily be overinclusive or underinclusive.” Id., at 236.

Matrixx argued that adverse-event reports regarding a pharmaceutical company’s products are not material unless a sufficient number of such reports establishes a statistically significant risk that the product is causing the events. The Court noted this argument rests on the flawed premise that statistical significance is the only reliable indication of causation. A lack of statistically significant data does not mean that medical experts have no reliable basis for inferring a causal link between a drug and adverse events. “As Matrixx itself concedes, medical experts [often] rely on other evidence to establish an inference of causation.” Justice Sotomayor also observed that the Food and Drug Administration (FDA) does not limit the evidence it considers in reviewing drugs to statistically significant data. “Given that medical professionals and regulators act on the basis of evidence of causation that is not statistically significant, it stands to reason that in certain cases reasonable investors would as well.”

Applying Basic’s “total mix” standard in this case, the Court concluded that the investors adequately pleaded materiality. Moreover, the Court held that applying a bright-line test of statistical significance would artificially exclude information that would otherwise be considered significant to a reasonable investor’s trading decision. “Although in many cases reasonable investors would not consider reports of adverse events to be material information, respondents have alleged facts plausibly suggesting that reasonable investors would have viewed these particular reports as material.”

Notably, the Court cautioned that pharmaceutical manufacturers need not disclose all reports of adverse events. The existence of such adverse events, which can be common occurrences, “says nothing in and of itself about whether the drug is causing the adverse events.” Something more than the “mere existence of reports of adverse events” is necessary, the decision states, but that “something more” need not be statistical significance. The issue is whether, in context, a reasonable investor would have viewed reports of adverse events as material even in the absence of statistically significant evidence of a causal link.

The decision also reiterated the principle that absent a duty to speak, silence cannot be the basis for securities liability; disclosure is required only to make previous statements not misleading: “Even with respect to information that a reasonable investor might consider material, companies can control what they have to disclose under these provisions by controlling what they say to the market.” The Court noted that “[t]his is not a case about a handful of anecdotal reports, as Matrixx suggests.” Rather, assuming the complaint’s allegations to be true, as required at the motion-to-dismiss stage, the Court found that “Matrixx received information that plausibly indicated a reliable causal link between Zicam and anosmia.” Based on the information allegedly available to Matrixx, the Court found that the complaint alleged facts “suggesting a significant risk to commercial viability of Matrixx’s leading product.” Because it was substantially likely that a reasonable investor would have viewed this information as having significantly altered the “total mix” of information made available, the investors adequately pleaded a material misrepresentation or omission.

The Court also found that the plaintiffs alleged scienter sufficiently. The Court noted that it has not yet determined whether recklessness alone is sufficient to satisfy the scienter requirements, and is saving that question for another day. The Court found that the allegations, “taken collectively,” give rise to a “cogent and compelling” inference that Matrixx elected not to disclose the adverse-event reports not because it believed they were meaningless but because it understood their likely effect on the market. Therefore, the Court found that respondents had adequately pleaded scienter.

— the Securities Litigation Practice, Paul Hastings, New York, NY

March 16, 2011

House Committee Proposes Draft Legislation to Amend Dodd-Frank

As we noted last week, there is presently a dichotomy between one provision of the Dodd-Frank Act concerning rating-agency liability and the SEC’s enforcement of that provision. On Monday, draft legislation was introduced addressing this conflict.

As a reminder, section 939G of the Dodd-Frank Act had made rating agencies potentially liable under section 11 of the Securities Act for statements concerning ratings. The rating agencies responded to the potential liability under the Dodd-Frank Act by refusing to have their ratings statements included in offerings of asset-backed securities (ABS). This created a stalemate in the ABS market, because Regulation AB requires disclosure of ratings for many ABS offerings. Fearing liability under Regulation AB, Ford Motor Company sought guidance from the SEC when it became apparent that the ratings agencies would not permit their ratings to be disclosed in its offering. On July 22, 2010, the SEC responded with a no-action letter stating it would not enforce Regulation AB’s disclosure requirement. In November 2010, the SEC extended this position indefinitely.

Early this month, the Massachusetts attorney general wrote to the SEC about the conflict between the SEC’s position and the law as written. The AG asked the SEC to resolve confusion in the market and to enforce the intent of Congress as set forth in the Dodd-Frank Act.

On Monday, March 14, the House Financial Services Committee unveiled four pieces of draft legislation amending Dodd-Frank. One of these, called the Asset-Backed Market Stabilization Act, repeals the potential rating-agency-liability provision of Dodd-Frank (section 939G). A repeal of this section would reinstate SEC Rule 436(g) and thereby insulate rating agencies from aection 11 expert liability. This would also eliminate any conflict between the SEC’s no-action letters and Regulation AB’s disclosure requirement. The act is sponsored by Rep. Steve Stivers (R-OH).

The other three pieces of draft legislation introduced were:

• The Small Business Capital Access and Job Preservation Act would exempt advisers to private equity funds from SEC registration. The draft legislation is sponsored by Rep. Robert Hurt (R-VA).
• The Business Risk Mitigation and Price Stabilization Act would codify the end-user exemption from derivatives regulation by ensuring businesses that use derivatives to effectively hedge legitimate business risk would not fall under the clearing requirements of Dodd-Frank Title VII. The Dodd-Frank Act requires derivatives transactions to be cleared through a registered clearing house, and exempts swaps and security-based swaps from this clearing requirement if one of the counterparties is not a financial entity. The draft legislation is sponsored by Rep. Michael Grimm (R-NY).
• The Burdensome Data Collection Relief Act would repeal a corporate-governance provision of Dodd-Frank requiring publicly traded companies to disclose their median annual total compensation of all employees. The draft legislation is sponsored by Representative Nan Hayworth (R-NY).

 

We will continue to monitor these pieces of draft legislation and update the committee with new developments.

— Sean Haran and Mor Wetzler, Paul Hastings, New York, NY

March 9, 2011

Massachusetts AG Urges SEC to Enforce Credit-Rating Regulations

In a letter to the SEC dated March 1, 2011, the Massachusetts attorney general urged the SEC to enforce certain legal requirements established under Regulation AB of the Dodd-Frank Act that require disclosure of ratings in asset-backed securitizations. As the Massachusetts AG notes in the letter, SEC staff attorneys have issued two no-action letters since July 22, 2010 that have effectively allowed the securitization and sale of asset-backed securities notwithstanding the absence of the required ratings disclosure and rating-agency consents. The letter argues to the SEC that the no-action letters create confusion in the market, contradict the law, and defeat the intent of Congress to protect investors.

Beginning in 1982, the SEC exempted ratings made by nationally recognized statistical rating organizations (NRSROs) from Securities Act section 11 liability. More specifically, Rule 436(g) of the Securities Act provided that NRSRO ratings would not be considered a part of the registration statement for purposes of sections 7 and 11 of the act. Section 939G of Dodd-Frank, however, nullified Rule 436(g), and made NRSROs subject to potential section 11 liability. In short, ratings made by NRSROs would now, under Dodd-Frank, be treated as “expert statements” within the meaning of section 11 and would subject the NRSROs to potential liability. In response, the major rating agencies issued public statements announcing their refusal to allow issuers to disclose their ratings in connection with the issuance of asset-backed securities. The situation escalated because SEC Regulation AB requires that issuers of asset-backed securities disclose ratings whenever the issuance or sale is conditioned on the assignment of a rating. In practice, the issuance of an asset-backed security is commonly conditioned on the assignment of such a rating. Not surprisingly, the public asset-backed-securitization markets temporarily froze on July 22, 2010. The SEC resolved the conflict by circulating a no-action letter to Ford Motor Credit on July 22, 2010, stating that it would not recommend enforcement action against Ford for Ford’s failure to comply with the ratings-disclosure requirements of Regulation AB. (Of course, Ford’s failure to comply was triggered by the NRSROs’ refusal to allow their ratings to be disclosed.) The SEC then circulated another no-action letter on November 23, 2010, extending indefinitely the position it took in the Ford Motor Credit letter.

According to the Massachusetts AG, the SEC no-action letters have created a divide between the plain language of the Dodd-Frank Act and market practice. The AG contends that the SEC’s no-action letters do not offer a legal interpretation or clarify any of the legal requirements on issuers and do not insulate issuers from liability, because violations of the Securities Act can still be enforced by private actors. The AG noted several alternative routes the SEC could choose from to ameliorate the situation, including a suspension of the Regulation AB requirements.

The AG recognized the SEC’s desire to maintain and encourage functioning public securitization markets, but urged the SEC to address the situation to end confusion in the marketplace. Specifically, the AG asked the SEC to enforce Regulation AB in its entirety and in a manner consistent with the intent of the Dodd-Frank Act. We will await the SEC’s response.

— Sean Haran and Mor Wetzler, Paul Hastings, New York, NY

March 2, 2011

Federal Judge Invokes All Writs Act to Stay Arbitrations

A group of consolidated putative class actions against Securities America is being closely watched by lawyers and broker-dealers across the country. The class plaintiffs have moved to certify "mandatory non-opt-out" classes for settlement purposes under Rule 23 (b)(1)(B) of the Federal Rules of Civil Procedure. The class plaintiffs also seek preliminary approval of a proposed settlement agreement on behalf of persons who invested through Securities America (1) approximately $47 million in a series of shale-gas ventures sponsored by Provident Royalties, LLC between September 2006 and January 2009, and (2) approximately $697 million in a series of notes sponsored by Medical Capital Holdings, Inc. between November 2003 and July 2008. Under the proposed settlement, the total paid to all investors would only amount to approximately $25 million (approximately 3.3  percent of the amounts sold) based on a so-called "limited fund" theory.

The class plaintiffs further seek a temporary restraining order (and ultimately, a permanent injunction) under the All Writs Act, 28 U.S.C. § 1651, enjoining all proceedings in state and federal courts, as well as all arbitration proceedings by members of the proposed settlement classes against Securities America arising from its offer and sale of the Provident Royalties and Medical Capital securities. The class plaintiffs argue that such proceedings, if allowed to continue, might exhaust the purported "limited fund" that Securities America has to pay defrauded investors. (Securities America was recently hit with a $1.2 million award in an arbitration involving Medical Capital notes.) If the class plaintiffs are successful, members of the defined classes would be prevented from opting out of the consolidated class actions, and any possible recovery for those investors would be limited to the proposed class settlement. The federal court judge assigned to the case recently issued an order restraining three Financial Industry Regulatory Authority arbitrations from proceeding, pending his ruling on the motion for preliminary approval of the motion for class certification and the proposed settlement.

Many class members, now facing the possibility of not being able to opt out of the class, are seeking to intervene in the class action for the purpose of opposing these motions by the class plaintiffs. At least two state regulators in Massachusetts and Montana also have reportedly expressed anger over the suggestion to halt their proceedings. Among other things, the would-be intervenors argue that: (1) Given that all of the assets of Securities America should be potentially available to claimants, the proposed settlement fund does not qualify as a true “limited fund” because it is based on an amount that is far less than the net worth of Securities America, e.g., In re Temple, 851 F.2d 1269, 1272 (11th Cir. 1988) (as quoted in Ortiz, 527 U.S. 815, 850 (1999); (2) the court lacks jurisdiction to enjoin arbitration under the All Writs Act, Stevenson v. Tycol (US) Inc., 2006 WL 2827635 (S.D.N.Y. Sept. 29, 2006); and (3) such an injunction would violate the Federal Arbitration Act, which divests the court of jurisdiction where the parties properly request arbitration, Wachovia Bank, N.A. v. VCG Special Opportunities Master Fund, Ltd., 2010 WL 1222026, at *5 (S.D.N.Y. Mar. 29, 2010).

The consolidated cases are Billitteri v. Securities America, Inc., 3:09-cv-01568-F, C. Richard Toomey, et al. v. Securities America, Inc. et al., 3:100-cv-01833-F, and McCoy et al. v. Cullum & Burks Securities, Inc. et al., 3-11-cv-00191-F (N.D. Tex.).

— Samuel T. Brannan, Page Perry LLC, Atlanta, GA

February 17, 2011

SEC Adopts First of More Rigorous ABS Disclosure Regulations

On January 20, 2011, the Securities and Exchange Commission (SEC) voted on two sets of rules for asset-backed securities (ABS). The commission approved both rules implementing aspects of section 943 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. One rule affects disclosure by adding a requirement that ABS issuers (defined more broadly than in Regulation AB) disclose the history of demands they received and repurchases made related to outstanding asset-backed securities. The second rule addresses issuer review of the underlying assets. All registered offerings of ABS after December 31, 2011, must comply with these rules.

Disclosure Rule for ABS Repurchases (Rule 15Ga-1)

The rule requires ABS issuers to file with the SEC a three-year repurchase history, as well as a history of repurchase requests received on outstanding asset-backed securities. The first filing is due February 14, 2012, after which issuers are required to file updated information on a quarterly basis regarding the repurchase histories for all outstanding ABS whether fulfilled or unfulfilled. This applies even if the securities were not SEC-registered as long as the underlying transaction agreements include a covenant to repurchase or replace a pool asset. In addition, an issuer in a registered ABS offering must disclose—in the body of a prospectus—repurchase history for the last three years for ABS of the same asset class as the securities being registered. This information must be included in registered offerings over a phase-in period commencing on February 14, 2012. In ongoing distribution reports on Form 10-D, issuers must disclose updated repurchase history for the particular, related asset pool.

The disclosure requirements apply to issuers of unregistered ABS, including municipal ABS. However, municipal ABS have an additional three-year phase-in period and may provide their information on EMMA, the Municipal Securities Rulemaking Board’s centralized public database for information about municipal securities issuers and offerings.

More specifically, the required disclosures include specified information in tabular form concerning all assets originated or sold by the securitizer that were the subject to a repurchase or replacement demand. Required information includes (i) whether or not the transaction was registered under the Securities Act of 1933, (ii) the name of the originator, and (iii) the number, outstanding principal balance, and percentage by principal balance of assets that were subject to a demand, in the aggregate and separately for assets that were repurchased or replaced, not repurchased or replaced, or pending repurchase or replacement. A required narrative disclosure must state the reasons why any repurchase or replacement is pending. There is no exemption for de minimus demands or for originators below a certain percentage of assets in the pool. To the extent that information about such demands is not available, the disclosure must so state.

This rule also requires rating agencies to disclose, in any report accompanying a credit rating for an ABS transaction, the representations, warranties, and enforcement mechanisms available to investors and how they differ from those in issuances of similar securities. Rating agencies have a six-month phase-in period to prepare for the rule.

Issuer Review Rule (Rule 193 and Amendments to Regulation AB Item 1111)

The second rule passed, implementing section 7(d) of the Securities Act, adopted amendments to Item 1111 of Regulation AB, and a new rule under the Securities Act of 1933. Together, these require any issuer of registered ABS to perform a review of the assets underlying the ABS and to disclose the nature of its review along with findings and conclusions. Moreover, the rule introduces principle-based minimum standards for performing these reviews. The rule now states that “the review must, at a minimum, be designed and effected to provide reasonable assurance that the prospectus disclosure about the assets is accurate in all material respects.” The rule notes that the requirement to perform this review should not be confused with, and is not intended to change, the due-diligence defense against liability under Securities Act section 11 or the reasonable-care defense against liability under Securities Act section 12(a)(2).

Third parties may conduct the reviews rather than the issuer, provided that they are named in registration statements as “experts” in accordance with section 7 and Rule 436 of the Securities Act. There are, however, some exceptions to this requirement. Issuers must also disclose whether, and if so, how, any assets in the pool deviate from the disclosed underwriting criteria and data on the amount and characteristics of those assets that did not meet the stated standards, including the entity that cleared them to be included in the pool.

The SEC postponed consideration of rules to implement section 15(E)(s)(4)(A) of the Exchange Act, which requires issuers or underwriters of ABS to make publicly available the findings and conclusions of any third-party due-diligence report the issuer or underwriter obtains. Proposed rules to implement section 15(E)(s)(4) are anticipated later this year.

Issuers and others involved in asset-backed securitization are well advised to familiarize themselves with these new rules. Although these rules do not impose immediate disclosure demands, the rules involve significant and mandatory new disclosures. Compliance with these rules will require information collection and planning in advance of the effective date. Furthermore, issuers should carefully select the best party to conduct the mandatory reviews given the potential for expanded liability under the new rules. Parties must also watch for additional expected rules, as these may impose further obligations.

—Carla Walworth, Bill Novomisle, and Mor Wetzler, Paul Hastings, New York, NY

February 10, 2011

SEC Approves Proposed FINRA Rule Change for Arbitration Panels

By a press release dated February 1, 2011, the Financial Industry Regulatory Authority (FINRA) announced that the Securities and Exchange Commission (SEC) has approved its proposed rule change governing the selection of non-public arbitrators in customer cases to allow any party to elect an arbitration panel composed entirely of public arbitrators. Under the amended rule, any party to an arbitration may strike up to all 10 arbitrators set forth on the non-public arbitrator list, thus assuring that no non-public arbitrator will serve on the panel.

Under the rule, if all of the non-public arbitrators are stricken by any party or the parties collectively, FINRA will appoint the next highest ranked available public arbitrator. If there are no remaining arbitrators on the public list that are available to serve, FINRA will appoint the next highest ranked arbitrator from the chairperson list. If none of these remaining arbitrators remain available, FINRA will randomly appoint a public arbitrator pursuant to the Neutral List Selection System described in Rule 12400(a).

FINRA’s definition of a non-public arbitrator is set forth in Rule 12100(p) and includes persons who are or were associated with a broker, dealer, commodities exchange, or registered futures association, individuals retired from such activities, professionals whose practice substantially involves the representation of entities involved in such activities, and employees of financial institutions that effect transactions in securities.

As part of the process of determining whether to propose the rule change, FINRA conducted a pilot program starting in October 2008 whereby 14 securities firms voluntarily allowed a number of cases filed by customers to proceed under the structure described above. FINRA recently published certain data taken from those cases through December 1, 2010. According to FINRA, 56 percent of the investors given the option to participate in the program did so. Of those, 50 percent of the investors elected to rank one or more non-public arbitrators, including 32 percent who ranked four or more non-public arbitrators prior to the September 2010 rule change increasing each arbitrator list from eight to ten potential arbitrators. Regarding the results reached by the panels in these cases, FINRA noted that the all-public panels in the pilot program awarded damages to investors more often than in cases in which a non-public arbitrator sat on the panel, whether in the pilot program or otherwise. FINRA further cited data reflecting that settlements were reached at a higher rate in cases in the pilot program.

Though some commentators have expressed concern regarding the effect the loss of the non-public arbitrator’s experience in the industry will have on a panel’s ability to understand the sometimes complex issues raised in securities disputes, the substantial majority of commentators who submitted comments to the SEC regarding the proposed rule change were in favor of the change. In the press release announcing the rule change, Richard Ketchum, FINRA chairman and chief executive officer, stated FINRA’s hope that “giving investors the ability to have an all-public panel will increase public confidence in the fairness of our dispute resolution process.”

The new rule applies to all customer cases requiring a three-arbitrator panel in which arbitrator lists have not been sent to the parties as of January 31, 2011.

