Compare and Contrast

NERA Economic Consulting and Cornerstone Research (in conjunction with the Stanford Securities Class Action Clearinghouse) have released their 2014 annual reports on securities class action filings.  As usual, the different methodologies employed by the two organizations have led to different numbers, although they both identify the same general trends.
The findings for 2014 include:

(1) The reports agree that filings have stayed flat.  NERA finds that there were 221 filings (compared with 222 filings in 2013), while Cornerstone finds that there were 170 filings (compared with 166 filings in 2013).  NERA normally has a higher filings number due to its counting methodology (see footnote 4 of the NERA report).

(2) Cornerstone notes that companies in the S&P 500 were less likely to be targeted by a securities class action in 2014 than in any year measured (2000 through 2014).  Not coincidentally, the dollar losses associated with the 2014 filings were significantly below the historical average.

(3) NERA found a sharp decrease in the average settlement amount to $34 million (down from $55 million in 2013, but the 2014 average is roughly the same as the 2012 and 2011 averages).  The median settlement amount decreased 29% from $9.1 million (2013) to $6.5 million (2014).   NERA also notes that while 59% of securities class actions filed between 2000 and 2010 were settled or dismissed within three years, the number of pending cases has been rising since 2011, “suggesting a slow-down of the resolution process over that period.”

The NERA report can be found here. The Cornerstone/Stanford report can be found here.

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Domestic Status

Under the Morrison test for extraterritoriality, a Section 10(b) claim for securities fraud may only be brought if the transaction involved “the purchase or sale of a security listed on an American stock exchange” or “the purchase or sale of any other security in the United States.”  Although nominally a bright-line test, it can be difficult to apply.  In United States v. Georgiou, 2015 WL 241438 (3rd Cir. Jan. 20, 2015), the court considered whether either prong was applicable to the purchase, by a foreign entity, of securities listed on the OTCBB or Pink Sheets.

First, the court examined whether the OTCBB or Pink Sheets were “stock exchanges.”  The court found that the Securities Exchange Act of 1934 draws a clear distinction between “securities exchanges” and “over-the-counter markets” and, moreover, the OTCBB and Pink Sheets are not on the SEC’s list of registered national securities exchanges.  Accordingly, it was “persuaded that those exchanges are not national securities exchanges within the scope of Morrison.”

Second, the court examined whether the purchases were nevertheless “domestic” securities transactions.  In doing so, the court adopted the Second Circuit’s approach and held that “a securities transaction is domestic when the parties incur irrevocable liability to carry out the transactions within the United States or when title is passed within the United States.”  Because there was evidence that the trades were facilitated by U.S. market makers and that in specific instances the securities were bought or sold from entities located in the United States, the court held that they met the “irrevocable liability” standard and could be the subject of a Section 10(b) claim.

Holding: Judgment of conviction affirmed.

 

 

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That Escalated Quickly

Item 303 of Regulation S-K requires issuers to disclose known trends or uncertainties “reasonably likely” to have a material effect on operations, capital, and liquidity. Plaintiffs often contend that if the disclosure required under Item 303 involves material information, then a company’s failure to disclose that information constitutes a material omission for purposes of securities fraud liability.  In October, the Ninth Circuit rejected that position, holding that the disclosure duty created by Item 303 cannot form the basis for an actionable securities fraud claim.  This week, the Second Circuit disagreed.

In Stratte-McClure v. Morgan Stanley, 2015 WL 136312 (2d Cir. Jan. 12, 2015), the Second Circuit addressed claims that Morgan Stanley, in 2007, failed to disclose a negative trend in a large credit default swap position.  Noting that its position is “at odds with the Ninth Circuit,” the court held 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 described it as a two-part test: (1) the “plaintiff must first allege that the defendant failed to comply with Item 303,” thereby “establish[ing] that the defendant had a duty to disclose;” and (2) the “plaintiff must then allege that the omitted information was material under Basic’s probability/magnitude test.”  In addition, of course, the plaintiff must sufficiently plead the other elements of a Section 10(b) claim.

