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October 24, 2016

FINRA Proposes Rule Changes Aimed to Increase Protection of Vulnerable Clients

On October 19, 2016, the Financial Industry Regulatory Authority, Inc. (FINRA) filed a proposed rule change with the Securities and Exchange Commission in an effort to combat the exploitation of senior and vulnerable investors. The proposed rule change would amend FINRA Rule 4512 to require firms to make “reasonable efforts to obtain the name of and contact information for a trusted contact person upon the opening of a non-institutional customer’s account.” Perhaps more significantly, the change would provide for the adoption of new FINRA Rule 2165 entitled “Financial Exploitation of Specified Adults.” This proposed rule would permit firms to temporary freeze withdrawals from the accounts of “specified adults” when there is a “reasonable belief” that those customers are being financially exploited. The rule would define “specified adult” as: (A) a natural person age 65 and older; or (B) a natural person age 18 and older who the member reasonably believes has a mental or physical impairment that renders the individual unable to protect his or her own interests.

In support of the proposed rule change, FINRA cited its experience with the FINRA Securities Helpline for Seniors as evidence that the financial exploitation “of seniors and other vulnerable adults is a serious and growing problem.” FINRA also took note that certain states have passed laws aimed at preventing such exploitation and cited the North American Securities Administrators Association’s model state act in support of its view that investors would benefit from the propagation of a “uniform national standard.”

Keywords: securities litigation, FINRA, rule change, 4512, seniors, specified adults

Joshua D. Jones, Bressler, Amery & Ross PC, Birmingham, AL


August 23, 2016

Ethics Board Explains Proper Conduct under Flat-Fee Arrangements

A new advisory opinion clarifies the propriety of flat-fee arrangements and the manner in which uch fees must be accounted for. According to the Ohio Supreme Court’s Board of Professional Conduct, the state’s Rules of Professional Conduct require a lawyer to deposit flat fees and expenses paid in advance for representation into a client trust account, and the lawyer can only withdraw funds as the fee is earned or as expenses are incurred. This requirement runs counter to the Board’s prior guidance, which instructed that flat fees be placed in the lawyer’s account. The revision brings Ohio’s position more in line with those of other states.

Fee Timing Is Crucial
“A flat fee is a type of fixed fee,” the opinion explained, noting that while “the terms ‘fixed fee’ and ‘flat fee’ are afforded the same meaning and are used interchangeably. . . . there are other types of fixed fees, such as a fixed hourly rate” and “[a] fixed fee may not necessarily be a ‘flat fee.’” When a flat fee is earned affects whether it must be placed in the lawyer’s trust account, the opinion held. Fees that are paid upfront but that have not yet been earned are still the client’s and must be placed in the trust account.

Conversely, an “earned upon receipt” flat fee is deemed earned upon payment regardless of the amount of future work performed. Those fees are considered the lawyer’s and should not be placed in a trust account. Doing so would impermissibly commingle a lawyer’s funds with those of a client. Regardless of whether the fee is designated as “earned upon receipt” or “nonrefundable,” the lawyer must advise the client that the client may be entitled to a refund if the lawyer fails to complete the representation for any reason.

“One thing that leads to the need for an opinion like this is that we think we know what these terms mean, but their meanings seem to be changing over time,” observes Gregory R. Hanthorn, Atlanta, GA, cochair of the ABA Section of Litigation’s Federal Practice Task Force. “Even careful lawyers might equate the terms flat fee and fixed fee. The Ohio opinion does a better job of defining its terms than some others, noting a flat fee is a type of fixed fee,” he adds.

Foregone Work a Consideration in Evaluating Reasonableness
“One of the issues that the Ohio opinion punted with, as do all of the other opinions in this area that I’ve seen, is how much weight to give to Model Rule 1.5(a)(2)—the likelihood that accepting this representation will preclude the lawyer from other employment, especially in the context of a criminal case,” Hanthorn remarks. “That is the single most significant thing that a criminal lawyer, particularly in a multi-defendant case, is giving up on day one. That can happen in an instant, as soon as he or she accepts representation of the client,” he explains.

Hanthorn notes that Georgia’s flat-fee rule, like Ohio’s, tracks Model Rule 1.5. The Georgia opinion expressly states “there is nothing in this obligation that prohibits an attorney from contracting for large fees for excellent work done quickly. When the contracted for work is done, however quickly it may have been done, the fees have been earned and there is no issue as to their non-refundability.” Like the Ohio opinion, the Georgia opinion recognizes that the “likelihood that the acceptance of the particular employment will preclude other employment by the lawyer” is a factor the attorney must consider in determining fee reasonableness under Rule 1.5. This preclusion, therefore, should be considered part of the attorney’s services in agreeing to represent a client.

Differing Views
“In my experience, in-house lawyers love flat-fee arrangements because it gives them some certainty, and they value certainty over a lot of other considerations,” says Joshua D. Jones, Birmingham, AL, cochair of the Section of Litigation’s Securities Litigation Committee. “There are three things to take into account before agreeing to a flat-fee arrangement,” Jones advises. “First, they work best in the litigation context when you are dealing with a series of cases with underlying similarities. Second, it’s important that both the client and the lawyer have experience with the type of case. It is difficult to build a flat-fee arrangement that works for both sides if one or both sides have a level of uncertainty with the type of work involved. Third, it’s important to have a process built in to the agreement that allows you to take specific matters out of the flat-fee structure.”

Unlike Ohio, however, not all states recognize an “earned upon receipt” designation, Jones cautions. “The concept of fees being earned upon receipt was rejected by Alabama,” he recalls. “In Alabama, if you have a flat fee, that money goes into the trust account, not to be distributed until earned. Even if it weren’t required by the Alabama opinion, I think that’s good business practice.” Similarly, Missouri does not allow funds to be “earned upon receipt.” Therefore, attorneys with offices in multiple states should be especially careful in how they approach flat fees and trust accounts.

Keywords: securities litigation, flat fee, fixed fee, Model Rule 1.5

Katerina E. Milenkovski, Columbus, OH.  This piece originally appeared in Litigation News on July 7, 2016.


July 28, 2016

Fifth Circuit Elaborates on the Two-Step Test for Assessing "Scienter" Under the PSLRA

Passed in response to a perceived rise in frivolous securities strike suits, the Private Securities Litigation Reform Act (PSLRA) imposes heightened pleading standards on plaintiffs who bring claims under the federal securities laws. In particular, the PSLRA significantly heightens the pleading requirements for a plaintiff’s allegations of “scienter,” or the fraudulent actor’s state of mind. The PSLRA requires a plaintiff to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C. § 78u-4. In the Fifth Circuit, that required state of mind is “an intent to deceive, manipulate, defraud or severe recklessness.” Lormand v. US Unwired, Inc., 565 F.3d 228, 251 (5th Cir. 2009). In two recent cases, the Fifth Circuit elaborated on the two-step test courts in this circuit should apply to analyze the “severe recklessness” standard in the context of circumstantial evidence of scienter: Owens v. Jastrow, 789 F.3d 529, 535 (5th Cir. 2015), and Local 731 I.B. of T. Excavators & Pavers Pension Trust Fund v. Diodes, Inc., 810 F.3d 951, 957 (5th Cir. 2016).

Owens arose from one of the largest bank failures in United States history, the collapse of Guaranty Bank. Damian Paletta, Guaranty Bank is 81st to Fail, Wall Street Journal, Aug. 22, 2009, (“Guaranty's collapse marks the 10th largest bank failure in U.S. history.”) The plaintiff-stockholders were wiped out by the failure. They brought claims against the bank’s former executives, alleging the executives made false statements in financial reports about the bank’s mortgage-backed-securities (MBS) losses to hide the bank’s insolvency. The principal issue in the case concerned whether the plaintiffs had pled sufficient facts to create a strong inference of scienter. Although recognizing there were other methods of analysis, the Fifth Circuit endorsed a two-step test for evaluating scienter. First, the district court would look “to the contribution of each individual allegation to a strong inference of scienter, [then second] the court must follow this initial step with a holistic look at all the scienter allegations.” 789 F.3d at 537.

In support of scienter, the Owens plaintiffs pointed to the defendant executives’ knowledge of Guaranty’s undercapitalization, the executives’ motive to raise additional capital to ward off insolvency, red flags indicating that the MBS portfolio was deteriorating, the large magnitude of the accounting irregularities, and internal warnings about faulty MBS modeling. The court noted that while knowledge and motive could contribute to a finding of scienter, allegations of motive and opportunity, without more, were not enough. Id. at 539–40. The court downplayed the motive, noting that all corporate insiders share the goal to raise capital. The court found that the public nature of the red flags, which were disclosed in financial reports, negated any inference of scienter. Id. As to the size of the accounting write-off, any inference of scienter was mitigated because valuing MBS involved “subjective accounting concepts that can yield a wide range of reasonable results,” a fact that had been disclosed. Id at 541. As for the warnings about faulty valuation models, the court noted that the warnings were contradicted by other outside information the defendants received from rating agencies, and it was not severely reckless for the executives to rely on the rating agencies rather than an internal warning. Id. at 544.Turning to the holistic analysis, the court found that the Owens plaintiffs’ allegations together failed to establish a strong inference of scienter sufficient to satisfy the PSLRA’s requirements.

Local 731 arose from a semiconductor manufacturer’s losses in connection with labor shortages in a Chinese factory. The company had previously disclosed the potential for labor problems, but its stock declined markedly when the company downgraded its financial guidance based on the labor shortages. The plaintiff stock purchasers sued the company and two executives, alleging that the company and executives had failed to disclose material information about the labor shortages. In support of scienter, the plaintiffs pointed to three facts: The executives must have expected and consciously disregarded the reaction of workers to the company’s harsh labor practices, the company shipped orders early to disguise coming financial problems, and the defendant executives sold shares of the company’s stock prior to announcing the full extent of the labor problem. Again, the court engaged in the two-step analysis, considering each allegation of scienter separately and then looking at the evidence holistically. As for the allegation that the executives should have expected workers’ response to the company’s harsh labor practices, the court noted that “an officer’s position with a company does not suffice to create an inference of scienter” and the plaintiffs had not pointed to any special circumstances that would suggest the executives were on particular notice of the problems here. 810 F.3d 958–59. The court dismissed the early shipping as evidence of scienter, noting that the practice was legal and could be supported by legitimate reasons, and there was no evidence the early shipping was an intentional effort to conceal the labor shortage. Id. at 960. Finally, in regard to the insider trading, the court noted that insider trading by itself cannot create a strong inference of scienter and refused to infer scienter from a single insider selling only 12 percent of his holdings. Id. at 960–61. The court then engaged in a cursory “totality of the circumstances” analysis, finding that the allegations taken as a whole failed to give rise to a strong inference of scienter. Id. at 961.

Other circuits have criticized the Fifth Circuit’s two-step approach, noting, “[The] method of reviewing each allegation individually before reviewing them holistically risks losing the forest for the trees,” and is “an unnecessary inefficiency.” Frank v. Dana Corp., 646 F.3d 954, 961 (6th Cir. 2011). As these two cases demonstrate, however, the Fifth Circuit appears to remain committed to engaging in a two-step test for reviewing allegations of scienter, particularly in cases that rely on circumstantial evidence.

Keywords: securities litigation, scienter, PSLRA, Fifth Circuit, Owens, Local 731

Jason W. Burge, Fishman Haygood, L.L.P., New Orleans, LA


June 10, 2016

Pro-Defense Post-Halliburton II Circuit Court of Appeals Ruling: IBEW Local 98 Pension Fund v. Best Buy

The Best Buy decision out of the Eighth Circuit Court of Appeals, issued on April 12, 2016, is the first appellate court opinion interpreting and applying the rebuttable presumption of reliance standard at the class certification stage following the Supreme Court’s decision in Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) (Halliburton II). And it is a definite win for defendants seeking to defeat rule 10b-5 class actions. In a 2-to-1 decision, with Judge Murphy dissenting, the court reversed the trial court’s decision certifying a class of purchasers of Best Buy stock between September and December of 2010. The trial court held that Defendants had failed to rebut the Basic v. Levinson presumption by “establishing that the challenged statements did not impact Best Buy’s publicly-traded stock price.” On appeal, the Eighth Circuit concluded that the trial court misapplied the price-impact analysis mandated by Halliburton II.

Before the court on appeal was the district court’s finding of predominance under rule 23 and the question of whether the defendants had adequately rebutted the fraud-on-the-market presumption of reliance such that certification of the class was improper. The court noted that, as the Supreme Court held in Halliburton II, if a defendant rebuts the presumption, the class should not be certified because individual questions of reliance will predominate over common questions of law and fact. Therefore, establishment of the presumption “is critical to a Rule 10b-5 plaintiff’s burden to establish that a class action should be certified.”

In support of their motion for class certification, the plaintiffs submitted an expert report and event study concluding that the company’s stock price increased in reaction to three allegedly misleading statements (one in a press release and two on an earnings call two hours later), without distinguishing the effects that occurred for each. Not surprisingly, the defendants rebutted the plaintiffs’ report with their own expert’s event study and report, which found that the rise in Best Buy’s stock price occurred after the first statement (in the press release, which contained appropriate safe-harbor cautionary language about forward-looking statements, and therefore, was not actionable) but before the guidance call in which the additional alleged misstatements were made. Because the price of the stock was virtually identical right before and after the call, the defendants’ expert concluded that the statements on the call had no discernable impact on the stock price. In response, the plaintiffs’ expert issued a revised report acknowledging that the statements on the call did not “immediately increase the stock price,” but claiming that they “fraudulently maintained” the price until the corrective disclosure was made in December, when another press release was issued reporting a decline in the preceding quarter’s sales (contrary to the statements made in September about earnings being on track and in line with expectations).

The court stated that, while it was clear the plaintiffs had made a prima facie showing of the presumption of reliance for purposes of class certification, per Halliburton II, an additional question must be answered at the class certification stage. That is, whether the defendants had rebutted the presumption with evidence showing an absence of price impact, which “severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price.” The district court found that the defendants did not adequately rebut the presumption. Instead, it found the plaintiff’s expert’s revised opinion persuasive, agreeing with him that the defendant’s alleged misstatements on the call could have “further inflated the price, prolonged the inflation of the price, or slowed the rate of fall.” The Eighth Circuit disagreed, stating that the district court ignored the defendants’ “strong evidence” showing a lack of price impact—i.e., ‘the opinion of Plaintiffs’ own expert.’” (emphasis in original). Most notably, the plaintiffs’ expert’s event study showed that the statements in the press release had an immediate impact on the stock price, whereas “the confirming statements in the conference call two hours later had no additional price impact.” Additionally, the court rejected the plaintiffs’ contention that the conference call statements effected a gradual increase in the stock price, finding such theory directly contrary to the efficient market hypothesis on which the Basic presumption is founded. The problem for the plaintiffs, in essence, was that any price inflation was admittedly (by the plaintiffs’ own expert) attributable to the first statements made in the press release, which were not actionable, and not to the statements made in the conference call. Accordingly, any “correction” to the stock price following the December press release was logically linked to the non-fraudulent statements from the first press release and not to the earnings call. Thus the court reversed certification and remanded for further proceedings.

The dissent strenuously disagreed with the majority opinion, arguing that the majority misapplied the presumption of reliance standard at the certification stage. The dissent made three key points in taking issue with the majority opinion: (1) that the defendants could have rebutted the presumption (to the plaintiffs’ price maintenance theory) by showing that “the alleged misrepresentations had not counteracted a price decline that would otherwise have occurred, but they failed to do so; (2) that the majority focused on the “gradual increase” theory over the price maintenance theory, which was ignored, causing the Eighth Circuit to diverge from other circuit courts that have recognized the theory; and (3) that the court’s finding that the statements in the press release and earnings call were nearly identical was factually inaccurate and an improper finding as to materiality (of the statements on the call), which is not permitted at the class certification stage.

The impact of the Best Buy decision on pending and new securities class actions remains to be determined. Undoubtedly, the defendants will rely on the court’s reasoning rejecting the gradual price increase theory as well as its implicit rejection of the more accepted (in other circuits) price maintenance theory and seek to defeat class certification following the template of the Best Buy expert where applicable and possible. On the other side, the plaintiffs will seek to distinguish the opinion and encourage courts in other circuits to disregard it as a poorly reasoned anomaly. Regardless, in the post-Halliburton II class certification era, the score stands at defendants one, plaintiffs zero. Stay tuned.

Laura J. O'Rourke, Baker McKenzie, Dallas, TX


June 7, 2016

Who's That Peeking in My Window?: SEC Scrutiny of Private Companies

One contributing factor as to why companies stay (or go) private is to avoid the costs, burdens, and regulatory and legal risks associated with being a public company. But private companies are not as insulated from SEC scrutiny as they may think—a fact underscored by two recent events: (1) a speech by SEC Chair Mary Jo White on March 31, 2016 and (2) news reports that Theranos—a private company estimated to be worth more than $1 billion—is the subject of a current SEC investigation.

On one hand, the SEC’s expressed interest in scrutinizing private companies may not seem so convincing. The SEC has only a few tools to police the conduct of private companies, although the SEC’s most powerful anti-fraud tool—Section 10(b) and Rule 10b-5 promulgated thereunder—are applicable when private companies buy or sell their securities (with that term being defined quite broadly). The SEC also lacks the same type of visibility into the operations of private companies as it has with public companies. Private companies also tend to have larger and more sophisticated investors who can understand the risks, spot red flags, and have the financial ability to seek their own legal remedies for any harm they suffer as a result of their investment (a fact that White acknowledged in her speech).

But all that aside, it does make sense to take White at her word that the SEC is “monitoring and responding to developments in the private markets”? Here are a few key areas where private companies can expect to see the most vigilance:

Pre-IPO stage. White emphasized the importance of complying with the federal securities laws for any company anticipating or planning for an initial public offering (IPO). She also explained the importance of incorporating many of the obligations arising under those laws, such as maintaining proper books and records and having adequate internal controls. This is not particularly surprising as companies planning for an IPO already anticipate the scrutiny from the SEC that that process will bring. But pre-IPO private companies should be aware of two other tools that the SEC can utilize. First, if a company seeks to withdraw its registration statement for any reason, the SEC can refuse the withdrawal request, thereby precluding—for all practical purposes—the company from doing a private placement with a similar structure as the proposed IPO. Second, the SEC can administratively issue a “stop order” if it determines that the registration statement contains an untrue or misleading statement. Of even more consequence, the SEC can initiate an investigation into whether the registration statement contains any untrue or misleading statements, and the registration statement will not be effective while that investigation is proceeding.

Employees paid with private company stock. While investors in private companies tend to have sufficient sophistication to look out for themselves, the SEC views employees of private companies as among the more potentially vulnerable victims of any potential fraud. Accordingly, White articulated that the SEC would be vigilant with respect to private companies that issue employees stock as part of their compensation. In fact, one of the more recent and high-profile enforcement actions involving a private company focused on this issue.

Unicorns and valuation issues. White, perhaps unsurprisingly, expressed potential concern with respect to “unicorns”—private companies with valuations over $1 billion. She questioned whether the prestige and status associated with becoming (or remaining) a unicorn could lead to inflation or distortion of a company’s true value, especially given her perception that private companies do not have the same level of internal accounting resources and controls as most public companies.

Monitoring of issuances under new regulations. In passing Regulation A+ and Regulation Crowdfunding, the SEC sought to make the capital markets more accessible to smaller companies by creating more ways to sell securities without being subject to registration requirements. While the practical impact of these regulations remains open to debate, White emphasized that she has directed staff from across the SEC to monitor these issuances for potential problems or abuses.

Secondary market trading. White noted the increase in secondary markets for pre-IPO shares of private companies, and emphasized how these markets raise issues with respect to valuation and liquidity, and that the SEC would “scrutinize these emerging platforms to ensure they provide a functioning market that operates within the parameters disclosed to investors.”

In closing, the limited toolbox the SEC has to work with in regard to regulation of private companies, coupled with the lack of visibility it has into their operations, suggests that there will not be a significant uptick in the number of enforcement actions against private companies. This possibility, however, will be cold comfort to any private company that does find itself in the SEC’s crosshairs, and so private companies operating in the areas outlined above should be particularly conscious of this heightened scrutiny.

Keywords: securities litigation, SEC regulations, initial public offerings

Bret Leone-Quick, Mintz, Levin, Cohn, Ferris, Glovsky and Popeo P.C., Boston, MA


May 10, 2016

Eighth Circuit Reverses Class Certification Based on Price Impact Evidence

On April 12, 2016, the Eighth Circuit reversed certification of a class of Best Buy shareholders on the grounds that defendants had established that the alleged misstatements at issue did not impact Best Buy’s stock price. The opinion marks the first time a circuit court has applied the U.S. Supreme Court’s 2014 holding in Halliburton v. Erica P. John Fund that a defendant in a Section 10(b) case is entitled to present evidence regarding price impact at the certification stage to defeat the fraud-on-the-market presumption that, following Basic v. Levinson, may permit plaintiffs to satisfy Rule 23.

The Eighth Circuit panel, in an opinion by Circuit Judge Loken, agreed with the district court that because “plaintiffs presented a prima facie case that the Basic presumption applie[d] to their claims, defendants had the burden to come forward with evidence showing a lack of price impact.” The circuit held, however, that defendants met that burden, as they were able to show an absence of “‘front-end’ price impact.”

Plaintiffs brought claims regarding statements made by Best Buy concerning increased earnings per share (EPS) guidance in an 8 a.m. press release and related statements regarding EPS performance on a subsequent 10 a.m. conference call. The district court held that the statements in the press release were forward-looking and protected by the PSLRA’s Safe Harbor provision but found the statements in the analyst call, including the statement “we are on track to deliver and exceed our annual EPS guidance,” were not forward-looking. Claims based on the press release were therefore dismissed in August 2013. The district court denied defendants’ request to certify the interlocutory dismissal order for immediate appeal and plaintiffs then successfully moved for class certification based on Basic’s fraud-on-the-market presumption to prove the reliance element of their Rule 10b-5 claim.

At the certification stage, plaintiffs’ expert did not differentiate between the effects of the press release and the conference call with analysts. Instead, he opined that the alleged misrepresentations on the call had the same “economic substance” as the non-actionable statements made earlier the same day in the press release. In addition, plaintiffs’ event study showed that the non-actionable statements about EPS guidance in the press release had an immediate impact on the share price, whereas the statements made on the call did not. In reversing the district court’s order certifying a class, the circuit panel found that the “overwhelming evidence . . . rebutted the Basic presumption” and observed that the district court “ignored . . . that defendants . . . present[ed] strong evidence on this issue – the opinion of plaintiffs’ own expert.”

In so holding, the circuit majority rejected the plaintiffs’ argument that a price drop due to a corrective disclosure months later sufficiently established price impact, finding that the “allegedly ‘inflated price’ was established by the non-fraudulent press release,” not the subsequent statements. As a result, the plaintiffs “failed to satisfy the predominance requirement of Rule 23(b)(3), and the district court abused its discretion by certifying the class.”

Circuit Judge Murphy, dissenting, observed that plaintiffs relied on a “price maintenance” theory—i.e., that Best Buy “disclosed ‘confirmatory information’ [in the conference call] which fraudulently maintained its stock at a constant price and counteracted expected price declines.” Judge Murphy opined that Best Buy was required to rebut the Basic presumption of reliance “by producing evidence showing that the alleged misrepresentations had not counteracted a price decline that would otherwise have occurred,” which it did not do.

Keywords: securities litigation, Best Buy, Halliburton, Basic, Rule 23, class certification

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


April 11, 2016

New Regulations Impose Fiduciary Standard on Retirement Fund Brokers

On April 6, 2016, after years of discussions with the brokerage and insurance industry as well as investor advocacy groups, the Department of Labor released new regulations imposing a “fiduciary” standard on brokers that manage assets in retirement accounts, including individual retirement accounts (IRA). The new regulations require financial advisors handling IRAs and 401(k)s to act in the “best interests” of their clients and remain free of conflicts of interest. As President Obama described it in a speech to the AARP last year, “It’s a very simple principle: You want to give financial advice, you’ve got to put your client’s interests first. You can’t have a conflict of interest.” And Labor Secretary Thomas Perez was quoted as saying, “Today’s rule ensures putting the clients first is no longer a marketing slogan. It’s now the law.”

The new regulations will protect, among others, those investors rolling their retirement funds from a 401(k) plan into an IRA. This is incredibly significant as funds rolled over from 401(k)s are overwhelmingly the largest source of funds in IRA accounts. Many investors have always assumed that brokers managing their retirement funds were obligated to act in their best interests, but that has not necessarily been the case. Investments in 401(k)s have been protected by the Employee Retirement Income Security Act, which generally requires that investment advisors act as fiduciaries to plan participants and choose investments that are in an investor’s best interests. IRAs, however, were handled differently prior to the new regulations. Aside from duties imposed under state law, IRAs were governed by the Financial Industry Regulatory Authority’s “suitability” standard, which requires only that brokers recommend that their investor-clients buy, sell, or hold investments that are suitable for the investor, based on the investor’s objectives, needs, and circumstances. While the “best interests” and “suitability” standards may sound similar, they can differ significantly in practice.

For example, one operating as a “fiduciary” or under the “best interests” standard could not generally recommend an investment with a higher cost structure over another otherwise identical investment, but one subject only to the “suitability” standard may be free to recommend a higher cost investment so long as that investment otherwise meets the customer’s risk profile. While a fiduciary cannot engage in a transaction with a conflict of interest, a broker working only under the “suitability” standard may be able to recommend products promoted by companies that offer the broker higher commissions or non-cash benefits. The Department of Labor (DOL) estimates that conflicted advice causes the returns in retirement accounts to be about 1 percentage point lower annually, costing investors $17 billion every year.

Some in the brokerage industry have embraced the new regulations, explaining that they have always acted in the best interests of their clients and hoping that the new rules will level the playing field across the industry. Others complain that the new rule will require them to turn away customers with relatively small IRA accounts because of the increased costs associated with operating under a fiduciary standard and because of the increased risk of arbitrations or lawsuits.

The actual impact of the new rules is not yet clear. While the DOL made some concessions at the request the brokerage industry (including continuing to allow firms to sell proprietary products and private placements and delaying the period of time for compliance) prior to the release of the final version, the rule still may be subject to future legal challenges.

Keywords: securities litigation, fiduciary duty, retirement brokers, Department of Labor, FINRA, 401(k), IRA, ERISA

Lance C. McCardle, Fishman Haygood, L.L.P., New Orleans, LA


April 4, 2016

Second Circuit Rules in Indiana Public Retirement System v. SAIC, Inc.

The Second Circuit reversed the dismissal of securities fraud violations under Section 10(b) of the Securities Exchange Act of 1934 in Indiana Public Retirement System v. SAIC, Inc., No. 14-4140-cv, 2016 U.S. App. LEXIS 5748 (2d Cir. N.Y. Mar. 29, 2016). In its opinion, the court clarified the pleading requirements for securities fraud claims premised upon violations of Item 303 of Regulation S-K. The court also addressed the standards applicable to GAAP violations under Financial Accounting Standard No. 5 relating to disclosure of loss contingencies.

The plaintiffs sued SAIC and certain of its executive officers for materially misstating the company’s liability to the City of New York for employee fraud in an illegal kickback scheme. The plaintiffs alleged, among other things, that SAIC failed to disclose appropriate loss contingencies in accordance with GAAP as well as known trends or uncertainties likely to have a negative impact on the company’s financial condition pursuant to Item 303.

The district court initially granted the defendants’ motions to dismiss, with the exception of the plaintiffs’ claims concerning the violations of GAAP and Item 303. The defendants moved for reconsideration and won. The plaintiffs then moved for relief from the district court’s order and sought leave to file a proposed amended complaint. The district court denied the motion.

On appeal, the Second Circuit vacated the district court’s decision and remanded for further proceedings. The Second Circuit held that the district court applied the wrong standard to the plaintiffs’ GAAP allegations. Pursuant to Financial Accounting Standard No. 5, issuers must disclose a loss contingency when a loss is a “‘reasonable possibility,’ meaning that it is ‘more than remote but less than likely.’” SAIC at *17. Contrary to the district court’s holding, the “reasonable possibility” standard is only replaced by a “probability” standard when a potential claimant has not “manifest[ed]” an “awareness of a possible claim.” Id. The plaintiffs’ allegations in the proposed amended complaint demonstrated that the City of New York had already evinced its intent to file a claim against SAIC. Accordingly, the Second Circuit applied the “reasonable possibility” standard and held that the plaintiffs adequately alleged that SAIC failed to properly disclose a loss contingency in its public filings.

With regard to liability under Item 303, the Second Circuit confirmed that disclosure of trends and uncertainties are required only when the issuer has “actual knowledge of the relevant trend or uncertainty.” Id. at *22. “It is not enough that it should have known of the existing trend, event, or uncertainty.” Id. With this in mind, the Second Circuit held that the plaintiffs’ proposed amended complaint “support[ed] a strong inference that SAIC actually knew” of the ongoing kickback scheme and that the Company could be implicated and held liable. Id. at *22–23. One fact the Second Circuit relied upon in rendering its decision was the importance of the project at issue to the Company and the likelihood that it would generate significant additional revenue. Id. The Second Circuit also relied on this fact in holding that the disclosures were not “‘so obviously unimportant’ either quantitatively or qualitatively that they could not be material.” Id. at *24–25.

Finally, the Second Circuit addressed the plaintiffs’ scienter allegations. The defendants argued that it was “simply implausible” that they “deliberately conceal[ed] the ‘misconduct of rogue employees for just over two months’” because such a “brief concealment” would have yielded little if any benefit. Id. at *26–27. The Second Circuit rejected the defendants’ argument as “confus[ing] expected with realized benefits”—if SAIC believed it had more time before being exposed, then “‘the benefits of concealment might [have] exceed[ed] the costs.’” Id. at *27 (quoting Makor Issues & Rights, Ltd. v. Tellabs Inc., 513F.3d 702, 710 (7th Cir. 2008)). This theory of scienter, according to the Second Circuit, was “hardly implausible.”