—Josh D. Jones, Maynard Cooper & Gale, P.C., Birmingham, AL

February 1, 2011

SEC Study Calls for Uniform Fiduciary Standard

As mandated by section 913 of the Dodd-Frank Act, the Securities and Exchange Commission (SEC) released a Staff Study on Investment Advisers and Broker-Dealers on January 22, 2011. The study recommends a uniform fiduciary standard of conduct for broker-dealers and investment advisers—no less stringent than currently applied to investment advisers under the Advisers Act—when those financial professionals provide personalized investment advice about securities to retail investors.

Currently, brokers and financial advisers who are registered through broker-dealers are not governed by the fiduciary standard that applies to investment advisors when they provide advice to retail customers. The study found that “many retail investors and investor advocates submitted comments stating that retail investors do not understand the differences between investment advisers and broker-dealers or the standards of care applicable to broker-dealers and investment advisers.” Given this confusion and other factors, the staff recommended that rulemakings be considered so to require a “uniform fiduciary standard,” that is, that “all brokers, dealers, and investment advisors, when providing personalized investment advice about securities to retail customers . . . shall . . . act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”

The study noted that the uniform fiduciary standard would impose a duty of loyalty, thereby requiring investment advisers and broker-dealers to eliminate or disclose conflicts of interest. It also recognized that the uniform fiduciary standard would require the issuance of interpretive guidance or rulemaking for issues involving principal trading, the duty of care to be owed to retail investors, the meaning of “personalized investment advice about securities,” and investor education.

Another recommendation of the study is the harmonization of regulations governing investment advisers and broker-dealers, which would add “meaningful investor protection,” including “providing retail investors the same or substantially similar protections when obtaining the same or substantially similar services from investment advisers and broker dealers.”

The staff recommended that “the Commission should engage in rulemaking and/or issue interpretive guidance to explain what it means to provide “personalized investment advice about securities.” The staff stated its belief that, at a minimum, the term should (1) “encompass the making of a ‘recommendation,’ as developed under applicable broker-dealer regulation,” (2) not include “‘impersonal investment advice’ as developed under the Advisers Act.” According to the staff, the term “personalized investment advice about securities” “could include any other actions or communications that would be considered investment advice about securities under the Advisers act (Such as comparisons of securities or asset allocation strategies), except for ‘impersonal investment advice’ as developed under the Advisers Act.”

The staff noted that the study represents its views and does not necessarily reflect those of the commission or the individual commissioners. That said, the study was approved for release by the commission (the three Democratic commissioners voted in favor). The two Republican commissioners, Kathleen L. Casey and Troy A. Paredes, were opposed to the study’s approval. They issued a joint statement stating their concern that the study does not adequately prove that the suggested changes would enhance investor protection, and that the study’s cost analysis did not adequately assess the costs of implementing the study’s recommendations to the industry.

On the same day that the study was issued, the Securities Industry and Financial Markets Association issued a press release stating its support for the uniform fiduciary standard.

— William S. Heyman, Tydings & Rosenberg LLP, Baltimore, MD

January 25, 2011

SEC Issues First Corporate Non-Prosecution Agreement

In what may be a preview of things to come, the Securities and Exchange Commission (SEC) entered into a non-prosecution agreement (NPA) for the first time on December 20, 2010. The agreement was entered into with Carter’s, Inc. to resolve allegations that its former executive vice president engaged in financial fraud and insider trading.

The SEC’s use of an NPA is significant because although NPAs and their counterpart, the deferred prosecution agreement (DPA), have been used frequently as an enforcement tool by the Department of Justice (DOJ), they were not previously available in SEC enforcement matters until January 2010. This is when the SEC announced its new Cooperation Initiative, which explicitly authorized its staff to use new tools such as NPAs and DPAs to encourage individuals and companies to cooperate and assist in SEC investigations.

NPAs and DPAs are formal written agreements in which a government agency agrees to forego an enforcement action against an individual or company if they agree, among other things, to cooperate fully and truthfully and to comply with express prohibitions and undertakings. The main difference between the two is that a DPA involves the filing of a formal charging document with the appropriate court, while an NPA does not involve the filing of formal charges. These agreements are intended to incentivize individuals and companies to report violations and provide assistance to the agency in its investigations.

According to the SEC press release on the Carter’s, Inc. matter, the use of the NPA “reflects the relatively isolated nature of the unlawful conduct, Carter’s prompt and complete self-reporting of the misconduct to the SEC, its exemplary and extensive cooperation in the investigation, including undertaking a thorough and comprehensive internal investigation, and Carter’s extensive and substantial remedial actions.” This exemplifies the SEC’s intent to use NPAs and DPAs to reward extensive cooperation by those being investigated.

The use of these agreements by the DOJ has increased in recent years, and with the recent SEC Cooperation Initiative explicitly authorizing their use, one can expect the SEC to start using them more often too. Their increased use is likely due to the belief that they can effectively reform corporate misconduct while also avoiding some of the collateral effects of traditional corporate prosecutions, such as suspension from participating in government contracting or healthcare programs. However, these agreements have also been criticized for allowing the prosecuting agency to utilize expansive interpretations of important statutes and to shield these interpretations from judicial review. If the DOJ’s use of NPAs and DPAs in recent years is any indication, one can expect many more SEC investigations to be resolved in this manner.

— David Edsall Jr., Gibson Dunn & Crutcher LLP, Los Angeles, CA

January 19, 2011

Oral Argument in Matrixx Initiatives v. Siracusano

On Monday, January 10, 2011, the U.S. Supreme Court heard oral argument in Matrixx Initiatives v. Siracusano, an important securities-fraud case under the Securities Exchange Act, on whether a complaint based on failure to disclose reports of major product problems must plead that the number of reports is “statistically significant” to establish “materiality.” The decision should provide guidance about when information on major product problems is “material” to investors.

Matrixx, the maker of Zicam cold products, argued that the number of adverse effect reports about its “over the counter” nasal spray must be “statistically significant” before the company had any duty to disclose them to investors. In the absence of “statistical significance,” the company argued that such reports are simply useless information. Supported by amici including the U.S. Chamber of Commerce, Matrixx argued that pharmaceutical companies would otherwise be forced to disclose all individual adverse-effect reports, flooding the market with volumes of unreliable and meaningless reports, even when millions use the product without harm.

The investor Siracusano urged the Court to reject a bright-line rule and argued that a reasonable investor could consider adverse-effect reports relevant, even if their number had not reached “statistical significance.” Arguing for application of the Basic “in the mix” test, rather than “statistical significance,” investor’s counsel urged the Court to consider the quality of the reports, who made them, whether they created a “scientifically plausible” allegation of causation, along with the totality of the circumstances in such instances.

The United States as amicus curiae argued in support of the investors, maintaining that while the Basic test for materiality does not require a company to disclose all potentially relevant information, investors may find information about the commercial viability of a product valuable, even if it is not “statistically significant.” Finally, the DOJ reiterated that a company need not disclose any information unless, for example, it must correct an inaccurate prior statement.

The justices explored the continuum of events that might require disclosure, questioning whether admittedly invalid reports that nonetheless might significantly affect the market must be disclosed, referring jokingly to reports by Satanists, “nutty-nuttys,” and psychics.

The justices seemed skeptical about requiring “statistical significance.” Justices Kagan and Scalia analogized to the Food and Drug Administration, which does not require any statistical threshold to remove a drug from the market. Justice Breyer asserted that he “can’t see how statistical evidence always works or always doesn’t work.” Justice Breyer also rejected the view that statistical significance should control, distinguishing between the views of a scientist and those of a reasonable investor. Justices Ginsburg, Alito, Sotomayor, and Kennedy and Chief Justice Roberts seemed similarly skeptical of a bright-line ”statistical significance” test, even questioning who evaluates such significance (judge or jury) and at what stage in the proceedings.

The justices actively questioned what standard to apply, ranging from “enough reports to affect the market, however false the reports might be” to “no duty to disclose irrational reports” to “reports should be given some degree of plausibility based on content-severity of injury-identity of those making the report.” Both Chief Justice Roberts and Justice Scalia expressed concern about any standard under which drug companies could never obtain judgment before trial, given that adverse-effect reports to drugs are a constant “background noise” in the industry. Justice Ginsburg focused more on the company’s previous disclosures, emphasizing twice that if the company implied there were no adverse reports, it would have a duty to correct that statement.

Oral argument did not address the suggestion, by several amici, that the Court apply heightened Rule 9(b) pleading requirements to materiality. The justices also robustly debated the interaction between materiality and scienter in this context, exploring whether “statistical significance” might be one way to establish scienter, rather than a factor relevant to “materiality.”

While the active debate suggested that the justices may reject a “statistical significance” standard, it seemed the justices disagreed about what exactly should trigger a duty to disclose to investors reports about problems with a major product. A narrow ruling may simply reject the proposed requirement for ”statistical significance” of reported product problems or, more narrowly still, for reports of adverse drug reactions, sending the case back to the district court for further consideration of factors that ought to be considered in analyzing materiality. A broad decision might have far-reaching implications for all securities disclosures. Regardless of scope, the ruling, expected in June, hopefully will clarify the Supreme Court’s stance on “materiality” under the securities laws in the context of significant product developments.

— Carla Walworth and Mor Wetzler, Paul Hastings, New York, NY

November 23, 2010

Shareholders Secure Verdict in First Credit-Crisis Jury Trial

On November 18, 2010, a panel of nine Miami jurors returned the first securities-fraud verdict to arise out of the credit crisis, against BankAtlantic Bancorp. Inc., its CEO and CFO, in In re BankAtlantic Bancorp, Inc. Securities Litigation (S.D. Fla. No. 07-61542). This case is just the tenth securities class action to be tried to a verdict following the passage of the Private Securities Litigation Reform Act of 1995, which governs such suits. The Honorable Ursula Ungaro of the U.S. District Court for the Southern District of Florida presided over the trial, which lasted four weeks. The jury spent another week deliberating before rendering its decisive verdict.

The jury found that eight statements made by BankAtlantic’s CEO, Alan Levan, and CFO, Valerie Toalson, concerning the quality of the Fort Lauderdale bank’s commercial-real-estate-loan portfolio were materially false and misleading. Seven of these statements were made by Levan over the course of two quarterly-earnings conference calls in 2007, while the eighth one was contained in the company’s second quarter 2007 Form 10-Q report, certified by Levan and Toalson. The jury found that both officers “knowingly” made these false statements to investors.

Over the course of the trial, 13 fact witnesses testified, including one senior bank-loan official who ranted about the poor quality of the bank’s loans in emails to a colleague, calling them “garbage” and accusing the bank’s management of “stick[ing] their heads in the sand and pretend[ing] there is no problem.” A financial expert testified for plaintiffs with respect to damages. The defendants did not put on a damages expert during the trial, after the plaintiffs succeeded in having the entirety of the defendants’ purported damages expert’s report, save one paragraph, excluded by the court following a pretrial Daubert briefing.

Perhaps the most significant development in this case was the court’s pretrial ruling granting partial summary judgment for the plaintiffs on the issue of objective falsity. In an August 18, 2010, ruling, Judge Ungaro ruled as a matter of law that four of the statements made by CEO Levan during a July 2007 earnings call with investors were false and misleading. The court instructed the jury after the close of evidence that this ruling was narrow and that the jury must still decide the remaining elements under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 with respect to these four statements—i.e.,materiality, scienter, loss causation, and damages.

The jury ultimately found that investors who purchased BankAtlantic securities between April 26, 2007 and October 25, 2007 paid in excess of $2.41 per share as a result of the defendants’ false and misleading statements that inflated the stock. While it is not clear at this time what the aggregate amount of class damages will be (as that figure depends on the number of eligible claims submitted), damages in the tens of millions of dollars are likely.

— Andrew L. Zivitz, Matthew Mustokoff, and Michelle M. Newcomer

November 12, 2010

Oral Argument in AT&T Mobility v. Concepcion

Yesterday, the U.S. Supreme Court heard oral argument in AT&T Mobility v. Concepcion. The question presented is whether section 2 of the Federal Arbitration Act (FAA) preempts state law on the unconscionability of class action arbitration waivers. The lawsuit, filed in California federal district court, is a consumer class action alleging that AT&T fraudulently offered a “free” phone to consumers, then charged consumers sales tax for “free” phones. AT&T demanded individual arbitration, relying on a provision in the contract that prohibited class actions. Both the district court and the Ninth Circuit ruled for the plaintiff by holding that the provision prohibiting class actions was unconscionable under California law.

A broad victory by AT&T could pave the way for businesses to avoid class-action lawsuits, while a broad victory by the plaintiff would severely limit the utility of arbitral class-action prohibitions.

At oral argument, Justices Scalia, Kagan, Ginsburg, and Sotomayor all appeared to favor the plaintiff and deference to state law because, in their view, the California rule was neutral and did not single out arbitration contracts from other types of contracts. Under this reasoning, the FAA does not preempt state law. Justice Kennedy also appeared to be leaning in favor of the plaintiffs, but not as strongly. Justice Alito and Chief Justice Roberts, however, appeared to support AT&T. In their view, California law applied disproportionately to arbitration contracts over other contracts—contrary to the FAA’s statutory language that an arbitration clause may only be held unenforceable if the legal rule invalidating it applies to “any contract.” Justices Breyer and Thomas did not appear to favor either side.

The primary debate among the justices was how to fashion a predictable rule for preemption. Questioning focused on whether the test for preemption should focus on the purpose of the state law (e.g., is the purpose to disfavor arbitration) or the effect of the state law (e.g., although facially neutral, did it nevertheless effectively discourage arbitration). The justices did not suggest which approach they favored. The ruling will be of significant interest in all class actions, including cases against investment advisors and managers and potentially any dispute between commercial parties with substantially disparate bargaining power.

— Bill Novomisle and Carla Walworth

November 12, 2010

What Will the Midterm Election Results Mean for Securities Laws and Regulations?

Over the years, legislative reform of the federal securities laws has cycled back and forth between initiatives—on one hand, to discourage abusive litigation and, on the other hand, to restrain corporate misconduct. Over the past year, sentiment was running high for legislative reforms that could expand liabilities under the federal securities laws. But the impetus for change spurred by the high-profile bankruptcies, post-Madoff environment, and Wall Street bailout may have reached its twilight given the results of the 2010 midterm elections.

With a Republican House in the 112th Congress, the legislative agenda for financial regulation is likely to shift, and could drastically affect securities litigation. After all, it was a Republican House that enacted the Private Securities Litigation Reform Act (PSLRA) over a veto by President Clinton. For example, we may see sections of the Dodd-Frank Act repealed, such as the expanded liability for rating agencies or the Volcker Rule. We may also see reform of Fannie Mae and Freddie Mac, and perhaps greater scrutiny of the Federal Reserve.

Representative Spencer Bachus (R-AL) is the most senior Republican on the House Financial Services Committee and slated to become the chair. He has indicated a desire to repeal the resolution authority allowing the government to seize and liquidate large failing financial firms. In July, Bachus wrote a letter asking for a hearing on the impact of the Volcker Rule on the competitiveness of American financial institutions. He also cosponsored a bill to introduce more private-sector funding in the U.S. mortgage market through the use of covered bonds.

A Republican House is also likely to ensure that there will not be any expansion of aiding-and-abetting liability, any attack on the PSLRA’s discovery stay, or any limitations on Dura, Twombly, or Iqbal.

However, the Commodity Futures Trading Commission and Securities and Exchange Commission are continuing to propose rules and regulations implementing Dodd-Frank, and will continue to do so. Democrats, despite losing the House, are unlikely to give in very easily to any drastic reforms, and we may be more likely to see a growing bipartisan consensus for many of the proposed reforms.

— Mor Wetzler

City of Cleveland Loses Its Appeal in the Sixth Circuit

On Tuesday, July 27, 2010, the U.S. Court of Appeals for the Sixth Circuit affirmed the dismissal of the City of Cleveland’s public nuisance suit brought against various Wall Street banks and mortgage lenders. See City of Cleveland v. Ameriquest Mortgage Securities, No. 09-3608, slip op. (6th Cir. July 27, 2010).

The city alleged that the 22 financial entity defendants were responsible for the failures of the subprime lending market in Cleveland and throughout the country. More specifically, although the city acknowledged in its complaint that defendants did not originate the majority of the subprime mortgages at issue in the case, Cleveland alleged that the defendants’ financing, purchasing, and pooling of vast amounts of these loans, to create mortgage-backed securities to sell to their customers, led to a foreclosure crisis that devastated the city’s neighborhoods and economy, thus constituting a public nuisance.

In an opinion authored by Circuit Judge Suhrheinrich, the three-judge panel of the Sixth Circuit held that Cleveland could not recover because the injuries it alleged were “too indirect to warrant recovery.” According to Judge Suhrheinrich, the same directness concerns at issue in the Supreme Court cases, Holmes v. Securities Investor Protection Corp., 503 U.S. 258 (1992) and Anza v. Ideal Steel Supply Corp., 547 U.S. 451 (2006), were implicated in this case.

The court reasoned: “the cause of the alleged harms is a set of actions (neglect of property, starting fires, looting, and dealing drugs) that is completely distinct from the asserted misconduct (financing subprime loans).” Accordingly, the city’s injuries could have been caused by various other factors unconnected to the defendants’ conduct, including, for example, home buyers choosing to enter into subprime mortgages or mortgagees not involved in securitization choosing to begin foreclosures. Similarly, Judge Suhrheinrich concluded that the city’s failure to allege that defendants directly made the subprime loans at issue to the homeowners of Cleveland was fatal to its claim.

The city alleged its foreclosures had risen to more than 7,500 in 2007 from fewer than 120 in 2002, and it sought to recover millions in municipal expenditures and diminished tax revenues as damages. Cleveland reportedly plans to seek review by all the Sixth Circuit judges.

District Court Dismisses "Hydra-Like" Securities Class Action

On July 19, 2010, Judge William H. Pauley, III of the Southern District of New York dismissed a putative securities class action complaint brought against American Express (Amex) and two of its officers (collectively, the Defendants), which alleged that the Defendants made misleading statements to investors regarding the relaxation of Amex's underwriting guidelines and the resulting exposure to delinquent cardholder payments. In his opinion, Judge Pauley described the 243-paragraph complaint as “hydra-like” and criticized the plaintiff for “lard[ing] a pleading with streams of consciousness from confidential witnesses and block quotes from analyst calls.” The court observed that the proffered confidential witnesses could not “identify a single specific report containing adverse credit data or relaxed underwriting guidelines.” In finding the plaintiff’s allegations insufficient to establish the Defendants’ scienter, the court noted the only motive identified by the plaintiff was the Defendants’ generic desire to maintain Amex’s strong credit rating so the company did not lose capital markets funding, which is insufficient as a matter of law. Judge Pauley also held the plaintiff’s allegations of reckless disregard for the truth to be “a gossamer patchwork of general statements from the CWs and inferences from reports published after the allegedly false and misleading statements were made.” After weighing the competing inferences as required under Tellabs, the court held that the complaint’s allegations “reveal a company attempting to increase its share of the credit card market during significant financial turmoil . . . [and whose] aggressive growth strategy was sideswiped by the collapse of the credit markets.” As Judge Pauley held, “[t]hat a business plan turned out to be ill-timed and, in hindsight, ill-advised does not transmogrify it into a securities fraud.” The plaintiff has until August 23, 2010, to request leave to file an amended consolidated class action complaint.