As to Morgan Stanley and its credit default swap position, the court concluded the plaintiffs had adequately alleged both that “Defendants breached their Item 303 duty to disclose that Morgan Stanley faced a deteriorating subprime mortgage market” and that the omission was material.  However, the court found that the complaint was “silent about when employees realized that the more pessimistic assessments of the market were likely to come to fruition and they would be unable to reduce [the credit default swap position].”  As a result, the complaint did not create a strong inference of scienter as to the Item 303-based claims.

Holding: Dismissal affirmed.

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The Circumstances of Fraud

Federal Rule of Civil Procedure 9(b) states that “[i]n alleging fraud or mistake, a party must state with particularity the circumstances  fraud or mistake.”  Whether FRCP 9(b) applies to the pleading of loss causation in securities fraud cases, however, has been an open question.

In the Dura case, the Supreme Court heard argument on the issue.  The Court ultimately punted, however, noting in its 2005 decision that it would “assume, at least for argument’s sake, that neither the Rules nor the securities statutes impose any special further requirement [beyond FRCP 8’s notice pleading standard] in respect to the pleading of proximate causation or economic loss.”  Perhaps not surprisingly, this quickly lead to a split in the lower courts, with some courts requiring notice pleading and other courts requiring particularity.  Moreover, this split has continued at the appellate level with, at a minimum, the Fifth Circuit (FRCP 8 applies) and the Fourth Circuit (FRCP 9(b) applies) taking opposite positions.

In Oregon Public Employees Retirement Fund v. Apollo Group, Inc., 2014 WL 7139634 (Dec. 16, 2014), the Ninth Circuit has addressed the split and come down firmly in favor of FRCP 9(b)’s particularity requirement applying to the pleading of loss causation (and, by extension, to every element of a securities fraud claim).  The court gave three reasons for its decision.  First, because FRCP 9(b) “applies to all circumstances of common law fraud, and since securities fraud is derived from common law fraud, it makes sense to apply the same pleading standard.”  Second, FRCP 9(b) applies on its face because loss causation, as an element of the claim, is “part of the ‘circumstances’ constituting fraud.”  Finally, applying FRCP 9(b) “creates a consistent standard through which to assess pleadings in 10(b) actions.”

Holding: Dismissal affirmed.

Quote of note: “We are persuaded by the approach adopted in the Fourth Circuit and hold today that Rule 9(b) applies to all elements of a securities fraud action, including loss causation.”

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Interpreting Halliburton

In its Halliburton II decision, the Supreme Court held that a securities fraud defendant can overcome the fraud-on-the-market presumption of reliance at the class certification stage of a case “through evidence that the misrepresentation did not in fact affect the stock price.”  Courts continue to interpret the scope of that ruling.

A recent decision from the Southern District of Florida, for example, explores the extent that a defendant’s rebuttal can be based on something other than an event study (i.e., an empirical analysis of the impact of certain information on a stock’s price).  In Aranaz v. Catalyst Pharmaceutical Partners, Inc., 2014 WL 4814352 (S.D. Fla. Sept. 29, 2014), the defendants were alleged to have falsely claimed that there was no effective and available treatment for Lambert-Eaton Myasthenic Syndrome (LEMS).  At class certification, the defendants argued (among other things)that the fraud-on-the-market presumption was inapplicable because the truth about the existence of such a LEMS treatment “was already known to the public and the alleged misrepresentation therefore could not have impacted the price of Catalyst common stock.”

The court found that this “truth-on-the-market defense,” however, “is merely an argument that the alleged misrepresentation was immaterial in light of other information on the market.”  Because the Supreme Court, in its earlier Amgen decision, had held that materiality cannot be used to indirectly rebut the fraud-on-the-market presumption at class certification, the court concluded that it could not consider “evidence that the truth was known to the public” in reaching its decision.

Held: Class certification granted.

Quote of note: “Here, Defendants’ burden is particularly onerous; not only is there a clear and drastic spike following the alleged misrepresentation and an equally dramatic decline following the revelation of the truth, but all agree that the publications containing the misrepresentation and its revelation respectively caused those price  swings. Under these circumstances, proving an absence of price impact seems exceedingly difficult, especially at the class certification stage in which it must be assumed that the alleged misrepresentation was material.”

