Innocent Third Parties

The scienter (i.e., fraudulent intent) of an officer who makes a false or misleading statement can be imputed to the company based on the law of agency, but that rule potentially is subject to an “adverse interest exception” in cases where the officer acted purely out of self-interest and his conduct did not benefit the company.  Earlier this year, The 10b-5 Daily discussed a decision from the Northern District of California where the court, in a case involving improperly claimed expenses, applied the adverse interest exception and found that the plaintiffs had failed to adequately plead that the company acted with scienter.  Accordingly, the case was only allowed to proceed against the officer who had engaged in the bad conduct.

In a decision issued last week, however, the Ninth Circuit considered the same issue and has rejected the application of the “adverse interest exception” as a pleading matter.  In In re ChinaCast Education Corp. Sec. Litig., 2015 WL 6405680 (9th Cir. Oct. 23, 2015), there was no dispute that the company’s CEO had embezzled millions of dollars of corporate assets and made false statements to investors while his fraudulent activities were ongoing.  The district court, however, invoked the “adverse interest exception” and refused “to impute scienter [to the company] from the fraud of a rogue agent.”

On appeal, the Ninth Circuit noted that the “adverse interest exception” is itself subject to an exception.  Under the relevant common law principles, “the adverse interest rule collapses in the face of an innocent third party who relies on the agent’s apparent authority.”  As set forth in the ChinaCast complaint, “third-party shareholders understandably relied on [the CEO’s] representations, which were made with the imprimatur of the corporation that selected him to speak on its behalf and sign SEC filings.”  Moreover, the court found, “imputation [of the CEO’s scienter to the company] also comports with the public policy goals of both securities and agency law – namely, fair risk allocation and ensuring close and careful oversight of high-ranking officials to deter securities fraud.”  Accordingly, at least as a pleading matter, the court found the adverse interest exception could not be invoked and the case against the company should proceed.

Holding: Dismissal reversed.

Quote of note: “Assuming a well-pled complaint, we recognize that, as a practical matter, having a clean hands plaintiff eliminates the adverse interest exception in fraud on the market suits because a bona fide plaintiff will always be an innocent third party. The gymnastic exercise of imposing a general rule of imputation followed by analyzing the applicability of the exception to the exception becomes unnecessary.  Of course, as the litigation proceeds, whether the plaintiff is an innocent third party and whether the presumption of reliance is rebutted remain open questions.”

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If At First You Don’t Succeed

If a securities class action is dismissed prior to class certification, is there anything stopping another investor from bringing the same case again?  In Dempsey v. Vieau, et al., 2015 WL 5231339 (S.D.N.Y. Sept. 8, 2015), the defendants (former officers and directors of A123 Systems, Inc.) argued that the case was barred by the doctrine of res judicata because a District of Massachusetts court previously had dismissed a substantially similar case brought by a different plaintiff.

The Supreme Court has held that a proposed class action or a rejected class action cannot bind nonparties.  The defendants argued that under the Private Securities Litigation Reform Act, however, the appointed lead plaintiff is charged with representing the class.  Accordingly, once the earlier securities class action was dismissed with prejudice, that ruling had a preclusive effect on any putative class member who sought to bring the suit again.

The district court disagreed, finding that there is “nothing in the plain language of the Private Securities Litigation Reform Act (“PSLRA”) that would preclude later litigation by an absent class member of a previously dismissed putative class action prior to certification, so long as the statute of limitations has not run.”  In sum, “lead plaintiff designation does not abnegate the necessity of class certification” for purposes of res judicata preclusion.

Holding: Denied motion on res judicata grounds, but dismissed case based on the plaintiffs’ failure to adequately plead their claims.

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Risky Business

In the BP securities class action related to the 2010 Deepwater Horizon spill, the plaintiffs put forward two theories in an attempt to satisfy the class certification requirement that damages be susceptible to measurement across the entire class.

First, the plaintiffs argued that for investors who purchased BP stock before the spill (the “Pre-Spill” class), the company had understated the risk of a catastrophe when it made disclosures about its safety processes.  Under a materialization-of-risk theory, the plaintiffs claimed that the Pre-Spill class should be able to recover the decline in BP’s stock price after the spill occurred because the spill was a forseeable consequence of BP’s alleged inability to prevent and effectively respond to serious safety incidents.