Goldman Sachs Settles with the SEC

On July 16, 2010, Goldman Sachs settled with the SEC over the SEC’s claims that Goldman defrauded investors in connection with its marketing of the ABACUS 2007-AC1 CDO. The SEC’s action was well-publicized, with advocates on both sides of the case trumpeting the necessity and weaknesses, respectively, of the SEC’s action. We’ve reviewed the proposed settlement papers on the SEC’s website and have noted—at present—three interesting issues.

1. The final judgment orders Goldman to make direct payment of the civil penalty amounts to the “wronged” investors. Although the final judgment provides that these disbursements are being made to investors pursuant to a Fair Fund, what is unique about this case is that the payments are being made directly by wire transfer from Goldman Sachs to the “wronged” investors. Traditionally, these funds would have been deposited into a Fair Fund and then distributed to the investors. This is consistent with Robert Khuzami cutting through the red tape at the SEC.

2. In a significant departure from past SEC practice, Goldman, while it neither admitted nor denied the allegations in the complaint, was required to acknowledge in its consent to entry of the judgment the misleading nature of the marketing materials. Although it is not clear whether and to what extent these acknowledgements will have preclusive effect down the road in other litigation, and furthermore the fact that the marketing material is misleading is just one component of a securities-fraud case (scienter would still need to be established), companies or individuals discussing settlement with the SEC need to consider this new twist.

3. Although not unheard of, undertakings in a federal district court action are generally rare in SEC cases. The SEC usually seeks to impose such undertakings in an administrative proceeding. Again, this is consistent with Khuzami’s criminal-practice leanings.

— Jerome Tomas, Chicago, IL

Supreme Court Rejects Application of Section 10(b) in Extraterritorial Contexts

On June 24, 2010, the U.S. Supreme Court issued its long-awaited decision in the landmark case of Morrison et al, v. National Australia Bank Ltd., et al., (NAB), 561 U.S. ___ (2010). In NAB, the Court voted 8–0 (Justice Sotomayor did not participate) to affirm dismissal of a “foreign-cubed” securities case (a securities class action filed in the U.S. against a foreign issuer by foreign investors who purchased securities on a foreign exchange), holding that section 10(b) of the Securities Exchange Act does not apply extraterritorially—but, rather, only to transactions listed on U.S. exchanges and to U.S. transactions in other securities.

In so holding, the Court rejected the use of a conduct/effects test (and, implicitly, the various tests applied inconsistently by different circuits) to determine the extraterritorial application of the antifraud provisions of the U.S. securities laws. In NAB, the lower court—the Second Circuit Court of Appeals—had applied its “conduct test,” finding that there was no basis for extraterritorial jurisdiction because the locus of the fraudulent activity (i.e., the issuance of false statements) was in Australia. The Supreme Court agreed with the result, based upon an entirely different analysis.

As a threshold matter, the Court found that the extraterritorial application of Section 10(b) does not implicate subject-matter jurisdiction (challenging under Fed. R. Civ. P. 12(b)(1) a federal court’s power to hear a case), but is, rather, a merits inquiry as to what conduct section 10(b) does and does not prohibit. Slip op. at 5 (acknowledging that the district court had jurisdiction under 15 U.S.C. § 78aa to adjudicate the question whether section 10(b) applied to defendant’s conduct). Thus, the Court affirmed dismissal of the claim against NAB, not because the court lacked subject-matter jurisdiction, but because the allegations failed to state a claim.            

The Court predicated its opinion on the “longstanding principle of American law” that, unless a contrary intent appears, legislation of Congress is meant to apply only within the territorial jurisdiction of the United States. Noting that Congress typically legislates with respect to domestic rather than foreign matters, the Court found that unless Congress clearly expresses the intention to give a statute extraterritorial effect, there is a presumption that it is primarily concerned with domestic matters. “When a statute gives no clear indication of an extraterritorial application, it has none.” Id. at 6.

Because there is no affirmative indication in the Securities Exchange Act that section 10(b) applies extraterritorially, the Court concluded that it does not. SEC Rule 10b-5, the regulation under which petitioners had brought suit, was promulgated under section 10(b) and, therefore, does not extend beyond conduct encompassed by section 10(b)’s prohibition.

Petitioners contended that even if section 10(b) does not apply extraterritorially, they merely sought domestic application because the underlying deceptive conduct occurred in the U.S. The Court acknowledged that application of the presumption against extraterritorial application often requires further analysis because it is the rare case that lacks all contact with the United States. However, the Court noted that the focus of the Exchange Act was not where the deception occurred, but upon the purchase and sale of securities in the United States. Id. at 17 (section 10(b) punishes “only deceptive conduct ‘in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered’”). Therefore, it is “only transactions in securities listed on our domestic exchanges, and domestic transactions in other securities, to which Section 10(b) applies.”

The decision is expected to have a major impact on securities actions involving foreign defendants. First, NAB may factor heavily in foreign corporations’ determinations as to where to list their securities. In this connection, it should be much more difficult, if not impossible, going forward for securities plaintiffs to bring claims against foreign issuers of securities that do not list in the United States. While the presumption will operate to limit meritless cases filed by enterprising class-action attorneys representing investors purportedly damaged in foreign securities markets, the decision does not lessen the ongoing risk for non-U.S. issuers whose securities are traded on U.S. exchanges or who engage in purchase or sale transactions in the U.S.

In addition, NAB is likely to affect class actions brought against foreign defendants even outside the “foreign-cubed” context, where the plaintiff-investors hail from both the United States and abroad. Among other questions, it may not be clear in every case whether a securities transaction is “domestic” (i.e., whether it has taken place in the United States)—with results turning on the facts of each case. Likewise, the decision is silent with respect to application of the presumption to claims brought by the Securities and Exchange Commission that do not involve domestically traded securities. Congress continues to consider a codification of the extraterritorial application of section 10(b). Any resulting legislation—the likelihood of which may increase as a result of the Court’s ruling—would presumably need to address these issues.

— Barrie Brejcha and Patrick Rideout

Supreme Court Bars So-Called Foreign-Cubed Securities Actions

In a decision that clarified the applicability of U.S. securities laws to foreign issuers in cross-border securities cases, on June 24, 2010, the U.S. Supreme Court closed the door on a securities class action brought by Australian petitioners who purchased shares in National Australia Bank (NAB), a foreign bank whose shares are traded on the Australian Stock Exchange Limited and on other foreign securities exchanges, but not on any exchange in the United States. Morrison v. National Australia Bank Ltd., No. 08–1191, 561 U. S. ____ (2010).

The opinion authored by Justice Antonin Scalia began by holding that the Second Circuit erred in considering section 10(b)’s extraterritorial reach to raise a question of subject-matter jurisdiction, thus allowing dismissal under Rule 12(b)(1). The Court held that the conduct section 10(b) reaches is a “merits question,” as opposed to an issue of “a tribunal’s “‘power to hear a case.’” Morrison, slip op. at 4 (citations omitted). Nevertheless, because the Court found that the analysis of the Second Circuit applied to consideration of the properly raised motion to dismiss for failure to state a claim under Rule 12 (b)(6), it unnecessary to remand for the lower court’s further review.

In deciding whether foreign plaintiffs may sue foreign issuers of securities for violations of section 10(b) based on transactions in foreign countries (so-called foreign-cubed actions), the majority held that the proper test is simply whether the security at issue was purchased or sold in the United States. If not, section 10(b) does not apply.

Accordingly, Justice Scalia found the instant petitioners failed to state a claim:

Section 10(b) reaches the use of a manipulative or deceptive device or contrivance only in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States. This case involves no securities listed on a domestic exchange, and all aspects of the purchases complained of by those petitioners who still have live claims occurred outside the United States. Petitioners have therefore failed to state a claim on which relief can be granted.

The decision is expected to have a major impact on securities actions involving foreign defendants. Further, this opinion may factor in foreign corporations’ determinations as to where to list their securities. In this connection, it should be much more difficult, if not impossible, going forward for securities plaintiffs to bring claims against issuers of securities that do not list in the United States. In addition, even outside the foreign-cubed context, Morrison is likely to affect class actions brought against foreign defendants where the plaintiff-investors hail from both the United States and abroad.

The Calculated Gamble: Nondisclosure of a Wells Notice

A recent Securities and Exchange Commission (SEC) lawsuit has sparked debate, and, not surprisingly, private civil litigation, over whether the defendant’s decision not to disclose its Wells notice constituted a separate violation of the federal securities laws. It should be noted that nondisclosure of the Wells notice did not become a basis for any of the SEC’s charges.

There are two primary reasons why companies almost always disclose the receipt of Wells notices: (1) The securities laws arguably require making such disclosures and (2) when a company is already under investigation by the SEC for potential disclosure issues, the prudent step is generally to leave no room for doubt as to the company’s transparency to investors.

As to the first issue, there is no express SEC rule or regulation requiring disclosure of a Wells notice. Over the years, various individuals and industry groups have requested that the SEC look into adopting such a rule, but those requests have yet to receive any serious consideration. Item 103 of Regulation S-K, however, does require companies to disclose in their quarterly and annual statements any material pending legal proceedings and “any such proceedings known to be contemplated by governmental authorities.”

It is this second clause that arguably mandates disclosure of the receipt of any Wells notice that contemplates a material enforcement proceeding or civil suit by the SEC. Although, it could be argued that a notice that the SEC’s Enforcement Division has made a preliminary determination to recommend bringing an action does not qualify as a contemplated government proceeding, especially where “contemplated” is generally defined as having some component of certainty to it (i.e., something that is “intended” or “viewed as being a future event”). Another argument for not disclosing a Wells notice is that the proceedings contemplated in the Wells notice are not material. Materiality is a sufficiently nebulous concept that this argument—with varying degrees of credibility— can almost always be made. But at the same time, the very nature of a contemplated SEC proceeding, which generally involves such material matters as a company’s public disclosures and the integrity of current or past members of management, arguably compels the conclusion that a contemplated SEC proceeding is always material. 

In any event, as long as Item 103 retains the materiality requirement, companies do have some room under certain situations to—in good-faith—choose not to disclose a Wells notice. What would lead a company to take this step? There is really only one primary benefit of not disclosing a Wells notice, and that is the potential avoidance of negative publicity resulting from a disclosure that the company is under investigation. This concern cannot be understated. For most companies, the publicity hit associated with being under investigation is generally the greatest sanction that can result from an SEC investigation given that most companies do not have much of a problem paying the typical civil penalty. This is especially true given that civil penalties are sometimes disfavored by the Commission because they potentially only harm shareholders and do little to deter future violations.

Accordingly, when faced with an investigation, a company’s priority is to minimize the damage of any public disclosures relating to the investigation. But does failing to disclose receipt of a Wells notice really accomplish this task? In most cases, probably not. This is because the great majority of cases that proceed through the Wells process result in either a public settlement with—or a proceeding against—the target company. And once news of a settlement or charges becomes public, a company’s failure to disclose its Wells notice will be revealed, and the company will probably be in worse shape, in terms of its public perception, than it would have been in had it simply disclosed its Wells notice upon receipt. Another risk that companies face is that once the Commission receives whatever Wells submission a company may decide to make, the Commission is under no obligation to notify that company prior to bringing charges. This means that a company will have a limited ability to do any damage control prior to the time when the charges become public.

So this is the risky gambit facing companies who choose not to disclose receipt of the Wells notice—they are banking on the fact that they are one of the few companies that can convince the Commission not to bring charges at all.

— Breton Leone-Quick, Boston, MA

Goldman Sachs under Siege

On April 15, 2010, the Securities and Exchange Commission (SEC) filed its well-publicized suit against Goldman Sachs and one of its vice presidents, Fabrice Tourre, for securities fraud in violation of section 17(a) of the Securities Act of 1933 and section 10(b) of the Securities Exchange Act of 1934. The alleged fraud centered on the marketing of a synthetic collateralized debt obligation (CDO) titled ABACUS 2007-AC1, the performance of which was tied to subprime residential mortgage-backed securities (RMBS). This complex financial product is not based on actual ownership of assets, but instead is designed to track the performance of a reference portfolio, in this case a pool of residential mortgages (represented by RMBS). Many observers, not all of them hostile, have compared synthetic CDOs to high-class wagering.

According to the SEC’s complaint, Paulson & Co., a hedge fund managed by John Paulson, hired Goldman Sachs to structure this trade so that Paulson could “short” the mortgage market. The SEC alleges that Paulson played a “significant role” in selecting mortgages for the pool. Paulson allegedly selected mortgages that he thought would perform poorly, then entered into credit default swaps (CDS) with Goldman Sachs, thus creating a financial structure that paid Paulson if the RMBS underlying ABACUS declined in value.

Goldman marketed ABACUS to its customers through an offering memorandum that allegedly represented that the reference portfolio was selected by ACA Management LLC, an experienced and well-known independent collateral manager. The SEC complaint admits that ACA had negotiated with Paulson regarding the composition of the pool, but nonetheless asserts that ACA did not know Paulson was shorting the mortgage market. The SEC alleges that the failure of Goldman Sachs to disclose Paulson’s role was misleading to ACA and investors. The essence of the SEC’s fraud claim is that both investors and ACA would have evaluated the synthetic CDO differently had they known that the reference mortgages were selected in part by an investor who wanted it to fail. With the implosion of the mortgage market, the value of the ABACUS investment declined dramatically, ultimately leading to huge losses for investors and huge profits for Paulson.

The case has aroused a storm of commentary in the press, in the blogosphere, and around coffee machines. Goldman Sachs itself issued a press release the day after the case was filed, asserting that: (1) It lost more than $90 million on the ABACUS transaction; (2) it provided extensive information to the investors, whom it described as being “among the most sophisticated mortgage investors in the world”; (3) ACA in fact selected the portfolio; and (4) it made no representations to ACA regarding Paulson’s investment strategy.

Some commentators have raised serious questions regarding the materiality of the alleged omissions. Investors, after all, were not alleged to have been misled regarding the nature or actual content of the reference portfolio, only how it was selected. Regardless of what Paulson may have thought about the underlying RMBS, ACA and the only investor mentioned in the complaint—the German bank IKB Deutsche Industriebank—were plainly competent to perform their own analyses of the collateral. The SEC will have to show that, even with the sophistication of the investors and their full access to information about the RMBS, knowledge of Paulson’s involvement would nevertheless have affected the total mix of available information. These points were made by Warren Buffett of Berkshire Hathaway, an investor in Goldman Sachs, both at Berkshire Hathaway’s annual meeting on May 1 and in a press conference the next day.

Moreover, it seems extraordinary that ACA and the rating agencies are portrayed by the SEC as victims, when in fact at least ACA knew of Paulson’s involvement, and could have directly inquired about his trading strategy. Did ACA believe that Paulson’s intention was to lose money on the deal? Did the rating agencies even ask questions regarding the selection of the reference portfolio? It seems unfair to lay these issues entirely at the feet of Goldman Sachs.

Given the apparent weaknesses in the case, and reports that the suit was authorized by the SEC by a slim 3–2 vote, questions have been raised about the potential political motivation underlying the SEC’s action. Prior to April 15, there had been growing publicity regarding Goldman Sachs’s alleged bets against its mortgage products. The press reported on January 22 that the Permanent Investigations Subcommittee of the Senate Homeland Security and Governmental Affairs Committee had begun an inquiry into the matter. Subcommittee representatives refused at the time to comment on the report, but the subcommittee had likely already requested that Goldman Sachs representatives appear. The SEC timed the filing of its complaint so that it was one of the main topics of discussion at the subcommittee hearings only one week later (on April 27). On April 29, the press reported that the SEC had referred the matter to the criminal division of the Department of Justice.

This of course was all happening in the middle of the controversy surrounding the financial reform bill. Indeed, the timing was so suspicious that Republican congressman Darrell Issa has asked the inspector general of the SEC, David Kotz, to investigate whether there was any relationship between the timing of the action and the upcoming debate on the administration’s financial reform bill. Kotz announced on April 23 that he would look into the matter.  

And on May 13, New York Attorney General Andrew Cuomo issued subpoenas to Goldman Sachs and seven other banks in connection with a publicly announced inquiry into whether the banks misled rating agencies with respect to RMBS.

Goldman Sachs is facing a political storm fueled by the continuing populist rage at Wall Street. There are some who are now expressing concerns of further damage to our economy if we continue to attack our financial institutions. President Obama and our congressional leaders must find a way to work together to pass regulatory reform and begin the process of restoring investor confidence in our financial markets and institutions. Regardless of whether the attack on Goldman Sachs is driven by politics or populism, the ugly and partisan debate in Congress over financial reform is causing increased skepticism and mistrust of our politicians and our financial industry. Public flogging of Goldman Sachs based upon the unconvincing allegations underlying the SEC’s lawsuit, while possibly politically expedient, is counterproductive and distracts from the core issues that must be addressed promptly.

— Howard J. Kaplan, New York, NY

Delaware Chancery Court Rebuffs Federal Preemption of Insider Trading, Upholds State-Law Claim

For decades, the federal courts have applied section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 to combat insider trading. However, the bar on insider trading has its roots in state corporate law, specifically, in the common-law doctrine of the fiduciary duty of loyalty. In Pfeiffer v. Toll, C.A. No. 4140-VCL (Del. Ch. Mar. 3, 2010), the Delaware Court of Chancery upheld shareholder derivative claims against eight corporate directors for insider trading under state law. In Toll, Vice Chancellor J. Travis Laster rejected the defendants’ arguments that the federal securities laws preempt this state-law cause of action for insider trading first recognized by the Court of Chancery 60 years ago in Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949).  In upholding Brophy—a precedent that has been challenged (though not overruled) in recent years by some courts in light of the expansive development of a federal insider-trading regime—the Toll decision illuminates the traditional role state courts have served in regulating insider trading and the remedial hole that the current federal regime leaves unplugged, namely, the absence of a federal remedy to the corporation (as opposed to shareholders or traders who suffer market losses mirroring insiders’ reciprocal gains).

Toll involved insider-trading claims against 8 of the 11 members of the board of directors of Toll Brothers, a U.S. homebuilder, who allegedly sold substantial amounts of Toll Brothers stock—14 million shares collectively for proceeds exceeding $615 million— during a time when they knew that the rate of new home construction contracts was plummeting and that Toll Brothers’ publicly disseminated sales projections were grossly inflated. The claims were brought derivatively on behalf of the corporation pursuant to the Delaware chancery court’s half-century-old decision in Brophy, where the court “recognized the right of a Delaware corporation to recover from its fiduciaries for harm caused by insider trading.”

