Creating Your Own Losses

Under the PSLRA, the presumptive lead plaintiff in a securities class action is the applicant with the “largest financial interest in the relief sought by the class.”  The largest financial interest is measured by assessing the approximate losses suffered, with courts generally holding that losses suffered as the result of “in-and-out” stock transactions that took place before any misconduct was revealed do not count.

With this background in mind, the court in Topping v. Deloitte Touche Tohmatsu, 2015 WL 1427317 (S.D.N.Y. March 27, 2015) faced a novel procedural twist in assessing competing lead plaintiff applications.  The applicant with the largest claimed losses actually sold all of its holdings before the corrective public disclosure alleged in the original complaint was made.  While that would normally be disqualifying, shortly after the lead plaintiff deadline, the applicant’s counsel filed a “Corrected Complaint” adding allegations about an earlier, partial disclosure that occurred prior to the applicant’s sales.  In its lead plaintiff briefing, the applicant argued that based on the Corrected Complaint, it was not an in-and-out trader and should be appointed.

The court rejected this argument on two grounds.  First, the court found that it could not look to allegations in a corrected or amended complaint filed after the lead plaintiff application deadline in assessing which applicant has the largest claimed losses.  Not only would doing so undermine the timeliness of the lead plaintiff process by inviting additional briefing, but it would prejudice other class members who had relied on the original complaint in determining whether and how to make their lead plaintiff applications.   Second, even if the court were to consider the Corrected Complaint, the alleged partial disclosure did not reveal anything about the alleged fraud and could not be used to demonstrate loss causation.

Holding: Appointed applicant with second-largest claimed losses as lead plaintiff.


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Omnicare Decided

The U.S. Supreme Court has issued a decision in the Omnicare case holding that opinions presented in registration statements can be subject to Section 11 liability if either (a) the opinion was not genuinely held, or (b) the registration statement omitted material facts about the issuer’s inquiry into, or knowledge concerning, the opinion.  It is a 9-0 decision authored by Justice Kagan, although Justices Scalia and Thomas filed separate concurring opinions that effectively function as dissents.

The decision addresses an existing split in the circuit courts.  While the Second, Third, and Ninth Circuits had held that the plaintiff must allege the opinion 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 found 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.”  The Supreme Court rejected both positions and, as was extensively discussed at the oral argument, endorsed a middle ground approach.

In Omnicare, the relevant opinions related to the company’s compliance with applicable law.  The plaintiffs failed to allege that the company did not believe it was legally compliant or that the opinions contained some false statement of underlying fact.  As a result, the Court held, the first prong of its liability analysis was inapplicable.

That said, the plaintiffs also alleged that Omnicare omitted to state facts that necessary to make its opinions on legal compliance not misleading.  The Court held that this was a potentially viable claim, because a reasonable investor “expects not just that the issuer believes the opinion (however irrationally), but that it fairly aligns with the information in the issuer’s possession at the time.” While it is not enough that some fact cuts against the stated opinion, if the investor can “identify particular (and material) facts going to the basis for the issuer’s opinion – facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have – whose omission makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context,” there can be Section 11 liability.  In the case of a legal opinion, for example, “if the issuer made the statement in the face of its lawyers’ contrary advice, or with the knowledge that the Federal Government was taking the opposite view,” the investor has “cause to complain.”

The Omnicare plaintiffs claimed the company received some contrary advice from an attorney about the legal risks associated with a particular contract.  The Court remanded the case for the lower court to determine whether (a) the excluded fact would have been material to a reasonable investor and (b) in light of the overall context, including other disclosures that Omnicare made about its legal compliance and risks, “the excluded fact shows that Omnicare lacked the basis for making those statements that a reasonable investor would expect.”

Holding: Judgment vacated and remanded for further proceedings.

Quote of note: “Section 11’s omissions clause, as applied to statements of both opinion and fact, necessarily brings the reasonable person into the analysis, and asks what she would naturally understand a statement to convey beyond its literal meaning.  And for expressions of opinion, that means considering the foundation she would expect an issuer to have before making the statement.  All that, however, is a feature, not a bug, of the omissions provision.”

Notes on the Decision

(1) The Court concluded that it will be “no small task for an investor” to adequately demonstrate that an omission has rendered an opinion misleading.  At the same time, it also found that to avoid exposure to liability “an issuer need only divulge an opinion’s basis, or else make clear the real tentativeness of its belief.”  Whether this judicial advice will change how opinions are presented in registration statements remains to be seen.

(2) As perhaps to be expected when the Court adopts a middle ground approach, both the plaintiffs and defense bars will have reason to be satisfied with the decision.  While the Court struck down the Sixth Circuit’s purely objective standard, it also arguably provided a new basis for opinion liability in the Second, Third, and Ninth Circuits (and those circuits are where the majority of securities class actions are filed).