Keywords: securities litigation, Securities Exchange Act of 1934, 10(b), SAIC, Second Circuit, Item 303

Adam M. Apton, Levi & Korsinsky, LLP, Washington, D.C.


March 30, 2016

Second Circuit Applies Omnicare to Statements of Opinion in Sanofi

The Second Circuit Court of Appeals affirmed the dismissal of federal law securities violations in Gen. Partner Glenn Tongue v. Sanofi, Nos. 15-588-cv, No. 15-623-cv, 2016 U.S. App. LEXIS 4107 (2d Cir. N.Y. Mar. 4, 2016). The court’s opinion focused on whether statements of opinion were actionable under the Supreme Court’s March 2015 decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318, 191 L. Ed. 2d 253 (2015).

The plaintiff-appellants in Sanofi acquired specialized financial instruments referred to as “contingent value rights,” which increased or decreased in value according to the achievement of development milestones. One of the key milestones at stake was the U.S. Food and Drug Administration’s (FDA) approval of the defendant-appellees’ new drug, Lemtrada. According to the plaintiff-appellants’ allegations, Sanofi and other senior members of management issued false and materially misleading statements of opinion. The plaintiff-appellants’ complaint included violations of Section 10(b) of the Securities Exchange Act of 1934 as well as Section 11 of the Securities Act of 1933.

The Second Circuit began its analysis by explaining how Omnicare impacted the Supreme Court’s previous rule concerning statements of opinion as set forth in Fait v. Regions Financial Corp., 655 F.3d 105 (2d Cir. 2011). Whereas Regions Financial required a plaintiff to plead that an opinion was both objectively false and disbelieved by a defendant at the time it was made, Omnicare calls only for the identification of particular and material facts going to the basis of the opinion whose omission renders it misleading to a reasonable person when read in context.

The Second Circuit then applied the Omnicare rule to three categories of allegations leveled by the plaintiff-appellants—statements concerning the expected timing of approval of Lemtrada, the expected launch of Lemtrada, and Lemtrada’s trial results. With respect to the first category, the plaintiff-appellants argued that Sanofi omitted to disclose to investors that the FDA had raised a number of objections to Sanofi’s use of a single-blind study (as opposed to the more commonly used double-blind study). The Second Circuit rejected this argument because, in its opinion, Sanofi’s statements did not conflict in sum and substance with the omitted information. Significantly, the Second Circuit held the plaintiff-appellants to a higher standard given the fact that they were sophisticated investors in complex financial instruments that were capable of understanding customs and practices within the pharmaceutical industry.

The Second Circuit affirmed the dismissal of the second and third categories of alleged misstatements for similar reasons. Sanofi’s statements concerning the expected launch of Lemtrada were too subjective to have misled a reasonable investor and, in any event, did not materially conflict with the allegedly omitted facts. Similarly, the Second Circuit rejected the plaintiff-appellants’ allegations concerning Lemtrada’s trial results, as the purported omissions involved nothing more than reasonable disagreements between Sanofi and the FDA over study data. Additionally, the Second Circuit held that the plaintiff-appellants failed to show how Sanofi’s statements concerning Lemtrada’s trial results were rendered misleading by feedback allegedly received from the FDA.

Keywords: securities litigation, Sanofi, Second Circuit, statement of opinion, Omnicare, Securities Exchange Act of 1934, 10(b), Securities Act of 1933

Adam M. Apton, Levi & Korsinsky, LLP, Washington, D.C.


February 16, 2016

SDNY Holds State Court Lacks Jurisdiction over Class Action Securities Act Claims

Judge Paul Oetken of the Southern District of New York recently held that a proposed class action asserting claims under the Securities Act of 1933 was properly removed to federal court because the state court lacked jurisdiction. In re iDreamSky Tech. Ltd. Securities Litigation, No. 1:15-cv-02514, 2016 WL 299034 (S.D.N.Y. Jan. 25, 2016). In doing so, the court addressed an issue that has "split federal district courts."

The question is whether state courts retained jurisdiction (concurrent with federal courts) over class action Securities Act claims after the passage of the Securities Litigation Uniform Standards Act (SLUSA). State courts have historically had concurrent jurisdiction over private actions under the Securities Act (unlike under the Securities Exchange Act of 1934, which from its enactment granted exclusive jurisdiction to federal courts), but SLUSA created an exception to that jurisdiction by inserting the italicized language below into the Securities Act (Section 77v):

The district courts of the United States . . . shall have jurisdiction of offenses and violations under this subchapter . . . and, concurrent with State and Territorial courts, except as provided in section 77p of this title with respect to covered class actions, of all suits in equity and actions at law brought to enforce any liability or duty created by this subchapter [emphasis added].

Section 77p was created by SLUSA, and includes these three sections, among others:

  • 77p(f)(2)(a) defines a "[c]overed class action" to include actions with at least 50 prospective class members, and in which questions of law or fact common to the class allegedly "predominate over any questions affecting only individual persons or members."

  • 77p(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 for the district in which the action is pending, and shall be subject to subsection (b)."

  • 77p(b) provides that "[n]o covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging—(1) an untrue statement or omission of a material fact in connection with the purchase or sale of a covered security; or (2) that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security."

In iDreamSky, the investor-plaintiff filed a purported class action under the Securities Act in New York state court, and the defendants removed to federal court. Thereafter, the plaintiffs moved to remand, citing the Securities Act's removal bar (contained in Section 77v), which prohibits the removal of cases arising under the Securities Act "and brought in any State court of competent jurisdiction."

Opposing the motion to remand, the defendants argued that SLUSA's amendment to the Securities Act's jurisdictional provision (granting concurrent jurisdiction to state courts "except as provided in section 77p of this title with respect to covered class action") was intended to divest state courts of jurisdiction over covered class actions brought under the Securities Act. Thus, after SLUSA, a "New York court is not a court of competent jurisdiction," and "the bar on removal does not apply." Although the plaintiff admitted that his case was a covered class action, he argued that SLUSA's reference to Section 77p was primarily intended to incorporate Sections 77p(b)–(c), which the plaintiff argued precluded only "certain state-law class actions."

Judge Oetken analyzed both arguments, and determined that the "[d]efendants have the better reading of the text." The court held that plaintiff's reliance on Section 77p(b)–(c) was misplaced: Under the plaintiff's reading, the Securities Act would "grant[] state courts jurisdiction over federal claims 'except' for certain state claims [emphasis added]. But state claims, of course, are not a subset of federal claims, excisable through an exception."

The court also determined that the defendants' reading was supported by the purpose of SLUSA, which was "to make 'federal court the exclusive venue for class actions alleging fraud in the sale of certain covered securities.'" The plaintiff's reading, in contrast, would "produce an odd result":

State-law class actions alleging securities fraud could be removed and dismissed. Federal-law securities class actions would encounter the PSLRA's procedural protections if filed in federal court. But federal-law securities class actions filed in state court would have to stay in state court and proceed without the PSLRA's protections. Taken together, the PSLRA and SLUSA would encourage plaintiffs to litigate federal securities class actions in state court, with lessened procedural protections, and they would prohibit defendants from removing such cases to federal court.

Likewise, Judge Oetken held that SLUSA's legislative history supported the defendants' reading. For example, the court cited a conference report that "explains that SLUSA 'bars from State court . . . actions brought on behalf of more than 50 persons, actions brought on behalf of one or more unnamed parties, and so-called 'mass actions.'"

Although SLUSA became law in 1998, courts are split as to its effect on state court class actions advancing claims under the Securities Act. Judge Oetken's analysis in iDreamSky reaffirms the approach adopted by district courts in the S.D.N.Y., permitting removal of such actions to federal court. On the other hand, recent decisions from the California district courts (although not unanimous) generally favor remand, and some state courts addressing the issue have ruled in favor of maintaining jurisdiction. Given the S.D.N.Y.'s deep experience applying the federal securities laws, its most recent decision in iDreamSky may be influential among other courts confronting the issue, and could result in renewed analysis within jurisdictions, like California, where courts have remanded Securities Act cases.

An interesting twist could come from the state courts, if one determines that it lacks jurisdiction to hear class action Securities Act claims. A case to watch is Beaver County Emps. Ret. Fund v. Cyan, Inc., No. 14 538355 (Cal. Super. Ct.), where the defendants in a state court action moved for judgment on the pleadings on the jurisdictional issue. The trial court denied that motion, and the defendants have filed a petition for review in the California Supreme Court (Case No. S231299).

Keywords: securities litigation, SLUSA, remand, iDreamSky, Oetken

Aaron T. Morris, Skadden Arps, Boston, MA


February 16, 2016

Latest SEC Report on Rating Agencies Resurrects Questions Concerning Conflicts of Interest

Last month, the SEC published its examination of the 10 nationally recognized U.S. statistical rating organizations or NRSROs (“2015 Summary Report of Commission Staff’s Examinations of Each Nationally Recognized Statistical Rating Organization,” December 2015). The annual report, mandated by the 2006 Credit Rating Agency Reform Act and conducted in accordance with the 2010 Dodd-Frank Act, reviewed the state of competition, transparency, and conflicts of interest at the rating agencies. In it, the SEC highlighted several examples of continued failures to manage potential conflicts of interest resulting from the agencies’ use of an “issuer pays” model. The commission’s findings resurrect questions raised in 2008 and 2014 of whether this compensation model should be improved or completely overhauled.  

In its 2015 report, the SEC identified violations mostly at the three “larger” credit rating agencies: S&P, Moody’s and Fitch. It indicated that a “larger NRSRO and three smaller NRSROs did not have sufficient policies, procedures, and controls to manage the issuer-paid conflict or to prevent analytical personnel’s access to fee or market-share information.” The SEC examination also pointed to one NRSRO without “sufficient policies and procedures to prevent prohibited unfair, coercive, or abusive practices” and whose “decision to issue an unsolicited rating of an issuer was motivated at least in part by market-share considerations.”

These findings echo those from its earlier examinations of the big three agencies eight years ago in connection with their ratings of subprime mortgage-backed products. The commission identified several issues in 2008 relating to “the management of conflicts of interest”. These stemmed from the agencies’ use of an “issuer pays” model, which creates a potential conflict between their incentive to generate business from firms seeking ratings and provide “ratings of integrity.” To remedy these issues, the commission implemented rules in 2008 (“SEC Approves Measures to Strengthen Oversight of Credit Rating Agencies,” December 3, 2008, https://www.sec.gov/news/press/2008/2008-284.htm) to increase transparency and accountability at the agencies and minimize the potential influence of issuers. These rules included required disclosure of information about underlying assets for structured products in order to potentially expose agencies whose ratings did not reflect fundamentals and were driven instead by business motives (“Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies,” July 2008, p. 27). More recently, in August 2014, the SEC adopted additional rules for the rating agencies to enhance governance and further protect against conflicts of interest (“SEC Adopts Credit Rating Agency Reform Rules,” August 27, 2014, http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542776658). These included requirements to improve disclosure of rating methodologies, performance statistics, and required certifications attesting that ratings were not influenced by other business activities. However, these new rules did not fundamentally alter the “issuer pays” model.

In spite of its repeated efforts to lessen potential conflicts of interest created by the “issuer pays” compensation model, the SEC continues to report failures in the management of these conflicts. This raises the question of whether the Commission will make further rule changes or increase its enforcement actions and disclosure requirements. The “issuer pays” compensation model has remained unchanged for many years. But, academic research finds it may lead to less timely and informative ratings; (see, for example, “Estimating the Costs of Issuer-Paid Credit Ratings,” Jess Cornaggia and Kimberly R. Cornaggia, June 2013, Review of Financial Studies, 26(10)). As of now, the SEC has not proposed any further overhaul of rating agency regulation. However, given the continuing concerns over conflicts of interest highlighted in its 2015 Summary Report, we may not have heard its last word on the issue.

Keywords: securities litigation, SEC, JP Morgan, JPM, conflicts

Pavitra Kumar, the Brattle Group, San Francisco, CA


December 30, 2015

JPMorgan to Pay $307 Million for Failing to Disclose Conflicts

On December 18, 2015, the Securities and Exchange Commission (SEC) announced that two JPMorgan Chase & Co. wealth management subsidiaries admitted wrongdoing and will pay $307 million to settle allegations that they put customers’ funds into the bank’s own investment products, which generated fees for JPMorgan, without disclosing the conflict of interest to clients.

“Firms have an obligation to communicate all conflicts so a client can fairly judge the investment advice they are receiving,” SEC Enforcement Division Director Andrew J. Ceresney stated in a press release. “These J.P. Morgan subsidiaries failed to disclose that they preferred to invest client money in firm-managed mutual funds and hedge funds, and clients were denied all the facts to determine why investment decisions were being made by their investment advisors.”

The JPMorgan subsidiaries will pay $267 million to settle charges by the SEC, including $127.5 million in disgorgement, $11.815 million in pre-judgment interest, and a $127.5 million penalty.  The $127.5 million penalty represents a record for the SEC against an asset manager; the agency’s previous record was $100 million for Alliance Capital Management, according to various news reports. They will pay an additional $40 million to resolve a parallel action brought by the Commodity Futures Trading Commission.

According to the SEC order, in May 2008, J.P. Morgan Securities, LLC (JPMS), a registered investment advisor and broker-dealer, launched its Chase Strategic Portfolio (CSP), a unified managed account program for distribution to its customers.  The SEC alleged that from May 2008 through 2013, JPMS breached its fiduciary duty to its clients by failing to disclose that it designed and operated CSP with a preference for JPMorgan-managed mutual funds.  The SEC further alleged that JPMS failed to disclose that there was an economic incentive to invest CSP assets in JPMorgan-managed mutual funds as a result of discounted pricing for services provided to JPMS by an affiliate and that less expensive mutual fund share classes were available.

Similarly, the SEC alleged that JP Morgan Chase Bank, N.A. (JPMCB) did not satisfy its disclosure duty to its clients by failing to disclose that from 2011 to 2014 it had a preference for JPMorgan-managed mutual funds, that from 2008 to 2014 it had a preference for JPMorgan-managed hedge funds, and that from 2008 to August 2015 it had a preference for third-party-managed hedge funds that shared their management and/or performance fees with an affiliate. JPMCB acts as the investment manager for certain discretionary portfolios offered to clients of J.P. Morgan Private Bank and Chase Private Bank, both of which typically serve affluent, high-net-worth and ultra-high net worth clients.

Keywords: securities litigation, SEC, JP Morgan, JPM, conflicts

Lance C. McCardle, Fishman Haygood, L.L.P., New Orleans, LA


December 22, 2015

Non-GAAP Measures: The SEC Awakens

In this holiday season, while many are focused on how the Jedi will defeat the Dark Side of the Force, others appear to be focused on what they believe is the dark side of something else: non-GAAP measures. In her keynote address at the 2015 AICPA National Conference, Mary Jo White, chairwoman of the SEC, noted that the use of non-GAAP measures “deserves close attention.” She added that “non-GAAP measures are used extensively and in some instances may be a source of confusion.” Following up on Chairwoman White’s comments, a Wall Street Journal article (“U.S. Corporations Increasingly Adjust to Mind the GAAP,” December 15, 2015) criticized companies’ increased use of non-GAAP measures in earnings releases and SEC filings. The authors claimed that such use obfuscates corporate earnings. But does it? 

Let’s examine one commonly used non-GAAP measure, adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization). Why calculate adjusted EBITDA? Generally, investors and other market participants are concerned with a company’s recurring cash earnings. Investors ultimately want cash. Non-cash earnings cannot result in cash, and investors perceive non-recurring earnings as temporary blips in a company’s ability to generate cash flows from its ongoing operations. But GAAP does not provide a measure of recurring cash earnings. To fill this void, companies and other interested parties, such as investors, M&A participants, investment bankers, and equity analysts, often calculate adjusted EBITDA as an estimation of a company’s recurring cash earnings. In addition to adding back to GAAP net income the impact of interest, taxes, depreciation, and amortization, calculations of adjusted EBITDA often include “one-time” addbacks such as restructuring charges, weather-related costs, and foreign currency gains and losses. These calculations of adjusted EBITDA, despite being labelled in the Wall Street Journal article as one form of “obfuscation,” can provide a useful, enhanced understanding of corporate earnings. The widespread use of adjusted EBITDA supports this notion.

So where’s the rub? GAAP defines interest, taxes, depreciation, and amortization, so the amount and nature of those addbacks are generally not controversial. GAAP, however, does not define other addbacks, which are then subject to subjective interpretation in their nature, type, and amount. For example, last winter’s "stormageddon" on the East Coast resulted in business interruption and other losses for many companies. Whether, and to what extent, an affected company adds back such losses in a calculation of adjusted EBITDA depends on the judgment of the company’s management.  Moreover, even if the company does not modify adjusted EBITDA for such losses, an investor or other interested party might. Without uniform guidance such as GAAP, companies and others are left to their own devices to calculate such modifications to adjusted EBITDA on a case-by-case basis. Perhaps as a result of this lack of standardization and comparability across companies, some have criticized non-GAAP measures as being, in the words of Chairwoman White, “a source of confusion.”

Complaining about non-GAAP measures does not, however, change the fundamental reason as to why companies present them: Investors demand them. Companies will continue to present them so long as investors demand them. If companies want these measures to be helpful to investors rather than “a source of confusion” or worse, a possible source of litigation, clear disclosure of the nature and calculation of such measures would serve to both enhance investors’ understanding of corporate earnings and reduce criticisms of such measures.

Keywords: securities litigation, non-GAAP, SEC, Mary Jo White, EBITDA

Adoria Lim, The Brattle Group, San Francisco, CA


December 4, 2015

Recent DOJ Memos and Investigations into Corporate Wrongdoing

Since 1999, the Department of Justice (DOJ) has issued a series of memoranda outlining the contours of criminal liability for corporate wrongdoing. The evolution of these memos over time, culminating with several recent developments, puts extra pressure on corporations to turn on its employees allegedly involved in the wrongdoing.

This article examines these recent developments and provides some general considerations for corporations if they become the focus of a DOJ investigation.

History of DOJ Policy Regarding the Prosecution of Corporations
The timeline below traces the evolution of the DOJ memos on corporate wrongdoing:

  • 1999:  Then-Deputy Attorney General, Eric Holder writes “Bringing Criminal Charges against Corporations.”

  • 2003: Deputy Attorney General Larry Thompson writes “Principles of Federal Prosecution of Business Entities.”  It is generally known as the “Thompson Memo.”

  • 2006:  Deputy Attorney General Paul McNulty writes a memo titled “The Principles of Federal Prosecution of Business Organizations.”  It is generally known as the “McNulty Memo.” 

  • 2008:  Deputy Attorney General Mark Filip writes a memo also titled “The Principles of Federal Prosecution of Business Organizations.”  This is generally known as the Filip Memo. It gives guidance regarding the prosecution of business entities and how such entities could receive credit for cooperating. The 2008 memo mentions the importance of corporate cooperation in holding individuals liable. However, despite corporate settlements increasing in number and size, individuals have historically been able to avoid liability. The DOJ has claimed that this was largely due to the difficulty in proving a specific individual’s intent.

Recent Developments in DOJ Investigations into Corporate Wrongdoing
A September 2014 speech by Deputy Assistant Attorney General Marshall L. Miller signaled that the DOJ was going to be more aggressive in pursuing individuals for corporate wrongdoing. In a September 9, 2015, memo written by Deputy Attorney General Sally Yates titled “Individual Accountability for Corporate Wrongdoing,” the DOJ definitively announced that it will aggressively pursue the individuals allegedly responsible for corporate wrongdoing. 

Before the memos, a company that wanted to receive cooperation credit had to provide any information requested, be forthcoming about its wrongdoing, and terminate the guilty employees. Under the new policies, a company must also provide all relevant facts, including any available evidence, and fully cooperate in federal criminal and civil actions against the individual wrongdoers to receive cooperation credit. A company must investigate the facts early in the process and accurately, reasonably, and promptly disclose those facts to the DOJ. According to the new policy, a company can no longer settle a case with favorable terms unless it assists in the prosecution of the individual wrongdoers from the beginning of the investigation.  In light of the new policies, corporations should give thought to how they will deal with the DOJ if they become the subject of an investigation.

Corporate Response to a DOJ Investigation
All corporations should already have a requirement that the board of directors be notified if they become the subject of a DOJ or any other governmental investigation. The directors have a fiduciary duty to the corporation and are obligated to do what is in the best interest of the corporation regardless of their relationship with officers or even other directors that may have personal liability.

Because the board cannot know the full scope of wrongdoing and all of the corporate participants before an investigation takes place, it is prudent to have an independent law firm promptly do a full investigation of the facts and report those facts back to the board. Doing the investigation internally risks the investigation becoming tainted, or—even worse—sabotaged by one or more wrongdoers if they are in a position to affect the investigation. If any members of the board are implicated, that member or those members should be recused from hearing the report while the investigation is ongoing and when making any decisions. Any implicated directors or employees should always retain their own independent counsel. Clearly there is a conflict between a corporation whose best interest may be to provide evidence against its employees and the employees themselves.

Once an investigation has been completed, the board must decide on a course of action. In most cases, full cooperation is a good idea for the corporation so that it receives cooperation credit and prevents a long battle that can be costly in terms of both money and reputation. However, in some cases, the wrongdoing may be far greater than the DOJ realizes, or the corporation may believe that it will be difficult for the DOJ to prove its case. Then a decision arises: cooperate, defend the case, or try to settle without the benefit of cooperation credit? If it appears that the DOJ knows most or all of the wrongdoing and that it likely can prove its case, there is very little downside for the corporation to cooperate. The only downside would be the loss of the guilty employees. Of course, the consequences for the employees are great.

Despite the benefits of cooperating, there is usually a knee-jerk reaction to protect the company and go into a defensive mode. However, if a corporation decides that it will defend a case, it takes the risk of a long, public battle with great monetary and reputational risks. Even if the case is won or damages and legal costs are less than a settlement, the corporation may suffer significant reputational damage. Whatever the corporation was trying to avoid coming out may be exposed anyway and in a much more public way. The corporation will receive no cooperation credit and may cause greater damage to its reputation. It also risks further prosecution by administrative regulators (e.g., the SEC) and private litigation.

Corporations should have robust compliance programs to help keep them out of the DOJ’s crosshairs. The DOJ has developed new policies that will require a corporation to provide evidence and assistance in prosecuting individual wrongdoers for the corporation to get cooperation credit. Corporations under investigation by the DOJ need to consider how to respond to such investigations in light of the new DOJ policies. Providing evidence and cooperation against its employees will frequently be in the corporation's best interest, even if it is not in the best interest of the employees.

Keywords: securities litigation, corporate wrongdoing, individual accountability, DOJ, internal investigations

David N. Mahler, the Bates Group, Miami, FL


November 12, 2015

Coscia Verdict Highlights Different Approaches to High-Frequency Trading

The jury finding that commodities trader Michael Coscia’s high-frequency trading behavior constituted spoofing will send a trader to prison. It is unclear whether this result provides useful guidance on the limits of allowed high-frequency trading conduct or will chill market activity overall. In either case, expect more Commodity Futures Trading Commission (CFTC) enforcement activity. The Coscia case resulted from the CFTC’s use of its Dodd-Frank authority, a trend which the director of enforcement, Aitan Goelman, has described as just starting (New York City Bar Association, October 16, 2015). Indeed, the CFTC recently initiated another high-frequency spoofing suit against 3Red.

These anti-spoofing cases highlight the differences between the enforcement stance of the CFTC and SEC over disruptive trading practices. SEC standards to address potentially disruptive trading have been anticipated for some time. The SEC’s plans for a new rule focus on operational integrity rather than risks posed by deliberate misconduct. As described by Mary Jo White in an October 20, 2015, speech, the SEC plan is to address “aggressive, destabilizing trading strategies by active proprietary traders in vulnerable market conditions.” This focus on preventing malfunctioning algorithms precipitating another flash crash would only proscribe certain conduct when market conditions met pre-defined vulnerability conditions. At any other time, these rules would not apply, leaving existing fraud-based rules to address trading misconduct under normal market conditions. At the November 2 SIFMA conference, the SEC’s Andrew Ceresney described market-manipulation cases as a priority for the agency and identified a spoofing case that the SEC recently resolved in an administrative proceeding (In the Matter of Briargate Trading, LLC and Eric Oscher, Exchange Act Release No. 76104, Oct. 8, 2015). However, this case did not involve manipulative high-frequency trading. The SEC’s enforcement record provides little guidance on what high-frequency trading practices constitute abuse, manipulation, or spoofing.

In Chairman Timothy Massad’s October 21 speech, the CFTC recently signaled that it too plans to introduce rules to reduce the risk of a flash crash triggered by algorithms going haywire. But the CFTC's use of its separate anti-spoofing authority remain a notable difference between its enforcement stance and that of the SEC.

As the CFTC's enforcement of its anti-spoofing rule expands, the limits of allowed conduct may become more clearly defined. The success of these enforcement actions will hinge on their ability to distinguish between desirable order cancellations associated with market making, and spoofing—defined as “submitting or canceling bids or offers with intent to create artificial price movements upwards or downwards,” 78 Fed. Reg. 31,890, 31,896 (May 28, 2013). Unfortunately, the use of criminal prosecution rather than civil fraud proceedings may delay the publication of written opinions that could clarify the practical application of the CFTC’s rule on the basis of careful economic analysis of the trading behaviors involved.

Keywords: securities litigation, Coscia, spoofing, high-frequency trading, SEC, CFTC

Paul Hinton and Shaun Ledgerwood, Brattle Group, New York City, NY, and Washington D.C.


October 6, 2015

UBS Puerto Rico Agrees to $34 Million Settlement with the SEC and FINRA

On September 29, 2015, UBS Financial Services Incorporated of Puerto Rico (UBS PR), a subsidiary of UBS Financial Services, Inc., agreed to settle charges brought by the SEC and FINRA relating to its alleged failure to reasonably supervise the sales of certain leveraged closed-end funds (CEFs) by paying fines of $34 million. In connection with the settlements, UBS PR neither admitted nor denied the charges alleged by FINRA or the SEC.

The SEC alleged in its "Order Instituting Administrative Proceedings" that “UBS PR failed reasonably to supervise [its broker] Jose G. Ramirez with a view to preventing and detecting his violations of the federal securities laws from at least 2011 through 2013.” The SEC found that Ramirez “offered and sold millions of dollars of CEFs to certain customers while soliciting them to use LOCs [letters of credit] to purchase such securities and fraudulently misrepresenting the risks of this strategy to them.” All told, Ramirez sold $50 million in CEFs to UBS PR customers from 2011 to 2013. By September 2013, the customers “had received tens of millions of dollars in maintenance calls” regarding their LOCs after the value of their leveraged CEFs declined when the Puerto Rican bond market collapsed. The SEC further found that UBS PR “had inadequate procedures or systems in place” regarding its LOC compliance policy and that it “failed to establish reasonable policies and procedures for follow-up indications of misuse of LOCs.” In addition to accepting a public censure from the SEC, UBS PR agreed to pay $15 million in disgorgement, prejudgment interest, and civil penalties.

For its part, FINRA similarly alleged in its "Letter of Acceptance, Waiver and Consent" that UBS PR “failed to establish and maintain a supervisory system and procedures reasonably designed to ensure the suitability of transactions in CEFs in certain circumstances.” FINRA specifically alleged that UBS PR failed to monitor customer concentration and leverage levels. UBS PR consented to a FINRA censure, a fine in the amount of $7.5 million, and restitution to various customers of $10,978,402.

UBS PR terminated Ramirez in January 2014; and he was permanently barred from association with any FINRA member in any capacity in August 2014. In addition, the former branch manager in Ramirez’s office agreed, in a separate settlement, to a $25,000 fine and to be suspended from supervisory roles for one year. Since October 2013, however, Ramirez has been named in at least 64 different FINRA customer complaints; and UBS PR and Ramirez are named respondents in several customer-initiated FINRA arbitration proceedings in Puerto Rico.

Keywords: securities litigation, UBS PR, Puerto Rico, SEC, FINRA

Lance C. McCardle, Fishman Haygood, L.L.P., New Orleans, LA


September 23, 2015

Second Circuit Rules in Favor of Argentina in Bondholder Dispute

In an important win for the Republic of Argentina and bond issuers alike, on September 16, 2015, the Second Circuit in Brecher v. Republic of Argentina vacated an order from the District Court for the Southern District of New York, finding that the class definition "all owners of a beneficial interest in the bonds" lacked specificity and violated the implied ascertainability requirement of Federal Rule of Civil Procedure 23. The Second Circuit found that the overly broad class definition made it impossible to determine an "identifiable and administratively feasible class." Brecher v. Republic of Argentina, No. 14-4385, slip op. at 2 (2d Cir. Sept. 16, 2015). Comparing the bondholder class definition to "[a] class defined as 'those wearing blue shirts,'" the Second Circuit explained that a class that is not time-limited and whose members are ever-changing is simply too vague to pass muster. The case is a significant victory for Argentina, a country that has faced billions of dollars' worth of lawsuits since declaring a default in 2002.

The complaint in the underlying action was filed on December 19, 2006, by Henry Brecher, individually and on behalf of all others who held a beneficial interest in a particular series of bonds issued by Argentina. The complaint alleges that Argentina promised to pay principal and interest on the bonds, but that, since it declared a moratorium on the payment of its foreign debt on or about December 23, 2001, Argentina had failed to make any payments of interest or principal on the bonds. The complaint defined the class as "all persons who from the date of class certification in this action until the date of final judgment in the District Court continuously hold beneficial interests in Bonds issued by the Republic of Argentina with ISIN XS0113833510."

The district court certified the class defined in the complaint because of its "continuous holder requirement, i.e., the class contained only those individuals who [] possessed beneficial interests in a particular bond series issued by the Republic of Argentina from the date of the complaint—December 19, 2006—through the date of final judgment in the District Court." Brecher, No. 14-4385, slip op. at 3. After the Second Circuit ruled in similar Argentinian bond cases that damages calculations were inflated due to a comparable class definition, plaintiff moved to modify the class definition, proposing that the district court remove the continuous holder requirement and expand the class to all holders of beneficial interests in the bond series. The district court granted the motion.