Second, the plaintiffs argued that for investors who purchased stock after the spill (the “Post-Spill” class), the company had made affirmative misstatements concerning the spill rate.  Under an out-of-pocket theory, plaintiffs claimed that the Post-Spill class should be able to recover the difference between their purchase price of BP stock and the price (as determined by an event study) they would have paid had the relevant information been properly disclosed.

Based on the issue of damages, the district court agreed only to certify the Post-Spill class.  On appeal – Ludlow v. BP, P.L.C, 2015 WL 5235010 (5th Cir. Sept. 8, 2015) – the U.S. Court of Appeals for the Fifth Circuit has affirmed that decision.

In Ludlow, the court drew a sharp distinction between the proposed damages methodologies and whether they allowed damages to be measured across each proposed class.  Under the materialization-of-risk theory for the Pre-Spill class, the alleged false statements “resulted in an investor being defrauded into taking a greater risk than disclosed, taking away plaintiffs’ opportunity to decide whether to divest in light of the heightened risk.”  Therefore, the plaintiffs argued, the Pre-Spill class members should be able to recover the bulk of the stock price drop that occurred once that risk materialized in the form of the spill.  The court concluded, however, that the materialization-of-risk theory “was not capable of class-wide determination” because it “hinges on a determination that each plaintiff would not have bought BP stock at all were it not for the alleged misrepresentations.”  This determination was “not derivable as a common question,” but rather required “individualized inquiry.”

In contrast, the court found that the more common out-of-pocket damages theory used for the Post-Spill class was acceptable.  The defendants did raise a number of objections as to the damage calculations, including whether the corrective events relied on by the plaintiffs’ expert were adequately tied to the alleged misstatements.  The court held that resolving these objections at the class certification stage, however, would “vitiate Halliburton I’s requirement that loss causation need not be proved at this stage, since proving the quality of the fit at this stage would also require bringing forward the plaintiff’s proof of causation.”  Moreover, if “certain corrective events were later determined to be independent of the misrepresentations,” they could be removed from the damages measurement without impairing the ability to apply it across the Post-Spill class.

Holding: Affirming district court’s decision to certify only the Post-Spill class.

Quote of note: “To summarize, plaintiffs’ materialization-of-the-risk theory cannot support class certification for two reasons. Unlike the stock inflation model, the materialization-of-the-risk model cannot be applied uniformly across the class . . . because it lumps together those who would have bought the stock at the heightened risk with those who would not have. It also presumes substantial reliance on factors other than price, a theory not supported by Basic and the rationale for fraud-on-the-market theory.”

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There Can Be Only One Ultimate Authority

In re Galena Biopharma, Inc. Sec. Litig., 2015 WL 4643474 (D. Or. Aug. 5, 2015) involves an interesting fact pattern.  The defendants are alleged to have “entered into an unlawful promotional scheme” that included the placement of “misleading articles on investor websites touting Galena.”   These articles allegedly were written by a stock promotion company hired by the company.

Plaintiffs argued that both Galena and the stock promotion company could be held primarily liable for the alleged misstatements contained in the web articles.  Under the Janus decision, however, primary liability is limited to the maker of the statement – i.e., “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”  The court rejected the idea that the individual authors (to whom the statements were attributed) or the stock promotion company (who employed the authors) were the makers of the statements.  Instead, the court found that the “lesson of Janus is that where legally distinct entities are involved, only one entity has the final say in what, if anything, is published.”  Because the plaintiffs had adequately alleged that Galena and its officers “had the final word regarding approved content and whether the article would be published,” primary liability for the alleged Rule 10b-5(b) violations was limited to those defendants.

Holding: Motion to dismiss denied in part and granted in part.  The extensive decision contains a number of other holdings, including on the issues of scienter, scheme liability, the applicability of the fraud-on-the-market presumption of reliance, and loss causation.

Quote of note:  “If the Court were to consider the individual authors [who worked for the stock promotion company] as the makers of those statements, then companies could avoid liability under the Exchange Act simply by paying third parties to write and publish false or misleading statements about the company, even when the company retains final decision-making authority over the content.  The holding in Janus does not support such a broad reading.”

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Better Plan Ahead

Does the fact that an individual defendant’s stock trading took place pursuant to a pre-determined Rule 10b5-1 trading plan undermine any inference that the trades were “suspicious”?  Courts continue to be split on this issue, with the answer often depending on the exact circumstances surrounding the plan’s formation and execution.