In affirming the state-law cause of action for insider trading, the Toll court emphasized three key principles:

• Insider trading harms not only contemporaneous traders who experience losses through the imbalance of material, non-public information—a harm whose remedy is recognized by federal securities law—but also harms the corporation in the form of, among other things, the costs of conducting internal investigations and defending legal proceedings, as well as the penalties and judgments that may be levied in civil, criminal, and regulatory actions. Thus, state corporate law provides a remedy for the corporation that is not provided for by Rule 10b-5 or the federal case law. In that regard, the court found that state law does not ”operate duplicatively with the federal securities laws to recover losses by contemporary traders,” but rather provides a mechanism for corporations to recover for the collateral harm suffered as a result of insider trading. 
• The text and the legislative history of the Securities Exchange Act, the amendments enacted through the Securities Litigation Uniform Standard Act of 1998 (SLUSA), as well as the body of case law interpreting these statutes, acknowledge and preserve the role of state law in policing aspects of securities transactions that are not expressly regulated by the federal regime.
• The federal jurisprudence on insider trading, as developed by the U.S. Supreme Court in landmark cases such as Chiarella v. United States, 445 U.S. 222 (1980), is fundamentally rooted in, and ultimately depends on, the state corporate-law concept of a fiduciary duty of loyalty owed by corporate directors and officers to shareholders. As the court explained, federal law, in and of itself, does not give rise to or establish fiduciary obligations; rather, such obligations are creatures of state law. Thus, the court reasoned, “[i]f Delaware were to hold that the fiduciary duties of directors and officers did not limit their insider trading, the cornerstone of the federal system would be removed.”  

Having concluded that the federal insider-trading regime depends on the continuing recognition of a state-law duty of loyalty to refrain from insider trading, the Toll court warned that any preemption of the state-law cause of action would be entirely at odds with the manner in which the federal law has evolved:

I cannot foresee what might happen were a Delaware court to hold, as the defendants ask, that insiders do not breach any fiduciary duty to the corporation they owe by engaging in insider trading. Such a holding would take insider trading outside the fiduciary relationship of trust and confidence that has formed the basis for the federal approach since Chiarella. Arguably the private right of action for insider trading under Rule 10b-5, which depends on a breach of fiduciary duty, would no longer function. Although I cannot predict the consequences of such a step, it is clear to me that it would be inconsistent with how the federal law of insider trading has developed. Contrary to the defendants’ argument, maintaining Brophy is consistent with federal law. Overruling Brophy would fly in the face of the federal approach. 

The Toll court also reasoned that the defendants’ arguments for preemption “would be stronger had Congress actually sought at some point to implement an over-arching regulatory scheme to govern insider trading.” Yet Congress has followed precisely the opposite course. First, the court pointed to section 28(a) of the 1934 act, which provides that “the rights and remedies provided by [the act] shall be in addition to any and all other rights and remedies that may exist at law or in equity,” thereby expressly preserving state-law claims. Second, the court focused on the so-called “Delaware carve-out” provision of SLUSA. While SLUSA preempts class actions based on state law that involve alleged fraud in connection with the purchase or sale of securities, the statute expressly preserves: (1) exclusively derivative actions brought by one or more shareholders on behalf of a corporation, and (2) class actions based on the state-law fiduciary duty of disclosure owed by corporate directors to shareholders in cases involving voting rights, tender offers, and other specifically delineated corporate transactions. As the Toll court suggests, this exception to SLUSA preemption is a reminder of Congress’s recognition of the limits of federal preemption in the securities arena.

— Matthew L. Mustokoff, Esq., Radnor, PA

FINRA Issues Regulatory Notice 10-22

On April 22, 2010, the Financial Industry Regulatory Authority (FINRA) issued Regulatory Notice 10-22 (Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings). The executive summary states:

 FINRA reminds broker-dealers of their obligation to conduct a reasonable investigation of the issuer and the securities they recommend in offerings made under the Securities and Exchange Commission’s Regulation D under the Securities Act of 1933—also known as private placements.

Regulation D provides exemptions from the registration requirements of Section 5 under the Act. Regulation D transactions, however, are not exempt from the antifraud provisions of the federal securities laws. A broker-dealer has a duty—enforceable under federal securities laws and FINRA rules—to conduct a reasonable investigation of securities that it recommends, including those sold in a Regulation D offering.

Moreover, any broker-dealer that recommends securities offered under Regulation D must meet its suitability requirements under NASD Rule 2310 (Suitability), and must comply with the advertising, supervisory and record-keeping rules of FINRA and the SEC.

The notice discusses some of the “significant problems” FINRA has uncovered in Regulation D offerings in several recent examinations and investigations including fraud and sales-practice abuses. The notice then goes on to outline a broker-dealer’s regulatory responsibilities to engage in a reasonable investigation of a Regulation D offering, enforceable under the antifraud provisions of the federal securities laws and FINRA rules, as well as NASD Rule 2310. These provisions, laws, and rules requiring that a broker-dealer must have reasonable grounds to believe that a recommendation to purchase, sell, or exchange a security is suitable for the customer. 

The notice highlights the fact that with respect to reporting companies under the Securities Exchange Act of 1934, in the absence of red flags, a broker-dealer that is not an underwriter typically may rely on the company’s registration statement and periodic reports. A broker-dealer may not, however, blindly rely on information provided by the issuer and its counsel instead of conducting its own reasonable investigation. While broker-dealers are not expected to have the same information as an issuer, they are required to exercise a “high degree of care” in investigating and independently verifying an issuer’s representations and claims. Indeed, when an issuer seeks to finance a new speculative venture, a broker-dealer “must be particularly careful in verifying the issuer’s obviously self-serving statements.” And in those cases where a broker-dealer lacks essential information about an issuer or its securities when making recommendations of securities in Regulation D offerings, it must disclose this fact as well as the risks resulting from the lack of information.

 The notice explains how the scope of a broker-dealer’s responsibility to conduct a reasonable investigation necessarily depends on its affiliation with the issuer, its role in the transaction, and the circumstances of the offering, including whether the offerees are retail investors or more sophisticated institutional investors. The notice further describes effective practices to discharge a broker-dealer’s reasonable investigation obligations. As discussed in the notice, such practices are highly relevant to Regulation D offerings of securities of companies that are non-reporting under the Securities Exchange Act of 1934.

 Any practitioner in this arena would be well advised to review this regulatory notice.

— Sandra D. Grannum, Orangeburg, NY

SDNY Revives Subprime-Securities Class Action Against Credit Suisse

After initially being dismissed for lack of subject-matter jurisdiction, a securities class action against Credit Suisse will now go forward. U.S. District Judge Victor Marrero of the Southern District of New York had previously dismissed the suit on the grounds that the court lacked subject-matter jurisdiction over claims brought by foreign investors who purchased their shares of the Swiss bank on foreign exchanges.

In a February 11, 2010, opinion, Cornwell v. Credit Suisse Group, No. 08-cv-03758 (S.D.N.Y. Feb. 11, 2010), the court granted the plaintiffs’ motion for leave to file an amended complaint which, Judge Marrero found, contained “new key allegations that would allow the Court to exercise subject matter jurisdiction” over claims by two of the United States-domiciled plaintiffs, namely, (1) that these new plaintiffs are U.S. residents, and (2) that more than 75.7 million shares of Credit Suisse securities were held by U.S. institutional investors during the class period, representing roughly 11.4 percent of the outstanding shares of the Swiss bank. The court concluded these newly alleged facts established subject-matter jurisdiction under the Second Circuit’s “effects” test for extraterritorial application of the securities laws, as enunciated in Morrison v. National Australia Bank Ltd., 547 F.3d 167 (2d Cir. 2008), presently on appeal to the Supreme Court of the United States.

In weighing the sufficiency of the fraud allegations, the court found that plaintiffs had adequately pled scienter through the statements of confidential witnesses which, the Court reasoned, “show[ed] that the Defendants had direct knowledge of information contradicting their public statements or access to similar statements they should have monitored.”

Among these allegations were charges from witnesses, including a director of market risk management in Credit Suisse’s New York offices, that Credit Suisse executives “reviewed specific reports that should have alerted them to the problems” regarding the bank’s exposure to subprime-mortgage assets “they later allegedly misrepresented.” The court also cited to the allegations of “widespread knowledge at [Credit Suisse] of the company’s problems with valuation, risk management and internal controls,” as demonstrated by, among other things, the fact that “millions of dollars of hedges related to [Credit Suisse’s] mortgage investments were left uncompleted.” As the court noted, “the proposed Complaint alleges that despite this knowledge” of the bank’s market exposure, “Defendants stated that internal controls and risk management were functioning so well that Credit Suisse’s exposure to the housing collapse was almost non-existent.”

The Credit Suisse decision is the latest in a line of securities cases involving foreign-domiciled companies and presenting issues of extraterritorial jurisdiction to be decided in the wake of the Second Circuit’s National Australia Bank decision. Oral argument before the Supreme Court in that case is scheduled for March 29, 2010.

— Matthew L. Mustokoff, Esq., Radnor, PA

Division of Enforcement Initiatives

On January 13, 2010, Enforcement Director Robert Khuzami announced a number of recommendations arising from the division’s vigorous self-assessment of its organization, process, and strategy. These include:

• appointment of leaders for the five national specialized units (Asset Management, Market Abuse, Structured and New Products, Municipal Securities, and Foreign Corrupt Practices Cases)
• creation of the Office of Market Intelligence, responsible for the collection, analysis, risk-weighing, triage, referral and monitoring of tips, complaints, and referrals, and the harvesting of that intelligence to better inform the division’s investigative focus and priorities
• a new cooperation initiative under which the division, in the appropriate circumstances, will enter into a formal agreement in which it agrees to provide benefits, including recommending reduced sanctions to people who agree to provide timely and accurate information, testimony an other assistance in pursuing fraud, and other securities-law violations.

 

Zubulake Revisited: Six Years Later

On January 11, 2010, Judge Shira Scheindlin of the Southern District of New York issued another important decision regarding e-discovery and the appropriate level of sanctions for discovery misconduct. See Pension Committee of the University of Montreal Pension Plan v. Banc of America Securities, 05 Civ. 9016, slip op. (S.D.N.Y. Jan. 11, 2010).

The opinion, which Judge Scheindlin titled "Zubulake Revisited: Six Years Later," follows up on her precedential opinions from 2003 and 2004 in the case, Zubulake v. UBS Warburg LLC, wherein she established strict procedures for the preservation of documents in an era where vast amounts of electronically stored information ("ESI") may be relevant to litigation and may be modified, lost or destroyed if a so-called "litigation hold" is not in place. As Judge Scheindlin stated in Zubulake Revisited: "By now, it should be abundantly clear that the duty to preserve means what it says and that a failure to preserve records paper or electronic - and to search in the right places for those records, will inevitably result in the spoliation of evidence." Slip op. at 2.

Plaintiffs originally brought this securities class action in Florida following the liquidation of two British Virgin Islands-based hedge funds in 2003. The action was subsequently transferred to Judge Scheindlin in 2005. As the Court found, although plaintiffs had a duty to preserve evidence and institute written litigation holds once litigation was reasonably anticipated in 2003, plaintiffs failed to issue a document hold until 2007. The court determined that plaintiffs also subsequently committed myriad errors in collecting the documents and attempted to conceal the shortcomings of the preservation and collection efforts.

In determining whether the plaintiffs' conduct required the Court to impose a sanction for the spoliation of evidence, Judge Scheindlin presented a new analytical framework for courts to use when assessing a litigant's discovery misconduct and the appropriate level of sanctions. The Court stated:

[T]here are several concepts that must be carefully reviewed and analyzed. The first is plaintiffs' level of culpability that is, was their conduct of discovery acceptable or was it negligent, grossly negligent, or willful. The second is the interplay between the duty to preserve evidence and the spoliation of evidence. The third is which party should bear the burden of proving that evidence has been lost or destroyed and the consequences resulting from that loss. And the fourth is the appropriate remedy for the harm caused by the spoliation.

Id. at 6.

Although the Court found that plaintiffs did not engage in "egregious" conduct such as purposefully destroying evidence, Judge Scheindlin labeled plaintiffs "careless and indifferent," and stated, "there can be little doubt that some documents were lost or destroyed." Id. at 5. After applying the analytical framework discussed above, the Court rejected Defendants' motion to dismiss the case as a direct result of the alleged discovery misconduct, but imposed (i) monetary sanctions on all plaintiffs and (ii) an adverse inference instruction to be delivered to the jury with respect to all grossly negligent plaintiffs. To that effect, the Court will instruct the jury that, as a matter of law, certain plaintiffs "failed to preserve evidence after its duty to preserve arose," and "[a]s a result, you may presume, if you so choose, that such lost evidence was relevant, and that it would have been favorable to [defendants]." Id. at 82.

New Study Confirms Slow Year for Securities Class-Action Filings

On the heels of the NERA report [PDF] discussed below, Stanford Law School’s Class Action Clearinghouse and Cornerstone Research have issued a study [PDF] that confirms that 2009 was a slow year for securities-fraud class-action filings.

The study reports that only 169 securities-fraud class actions were filed in 2009. This number represents a 24 percent decrease in the number of similar suits filed in 2008 and a decline significantly larger than the one identified by the earlier NERA report. The number of filings in 2009 was also 14 percent below the historical average of 197 annual filings made between 1997 and 2008.

Two trends were identified as being responsible for the decline. The decline in the first half of 2009 was attributed to a decline in “traditional” class-action filings, defined by the authors as those that were unrelated to the credit crisis. By mid-year “traditional” class-action filings picked up considerably, but this increase was offset by a sizeable decline in filings related to the credit crisis. Overall, the number of class-action filings related to the credit crisis declined from a total of 100 in 2008 to just 53 in 2009 (only 17 of which were filed in the second half of the year).

The study also suggests that trends in the 2009 data could indicate a more fundamental shift in the securities class-action landscape for 2010. Noting that 2009 filings were marked with longer lag times between the filing date and the end of the class period, and that longer lag times are typically associated with higher dismissal rates, the authors contend that this trend “suggests that the pool of current litigation opportunities is shrinking and that plaintiff law firms are revisiting cases involving more distant price drops that were previously viewed as being lower in priority because, among other reasons, they are more likely to be dismissed.” The implications of this trend also have been discussed by others, including Sheri Qualters in the National Law Journal and the D&O Diary’s Kevin LaCroix.

Other noteworthy trends identified by the study include a continuing decline in the number of both 10b-5 claims and allegations of insider trading. In 2005, 10b-5 claims accounted for 91 percent of total filings. This number has declined every year since (87 percent in 2006, 80 percent in 2007, and 75 percent in 2008), and by 2009, 10b-5 claims accounted for just 66 percent of class-action filings. Allegations of insider trading have also declined significantly despite an uptick in high-profile enforcement actions and indictments coming from the Securites and Exchange Commission and the Department of Justice. Included in 45 percent of all securities class-action filings in 2005, insider trading allegations appeared in only 12 percent of filings in 2009.

— Darin Sands, Portland, OR

NERA Publishes 2009 Year-End Update on Recent Trends in Securities Class Action Litigation

Earlier this month, NERA Economic Consulting published the latest installment of its biannual study on recent trends in securities class-action litigation.

In its study, NERA predicts the total number of federal securities filings in 2009 to top out at 235, which represents only a slight decline from the 253 actions filed in 2008. While the volume of cases may have declined in 2009, this year’s numbers still greatly exceed the 130 filings in 2006, before the start of the credit crisis.

NERA reports that the pace of credit-crisis filings gradually declined throughout 2009, but these cases still represent approximately 30 percent of all securities filings. While filings related to the credit crisis, including those related to the collapse of the auction-rate-securities market, appear to have spiked in 2008, other types of securities cases are replacing these filings. For example, 2009 saw an increase in Ponzi-scheme cases and the advent of a new category of cases related to exchange-traded funds (ETFs). NERA reports that 13 ETF-related cases were filed between August and November 2009.

According to NERA, the average securities class action settlement in 2009 was up $11 million to $42 million. This figure excludes the “outlier” 309 settlements in In re IPO Securities Litigation, which, if included, would lower the average settlement figure in 2009 to $12 million.

With respect to settlement size and investor losses, NERA senior consultant and coauthor Dr. Stephanie Plancich noted:

In recent years, median investor losses for settled cases have been well over $300 million. For cases filed in 2008 and 2009, though, median investor losses have been almost 40% higher, over $500 million. This may be an indication that although there has not been an upward trend in recent settlements, future settlements may be larger once these recently filed cases begin to settle in more substantial numbers.

Second Circuit Looks to New York Court of Appeals for Guidance in Refco Trustee’s Case

On December 23, 2009, the U.S. Court of Appeals for the Second Circuit certified numerous questions to the New York Court of Appeals regarding whether plaintiff-appellant Marc Kirschner (the trustee), in his capacity as the trustee of the Refco Litigation Trust, has standing to sue former senior managers of Refco, and its lawyers and auditors, who allegedly participated in defrauding Refco’s creditors.

The trustee alleged that Refco’s officers, with the aid of certain professionals and advisors, orchestrated a scheme to artificially enhance the company’s performance and conceal Refco’s true financial condition, so that these insiders, through the company’s leveraged buyout and subsequent IPO, could cash out their interests in the company on lucrative terms.

On May 8, 2009, then District Judge Gerard E. Lynch dismissed the suit as against various third-party defendants for want of standing under the so-called Wagoner rule, whereby the trustee for a debtor corporation lacks standing to recover against third parties for damage to creditors. See Shearson Lehman Hutton, Inc. v. Wagoner, 944 F.2d 114, 118 (2d Cir. 1991).

The issue raised on appeal is whether, under New York law, the acts of the corporate insiders can be imputed to the corporation, in which event, pursuant to the Wagoner rule, the trustee lacks standing, or whether the “adverse interest” exception precludes imputation.

On appeal, the trustee principally argued that the district court erred in imputing the insiders’ wrongdoing to Refco because the Refco insiders totally abandoned the company’s interests, and therefore the adverse interest exception to imputation should apply. The appellees responded that the adverse interest exception does not depend on the insiders’ intent, and that the exception requires harm to the corporation and the insiders’ acts conferred benefits on Refco.

As the Second Circuit remarked, “the issues concerning imputation and the adverse interest exception raise questions of New York law as to which considerable uncertainty exists.” Slip op. at 4. The court held:

[The parties’] differing uses of New York cases, coupled with the somewhat divergent language used by the District Court in the pending case and by our Court in [In re CBI Holding Co. v. Ernst & Young, 529 F.3d 432 (2d Cir. 2008)], both endeavoring to interpret New York law, make it appropriate to seek authoritative guidance from the New York Court of Appeals.

Id. at 18.

The Second Circuit invited the court of appeals to expand upon or vary the terms of the eight certified questions as it deems appropriate, and also asked the court of appeals, in the event it is disinclined to answer or discuss all of the questions, to focus on (i) whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct and (ii) whether the exception is available only where the insiders’ misconduct has harmed the corporation.

According to the court, “[a]lthough the precise allegations in the pending case are distinctive, the recent frequency of insider misconduct in the corporate world underscores the virtue of using certification.” Id. at 18–19.

The Second Circuit will resume its consideration of the trustee’s appeal after disposition of its certification by the New York Court of Appeals.

Second Circuit Affirms Dismissal of PXRE Securities Class Action

On December 22, 2009, the U.S. Court of Appeals for the Second Circuit issued a summary order upholding the “well-reasoned” dismissal of a securities-fraud class action against reinsurer PXRE Group Ltd., as well as certain of its former executives, for failure to adequately allege a strong inference of scienter.

In the Second Circuit, a plaintiff may establish a strong inference of scienter “by alleging either (1) that defendants had the motive and opportunity to commit fraud, or (2) strong circumstantial evidence of conscious misbehavior or recklessness.” ECA v. JP Morgan Chase Co., 553 F.3d 187, 198 (2d Cir. 2009). In assessing allegations of scienter the court must consider “all of the facts alleged, taken collectively,” and must also “take into account plausible opposing inferences.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322–23 (2007).