The Second Circuit vacated and remanded. The court wrote that "[l]ike our sister Circuits, we have recognized an implied requirement of ascertainability' in Rule 23 of the Federal Rules of Civil Procedure," and "that the touchstone of ascertainability is whether the class is 'sufficiently definite so that it is administratively feasible for the court to determine whether a particular individual is a member.'" Brecher, No. 14-4385, slip op. at 4–5 (citations omitted). The Second Circuit rejected the argument that reference to objective criteria is sufficient to meet the ascertainability requirement, finding that "the use of objective criteria cannot alone determine ascertainability when those criteria, taken together, do not establish the definite boundaries of a readily identifiable class," and that the objective standard in the case—owning a beneficial interest in a bond series—was "insufficiently definite to allow ready identification of the class or the persons who will be bound by the judgment." Id. at 6–7 (citation omitted). The Second Circuit noted in particular that the fact that the Argentinian bonds are traded on the secondary market would make it especially difficult to identify potential members of the class. The decision is good news for Argentina, as well as other bond issuers, as it makes clear that amorphous class definitions will be rejected and leaves open the possibility that damages may not be available on a class-wide basis.

Keywords: securities litigation, Argentina, rule 23, ascertainability, Brecher

Abigail Sheehan, Skadden Arps, New York City, NY


September 23, 2015

Second Circuit Denies Employees' Arbitration Bid

The Second Circuit recently affirmed the Southern District of New York’s decision to enjoin two Citigroup employees from proceeding with their FINRA arbitration based on the employees’ failure to properly opt out of a class action settlement. The case is Burgess v. Citigroup Inc., Case No. 13-3014-cv (2d Cir. September 14, 2015). One employee failed to properly complete his opt-out form and also mailed it to the incorrect address.  The second signed a release during the settlement discharging all subsequent claims and received a $43 settlement check in August 2012. Both employees filed a FINRA arbitration in December 2013.

The court rejected the first employee’s contention that “excusable neglect” entitled him to arbitrate his claims. The court additionally found no abuse of discretion in the district court’s determination that the employees’ FINRA actions were based on the same factual predicate as the underlying claims in the settled class action, as both centered on the employees’ allegations that Citigroup’s stock (which they received in part as equity compensation) was overvalued due to its misrepresentations about exposure to toxic assets. 

The court acknowledged that both employees had added additional facts to their FINRA statement of claim, but found that the new facts were not necessary to prove Citigroup’s liability and therefore did not establish a different factual predicate from the settled litigation. Additionally, the Second Circuit rejected the employees’ contention that their interests were not adequately represented during the class action settlement because they received their stock as part of equity compensation, whereas the other class plaintiffs received their stock outside an employment relationship. The court found that the class settlement was designed to compensate all participants for losses from Citigroup stock, no matter how acquired. Lastly, the court upheld the district court’s determination that the class action settlement superseded the employees’ prior agreement to arbitrate, because the settlement agreement expressly released any and all claims, including those originally agreed to arbitrate.

Keywords: securities litigation, FINRA, arbitration, Citigroup

Catherine Phillips Crowe, Bressler, Amery & Ross, P.C., Birmingham, AL


September 23, 2015

Judge Sheindlin Rules in In re Vivendi Universal, S.A. Securities Litig.

Following a jury trial on class action securities fraud claims, Judge Shira Scheindlin of the Southern District of New York determined that one class member was not entitled to a recovery because it did not rely on a false statement when it purchased the company's stock. In re Vivendi Universal, S.A. Securities Litig., No. 02-cv-5571, 2015 WL 4758869 (S.D.N.Y. August 11, 2015). Her ruling is one of only a handful of cases in which a defendant had an opportunity to challenge the presumption of reliance on market price on an evidentiary record.

In the Vivendi action, a class of investors asserted securities fraud claims based on certain statements about the company's liquidity. After a verdict for the plaintiffs on class-wide issues of liability, Judge Scheindlin established post-trial proceedings to adjudicate individualized issues of reliance and damages. Within those proceedings, the defendants challenged whether one class member—a "value investor" that used a "price-value ratio" to identify underpriced stocks—relied on the market price when purchasing Vivendi shares.

By way of background, a plaintiff in a securities action may prove reliance in two ways: either directly by proving that he relied on a false statement that was believed to be true, or indirectly by proving that he relied on the "integrity of the market price," which unbeknownst to the investor was compromised by a false statement. The latter method of proving reliance was established by the Supreme Court in Basic v. Levinson, 485 U.S. 224 (1988), which held that investors who buy and sell stock in well-developed, impersonal markets are entitled to a presumption of reliance at class certification under certain circumstances. Basic also made clear, however, that the presumption of reliance is rebuttable by "[a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price."

In Vivendi, Judge Scheindlin determined that the value investor had purchased a large block of Vivendi shares after four of the nine corrective statements were made, and the investor admitted that "none of the nine corrective disclosures" had "corrected any misunderstanding" about the value of Vivendi's business. Indeed, the trader responsible for purchasing Vivendi shares testified that he "was not misled" by the allegedly fraudulent statements, and described the company's liquidity crisis as "overblown." Moreover, the investor's decision to purchase Vivendi shares depended "heavily" on its proprietary price-to-value formula, which used market price only as a comparator:  The investor sought to purchase companies with shares priced at 60 percent or less of the investor's proprietary valuation. In light of that evidence, Judge Scheindlin held that the investor had not relied either directly on a false statement or on the integrity of the market price when deciding to purchase Vivendi shares. The court noted the "key difference" between relying on market price as a comparator in a trading formula, as the value investor did here, and "relying on the integrity of the market price," as required by Basic to demonstrate reliance.

Judge Scheindlin rejected the plaintiffs' contention that the Supreme Court's decision in Halliburton Co. v. Erica P. John Fund (Halliburton II), 134 S. Ct. 2398 (2014), precluded this defense. In Halliburton II, Chief Justice John Roberts noted that a "value investor" may rely on the price of a stock so long as he traded "on the belief that the market price will incorporate public information within a reasonable period."  Judge Scheindlin agreed that read "in isolation" that portion of Halliburton II supported the plaintiffs' position because the value investor's trading strategy "derived," in part, from market price, and the investor hoped that the market price would "move in the direction" of its proprietary valuation. But Halliburton II considered the reliance element at class certification, where investors are entitled to a presumption of reliance under certain circumstances. The Court in Halliburton II did not intend to "jettison" the presumption of reliance at class certification in favor of an "iron-clad" rule that investors always rely on market price. Indeed, Judge Scheindlin noted that the Halliburton II decision acknowledged that not all investors will "rely on the security's market price as an unbiased assessment of [its] value," and the evidence in this case demonstrated that the value investor did not rely on market price.

The Vivendi decision may be noteworthy less for its holding than simply the court's opportunity to consider the element of reliance on a fully-developed factual record. In the years following Basic, the question of how to rebut the presumption of reliance on an investor-by-investor basis has been overshadowed by the question of when the challenges can be made. In Halliburton II, the Court confirmed a defendant's right to challenge the class's entitlement to the presumption at class certification. But it also held that if the plaintiffs can prove the "prerequisites for invoking the presumption," a class may be certified, even if doing so "leav[es] individualized questions of reliance in the case" for adjudication down the line. Whether or not such an approach makes sense in theory, as Justice Thomas noted in his dissent in Halliburton II, the "in terrorem settlement pressures brought to bear by certification" all but preclude defenses deferred until the merits stage. Yet, notwithstanding these procedural hurdles, it is likely that many class members would be unable to prove reliance if required to do so. The Vivendi decision therefore offers a glimpse into a successful challenge to a sophisticated investor's reliance on market price, and suggests that such challenges—when the opportunities arise—may be more successful than not.

Keywords: securities litigation, Vivendi, Judge Sheindlin, reliance, rebuttable presumption

Aaron T. Morris, Skadden Arps, Boston, MA


September 14, 2015

Second Circuit Rules in Acticon AG v. China North

In Acticon AG v. China North East Petroleum Holdings Ltd., No. 15-172, 2015 U.S. App. LEXIS 15187 (2d Cir. N.Y. Aug. 28, 2015), the Second Circuit provided guidance on what allegations may be sufficient to plead scienter in a Section 10(b) claim.

China North East Petroleum was an oil exploration and production company based in the People’s Republic of China. Wang Hung Jun, the company’s chief executive officer, owned approximately one-third of the company’s outstanding stock. Mr. Jun’s mother and brother-in-law sat on the company’s board of directors. Between 2008 and 2010, the company and its executive management allegedly misled investors by inflating oil reserve estimates, accounting improperly for warrants, and transferring corporate funds to personal accounts.  When the truth emerged in 2010, investors discovered that the company’s income had been inflated by almost 100 percent during certain reporting periods. Restatements followed along with revelations of material weaknesses over internal controls and abrupt resignations from senior management. China North’s stock declined by over 50 percent in connection with the company’s revelations, falling to $4.42 per share from $9.37 per share over the course of several months. The plaintiffs filed suit in the Southern District of New York shortly thereafter.

In January 2015, the district court dismissed the plaintiff’s claims against China North, Wang, and the remaining defendants. According to the district court, the plaintiff’s allegations concerning the company’s internal controls and illicit transfers of funds did not give rise to the requisite strong inference of scienter.

On August 28, 2015, the Second Circuit issued a summary order vacating the dismissal of the claims against China North and Wang and affirming the remainder of the decision. The court found that the Plaintiff had adequately pled Wang’s “motive and opportunity to commit fraud” by alleging that, “[a]s China North’s former CEO, Wang signed all of the relevant SEC filings attesting to the company’s internal controls, while allegedly simultaneously looting China North’s treasury and engaging in unauthorized transfers of company funds.”  Further, because Wang was CEO, his scienter could be imputed to China North.

In affirming the dismissal of the claims against other defendants, the circuit noted that while defendant Ju Guizhi may have been involved in the transfers, the plaintiff failed to allege that she “reviewed or signed any of the allegedly false SEC filings, and thus [there was] no basis to conclude that she made a material misrepresentation.” Similarly, the Second Circuit held that the plaintiff had not adequately alleged scienter for the remaining defendants based on failure to identify defects in China North’s internal controls or GAAP violations, observing that generally “failure ‘to identify problems with [a] defendant-company’s internal controls . . . does not constitute reckless conduct sufficient for 10(b) liability.’”

The case has been remanded to the district court for further proceedings.

Keywords: securities litigation, China North East Petroleum, scienter, Second Circuit, internal controls, restatement, Securities Exchange Act of 1934, 10(b)

Adam Apton, Levi & Korsinsky, LLP, Washington, D.C.


September 10, 2015

Dole Insiders Liable for $148 Million Following Merger

The Delaware Court of Chancery issued a post-trial opinion on August 27, 2015, finding Dole Food Co. Inc. CEO David Murdock and general counsel C. Michael Carter liable for $148 million in damages as a result of their conduct in connection with a 2013 transaction in which Murdock—then Dole's 40 percent shareholder, chairman, CEO, and "de facto controller"—acquired all of the company's common stock. Vice Chancellor Laster found that Murdock and Carter fraudulently drove down the share price and deprived the board and shareholders of information necessary to fairly consider the transaction.

Although Murdock conditioned his proposal on approval from a board committee of disinterested and independent directors and a vote in favor by a majority of the unaffiliated shares, the court, applying an entire fairness standard of review, found these steps insufficient under the circumstances, where Murdock and Carter “sought to undermine the Committee from the start.” The court held that “what the Committee could not overcome, what the shareholder vote could not cleanse, and what even an arguably fair price does not immunize, is fraud.”

The court found that Murdock and Carter took various steps to depress the share value, including suspending a share repurchase program, while Carter gave the merger committee “lowball management projections” and provided Murdock’s advisors with more positive and accurate numbers the following day. These actions “deprived the Committee of the ability to negotiate on a fully informed basis and potentially say no to the Merger.” They also “deprived the stockholders of their ability to consider the Merger on a fully informed basis and potentially vote it down.” Moreover, these acts “were not innocent or inadvertent, but rather intentional and in bad faith.”

Under the circumstances, the court found, even if the $13.50 per share transaction price was fair, the stockholders "are not limited to a fair price. They are entitled to a fairer price designed to eliminate the ability of the defendants to profit from their breaches of the duty of loyalty." As a result, the court award damages of $2.74 per share, which it noted was "conservative relative to what the evidence could support," with pre- and post-judgment interest compounded quarterly.

The court found no evidence that the remaining defendants, including Murdock's financial adviser, Deutsche Bank, were liable. The court determined that the bank was not liable for aiding and abetting because it did not knowingly particulate in the fraudulent conduct or causally contribute to damages.

Keywords: securities litigation, entire fairness, duty of loyalty, Dole

Mollie Kornreich, Skadden Arps, New York, NY


August 18, 2015

District Court Rules on Class Certification in Halliburton

On July 25, 2015, the Northern District of Texas, in Erica P. John Fund, Inc. v. Halliburton Co., No. 3:02-cv-1152-M, 2015 WL 4522863 (July 25, 2015 N.D. Tex), issued its decision on class certification on remand from the Supreme Court following the Supreme Court's 2014 opinion, which clarified that price impact evidence may be introduced at the certification stage in a Section 10(b) class action. The court certified a class of investors, but only as to one of the six purported corrective disclosures alleged by plaintiffs. The decision illustrates how certification may play out in Section 10(b) cases in the wake of the high court's decision, as defendants attempt to defeat class certification through expert evidence on price impact.

The Halliburton case has been before the Supreme Court twice, first in 2011, when the Court determined that plaintiffs were not required to prove loss causation in order to certify a class, and more recently in 2014. In Halliburton II, the Supreme Court held that defendants are entitled to attempt to defeat class certification in a Section 10(b) action by rebutting any presumption of class-wide reliance on defendants’ alleged misstatements or omissions by demonstrating that they had no impact on the stock price.

On remand, the district court found that defendants successfully demonstrated a lack of price impact for five of the six alleged corrective disclosures. Northern District of Texas District Judge Barbara Lynn began by addressing two "threshold" legal issues. First, the court held that defendants had the burden on the question of price impact. Second, the court found that "class certification is not the proper procedural stage . . . to determine, as a matter of law, whether the relevant disclosures were corrective."

The court then carefully considered the event studies submitted by the parties’ experts and determined which party’s study was "more probative of price impact." Notably, the court found that using a two-day window to measure price impact, as opposed to a one-day window, was inappropriate because an efficient market could be expected to absorb news into the price "in a matter of minutes." As a result, the Court rejected both plaintiffs' argument that the price was impacted when it fell the day after a disclosure and defendants' argument, with respect to a different disclosure, that a price rebound on day two indicated a lack of price impact.

Keywords: Section 10(b), fraud on the market, price impact, event studies, Halliburton

Mollie Kornreich, Skadden Arps, New York, NY


July 25, 2015

Supreme Court to Consider Scope of Federal Jurisdiction Over Securities Claims

On June 30, 2015, the U.S. Supreme Court granted a petition for a writ of certiorari filed by Merrill Lynch and other financial institutions seeking to appeal a Third Circuit decision that held a shareholder lawsuit asserting state-law claims regarding alleged short selling should be remanded to state court.

The question presented by the certiorari petition is whether section 27 of the Securities and Exchange Act of 1934, which grants federal courts "exclusive jurisdiction' over violations of the Act or its regulations and all suits "brought to enforce any liability or duty created by" the Act or its regulations, "provides federal jurisdiction over state-law claims seeking to establish liability based on violations of the Act or its regulations or seeking to enforce duties created by the Act or its regulations."  The petition highlighted a split between the Fifth and Ninth Circuits, which have held that section 27 creates such jurisdiction, and the Second and Third Circuits, which have held that section 27 merely strips state courts of jurisdiction where there is an independent basis for federal jurisdiction.

The case was brought by shareholders of Escala Group, Inc. who allege that defendants engaged in short selling of Escala stock in violation of SEC Regulation SHO, which governs short sales of equity securities.  Plaintiffs assert various state law causes of action, including common law claims and claims under New Jersey's RICO statute based on predicate acts of state law securities fraud and theft.  The case was filed in New Jersey Superior Court, but was removed to the District of New Jersey.  The district court denied plaintiffs’ motion to remand and certified the question of whether remand was appropriate to the Third Circuit.

The Third Circuit was squarely presented with the question of whether section 27 provided an independent basis for federal question jurisdiction because it first held that plaintiffs' claims did not fall under section 1331, which gives district courts original jurisdiction over disputes "arising under" federal law. Recognizing that other circuits had reached disparate conclusions, the Third Circuit reversed the district court and held that "§ 27 is coextensive with § 1331 for purposes of establishing subject-matter jurisdiction."

Mollie Kornreich, Skadden Arps, New York, NY


July 25, 2015

Second Circuit Rules in Cohen v. UBS Financial Services

On June 30, 2015, the United States Court of Appeals for the Second Circuit held that rule 13204 of the FINRA Code of Arbitration Procedures does not prevent member firms from enforcing otherwise sound arbitration agreements and class/collective action waivers. In Cohen v. UBS Financial Services, Inc., (Docket No. 14-781-cv), the plaintiff, a UBS financial advisor, filed a putative collective action under the Fair Labor Standards Act (FLSA) in federal court, seeking unpaid overtime compensation on behalf of himself and other UBS brokers. UBS moved to stay the federal court litigation and compel arbitration of Cohen’s individual claims based on Cohen’s pre-dispute employment agreement that (1) required him to arbitrate any FLSA claims and (2) waived his right to file or participate in any actual or putative class or collective actions relating to his employment. The district court granted UBS’s motion and ordered Cohen to arbitrate his individual claims with FINRA.

On appeal, Cohen acknowledged that he signed his employment agreement containing these arbitration and class waiver provisions, but argued that FINRA's rule 13204 prohibited arbitration of his claims. Rule 13204 provides that "a member or associated person may not enforce an agreement to arbitrate in [FINRA] against a member of a certified or putative collective action with respect to any claim that is subject to the certified or putative collective action until the collective action certification is denied or the collective action has been certified." In essence, Cohen argued that by filing a putative collective action in federal court (a right he waived in his employment agreement), rule 13204 barred arbitration of his claims while his putative collective action remained viable (i.e., the court had not denied a motion for conditional certification and had not decertified any conditionally certified collective group).

The Second Circuit rejected Cohen’s argument, finding that rule 13204 "says nothing about class action waivers, and cannot be read to bar enforcement of them." The court further held that Cohen could not use the collective action he filed in federal court (in direct contravention to his employment agreement) as a shield to bar the arbitration of his individual claims. Accordingly, the appellate court affirmed the district court’s order requiring Cohen to arbitrate his individual claims.

Stuart D. Roberts, Bressler, Amery & Ross, P.C., Birmingham, AL


July 7, 2015

Energy Markets Exempted from Price Manipulation Claims

Private litigants will not find a safe harbor under the Commodity Exchange Act (CEA) when bringing energy-related claims alleging manipulation in organized energy markets. Relying on a Commodity Futures Trading Commission final order exempting energy markets from most CEA claims, the United States District Court for the Southern District of Texas dismissed claims under the CEA alleging harm by manipulation of prices in energy trading markets, ruling that private litigants could not bring such claims. Aspire Commodities, LP v. GDF Suez North America, Inc. One observer sees the decision as a watershed case testing the court’s willingness to accept the CFTC’s authority and interpretation of the regulatory scheme under the CEA.

The Aspire Case
In Aspire, the plaintiffs were traders on Texas’ energy markets alleging that, because of GDF Suez and other energy generators’ manipulation of prices in the Texas energy markets regarding the sale of electricity, the defendants had created artificial and unpredictable prices in the energy markets. The plaintiffs claimed that the defendants’ intentional misconduct violated the CEA and caused the plaintiffs to lose substantial amounts of money in their trades on those markets. The plaintiffs sued under Section 22 of the CEA, which provides a private right of action to persons harmed by a CEA violation.

The defendants moved to dismiss the CEA claim on standing grounds, arguing that the energy transactions at issue were exempted from CEA requirements under a final order issued by the Commodity Futures Trading Commission (CFTC). Notably, in its order, the CFTC stated that certain energy claims would not be exempted from Section 22 of the CEA. Specifically, the general anti-fraud, anti-manipulation, and scienter-based provisions of the CEA were excepted from the CFTC’s order.

The defendants argued that since the energy transactions at issue were exempt from the CEA requirements, the plaintiffs could not bring a private right of action pursuant to Section 22. The district court agreed, finding that dismissal was warranted since the plaintiffs did not make any claims under the provisions that fell into the exceptions set forth in the CFTC’s order. The plaintiffs have appealed the district court’s dismissal to the United States Court of Appeals for the Fifth Circuit.

CFTC Order Exempting Energy Transactions from CEA
“This case acted as a test case confirming that the exception granted by the CFTC is going to be honored by the courts,” Richard G. Douglass, Chicago, IL, cochair of the Membership Subcommittee of the ABA Section of Litigation’s Energy Litigation Committee. In the instance of energy markets, which were regulated by either the Federal Energy Regulatory Commission (FERC) or their state-run public utility, “there was an issue regarding the potential for the organized power market to be regulated by two regulators, the CFTC and the FERC,” says Douglass. To resolve this issue, “an agreement was reached where the CFTC would grant an exception stating that it would not regulate generators of power on markets; instead, that would be left to the FERC or the state department of public utility,” he adds.

“The CFTC determined that the exemption in question was in the public interest, in part, because the requesting parties and relevant transactions were already subject to comprehensive federal and state regulation,” says Joshua D. Jones, Birmingham, AL, cochair of the Section of Litigation’s Securities Litigation Committee. For example, in the Aspire case, the energy markets were regulated by the Public Utility Commission of Texas.

Can Private Litigants Avoid Dismissal under the CFTC Exemption?
So what does one do if he is a private litigant claiming a wrong is committed by an energy generator? “There are a couple of options,” says Jones. “One is that a plaintiff could state claims under the anti-fraud, anti-manipulation, or scienter-based provisions contained in the CEA because those claims aren’t exempted from the CFTC’s final order. Another approach is the approach the plaintiffs tried to take in this case, which is to argue that the transactions fall outside the purview of the exemption.”

“You could also pursue any remedies available under state regulations, or, if you believe the manipulation occurred in two different markets, focus your claim on the market that does not fall under the exception,” says Douglass.

Regardless of what claims one can state, Section leaders agree that it is important to look closely at the terms of the CFTC’s final order to determine if a certain transaction is exempted. “You need to look at the provisions regarding both the type of transaction and the type of claim relating to the transaction because only certain types of claims are exempted,” says Jones. “It’s a fact-dependent inquiry,” he adds.

Catherine R. McLeod, Kansas City, MO.  This piece originally appeared in Litigation News on May 19, 2015.


July 7, 2015

Legislative Prohibition on Fee-Shifting Signed into Law by Delaware Governor

The recent edition of the Securities Litigation Journal, Spring 2015, Vol. 25 No. 3, focused on the much-discussed adoption of fee-shifting provisions in the bylaws of Delaware companies and the issues it presents. Included in the issue was our article, Fee-Shifting After ATP Tour (log-in required)In a recent development regarding the legislative response in Delaware discussed in the article, a legislative prohibition on fee-shifting was signed into law by Delaware Governor Jack Markell on June 24, 2015. The law prohibits Delaware companies from passing liability for attorney fees and expenses of the corporation to shareholders seeking to bring an internal corporate claim. It also confirms the ability of Delaware companies to require that such claims be brought in the Delaware courts.

The law was initially drafted by the Corporation Law Council, a committee of the Delaware State Bar Association, in response to the Delaware Supreme Court's decision in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014). In ATP, the court opined that fee-shifting bylaws are permissible under Delaware law but that their enforcement is subject to equitable review. Shortly after the decision, companies—at last count more than 70—began to add such provisions to their bylaws. The law was proposed by its drafters and sponsor, Delaware State Senator Bryan Townsend, as a balanced approach to concerns expressed at both ends of the spectrum by shareholder advocacy groups and the U.S. Chamber of Commerce as it also specifically endorses Delaware bylaw forum selection clauses, another issue that has provoked substantial debate.

Keywords: securities litigation, Securities Exchance Commission, guidance, administrative proceedings

George Aguilar and Michael Nicoud, Robbins Arroyo LLP, San Diego, CA


May 19, 2015

SEC Considers Issuing Guidance on Use of Administrative Proceedings

Upon questioning before a Senate Appropriations subcommittee on Tuesday, May 5, 2015, Securities Exchange Commission (SEC) Chairman Mary Jo White told Senator John Boozman of Arkansas that "clearly questions have been raised" regarding the criteria the SEC uses to bring enforcement actions in administrative proceedings versus filing in the U.S. District Courts, and she acknowledged that "the appearance of fairness is important" with respect to that issue. In defending the commission's right to utilize the administrative forum, Chairman White noted that the forum has been around and in use by the SEC since the 1940s, that the Dodd-Frank Act did in fact expand the penalties that can be issued in such proceedings, and that "for litigated cases," 57 percent of actions are still brought in federal court and not in administrative proceedings. Nonetheless, conceding that there have been challenges to, and criticisms of, the SEC’s increasing use of the administrative forum and the lack of transparency into the criteria for doing so, Chairman White responded that issuance of public guidelines is being considered by her and the other commissioners for the benefit of the public and participants in the process.

With respect to some of the challenges and criticisms levied at the commission for its increased use of the administrative forum (in which the SEC's success right is far better than in cases brought to trial in federal courts), defendants have argued, among other things, that (1) the use of administrative judges that are hired by the very agency that is pursuing the enforcement action is inherently unfair; (2) the limits on discovery prejudice defendants and benefit the SEC, which has full subpoena power and largely unfettered access to documents, witnesses, and information during the investigative phase of an enforcement proceeding; (3) the expedited timing harms defendants, who are forced to marshal their evidence and defenses in a contracted time frame, in what are often highly complex cases, while the SEC may have had months or even years to conduct its investigation before instituting the administrative proceeding; and (4) the inability to try the case to a jury deprives defendants of due process under the Constitution. To date, all such challenges have been unsuccessful, and the commission's issuance of guidelines for bringing administrative actions is unlikely to address or assuage any of these concerns. Rather, such guidance will purportedly lend transparency into the decision-making process regarding the types of cases the SEC will bring in an administrative forum, which the SEC hopes will "avoid the perception that the commission is taking its tougher cases to its in-house judges." There is no current timeline or estimated date by which the guidelines may be issued.

Keywords: securities litigation, Securities Exchance Commission, guidance, administrative proceedings

Laura J. O'Rourke, Baker McKenzie, Dallas, TX


April 21, 2015

Cornerstone Reports that Class Action Securities Settlements Hit 16-Year Low

According to a report released by Cornerstone Research, securities class action settlements in 2014 were collectively at their lowest dollar amount in 16 years. Total settlement value fell from $4.8 billion in 2013 to $1.1 billion due primarily to the lower number of unusually large settlements. The 2014 figure is 84 percent below the average for the previous nine years. The number of settlements, however, did not significantly change from 2013. The database used for the report focused on cases in which purchasers of common stock claimed fraudulent inflation of the stock price and alleged violations of Rule 10b-5 and/or Sections 11 or 12(a)(2) of the Securities Act of 1933.

Cornerstone indicated that the average settlement for these cases in 2014 was $17 million. While that number reflects a significant decrease from the $73.5 million average in 2013, the median settlement amount declined only slightly, from $6.6 million to $6 million.  Most years have multiple settlements at or above $100 million, but there was only one such settlement in 2014, and there were no cases that settled for an amount in excess of $500 million.

The report found that for the cases settled in 2014 the “estimated damages”—a simplified calculation of potential shareholder losses Cornerstone uses as a factor in predicting settlement amounts—decreased significantly from 2013.  In 2014, there were only five settlements with estimated damages over $5 billion, compared to an average of nine cases for each of the preceding nine years. The report suggested that this lower number may reflect reduced stock volatility in the years that these cases were filed, typically two to four years before settlement—and given the recent relative stability of the market, this trend may continue.

Only 10 of the 63 securities class action settlements in 2014 involved Section 11 and/or Section 12(a)(2) claims, and all but three of these also involved Rule 10b-5 claims. Median settlement amount as a percentage of estimated damages tends to be higher in cases involving only Section 11 and/or Section 12(a)(2) claims than it is for cases involving only Rule 10b-5 claims. 

For all cases that settled in 2014, the median and average time from filing to settlement was three years. Matters with larger estimated damages generally took longer to reach settlement.

Notably, there was an overall decline in settlements involving financial firms, likely reflecting the smaller amount of credit-crisis litigation still ongoing.

The number of newly filed securities class actions (defined as cases involving Rule 10b-5, Section 11, and/or Section 12(a)(2)) increased in 2014, for the second year in a row.

Keywords: securities litigation, securities class action settlements, Cornerstone Research

Mollie Kornreich, Skadden Arps, New York, NY


April 21, 2015

SCOTUS Rules in Omnicare, Resolves Circuit Split

On March 24, 2015, the Supreme Court resolved a circuit split and unanimously held that an issuer cannot be held liable for making an "untrue statement of material fact" in violation of Section 11 of the Securities Act of 1933 if the statement at issue is a sincere expression of pure opinion, regardless of whether an investor can ultimately prove the belief wrong. The Court identified two ways in which an issuer may liable for material false statements of opinion made in a registration statement: (1) if the issuer did not hold the stated belief or embedded statements of untrue facts in the opinion or (2) if the issuer failed to disclose material facts regarding the opinion's foundation.

The case arose from a 2005 registration statement filed by Omnicare that contained statements regarding the company's compliance with legal requirements (for example: "We believe that our contract arrangements. . . are in compliance with applicable federal and state laws.").  After the federal government brought lawsuits against Omnicare for violating anti-kickback laws, the plaintiffs brought claims under Section 11 alleging that statements were "materially false," and that the company failed to disclose facts necessary to make its representations not misleading.