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One Percent Responsible

Longtop Financial Technologies, a Chinese financial software company, was a notorious financial fraud (see here for a NYT column on the discovery of the fraud).  Both its outside auditors, Deloitte Touche Tohmatsu, and its Canada-based CFO, Derek Palaschuk, were apparently taken in by the company’s scheme to exaggerate its cash balances and revenue, under-report bank loan balances, and hide employee costs in an off-balance-sheet entity.  Last year, a securities class action brought on behalf of investors in Longtop’s American Depositary Shares obtained an $882.3 million default judgment against Longtop and its CEO, but Palaschuk decided to take the claims against him to trial.

On Friday, after a short trial in New York federal court, a jury found Palaschuk liable for securities fraud based on his failure to act despite the presence of “red flags” indicating that the company’s accounting might be fraudulent.  According to press reports, the inability to compel the presence of Chinese witnesses meant that Palaschuk was the only fact witness to testify.  Because Palaschuk’s liability was based on recklessness (rather than actual knowledge of the fraud), however, he presumably was subject to the PSLRA’s proportionate liability provisions.  Under these provisions, he only could be liable “for the portion of the judgment that corresponds to [his] percentage of responsibility.”  In an interesting twist, the jury reconvened today and found that Palaschuk was only 1% responsible for the fraud, assigning the other 99% of the responsiblity to Longtop and its CEO.  According to the plaintiffs, that still means Palaschuk will owe at least $5 million.  Palaschuk plans to challenge the verdict.  Stay tuned.

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Omnicare Argued

On Monday, the U.S. Supreme Court heard oral argument in the Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund case, which addresses the pleading standard for a claim under Section 11 of the Securities Act alleging a false or misleading opinion in a registration statement.  While the Second, Third, and Ninth Circuits have held that the plaintiff must allege the statement was both objectively and subjectively false – requiring allegations that the speaker’s actual opinion was different from the one expressed – in Omnicare the Sixth Circuit held that if a defendant “discloses information that includes a material misstatement [even if it is an opinion], that is sufficient and a complaint may survive a motion to dismiss without pleading knowledge of falsity.”

At oral argument, the focus was on what role the speaker’s basis, or lack thereof, for the opinion should play in evaluating falsity.  Omnicare argued that the “ultimate legal inquiry is whether the speaker did not possess the stated belief,” but “if it’s a case where the speaker truly has no basis for the opinions, we believe it will be quite possible for a plaintiff to include all of these underlying allegations about the basis as a way of showing subjective disbelief.”  The Court appeared concerned, however, about situations where a defendant could avoid liability even though the speaker either (a) had not done any due diligence to support the stated opinion (Justice Breyer), or (b) knew, but failed to disclose, that the basis for the opinion was weak (Justice Kagan).  Justice Kagan, in particular, suggested that if a registration statement contained an opinion that a transaction was legal, “a reasonable reader would look at that statement and say two things actually: Both, he’s done something to try to check as to whether the transaction is legal, and he doesn’t know anything that’s very dispositive going the other way.”

At the same time, the Court did not appear noticeably more sympathetic to the position taken by the plaintiffs (and the Sixth Circuit), who argued that even if an opinion had a reasonable basis, it could be actionable if it turned out to be objectively false.  Justice Ginsburg noted that the effect of that position is “there is no such thing as an opinion versus a fact, that it’s just the same as if they left out ‘we believe.'”

Ultimately, the Court spent most of the argument discussing the government’s proposed “middle ground,” which is that an opinion should be actionable if “[e]ither they didn’t believe what they were saying, or there was no reasonable basis for what they were saying.”  Justice Alito expressed concern that the Court needed “some more concrete guidance as to what is reasonable.”  For example, if a CEO plans to state his opinion that nobody in the company was paying bribes, “[d]oes he have to hire an outside firm to do an investigation to see if maybe somebody is paying bribes?”  Both plaintiffs and the government suggested that reasonableness is a “context-specific inquiry,” but Justice Alito countered that if the opinion turned out to be inaccurate, “it’s not going to be very hard” for the plaintiff to assert that a “reasonable investigation” would have revealed that the opinion was false or misleading.  Omnicare, for its part, argued that “an amorphous liability standard like the reasonable basis standard will really have a chilling effect” by encouraging companies not to offer their opinions about the company’s prospects.

The Court will issue its opinion by next June.

 

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