On March 4, 2009, Judge Richard J. Sullivan of the Southern District of New York dismissed the action, finding the plaintiffs’ claims of scienter “far too generalized” and “deficient” to satisfy either prong of the ECA test. See In re PXRE Group Ltd. Sec. Litig, 600 F. Supp. 2d 510, 532, 536 (S.D.N.Y. 2009). Last week, the three-judge appellate panel comprising Circuit Judges Calabresi, Cabranes, and Parker, agreed with Judge Sullivan and affirmed the dismissal “substantially for the reasons stated by the District Court’s careful order and opinion.” Slip op. at 3.

This class action arose principally out of statements made by the defendants regarding losses that PXRE would be exposed to in the wake of Hurricane Katrina. The complaint alleged that the defendants understated projected operating losses by hundreds of millions of dollars in an effort to boost the company’s credit rating and keep the company in business.

According to the complaint, the company’s stock fell by approximately $8 per share when PXRE was downgraded by A.M. Best from an A- rating to a B+ rating in February 2006. PXRE stopped writing new business shortly thereafter.

In 2007, San Antonio-based Argonaut Group Inc. bought PXRE in a cash-and-stock deal. The combined entities now conduct business as Argo Group International Holdings, Ltd.

Dramatic Dismissal of Broadcom Options Backdating Criminal Case

In a stunning end to the two-month criminal trial of former Broadcom CFO William J. Ruehle, on December 15, 2009, Central District of California Judge Cormac J. Carney dismissed all charges against Mr. Ruehle as a direct result of prosecutorial misconduct.

Just two days before jury deliberations were set to begin, the court concluded that the government “intimidated and improperly influenced the three witnesses critical to Mr. Ruehle’s defense,” and found “the cumulative effect of that misconduct has distorted the truth-finding process and compromised the integrity of the trial.” Judge Carney ruled, “[t]o submit this case to the jury would make a mockery of Mr. Ruehle’s constitutional right to compulsory process and a fair trial.”

The court chastised the government for its treatment of key defense witnesses, asserting that “the Lead Prosecutor somehow forgot that truth is never negotiable.” Judge Carney scrutinized the improper conduct with respect to each witness, notably describing the prosecution’s treatment of Broadcom’s cofounder and Chief Technical Officer Dr. Henry Samueli as “shameful and contrary to the American values of decency and justice.” On December 9, 2009, Judge Carney dismissed the case against Dr. Samueli by vacating his allegedly tainted guilty plea.

Understanding that his decision would be controversial, Judge Carney preemptively responded to his critics by stating:

I have a solemn obligation to hold the government to the Constitution. I am doing nothing more and nothing less. And I ask my critics to put themselves in the shoes of the accused. You are charged with serious crimes and, if convicted on them, you will spend the rest of your life in prison. You only have three witnesses to prove your innocence and [the] government has intimidated and improperly influenced each of them. Is that fair? Is that justice? I say absolutely not.

Because Broadcom c-founder and former CEO Henry T. Nicholas III would need to rely on the same three witnesses as Mr. Ruehle to prove his innocence, Judge Carney also dismissed all backdating-related charges against Mr. Nicholas. In addition, the court challenged the government to defend certain unrelated drug charges against Mr. Nicholas.

Judge Carney also dismissed without prejudice the SEC civil action against the former Broadcom executives and discouraged the government from pursuing the matter any further. According to the court, the SEC would have “great difficulty” establishing the requisite scienter. Raising questions as to whether criminal prosecution or enforcement actions are appropriate in such cases, the court stated:

The accounting standards and guidelines were not clear, and there was considerable debate in the high-tech industry as to the proper accounting treatment for stock option grants. Indeed, Apple and Microsoft were engaging in the exact same practices as those of Broadcom.

The defendants and their counsel were notably moved by the court’s ruling, with many stating that Judge Carney had restored their faith in the judicial system. The prosecution declined to comment, but acting U.S. Attorney George Cardona told the judge he did not agree with the ruling. The government may appeal the dismissal of Mr. Nicholas’s indictment, but Mr. Ruehle cannot be retried.

Wells Fargo Agrees to Buy Back Up to $1.4 Billion of Auction Rates Securities

On November 18, 2009, Wells Fargo announced that it has reached settlement agreements with the California Attorney General’s Office and the North American Securities Administrators Association (NASAA) to repurchase up to $1.4 billion of illiquid Auction Rate Securities (ARS) from eligible investors nationwide who bought ARS through one of three of Wells Fargo’s broker-dealer subsidiaries prior to February 13, 2008.

Customers of Wells Fargo Investments reportedly held $2.95 billion in ARS at the time of the market’s collapse in early 2008. These settlements resolve all active regulatory investigations and enforcement actions surrounding Wells Fargo’s participation in this market. Though Wells Fargo has not admitted the allegations leveled in the various complaints and investigations, the firm has agreed to pay securities regulators $1.9 million in penalties as part of the settlements. Wells Fargo will also reimburse clients who sold ARS at a discount after the market failed. Under the terms of the agreements, the firm must buy back the ARS from eligible investors by April 18, 2010.

NASAA President Denise Voigt Crawford and California Attorney General Edmund G. Brown Jr. issued competing press releases disclosing the settlements.

“Today’s settlement demonstrates the value of states working in concert to benefit investors nationwide,” said Crawford. “State securities regulators continue to lead the effort to ensure that investors receive redemptions for their frozen auction rate securities, which were marketed as safe and liquid investments, and we will continue to seek much needed relief for investors who have suffered from the collapse of the ARS markets.”

Attorney General Brown, who brought suit in April 2009, championed the settlement as a victory for misled investors:

Wells Fargo convinced thousands of investors to purchase auction-rate securities with promises of robust returns and liquidity, but when the market collapsed, investors were left out in the cold. Based on misleading advice, investors bought these risky securities. Now, retail investors and small businesses are finally getting their money back.

The investigation into possible violations by Wells Fargo forms part of a larger, ongoing effort directed by securities regulators to address whether prominent investment firms systematically misled investors when placing them in ARS. Since the collapse of the ARS market in 2008, regulators have secured settlements calling for firms to repurchase from investors more than $61 billion in ARS.

Plaintiffs Obtain Relief from PSLRA’s Automatic Stay of Discovery

On November 16, 2009, the U.S. District Court for the Southern District of New York granted the securities-class plaintiffs’ request for relief from the Private Securities Litigation Reform Act’s (PSLRA) automatic discovery stay. In re Bank of America Corp. Securities, Derivative and ERISA Litig., No. 09-MDL-2058, Slip Op. (S.D.N.Y. Nov. 16, 2009).

After the defendants filed motions to dismiss, discovery in the matter was automatically stayed pursuant to the PSLRA. See 15 U.S.C. § 78u-4(b)(3)(B). But, as is often the case in complex matters of this type, the defendants produced a substantial number of documents and responded to other requests in parallel proceedings and related government investigations. The securities-class plaintiffs sought relief from the PSLRA stay, arguing that they would be unduly prejudiced if they were forced to remain singly in the dark in a “‘rapidly shifting’ litigation landscape.” Securities Class Plaintiffs’ October 6, 2009, Letter to Judge Denny Chin at 2.

In his order, Judge Chin agreed and lifted the automatic stay, permitting the plaintiffs’ access to discovery provided in the investigations and other proceedings. The court concluded that the plaintiffs faced sufficient undue prejudice for two reasons: (1) “Without access to documents produced in these other proceedings, plaintiffs . . . will be less able to make informed decisions about litigation strategy,” and (2) “Plaintiffs’ pursuit of discovery will also ‘fall substantially behind the SEC and other government actions.’” Order at 5 (quoting Plaintiffs’ October 6, 2009, Letter at 2). Judge Chin also found that the discovery sought did not amount to a “fishing expedition” and that the burden of “making another copy for plaintiffs here will be slight.” Order at 5–6.

This recent decision is one of many in an apparent split in the Southern District of New York as to what constitutes “undue prejudice” in order to merit lifting a PSLRA discovery stay. Thus, the open question in many securities litigators’ minds is whether the Bank of America decision signals a trend: Will the “undue prejudice” exception swallow the rule of an automatic discovery stay? As the number of securities-litigation-related filings and corresponding government investigations increases, it is difficult to imagine a set of circumstances substantively different from those at issue in Bank of America.

If the mere existence of parallel proceedings in which discovery has commenced is sufficient to warrant a lifting of the automatic stay, the “undue prejudice” exception may very well consume the “automatic” stay of discovery rule. The Bank of America court reasoned that while some form of undue prejudice must be shown, courts were generally more willing to modify the discovery stay if doing so would not “‘frustrate Congress’s purposes in enacting the PSLRA.’” Order at 3 (quoting Seippel v. Sidley, Austin, Brown & Wood LLP, No. 03 Civ. 6942, 2005 WL 388561, at *1 (S.D.N.Y. Feb. 17, 2005)). But in lifting the stay, other courts have found some particularized circumstance that warranted the plaintiff class’s access to certain documents at that moment in time. E.g., In re Worldcom, Inc. Sec. Litig., 234 F. Supp. 2d 301, 306 (S.D.N.Y. 2002) (noting that delay in access to information may disadvantage securities class plaintiffs in pursuing a defendant whose assets would be rapidly depleted by settlements with other parties); see also Waldman v. Wachovia Corp., No. 08 Civ. 2913, 2009 WL 86763, at * 2 (S.D.N.Y. Jan. 12, 2009) (finding plaintiffs’ need to access information legitimate where they must assess whether to continue litigation given the defendant’s settlement with the SEC). The Bank of America court, however, essentially found that any delay in discovery, perhaps especially where the perceived burden to defendant was slight, was sufficiently unfair as to invoke the “undue prejudice” exception. Only time will tell whether this decision signals the increasing erosion of the PSLRA discovery-stay provision.

— Monica K. Loseman, Denver, CO

Acquittal for Two Bear Stearns Executives in the Eastern District of New York

In what has been reported to be the first high-profile jury trial borne out of the subprime meltdown, a federal jury in the U.S. District Court for the Eastern District of New York took less than six hours of deliberations to find two former Bear Stearns money managers, Ralph Cioffi and Matthew Tannin, not guilty on all charges, which included securities fraud, wire fraud, conspiracy, and insider trading.

The November 10, 2009, verdict came after a month-long trial surrounding the two executives’ representations to investors regarding two hedge funds they managed. These funds were backed largely by subprime mortgages and eventually lost all value, costing investors a reported $1.6 billion.

In its June 2008 indictment, the government alleged that both Cioffi and Tannin knew the hedge funds were “at risk of collapse” but “rather than disclosing the true state of the Funds . . . agreed to make misrepresentations in the ultimately futile hope that the Funds’ bleak prospects would change.”

According to reports published throughout the trial, the prosecutors relied on email communications between Cioffi and Tannin, including emails purportedly made by the two men using their wives’ email accounts, to prove behind-the-scenes panic as the hedge funds began to lose value. Defense lawyers countered, arguing that prosecutors took these emails out of context and asserting that the two men were honest about the volatility of the market.

Based on the evidence presented, the jurors concluded that the two money managers did not lie to investors about the hedge funds they managed. The jury apparently found that Cioffi and Tannin were being blamed for market forces outside their control, and thus chose to reject the prosecution’s invitation to make these executives into scapegoats for the subprime-related crisis. Had they been convicted, the men could have each faced up to 20 years in prison.

Heightened Pleading Standards of the PSLRA Lead to “Fatality” for Suit Against Midway Games

Midway Games, the former developer of such games as Mortal Kombat, secured a dismissal with prejudice in a putative securities class action suit. See Zerger v. Midway Games, Inc., No. 1:07-cv-03797, 2009 U.S. Dist. LEXIS 96872 (N.D. Ill. Oct. 19, 2009). The case illustrates the “stringent” pleading standards of the Private Securities Litigation Reform Act (PSLRA) and the importance of challenging conclusory allegations of both falsity and scienter. 

The plaintiffs alleged that shortly after Midway announced its first profitable quarter in five years in February 2005, the company informed the market that it would be robustly growing, in part by acquiring competitors in the interactive entertainment industry. One smaller development company it acquired was Ratbag Holdings Properties, Ltd. Id. at *5–7. But, as the district court noted, “all was not well” with Midway’s business plan. Id. By September 2005, Midway was forced to borrow money to fund its day-to-day operations, and by December Midway had “shutdown” Ratbag. Id. at 6. It was also forced to fire developers and cancel development of an important game title.

As a result of its financial performance and lack of cash, the plaintiffs alleged that Midway would be forced to issue a debt offering to raise the funds necessary to operate on a day-to-day basis. Before doing so and allegedly with this knowledge, Midway’s executives sold a large number of shares. Id. at *8. At the same time, Sumner Redstone of Viacom bought a large amount of Midway’s stock as part of his evaluation of it as a potential target. Id. at *9. This along with the lack of disclosure by Midway caused its stock to be “artificially inflated.” Id. The plaintiffs alleged that Midway disclosed its precarious cash-flow problems slowly to sell a large amount of its stock before this information was fully disclosed to the market. Id. When the information was finally disclosed, the market was “shocked” and fell 17.4 percent in two days. Id.

The court examined the alleged false statements closely. The lynchpin of the plaintiffs’ theory was that Midway made a decision as of October 2005 to “shutdown” Ratbag but did not disclose it to the market until December. Id.at *21. The district court concluded this was a perfect example of a conclusory allegation based on speculation that could not be credited under the PSLRA’s heightened pleading standard:

Plaintiffs do not allege any facts contemporaneous to the statements to support their theory that the “plan” had already been hatched—or that Midway’s eventual debt offering was, at that time, a knowable consequence of the “plan” and the mounting need for cash it would create. In sum, Plaintiffs have alleged no facts (as opposed to conclusions) that Defendants’ statements relating to the acquisition of Ratbag were false or misleading when made, or even material; thus, they have asserted no factual basis for § 10(b) liability against Defendants.

Id. at *22–23.

The district court also found the plaintiffs had failed to adequately plead scienter. The plaintiffs set forth allegations that Midway’s executives had to know the statements were false because they related to “key” business decisions, and their suspicious stock sales also support an inference of scienter. Id. at *29–30.

As for the “core operations theory,” the district court again refused to credit the plaintiffs’ conclusion that Midway’s executives had made the decision to shut down Ratbag’s operations in October 2005. In sum, the plaintiffs had failed to support their conclusory allegations of when Midway’s executives made the “key” business decisions that allegedly led to the fraud.

As for the plaintiffs’ allegations of insider trading, the district court looked at the timing of the sales and noted that they were clustered around Redstone’s announcement that he had decided not to acquire Midway, and were not clustered around the alleged fraudulent statements. Id. at *34. According the court, “the stock sales do not support an inference that Defendants intended to deceive the public about the state of affairs at Midway. That inference of scienter is weak and ill-supported in its own right.” Id. at *35.

In sum, this case illustrates the stringent pleadings standards that must be satisfied to successfully plead a violation of the securities laws under the PSLRA. A court, like the district court here, may refuse to credit a plaintiff’s conclusory allegations and is free to consider the strength of competing inferences.

» For further discussion see Class Action Defense Blog

— Andrew J. Demko, Los Angeles, CA

S.D.N.Y. Approves Settlement of 309 Consolidated Securities Class Actions

On October 5, 2009, Judge Shira A. Scheindlin of the U.S. District Court for the Southern District of New York provided the final approval for a consolidated settlement that puts to rest over three hundred separate securities class actions and caps eight years of multi-district litigation. See In re Initial Public Offering Sec. Litig., No. 1:21-mc-00092 (S.D.N.Y. Oct. 5, 2009).

The consolidated action consisted of 309 securities class actions brought against more than 300 issuers, hundreds of individuals associated with these issuers, and 55 underwriters of technology stocks that went public during the so-called Tech Bubble in the late 1990s. The plaintiffs allegedly lost billions of dollars as a result of the defendants’ scheme to defraud the investing public by requiring IPO clients to purchase additional shares in the aftermarket, often at escalating prices, to create artificial demand and drive up stock prices.

Recognizing that “adjudication of these actions would have been a daunting task,” slip op. at 29, Judge Scheindlin held the $586 million settlement was fair, reasonable, and adequate. The defendants were not required to admit any wrongdoing and, as detailed in the settlement agreement, agreed to the settlement to avoid protracted and expensive litigation. The plaintiffs’ attorneys were awarded $217 million in fees and expenses.

S.D.N.Y. Rejects SEC and Bank of America Proposed Settlement

 In Securities and Exchange Commission v. Bank of America, 09 Civ. 6829 (S.D.N.Y. Sept. 14, 2009), Judge Jed S. Rakoff of the Southern District of New York took both the Securities and Exchange Commission (SEC) and Bank of America to task for “contriv[ing]” a settlement that essentially re-victimized Bank of America shareholders.

The decision was the product of the “perfect storm.” The SEC’s Division of Enforcement has been the subject of harsh criticism from the media, Congress, and its own inspector general in the wake of the subprime credit market crisis and the unprecedented Madoff scandal. At the same time, the Obama administration has called for increased financial reform and greater regulation of financial institutions. And the New York attorney general is reportedly investigating the circumstances surrounding the acquisition of Merrill Lynch. Given this environment, the parties involved and the injunctive relief requested, Judge Rakoff likely felt empowered—if not obligated—to scrutinize the settlement proposal even more closely to ascertain whether it was “fair, reasonable and adequate” and served the public interest.

In rejecting the proposed settlement, which the court labeled a “contrivance” that “cannot remotely be called fair,” Judge Rakoff questioned why the victims of Bank of America’s purported lies—the bank’s shareholders—should pay $33 million to the SEC for their own victimization. The court was highly critical of the settlement, stating that it “suggests a rather cynical relationship between the parties: the SEC gets to claim that it is exposing wrongdoing on the part of the Bank of America in a high-profile merger, the bank’s management gets to claim that they have been coerced into an onerous settlement by overzealous regulators. And all this is done at the expense, not only of the shareholders, but also of the truth.”

It remains to be seen whether the decision marks a sea change for more heightened scrutiny of securities class action settlements generally. 

Eighth Circuit Affirms Novastar Dismissal

In the first appellate decision borne out of the wave of litigation related to the subprime meltdown and credit crisis, on September 1, 2009, the U.S. Court of Appeals for the Eighth Circuit affirmed the Western District of Missouri’s dismissal of a securities class action brought against Novastar Financial, Inc.

The plaintiffs filed numerous complaints against Novastar—a residential subprime mortgage lender and originator of mortgage-backed securities—following a February 2007 earnings announcement that precipitated a one-day 40 percent drop in the company’s share price. A subsequent consolidated class action complaint alleged a deterioration of Novastar’s underwriting standards and auditing processes, and identified a laundry list of purportedly false or misleading statements issued by Novastar and its officers and directors during the class period.

In June 2008, the district court granted Novastar’s motion to dismiss, rejecting the complaint on both falsity and scienter grounds. The court additionally criticized the plaintiffs for drafting a 100-page complaint that failed to be sufficiently specific, and denied the plaintiffs the opportunity to amend because any such attempt would be “futile.”