The district court granted Omnicare’s motion to dismiss, but the Sixth Circuit reversed, holding that a plaintiff need only plead that an opinion in a registration statement was "objectively false" when made.  This decision created a split with the Second, Third, and Ninth Circuits, which had previously held that a statement of opinion could give rise to liability only if it was both objectively and subjectively false.  See Fait v. Regions Fin. Corp., 655 F.3d 105, 106 (2d Cir. 2011); Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156, 1162 (9th Cir. 2009); In re Donald J. Trump Casino Sec. Litig.-Taj Mahal Litig., 7 F.3d 357, 368 (3d Cir. 1993).

The Supreme Court considered the sufficiency of Omnicare’s allegations on two distinct theories: whether Omnicare had made a false statement and whether it had omitted material facts that would have rendered the statements not misleading. 

With respect to misstatements, the Court held that, assuming the statements were material, a stated opinion could give rise to Section 11 liability if the speaker did not hold the professed belief or if factual assertions embedded in the statement were untrue.  The Court rejected the approach urged by the plaintiffs-respondents that a statement of opinion that is ultimately found incorrect, even if believed at the time made, may constitute an "untrue statement of material fact."

Writing for the majority, Justice Elena Kagan observed that this argument "wrongly conflate[d] facts and opinions."  "A statement of fact . . . expresses certainty about a thing, whereas a statement of opinion . . . conveys only an uncertain view as to that thing." The Court noted, however, that every expression of opinion "explicitly affirms one fact:  that the speaker actually holds the stated belief." In addition, some statements that begin with an opinion contain embedded statements of fact. Justice Kagan offered the following example of a statement by a company's CEO: “I believe our TVs have the highest resolution available because we use a patented technology to which our competitors do not have access.” This statement contains both a statement of belief and the factual assertion that that the company uses a patented technology. Accordingly, the Court concluded that liability under Section 11's false-statement provision would follow (assuming materiality) not only if the speaker did not hold the professed belief, but also if the supporting facts supplied in the statement of opinion were untrue. Because the particular Omnicare statements at issue were “pure statements of opinion” that merely turned out to be wrong, the plaintiffs-respondents could not avail themselves of either way of demonstrating liability for a false statement. 

Addressing the plaintiffs’ allegations that Omnicare had omitted facts necessary to make its opinions not misleading, the Court explained that “a reasonable investor may, depending on the circumstances, understand an opinion statement to convey facts about how the speaker has formed the opinion . . . . And if the real facts are otherwise, but not provided, the opinion statement will mislead its audience.” Put differently, “if a registration statement omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from the statement itself, then §11’s omissions clause creates liability.” The Court cautioned, however, that not every failure to disclose a “fact cutting the other way” will render a statement misleading: “A reasonable investor does not expect that every fact known to an issuer supports its opinion statement.” Because the lower courts had not considered the plaintiffs’ omission theory under the proper standard, the Supreme Court remanded the case.

Justice Kagan was joined by Chief Justice Roberts and Justices Kennedy, Ginsburg, Breyer, Alito and Sotomayor. Justices Scalia and Thomas each filed a concurring opinion.

Keywords: securities litigation, Section 11, Securities Act, Supreme Court, statement of opinion, Omnicare

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


February 18, 2015

Court Eases Requirements to Plead Securities Fraud Claims

A substantial hurdle for plaintiffs in securities litigation—pleading and proving losses caused by the corporation’s misrepresentations—may have been lowered. In Public Emples. Ret. Sys. of Miss. v. Amedisys, Inc., the U.S Court of Appeals for the Fifth Circuit reinstated a complaint in a consolidated securities class action. Observers see the decision as a blueprint for investors to plead securities fraud claims and to increase their potential damages.

The Alleged Fraud Scheme
In this class action, the plaintiffs alleged that defendant Amedisys, a health services company that derived about 90 percent of its revenue from Medicare, perpetrated a Medicare fraud scheme by providing medically unnecessary treatments to hit the most lucrative Medicare reimbursement levels. The plaintiffs also alleged that the company concealed these facts from investors until the company’s misrepresentations became publicly known through five partial disclosures.

According to the plaintiffs, as the truth was leaked to the public over time, the stock price dropped. Ultimately, the five corrective disclosures caused the share price to plummet from $66.07 as of August 11, 2008 to $24.02 in September 28, 2010.

Corrective Disclosures
The five corrective disclosures that allegedly revealed the fraud spanned nearly a two-year period. The first disclosure was an online report that raised questions about the company’s accounting and Medicare billing practices. The same day that this report was made, the company’s stock fell $11.80.

The second came on September 3, 2009, when the company reported that its chief executive officer and chief information officer were leaving to “pursue other interests.” The stock fell $9.42 that same day.

The third alleged partial disclosure was an article published by the Wall Street Journal on April 26, 2010. The article included an analysis of Medicare data by a professor, who found a questionable pattern of home visits clustered around reimbursement targets. The next day, the company’s stock fell $3.98 per share.

The fourth alleged partial disclosure was a combination of three government investigations into the company’s billing practices relating to Medicare. The fifth alleged partial disclosure was the company’s July 12, 2010, announcement that it had disappointing second quarter results.

District Court Dismisses Case for Lack of Causation
Investors filed a series of class action lawsuits against the company that were consolidated and subject to the defendants’ motion to dismiss. The U.S. District Court for the Middle Distrct of Louisiana granted the motion, reasoning that the plaintiffs had failed to adequately plead loss causation. “Loss causation is proximate cause for securities cases,” explains, Joshua D. Jones, Birmingham, AL, cochair of the Securities Litigation Committee of the ABA Section of Litigation. The district court examined each of the partial disclosures in isolation and found that none of them taken alone revealed the fraud scheme and so none could constitute a corrective disclosure. Accordingly, the district court dismissed the suit.

On appeal, the Fifth Circuit rejected the district court’s piecemeal approach and instead examined the disclosures collectively. The appellate court reasoned that partial disclosures must be relevant to the fraud, but need not individually reveal the fraud. The court examined each of the five partial disclosures, found that they “collectively constitute and culminate in a corrective disclosure that adequately pleads loss caution,” and reversed the district court’s dismissal.

Securities Fraud Cases May Be Easier to Plead
“This test acknowledges the reality that news about a fraud leaks out into the market over time and through various sources,” says Matthew L. Mustokoff, Radnor, PA, cochair of the Class Actions Subcommittee of the Securities Litigation Committee. “This case makes pleading a securities fraud case easier,” Mustokoff says, “by not requiring each partial disclosure to reveal the fraud scheme individually.” The court held that the partial disclosure must now be “related to” or “relevant to” the company’s alleged fraud and misstatements.

The decision may be more far-reaching than just affecting pleading standards. “If you are dealing with partial disclosures over a couple of years, an experienced plaintiff’s lawyer is going to consider whether to attempt to extend the timeframe at issue by citing an earlier partial disclosure in an effort to increase the potential damages,” says Jones.

The case also provides a roadmap for securities litigators. “Plaintiff’s counsel will want to provide much detail as possible as to the timeline on the purported fraud because any partial disclosure may be the one that ‘culminates’ in a corrective disclosure,” Jones notes. “In addition, doing so may allow plaintiffs to expand the damages range by securing a larger drop in share price.” On the other hand, Jones suggests that defense counsel should focus on whether each partial disclosure is relevant to the underlying fraudulent misrepresentation. “If not,” Jones observes, “it should not contribute to a finding of a cumulative corrective disclosure.”

Andrew J. Kennedy, Indiana, PA. This piece originally appeared in Litigation News on January 7, 2015.


February 17, 2015

Second Circuit Finds Failure to Make Item 303 Disclosure May Be Actionable Under Section 10(b)

On January 12, 2015, the Second Circuit affirmed the dismissal of a securities fraud suit against Morgan Stanley for failure to inform investors of exposure to losses from swap positions tied to the subprime mortgage market, concluding that plaintiffs failed to allege facts giving rise to a strong inference of scienter. Stratte-McClure v. Morgan Stanley, No. 13-0627-CV (2d Cir. Jan. 12, 2015). In so holding, the court addressed “a matter of first impression” in the circuit and found that “failure to make a required Item 303 disclosure in a 10-Q filing is indeed an omission that can serve as the basis for a Section 10(b) securities fraud claim,” so long as the omission is material and the other elements of the claim are satisfied.

Plaintiffs alleged that Morgan Stanley and six of its officers and former officers made material misstatements and omissions in an effort to conceal the bank's exposure to and losses from the subprime mortgage market. Plaintiffs contended that Item 303 imposed a duty on Morgan Stanley to make disclosures regarding the impact of the deteriorating mortgage market on the company’s financial position. Item 303 of Regulation S-K requires companies to disclose, among other things, “any known trends or uncertainties . . . that the registrant reasonably expects will have a material . . . unfavorable impact on . . . revenues or incomes from continuing operations.”

In January 2013, the district court dismissed the action, finding that Morgan Stanley did have a duty to make certain disclosures under Item 303, but nevertheless dismissing the case for failed to plead "a strong inference of scienter." See Stratte-McClure v. Morgan Stanley, No. 09-Civ-2017, 2013 WL 297954 (S.D.N.Y. Jan. 18, 2013).

On appeal, the Second Circuit concluded that “Item 303’s affirmative duty to disclose in Form 10-Qs can serve as the basis for a securities fraud claim under Section 10(b).” The court noted that under its previous decisions in Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114 (2d Cir. 2012), and Litwin v. Blackstone Group, L.P., 634 F.3d 706 (2d Cir. 2011), failure to comply with Item 303’s disclosure requirements could be “actionable under Sections 11 and 12(a)(2) of the Securities Act of 1933.” The court reasoned that Section 10(b), like Section 12(a)(2), requires disclosure of material facts necessary to make statements not misleading, and because Item 303 disclosures are “obligatory . . . a reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of ‘known trends or uncertainties . . . that the registrant reasonably expects will have a material . . . unfavorable impact on . . . revenues or income from continuing operations.’” Moreover, “a duty to disclose under Section 10(b) can derive from statutes or regulations that obligate a party to speak.” 

In a key limitation, the Second Circuit held that any omission must still meet the Section 10(b) materiality standard, as articulated by the Supreme Court in Basic Inc. v. Levinson.  Accordingly, merely meeting the different standard for a duty to report under Item 303 does not necessarily establish the materiality element of a Section 10(b) claim. The court further emphasized that the other elements of the claim must be met, including that the defendants acted with scienter. 

The view that failure to disclose under Item 303 may give rise to 10(b) liability creates a split with the Ninth Circuit, which recently held otherwise in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014). 

Ultimately, the Second Circuit held that although plaintiffs “adequately alleged that defendants breached their Item 303 duty to disclose that Morgan Stanley faced a deteriorating subprime mortgage market that, in light of the company's exposure to the market, was likely to cause trading losses that would materially affect the company's financial condition,” plaintiffs had failed to adequately plead scienter. 

Judge Livingston drafted the Second Circuit opinion, which was joined by Judges Cabranes and Wesley.  The circuit affirmed the dismissal of the remaining claims in a summary order.

Mollie Kornreich, Skadden Arps, New York, NY


January 13, 2015

Second Circuit Reverses Insider Trading Convictions

On December 10, 2014, the Second Circuit reversed two insider trading convictions on the grounds that prosecutors failed to establish defendants’ knowledge that the tipster received a benefit for disclosing inside information. Moreover, the circuit held, the benefit received must be more than mere friendship.

Defendants Todd Newman and Anthony Chiasson were convicted of securities fraud after a six-week trial. Prosecutors alleged that the two men had traded securities based on inside information illicitly obtained from analysts who received the information from employees of publicly traded tech companies. The district court declined to instruct the jury that the government was required to prove defendants’ knowledge that the insiders had disclosed the information for a personal benefit.

On appeal, the unanimous circuit court panel found that “in order to sustain a conviction for insider trading, the government must prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.”  Relying heavily on the Supreme Court’s decision in Dirks v. S.E.C., 463 U.S. 646 (1983), the opinion by Judge Barrington Parker noted that the “test for determining whether the corporate insider has breached his fiduciary duty ‘is whether the insider personally will benefit, directly or indirectly, from his disclosure,” and that “a tippee may be found liable ‘only when the insider has breached his fiduciary duty . . . and the tippee knows or should know that there has been a breach.’” In short, “the exchange of confidential information for personal benefit is not separate from an insider’s fiduciary breach; it is the fiduciary breach that triggers liability for securities fruit under Rule 10b-5.”  The government therefore cannot establish that the tippee has knowledge of the breach without showing that the tippee “knows of the personal benefit received by the insider in exchange for the disclosure.”

Addressing policy arguments, the opinion emphasized that, “[a]lthough the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.” It also noted the “doctrinal novelty of [the government’s] recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders.” 

Additionally, the evidence against the defendants was insufficient in two respects. First, the government failed to establish that the insiders received a personal benefit—merely demonstrating that they received “friendship, particularly of a casual or social nature” is insufficient. Second, there was no evidence that the defendants knew that they were “trading on information obtained from insiders, or that those insiders received any benefit in exchange for such disclosures, or even that Newman and Chiasson consciously avoided learning of these facts.”

The decision calls into question the validity of several recent convictions in the Southern District of New York. Following the opinion, U.S. Attorney Preet Bharara stated that the opinion “appears in our view to narrow what has constituted illegal insider trading,” and that it “interprets the securities laws in a way that will limit the ability to prosecute people who trade on leaked inside information.”

Read the full opinion, U.S. v. Newman.

Mollie Kornreich, Skadden Arps, New York, NY


November 25, 2014

Second Circuit Finds Jurisdiction Over Facebook IPO Claims, Prevents Arbitration

On October 31, 2014, a divided Second Circuit panel held that it had jurisdiction over a declaratory judgment action involving state law claims arising out of the May 2012 Facebook initial public offering (IPO), and affirmed an injunction preventing UBS Securities, LLC, from pursuing arbitration against NASDAQ for these claims. 

The Facebook IPO offered 421 million shares for a total value of $16 billion, making it one of the largest in history. NASDAQ’s purported failings on the day of the IPO ultimately resulted in an SEC investigation and changes to NASDAQ rules. UBS declined to pursue remedies under new NASDAQ rules, instead initiating an arbitration proceeding against NASDAQ. In response, NASDAQ filed suit in the Southern District of New York seeking a preliminary injunction to halt the arbitration. District Judge Robert W. Sweet granted the injunction, and UBS appealed.

A primary issue before the Second Circuit was whether the district court had jurisdiction to issue the injunction. As applied in declaratory judgment actions seeking to establish a plaintiff’s nonliability, the “well-pleaded complaint” rule considers for jurisdictional purposes the complaint “as if the party whose adverse action the declaratory judgment plaintiff apprehends had initiated a lawsuit.” UBS's arbitration demand asserted only state law claims, including breach of contract, indemnification, breach of implied duties of good faith and fair dealing and gross negligence. 

Nevertheless, the majority opinion, drafted by Judge Reena Raggi and joined by Judge Pierre Leval, found that this case fell into the “special and small” category of state claims that “present significant, disputed issues of federal law.” The majority reasoned that UBS’s claims were predicated on NASDAQ’s alleged violation of its “duty to operate a fair and orderly market,” and that this obligation “derives directly from federal law.” Moreover, the question of how this duty operated with respect to the Facebook IPO presented a question of federal law.  The majority further found that the contested federal issue was “substantial” in the sense that it was “sufficiently significant to the development of a uniform body of federal securities regulation to satisfy the requirement of importance to the federal system as a whole” (internal quotation marks omitted). In particular, the opinion emphasized the importance of stock exchanges to the national economy, and observed that UBS's claims “charge NASDAQ with violating the core duty of a federally registered SRO under the Exchange Act: to provide a fair and orderly market for a public stock offering,” in the context of “one of the largest public stock offers in history.” 

The majority found that other considerations that could weigh in favor of declining federal jurisdiction, such as the retrospective nature of the claim, were absent, and the decision “would likely have far-reaching prospective consequences.” Finally, the majority noted that the appropriate balance of federal and state judicial responsibilities supported federal jurisdiction, as it “comports with Congress’s expressed preference for alleged violations of the Exchange Act, and of rules and regulations promulgated thereunder, to be litigated in a federal forum.”

Once it determined the existence of federal jurisdiction, the majority went on to affirm the district court’s holding that it, rather than an arbitrator, could determine arbitrability, and that UBS’s claims were not subject to arbitration. 

Judge Chester Straub, in dissent, opined that the majority “extends federal court jurisdiction far beyond its permissible bounds,” by exercising jurisdiction over “state law claims that are premised on the internal rules of a private corporation.”

How this decision will impact federal question jurisdiction in other securities cases involving state law claims remains to be seen. The majority cautioned that “most federal questions raised in connection with state law claims will not be deemed substantial.”

Mollie Kornreich, Skadden Arps, New York, NY


November 19, 2014

Private Equity Firms Beware of Potentially Conflicting Fiduciary Duties

The Delaware Chancery Court recently reaffirmed that minority shareholders may owe fiduciary duties to the corporation and to other shareholders where the members of the control group are connected in a “legally significant way” and exercise control. Frank v. Elgamal, 2014 Del. Ch. LEXIS 37, *5 (Del. Ch. Mar. 10, 2014).

It has long been recognized under Delaware law that a minority shareholder may be deemed a controlling shareholder and assume fiduciary duties for purposes of specific transactions even where it does not generally exercise control over the company’s business affairs or over the board of directors. In re Western Nat'l Corp. Shareholders Litig., 2000 Del. Ch. LEXIS82, at *70 (Del. Ch. May 22, 2000).  “A number of shareholders, each of whom individually cannot exert control over the corporation (either through majority ownership or significant voting power coupled with formidable managerial power), can collectively form a control group where those shareholders are connected in some legally significant way, e.g., by contract, common ownership, agreement, or other arrangement-to work together toward a shared goal.” Dubroff v. Wren Hldgs., LLC, 2009 Del. Ch. LEXIS 89, *12 (Del. Ch. May 22, 2009). In Dubroff, allegations that a group of investors planned and caused a series of transactions in order to enrich themselves at the expense of minority shareholders, supported by detailed allegations of the steps taken by the group, were held sufficient to uphold claims of control.

Application of this principle is also seen in In Zimmerman v. Crothall, 2012 Del. Ch. LEXIS 64, at *36–38 (Del. Ch. 2012). There, two venture capital investors who cumulatively held 66 percent of the company’s stock were deemed a control group based on the facts that they were the two largest investors in the company, were early stage investors with similar economic interests, had appointed two of five directors, and were involved in communications regarding capital-raising efforts.  

Where the controlling minority shareholder has its own shareholders, the situation becomes more complex because the minority shareholder may also owe fiduciary duties to its own investors.  This happens frequently with private equity investors. Often the interests of the corporation conflict with those of the private equity firm’s own investors. But this does not mean that such private equity firms who qualify as controlling shareholders cannot participate in transactions that have the potential to enrich themselves. Rather, where private equity firms are found to be dual fiduciaries, their conduct will be scrutinized under the entire fairness standard. Carsanaro v. Bloodhound Techs., Inc., 65 A.3d 618, 636-640 (Del. Ch. 2013) (directors who were fiduciaries of funds approved deals favoring the funds); In re Primedia, Inc., 2013 Del. Ch. LEXIS 306, at *24 (Del. Ch. Dec. 20, 2013) (“Because KKR was Primedia's controlling stockholder and received a special benefit in the Merger, the operative standard of review would become entire fairness.”); In re Trados Inc. S'holder Litig., 73 A.3d 17 (Del. Ch. 2013) (six of seven directors were held to be not disinterested and independent and three directors who were fiduciaries of venture capital funds faced a conflict as “dual fiduciaries,” where the merger triggered the preferred stockholders’ liquidation preference such that those directors had “a divergent interest in the Merger that conflicted with the interests of the common stock”).

Private equity and venture capital firms that invest in Delaware corporations need to be aware of the possibility that they have dual (and perhaps competing) fiduciary obligations, particularly where they are significant minority shareholders or may be considered part of a control group.

Lynda J. Grant and Nicholas Kalfka, the Grant Law Firm, New York City, NY


November 14, 2014

Fifth Circuit Fashions Totality of the Circumstances Test For Loss Causation

Corrective disclosures for loss causation can now be established through a "totality of the circumstances" test, at least in the Fifth Circuit. In Public Emples. Ret. Sys. of Miss. v. Amedisys, Inc., No. 13-30580 (5th Cir. Oct. 2, 2014), the Fifth Circuit held that a series of partial disclosures "collectively constitute and culminate" in a corrective disclosure that adequately pleads loss causation for purposes of 12(b)(6) dismissal analysis. The Retirement System (lead plaintiff in the class action) relied on five separate disclosures from August 2008 through July 2010 in support of its claims that Amedisys defrauded investors by concealing fraudulent Medicare billing practices and issued false statements resulting in artificially inflated trading prices throughout the class period, causing a 63.6 percent drop in stock value. The five partial disclosures were (1) an August 2008 research report "raising questions" about Amedisys's accounting and Medicare billing practices; (2) the September 2009 resignation of Amedisys's CEO and CIO; (3) an April 2010 Wall Street Journal article analyzing publicly available Medicare data and showing a statistical correlation between Medicare reimbursement thresholds and the number of home visits performed by Amedisys therapists; (4) the commencement of three government investigations into Amedisys practices (by the Senate Finance Committee, the Securities Exchange Commission, and the Department of Justice) from May 2010 through September 2010; and (5) Amedisys’s disappointing second quarter operations results, released in July 2010.

The district court had examined each of the five disclosures individually, found none of them alone sufficient to establish a corrective disclosure for purposes of pleading loss causation, and granted Amedisys’s motion to dismiss for failure to state a claim. However, the Fifth Circuit focused on "relevance" as used in the Lormand standard for establishing proximate causation, i.e., a plaintiff must allege that the truth that emerged via the disclosures was "related to" or "relevant to" the defendant's fraud or earlier misstatements, finding that the "relevant truth" test "simply means that the truth disclosed must make the existence of the actionable fraud more probable than it would be without that alleged fact, taken as true." The court also reiterated that "the truth can be gradually perceived in the marketplace through a series of partial disclosures." The court then combined these approaches, examining each of the Retirement System's five partial disclosures individually against the relevant truth test, but then considering them collectively to determine whether a corrective disclosure had been made to plead loss causation at the motion to dismiss stage.

The Fifth Circuit agreed with the district court that neither the 2008 research report, the executives' resignation, nor the commencement of government investigations alone constituted a corrective disclosure. However, the court held that the district court erred in finding that a government investigation must discover actual fraud to constitute a corrective disclosure and specifically reversed on application of this "overly rigid" rule. For now, the new plausibility standard for loss causation at the dismissal stage in the Fifth Circuit requires: specific allegations of a series of partial corrective disclosures, a subsequent drop in stock value, and the absence of any other contravening negative event.

Catherine Phillips Crowe, Bressler, Amery & Ross, P.C., Birmingham, AL


October 20, 2014

Ninth Circuit: Item 303 Does Not Create a Duty to Disclose for Purposes of Section 10(b)

On October 2, 2014, the Ninth Circuit affirmed the dismissal of a shareholder securities fraud lawsuit, holding that plaintiffs failed to adequately allege that the defendants acted with the required state of mind.  In so holding, the Circuit found that the defendant corporation's alleged failure to comply with SEC disclosure requirements was insufficient to establish scienter under Section 10(b) of the Securities Exchange Act of 1934.

The case involved allegations that NVIDIA Corp., a semiconductor company, misled the market with respect to defects in certain semiconductor chip products it produced.  In July 2008, NVIDIA stated in a Form 8-K that it would be taking a charge to cover costs arising from the defect. This announcement was followed by a 31 percent decline in share price and a contraction of over $3 billion in NVIDIA's market capitalization. Putative class plaintiffs had purchased NVIDIA stock between November 8, 2007, and July 2, 2008. They alleged that NVIDIA knew of the defect during this period, and that failure to disclose it rendered various public statements materially misleading, in violation of Section 10(b). The district court dismissed the claims on the grounds that plaintiffs failed to establish that defendants acted with scienter. 

A unanimous, three-judge panel of the United States Court of Appeals for the Ninth Circuit affirmed the dismissal, finding that plaintiffs failed to allege facts that would give rise to a "strong inference" that NVIDIA knowingly kept investors in the dark about the defects in its chips. "Although there is some slight support for an inference that NVIDIA knew it was responsible for the problem before its disclosure and thus acted with intent to deceive at least its customers if not investors, a more compelling inference is that NVIDIA did not disclose because it was investigating the extent of the problem [and] whether it was responsible," wrote Judge Beverly Reid O'Connell, in an opinion joined by Judges Richard C. Tallman and Sandra S. Ikuta.

Plaintiffs argued that defendants' fraudulent intent could be inferred from their violations of disclosure obligations under Item 303 of Regulation S-K, which requires disclosure of certain information including "any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations."  Item 303, 17 C.F.R. § 229.303(a)(3)(ii). The Ninth Circuit disagreed:  "We have never directly decided whether Item 303's disclosure duty is  actionable under Section 10(b) and Rule 10b-5. We now hold that it is not."  The court reasoned that the disclosure standards under Section 10(b) and Item 303 "differ considerably," and "neither Section 10(b) nor Rule 10b-5 'create[s] an affirmative duty to disclose any and all material information.'" (citing Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1321-22 (2011) (alteration in original). The opinion favorably cited the Third Circuit's decision in Oran v. Stafford, 226 F.3d 275, 287-88 (3d Cir. 2000), which reached the same conclusion.

The panel also concluded that neither the corporate scienter doctrine nor the core operations doctrine supported a strong inference of scienter.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


September 29, 2014

Financing Authorities to Petition SCOTUS after Forum Selection Clause Supersedes FINRA's Mandatory Arbitration Rule

Two public financing authorities are hopeful the Supreme Court will agree to resolve an apparent circuit split as to whether the forum selection clauses in their agreements with two investment banks requiring any disputes to be brought in federal district court supersedes a FINRA rule requiring such disputes to be arbitrated. On August 21, 2014, the Second Circuit upheld the district court rulings refusing to compel the investment banks to arbitration, but recently withheld the issuance of a mandate to allow the parties to appeal the issue to the Supreme Court. The financing authorities point to a circuit split as the Fourth Circuit has held that a similar forum selection clause does not supersede the FINRA rule in question.  The financing authorities argue that the Court should address the “substantial questions” surrounding these matters and resolve the apparent split concerning the intersection between FINRA's mandatory arbitration rule and contractual forum selection clauses. The cases before the Second Circuit are Goldman Sachs & Co. v. Golden Empire Sch. Fin. Auth., case number 13-797-cv, and Citigroup Global Markets Inc. v. North Carolina Eastern Municipal Power Agency, case number 13-2247-cv.

W. Preston Martin, Bressler, Amery & Ross, P.C., Birmingham, AL


September 23, 2014

Second Circuit Applies Morrison Extraterritoriality Rule to Commodities Exchange Act Claim

On September 4, 2014, the United States Court of Appeals for the Second Circuit held that a private right of action under Section 22 of the Commodities Exchange Act (CEA) must be predicated on a transaction that occurred within the United States, following the Supreme Court’s decision in Morrison v. National Australia Bank Ltd.  The court also held that a wire transfer from Russia to a New York bank was insufficient to establish that the transaction was domestic. 

The case involved a Russian investor, Ludmila Loginovskaya,  who alleged that she invested with some of the entities comprising the Thor Group, a financial services organization.  The Thor Group CEO solicited Loginovskaya in Moscow to invest in Thor programs in the United States. In the process, Loginovskaya allegedly received certain assurances regarding the nature of the risk and her ability to withdraw her funds.  Loginovskaya entered into investment agreements with Thor United, an entity that invested in several related Thor entities, and transferred money to Thor United’s accounts in New York.  Loginovskaya lost her investment, and she brought a claim against several Thor companies and affiliated individuals under Section 40 of the CEA, which contains anti-fraud provisions that may be enforced through a private right of action established by Section 22. 

The district court dismissed the claim on the grounds that the complaint failed to allege a domestic transaction.  On September 4, the Second Circuit affirmed in an opinion by Judge Jacobs, joined by Judge Droney.  After observing that the CEA "is silent as to extraterritorial reach," the majority noted that Section 22 provides for a private right of action in four circumstances, "each of them explicitly transactional in nature."  It found that "[g]iven that CEA § 22 limited the private right to suits over transactions, the suits must be based on transactions occurring in the territory of the United States."

The majority next held that Loginovskaya failed to allege a domestic transaction.  Applying precedent from its Section 10(b) cases, the court explained that because Loginovskaya alleged that her claim was based on "purchase, sale, or placing an order for the purpose or sale of an interest or participation in a commodity pool," she was required to "demonstrate that the transfer of title or the point of irrevocable liability for such an interest occurred in the United States."  The majority rejected Loginovskaya's argument that title was transferred in New York, noting that she purchased an interest in Thor United, but never directly took title to the programs in which that entity invested.  Thor did not incur irrevocable liability in the United States because the investment was solicited in Russia, and the agreements were negotiated and executed there.  While Loginovskaya had purportedly wired funds to Thor's New York bank account, this transfer was "needed to carry out the transactions, and not the transactions themselves—which were previously entered into when the contracts were executed in Russia."

Judge Lohier, in dissent, argued that panel should have focused on Section 40, which focuses on the defendants' fraudulent acts, rather than Section 22.  

Mollie Kornreich, Skadden Arps, New York, NY


July 22, 2014

Supreme Court Issues Decision in Halliburton, Declines to Overturn Basic

On June 23, 2014, the Supreme Court issued its highly anticipated decision in Halliburton v. Erica P. John Fund, declining to jettison the fraud-on-the-market presumption first established in 1989 by Basic Inc. v. Levinson but clarifying that defendants in Section 10(b) actions can rebut plaintiffs’ reliance evidence at the class certification stage.  See 134 S. Ct. 2398 (2014).