(3) Justice Scalia’s concurrence took issue with the majority’s omissions analysis, arguing that “[t]he objective test proposed by the Court – inconsistent with the common law and common intuitions about statements of opinion – invites roundabout attacks upon expressions of opinion.”

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The Streak Is Over

Plaintiffs in securities class actions often point to insider trades as evidence that the individual defendants had a pecuniary motive to commit fraud.   But if the plaintiffs do not make any allegations related to insider trades, can defendants conversely use SEC filings to show, at the motion to dismiss stage, that there was no suspicious trading (and, accordingly, no pecuniary motive)?

In Zak v. Chelsea Therapeutics Int’l, Ltd., 2015 WL 1137142 (4th Cir. March 16, 2015), the district court took judicial notice of certain SEC filings concerning insider sales and the individual defendants’ stock holdings.  It then “concluded that the defendants’ purported failure to sell Chelsea stock during the class period ‘tip[ped] the scales’ of the competing inferences of scienter” in favor of the defendants.  The Fourth Circuit held that this analysis was improper.  First, the district court should not have considered the SEC filings because they “were not explicitly referenced in, or an integral part of, the plaintiff’s complaint,” which did not contain any allegations related to insider trades.   Second, the SEC filings the district court considered did not conclusively establish that none of the individual defendants sold any Chelsea stock during the class period.

Holding: Dismissal vacated.

Addition:  One of the panel members dissented from the decision, but stated that he agreed with the majority’s “determination that the district court misused the challenged SEC documents.”  Interestingly, the dissent notes that prior to the instant case, the Fourth Circuit had never overturned, in the post-PSLRA era, a district court decision holding that the plaintiffs had failed to plead facts supporting a strong inference of scienter (eight total cases).

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Core Workout

The core operations theory, as developed in the Ninth Circuit, holds that it may be possible to infer a strong inference of scienter in situations where the nature of the alleged fraud “is of such prominence that it would be ‘absurd’ to suggest that the management was without knowledge of the matter.”   The theory has come under criticism from other courts and there are relatively few reported decisions where it has been successfully invoked.

In Patel v. Axesstel, Inc., 2015 WL 631525 (S.D. Cal. Feb. 13, 2015), however, the court found the alleged facts supported the application of the core operations theory.  As the court summarized the situation: “it would be absurd to think that the CEO and CFO of a company with just thirty-five employees, or whom only ten are involved in sales, general or administration, would be unaware of the lack of written agreements or definitive payment terms with the five new customers in Africa that represented the company’s first sales of a significant new product that constituted between twenty and forty percent of Axesstel’s overall revenue.”  Moreover, the individual defendants made “numerous statements . . . indicating that they were directly involved in sales and knew the details of Axesstel’s dealings with its African customers.”  Accordingly, the court held that the plaintiffs had adequately plead a strong inference of scienter.

Holding: Motion to dismiss denied.

Quote of note: “[The individual defendants’] roles in Axesstel are magnified by the exceedingly small size of the company.  Axesstel is not to be confused with Apple.  The individual defendants here are not officers in a large company who may be removed from the details of a specific business line or remote business activity.”

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Give and Take

To what extent does a company have to anticipate that its actions could result in a negative regulatory outcome?  In Fire and Police Pension Association of Colorado v. Abiomed, Inc., 2015 WL 500748 (1st Cir. Feb. 6, 2015), the plaintiffs asserted that the company’s alleged off-label drug marketing rendered false or misleading its (a) financial statements, and (b) disclosures about its interaction with the Food and Drug Administration (FDA) on the issue of marketing.  On appeal, the court held that the plaintiffs had failed to plead the requisite “strong inference” of scienter as to any of the defendants.

The court found that it was not clear that the alleged off-label drug marketing had materially impacted Abiomed’s financial results, which “weighs against an argument that defendants here possessed the requisite scienter.”  Moreover, the company promptly disclosed when the FDA sent it a “warning letter” about its marketing and explicitly told investors that the FDA might conclude that it had engaged in improper marketing.  Abiomed also took corrective actions and the FDA “eventually closed out its investigation of Abiomed without taking any action adverse to the company.”  Finally, the alleged insider trading “was neither unusual nor suspicious.”  Indeed, one of the individual defendants actually increased his holdings of Abiomed stock during the class period.

Holding: Dismissal affirmed.

Quote of note: “Under plaintiffs’ theory of the case, Abiomed should have affirmatively admitted widespread wrongdoing rather than stating that the outcome of its regulatory back-and-forth with the FDA was uncertain.  That would be a perverse result; such an admission would have been misleading, since the off-label marketing issues had the potential to be resolved with no adverse action from the FDA. . . . There must be some room for give and take between a regulated entity and its regulator.”

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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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