In the opinion authored by Circuit Judge Raymond Gruender, the Eighth Circuit conducted a de novoreview and agreed with the district court that the plaintiffs’ complaint did not satisfy the heightened pleading requirements of the Private Securities Litigation Reform Act (PSLRA). The court did not reach the issue of scienter, but held with respect to falsity that, by simply reproducing lengthy excerpts from press releases, Securities and Exchange Commission filings, and conference calls transcripts, the plaintiffs failed to satisfy the PSLRA’s pleading requirements. Judge Gruender noted that “any indication as to what specific statements within these communications are alleged to be false of misleading” was conspicuously absent from the complaint. Slip. op. at 7.

Given that the plaintiffs did not identify which statements were alleged to be false or misleading, the court found it “difficult, if not impossible, to determine whether the complaint adequately specified why each statement was misleading.” Id. at 8. The Eighth Circuit also noted that “[e]ven if we were able to identify specific statements that were alleged to be misleading,” the complaint “does not provide any link between an alleged misleading statement and specific factual allegations demonstrating the reasons why the statement was false and misleading.” Id.

The court affirmed the denial of leave to amend, holding that the plaintiffs failed to submit a proposed amended pleading to the district court and thus did not preserve this right. Id. at 10.

As the first substantive appellate decision concerning a subprime-related securities class action, this decision represents an important development for defendants embroiled in the wave of credit crisis litigation. Certainly, prospective subprime defendants will rely on this decision to make clear that plaintiffs may not rely on the kitchen-sink approach to pleading securities fraud, whereby courts are left to identify what statements are allegedly false or misleading and why. However, given the Eighth Circuit did not reach the often hotly contested issues of scienter and loss causation, this decision’s precedential value may be somewhat limited.

Plaintiffs' Allegations of Insider Trading Insufficiently Probative of Scienter in In re Gildan Activewear, Inc. Securities Litigation

On July 1, 2009, Judge Harold Baer Jr. of the U.S. District Court for the Southern District of New York dismissed a putative securities class action brought against Gildan Activewear, Inc. and two of its officers and directors. See In re Gildan Activewear, Inc. Securities Litigation, No. 08 Civ. 5048 (HB), 2009 BL 140830 (S.D.N.Y. Jul. 01, 2009).

After posting record profits every quarter and meeting or exceeding its earnings projections throughout the 2007 fiscal year and the first quarter of fiscal year 2008, Gildan reduced its earnings guidance in April 2008 as a result of problems it had been experiencing with its textile facility in the Dominican Republic and its acquisition of Kentucky Derby Hosiery in July 2006. The company’s stock price fell 30 percent after the announcement and the plaintiffs subsequently brought suit.

Judge Baer dismissed the action brought under sections 10(b) and 20(a) of the Securities Exchange Act of 1934 for failure to sufficiently plead scienter under the Private Securities Litigation Reform Act. As the court correctly noted, “[s]cienter can be established by alleging sufficient facts to show either (1) that defendants had the motive and opportunity to commit fraud, or (2) strong circumstantial evidence of conscious misbehavior or recklessness.” Id. at *7 (citing ATSI Commc’ns v. Shaar Fund, Ltd., 493 F.3d 87, 99 (2d Cir. 2007)).

With respect to the former, the plaintiffs sought to establish motive and opportunity by pointing to the insider trading of the two individual defendants. The court held that neither the timing (well in advance of all relevant press releases) nor the volume of shares transacted (between 4.9 and 22.5 percent of the individual defendants’ holdings) were probative of scienter. Similarly, Judge Baer observed that 99 percent of the total alleged insider trading, both by volume and value, “occurred pursuant to a non-discretionary Rule 10b5-1 trading plan, which undermines any allegation that the timing or amounts of the trades was unusual or suspicious.” Id. at *10. Finally, the court found the absence of any allegations of other insiders trading Gildan stock “undercuts any finding of the requisite strong inference of scienter.” Id.at *9.

With respect to the latter, the plaintiffs did not establish recklessness sufficiently probative of a strong inference of scienter. Though the plaintiffs alleged that problems at the Dominican facility made it “impossible” or “patently unrealistic” for Gildan to achieve its projected earnings, the plaintiffs did not allege any facts to suggest what information in the company’s possession (namely internal modeling data) revealed at the time, or what effect the models might have had on Gildan’s financial results. The court concluded, “while it would be troubling if the Company had been aware that the problems at the Dominican facility contradicted their bullish comments about projected earnings, Plaintiffs have failed to allege with the requisite specificity exactly what contemporaneous data Defendants had, even to be able to suggest such knowledge.” Id. at *11. The court also rejected finding any inference of scienter from the plaintiffs’ general allegations of the individual defendants’ senior positions at Gildan.

Lastly, Judge Baer also held that Gildan’s statements were “simply vague expressions of optimism” that corporate executives are entitled to make. Id. at *12–13.

S.D.N.Y. Cites Similarities to Stoneridge in Dismissing Case

The U.S. District Court for the Southern District of New York dismissed, without leave to amend, claims against Motorola and Scientific-Atlanta for purportedly violating section 10(b) of the Securities Exchange Act of 1934 by entering into a scheme with Adelphia intended to “artificially inflat[e]” Adelphia’s EBITDA, because those claims were not materially different from the scheme at issue in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. See In re Adelphia Commc’ns Corp. Sec. & Derivative Litig., No. 03 MDL 1529 (LMM) (S.D.N.Y. June 16, 2009).

Under the scheme, Adelphia would buy cable boxes from Motorola and Scientific-Atlanta at a premium on the contract price, and Motorola and Scientific-Atlanta would pay Adelphia the equivalent amount as “marketing support payments.” Judge Lawrence McKenna determined the Stoneridge decision required the complaint to be dismissed, because “nothing [Scientific-Atlanta or Motorola] did made it necessary or inevitable for [Adelphia] to record the transactions as it did,” and the decision foreclosed the argument that the news reports about Motorola’s and Scientific-Atlanta’s “multi-hundred million dollar” sales of cable boxes were “statements relating to a security.” Consequently, Judge McKenna concluded that, under Stoneridge, it would be futile to replead to include both the facts relied upon by the news stories and the public’s reliance on those stories.

S.D.N.Y. Adopts Order Compelling Vivendi’s U.S. Auditor to Produce Documents

The U.S. District Court for the Southern District of New York adopted a magistrate judge’s order compelling Vivendi’s U.S. auditor (Ernst & Young LLP) to produce documents responsive to a nonparty subpoena. See In re Vivendi Universal, S.A. Sec. Litig., Nos. 02 Civ. 5571, 03 Civ. 2175 (RJH)(HBP) (S.D.N.Y. May 28, 2009).

The plaintiffs sought Vivendi’s U.S. auditor’s documents relating to its audits of Vivendi’s U.S. subsidiaries at the request of Vivendi’s French statu­tory auditors. The U.S. auditor objected, claiming that producing the documents would violate French law and subject it to criminal prosecution. After conducting the generally required comity analysis, Judge Richard Holwell concluded that the magistrate judge’s determination was neither clearly erroneous nor contrary to law and, accordingly, ordered the U.S. auditor to produce the subpoenaed documents (approximately 38 boxes of material).

The first two factors weighed in favor of production. “[T]he United States has a strong interest in enforcing its secu­rities law and ensuring the compliance of its citizens with the Federal Rules of Civil Procedure.” The only French interest in this issue—which involved an American company’s auditing of American companies in accordance with American accounting principles—was that the U.S. auditor’s audits of Vivendi’s American subsidiaries were “pursuant to instructions from French accounting firms.” Second, there was not a “realistic threat of prosecution,” even though the U.S. auditor presented a legal expert who declared that the “possibility of . . . criminal prosecu­tion was not remote.” The third factor was neutral, as the subpoenaed documents were “di­rectly relevant” but the plaintiffs had not shown they were “crucial” to their case. Even though the fourth factor weighed against production—the U.S. auditor withheld the documents “on advice from French counsel”—it was “not enough to overcome the first two factors tipping in favor of production.” Although the court could not order the documents produced simply because it had jurisdiction over the U.S. auditor who had custody of the documents, the court concluded that the four factors in the required comity analysis favored enforcing the subpoena.

On June 11, 2009, the U.S. auditor filed a motion requesting that Judge Holwell reconsider this decision.

S.D.N.Y. Certifies Class in Suit Alleging Sections 10(b) and 20(a) Violations by Seven NYSE Specialist Firms

In a decision recently unsealed in May, the U.S. District Court for the Southern District of New York certified a class, and appointed CalPERS and Market Street Securities as class representatives, in a lawsuit against the seven New York Stock Exchange (NYSE) special­ist firms. See In re NYSE Specialists Sec. Litig., No. 03 Civ. 8264 (S.D.N.Y. Mar. 14, 2009). The suit alleges that those firms violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by trading for their own benefit (in violation of the NYSE priority rules) instead of maintaining the two-sided auction market.

Judge Robert Sweet determined that the proposed class satisfied Rule 23’s requirements. As to the four Rule 23(a) requirements, the class representatives satisfied numerosity by identifying 1.1 million trades violating the priority rules and satisfied commonality by identifying six common issues. Further, the class represen­tatives’ claims were typical, even though CalPERS used a specific benchmark for its invest­ment decisions and Market Street was a market maker on the Philadelphia Stock Exchange. The court also noted that, “[s]tanding alone,” Market Street’s president’s comment that he “certainly wondered why [he] didn’t get certain trades” did not give rise to inquiry notice or a statute-of-limitations defense. Moreover, CalPERS and Market Street were adequate repre­sentatives: They bought and sold stock and could represent both buyers and sellers without “any ‘allegiance.”

Judge Sweet rejected arguments that damages and the need for subclasses should prevent class certification; those, he explained, could be addressed later. Judge Sweet also explained that the proposed class satisfied Rule 23(b)(3)’s predominance and superiority requirements. As for predominance, CalPERS’ algorithm would allow it to prove misrepre­sentations on a classwide basis, and scienter could be proven by reference to testimony that “high-level members of the Specialist Firms” knew about those violations. Additionally, the class representatives could prove, under Basic v. Levinson, that the class relied upon “the efficiency and fairness of the NYSE,” and could prove individual damages through CalPERS’ algorithm, including “the price an investor would have received ‘but for’ the Specialist Firms’ alleged misconduct.” Finally, class treatment would be superior to the alternative option (pro­hibitively expensive individual cases), because class treatment would “promote economy and uniformity,” avoid double recovery, and act as “an essential supplement” to the SEC’s civil and criminal investigations.

Subprime Dismissal for City of Cleveland

In one of the more unconventional lawsuits borne out of the subprime meltdown, on May 15, 2009, Judge Sara Lioi of the U.S. District Court for the Northern District of Ohio dismissed an action brought by the City of Cleveland against over 20 financial institutions involved in the securitization of subprime mortgages. See City of Cleveland v. Ameriquest Mortgage Securities, Inc. [PDF], No. 1:08 cv 139 (N.D. Oh. May 15, 2009).

One of the cities hardest hit by the subprime crisis, Cleveland brought this diversity suit sounding in public nuisance, claiming that subprime lending was categorically inappropriate for the city and blaming defendants for its epidemic of foreclosures. The defendants individually and jointly filed eight motions to dismiss, presenting numerous arguments, four of which the court found were independently sufficient to support dismissal of the case.

The court first agreed with the defendants that the plaintiff’s claims were preempted by Ohio state law. Specifically, the court found the city’s complaint constituted a form of municipal regulatory action seeking to indirectly regulate “the origination, granting, servicing, or collection of loans or other forms of credit,” in contravention of Ohio Revised Code § 163.

Second, Judge Lioi held that the economic loss rule precluded the plaintiff’s claims. As a general matter, the economic loss rule precludes recovery in tort for purely economic losses not arising from tangible physical harm to property. The plaintiff advanced two categories of damages: the diminished tax receipts resulting from the foreclosure crisis, and the cost of maintaining and demolishing the “blighted post-foreclosure properties.” With respect to the former category, the court rejected these damages outright as purely economic in nature. With respect to the latter category, the court held that the plaintiff’s claims were similarly barred because the city did not allege that it had an interest in the properties when the physical damage occurred. Indeed, the only tangible physical harm to property took place when the homeowners were going through foreclosure and not when the city had any interest in the subject properties.

The court next rejected the public nuisance claim on the basis that the defendants were immune because subprime lending was heavily regulated—even expressly encouraged by the state and federal legislatures—and the city did not challenge the defendants’ compliance with those regulations. Judge Lioi followed “a long line of decisions” holding that “a showing that the challenged conduct is subject to regulation and was performed in conformance therewith insulates such conduct from suit as a public nuisance.” The court disagreed with the plaintiff’s attempt to distinguish its challenge to securitization from a challenge to the regulated subprime lending itself, holding:

[I]f the underlying lending activity was lawful, it is impossible to say that supporting that activity by supplying funds and creating [mortgage-backed securities]—at least one step removed from the actual lending—was itself unlawful. Stated the other way, the City’s public nuisance theory cannot succeed against Defendants unless the subprime lending Defendants allegedly facilitated also constituted a public nuisance.

Lastly, Judge Lioi held that the city’s complaint failed to establish proximate causation, because both categories of damages alleged by the city were dependent on the existence of intervening foreclosures suffered by third-party subprime borrowers. Rejecting the argument that resolution of causation issues is improper on a motion to dismiss, the court found the plaintiff’s allegations failed to satisfy the directness requirement set forth in Holmes v. Securities Investor Protection Corp., 503 U.S. 258 (1992), because the complaint did not allege any direct relationship between the alleged injury and the defendants’ conduct, and the city’s losses were contingent upon the insolvency of non-parties.

The complaint was dismissed with prejudice. The City of Cleveland is expected to appeal the decision.

Securities Fraud Jury Verdict Against Household International

In what is only the seventh jury verdict in a securities class action since the passage of the Private Securities Litigation Reform Act, on May 7, 2009, a jury found Household International and three of its former executives liable for issuing 16 false and misleading statements to investors. See Lawrence E. Jaffe Pension Plan v. Household International Inc., no. 02-cv-05893, in the U.S District Court for the Northern District of Illinois.

Now part of HSBC, Household was a leading consumer finance firm, focused on issuing credit cards, auto financing, and mortgages to subprime borrowers. The seven-year-old class action was filed in August 2002, shortly after the company disclosed that it had earned almost $400 million less than it had reported. The complaint alleged that Household had failed to record certain expenses and properly account for co-branding arrangements.

The case is now headed into the damages phase, where plaintiffs may be seeking as much as $1 billion. HSBC has stated publicly that it strongly disagrees with the verdict and “will ask the court to overturn the decision.”

No Undue Prejudice to Plaintiffs from PSLRA Stay of Discovery in Auction Rate Securities Class Action

On April 7, 2009, Judge William H. Pauley III denied a motion to lift the Private Securities Litigation Reform Act (PSLRA) stay of discovery in yet another class action filed in the wake of the collapse of the auction rate securities market. See Brigham v. Royal Bank of Canada [PDF], 08 Civ. 4431 (S.D.N.Y. April 7, 2009). The lead plaintiff brought the securities class action against Royal Bank of Canada, and affiliated corporations (RBC), alleging violations of the 1934 act in connection with RBC’s underwriting, marketing, and sale of auction rate securities.

After the case was filed, RBC entered into settlement agreements with the Securities Exchange Commission and state regulators, whereby it offered to repurchase over $850 million in auction rate securities from its retails investors and reimburse certain eligible investors. Contending that he would suffer undue prejudice if he had to make decisions regarding the future of the litigation without all of the information that RBC made available to the regulators, the lead plaintiff sought to partially lift the PSLRA stay of discovery.

Pursuant to the PSLRA, a court may only lift the mandatory stay of discovery to preserve evidence or prevent undue prejudice to the plaintiffs. Judge Pauley recognized that recent opinions in the Southern District appear to diverge on the meaning of undue prejudice in this context.

The court distinguished the case at bar from two “exceptional circumstances” that could merit lifting the stay, for example (i) when the defendant is insolvent or (ii) when plaintiffs would be disadvantaged by discovery proceeding in other actions against the defendant. Judge Pauley similarly rejected the plaintiffs’ argument that the stay otherwise may be lifted if the objective of Congress in enacting the PSLRA—preventing plaintiffs from filing frivolous lawsuits—is not implicated.

The court held that while access to the documents produced to the regulators would make Brigham’s decision whether to continue the litigation easier, “the plaintiff’s inability to plan a litigation strategy is not evidence of undue prejudice.”

This decision constitutes the latest of several cases in the Southern District of New York to rule on whether the PSLRA stay of discovery creates undue prejudice to plaintiffs in auction rate securities class actions. Judge Pauley noted that two recent decisions in the Southern District of New York were split on the issue. As the court followed the decision of Judge McKenna in In Re UBS Auction Rate Sec. Litig., 08 Civ. 2967 (S.D.N.Y. Nov. 21, 2008), that the stay does not impose undue prejudice on the plaintiffs, similarly situated plaintiffs in future auction rate securities cases may have a greater challenge in lifting the PSLRA stay of discovery.

Southern District of New York: “No State Court Has Subject Matter Jurisdiction over Covered Class Actions Raising 1933 Act Claims”

Last month, U.S. District Judge William H. Pauley III denied the plaintiff’s motion for remand in yet another opinion interpreting the anti-removal provision of the Securities Act of 1933 (the 1933 act).

In Knox v. Agria Corp [PDF], 08 Civ. 7651 (S.D.N.Y. Jan. 27, 2009), plaintiff Robert Knox filed a putative class action in New York Supreme Court asserting claims under the 1933 Act that tracked the allegations of three federal securities class actions pending in the Southern District of New York. After the defendants removed the action pursuant to 28 U.S.C. 1441(a) and the jurisdictional provisions in section 22(a) of the 1933 act as amended by the Securities Litigation Uniform Standards Act of 1998 (SLUSA), Knox moved the court to remand.

The question before Judge Pauley was whether the anti-removal provision of section 22(a), as amended by SLUSA, allows for removal of covered class actions raising only 1933 act claims.

SLUSA amended the 1933 act to define “covered class actions” and “cover securities.” A “covered class action” is a lawsuit where damages are sought on behalf of more than 50 people, and a “covered security” is a security traded nationally and listed on a regulated national exchange. 15 U.S.C. §§ 77p(f)(2)–(3). While claims arising under federal law are generally removable to federal court, section 22(a) of the 1933 act contains an “anti-removal” provision that states: “Except as provided in section [16(c)] of [the 1933 act], no case arising under [the 1933 act] and brought in any State court of competent jurisdiction shall be removed to any court of the United States.” 15 U.S.C. § 77v(a). Section 16(c) provides that “[a]ny covered class action brought in any State court involving a covered security, as set forth in subsection (b), shall be removable to the Federal district court . . . and shall be subject to subsection (b).” 15 U.S.C. § 77p(c). Subsection (b), in turn, prohibits state or federal courts from hearing any covered class action raising state or common law claims based on untrue statements or deceit in the sale of a nationally traded security. See 15 U.S.C. § 77p(b).