In Basic, the Court held that the reliance requirement of a claim under Section 10(b) of the Securities and Exchange Act of 1934 could be satisfied through a rebuttable presumption.  485 U.S. at 245. The Basic Court based that presumption on what is known as the "fraud-on-the-market" theory, which holds that "the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations." Id., at 246. In other words, a publicly traded company’s stock price reflects any material public misinformation, and, as a result, anyone who traded on that price “relied” on the misstatement or omission. This presumption has become instrumental in the certification of securities class actions. Without it, plaintiffs would likely be unable to meet the predominance requirement of Federal Rule 23(b)(3) because investors would be required to prove reliance on an individual basis, meaning individual issues would predominate over common ones.

The majority opinion in Halliburton, authored by Chief Judge Roberts and joined by Justices Anthony Kennedy, Ruth Bader Ginsburg, Stephen Breyer, Sonia Sotomayor, and Elena Kagan, emphasized that Basic’spresumption is “long-settled precedent.” Defendant’s arguments that the presumption is inconsistent with congressional intent and that its theoretical underpinnings are no longer sound were ultimately insufficient to overcome stare decisis. The Court attempted to reconcile the presumption with its recent decisions raising the bar for class certification, particularly Wal-Mart Stores, Inc. v. Dukes and Comcast v. Behrend, by stressing that “[t]he Basic presumption does not relieve plaintiffs of the burden of proving—before class certification—that [the predominance] requirement is met.” It does, however, permit a plaintiff to “satisf[y] that burden by proving the prerequisites for invoking the presumption—namely, publicity, materiality, market efficiency, and market timing.” 

The Court also addressed Halliburton's alternatives to overruling Basic, namely (1) requiring plaintiffs seeking to invoke the Basic presumption to prove that the alleged misrepresentation actually affected the stock price—referred to as "price impact"—or, alternatively (2) permitting defendants to rebut the presumption of reliance with evidence of a lack of price impact before class certification. Rejecting the first alternative, the Court found that requiring plaintiffs to affirmatively prove price impact "would radically alter the required showing for the reliance element of the Rule 10b-5 cause of action," and, thus, would go too far towards undermining the Basic presumption.

The majority agreed, however, with Halliburton's second alternative, finding that defendants “should at least be allowed to defeat the presumption at the class certification stage through evidence that the misrepresentation did not affect the stock price.” The Court explained that, “[w]hile Basic allows plaintiffs to establish [price impact] indirectly, it does not require courts to ignore a defendant’s direct, more salient evidence showing that the alleged misrepresentation did not actually affect the stock’s market price.” The case was remanded to the Fifth Circuit, which had previously barred introduction of such evidence at the class certification stage.

In a concurring opinion, Justice Clarence Thomas maintained that the fraud-on-the-market presumption should be overturned:  “Logic, economic realities, and our subsequent jurisprudence have undermined the foundation” of the presumption.  Justices Scalia and Alito joined the opinion. Justice Ginsburg, joined by Justices Breyer, and Sotomayor, wrote separately to express that the opinion should “impose no heavy toll” on securities plaintiffs with meritorious claims, as defendants have the burden of showing price impact.

While the decision does not sound a death knell for securities class actions, it provides defendants with a potentially powerful tool at the certification stage.  Whether this will affect the percentage of classes certified remains to be seen.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


July 15, 2014

Second Circuit Vacates Judge Rakoff's Order in SEC-Citigroup Settlement

On June 4, 2014, the United States Court of Appeals for the Second Circuit issued its long-awaited decision on whether District Judge Jed Rakoff abused his discretion in refusing to approve a settlement between the Securities and Exchange Commission (SEC) and Citigroup Global Markets, Inc. Clarifying the standard for reviewing an enforcement agency’s consent judgment, the three-judge panel (Pooler, Lohier, and Carney) vacated the order and remanded the case back to the district court.

In October 2011, the SEC filed a complaint in the Southern District of New York alleging Citigroup made various material misstatements regarding its interest in a fund.  Soon thereafter, the SEC filed a proposed consent judgment under which Citigroup agreed to disgorgement of $160 million in alleged profits; $30 million in prejudgment interest; a $95 million civil penalty; an injunction barring Citigroup from violating certain provisions of the Securities Act of 1933; and certain internal changes at Citigroup.  The consent decree did not contain any admission of fault.

In November 2011, Judge Rakoff controversially refused to approve the consent decree on the grounds that it was “neither fair, nor reasonable, nor adequate, nor in the public interest.”  He noted that the parties had “not provide[d] the Court with a sufficient evidentiary basis to know whether the requested relief [was] justified” and was critical of the use of “no admit, no deny” settlements.

Both parties appealed Judge Rakoff’s order and, in March 2012, the Second Circuit granted a stay pending appeal, finding that the SEC had shown a strong likelihood of success on the merits.  See S.E.C. v. Citigroup Global Markets Inc., 673 F.3d 158, 163-65 (2d Cir. 2012). 

In its June 4 opinion authored by Judge Rosemary Pooler, the unanimous panel held that “the district court abused its discretion by applying an incorrect legal standard.” After determining that it had jurisdiction over the interlocutory appeal, the circuit court emphasized that “there is no basis in the law for the district court to require an admission of liability as a condition for approving a settlement between the parties.” The court then clarified that the standard for reviewing “a proposed consent judgment involving an enforcement agency” is “whether the proposed consent decree is fair and reasonable,” and where injunctive relief is proposed, the court must also find “that the ‘public interest would not be disserved.’” On this point, the SEC’s determination that a consent decree serves the public interest “merits significant deference.” Further, the circuit held that it was an abuse of discretion for the district court to require that the consent decree be premised on the truth of the allegations. Additionally, Judge Pooler wrote, “[t]o the extent the district court withheld approval of the consent decree on the ground that it believed the [SEC] failed to bring the proper charges against Citigroup, that constituted an abuse of discretion.” 

On remand, the district court is to “consider whether the public interest would be disserved by entry of a consent decree." The circuit court expressly cautioned the district court against “find[ing] the public interest disserved based on its disagreement with the [SEC’s] decisions on discretionary matters of policy, such as deciding to settle without requiring an admission of liability.” 

In a statement, SEC Enforcement Director Andrew Ceresney expressed the agency’s satisfaction with the outcome. 

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


June 13, 2014

Second Circuit Applies Morrison Limitation to Foreign Transactions Involving Securities Cross-Listed on a Domestic Exchange

On May 6, 2014, the United States Court of Appeals for the Second Circuit held that the Supreme Court’s limitation on extraterritorial application of the Securities Exchange Act of 1934 in Morrison v. National Australia Bank Ltd. extends to “claims brought . . . by purchasers of shares of a foreign-issuer on a foreign exchange, even if those shares were cross-listed on a U.S. exchange.” City of Pontiac Policemen’s and Firemen’s Retirement System v. UBS AG, No. 12-4355, 2014 WL 1778041 at *1 (2d Cir. May 6, 2014).

Plaintiffs were foreign and domestic investors who purchased a class of shares dually listed on foreign exchanges and the New York Stock Exchange (NYSE). They brought a putative securities class action against UBS and related defendants, alleging violations of Sections 10(b) and 20(a) of the Exchange Act and Sections 11, 12(a)(2) and 15 of the Securities Act of 1933. Plaintiffs alleged that the defendants had made fraudulent statements in connection with the Bank's mortgage-backed securities portfolio, allegedly overvaluing certain mortgage backed securities and collateralized debt obligations, and that the Bank had failed to disclose an alleged tax fraud scheme.

Under Morrison, which addressed the territorial limitations of the Exchange Act, a foreign plaintiff cannot bring a Section 10(b) claim against foreign defendants “for misconduct in in connection with securities traded on foreign exchanges.”  Morrison, 561 U.S. at 250-51.  Rather, to have a private cause of action under Section 10(b), the securities must be listed on a domestic exchange or the transaction must otherwise have been domestic.  Plaintiffs in UBS who purchased on foreign exchanges argued that they were not barred by this rule because their shares were cross-listed on the NYSE.  The Second Circuit, however, rejected this claim as “irreconcilable with Morrison read as a whole,” particularly given Morrison’s creation of a bright-line rule based on the site of the transaction.  UBS, 2014 WL 1778041 at *3. Construing Morrison the Court noted, “the focus of both prongs was domestic transactions of any kind, with the domestic listing acting as a proxy for a domestic transaction.”  Id.  With respect to a plaintiff who had placed a “buy order” in the Untied States which was executed on a foreign exchange, the Circuit held that placement of this order was insufficient to be characterized as a domestic transaction under Morrison’s second prong. 

The Second Circuit also affirmed the District Court’s dismissal of the remaining Securities Act and Exchange Act claims.  Regarding disclosure of the purported tax scheme, the court observed that “’disclosure is not a rite of confession,’ and companies do not have a duty ‘to disclose uncharged, unadjudicated wrongdoing.’”  Id. at *5.  The Bank’s disclosure that it was being investigated and the possibility that those investigations would result in substantial penalties and costs was sufficient.  Id.  (internal citation omitted).  Moreover, the Bank’s statements “about compliance, reputation, and integrity” were “inactionable ‘puffery,’ meaning that they are ‘too general to cause a reasonable investor to rely upon them.’”  Id. at *5 (internal citation omitted).  As to the purported securities valuation misstatements, the Circuit affirmed the District Court’s holding that plaintiffs had failed to adequately allege that UBS was reckless in ignoring red flags regarding the true value of its assets.  The decision not to write down the asset portfolio was not “highly unreasonable, representing an extreme departure from the standards of ordinary care.”  Id. at *7 (internal citations omitted). 

By resolving one of several open issues following Morrison, the UBS decision should give clarity to issuers with cross-listed securities. Other Circuits have not yet spoken on the dual listing question.

Mollie Kornreich, Skadden Arps, New York, NY


April 9, 2014

Supreme Court Hears Fraud-on-the-Market Argument in Halliburton Case

On March 5, 2014, the United States Supreme Court heard argument in Halliburton Co. v. Erica P. John Fund, Inc. on the question of whether to overrule or modify the holding of Basic Inc. v. Levinson, 485 U.S. 224 (1988), to the extent that it recognizes a presumption of class-wide reliance based on the fraud-on-the market theory. Although the Halliburton case has the potential to radically alter plaintiffs' ability to bring securities fraud class actions, the justices' questioning suggested that the Court may modify how the presumption is applied without jettisoning it altogether.

Basic’s fraud-on-the-market theory posits that, in an efficient capital market, misrepresentations are baked into the price of securities, and investors purchase stock in reliance on the price as a reflection of fair value. As a result, members of a putative securities class need not prove that class members made purchases in reliance on the alleged misstatements.  

In Halliburton, the Fifth Circuit affirmed certification of a class based on the fraud-on-the-market presumption. Although the presumption is rebuttable, the Circuit did not permit defendants to rebut it at the class certification stage. The Supreme Court granted certiorari in November 2013 to consider (1) whether to overrule or substantially modify Basic and (2) whether a defendant can rebut the presumption at the certification stage through evidence that the alleged misrepresentations did not distort the stock price.

Based on the justices' questioning during argument, which is no sure indication of the ultimate outcome, there does not appear to be a majority to wholly overturn Basic. Some of the justices, however, asked about the possibility of what Justice Anthony Kennedy described as a “midway position,” which would allow introduction of some elevated showing of market distortion (i.e., price impact) at the class certification stage. (Tr. At 17:11-17.)  Justice Kennedy noted that even under the "Basic framework, at the merits stage there has to be something that looks very much like an event study"—an analysis of market distortion due to the misrepresentation—and asked, "why not have it at the class certification stage?"  (Tr. at 18:8-11, 14-16.)  The Fund’s counsel maintained that this would increase the "cost and expense at the class certification stage" and introduce delay.  As the Deputy Solicitor General noted, however, plaintiffs ultimately have the burden of proving price impact regardless.

Much of the argument was devoted to the question of when defendants should be able to rebut Basic's reliance presumption. Halliburton's counsel noted that outside the Second Circuit, which requires price impact to be proven at the class certification stage, it is "very unusual" for defendants to rebut the presumption. (Tr. at 8:22-24.)  Because cases so rarely last beyond class certification, as Halliburton's counsel explained, the timing is critical.

Mollie Kornreich, Skadden Arps, New York, NY


February 25, 2014

FINRA Proposes Revisions to Definition of "Public Arbitrator"

FINRA recently proposed new limitations regarding who can serve as a "public" arbitrator under the Customer and Industry Codes of Arbitration Procedure. The rule amendments would prohibit anyone who has worked in the securities industry at any time from ever being classified as a public arbitrator. FINRA's current rules allow individuals who have been out of the industry for at least five years to serve as public arbitrators.

In addition, professionals who represent investors or the financial industry as a "significant part of their business" would also be defined as non-public arbitrators. Current rules allow professionals whose firm has not derived 10 percent or more of its income over the past two years from the financial industry to serve as public arbitrators. Unlike those who worked directly in the industry, these professionals under the proposed amendments would be eligible to serve as public arbitrators after an unspecified "cooling off period." FINRA chairman and CEO Richard Ketchum called the amendments "a very balanced response to concerns on both sides" about how arbitrators are classified. The proposed amendments are being filed with the SEC for approval.

Joshua D. Jones and Joel M. Everest, Bressler, Amery & Ross PC, Birmingham, AL


February 4, 2014

NERA Releases 2013 Securities Class Action Report

On January 21, 2014, National Economic Research Associates (NERA) released its annual report, “Recent Trends in Securities Class Action Litigation: 2013 Full-Year Review,” subtitled “Large Settlements get larger; small settlements get smaller.” The subtitle is a reference to divergent settlement trends, with the average settlement amount reaching a record high while the median settlement amount decreased in comparison to 2012.

The report found a small increase in the number of complaints filed in 2013, both for securities class actions in general—which it defined broadly as “class actions filed in federal courts that involve securities”—and for Rule 10b-5 cases in particular. There was a 10 percent increase over securities cases filed in 2012, and a 15 percent increase in actions alleging violations of Rule 10b-5, Section 11, or Section 12. These “standard” filings were more numerous than in any year since 2008.

As in past years, the bulk of the filings were in the Second or Ninth Circuit, which together accounted for 53 percent of the total.  No other circuits came close, but the Fifth Circuit did see twice as many filings in 2013 as in 2012—up from 12 to 25. The percentage of filings against foreign issuers dropped slightly from 2012, and remained roughly in proportion to the percentage of listings represented by foreign companies.

The breakdown of filings by industry remained roughly constant, with the finance sector as a primary defendant in 15 percent of cases.  This number has fallen significantly since 2008, when that sector accounted for almost half of all securities class action filings. NERA reports that accounting firms were codefendants in only 2.1 percent of actions, which is consistent with the numbers from 2010 onward.  The report hypothesizes that this may be due to the Supreme Court’s decisions in Stoneridge Inv. Partners, LLC v. Sci.-Atlanta, Inc. in 2008 and Janus Capital Group, Inc. v. First Derivative Traders in 2011.

Forty-one percent of the complaints surveyed contained allegations regarding misleading earnings guidance, a sharp jump from the past few years. Another notable change from 2012 was the accelerated median filing time: half the cases were filed within 16 days of the end of the class period. Those cases not filed during that brief window were filed more slowly than in years past. The average time for filing—139 days—rose from 2012 numbers.

Motions to dismiss were filed in 95 percent of the cases.  Where the court reached a decision, 48 percent were granted with prejudice, 6 percent were granted without prejudice, 25 percent were granted in part, and 21 percent were denied outright.  Seventy-three percent of all cases were settled or dismissed before any motion for class certification was filed.  For the remaining twenty three percent of cases, the court reached a decision on class certification a little more than half of the time (56 percent), which equates to a class certification decision issued in approximately 15 percent of all securities class actions. Notably, courts deciding the issue granted certification 77 percent of the time. NERA cautioned that the vast majority of the decisions on a motion for class certification precede the Supreme Court's decisions in Erica P. John Fund, Inc. v. Halliburton Co. and Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds, which are likely to have a significant impact. NERA reports the median time for a decision on class certification from the date of filing a complaint is almost two and a half years.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


January 21, 2014

London Whale Derivative Suit Dismissed

A shareholder derivative suit against JPMorgan Chase & Co. executives relating to the 2012 so-called London Whale incident was dismissed on January 15, 2014, by New York Supreme Court Judge Jeffrey Oing.  The court held that the plaintiffs had not adequately alleged demand futility.

The plaintiffs alleged that defendants failed to "properly implement appropriate internal controls, oversight and risk management," which allowed a rogue trader to execute the infamous $6 billion trading loss.  The plaintiffs further alleged that the defendants "systematically concealed" the losses stemming from the company’s chief investment office (CIO) synthetic credit portfolio.

With respect to demand futility, the plaintiffs argued that JP Morgan's board members were conflicted and had recklessly disregarded CIO issues and indicated hostility to the underlying breach of fiduciary duty claims. In their motion to dismiss, the defendants emphasized that previous shareholder derivative claims relating to the same losses had been dismissed for failure to adequately plead demand futility. The defendants also noted that, following demands by other shareholders, the board had reviewed the CIO's losses, commenced an investigation by management, and implemented remedial measures. 

Ruling from the bench, Judge Oing rejected plaintiffs' arguments regarding director conflicts and noted that other courts ruling on derivative suits relating to the company's London Whale losses have consistently found that demand was not excused: "Of all the shareholder derivative lawsuits brought against JPMorgan, I haven't seen a court yet say that demand is excused."  Turning briefly to the merits, the court also questioned whether the defendants' purported failure to implement appropriate controls resulted in the trading losses. Judge Oing asked, "Is there an allegation here that says even if we had these risk controls in place, that the guy in London would of stopped what he was doing?"

The case is Wandel et al. v. Dimon et al., Index No. 651830/2012, in the Supreme Court of the State of New York, County of New York.  This ruling comes on the heels of JP Morgan's September 2013 settlement with US and UK regulators.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


January 7, 2014

Facebook IPO Class Action Survives Motion to Dismiss

On December 11, 2013, Facebook's motion to dismiss a securities class action relating to the company's May 2012 IPO was denied by U.S. District Judge Robert Sweet. The court held that the plaintiffs had adequately alleged that defendants—Facebook, certain individual officers and directors, and the IPO underwriters—failed to meet disclosure obligations regarding the impact of mobile products on the company's fiscal health, in violation of sections 11, 12(a) and 15 of the Securities Act. 

According to the complaint, Facebook's revenue was derived almost entirely from ad sales, yet at the time of the IPO, the company allegedly did not display ads on its mobile products—an increasingly large portion of its user base. The plaintiffs argued that Facebook had a duty, under Item 303 of SEC Regulation S-K, to disclose mobile usage issues because they were a "known trend" that the company "reasonably expected to have a material unfavorable impact" on revenues, and that Facebook made material misrepresentations regarding the impact of growing mobile usage.

Judge Sweet's opinion focused on the defendants' purported undisclosed knowledge of the degree to which mobile usage was impacting revenue. First, relying heavily on the Second Circuit's decisions in Litwin v. Blackstone Group, L.P.  and Panther Partners v. Ikanos Communications, Inc., the court found that the plaintiffs sufficiently pleaded that defendants did not satisfy their disclosure obligations under Item 303. Judge Sweet reasoned, "[t]aking Litwin and Panther Partners together, an issuer has a duty to disclose any trend, event or uncertainty that is 'known and existing at the time of the IPO' that 'was reasonably likely to have a material impact'  on the issuer's financial condition." The court characterized Facebook's disclosures regarding the impact mobile use could potentially have on revenue as "generalized and indefinite" and held that they were inadequate because Facebook allegedly "knew of the certainty of the trends in mobile usage." The court found that the disclosures were also inadequate in light of alleged statements suggesting that decreasing the number of ads displayed would not necessarily hurt revenue. In sum, the court held that "Facebook should have disclosed more of [the] relationship" between mobile use and revenue. 

In addition to the alleged Item 303 omissions, the court determined that the complaint sufficiently alleged that Facebook had made material misrepresentations by making "positive statements concerning the impact of mobile usage on Facebook’s financial prospects, "and by stating that mobile use "may negatively affect" revenue, when in fact it already had:  "The company's purported risk warnings misleadingly represented that this revenue cut was merely possible when, in fact, it had already materialized." The court further held that the plaintiffs had adequately pled materiality, and that defendants had not sufficiently established a lack of loss causation to warrant dismissal.

In a statement, Facebook said,  "We continue to believe this suit lacks merit and look forward to a full airing of the facts."

The investor securities class action against Facebook and the underwriters is part of a broader multidistrict litigation related to the Facebook IPO. Other cases in the MDL include a consolidated class action against NASDAQ and various derivative actions.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


December 20, 2013

Attend the Committee's Panels at the Section Annual Conference

The Securities Litigation Committee is proud to announce its sponsorship of the following panels at the 2014 Section of Litigation Annual Conference in April:

The SEC’s New Settlement Policy:  It Is a Whole New World. The SEC recently announced an historic change in its settlement policy—requiring, in certain circumstances, an admission of wrongdoing. This program will explore the history behind this change, how the policy is likely to be applied, and its practical repercussions, including on class actions, insurance coverage, and parallel proceedings. Speakers include Patricia Canavan, UBS AG, executive director, Litigation and Investigations (Moderator); Jennifer Chunias, Goodwin Procter; and Lori Echavarria, SEC, Division of Enforcement.

How and When Do You Want the Government Involved? The theft of intellectual property or trade secrets, counterfeiting, data breaches, fraud, competitors engaged in illegal activity—all of these situations can raise the question of whether to reach out to the government for help. This program will explore the advantages and disadvantages of doing so, who to contact, and how to package your case for acceptance. Speakers include: Monica Bickert, Facebook; Phil Guentert, AUSA, Northern District of California; Randy Cook, security consultant for the NFL; A.J. Bosco, vice president, assistant general counsel, JPMorgan Chase; and Grant Fondo as moderator.

The Inside View on Securities and Derivative Litigation, and SEC and White Collar Investigations and Prosecutions: Corporate Counsels' Perspective. Coming from the perspective of general counsels and corporate counsel, this program will explore what in-house counsel look for when retaining counsel; the dos and don’ts of pitches; the competing interests in-house counsel face; tips for plaintiffs' firms; what counsel representing individual D&Os should know; and best and worst practices. Speakers include Seth Rodner, general counsel, Medicis Pharmaceutical; Patricia Canavan, UBS AG, executive director, Litigation and Investigations; and Grant Fondo as moderator.

Strategies for Dealing with Investigations and Enforcement Actions Brought by Multiple Regulators. What do you do when multiple regulators converge on your client at once? A panel of current and former regulators and in-house and outside counsel will discuss strategies for managing and resolving investigations and enforcement proceedings brought on multiple fronts. The panel will share practical tips and strategies for dealing with multistate investigations and proceedings, as well as proceedings involving multiple regulators (e.g., SEC, FINRA, state AGs, CFPB etc.), including a discussion of how such matters are coordinated and who takes the lead; and how to coordinate settlement and resolution efforts. The panel includes Robert Khuzami of Kirkland and Ellis, recent past director of the Division of Enforcement of the SEC; Lucy Morris, deputy enforcement director at the Consumer Financial Protection Bureau; Joy Weber, head of the regulatory group at UBS; and Charles Harris II of Mayer Brown as moderator.

Corporate Liability for Insider Trading and the Government's Expanding Theories of Insider Trading. The recent decision by the United States Attorney for the Southern District of New York to bring charges against SAC Capital for insider trading by certain of the fund's traders and the Securities and Exchange Commission's lawsuit seeking to hold SAC Capital liable for failing to supervise those traders' trading activities potentially highlight a new government focus on holding corporate entities responsible for insider trading committed by their employees. At the same time, recent cases brought by both the Department of Justice and the Securities and Exchange Commission demonstrate that the government may be expanding existing theories of insider trading liability. What are the new developments in the law of insider trading? What factors does the government use to determine whether to assert criminal charges or civil claims against corporations for insider trading by their employees? What can corporations do to avoid these charges or claims? What defenses are available after charges or claims have been filed? This panel, which will be comprised of lawyers representing the Department of Justice, Securities and Exchange Commission, and white-collar criminal defense bar, will explore these questions and more.


December 5, 2013

SEC Approves Amendments to FINRA Discovery Guide for Customer Arbitrations

The SEC recently approved amendments to FINRA’s Discovery Guide governing customer arbitrations (the Amended Guide). The amendments are effective December 2, 2013, and apply to all customer arbitrations filed on or after that date.  They address issues related to (1) the “form” of electronic discovery, (2) discovery issues unique to product cases, and (3) requests for affirmation of compliance with FINRA’s discovery requirements.

With regard to e-discovery, the Amended Guide requires parties to produce electronic documents in a “reasonably usable format.”  Generally, an electronic file should be produced in either the format in which it is ordinarily maintained or a converted format that does not make it more difficult to use in arbitration.  Where the arbitrator must resolve e-discovery disputes, the Amended Guide instructs the arbitrator to consider the totality of the circumstances, including the following three factors:

  1. For the producing party, whether the document is being produced in a format different from that in which it is ordinarily maintained

  2. For a document obtained from a third party, whether the document is being produced in a format different from that in which the third party provided it

  3. For a document converted from original format, the party’s reason for conversion, how the documents are affected by the conversion, and whether the conversion affects the requesting party’s ability to use the document

The Amended Guide further provides that arbitrators may allow a different format to decrease the cost and burden of producing electronic documents.

The Amended Guide also explains that product cases are a unique form of customer cases in which the claims are focused on “widespread mismarketing or defective development” of a security or group of securities. Generally, discovery in product cases differs from ordinary customer cases due to the volume of documents, the existence of multiple claimants seeking the same documents, non-client specific documents, the possible existence of a regulatory investigation, and documents related to due diligence performed by persons uninvolved with the customer’s account.  Because the Document Production Lists may not address all these issues, the Amended Guide emphasizes that the parties in product cases are not necessarily limited to the production lists and may request additional documents.

Finally, the Amended Guide clarifies the circumstances under which a party may request an affirmation of discovery compliance.  The new language allows parties to request an affirmation when the opposing party has made either no production or a partial production of the documents included in the Document Production Lists.  Such affirmation must confirm in writing that the party has conducted a good-faith search and state the sources that it searched.

Joshua D. Jones and Jaime H. Scivley, Maynard Cooper & Gale, P.C., Birmingham, AL


November 1, 2013

Countrywide Verdict Might Prompt More FIRREA Actions

On October 23, 2013, a federal jury concluded that Bank of America and former Countrywide executive Rebecca Mairone committed fraud.  U.S. ex rel. O’Donnell v. Countrywide Fin. Corp., No. 12-cv-1422 (S.D.N.Y.).  The government’s case, brought under the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), arose from a Countrywide program to increase the sale of mortgage loans to Fannie Mae and Freddie Mac (collectively, the GSEs).  The government alleged that the defendants engaged in a scheme to defraud the GSEs by falsely representing that loans from the program complied with the GSEs’ loan purchasing guidelines. The caseindicates that FIRREA is potentially a powerful tool for policing federally insured financial institutions (FIFIs), which the government will use to continue its scrutiny of financial crisis conduct.

According to the government’s complaint, when the subprime mortgage loan market collapsed in 2007, Countrywide adapted its subprime mortgage loan platform to originate loans to sell to the GSEs under their purchasing standards.  Countrywide allegedly implemented the HSSL program (short for “high-speed swim lane,” or hustle) to speed the flow of those loans by tying employee compensation to the volume of loans originated and eliminating quality controls.  As a result, Countrywide allegedly sold loans that it knew did not conform to the GSEs’ standards, while representing otherwise.  Countrywide is now part of Bank of America (BOA). The government built its case on information from a whistleblower who might recover a statutory bounty of up to $1.6 million. The whistleblower now works for Fannie Mae.

FIRREA was enacted in the wake of the S&L crisis. Among its provisions, FIRREA authorizes civil penalties against those who commit certain criminal offenses, such as mail or wire fraud, “affecting” FIFIs.  The GSEs are not FIFIs, but the government advanced a novel interpretation to address the issue; it argued that BOA's alleged fraud affected BOA itself.  In a pretrial ruling, Judge Jed Rakoff accepted this “self-affecting” theory, as have two other judges in other FIRREA cases pending in the Southern District of New York. This application of FIRREA has yet to be reviewed by an appellate court. Mairone is expected to appeal.

A review of the jury charge and the verdict suggest that the jury concluded the defendants (a) devised a scheme (HSSL) to induce at least one GSE to buy mortgage loans by materially misrepresenting loan quality; (b) sacrificed loan quality to speed loan origination; and (c) participated in the scheme knowingly and with the specific intent to deceive and harm at least one GSE through false statements about the loans. The court instructed the jury that the government must prove the scheme existed, but not that the scheme succeeded, benefitted the defendants, or caused the GSEs to lose money, and not that the GSEs were without fault. The court did not instruct the jury on the “self-affecting” theory.

Under FIRREA, the government may sue FIFIs for mail or wire fraud under the civil standard of proof; the act’s 10-year statute of limitations is double that for federal criminal, or civil securities, fraud; and its penalties are $1 million per violation and $5 million for a continuing violation, and potentially more if the defendant’s gains or the victim’s losses exceed the penalties. In Countrywide, the government seeks up to $848.2 million.

James Goldfarb, Murphy & McGonigle, P.C., New York, New York


October 31, 2013

Second Circuit Affirms Dismissal of Lehman Securities Class Action

On October 28, 2013, the Second Circuit affirmed dismissal of a Consolidated Amended Complaint (CAC) in the multidistrict litigation surrounding securities issued by Lehman Brothers prior to its bankruptcy. The court held that the claims were barred by the Securities Act’s statute of repose and were not saved through relation back to the allegations in the original complaint.

The original complaints were filed in the fall of 2008 as “separate yet materially identical putative class actions.” Caldwell v. Berlind et al, 13-156-cv (Oct. 28, 2013). They alleged that the offering documents failed to disclose Lehman’s 30:1 gross leverage ratio. In November 2011, the plaintiffs filed the CAC, which rested on a different theory of liability—i.e., that Lehman failed to disclose that it had engaged in repurchase and resale transactions which “improperly ‘remove[d]’ billions of dollars from its balance sheet,” and that it mislead purchasers regarding the company’s risk management. District Court Judge Kaplan, in the Southern District of New York, granted defendant’s motion to dismiss.