One recurring issue, which appellate courts have begun to weigh in on, is whether it makes a difference if the trading plan was entered into before or after the outset of the alleged class period (i.e., before or after the fraud allegedly began).  Last year, the Fourth Circuit held that because one of the trading plans relied on by a defendant was instituted during the class period, it did “less to shield [that defendant] from suspicion.”  The Second Circuit now has issued a more emphatic holding on this topic.

In Employees’ Retirement System of Govt. of the Virgin Islands v. Blanford, 2015 WL 4491319 (2d Cir. July 24, 2015), the defendants argued that their stock trading did not support any inference of scienter because it was done entirely pursuant to Rule 10b5-1 trading plans.  The court found that this argument “ignores that [the defendants] entered this trading plan in May after the second quarter investor call, long after the Complaint alleges that Green Mountain’s fraudulent growth scheme began.”  Indeed, “[w]hen executives enter into a trading plan during the Class Period and the Complaint sufficiently alleges that the purpose of the plan was to take advantage of an inflated stock price, the plan provides no defense to scienter allegations.”

Holding: Reversing dismissal of complaint and remanding for further proceedings.

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Cornerstone Releases Midyear Report

Cornerstone Research (in conjunction with the Stanford Securities Class Action Clearinghouse) has issued its 2015 midyear report on securities class action filings.

The findings for the first half of 2015 include:

(1) There were 85 new filings, which is a slight increase over the first half of 2014 (but still lagging behind the semiannual average of 94 filings).

(2) Foreign companies were a significant percentage of the new filings, with 20 filings (i.e., 24 percent of the total) being brought against companies headquartered outside the United States.

(3) Filing activity in the technology industry has increased, leading to a surge in filings in the Ninth Circuit (nearly double when compared with the second half of 2014).

(4) Companies with large market capitalizations continue to face fewer filings than in the past.  On an annualized basis, only 1.6% of S&P 500 companies were the subject of securities class actions in the first half of 2015.

Quote of note (Professor Grundfest – Stanford): “Securities class actions continue to percolate at a relatively low level, whether measured by the number of cases filed or the dollar amounts at stake.  The interesting question is ‘why?’  Some observers point to high stock price valuations and the lack of volatility in equity markets.  Others point to the fact that many of the major accounting scandals now appear to be happening abroad.  A combination of both factors could well be at work.”

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How Strong is “Very Strong”?

The U.S. Court of Appeals for the District of Columbia only hears a small number of securities cases, which means that it is often playing catch-up on the relevant legal standards.  In In re Harman Int’l Industries, Inc. Sec. Litig., 2015 WL 3852089 (D.C. Cir. June 23, 2015), the court appears to have issued its first decision addressing (a) the PSLRA’s safe harbor for forward-looking statements and (b) the concept of corporate puffery.

(1) Safe Harbor – The PSLRA’s safe harbor renders forward-looking statements inactionable if they are “accompanied by meaningful cautionary statements.”  The court, citing Second Circuit and Seventh Circuit precedent, held that cautionary language cannot be meaningful if it is misleading in light of historical facts.  For example, “[i]f a company were to warn of the potential deterioration of one line of its business, when in fact it was established that that line of business had already deteriorated, then . . . its cautionary language would be inadequate to meet the safe harbor standard.”

While Harman had warned investors about the risk that its products could become obsolete and had reported growing inventories of its personal navigation devices (PNDs), the court found that the complaint sufficiently alleged that Harman already knew (but failed to disclose) that it was experiencing a serious inventory obsolescence problem related to those products.  Moreover, the court’s conclusion that the safe harbor could not be invoked was “reinforc[ed]” by the fact that Harman made no changes to its cautionary statements during the relevant time period, suggesting that the cautionary language was merely boilerplate.

(2) Puffery – The court agreed with the general legal proposition that corporate puffery (i.e., “generalized statements of optimism that are not capable of objective verification”) is immaterial to investors.  In this case, however, the supposed puffery consisted of a statement that “sales of aftermarket products, particularly PNDs, were very strong during fiscal 2007.”  The court found that this statement was “tied to a product and a time period” and therefore was “not too vague to be material.”  Although defendants argued that “very strong” lacked a standard against which it could be assessed, the court noted that nothing in the case law “purports to render inactionable any statement that does not contain its own metric.”

Holding: Dismissal of complaint reversed as to statements at issue.

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