The court began its analysis by noting that lower courts were divided on this issue. Judge Pauley observed that “SLUSA was intended to curtail the proliferation in state courts of securities fraud class actions (federal or state) beyond the reach of the PSLRA’s heightened pleading standards.” The court cautioned that a “constricted approach” would threaten “to spawn federal securities fraud class actions in state courts where they could proceed under the PSLRA radar”—a “bizarre result” that “would shift the center of gravity of federal securities fraud class actions under the 1933 Act from federal to state courts.”

The court’s resolution of this issue turned on the phrase “any state court of competent jurisdiction.” In an admitted departure from the analysis of certain other courts, Judge Pauley reasoned that “because the anti-removal provision only applies to claims brought in a state court of competent jurisdiction, once SLUSA stripped state courts of subject matter jurisdiction over covered class actions raising 1933 Act claims, the reach of the anti-removal provision receded, leaving covered class actions raising 1933 Act claims exclusively for federal courts.” As such, the court denied the plaintiff’s motion to remand, holding that “no state court has subject matter jurisdiction over covered class actions raising 1933 Act claims.”

Given the identical nature of the case to the three federal securities class actions pending in the Southern District of New York, Judge Pauley ordered consolidation with the other cases under the caption In re Agria Corporation Securities Litigation, 08 Civ. 3536.

Ninth Circuit Interprets Tellabs: “Dual Inquiry” for Scienter

On January 12, 2009, the Ninth Circuit clarified the impact of the U.S. Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), on the requirements for pleading scienter in a 10b-5 action. See Zucco Partners v. Digimarc Corp. [PDF], --- F. 3d ---, No. 06-35758 (9th Cir. 2009).

In reaffirming the heightened requirements for pleading scienter, the Ninth Circuit in Digimarc explained that Tellabs did not materially alter the particularity requirements established in its previous holdings. Rather, Tellabs added an additional “holistic” component to those requirements. Thus, following Tellabs, a district court in the Ninth Circuit will “conduct a dual inquiry”: first, the court 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, the court 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.

On September 13, 2004, Digimarc publicly announced that it had erroneously accounted for internal software expenditures and that due to these accounting errors it had likely overestimated earnings for the previous six quarters. While “there was no question that Digimarc erroneously capitalized expenditures,” the district court determined that the plaintiffs’ complaint failed to allege scienter with the requisite particularity to survive dismissal under the Private Securities Litigation Reform Act’s (PSLRA’s) heightened pleading standards.

After analyzing the allegations of scienter individually and then in the aggregate, the Ninth Circuit affirmed the District of Oregon’s dismissal, finding that the plaintiffs’ allegations, though “legion” and “voluminous,” were not pled with the particularity required to survive a Rule 12(b)(6) dismissal under the standards enumerated in Rule 9(b) and the PSLRA.

Finding that the more plausible inference was that “there was no specific intent to fabricate the accounting misstatements at issue here,” the court stated:

[T]he plaintiffs in this case assume that compiling a large quantity of otherwise questionable allegations will create a strong inference of scienter through the complaint’s emergent properties. Although Tellabs instructs us to view such compilations holistically, even such a comprehensive perspective of Zucco’s complaint cannot transform a series of inadequate allegations into a viable inference of scienter. We therefore affirm the district court’s dismissal of the Second Amended Complaint with prejudice.

The court also affirmed the denial of leave to amend the complaint.

Seventh Circuit: CAFA Trumps the Anti-Removal Provisions of Section 22 of the Securities Act

The U.S. Court of Appeals for the Seventh Circuit has made it more difficult for plaintiffs bringing securities actions in state court to prevent removal to federal court, holding that the Class Action Fairness Act of 2005 (CAFA) trumps the Securities Act of 1933.

In Katz v Gerardi, No. 08-8031 (7th Cir. January 5, 2009), an opinion authored by Chief Judge Frank Easterbrook, the Seventh Circuit diverged from the Ninth Circuit’s recent decision in Luther v. Countrywide Home Loans Servicing, 533 F.3d 1031 (9th Cir. 2008), which held that the “general grant of the right of removal of high-dollar class actions does not trump” section 22(a) of the Securities Act, which contains a “specific bar to removal of cases arising under the . . . Act.”

In rejecting the Ninth Circuit’s holding, the court held that “Luther failed to recognize that § 22(a) of the 1933 Act is not a subset of the 2005 Act,” and thus “the canon favoring preservation of specific statutes arguably affected by newer, but more general, statutes” was inapplicable.

Further, in finding that all securities class actions covered by CAFA are removable subject only to the three enumerated exceptions contained in § 1453(d) of CAFA itself, the court held that “Section 1453(d) leaves no doubt about how the 1993 Act, 1934 Act, and 2005 Act fit together,” and that to read § 22(a) differently would “make most of §1453(d) pointless.”

The dispute in Katz arose from a real estate investment trust merger in 2007. While the Seventh Circuit remanded the case to the Northern District of Illinois, the case is now set to be transferred to a related action in Colorado, which was filed federally as a contractual dispute subject to arbitration. See Stender v. Gerardi, No. 07-cv-2503 (D. Colo.).

Inspire Pharmaceuticals Dismissal Affirmed

On December 12, 2008, in an opinion written by Circuit Judge J. Harvie Wilkinson III, the Fourth Circuit affirmed the dismissal of a securities class action brought against defendant Inspire Pharmaceuticals Inc. in the Middle District of North Carolina.

The plaintiffs’ primary allegation in Cozzarelli v. Inspire Pharmaceuticals Inc., 549 F.3d 618 (4th Cir. 2008), was that the defendant overstated the prospects for an experimental drug that the company was developing to treat dry eye disease. More specifically, the plaintiffs’ theory was that Inspire and its directors intentionally misled the public to believe that a “confirmatory trial” mandated by the FDA was likely to succeed, thereby artificially inflating the price of Inspire’s stock.

With respect to the plaintiffs’ 10b-5 claims, Judge Wilkinson agreed with the District Court that there was a “substantial question” as to whether plaintiffs had satisfied the PSLRA’s requirements for pleading falsity with specificity, but found it “quite clear” that the “plaintiffs failed to allege facts giving rise to a strong inference of scienter.”

Following Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499, 2509–10 (2007), the Fourth Circuit held that the inference that defendants acted with the non-fraudulent intent to protect their competitive advantage was “more powerful and compelling than the inference that defendants acted with an intent to deceive.” In finding that the plaintiffs’ allegations were “conclusory,” “improbable” and in one case “ignore[d] reality,” the court held that the plaintiffs were “stringing together a series of isolated allegations without considering the necessary context.”

The court also noted that “the complaint quotes selectively from various reports by investment analysts,” and held that “[i]f 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.”

With respect to the plaintiffs’ claims under sections 11 and 12(a)(2) of the Exchange Act, the Fourth Circuit held that plaintiffs failed to allege that the prospectuses in question were false or materially misleading with the particularity required by Rule 9(b). Moreover, the court noted that there were “serious doubts” as to whether plaintiffs “‘nudged the[se] claims across the line from conceivable to plausible,’ as required by the minimal pleading standards of Rule 8” and delineated by the Supreme Court in Bell Atl. Corp. v. Twombly, 127 S. Ct. 1955, 1974 (2007).

Second Circuit Holds “Storm Warnings” Insufficient in Suit Against The Hartford Financial Services Group

On November 17, 2008, the Second Circuit revived a securities class action brought against insurer The Hartford Financial Services Group based on its alleged failure to disclose the so-called “contingent commission” arrangements it entered into with insurance brokers, which purportedly inflated its stock price. See Staehr v. Hartford Financial Services Group, Inc. 547 F.3d 406 (2d Cir. 2008).

This action was filed in 2004, immediately after then-New York Attorney General Elliot Spitzer commenced legal action against the company for these alleged practices. In July 2006, the U.S. District Court for the District of Connecticut dismissed this action as time-barred under the applicable two-year statute of limitations, holding that, as a matter of law, plaintiffs were on inquiry notice of their claims three years prior to the commencement of the action. Staehr v. Hartford Fin. Servs. Group, Inc., 460 F. Supp. 2d 329, 340 (D. Conn. 2006).

On appeal, the Second Circuit reversed, holding that to place an investor on inquiry notice of a defendant’s potential fraud, information must generally be both defendant-specific and reasonably accessible to an investor of ordinary intelligence.

The court began its analysis by reaffirming prior Second Circuit case law holding that courts can make inquiry notice determinations on Rule 12(b)(6) motions where the facts necessary to establish inquiry notice can be gleaned from “the face of the complaint, and matters of which the court may take judicial notice.” In rejecting defendant’s reliance on news reports to place plaintiffs on inquiry notice, however, the court emphasized the lack of company specific information: “Because nearly all of the stories in the record are devoid of company-specific information, the argument that they constitute ‘storm warnings’ is far from compelling.” The court also concluded that a reasonable plaintiff would not have come across the majority of the reports, because they were not reasonably accessible. The same finding was made with respect to a lawsuit involving the defendant’s subsidiaries containing specific allegations pertaining to the kickback schemes at the heart of Staehr. The Second Circuit held that while this prior litigation “would trigger a duty to inquire further,” it was not reasonable to expect an ordinary investor would know about an obscure and unpublicized lawsuit.

Second Circuit: No Subject Matter Jurisdiction to Hear ‘Foreign-Cubed’ Securities Action

In an opinion written by Judge Barrington Parker in Morrison v. National Australia Bank Ltd., 07-0583-CV (2d Cir. Oct. 23, 2008), the U.S. Court of Appeals for the Second Circuit gave some guidance to what the court called “the vexing question of the extraterritorial application of the securities laws.”

Holding that the U.S. District Court for the Southern District of New York lacked subject matter jurisdiction over a so-called “foreign-cubed” or “f-cubed” case, the Second Circuit affirmed the dismissal of claims brought under American securities laws by foreign investors who bought shares of National Australia Bank (Australia’s largest bank) on a foreign exchange.

Applying established Second Circuit precedent, the court held that subject matter jurisdiction would exist “‘if the defendant’s conduct in the United States was more than merely preparatory to the fraud, and particular acts or culpable failures to act with the United States directly caused losses to foreign investors abroad.’”

Notably, however, the court declined the invitation of the appellees and certain amicus curiaeto “eschew this analysis” in favor of a bright-line rule, stating that there is no need to jettison “our conduct and effects tests for foreign-cubed securities fraud actions[.]” In support of its holding, the court explained:

[D]eclining jurisdiction over all ‘foreign-cubed’ securities fraud actions would conflict with the goal of preventing the export of fraud from America. As the argument goes, the United States should not be seen as a safe haven for securities cheaters; those who operate from American soil should not be given greater protection from American securities laws because they carry a foreign passport or victimize foreign shareholders.

Having rejected the bright-line test, the court went on to observe that “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.”

Applying the “conduct test” to the case at bar, the Second Circuit held that the alleged accounting manipulation at a U.S. subsidiary of National Australia Bank was merely preparatory to the purported fraud, and thus the district court did not have jurisdiction to hear the case.

This decision is of particular interest given the wave of litigation involving foreign companies sued in connection with the subprime meltdown and credit crisis. In spite of the fact that the Second Circuit affirmed the dismissal for lack of subject matter jurisdiction, the court’s decision not to institute a bright-line rule means foreign claimants likely will continue to try to assert securities claims against foreign-domiciled companies in U.S. courts.

Another Subprime Dismissal

On October 28, 2008, Judge Florence-Marie Cooper of the U.S. District Court for the Central District of California dismissed a securities class action brought against Fremont General Corporation and a number of its executives. The plaintiffs’ consolidated amended complaint, which was filed shortly after the subprime originator announced that it had consented to an FDIC cease-and-desist order, alleged that Fremont General and its officers made false and misleading statements in press releases, analysts’ calls, and SEC filings, deliberately misrepresenting the company’s lending practices.

Describing the “cross-referenced allegations” as “disjointed” and “conclusory,” Judge Cooper “scoured the 175 pages of the [amended complaint]” and found that the plaintiffs had failed to establish the defendants’ scienter or the material falsity of the alleged statements.

This decision marks one of the first 12(b)(6) dismissals of a subprime-related 10-b-5 litigation. Given the heightened sensitivity to subprime-related litigation and the current financial crisis, Judge Cooper’s decision reinforces the importance of requiring plaintiffs to demonstrate the bona fides of their complaint and fulfill the mandates of the PSLRA and recent Supreme Court precedent.

Now in bankruptcy, Fremont General was one of the largest subprime originators in the country. Plaintiff has 45 days to file an amended complaint.

Delaware District Court Dismisses Complaint Against Countrywide Directors

On October 7, 2008, the U.S. District Court for the District of Delaware dismissed the complaint against two former directors in In re Countrywide Financial Corp. Derivative Litigation. In so doing, Judge Sue L. Robinson affirmed the post-merger limits on derivative shareholder claims under Delaware law.

The Countrywide board faced more than $2 billion in damages for claims of breach of fiduciary duty and insider trading stemming from Countrywide’s subprime mortgage practices and two stock repurchase plans implemented in 2006 and 2007.

The court held that the plaintiffs lacked standing to pursue derivative claims against Countrywide board members. While the plaintiffs owned Countrywide stock and thus had standing when they commenced the action, the court held that a stock-for-stock merger with Bank of America in July 2008 eliminated their standing because all of their Countrywide shares were converted to shares of the bank’s stock. 

This decision follows the bright-line rule reaffirmed by the Delaware Supreme Court in Lewis v. Anderson, 477 A.2d 1040 (Del. 1984), pursuant to which a shareholder in a derivative suit loses standing post-merger because, having received new stock, the shareholder no longer satisfies the continuous ownership rule.

Notably, the Delaware district court “decline[d] plaintiffs’ invitation to overturn Delaware state law precedent” and follow the Third Circuit’s controversial 1992 decision in Rales v. Blasband, 971 F.2d 1034 (3d Cir. 1992), which held that stockholders could continue to pursue derivative claims after a stock-for-stock merger. Ultimately, Judge Robinson agreed with the numerous Delaware decisions that have characterized the Rales opinion as inconsistent with well-settled Delaware law.

Class Certification Stage Reaffirmed as Important Battlefield in Second Circuit Salomon Analyst Litigation

On September 30, 2008, the U.S. Court of Appeals for the Second Circuit issued a significant decision clarifying the standard applicable to class certification when applying the so-called fraud-on-the-market presumption to non-issuers.

In vacating and remanding Judge Gerard E. Lynch’s June 20, 2006 opinion in In re Salomon Analyst Metromedia Litigation, which had granted plaintiffs’ motion for class certification, the Second Circuit held that:

1. the fraud-on-the-market presumption established by the Supreme Court in Basic v. Levinson, 485 U.S. 224 (1988) could be applied against secondary actors such as research analysts,
2. plaintiffs bear no burden of proving that the alleged misrepresentations affected the stock price to take advantage of the presumption, but
3. defendants are entitled to rebut the elements giving rise to the presumption and the court must consider defendants’ rebuttal arguments before certifying a class.

 

The case arose from allegations that Citigroup, various subsidiaries, and analyst Jack Grubman participated in a scheme to defraud Metromedia investors by disseminating materially false analyst reports.

Applying the Supreme Court’s decision in Basic, the Second Circuit held that the District Court erred in holding that he could not consider defendants’ rebuttal arguments prior to class certification:

The Basic Court explained that a successful rebuttal defeats certification by defeating the Rule 23(b)(3) predominance requirement. See Basic, 485 U.S. at 249 n. 29. Hence, the court must permit defendants to present their rebuttal arguments ‘before certifying a class . . . .’ (Slip Op. at 19.)

This decision thus reaffirms class certification as an important battlefield in securities litigation.

Second Dismissal for American Express in the Southern District of New York

In one of the first ostensible subprime securities fraud cases, Judge William Pauley III of the U.S. District Court for the Southern District of New York has for the second time rejected a securities class action lawsuit brought against American Express Co. and certain of its current and former executives. See In re American Express Co. Sec. Litig., 02 Civ. 5533 (S.D.N.Y. Sept. 26, 2008).

Plaintiffs claimed that the company "misrepresented Amex's high yield investments as conservative when, in fact, they were high risk; concealed the extent of Amex's high-yield exposure; failed to disclose the lack of risk management controls; and failed to disclose the fact that Amex's accounting was not in accordance with GAAP." On remand, after an earlier dismissal on statute of limitations grounds was reversed by the Second Circuit, Judge Pauley granted defendants' motion to dismiss, ruling that plaintiffs failed to adequately plead scienter in light of the U.S. Supreme Court's recent decision in Tellabs Inc. v. Makor Issues & Rights Ltd., 127 S. Ct. 2499 (2007).

In weighing competing inferences of fraudulent intent, the court rejected plaintiffs' generalized allegations of insider knowledge and recklessness and refused to find a compelling inference of scienter based upon the allegations of confidential witnesses. The Second Amended Complaint failed to allege that any of these confidential witnesses "had any contact with the Individual Defendants or . . . knowledge of what they knew or should have known during the Class Period." Moreover, "none of the confidential witnesses state[d] that any Individual Defendant ha[d] information or access to information indicating that Amex was not properly valuing the High Yield Debt, that its risk control policies were inadequate, that Amex was violating GAAP, or that contradicted the Company's statements in 2001." Judge Pauley also held that the more compelling inference was that the executives were finding out about the extent of the losses as they were incurred, and thus did not hide any information from investors.

Defendants in future securities class actions will likely cite this new decision as the correct application of Tellabs and a guide for judges evaluating competing inferences of scienter in securities fraud cases.

Second Circuit Rules on the Doctrine of “Collective Scienter”

On June 26, 2008, the Second Circuit Court of Appeals issued an eagerly anticipated opinion addressing the use of the doctrine of "collective scienter" in securities fraud cases. In Teamsters Local 445 Freight Division v. Dynex Capital, Inc., No. 06-2902-cv, 2008 WL 2521676 (2d Cir. June 26, 2008), the Second Circuit reversed the district court and held that the plaintiffs failed adequately to allege scienter against corporate defendants Dynex Capital and Merit Securities. In February 2006, Judge Harold Baer of the Southern District of New York had held that plaintiffs had adequately alleged scienter against the corporate defendants, despite finding that plaintiffs insufficiently pleaded scienter against individual defendants Stephen Benedetti and Thomas Potts—two high-ranking officers at Dynex—or any other officer or employee of either company. The complaint alleged that Dynex had misrepresented the credit worthiness of loans and the value of collateral underlying certain Dynex bonds. But the lower court held that although Teamsters adequately pleaded "a pattern of reckless corporate behavior," there were insufficient allegations that Benedetti and Potts directly supervised or were personally involved in wrongdoing.

In vacating the decision and remanding the case, the Second Circuit clarified that the Public Securities Litigation Reform Act of 1995 (the "PSLRA") and Rule 12(b)(6) mandate dismissal of a securities fraud claim absent allegations demonstrating a "strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter." Id. at *4 (emphasis added). Apart from the inadequate allegations against individual defendants Benedetti and Potts, Teamsters failed to allege that Dynex's management knew about or had access to "information showing that the primary cause of the bonds' poor performance was not the general weakness in the mobile homes market," or that "anyone at Dynex or Merit had a compelling motive to mislead investors." Id.at *6. Consequently, the Second Circuit held that plaintiffs' proffered inferences of scienter were not "at least as compelling" as the competing inferences – that Dynex's statements were either not misleading, or were simply the result of "careless mistakes at the management level" – a pleading requirement under Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499, 2504-05 (2007). Notably, the court found that the stronger inference to be drawn from the poor performance of certain mortgage-backed securities issued by a Dynex subsidiary was that of general market weakness, rather than fraud.