On appeal, the Second Circuit (Judges Livingston, Lynch, Droney) affirmed the dismissal in a summary order, finding that plaintiffs’ claims were “barred by both the statute of limitations and the statute of repose in Section 13 of the Securities Act.” Id. The Circuit held that the statute of limitations was triggered by the plaintiffs' awareness of their claims no later than when the lead plaintiffs’ filed their amended complaint in April 23, 2010, over a year before the CAC was filed. With respect to the statute of repose, the action was not brought within three years of the November 2007 offering. The plaintiffs contended that the statutes of limitation and repose should be tolled under the American Pipe doctrine. The court rejected that argument as foreclosed by the Second Circuit’s recent decision in Police & Fire Ret. Sys. v. IndyMac MBS, Inc., 721 F.3d 95 (2d Cir. 2013), which held that “American Pipe’s tolling rule does not apply to the three-year statute of repose in Section 13.” Because the claims were barred by the statute of repose, it was unnecessary to consider whether the statute of limitations might be tolled.

The circuit also rejected the plaintiffs’ assertion that their claims were not time-barred because they related back to the original claims under Federal Rule of Civil Procedure 15(c). The court found that the CAC’s claims were “based on an entirely new theory encompassing different conduct” and therefore did not relate back to the original claims. The bulk of the plaintiffs’ claims were properly dismissed as untimely.

While there were allegations in the CAC from the original complaint relating to Lehman’s failure to disclose its CDO exposure, the Circuit found that “these allegations were also correctly dismissed by the district court for failing to state a plausible Securities Act claim.” Notably, the CAC failed to allege key information, including how much Lehman held in CDOs at the time of offerings or how much “was sufficient to be material to an investor at the time of the challenged offerings.”

Mollie Kornreich, Skadden Arps, New York, New York


October 22, 2013

FINRA Issues Supplemental Guidance on Expungement Process

On October 14, 2013, FINRA issued a notice to arbitrators and litigants that provided expanded guidance on the expungement process by which registered representatives may have customer complaints, including arbitration claims, removed from their records with the Central Registration Depository (CRD). The five points of guidance provided in the notice included

  1. 1. FINRA described expungement of a complaint as "an extraordinary remedy that should only be granted under appropriate circumstances." FINRA further stressed the importance of the CRD disclosures and noted that expungement is appropriate "only when [the information] has no meaningful investor protection or regulatory value."

  2. 2. Given the importance of maintaining the integrity of the information in the CRD system, FINRA described the role of arbitrators in the expungement process as "unique" and "significant." FINRA charged arbitrators with ensuring that they have the information needed "to make an informed and appropriate recommendation on expungement."

  3. 3. FINRA directed arbitrators to review a current copy of the registered representative’s BrokerCheck report when considering expungement.

  4. 4. FINRA further explained the importance of providing a written explanation for the recommendation of expungement, including citation to any documentary or other evidence relied on by the arbitrator in reaching the decision.

  5. 5. Finally, FINRA directed arbitrators to determine and consider whether a settlement between the parties had been conditioned upon an agreement not to oppose an expungement request.

Both parties and arbitrators should give careful consideration to the expanded guidance when faced with a request for expungement. Though the guidance provided is consistent with FINRA Rules 2080, 12805, and 13805 and not necessarily beyond the scope of what counsel would have recommended to a requesting party prior to its issuance, the notice does serve as a reminder to all involved of the importance of the issue to FINRA and the continued diligence with which it will act to ensure the continued integrity of what it views as one of the cornerstones of the CRD system. 

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


October 1, 2013

JPMorgan Settles with Government Regulators on "London Whale" Investigations

On September 19, 2013, JPMorgan Chase & Co reached a $920 million coordinated settlement with U.S. and UK regulators, resolving four agencies’ investigations into the 2012 "London Whale" incident. These regulators will split the settlement proceeds, with $200 million going to the Securities and Exchange Commission, $200 million to the Federal Reserve, $300 million to the Office of the Comptroller of the Currency, and $220 million to the UK Financial Conduct Authority.

As part of the settlement, JPMorgan acknowledged that it lacked appropriate controls to monitor the portfolios of its chief investment office (CIO) and that senior management did not make the audit committee sufficiently aware of CIO activity.  "We have accepted responsibility and acknowledged our mistakes from the start, and we have learned from them and worked to fix them," said JPMorgan chairman and CEO Jamie Dimon in a statement. These and other factual admissions may reflect the SEC's recent shift away from no-admit-no-deny settlements.

Notably absent from the settlement was the Commodity Futures Trading Commission (CFTC), which has issued a "Wells notice" informing JPMorgan that it intends to recommend an enforcement action. Following regulations promulgated in 2011 under the Dodd-Frank Act, the CFTC now only needs to show recklessness—not intent—to prove market manipulation in violation of the Commodity Exchange Act.

Two JPMorgan traders charged with concealing losses, Javier Martin-Artajo and Julien Grout, have been indicted by a federal grand jury. Bruno Iksil, the trader who caused the losses, reached a non-prosecution agreement with the government.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, New York


September 18, 2013

Second Circuit Applies Morrison to Criminal Securities Fraud Cases

On August 30, 2013, the United States Court of Appeals for the Second Circuit held that criminal liability under Section 10(b) of the Securities and Exchange Act of 1934 is, like civil liability, limited to conduct involving domestic securities transactions.  In so holding, the Second Circuit answered one of the questions left open following the Supreme Court’s 2010 decision in Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010), which addressed civil liability under the statute.

The case involved two prominent investment managers and advisers, Alberto Vilar and Gary Tanaka, who managed funds through a U.S. corporation, registered with the Securities and Exchange Commission (SEC), as well as corporations in Panama and the United Kingdom.  After a nine-week trial held before Judge Sullivan and a jury in the Southern District of New York, on November 19, 2008, Vilar and Tanaka were convicted of securities fraud and related crimes as a result of misstating the nature and quality of certain investments.

Following their conviction, the Supreme Court held in Morrison that liability under Section 10(b) and Rule 10b-5 was limited to "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.”  Morrison, 130 S. Ct. at 2888.  On appeal, Vilar and Tanaka argued that Morrison’s limit on the scope of Section 10(b) liability extends to criminal prosecutions brought under that provision, and that the conduct underlying their convictions for securities fraud was “extraterritorial,” and therefore not criminal under Section 10(b) or Rule 10b-5.  The government contended that Morrison was limited to civil cases.

In an opinion authored by Judge Cabranes and joined by Judges Newman and Straub, the Second Circuit agreed with the defendants that Morrison applies to criminal actions brought pursuant to Section 10(b) and Rule 10b-5.  The panel squarely rejected the government’s argument that the presumption against extraterritorial application of a federal statute does not apply to criminal laws.  It then reasoned that, inasmuch as extraterritoriality is a question of statutory interpretation and the conduct proscribed by Section 10(b) is the same in civil and criminal matters, the case was governed by Morrison’s extraterritoriality analysis.

The court nevertheless affirmed the convictions on the ground that at least some of the transactions— none of which involved securities listed on an American exchange—were “domestic” under Morrison.  Quoting its recent opinion in Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60, 65 (2d Cir. 2012), the court explained that a “securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States.”  Because the victims entered into their purchase agreements in the United States, the Second Circuit held that had the jury considered the question, it would have found that Vilar and Tanaka engaged in domestic transactions.

In addition to breaking new ground by applying Morrison in a criminal context, the Circuit also reaffirmed that reliance is not an element of a government enforcement action under Section 10(b) and rule 10b-5, as it is for a private action under that statute.  The Circuit remanded for the sentencing court to recalculate restitution in light of the holding that individuals who purchased securities abroad are not “victims” under Section 10(b) and to address “whether losses suffered by victims who purchased [securities] abroad may constitute ‘relevant conduct’ under” the Sentencing Guidelines.

An open question remains on how courts will interpret Vilar in light of the Dodd-Frank Wall Street Reform and Consumer Protection Act's “extraterritorial jurisdiction” amendment to the Exchange Act.  Enacted less than a month after Morrison, Dodd-Frank expressly acknowledged the federal courts’ extraterritorial reach by amending the Exchange Act to now provide that courts have jurisdiction over actions by the SEC or DOJ involving “(1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.” 15 U.S.C. § 78aa(b). Presumably because the conduct of Vilar and Tanaka predated this amendment, in Vilar, the government did not attempt to invoke Dodd-Frank's “extraterritorial jurisdiction” amendment.  We can expect courts to grapple with the interplay between Morrison, Vilar, and Dodd-Frank going forward.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, New York


September 18, 2013

Government Charges Former JPMorgan Traders

On August 14, 2013, the Department of Justice (DOJ) and Securities and Exchange Commission (SEC) brought parallel suits against two former JPMorgan Chase & Co. (JPMorgan) traders, charging them with concealing losses caused by the 2012 "London Whale" incident.

The complaints contend that the traders, Javier Martin-Artajo and Julien Grout, were responsible for a portfolio of synthetic credit derivative products which they deliberately overvalued as losses mounted in early 2012.  The traders allegedly mismarked the value of the portfolio and limited reporting of losses.  As a result, JPMorgan overstated its consolidated income by hundreds of millions of dollars in April 2012 and, following an internal investigation, restated its first quarter financials in July of 2012.  As alleged in the complaints, Martin-Artajo was a managing director and head of Europe and Credit & Equity, and was responsible for overseeing the portfolio.  Grout was a vice president who reported to Martin-Artajo and followed his valuation instructions.

In its criminal complaints, the DOJ charged both Martin-Artajo and Grout with falsification of books and records, wire fraud, making false filings with the SEC, and conspiracy to commit those acts. The SEC brought  claims for violation of sections 10(b) and 13(b)(5) of the Securities and Exchange Act of 1934  and associated rules. The cases were filed in the Southern District of New York.

Bruno Iksil, the trader whose derivatives position caused the losses, has not been charged.  He reached a non-prosecution agreement with the U.S. Attorney’s Office, and the Wall Street Journal has reported that enforcement staff at the SEC and Commodity Futures Trading Commission have agreed not to recommend civil suits against him.

Mollie Kornreich, Skadden Arps, New York, New York


July 22, 2013

Second Circuit Affirms Dismissal of Madoff Trustee's Claims Against Banks for Allegedly Aiding Ponzi Scheme

On June 20, 2013, the Second Circuit held that the trustee of Bernard Madoff's defunct broker-dealer business could not sue several banks that allegedly facilitated Madoff's Ponzi scheme.  The court found that the trustee was barred under New York law from asserting claims on behalf of the estate and lacked standing to bring suit on behalf of Madoff's victims.

The trustee, Irving Picard, was appointed under the Securities Investor Protection Act (SIPA), which aims to streamline the process of distributing customer property following the collapse of a brokerage firm like Madoff's.  In addition to assessing customer claims, a SIPA trustee has authority to recover and distribute funds.  In this capacity, Picard brought suits against JPMorgan Chase & Co., UBS AG, UniCredit S.p.A., HSBC Bank plc, and various affiliates, alleging among other causes of action common law claims that the banks aided and abetted Madoff's misconduct.  U.S. District Judges Jed S. Rakoff and Colleen McMahon dismissed the common law claims.

In an opinion authored by Chief Judge Dennis Jacobs (joined by Judges Winter and Carney), the Second Circuit affirmed.  Applying New York's doctrine of in pari delicto and the related federal "Wagoner Rule," which bar one wrongdoer from recovering against another, the court held that the trustee "stands in the shoes" of Madoff's firm, Bernard L.  Madoff Investment Securities LLC (BLMIS).  The Trustee therefore could "not assert claims against third parties for participating in a fraud that BLMIS orchestrated."  The court found the Trustee's attempt to bring the claims under the "adverse interest" exception to the doctrine unpersuasive, as Madoff's fraud was not committed against BLMIS, but on its behalf.  With respect to the Trustee's claim for contribution—which was not necessarily barred by the doctrine of in pari delicto – the court held that "[b]ecause the Trustee's payment obligations were imposed by a federal law that does not provide a right to contribution, the district courts properly dismissed these claims."

Clarifying a point on which there had been significant conflicting precedent, the Second Circuit further held that the Trustee lacked standing to assert claims on behalf of BLMIS's customers.  Noting that a bankruptcy trustee does not have third-party standing, the court declined to distinguish SIPA liquidations from those in bankruptcy.  The court rejected the Trustee's contentions that he could bring suit as a bailee or that the Securities Investor Protection Corporation (SIPC)—a statutorily created nonprofit that intervened to recover money it had advanced to Madoff victims—could assert customers' claims as a subrogee.  The case is captioned In re Bernard L. Madoff Investment Securities LLC.

Read the opinion.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, New York


July 9, 2013

Defining "Customer" for Purposes of Securities Arbitration

The Fourth Circuit has, for the first time, defined who is a "customer" for purposes of FINRA (Financial Industry Regulatory Authority) rules that entitle customers of a securities firm to demand arbitration. The court held that a "customer" is "one, not a broker or dealer, who purchases commodities or services from a FINRA member in the course of the member's business activities insofar as those activities are regulated by FINRA—namely investment banking and securities business activities." The court then applied that definition in two cases, with opposite results.

In the first case, UBS Financial Services, Inc. v. Carilion Clinic, Carilion retained UBS and Citi as investment advisers in connection with a bond offering. UBS and Citi provided various services to Carilion, including advising on the structure of the financing, serving as underwriters for the bonds, and acting as Carilion's agent in dealing with rating agencies. Later, the market for Carilion's bonds collapsed, forcing Carilion to refinance and thereby lose millions of dollars. Carilion, claiming that these losses were caused by UBS and Citi's malfeasance, initiated arbitration proceedings with FINRA pursuant to FINRA Rule 12200, which requires FINRA members (including UBS and Citi) to arbitrate disputes between themselves and a "customer" if requested by the customer.

UBS and Citi sought to enjoin the arbitration, contending that Carilion was not a "customer" within the meaning of Rule 12200, because that rule was intended to protect investors rather than issuers such as Carilion. The Fourth Circuit rejected this argument on the grounds that (a) the ordinary meaning of "customer" includes all products offered by a company, and (b) nothing in the FINRA rules limit "customers" to investors. Thus, by purchasing underwriting and auction services from UBS and Citi, Carilion was a customer for purposes of Rule 12200.

UBS and Citi further contended that even if Carilion was a customer, Carilion waived its right to arbitration by contractually agreeing to a forum selection clause providing that "all actions and proceedings arising out of this Agreement . . . shall be brought in the United States District Court in the County of New York." Addressing this argument, the court acknowledged that the obligation to arbitrate under Rule 12200 can be superseded and displaced by a more specific agreement between the parties. The court added, however, that any such agreement "must be sufficiently specific to impute to the contracting parties the reasonable expectation that they are superseding, displacing, or waiving the arbitration obligation created by FINRA Rule 12200."  The court then held that the forum selection clause in this case, which says nothing about arbitration, was not sufficiently specific to show an intent to waive Rule 12200.

Two weeks later, in Morgan Keegan & Co. v. Silverman, the Fourth Circuit again addressed the definition of "customer" under FINRA Rule 12200.  Defendants invested in bond funds that were distributed and underwritten by FINRA member Morgan Keegan. Defendants did not purchase the funds directly from Morgan Keegan but rather on the secondary market through their brokerage account at Legg Mason. The value of the funds dropped in 2007, causing defendants to lose money. Defendants initiated FINRA arbitration proceedings against Morgan Keegan, alleging that Morgan Keegan failed to disclose information about the high-risk nature of the funds and falsely inflated the funds’ asset values.

Morgan Keegan sought to enjoin the arbitration on the grounds that the defendants were not its "customers" under Rule 12200 and therefore not entitled to demand arbitration. The Fourth Circuit, applying the definition of "customer" from the UBS case, held in Morgan Keegan's favor on the grounds that defendants did not "purchase commodities or services" from Morgan Keegan. Rather, the defendants' relationship was with their broker, Legg Mason. The court explained that merely having "a remote association with alleged misconduct falling within the general ambit of FINRA's regulatory interests" is insufficient to create a customer relationship for purposes of Rule 12200.

These cases together show that a "customer" for purposes of FINRA arbitration rules must have a direct relationship with the securities firm at issue, but once such a relationship is established, the right to arbitrate is broad enough to cover disputes relating to most commodities or services offered by a securities firm.

Clifton L. Brinson, Smith, Anderson, Blount, Dorsett, Mitchell & Jernigan, L.L.P., Raleigh, NC


July 9, 2013

Update: SEC Commissioner Calls for Reform of "Accredited Investor" Definition

On May 20, 2013, SEC Commissioner Elisse Walter spoke frankly about her support for reformation of the "accredited investor" definition under the Securities Act of 1933 and called for an open discussion of revisions to the definition.  According to Walters, the commission "desperately" needs to address the outdated "accredited investor" definition.  Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the commission is restrained from substantively amending the definition until mid-2014. In Walter's view, the commission should act rapidly when the prohibition is lifted.

Under the current definition, an individual is an "accredited investor" if the individual has a net worth of over $1 million, excluding primary residence, or if the individual has an income of over $200,000 for each of the past two years with the expectation of the same income level in the current year. Walter suggested removing the income and net worth factors from the definition and shifting to a test focusing on the amount of an investor’s assets that are to be invested. In Walter's opinion, such a test will be easier to measure and verify than the current definition.

As the Investor and Purchaser Subcommittee of the SEC's Investor Advisory Committee acknowledged last year, the current accredited investor definition focuses on incoming assets and does not necessarily address an investor's ability to assess risk. Adoption of an "assets invested" standard such as the one proposed by Walter could offer greater protection to individuals who, despite their high net worth or annual income, lack the investment acuity that is presumed under the current definition. For example, many individuals qualify as accredited investors under the current definition due to wealth that was obtained without any investment knowledge, such as through a personal injury settlement or a one-time inheritance. For such individuals, an "assets invested" test could more appropriately consider whether the individual has enough discretionary income to assume investment risks and the potential financial losses associated with such investments.

As the end of the prohibition on amendment of the accredited investor definition nears, practitioners can expect the commission, and advocates for both investors and issuers, to continue discussions of potential reform and possibly the implementation of an entirely new definition.

Meghan E. George, Baker & McKenzie, LLP, Dallas, TX


June 26, 2013

Second Circuit Applies Janus and Stoneridge to Market Manipulation Suit

On May 7, 2013, a split Second Circuit panel held that a defendant who had not individually communicated a misrepresentation to the plaintiffs could not be liable for market manipulation in a private action under Section 10(b) of the 1934 Act.

The case, Fezzani v. Bear, Stearns & Co. Inc., involved an alleged "pump and dump" scheme in which a broker-dealer, A.R. Baron, induced customers to purchase securities of small companies while allegedly falsely representing the stock's profitability. One of Baron's principal investors, Isaac Dweck, allegedly facilitated the fraud by funding the company and allowing it to "park" securities in his accounts with a guaranteed return, purportedly creating a false impression of the stock's value.

Because there is no aiding and abetting liability in private rights of action under Section 10(b), Plaintiffs did not argue that Dweck aided and abetted the fraud.  Instead, they maintained that, although Dweck never communicated directly with investors and his involvement in the scheme was not disclosed, his conduct was sufficient to make him a primary violator of Rule 10b-5.  Judge Paul A. Crotty of the U.S. District Court for the Southern District of New York dismissed the claim against Dweck because plaintiffs failed to plead he made any misrepresentations to plaintiffs or that plaintiffs relied on misrepresentations made by him.

The United States Court of Appeals for the Second Circuit affirmed the dismissal. Writing for the court, Judge Winter, joined by Judge Cabranes, found these facts insufficient to state a claim for market manipulation because Dweck was not alleged to have been "involved in any communication" with plaintiffs. The decision hinged on application of  two Supreme Court cases, Stoneridge Investment Partners v. Scientific-Atlanta and Janus Capital Group Inc. v. First Derivative Traders. The majority held that, under these cases, "only the person who communicates the misrepresentation is liable in private actions under Section 10(b)."  The opinion explained that knowingly participating in and facilitating a fraud, without more, does not create primary violator liability: "an allegation of acts facilitating or even indispensible to a fraud is not sufficient to state a claim if those acts were not the particular misrepresentations that deceived the investor."

The dissent, authored by Judge Lohier, disagreed with this reading and drew a distinction between market manipulation claims and misrepresentation claims with respect to the limitations on secondary actor liability established by Stoneridge and Janus.  While acknowledging that Janus and Stoneridge applied to misrepresentation claims, Judge Lohier would have found them inapplicable to market manipulation claims, which rely on the fraud-on-the-market doctrine.

Although the Section 10(b) claim was dismissed, the circuit found that plaintiffs' state law claims should survive the motion to dismiss, and remanded for further proceedings.

Read the opinion.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, New York


June 19, 2013

In Memoriam: J. Boyd Page

The ABA Securities Litigation Committee lost a dear friend and valued member with the recent passing of J. Boyd Page. Boyd was a gentleman, an honorable advocate for his clients and  investor rights, and a worthy adversary to those in the defense bar.  A list of his accomplishments, though too lengthy to set forth in this space, include the founding of his firm Page Perry, LLC, undergraduate and law degrees from the University of Virginia, testimony before Congress on the securities arbitration process, service as a founder and past president of the Public Investors Arbitration Bar Association, and receipt of the “Outstanding Georgia Citizen Award” from the Georgia Secretary of State. He also had been serving as the cochair of this Committee’s Securities Arbitration Subcommittee, a position which he had held for a number of years. Boyd will be missed. The Committee members extend their condolences to Boyd’s family, friends, and colleagues.


>May 22, 2013

Florida Arbitration Claims Are Subject to Statutes of Limitation

In a recent opinion, the Supreme Court of Florida ruled that claims in arbitration are subject to the state's statutes of limitation. The plaintiffs, a group of investors who filed a joint arbitration claim against Raymond James in 2005, claimed that their brokerage accounts were unsuitably invested in high-risk securities that were inconsistent with their investment objectives. The investors' complaint set forth claims alleging violations of federal securities law and Florida state law. Raymond James argued that the investors' claims, which were filed more than six years after the first unsuitable investment and more than four years after the last of the alleged unsuitable purchases, were barred by the statute of limitations.

In reversing the District Court of Appeal of Florida, Second District, the high court found that an arbitration proceeding qualifies as a “civil action or proceeding” under the terms of Section 95.011 of the Florida Statutes. Accordingly, claims in arbitration are subject to applicable statutes of limitation. In so ruling, the high court looked to the plain language of Section 95.011, the legislative intent behind its passage, and the purpose of the statute.

In reviewing the common usage of the terms used in Section 95.011, the high court found that the statutory term "proceeding" was a broad term that includes arbitration. Further, the high court noted that the legislative history of Section 95.011 "indicates an intent to expand the term beyond just those actions occurring in a judicial proceeding." Finally, acknowledging that the purpose of the statute of limitations is to protect defendants from "unfair surprise and stale claims[,]" the high court instructed as follows:

Interpreting the phrase "civil action or proceeding" to apply only to judicial actions and to exclude arbitration is contrary to the very purpose of the statute of limitations to discourage stale claims. Moreover, this interpretation would mean that the statute of limitations does not apply to the exact situation where parties have contractually agreed to pursue arbitration in order to resolve disputes efficiently, quickly, and inexpensively.

The case is Raymond James Financial Services, Inc. v. Phillips, et al., case number SC11-2513 (May 16, 2013).

Joshua D. Jones and W. Preston Martin, Maynard Cooper & Gale, P.C., Birmingham, AL


April 16, 2013

Supreme Court Heightens Class Certification Analysis and Review

On March 27, 2013, the U.S. Supreme Court clarified the standard for courts considering class certification, holding , for the first time, that a class “was improperly certified” because plaintiffs “had failed to establish that damages could be measured on a class-wide basis.” The Court further held that the "rigorous analysis" framework of Rule 23(a) also governs Rule 23(b). These holdings have potentially far-reaching implications, including in the securities context.

The case, Comcast Corp. v. Behrend, involved a class of over 2 million current and former Comcast subscribers that was certified under Rule 23(b)(3) by the District Court. A divided panel of the Third Circuit affirmed the class certification and refused to consider whether it was flawed due to the overbroad damage modeling. Instead, the Third Circuit found, it was unnecessary at the certification stage to tie the damages calculation methodology to a particular theory of antitrust impact, or to determine whether the methodology created “a just and reasonable inference” of class-wide damages.

The majority opinion, penned by Justice Antonin Scalia and joined by Chief Justice John Roberts and Justices Anthony Kennedy, Clarence Thomas, and Samuel Alito, addressed the circuit’s reluctance to evaluate the damage methodology. Quoting heavily from its 2011 opinion in Wal-Mart Stores, Inc. v. Dukes, the Court emphasized that certification requires a “rigorous analysis” to ensure Rule 23(b)(3)’s requirements have been satisfied. The Court  specifically reiterated that, at the certification stage, “it ‘may be necessary for the court to probe behind the pleadings before coming to rest on the certification question.’”  While the Court had previously applied this “rigorous analysis” framework to Rule 23(a), it broke new ground by explicitly stating that “the same analytical principles govern Rule 23(b).”

The majority went on to hold that, “under the proper standard for evaluating certification, respondents’ model falls far short of establishing that damages are capable of measurement on a classwide basis. Without presenting another methodology, respondents cannot show Rule 23(b)(3) predominance: Questions of individual damages calculations will inevitably overwhelm questions common to the class.” Moreover, the Court held that plaintiffs’ damages model must be consistent with the liability case, and “courts must conduct a ‘rigorous analysis’ to determine whether that is so,” even if such analysis necessitates examination of the underlying merits of the claim.

The Court’s opinion in Comcast may answer some questions arguably left open by the Court’s recent opinion in the securities class action Amgen Inc. v. Connecticut Retirement Plans & Trust Funds. There, the Court held that materiality in a securities fraud class action need not be established to obtain class certification on the basis of the “fraud on the market” theory, despite the fact that proof of materiality is a necessary element of that theory and that the plaintiff could only establish predominance if the fraud-on-the-market theory were applicable. Because materiality is objective under a fraud-on-the-market theory, the Court reasoned, the question of materiality is common to the class, regardless of whether, on the merits, the allegedly misleading statements were in fact material. In so holding, the Court drew a firm line between the certification and merits stages and noted that Rule 23(b)(3) “does not require a plaintiff seeking class certification to prove that each ‘elemen[t] of [her] claim [is] susceptible to classwide proof.’” This led some commentators to doubt the continued vitality of the principles articulated in Dukes.

The majority opinion in Comcast, however, reaffirmed that the requisite “rigorous analysis” under Rule 23(b) may “overlap with the merits” and found that certification  may be inappropriate if plaintiffs fail to demonstrate that damages (also an essential element of securities claims) are measurable on a class-wide basis. The application of this holding in Comcast appears to restrict the Amgen pronouncement that 23(b) (3) does not require a plaintiff to prove that each element is susceptible to class-wide proof.  By restating the principles laid out in Dukes and insisting on a “rigorous,” fact-intensive analysis, the Comcast decision is important for any corporation that has been targeted by a class action. While this opinion’s impact is potentially profound, it will be up to lower courts to grapple with any perceived tension between Amgen and Comcast.

Read the opinion here.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, New York


March 28, 2013

Securities Class Action Settlements at 14-Year Low in 2012, but Values High

A 14-year low in the number of securities class action settlements occurred in 2012, according to a recent report issued by Cornerstone Research. The total dollar value of the settlements, however, increased over 100 percent from 2011.

The report, published on March 20, 2013, found 53 court-approved securities class action settlements in 2012, which not only represents the lowest number in 14 years, but also continues the four-year trend of the diminishing number of total settlements.

The increase in total dollars and average settlement amount is partially due to an increase in the number of settlements in excess of $100 million. The report found that 11 percent of all settlements in 2012 were such “mega-settlements”—the highest figure since 2006, and well above 2011’s 5 percent. These large payouts accounted for 74 percent of all settlement dollars in 2012, compared to only 41 percent in 2011.

Continuing another long-term trend, public pensions were lead plaintiffs in 49 percent of the 2012 cases. This percentage is higher than the 40 percent in 2011, and much higher than the 6 percent Cornerstone observed for 2003.

The study reports that over half of the 2012 cases were accompanied by a derivative action—a higher percentage than Cornerstone found over the past few years. Additionally, more than 20 percent involved a corresponding SEC action prior to settlement. Although greater than the 2011 percentage, this number is lower than it has been in some recent years.

The report further found, not surprisingly, that the stage of litigation impacted settlement amounts. The median settlement in cases that survived summary judgment was dramatically higher than in cases that settled earlier. Settlements following denial of a motion to dismiss were higher than those that took place earlier in the litigation, but the difference was not as marked as the pre- and post-summary judgment disparity.

In defining its research pool, the Cornerstone report focused on cases where purchasers of a corporation’s common stock alleged fraudulent inflation of the stock price, in violation of Rule 10b-5, Section 11, and/or Section 12(a)(2).

The report speculates that, due to the long lifespan of these class actions, the 2012 figures likely reflect the relatively low number of securities class actions filed in 2009 and 2010.

Read the report here.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, New York


March 20, 2013

Second Circuit Overturns Class Certification Against Bear Stearns

The Second Circuit recently overturned the district court’s certification of a 10b-5 class action against Bear Stearns. In an opinion issued March 15, 2013, the Second Circuit concluded that the plaintiffs failed to allege that Bear Stearns had “sufficiently direct involvement” in a broker-dealer’s fraud to create an actionable duty.  The court’s decision arguably lessens the potential liability of a clearing broker to investors who are defrauded by broker-dealers.

