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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Big Verdicts and Big Appeals

Securities class actions rarely go to trial.  When they do, as in the Household International case where the plaintiffs won a $2.46 billion verdict, they make the news.  But it is axiomatic that big verdicts lead to big appeals.  Last month, the Seventh Circuit agreed with the defendants that a new trial was warranted, at least as to certain determinations.

In Glickenhaus & Co. v. Household Int’l, Inc., 2015 WL 2408028 (7th Cir. May 21, 2015), the court offered guidance on two interesting issues.

(1) Loss causation – The jury applied a “leakage model” to determine damages, apparently concluding that information about Household’s alleged fraud had become available to market participants before the relevant disclosures.  This model “calculates every difference, both positive and negative, between the stock’s predicted return [using a regression analysis] and the stock’s actual return during the disclosure period.”  All of these residual returns are then added up and this amount is “assumed to be the effect of the disclosures.”  While the Seventh Circuit agreed that the leakage model of loss causation was legally sufficient, it also found that the expert’s “conclusory opinion that no firm-specific, nonfraud related information affected the stock price during the relevant time period” was subject to challenge.  It ordered a new trial on the issue of loss causation to allow the defendants an opportunity to rebut the accuracy of that opinion.

(2) Maker of the statements – The jury was instructed that the defendants could be held liable if they “made, approved, or furnished information to be included in a false statement of fact.”  The Supreme Court subsequently issued its Janus decision, holding that liability is limited to “the person or entity with ultimate authority over the statements, including its content and whether or how to communicate it.”  When the defendants moved for a new trial based on Janus‘s holding, the district court denied the motion, “reasoning that the Court’s holding applied only to legally independent third parties.”  On appeal, the Seventh Circuit found that this was error because “[t]he Court’s interpretation applies generally, not just to corporate outsiders.”  Accordingly, it ordered a new trial as to which of the false statements were “made” by the individual officer defendants (this would include, for example, a jury determination as to whether Household’s CEO actually exercised control over the company’s press releases).

Holding: Defendants are entitled to a new trial on loss causation and whether the individual officer defendants “made” certain of the false statements.

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Adverse Interests

Is it possible for a securities class action based on alleged misrepresentations in a company’s public filings to proceed against an individual officer, but not the company (presuming the company is not otherwise immune from suit)?  The answer is yes, but the circumstances will be unusual.

In Nathanson v. Polycom, et al., 2015 WL 1517777 (N.D. Cal. April 3, 2015), the plaintiffs alleged that as the result of the former CEO’s improperly claimed personal expenses, the company misstated its operating expenses and failed to disclose that the CEO would be subject to termination.  The court found that the plaintiffs had adequately alleged the existence of material misstatements and, as to the CEO, a strong inference of scienter.

Normally, a CEO’s scienter can be imputed to the company based on the law of agency, but that rule 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.  The improper claiming of personal expenses did not benefit Polycom.  Accordingly, the court concluded that the adverse interest exception applied, the CEO’s scienter could not be imputed to Polycom, and, as a result, the case could not proceed against the company.

Holding: Motion to dismiss granted in part (Polycom and other individual defendants) and denied in part (former CEO).

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