With respect to the viability of the "collective scienter" doctrine, the Second Circuit declined to go so far as to accept the defendants' contention that Teamsters' pleading against Dynex failed as a matter of law because Teamsters failed to adequately allege scienter against any of the individual defendants. The court reasoned that the PSLRA's strict requirements for securities fraud pleadings did not foreclose the possibility that a plaintiff may raise the requisite "strong inference" of scienter against a corporate defendant without successfully pleading against any of its named officers. Id. at *3. Plaintiffs have thirty days leave to re-plead.

Second Circuit Expands Federal Jurisdiction over Securities-Related Class Actions

On May 13, 2008, the Second Circuit expanded federal jurisdiction over securities-related class action suits, deciding a question of first impression concerning the removal provisions of the Class Action Fairness Act (CAFA), 28 U.S.C. §§ 1332(d), 1453, 1711-1715 (2005).  Pew v. Cardarelli, No. 06-5703-mv, 2008 WL 2042809, at *1 (2d Cir. May 13, 2008). This decision is noteworthy for two reasons. First, the Second Circuit exercised its authority under CAFA to hear the defendant's appeal even though district court remand orders traditionally are not reviewable. Id. at *3. Second, the court narrowly interpreted CAFA's securities exception by ruling that a district court had original jurisdiction based on diversity over a suit that did not involve nationally-traded securities and appeared to be rooted in state law.

Plaintiffs brought the complaint under state consumer fraud law, alleging that defendant Agway Inc. failed to disclose its insolvency while issuing money market certificates to the plaintiff class of purchasers. After defendants removed pursuant to CAFA, the district court remanded, holding that the action was not properly removed because it fell within an exception to CAFA's removal provisions that excludes from federal jurisdiction actions which solely involve the "rights, duties … and obligations related to or created by … any security." 28 U.S.C. § 1332(d)(9)(c) (2005). Defendants petitioned the Second Circuit to appeal the district court's remand order.

Exercising its discretionary power under CAFA, the Second Circuit elected to hear the appeal because the action raised an "important and consequential" question requiring clarification in the district courts. Pew, at *3. The court held that the case had been properly removed under CAFA's relaxed diversity requirements (and thus the federal courts had jurisdiction), and that the securities exception did not apply. The court concluded that Congress intended to reserve the exception for disputes over terms contained within securities, such as those that determine "how interest rates are to be calculated," in order to keep cases of primarily local significance in state courts. Id. at *6-7. Because this consumer fraud action alleging defendant's concealment of insolvency is not covered by the court's narrow interpretation of the exception, the court ruled the suit properly fell within the realm of federal jurisdiction. Plaintiffs are petitioning for a rehearing en banc.

Sub-Prime Plaintiffs Defeat Countrywide Motion to Dismiss

On May 14, 2008, Judge Pfaelzer of the Central District of California denied Defendants' motion to dismiss the shareholder derivative and class action suit brought against Countrywide and fourteen of its officers and directors. In re Countrywide Financial Corp. Deriv. Litig., No. CV-07-06923, 2008 WL 2064977 (C.D. Cal. May 14, 2008). The Court sustained the Plaintiffs complaint which alleges violations of Section 10(b) of the Securities Exchange act among other claims. The Court found that "Plaintiffs' allegations create a cogent and compelling inference that the Individual Defendants misled the public with regard to the rigor of Countrywide's loan origination process, the quality of its loans and the company's financial situation – even as they realized that Countrywide had virtually abandoned its own underwriting process." In re Countrywide, slip op. at 15.

The Countrywide Complaint may be noteworthy to prospective sub-prime plaintiffs with respect to its use of confidential witnesses. The court in Countrywide relied heavily on confidential witnesses from various levels in the corporate hierarchy and different satellite offices to "paint a compelling portrait of a dramatic loosening of underwriting standards in Countrywide branch offices across the United States." Id. at 16. This decision stands in contrast to the recent sub-prime dismissal, Tripp v. IndyMac Financial Inc., No. CV07-1635, 2007 WL 4591930, at *4 (C.D. Cal. Nov. 29, 2007), where confidential witness allegations were not sufficiently probative of scienter and generalized allegations such as "[t]he Company's policy of 'pushing through' unqualified loans evidences a Company-wide knowledge of IndyMac's underwriting problems" were insufficiently particularized.

Countrywide may also garner attention because of the court's willingness to impute knowledge of facts relevant to the scienter of certain individual defendants because of their participation on particular board committees. See In re Countrywide, slip op. at 22. As the Court stated, "it is difficult to believe that the Individual Defendants were unaware of the implications of the meteoric rise in negative amortization, especially when the overwhelming majority of these loans were approved with little documentation by the borrower." Id. The Countrywide court drew these conclusions even though other courts considering scienter have required specific factual allegations showing that the directors either wholly failed to put systems in place, or had actual knowledge of the wrongdoing. See, e.g., Guttman v. Huang, 823 A.2d 492, 494 (Del. Ch. 2003) (refusing to infer that members of audit committee must have known of accounting problems); DeSimone v. Barrows, 924 A.2d 908, 938 (Del. Ch. 2007) (rejecting the plaintiffs' allegations that members of the compensation committee must have known about options backdating because the committee administered the stock option plan).

It is unclear what broader impact Countrywide will have on sub-prime litigation, but it is likely to attract careful scrutiny from securities litigators across the nation.

Second Circuit Set to Hear Oral Arguments in Collective Scienter Case

On January 30, 2008, the Second Circuit will hear oral arguments in the case Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital Inc., et al, 06-2902-cv. The central question is whether a claim under 10 (b) of the Securities Exchange Act may proceed against a corporation on a theory of collective scienter. In other words, in the absence of viable claims against individual employees of the corporation due to lack of scienter, could a claim against the corporation be sustained, nonetheless, based on the theory that the combined knowledge of employees sufficiently established corporate scienter.

In the district court, Dynex Capital Inc., along with its subsidiary Merit Securities Corp. and two officers of the corporation, faced a putative class action for alleged violations of Section 10(b) of the Securities Exchange Act of 1934 in connection with the sale of asset-backed bonds. In June of 2006, Judge Harold Baer of the Southern District of New York dismissed the case against the individual defendants, finding that the plaintiffs did not adequately plead the requisite "scienter" for a §10(b) claim. Notably, however, Judge Baer did not dismiss the claims against the corporate entities. Applying what is known as the "collective" or "corporate" scienter theory, the court held that a plaintiff "may … allege [] scienter on the part of a corporate defendant without pleading scienter against any particular employees of the corporation." Recognizing that "there is substantial ground for difference of opinion" with respect to pleading collective scienter, Judge Baer subsequently certified the case for immediate appeal to the Second Circuit.

Over the past year, the Dynex appeal has garnered considerable attention, with over a dozen amicus curiae briefs filed by individual states, banks, pension funds, and other interested parties. Oral Argument is scheduled for January 30, 2008, before Judges Walker, Calabresi and Pooler.

High Court Ruling Reaffirms Limits on Private Right of Action under Section 10(b)

The U.S. Supreme Court, in a 5-3 decision written by Justice Anthony Kennedy, ruled that investors do not have a private right of action under Section 10(b) of the Securities Exchange Act of 1934 against third parties in corporate-fraud cases unless they relied on statements or representations by those parties when making investment decisions.

The high court affirmed a lower court ruling that had barred an investor lawsuit against Scientific-Atlanta, Inc., now a unit of Cisco Systems, Inc., and Motorola, Inc. The companies, vendors for cable company Charter Communications Inc., were alleged to have participated in a cable control box sales scheme that inflated Charter's revenue by $17 million in a much larger accounting scheme. The defendants, however, had no role in preparing or disseminating the alleged misleading financial statements to investors.

At issue in this case was whether a secondary actor could be liable under Section 10(b) if it engaged in deceptive conduct that was never disclosed to the investing public but had the purpose and effect of creating a false appearance of fact to further a scheme to misrepresent an issuer's financial statements. Corporations, as well as the U.S. Justice Department, which appeared at the oral arguments, argued that allowing 10(b) liability for this type of conduct would dispense with the critical element of reliance and that a secondary actor that did not actually make or participate in the making of a false statement was at most guilty of "aiding and abetting," conduct, which the Court already ruled could not form the basis of a 10(b) claim in Central Bank v. First Interstate Bank, 511 U.S. 164 (1994).

Kennedy's opinion said investors must rely on deceptive acts in order for a civil lawsuit to succeed under federal securities laws: "Reliance by the plaintiff upon the defendant's deceptive acts is an essential element." Because the defendants did not have an affirmative duty to disclose information to the public and did not participate in the deceptive acts communicated to the public, no reliance could be demonstrated.

Kennedy was joined in the majority by Chief Justice John Roberts Jr., Antonin Scalia, Clarence Thomas and Samuel Alito. Justice John Paul Stevens authored the dissent, in which Justices David Souter and Ruth Bader Ginsburg joined. Justice Stephen Breyer took no part in the consideration or decision of the case.

CEO Found Guilty of Fraud in SEC Action

On November 19, 2007, a jury in the U.S. District Court for the District of Massachusetts found Brian Adley, a former CEO of transportation-leasing equipment company Chancellor Corp., liable for fraudulent accounting.

The action, commenced by the SEC in 2003, alleged that Adley caused Chancellor to file false financial statements in 1999 and 2000. The complaint alleged that Adley directed the fabrication of corporate documents; instructed that the fabricated documents be given to the company's auditors; and coordinated the filing of false financial statements with the SEC.

The jury found Adley liable for violating the antifraud and record-keeping provisions of the federal securities laws, for making false statements to its accountants, and for aiding and abetting Chancellor's violation of reporting and recordkeeping provisions of the securities laws.

The SEC previously settled with 10 other defendants, including Chancellor's former chief financial officer, chief operating officer, audit committee and outside auditor.

A hearing will be held on December 7 to determine the penalty in the case.

Amaranth Decision Highlights Blurred Jurisdictional Lines of U.S. Regulatory Agencies

A New York judge has denied hedge fund Amaranth Advisors’ request to prevent the Federal Energy Regulatory Commission (FERC) from pursuing an administrative enforcement proceeding against it while Amaranth is simultaneously being sued by the Commodity Futures Trading Commission (the "CFTC"), based on the same alleged misconduct.

Defendant Amaranth traded in the natural gas futures market. Brian Hunter, also a defendant, was a natural gas trader and portfolio manager at Amaranth. In April 2006, FERC observed anomalies in the prices of the March and May 2006 natural gas futures contracts on the New York Mercantile Exchange ("NYMEX"). In response, FERC and the CFTC to conducted coordinated investigations of Amaranth. On July 25, 2007, CFTC commenced its action in the SDNY against Amaranth claiming that Amaranth violated the Commodity Exchange Act by engaging in market manipulation and making false statements to the NYMEX, concerning the March and May futures trades. On July 26, 2007, FERC commenced an administrative action, based on the same conduct alleged by CFTC, and claiming violations of FERC’s Anti-Manipulation Rule.

Faced with a near identical lawsuit and administrative proceeding, Defendant Hunter, asked the Southern District of New York, to enjoin FERC—a non-party to the CFTC action—from proceeding with its administrative action pending the outcome of CFTC’s suit. Although Judge Denny Chin "agree[d] that it would be prudent for FERC to defer to this lawsuit" he declined to stay FERC’s administrative action. Specifically, Judge Chin looked to his powers to preliminary enjoin proceedings of an non-party federal administrative agency under FRCP 65 and the All-Writs Act (28 U.S.C. 1651), and determined that neither granted him the authority to enjoin the FERC proceeding. Judge Chin found that (1) FRCP 65 only applies to parties (or officers, agents, servants, employees, or attorneys of parties) to an action, and FERC, as a non-party to the SDNY proceeding could not be enjoined pursuant to the Rule; and (2) the FERC proceeding in no way threatened the jurisdiction of the Court, and thus a preliminary injunction granted pursuant to the All-Writs Act would be improper.

Hunter further argued that the CFTC has exclusive jurisdiction to prosecute Amaranth’s trading activities in the commodity markets, and thus the FERC proceeding should not go forward. The Court rejected this argument finding that under the statute, the circuit courts and not the district courts are the proper fora for defendants to challenge FERC’s jurisdiction.

This latter argument, whether the CFTC’s holds primacy over FERC as the regulator of futures markets, has been the subject of some debate.

SEC to Weigh Effect of Securities Litigation on U.S. Companies

The U.S. Securities and Exchange Commission intends to hold public hearings next spring in an attempt to gauge the effect shareholder litigation is having on U.S. companies, and specifically to evaluate whether such litigation is making companies less competitive. The roundtable was spurred by recent studies suggesting that litigation has had a detrimental effect on the U.S. market.

New Mortgage Bill Could Create Liability For Bankers and Lenders

On October 23, 2007, the chair of the House Committee on Financial Services introduced a bill aimed at restricting abusive lending that could result in a surge of litigation by borrowers against banks that package mortgage securities.

The legislation, introduced by Rep. Barney Frank (D-Mass.) and titled “The Mortgage Reform and Anti-Predatory Lending Act of 2007,” was drafted in response to the sudden surge in mortgage defaults and foreclosures., and is specifically designed to protect future borrowers. Among other things, the bill would:

• bar mortgage lenders and brokers from receiving incentive payments to sign up borrowers for overly expensive loans;
• force lenders to give borrowers a range of suitable loan options and to make sure the consumer has a reasonable ability to repay the loan;
• make banks that package mortgage securities into investments explicitly liable for violations of lending laws under certain conditions;
• require mortgage brokers and bank loan officers to be licensed by state or federal authorities; and
• enact strict limits, but not an outright ban, on penalty charges made to borrowers who make their payments early.

Under the bill, banks that package mortgage securities would be legally responsible for loans that violate minimum standards, and borrowers would be granted the right to file a lawsuit to get any such loan nullified.

According to Frank, the bill reflects a common sense principle: "People should not be lent money that’s beyond what they can be expected to pay back."

There are, however, many concerns related to the bill including the increased regulatory burden on federally insured depository institutions, the proposals failure to establish a uniform underwriting standard as states could still pass more aggressive rules, and the extension of liability to the secondary market – i.e., investment banks that fund loans.

Stoneridge v. Scientific-Atlantic, Inc.: Supreme Court Revisits Aiding and Abetting Liability Under the Securities Laws

On October 9, 2007, eight justices of the United States Supreme Court (Justice Stephen Breyer had recused himself) heard oral argument in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., No. 06-43. The potentially significant impact of the case on the securities laws of the United States was evidenced by the more than two dozen amici submissions and a courtroom packed with spectators. At issue is whether two vendors of cable television boxes, who participated in transactions with Charter Communications, Inc. ("Charter") that allegedly were improperly accounted for in Charter’s financial statements, are subject to claims under § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5(a) and (c) when the vendors neither made nor caused to be made direct statements to Charter’s shareholders. The scope of any scheme liability calls into sharp focus the Supreme Court’s ruling in Central Bank v. First Interstate Bank, 511 U.S. 164 (1994), where the Court held that "a private plaintiff may not maintain an aiding and abetting suit under § 10(b)" id. at 191, finding that § 10(b) "prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act" and "does not include giving aid to a person who commits a manipulative or deceptive act." Id. at 177.

Petitioner alleged that Respondents participated in a scheme whereby Charter deliberately overpaid for the vendors’ products. The vendors purportedly used these overpayments to purchase advertising from Charter. Charter then allegedly booked the "advertising" funds as additional revenue. Petitioner’s counsel Stanley Grossman argued that Respondents conduct enabled Charter to misrepresent its financial statements. Grossman stated that a § 10(b) claim was cognizable because Respondents 1) directly engaged in deceptive conduct, creating documents falsely suggesting that there was a legitimate reason for the increased payments for their cable boxes, and 2) did so, either knowingly or recklessly in furtherance of the scheme to defraud its shareholders by improperly inflating Charter’s revenues. Grossman asserted that in the context of scheme liability, "[i]t’s not enough just to have the deceptive act. The deceptive act for scheme liability has to be with the purpose of furthering a scheme to defraud its investors." (Transcript of Oral Argument ("Tr.") at 8.)

Justices Scalia, Alito and Chief Justice Roberts focused on the issue of whether the Court should expand aiding and abetting liability in light of Congress’s active role in passing relevant legislation since the Court’s Central Bank opinion. Chief Justice Roberts offered, "Why shouldn’t we be guided by what Congress did in the action to the Central Bank case? There we said there’s no aiding and abetting liability, Congress amended the statute in 20(e) to say yes, there is, but private plaintiffs can’t sue on that basis. Why shouldn’t that inform how we further develop the private action under 10b-5?" (Tr. at 11-12.) The Chief Justice suggested that "we should get out of the business of expanding [private right of action] 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)." (Tr. at 7.) Justice Souter questioned whether the test propounded by Petitioner was "making a distinction that in the real world is not a distinction?" (Tr. at 20.)

Respondents argued that Petitioner was asking the Court "to expand an implied [private] cause of action by diluting traditional requirements such as the reliance requirement and by eroding this Court’s precedent in the Central Bank case." (Tr. at 26.) Respondents’ counsel, Stephen Shapiro, continued, "The Court has said in the past that it must be very cautious about expanding implied causes of action, but here there are special reasons for caution. … Congress wanted cases like this one to be handled by an expert and disinterested administrative agency." (Tr. at 26.)

Justice Ginsberg asked Respondents’ counsel whether there is "a ’middle category’ between Charter, who is clearly primarily liable, and Central Bank, that didn’t do anything deceptive." (Id.) Respondents asserted that "[i]ndependent actors that don’t speak to the markets and cause direct reliance on their statements are aiders and abettors. And they are supposed to be dealt with by the SEC, an expert agency." (Tr. at 41.) The government’s counsel, Deputy Solicitor General Thomas G. Hungar, amplified this point, stating that creation of a new private right of action was not necessary to hold such actors responsible. Both Respondents’ and the government contended that Congress had determined that the SEC was in best position to evaluate whether such conduct should be prosecuted. Mr. Hungar maintained that the SEC could prosecute theses claims and investors would be able to recover monetarily under the fair funds provision of the Sarbanes-Oxley Act.

Justice Souter also questioned Respondents whether it was possible for an overlap to exist between a primary actor and an aider and abettor which would permit a middle category of (presumably liable) actors. Respondents countered that there are only two separate categories as Central Bank itself provided: a primary violator makes a statement to the market upon which investors rely and an aider and abettor does not. But Justice Ginsburg observed that Respondents’ failure to make any statement was the very "essence of the scheme." (Tr. at 35.) She stated that Respondents did not need to say anything because "they set up Charter to make those statements, to swell its revenue – revenue that it in fact didn’t have." (Id.)

During Respondents’ argument, Justice Kennedy asked whether liability would attach to an outside attorney or accountant who deliberately prepares a false statement intended for investors and gives it to the primary actor to disseminate to the market. Respondents distinguished that situation by observing that if an outside accountant or lawyer prepared such a statement and it was attributable to him or her, then liability would attach because such conduct is made to the market and induced investor reliance.

The Court is expected to issue a decision in the first half of 2008.