The case originated from a fraudulent scheme run by Sterling Foster & Co., a New York-based broker-dealer, who is alleged to have defrauded thousands of investors out of more than $70 million in the 1990s. Bear Stearns, an investment bank acquired by J.P. Morgan Chase & Co. in 2008, acted as a clearing broker in five initial public offerings underwritten by Sterling Foster in 1996. The plaintiffs alleged that Bear Stearns was liable for participating in “Sterling Foster’s conduct by, among other things, continuing to clear transactions for Sterling Foster despite alleged knowledge of the ongoing manipulative scheme.”

The Eastern District of New York certified the plaintiff class, made up of about 2,000 Sterling Foster clients, in July 2010. The district court concluded that Bear Stearns’s alleged participation in Sterling Foster’s scheme was sufficient to trigger a duty of disclosure to Sterling Foster’s clients.  This duty of disclosure allowed the plaintiffs a presumption of reliance with respect to Bear Stearns’ failure to disclose the Sterling Foster scheme. The presumption of reliance, in turn, enabled the class to satisfy the predominance requirement under Rule 23(b)(3), which requires that “the questions of law or fact common to class members predominate over any questions affecting only individual members.”

On interlocutory appeal, the Second Circuit reversed, concluding that the plaintiffs’ allegations were insufficient to establish Bear Stearns’s duty of disclosure to the plaintiffs. The Second Circuit stated that “sufficiently direct involvement” is required of a clearing broker in a broker-dealer’s fraud in order to create an actionable duty, such as directing or instigating the fraud. Because the plaintiffs could not establish a duty to disclose, the Second Circuit concluded that the plaintiffs were not entitled to a presumption of reliance and therefore did not satisfy the predominance requirement for certification of a class.

Read the opinion here.

Julie H. Firestone and Christine J. Kim, Briggs and Morgan, P.A., Minneapolis, MN


March 5, 2013

Supreme Court Holds SEC to Statute of Limitations in Fraud Case

On February 27, 2013, the Supreme Court unanimously held in Gabelli v. Securities and Exchange Commission that the five-year statute of limitations in a fraud-related civil penalty action brought by the SEC runs from the date the defendant completes the alleged fraud, not the date the government discovers it.

The opinion, authored by Chief Judge John Roberts, rejected the SEC’s argument that it should benefit from the “discovery rule,” which typically applies in fraud suits brought by private citizens. An exception to the “standard rule” that a claim accrues when the plaintiff has been injured, the “discovery rule” recognizes that fraudulent conduct may prevent a plaintiff from learning of his claim and stops the clock on the statute of limitations from beginning to run until the time that plaintiff could reasonably have discovered the fraud.

The SEC brought the claim at issue against Marc Gabelli and Bruce Alpert under the Investment Advisors Act of 1940, accusing them of defrauding mutual fund clients until August 2002. The District Court dismissed the SEC’s civil penalties claim, filed in April 2008, as untimely. The Second Circuit acknowledged the five-year statute of limitations but reversed on the grounds that the discovery rule applied.

The Supreme Court reasoned that the rationale behind the discovery rule was inapplicable in the enforcement agency context: “Unlike the private party who has no reason to suspect fraud, the SEC’s very purpose is to root it out, and it has many legal tools at hand to aid in that pursuit.” Additionally, the opinion expressed a pragmatic concern that it would be difficult for courts to determine when the government “knew or reasonably should have known of a fraud,” given the size of many agencies and the complexity of the investigative process.

As Justice Stephen Breyer observed during oral argument, the case has potentially far-reaching consequences.  The statute of limitations is not specific to securities law but applies to other penalty provisions in the U.S. Code. Moreover, nothing in the opinion limits its rejection of the discovery rule for government agencies to securities fraud cases.

The SEC’s claims against Gabelli and Alpert for disgorgement and injunctive relief were not dismissed as time barred and survive the appeal.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, New York


March 5, 2013

Plaintiffs Need Not Prove Materiality to Obtain Class Certification

In Amgen Inc. v. Connecticut Retirement Plans & Trust Funds, issued Wednesday, February 27, 2013, the Supreme Court held that proof of materiality is not a prerequisite to class certification in federal securities fraud cases. While acknowledging that materiality is a prerequisite to invoking the fraud-on-the-market presumption of reliance adopted in Basic Inc. v. Levinson, the Court drew a distinction between class considerations and merits issues. It held that materiality is a common question for class certification purposes under Rule 23(b)(3); but whether a plaintiff can prove that an alleged misstatement is material is an issue to be resolved on the merits, such as on a summary judgment motion. The opinion, written by Justice Ginsburg for the 6-3 majority, resolves a Circuit Court split over whether a plaintiff must prove materiality at the class certification stage. But four justices questioned Basic’s continuing validity.

Plaintiff alleged that Amgen and certain of its officers violated Section 10(b) by making misstatements about two of Amgen’s drugs. Opposing class certification, Amgen argued that plaintiff failed to prove materiality. Absent proof of materiality, plaintiff could not invoke Basic’s rebuttable presumption of reliance and, therefore, could not show that common questions predominated and merited class treatment. The district court and the Ninth Circuit rejected that argument. The Supreme Court affirmed.

The Court held that Rule 23(b)(3) requires a plaintiff to show that common questions, not questions affecting only individual class members, predominate.  Because materiality is measured by an objective standard, the Court held that whether a misstatement is material is a common question for Rule 23(b)(3) purposes. The Court rejected the argument that a plaintiff must prove materiality at the class certification stage to ensure that common questions predominate. The Court held that a “failure to present sufficient evidence of materiality to defeat a summary-judgment motion or to prevail at trial would not cause individual reliance questions to overwhelm the questions common to the class.  Instead, the failure of proof on the element of materiality would end the case on[c]e and for all.”  Absent the risk of “individual questions overwhelming common ones, materiality need not be proved prior to Rule 23(b)(3) class certification.”

Under Amgen, a defendant apparently no longer may prevent a plaintiff from invoking Basic’s rebuttable presumption of reliance at the class certification stage by challenging materiality.  But a defendant still may defeat the presumption of reliance at that stage by showing that the lead plaintiff cannot prove (i) the securities traded in an efficient market, (ii) the misstatements were public, or (iii) the lead plaintiff’s transaction occurred between the time the alleged misstatement was made and the time the truth was revealed. The Court also confirmed that a class ultimately must prove materiality to prevail on the fraud-on-the-market theory, and it noted no fewer than four times that a court may resolve materiality questions on summary judgment. Finally, in concurring and dissenting opinions, four Justices questioned Basic, which suggests that, given an opportunity, the Court might reexamine the fraud-on-the-market presumption of reliance or the efficient-market hypothesis on which it is based.

James Goldfarb and Michael Rella, Murphy & McGonigle, P.C., New York, New York


March 1, 2013

Department of Justice Files Action Against Standard & Poor's

On February 4, 2013, the Department of Justice (DOJ) filed a lawsuit in the Central District of California against credit-rating agency Standard & Poor’s Ratings Services (S&P) and its parent corporation, McGraw-Hill Companies, Inc., alleging that S&P falsely represented the nature of its ratings and engaged in a scheme to defraud investors in residential mortgage-backed securities and collateralized debt obligations. Attorneys general from 13 states and Washington, D.C., joined in the DOJ’s action and have also commenced parallel suits.

This is the federal government’s first attempt to hold a credit-rating agency liable for conduct leading up to the 2008 financial crisis. The DOJ complaint asserts claims under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) for mail fraud, wire fraud, and financial-institution fraud. The complaint alleges that this activity took place from 2004 to 2007, which is well within FIRREA’s generous ten-year statute of limitations.

Passed in the wake of the savings and loan crisis, FIRREA permits the government to bring civil claims for violations of various criminal statutes. By bringing a civil action under FIRREA, the DOJ faces a lower burden of proof than it would in a criminal case. The statute has not previously been used to bring claims against rating agencies, however, and the government will have the burden of establishing that each alleged violation affected a federally insured financial institution.

The filing in the Central District of California was the culmination of a three-year investigation and subsequent breakdown in settlement negotiations, which the New York Times reported was precipitated by the DOJ’s insistence on at settlement of at least $1 billion and an admission of wrongdoing.

On February 5, 2013, McGraw-Hill issued a statement calling the landmark DOJ suit “entirely without factual or legal merit.”

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, New York


February 6, 2013

Who Is Really a "Customer" According to FINRA Rules?

The Fourth Circuit Court of Appeals has clarified the definition of the term “customer” as it is used in the FINRA Code of Arbitration Procedure for Customer Disputes. FINRA is the Financial Industry Regulatory Authority, the securities industry’s self-regulatory organization. FINRA was chartered under the Exchange Act to oversee the securities industry. Part of FINRA’s mission involves investor protection and administering its arbitration forum for the resolution of disputes that arise between its member firms (broker-dealers) and customers of such firms.

FINRA Rule 12200 provides that member firms must arbitrate a dispute when a customer so requests, as long as the dispute is between a customer and a member or an associated person of a member, and arises in connection with the business activities of the member or associated person. The rule also requires members to arbitrate if arbitration is required by a written agreement, such as a customer-account agreement, but that was not the situation faced by the Fourth Circuit.

FINRA rules define the term “customer” as follows: “A customer shall not include a broker or dealer.” They are silent, however, on what non-brokers and non-dealers are customers. As noted below, there has been some inconsistency in circuit-court rulings on the meaning and scope of the term “customer” as it is used in Rule 12200.

This issue was presented to the Fourth Circuit in the recent case of UBS Financial Services, Inc. and Citigroup Global Markets, Inc. v. Carilion Clinic, 2013 WL 239051 (4th Cir. Jan. 23, 2013). In that case, UBS and Citigroup sought to enjoin FINRA arbitration proceedings commenced by Carilion. The clinic alleged, in essence, that UBS and Citigroup breached a number of duties in connection with advising Carilion regarding its issuance of auction-rate securities.

UBS and Citigroup argued that they could not be compelled to arbitrate Carilion’s claims because, among other reasons, Carilion was not their customer within the meaning of FINRA Rule 12200. The banks argued that, to be their customer, one must have a brokerage account or an investment relationship with them, and Carilion did not.

The Fourth Circuit, in rejecting that narrow interpretation and affirming the district court’s denial of the banks’ motion for preliminary injunction, held that, for purposes of FINRA Rule 12200, “customer” means “one, not a broker or a dealer, who purchases commodities or services from a FINRA member in the course of the member’s business activities insofar as those activities are regulated by FINRA—namely investment banking and securities business activities.” This more expansive definition is consistent with FINRA’s mission, which is not restricted to investor protection, but extends to “comprehensive oversight of the securities industry,” the court explained.

The Fourth Circuit court stated that its definition is “fully supported by the decisions of other courts” (citing one Second Circuit case and two district-court decisions from California and New York), and distinguished Fleet Boston Robertson Stephens, Inc. v. Innovex, Inc., 264 F.3d 770 (8th Cir. 2001) (holding that a party receiving banking and financial advice was not a “customer” under NASD rules and could not invoke a member’s arbitration obligation), which was relied upon by UBS and Citigroup.

The Innovex court defined “customer” as “one who receives investment and brokerage services or otherwise deals more directly with securities than what occurred here” (emphasis added by the Carilion court). Because the Innovex court did not explain what it meant by the italicized language, and because it dealt with a customer who merely received banking and financial advice, the Fourth Circuit declined to follow its limitation of the scope of “customer” to “one who receives investment and brokerage services.”

While the Fourth Circuit’s interpretation is not as broad as the one suggested by FINRA’s definition (i.e., everyone who is not a broker or a dealer), or the dictionary definition (anyone who purchases some commodity or service), it provides some clarification of the procedural rights of claimants who did not receive investment or brokerage services.

J. Boyd Page, Page Perry, Atlanta, GA


February 6, 2013

Study: SEC Investigations Not as Effective as Private Actions

Professors Stephen J. Choi of New York University Law School and Adam C. Pritchard of the University of Michigan Law School have recently published a study finding that private securities cases may provide a greater deterrent to securities fraud than Securities & Exchange Commission (SEC) investigations. In their study entitled “SEC Investigations and Securities Class Actions: An Empirical Comparison,” New York U. School of Law, Law & Economics Research Paper Series, Working Paper No. 12-28 (Dec. 2012), Professors Choi and Pritchard conclude that private securities-law actions encompass more egregious fraud schemes and result in larger recoveries, more officer terminations, and greater institutional shareholder turnover than do SEC investigations. Those findings lead them to conclude that the filing of a private securities action has a far greater impact on securities markets and individual fraud players than the announcement of an SEC investigation.

The study undercuts the common belief that SEC enforcement actions are the superior method for deterring securities fraud because the SEC has greater investigative and subpoena power and its investigations are more targeted. It also contradicts the often repeated premise that private securities class actions add little deterrent effect to SEC investigations.

Some of the reasons given in support of the study’s findings include that private class-action attorneys, who must demonstrate loss causation as an element of a federal securities-fraud claim, target larger and consequently more egregious frauds. Others are that SEC investigations do not always result in monetary settlements, they focus on smaller, more targeted settlements, or they focus upon violations other than those arising from disclosure issues. SEC investigations thus may cause less concern to market participants than the filing of a private securities class action as measured by less shareholder turnover, fewer officer terminations, and a smaller spread between the bid and ask price of the stock of a company under investigation as compared to one subject to a private securities-fraud class action.

Professors Choi and Pritchard conclude,

Our findings offer little support to commentators who call for a shift from private actions to greater public enforcement. We found that class action only filings focus on securities law violations that are comparable to, and in some tests, greater than the violations on which the SEC alone focuses. Our results suggest that private plaintiffs’ attorneys, if anything, provide greater deterrence against more serious securities law violations compared with the SEC.

Andrew Morganti, Morganti Legal, P.C., Detroit, MI and Toronto, Ontario; Lynda J. Grant, TheGrantLawFirm, PLLC, New York, NY


January 24, 2013

Obama Nominates Former Prosecutor Mary Jo White to Lead SEC

On January 24, 2012, President Obama nominated Mary Jo White to serve as chairperson of the Securities and Exchange Commission (SEC). Prior to her nomination to lead the SEC, Ms. White served as the U.S. attorney for the Southern District of New York from 1993 through 2002. At the U.S. Attorney’s Office, Ms. White oversaw some of the most notorious cases and investigations in the last 20 years, including the successful prosecutions of mob boss John Gotti and terrorists responsible for the 1993 bombing of the World Trade Center, as well as the investigation of President Clinton’s final-day pardon of Marc Rich.

Speaking during a brief ceremony at the White House, President Obama remarked that he expected Ms. White to be a capable and tough leader. Describing her work at the U.S. Attorney’s Office, the president stated that “You don’t want to mess with Mary Jo. As one former SEC chairman said, Mary Jo does not intimidate easily.” Ms. White remarked that she would act to “protect investors and ensure the strength, efficiency and transparency of capital markets.”

Ms. White currently chairs Debevoise & Plimpton LLC’s litigation department and represents clients in litigation matters involving white-collar issues, internal investigations, securities and corporate governance, and health-care matters. Given her work at Debevoise, Ms. White is expected to be questioned about her defense of several Wall Street heavyweights, including Bank of America’s former CEO Ken Lewis. Ms. White’s confirmation hearing has not yet been scheduled.

Julie H. Firestone and Daniel J. Supalla, Briggs and Morgan, P.A., Minneapolis, MN


January 24, 2013

Plaintiffs Have Private Rights of Action under the ICA

Although private rights of action under the Investment Company Act of 1940 (ICA) are restricted by the language of the statute itself and have been interpreted narrowly by the courts (see, e.g., Northstar Fin. Advisors, Inc. v. Schwab Invs., 615 F.3d 1106 (9th Cir. 2010)), the ICA remains a viable statutory vehicle for fiduciary-breach claims against a fund’s investment advisor in certain circumstances.

Section 36(b) of the ICA (15 U.S.C.S. § 80a-35(b)) imposes an express fiduciary duty on a fund's investment advisor with respect to the management fees it receives. Section 36(b) also authorizes the security holders of a registered investment company to bring a private right of action “on behalf of the company” against the company's investment advisor and its affiliates for breach of that fiduciary duty. Courts have held that this private right of action may be asserted either in a derivative action or a direct class action based on the specifics of the claim and whether the underlying state law would consider it a direct or a derivative claim. See e.g., Strougo v. Bassini, 282 F.3d 162 (2d Cir. 2002). If the section 36(b) claim is brought as a derivative suit, no demand on the board need be made. Daily Income Fund v. Fox, 464 U.S. 523, 542 (1984) ("Rule 23.1 does not apply to an action brought by a shareholder under §36(b) . . . and . . . the plaintiff in such a case need not first make a demand upon the fund’s directors before bringing suit.").

Section 44 of the ICA (15 U.S.C.S. §80a-43) grants concurrent federal and state jurisdiction over “all suits in equity and actions at law” brought to enforce the provisions of the entire ICA. See Northstar, 615 F.3d at 1117–18. Moreover, section 36(b) class actions may be combined with certain fiduciary-breach claims arising under state law. See Strougo, supra.

Section 47(b) of the ICA (15 U.S.C.S. §80a-46(b)(1)) provides that a contract that violates the ICA or any rule, regulation, or order thereunder, is unenforceable unless a court finds that under the circumstances, enforcement would produce a more equitable result. Section 47(b) contains a remedy, but not a substantive right, and thus does not provide a distinct cause of action or basis of liability. See Smith v. Oppenheimer Funds Distrib., 824 F. Supp. 2d 511, 519–20 (S.D.N.Y. 2011) (and cases cited therein). Consequently, the remedy of rescission under section 47(b) is available only if there is a predicate substantive violation of a different provision of the ICA that does afford a private right of action.

Lynda J. Grant, TheGrantLawFirm, PLLC, with assistance from Nicholas Kalfa


January 24, 2013

Supreme Court Oral Argument: Gabelli v. SEC

On January 8, 2013, the Supreme Court heard oral argument in Gabelli v. Securities and Exchange Commission, a matter that will decide how long the Securities and Exchange Commission (SEC) and other enforcement agencies have to seek civil penalties against private entities for claims based on fraud. In its initial action, the SEC alleged that petitioners Gabelli and Alpert allowed a single investor in the mutual fund they managed to engage in trades while simultaneously representing to directors and investors that such trades would not be tolerated. The SEC argued that this constituted securities fraud but the action was dismissed in the district court for having violated the statute of limitations. The Second Circuit Court of Appeals reversed, finding that the limitations period did not begin running until the SEC discovered the alleged misconduct, rather than when the alleged misconduct first occurred. At issue is whether this “discovery rule” applies to the statute of limitations set out in 28 U.S.C. § 2463, which provides that any “action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture” must be commenced within 5 years from “the date when the claim first accrued.”

At the heart of the parties’ disagreement, and entertained at length by the Court, was the question of whether civil penalty claims deserve distinct treatment, in terms of the applicable statute of limitations, from other civil claims asserted by the government. Arguing for the petitioners, Lewis Liman began by emphasizing that the statute at issue applies only to penalty claims, where the government seeks neither remedial measures nor recovery for itself as a victim or other victims of the allegedly fraudulent conduct at issue. The petitioners argued that, as with other claims meant to punish unlawful conduct, Congress thus provided “a clear and easily administered statutory time limitation on the government’s power to punish.”

Most questions directed at the petitioners, including from Justices Sotomayor and Kagan, sought to understand the significance of this distinction. Justice Scalia similarly requested justification for interpreting the statute such that, in certain instances, an injured plaintiff would enjoy a longer statute of limitations than the government. In response, the petitioners emphasized the underlying rationale for the discovery rule—that a plaintiff who cannot discover an injury cannot timely “investigate and determine whether they’ve got a cause of action.” He argued that the policy is inapplicable in the context of a penalty claim brought by a government agency, where the government is not a party to the underlying transaction and will not necessarily even know it occurred. Under these circumstances, there is no date from which the government should reasonably know about the injury and thus no “natural start date” from which to calculate the statute of limitations.

Numerous justices raised this point at length with Jeffrey Wall, the respondents’ counsel, suggesting that imposition of the discovery rule to the statute would be “practically impossible” for this reason. Justice Sotomayor expressed skepticism that any party could prove that a government agency was not reasonably diligent in discovering alleged misconduct. Highlighting these difficulties, Justices Roberts and Alito asked whether the reasonableness inquiry would depend on which government agency sought to enforce the penalty and that particular office’s resources. In reply, the respondent suggested that a plaintiff could prove that the government should have been on notice of certain circumstances based on public information and that other statutes, such as the False Claims Act, already required courts to make a reasonableness determination.

More broadly, the respondent asserted that nothing justifies treating civil penalty claims based on fraud differently from other fraud and concealment claims, which receive the benefit of the discovery rule. The illogical result of disparate treatment would be to allow a defendant “to escape paying civil penalties but not private damages.” Despite these arguments, justices from across the ideological spectrum, including Justices Breyer, Scalia, and Chief Justice Roberts, continued instead to analogize civil penalty claims under section 2463 to criminal penalties imposed by a sovereign, where concerns about repose are most compelling and thus potentially justify different treatment.

Justice Breyer expressed concern that the statute is not limited to securities or the SEC but applies to all government actions, and is about 200 years old. Until 2004, Justice Breyer was unable to find a single case where the government tried to assert the discovery rule where it sought a civil penalty, not to try to make itself as a victim whole, with only one exception—a nineteenth century case where that assertion by the government was struck down by the district court. Mentioning Social Security, Veterans Affairs, and Medicare, Justice Breyer noted that this has enormous consequences for the government suddenly to try to assert a “quasi-criminal penalty” and “abolish the statute of limitations” in a vast set of cases. The respondent was unable to identify any other case but noted that the SEC did not have the statutory power to seek civil penalties until 1990.

Mor Wetzler and Jena Sold, Paul Hastings LLP, New York, NY


January 18, 2013

NERA Releases Report on SEC Enforcement-Action Settlements

On January 14, 2013, NERA Economic Consulting released its annual update on trends in the number of Securities and Exchange Commission (SEC) enforcement-action settlements and settlement values for the fiscal year 2012, reporting that the SEC settled more cases in fiscal year 2012 than it has in any year since 2007, with a large increase in the number of individual settlements.

The report—which uses the term "settlement" to encompass both settlements and judgments in enforcement actions—concludes that the number of cases resolved in 2012 was 6.6 percent higher than in 2011. The number of individual settlements jumped 14 percent to 537, the greatest number since 2005.

More broadly, NERA's statistics suggest a heightened SEC focus on holding individuals accountable for corporate decisions. Median settlement values for individuals increased for the third year in a row to a new post-Sarbanes Oxley high of $221,000—more than double the 2009 median. In contrast, median settlement values for companies declined, from $1.4 million in 2011 to $1.0 million in 2012. Of the year's ten largest settlements, six were against individuals.

The SEC's largest settlement of the year was one it reached with Citigroup Global Markets, Inc. (CGM), for $285 million. That case, which alleged that CGM made material misrepresentations to investors in connection with its offering of a $1 billion CDO, made headlines when Judge Rakoff of the Southern District of New York rejected the consent judgment. It is currently on appeal before the Second Circuit and, if upheld, will be the 12th largest settlement since NERA began keeping records in July 2002.

The percentage of settlements with monetary penalties continued to increase, up to 69 percent. This is well above the 57 percent figure for 2011 and the 59.9 percent average over the preceding seven years.

As reported by NERA, given the time necessary for actions to move from investigation to settlement, the 2012 statistics are the best reflection yet of the SEC's enforcement priorities under the stewardship of former SEC Chairperson Mary Schapiro. Appointed by President Obama in January 2009, Schapiro led the SEC in the aftermath of the credit crisis and, under her leadership, the agency brought a record number of enforcement actions. The effect of Schapiro's resignation in December 2012 has yet to be seen and may not be reflected in next year's report.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


January 18, 2013

Judge Rakoff Raises Evidentiary Bar for Remote Tippee Liability

A recent opinion by U.S. District Judge Jed Rakoff of the Southern District of New York could result in increasing the government’s evidentiary obligations in remote-tippee insider-trading prosecutions. Judge Rakoff’s December 5, 2012, opinion memorialized the court’s earlier formulation of jury instructions in the Douglas Whitman insider-trading scandal (U.S. v. Doug Whitman, S.D.N.Y. Case No. 12 Cr. 125 (JSR)). The opinion holds that in situations involving hedge-fund principals making trading decisions based on material non-public information received indirectly from sources within publicly traded companies, a remote tippee can be found guilty of insider trading if the government proves not only the traditional elements of the offense but also that the remote tippee (1) generally knew that a fiduciary duty was breached as part of the initial communication from the insider to the intermediate tippee, (2) generally knew that the insider received some sort of benefit from the tip, and (3) had the specific intent to defraud the company to which the confidential information related. The latter two additional elements had not been previously been applied to remote-tippee liability.

Regarding the “knowledge of the benefit” requirement, the court stated that a “tippee must have knowledge that . . . self-dealing [i.e., a benefit] occurred . . . Without such a knowledge requirement, the tippee does not know if there has been an ‘improper’ disclosure of inside information.” As for the “specific intent” requirement, the court stated that in insider-trading cases, “the heart of the fraud is the breach of the duty of confidentiality owed to both the company and its shareholders, and accordingly the specific intent to defraud must mean, in this context, an intent to deprive the company and its shareholders of the confidentiality of its material nonpublic information.”

Ryan E. Blair, Cooley LLP, San Diego, CA


January 15, 2013

Supreme Court Hears Argument in Standard Fire v. Knowles

On January 7, 2013, the U.S. Supreme Court heard oral argument in Standard Fire Insurance Co. v. Knowles, Case No. 11-1450, to determine whether a putative class representative can defeat removal of a state-court action to federal court by “stipulating” to limit damages below $5 million, the jurisdictional threshold for removal under the Class Action Fairness Act (CAFA).

Respondent Knowles seeks to represent a class where the aggregate amount of the proposed class’s claims exceeds $5 million (albeit by only around $24,000), yet Knowles filed a “stipulation” whereby the proposed class agreed to seek damages less than $5 million. Standard Fire argued that the stipulation was motivated by the desire to keep the action in a plaintiff-friendly Arkansas state court that often permits plaintiffs to drag defendants into drawn-out and costly discovery before even the certification hearing. Removal could provide the defendants with federal-court discovery protections.

Arguing for Standard Fire, Theodore J. Boutrous initially focused on the text of CAFA, arguing that the text’s instruction to “aggregate the claims” of individual class members means that a would-be class representative cannot artificially limit class damages. Chief Justice Roberts questioned whether the same objection applied if a class with two potential substantive claims pleaded only one worth less than $5 million. When Boutrous responded “not necessarily,” Chief Justice Roberts noted the slippery slope, and Justice Kagan later questioned along the same lines, noting “a thousand ways” in which a plaintiff could construct a case. As the argument progressed, questions involved split substantive claims, rejected punitive damages, and putative classes divided by last names or counties.

Justice Sotomayor questioned whether the class-certification process itself offers the necessary protections because a grossly unfair stipulation should lead to a judge not certifying the class, not finding the plaintiff an adequate representative, and/or class members opting out. Boutrous responded that class-certification requirements varied between state and federal courts, and that CAFA itself demonstrates Congress’s concern regarding the class-certification protections in state court (as well as the potential for extensive discovery). Boutrous also argued that the stipulation only takes effect after the named plaintiff is certified to represent the class, and therefore, “because we judge jurisdiction at the time of removal [a]nd at the time of removal there was no binding limitation on the recovery that could be obtained,” the “undisputed facts” showed that the proposed class’s aggregate claims exceeded the $5 million threshold necessary for removal. Justice Alito offered that under recently amended section 1446(c)(2), a removing defendant may offer proof that the amount exceeds the jurisdictional amount.

Justice Kagan challenged the notion that the stipulation should be disregarded because “the idea of master of the complaint is inherent in every class litigation.” She repeated the slippery-slope sentiment that defendants could similarly argue that the named plaintiff cannot define the claims or name the defendants.

For Knowles, David C. Frederick argued that the stipulation was in fact binding, and therefore that the amount in controversy fell short of the threshold for removal. Frederick said that the statute defines “class action” “in terms of the civil action that was filed” and that “everybody knows [the stipulation] will be binding if the class is certified.”

Several justices, however, expressed concern over allowing plaintiffs to file stipulations to circumvent the amount-in-controversy threshold, worrying that the alternative would thwart CAFA’s goal of having the largest class actions adjudicated in federal court so that state-court abuses could be avoided. For instance, Chief Justice Roberts asked whether a lawyer could bring split class actions between those whose names begin with “A to K,” for “$4 million” and “in the next county” file a case for those whose names begin with L to Z” for another $4 million.” Frederick replied “that for federal jurisdiction purposes, that kind of legal strategy is perfectly appropriate under the master of the complaint [rule].” Justice Breyer noted that such a loophole would swallow the entire statute and later added that although the “words in the statute do favor that, at the moment. But the purpose [of CAFA] seems to strongly cut the other way.” Justice Breyer suggested, to avoid “a mechanical method of avoiding the purpose of the statute,” that the statute could be interpreted to mean aggregating “the real value of the real amounts that the class is likely to have.”

Frederick also pointed to two tools to help prevent plaintiffs from using “manipulative” stipulations: Rule 11’s prohibition against frivolous assertions and the Court’s holding in St. Paul Mercury v. Red Cab, 303 U.S. 283 (1938) requiring any stipulation for less than the jurisdictional amount to be made in “good faith.”

On rebuttal, Boutrous replied that the Court has never held that the amount in controversy is subject to the well-pleaded-complaint rule or the master-of-the-complaint doctrine, and repeated that the Court should look past the face of the pleadings. Justice Kagan suggested that this was “really [] asking us to blow up the whole world.” Boutrous concluded with the request that the defendants be permitted to offer proof regarding the actual amount in controversy.

Read the oral argument transcript.

Mor Wetzler, Paul Hastings LLP, New York, NY


January 15, 2013

Second Circuit Limits Short-Swing Profit Rule

On January 7, 2013, the Second Circuit held that section 16(b) of the Securities Exchange Act of 1934—often called the "short-swing profit rule"—does not require insiders to disgorge profits earned from buying and selling different types of stock in the same company within a six-month period.

Section 16(b) provides that corporate insiders are required to disgorge profits "realized . . . from any purchase or sale, or any sale and purchase, of any equity security of [the corporate] issuer . . . within any period of less than six months," irrespective of the insider’s intent or actual use of inside information. 15 U.S.C. § 78p(b). Defendant John Malone was a director of Discovery Communications, Inc. who engaged in nine sales of Discovery's "Series C" stock and 10 purchases of the corporation's "Series A" stock within a 13-day period in 2008, triggering a shareholder suit for disgorgement of profits under section 16(b).

In unanimously affirming the dismissal order of U.S. District Judge Barbara S. Jones of the Southern District of New York for failure to state a claim under section 16(b), the Second Circuit rejected extension of the short-swing profit rule to different types of stock in the same company, holding that the rule does not apply to a corporate insider who "sells shares of one type of stock issued by the insider's company and purchases shares of a different type of stock in that same company," at least where the stocks are separately traded, nonconvertible, and have different voting rights. Gibbons v. Malone, No. 11-3620-cv (2d Cir. Jan. 7, 2013).

The Second Circuit's opinion, written by Judge Cabranes and joined by Judges Leval and Katzmann, focused on the statute's use of the term "equity security." The court inferred from Congress's use of the singular "security" that the statute does not apply to purchase and sale of different securities, even if issued by a single corporation. The panel squarely rejected the appellant's argument that it was sufficient for the securities to be "substantially similar," opting for a more easily enforceable bright-line rule, but leaving open the possibility that the statute "could apply to transactions where the securities at issue are not meaningfully distinguishable." In so holding, the court emphasized that the shares at issue were "distinct not merely in name but also in substance." The difference in voting rights meant that "[a]n insider could easily prefer one security over the other for reasons not related to short-swing profits." Moreover, because the shares were not fixed-ratio convertible instruments, they did not fall under the circuit's "economic equivalence" doctrine.

While the court acknowledged the "plausibility" of the appellant's argument to expand liability under section 16(b), it "decline[d] to go down this road absent SEC direction." Accordingly, absent further guidance from the Securities and Exchange Commission, it appears that courts in the Second Circuit will apply a bright-line rule exempting from section 16(b) short-term profits earned in transactions by corporate insiders in different, separately traded, and otherwise unconnected securities from the same issuer.

Mollie Kornreich and Patrick G. Rideout, Skadden Arps, New York, NY


December 18, 2012

SEC Chairperson Walters Appoints Two Acting Directors

On December 17, 2012, in her first day in the position, Securities and Exchange Commission (SEC) Chairperson Elisse Walters appointed two acting directors, naming Lona Nallengara to lead the Division of Corporation Finance and John Ramsay to lead the Division of Trading and Markets. Both Nallengara and Ramsay will serve as acting directors on an interim basis.

The Division of Corporation Finance oversees companies as they initially offer securities to the public and continues to monitor them to ensure companies make proper disclosures to the public. Nallengara has served as deputy director for legal and regulatory policy of the Division of Corporation Finance since March 2011. As deputy director, Nallengara was responsible for overseeing the division’s offices of chief counsel, enforcement liaison, international corporate finance, mergers and acquisitions, and small business policy. Nallengara has been credited with leading a series of complex rulemakings required by the Dodd-Frank Act and the division’s implementation of the Jumpstart Our Business Startups Act. As acting director, Nallengara replaces Meredith Cross, who will leave the SEC to return to the private sector.

The Division of Trading and Markets regulates major securities market participants, including broker-dealers, transfer agents, and self-regulatory organizations. Ramsay previously served as deputy director for the Trading and Markets Division, where he played a key role in the advancement of rules mandated by the Dodd-Frank Act. In addition to working at the SEC from 1989 to 1994 in various posts, Ramsay also held key regulatory policy positions at the Commodity Futures Trading Commission and the National Association of Securities Dealers (now the Financial Industry Regulatory Authority). In the private sector, Ramsay worked as senior vice president at the Bond Market Association (now the Securities Industry and Financial Markets Association), and as managing director and deputy general counsel and Citigroup Global Markets. Ramsay will replace Robert Cook as head of the Division of Trading and Markets, who will step down after a short transition period.

Julie H. Firestone and Christine J. Kim, Briggs and Morgan, P.A., Minneapolis, MN


November 27, 2012

SEC Chairperson Departs; Elisse Walter Named Replacement

On November 26, 2012, Securities and Exchange Commission (SEC) Chairperson Mary Schapiro has announced that she will leave the agency on December 14. Schapiro, 57, was appointed as the 29th chairperson by President Obama, and assumed the role in January 2009. Schapiro took over the SEC as it faced the pressures of the 2008 financial crisis and strong criticism for failing to uncover the Bernie Madoff Ponzi scheme. She subsequently led the SEC through the fallout from the May 6, 2010, Flash Crash, a contentious Republican House majority, and complex regulations mandated by the Dodd-Frank Act.

The Obama administration has designated current SEC commissioner Elisse Walter to replace Schapiro as chairperson. Walter, 62, was originally appointed SEC commissioner by President George W. Bush in 2008. She previously served as chairperson for a short period in January 2009, after the departure of former chairperson Christopher Cox and before Schapiro was sworn in. Walter is widely expected to keep Schapiro’s priorities intact, as her record indicates she almost always voted alongside Schapiro on new rules and enforcement cases.

The SEC consists of five commissioners, one of whom is designated by the president as chairperson. Walter’s previous confirmation by the Senate as a commissioner will allow her to serve as chairperson until the end of 2013 without the need for a second confirmation. But because the Obama administration has not immediately nominated a new commissioner, Schapiro’s departure will leave only four SEC commissioners, evenly split between two Democrats and two Republicans. This split is causing many to doubt that the SEC will be able to enact new rules or policies until a new commissioner is appointed.

Julie H. Firestone and Christine J. Kim, Briggs and Morgan, P.A., Minneapolis, MN


November 15, 2012

Rakoff Rules Against Banks in Mortgage Repurchase Suits

U.S. District Judge Jed Rakoff released a 24-page opinion on September 25, 2012, denying Flagstar Bank summary judgment in its case against Assured Guaranty Ltd., becoming the third New York judge to side with bond insurers in a barrage of mortgage repurchase suits against banks that administered defective mortgage-backed securities.

Flagstar and Assured Guaranty had a contractual agreement under which Flagstar would be obligated to repurchase residential mortgage-backed securities (RMBS) in the event that breaches of representations or warranties involving the risks of these RMBS “materially” or “adversely” impacted their value. While Flagstar contended that such adverse impact must be proven through an explicit causal link between misrepresentations made and losses suffered, Rakoff disagreed.

Instead, Rakoff ruled that to compel Flagstar to repurchase the defective RMBS in question, Assured need only demonstrate that Flagstar’s misrepresentations caused Assured to incur an increased risk of loss. Rakoff noted that the parties could have included “direct loss causation” as a necessary condition in the relevant clause of their contract if they intended for such causation to be requisite. As no such condition existed, Rakoff predicated his decision on a tenet of New York insurance law, which provides that an insurer may rescind a policy if it later becomes aware of a material misrepresentation that would have prevented it from offering the policy originally.

Eduard Korsinsky and Mary Morrone, Levi & Korsinsky, LLP, New York, NY


November 15, 2012

Mortgage-Backed Securities Claims Against S&P Move Forward

Illinois Attorney General Lisa Madigan received a favorable ruling from Cook County Circuit Court Judge Mary Anne Mason on November 7, 2012, allowing a lawsuit against Standard & Poor’s (S&P) Ratings Services alleging that the firm deceived investors regarding mortgage-backed securities to proceed.

Madigan claims that to increase profits and appease clients, S&P misled investors by granting defective mortgage-backed securities the firm’s highest ratings during the years leading up to the crash of the housing market. S&P moved to dismiss the case in March, contending that their ratings were opinions protected under the First Amendment. However, Judge Mason honed in on S&P’s public declarations that avowed its rating process to be both independent and objective, stating: “Courts have long held that neither the federal nor state constitutions protects false, misleading, or deceptive practices. . . .” In refusing S&P’s motion to dismiss, Mason further stressed that Madigan’s complaint challenges “these repeated statements of fact regarding S&P’s independence and objectivity, and its internal conflicts controls . . .” rather than S&P’s rating opinions.

Madigan has since stated that the ruling indicates, “S&P isn’t going to be able to legally maneuver their way out of the fact that they committed fraud.” This indication is particularly notable in light of the difficulty investors have experienced over the past several years in moving forward with claims related to subprime mortgage-backed securities. S&P must answer the attorney general’s complaint by December 5, 2012.

Eduard Korsinsky and Mary Morrone, Levi & Korsinsky, LLP, New York, NY


November 15, 2012

Government Leans on Private-Sector Attorneys

On October 1, 2012, New York Attorney General Eric T. Schneiderman filed a complaint against JPMorgan Chase, alleging that the Bear Stearns business, which was taken over by JPMorgan in 2008, issued and underwrote defective residential mortgage-backed securities. The complaint was intended to be an initial flex of the muscle for the Residential Mortgage-Backed Securities Working Group, the state and federal task force led by Schneiderman; U.S. District Attorney John Cole of Colorado stated that the case “underscores the strength of the working group’s structure, which gives each office and law enforcement team the opportunity to bring unique investigatory and enforcement strengths to the table.”

However, perhaps what stood out most about Schneiderman’s efforts is how much they centered on allegations and analyses already developed by private-sector attorneys. The complaint makes frequent reference to the amended complaint filed against JPMorgan by Quinn Emanuel Urquhart & Sullivan on behalf of the Federal Housing Finance Agency (FHFA) in June 2012. Schneiderman even depends upon FHFA’s analysis of securitized home loans to support the central claim that Bear Stearns discarded loan-underwriting criteria. Schneiderman’s complaint also draws from the litigation of firms such as Bernstein Litowitz Berger & Grossman, Wolf Popper, and Patterson Belknap Webb & Tyler against JPMorgan.

Schneiderman has been open regarding the private sector’s assistance in building the government’s case against JPMorgan, candidly praising FHFA for the “key role” it has played.

Eduard Korsinsky and Mary Morrone, Levi & Korsinsky, LLP, New York, NY


November 8, 2012

FINRA Agrees to Accept Disputes Between Non-FINRA Firms

FINRA Dispute Resolution recently announced that it would make its arbitration and mediation forum available to investors and investment advisers who are not FINRA members for submission and resolution of disputes on a voluntary basis. In addition, FINRA has agreed to accept on a voluntary basis industry disputes between non-member investment advisers and their employees. Submission of these disputes to arbitration are subject to the following conditions: (1) submission of a post-dispute agreement to arbitrate by all parties, (2) agreement by the investment advisor or other parties agree to pay all arbitration surcharge fees, and (3) filing by the investor (or employee) a submission agreement executed by all parties. In the submission agreement, the parties must acknowledge that FINRA cannot enforce awards against non-member investment advisors and/or their employees, that the investment advisor may be barred from the forum in future cases if it fails to pay any award, settlement agreement, or FINRA fees, that FINRA will not be liable in connection with its handling of the dispute, that the FINRA Codes of Arbitration Procedure will apply, and that the final award will be publicly available.

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


October 10, 2012

Pleading Demand Futility Difficult Without Pre-Filing Investigation

Two recent cases concerning demand futility under Delaware law signal increasing hostility to derivative cases, and illustrate an apparent emerging trend to require a pre-filing investigation under section 220 of the General Corporation Law, 8 Del. C. § 220, to adequately plead demand futility.

In South v. Baker, C.A. No. 7294-VCL (Del. Ch. Sept. 25, 2012), the Delaware Chancery Court held that in a Caremark case where demand futility is alleged, a plaintiff must plead facts sufficient to establish board involvement in conscious wrongdoing by pleading a sufficient connection between the corporate trauma and the board such that at least half of the directors face a substantial likelihood of personal liability. In the absence of a section 220 pre-filing investigation and review of the books and records, a hastily filed Caremark claim filed after a public announcement of a corporate trauma will likely result in the plaintiff being held to be inadequate to represent the corporation. Indeed, in South v. Baker, the Delaware Chancery Court dismissed the plaintiff’s claims with prejudice without leave to amend as to the named plaintiff (noting that a “with-prejudice dismissal does not have preclusive effect if the initial plaintiff failed to provide adequate representation for the corporation”).

Similarly, in North Miami Beach General Employees Retirement Fund v. Parkinson, Case No. 1:10-cv-06514 (N.D. Ill. September 19, 2012), the U.S. District Court for the Northern District of Illinois, applying Delaware law, held that the plaintiffs failed to sufficiently allege demand futility under the Aronson test (see Aronson v. Lewis, 473 A.2d 805 (Del. 1984)), where the plaintiff alleged not that defendants did nothing, but that the defendants did not do enough, and what they did do they did not do well. Similarly, in analyzing different factual allegations under the Rales demand-futility requirements (see Rales v. Blasband, 634 A.2d 927 (Del. 1993)), the court held that, in the absence of any explanation as to why it was unreasonable for the board to rely on government inspections and regulators’ efforts with respect to a defective regulated product, the plaintiffs failed to allege that the board knew it was not discharging its fiduciary obligations. Accordingly, because there was no reasonable doubt as to the directors’ ability to evaluate a shareholder demand, the plaintiff lacked standing to pursue the derivative claims.

Underlying both decisions is a philosophy that in a derivate suit, a shareholder seeks to displace the board’s authority. To do so, the complaint must allege with particularity that the board was presented with a demand and wrongfully refused it, or that the board could not properly consider a demand, thereby excusing the effort to make a demand as futile. Both the South v. Baker and North Miami Beach courts strongly affirmed that a shareholder cannot displace a board’s authority simply by describing a calamity and alleging that it occurred on the directors’ watch. Indeed, imposition of liability requires a showing that the directors knew they were not discharging their fiduciary obligations; or at least, circumstantial evidence that can give rise to a reasonable inference that the directors knowingly did so.

The hurdles are high. In South v. Baker, the court provided an example of what would constitute sufficient factual allegations for purposes of pleading demand futility. The court observed that a plaintiff might plead, for example, that the directors "ignored 'red flags' indicating misconduct in defiance of their duties. A claim that an audit committee or board had notice of serious misconduct and simply failed to investigate, for example, would survive a motion to dismiss, even if the committee or board was well constituted and was otherwise functioning." (citing David B. Shaev Profit Sharing Account v. Armstrong, 2006 WL 391931, at *5 (Del. Ch. Feb. 13, 2006)). With respect to the factual allegations in the case, the South v. Baker court held that the plaintiff must allege that the board had knowledge of the wrongdoing, and did nothing about it. Indeed, the court chastised the plaintiff for not using a section 220 investigation in advance of filing:

Although the complaint asserts that the directors knew of and ignored the 2011 safety incidents, the complaint nowhere alleges anything that the directors were told about the incidents, what the Board’s response was, or even that the incidents were connected in any way. Here, again the Souths might have used Section 220 to investigate what the directors knew and did, evaluate their theories of liability, and make an informed decision about whether or not to sue.

Finally, in the North Miami Beach case, the court held that the dismissal was without prejudice as to shareholder standing to assert the substantive causes of action because a failure to make a demand on the board can be cured. However, the North Miami Beach court held that the dismissal on the issue of demand futility was with prejudice because the plaintiffs could not plead facts to establish that demand would have been futile. Accordingly, like South v. Baker, the North Miami Beach case was dismissed and the dismissal constituted a final and appealable order.

There are many lessons to be learned from South v. Baker and North Miami Beach, the biggest of which is that plaintiffs would be wise to initiate a section 220 books-and-records investigation in advance of filing a derivative action, so that they can discover sufficient factual evidence of the board’s role (or lack thereof) in whatever corporate calamity is at issue. Otherwise, the pleading hurdles will continue to be nearly insurmountable and there is a strong risk that a motion to dismiss for failure to plead demand futility will be granted, with prejudice.

Erik A. Christiansen, Parsons Behle & Latimer, Salt Lake City, UT


August 1, 2012

New Bill: "Stronger Enforcement of Civil Penalties Act of 2012"

On July 23, 2012, Senators Jack Reed (D.-R.I.) and Chuck Grassley (R.-Iowa) introduced the above-entitled bill, the stated purpose of which is “to enhance civil penalties under the Federal securities laws, and for other purposes.” (emphasis added) The enhancement-of-civil-penalties purpose is clearly met through the increased dollar limits on maximum civil penalties in all applicable Securities Act, Exchange Act, Investment Company Act, and Investment Advisers Act sections dealing with such penalties. The “other purposes,” on the other hand, are perhaps less obvious but no less concerning for any potential target of the Securities Exchange Commission (SEC), particularly in the context of an administrative action.

Although the bill contains no express statement calling for increased use of administrative proceedings by the SEC, it is highly likely that such an increase will in fact occur should the act become law. The main reason for this is that the penalty amounts that the SEC would be permitted to seek in an administrative proceeding would be identical to those they could seek in civil litigation in district court, a significant change in the statutory scheme. Under the existing construct, the maximum penalty the SEC can seek in administrative action—at the “third tier” level—is $150,000 for a natural person or $725,000 for any other person. These penalties are only available if the act or omission involved fraud or deceit anddirectly or indirectly resulted in substantial losses or risk of substantial losses to investors or substantial pecuniary gain to the person who committed the act or omission. 15 U.S.C. § 77h-1(g)(2)(C). In contrast, the maximum third-tier penalty that can currently be sought by the SEC in a court proceeding (under the Securities Act) is $100,000 for a natural person or $500,000 for any other person, or “the gross amount of pecuniary gain to such defendant as a result of the violation” if the fraud/deceit and substantial loss/risk of loss criteria are also met. 15 U.S.C. § 77t(d)(2)(C). The availability of the “gross amount of pecuniary gain” penalty for fraud actions is a significant arrow in the SEC’s enforcement quiver, and one that clearly drives high-profile, high-dollar-value enforcement actions to the courts—for now. The act’s provision for identical monetary penalties in administrative and civil actions will undoubtedly result in a swift and noticeable shift from civil actions to administrative actions.

Administrative proceedings are largely preferable to court proceedings for the SEC, for a myriad of reasons, including but not limited to, limitations on discovery, the use of fewer already-strained resources, familiarity with administrative-law judges, and a shorter timeline. Accordingly, should the “Stronger Enforcement of Civil Penalties Act of 2012” be enacted, companies and individuals who may find themselves on the receiving end of an SEC investigation may expect to be forced to adjudicate enforcement proceedings in an administrative action, without the benefit of such luxuries as the Federal Rules of Civil Procedure and Evidence and the potential for appeal to a circuit court of appeals.

Elizabeth Yingling and Laura O’Rourke, Baker & McKenzie LLP, Dallas, Texas


April 12, 2012

Obama Signs Jumpstart Our Business Startups Act into Law

On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (the JOBS Act). The JOBS Act eliminates a number of securities regulations, and permits so-called crowd funding, allowing companies to raise small amounts of capital from large pools of individual non-accredited investors by "notices," which direct investors to the Internet funding portal for the offering or to a broker offering the shares.

Through crowd funding, a company can now raise up to $1 million in the aggregate in a 12-month period from non-accredited investors, provided investors invest only limited sums and certain required disclosures are made. The limits range from the greater of $2,000 or five percent of an investor’s annual income or net worth, up to a cap of $10,000 for people earning or having a net worth of $100,000 or more. In other words, shares can be sold in small companies to non-accredited investors in amounts of $1 to $10,000. The shares, however, only can be sold through “funding portals” or brokers registered with the Securities and Exchange Commission (SEC) or a self-regulatory organization.

To attempt to prevent fraud, the JOBS Act requires companies to provide basic financial information to investors in seeking crowd funding, and empowers the SEC to monitor and pass anti-fraud regulation in implementation of the legislation.

The JOBS Act also allows companies to stay private longer, by increasing the number of investors a company can have before the number of shareholders triggers an obligation to become a public reporting company. Previously, a company was obligated to become a public reporting company when a company’s assets reached $10 million and it had 500 shareholders. Now, a company must become a reporting company only when it has $10 million in assets and 500 “unaccredited” shareholders, or 2,000 total shareholders. The JOBS Act also removes the ban on general solicitation and advertising for private offerings in connection with Rule 506 offerings to accredited investors, and under Rule 144A for qualified institutional investors.

The JOBS Act also creates a new class of companies called emerging growth companies, which are newly public companies with less than $1 billion in annual gross revenues. Emerging growth companies are now exempted from providing auditor attestation reports on internal controls under section 404(b) of Sarbanes-Oxley, need not provide more than two years of audited financial statements in an IPO registration statement, and can take advantage of confidential submissions of draft IPO registration statements.

Supporters of the legislation believe it makes it easier for startups to raise money by getting rid of limits on obtaining funds only from accredited or institutional investors, while critics complain that the JOBS Act will give rise to unprecedented exploitation of non-accredited investors in crowd-funding scams. The SEC has up to 270 days to revise its rules to be consistent with the legislation. The SEC is required to report once every two years on the amount of fraud related to the JOBS Act.

Erik A. Christiansen, Parsons Behle & Latimer, Salt Lake City, UT


April 4, 2012

Supreme Court Rejects Whittaker Rule for Tolling Section 16(b) Claims

On March 26, 2012, the U.S. Supreme Court unanimously held that the two-year limitations period for insider-trading claims under section 16(b) of the Securities Exchange Act of 1934 is not automatically tolled pending the filing by an insider of the public-disclosure statement required by section 16(a).  See Credit Suisse Secs. v. Simmonds, No. 10–1261 (decided March 26, 2012).

In 2007, Simmonds filed 55 "nearly identical actions under § 16(b) against financial institutions that had underwritten various initial public offerings (IPOs) in the late 1990's and 2000." Opinionat 2. Simmonds alleged that the underwriters of certain IPOs, as well as corporate insiders, "employed various mechanisms to inflate the aftermarket price of the stock to a level above the IPO price, allowing them to profit from the aftermarket rate." Id.at 2–3. Simmonds further alleged that the underwriters and insiders as a group "owned in excess of 10% of the outstanding stock during the relevant time period, which subjected them to both disgorgement of profits under §16(b) and the reporting requirements of §16(a)." Id.at 3.

The District Court for the Western District of Washington dismissed all of Simmonds's complaints, 24 of which—those at issue before the Supreme Court—were dismissed on the ground that the two-year time limit under section 16(b) had expired. The Ninth Circuit reversed in relevant part on the basis of its earlier decision in Whittaker v. Whittaker Corp., 639 F.2d 516 (9th Cir. 1981), which held that "tolling of the two year time period is required when the pertinent § 16(a) reports are not filed." Id.at 528.

In a decision authored by Justice Scalia, the Supreme Court squarely rejected the Whittaker rule, holding it is "completely divorced from long-settled equitable-tolling principles." Opinion at 5. Relying on the well-established principle that, "when a limitations period is tolled because of fraudulent concealment of facts, the tolling ceases when fraudulently concealed facts are, or should have been, discovered by the plaintiff," id., the Court observed that "[a]llowing tolling to continue beyond the point at which a §16(b) plaintiff is aware, or should have been aware, of the facts underlying the claim would quite certainly be inequitable and inconsistent with the general purpose of statutes of limitations: 'to protect defendants against stale or unduly delayed claims.'" Id. (emphasis in original).Justice Scalia explained that "Congress could have very easily provided that 'no such suit [under § 16(b)] shall be brought more than two years after the filing of a statement under subsection (a)(2)(C).' But it did not. The text of section 16 simply does not support the Whittaker rule." Id.at 4–5 (emphasis in original). Reflecting on the case at bar, the Court observed:

The oddity of Simmonds' position is well demonstrated by the circumstances of this case. Under the Whittaker rule, because petitioners have yet to file § 16(a) statements (as noted earlier they do not think themselves subject to that requirement), Simmonds still has two years to bring suit, even though she is so well aware of her alleged cause of action that she has already sued. If § 16(a) statements were, as Simmonds suggests, indispensable to a party's ability to sue, Simmonds would not be here.

Id.at 7.

Accordingly, the Supreme Court remanded the case back to the district court to apply "the usual rules of equitable tolling." Id.at 8. The Court divided four to four (Justice Roberts recused himself) concerning the petitioners' contention that the two-year period in section 16(b) establishes a statute of repose immune to equitable tolling, leaving the issue undecided and the Ninth Circuit's opinion that equitable tolling may apply untouched.

Having discarded the prospect of any bright-line rule based on the filing of section 16(a) forms, the Supreme Court has left it to the lower courts to decide how equitable tolling applies to insider trading claims under section 16(b) on a case-by-case basis.

Kenneth Grad and Patrick G. Rideout, Skadden, Arps, Slate, Meagher & Flom LLP, New York, NY


March 8, 2012

Second Circuit Clarifies Extraterritorial Reach of U.S. Securities Laws

On March 1, 2012, the Second Circuit clarified the test for extraterritorial applicability of the securities laws established in the Supreme Court's landmark decision, Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010). See Absolute Activist Value Master Fund Limited v. Ficeto, No. 11-0221-cv (2d. Cir. March 1, 2012).

In Morrison, the Supreme Court addressed the reach of the Exchange Act in so-called Foreign-Cubed or F-Cubed cases (involving transactions in foreign securities of foreign issuers by foreign investors), holding that section 10(b) and Rule 10 b-5 apply only to "transactions in securities listed on domestic exchanges[] and domestic transactions in other securities." Id. at 2884 (emphasis added). On March 1, 2012, the Second Circuit provided guidance as to what renders a transaction "domestic" when the securities at issue are not listed on a U.S. stock exchange, concluding that "transactions involving securities that are not traded on a domestic exchange are domestic if irrevocable liability is incurred or title passes within the United States."

The plaintiffs in Absolute Activist, nine Cayman Islands hedge funds, alleged that the defendants engaged in a "pump-and-dump" penny-stock scheme, purportedly causing the plaintiffs to incur losses of at least $195 million. Judge Daniels of the Southern District of New York previously dismissed the complaint, finding that the court lacked subject-matter jurisdiction over the case because the complaint failed to sufficiently allege that the foreign plaintiffs' off-market transactions were "domestic." Affirming in part, the Second Circuit agreed that the funds failed to state a claim under the Exchange Act, holding "the mere assertion that transactions 'took place in the United States' is insufficient to adequately plead the existence of domestic transactions."

In overturning the dismissal of the action, the court found that the plaintiffs should be given the opportunity to amend their pre-Morrison complaint. Writing for the court, Circuit Judge Katzmann explained, "Given that the funds understandably drafted their complaint in accordance with pre-Morrison doctrine, they cannot be faulted for their failure to allege facts suggesting that irrevocable liability was incurred within the United States." Offering guidance to the plaintiffs in repleading their complaint, the Second Circuit held that off-market securities transactions are "domestic" whenever (1) a trader incurs irrevocable liability within the United States to purchase or deliver a security, or (2) title to a security is transferred in the United States. With respect to what constitutes "irrevocable liability," the court explained that liability becomes irrevocable when "the parties [have] obligated themselves to perform what they had agreed to perform even if the formal performance of their agreement is to be after a lapse of time."

In determining that an amendment would not be futile, the Second Circuit relied on the plaintiffs' representations in their briefing and at argument that they are in possession of underlying trading records, private placement offering memoranda, and other documents showing both that the purchases became irrevocable upon payment and that payment was made in the United States. Future opinions in this case may yield further insight into the contours of the Morrison rule. For now, the Absolute Activist opinion offers practical and easily understandable guidance as to the meaning of a "domestic" transaction and the extraterritorial reach of U.S. securities laws.

Kenneth Grad and Patrick G. Rideout, Skadden, Arps, Slate, Meagher & Flom LLP, New York, NY


February 24, 2012

FINRA Proposes Raising Limit for Simplified Arbitrations to $50,000

In a press release dated February 22, 2012, the Financial Industry Regulatory Authority (FINRA) announced that it had filed with the Securities and Exchange Commission (SEC) a proposed rule change that would raise the limit for requested damages in simplified arbitration from $25,000 to $50,000. The current rule has been in place since 1998, when the threshold was raised from $10,000. In the release, FINRA stated its belief that the proposed rule change would benefit forum users by reducing forum fees, reducing other costs associated with preparing for and attending hearings, allowing non-represented parties to decide whether to request a hearing, and reducing the time to process cases. Interested parties are invited to submit written data, views, or arguments to the SEC within 21 days of publication of the proposed rule in the Federal Register.

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


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

Anne C. Flannery
Morgan Lewis & Bockius, LLP
101 Park Avenue
New York, NY 10178-0600

Andrew W. Sidman
Bressler, Amery & Ross, P.C.
17 State Street
New York, NY 10017

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,

Citigroup created a billion-dollar fund . . . that allowed it to dump some dubious assets on misinformed investors . . . by misrepresenting that the Fund’s assets were attractive investments rigorously selected by an independent investment advisor, whereas in fact Citigroup had arranged to include in the portfolio a substantial portion of negatively projected assets and had then taken a short position in those very assets it had helped select.

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:

[W]hen a public agency asks a court to become its partner in enforcement by imposing wide ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court, and the public need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in matter of obvious public importance.


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:

Read together, CPC Int’l and Kerusa stand for the proposition that a private litigant may not pursue a common-law cause of action where the claim is predicated solely on a violation of the Martin Act or its implementing regulations and would not exist but for the statute. But, an injured investor may bring a common-law claim (for fraud or otherwise) that is not entirely dependent on the Martin Act for its viability. Mere overlap between the common law and the Martin Act is not enough to extinguish common-law remedies.

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

[a]llocating compensation as a percentage of net revenues does not make it virtually inevitable that management will work against the interests of the stockholders . . . management and stockholder interests were aligned. Management would increase its compensation by increasing revenues, and stockholders would own a part of a company which has more assets available to create future wealth.

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

even if New York Courts have, as yet, not required application of Delaware’s “meritorious when filed” standard when addressing a fee claim under subsection (e)[of Section 626 of the New York Business Corporation Law], there can be no doubt that any party seeking an award of attorneys fees under the auspices of § 626(e) must comply with the other provisions within the statute.

 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.

Joshua 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.