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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Not Congress’s Concern

The Securities Litigation Uniform Standards Act (“SLUSA) is designed to limit the ability of plaintiffs to avoid the heightened pleading standards (and other procedural and substantive protections) applicable to federal securities class actions by pleading their cases as violations of state law.  Accordingly, the statute precludes certain class actions based upon state law that allege a misrepresentation or deceptive conduct in connection with the purchase or sale of nationally traded securities.  Although SLUSA was enacted in 1998, the exact scope of its preclusive effect continues to be a hot topic, with a recent Supreme Court decision addressing the “in connection with” requirement.

In In re Kingate Management Ltd. Litigation, 2015 WL 1839874 (2d Cir. April 23, 2015), the court considered a different interpretive question: what does SLUSA mean when it proscribes the “main[tenance]” of a covered class action “alleging . . . [false conduct] in connection with the purchase or sale of a covered security”?  The Second Circuit concluded that “alleging” must be interpreted narrowly to only cover “conduct by the defendant falling within SLUSA’s specifications of conduct prohibited by the anti-falsity provisions” of the federal securities laws.  A broader application – e.g., to claims where the requisite falsity is a “necessary predicate of the plaintiffs’ claim” but “the falsity is not chargeable to the defendant and the claim could not have been brought against the defendants under the federal securities laws” – would improperly “bar state law claims in a manner unrelated to SLUSA’s purposes.”

The Second Circuit, however, did add some important caveats to its holding.  First, plaintiffs cannot engage in artful pleading to avoid SLUSA preclusion.  Any time “the success of a class action claim depends on a showing that the defendants committed false conduct conforming to SLUSA’s specifications, the claims will be subject to SLUSA,” even if the plaintiffs choose to invoke a state law theory that does not include false conduct as an element.  Second, consistent with the Supreme Court’s Dabit decision, SLUSA preclusion may apply even if the alleged conduct could not lead to a private claim (as opposed to an enforcement action by the SEC).  Finally, even if the plaintiffs do not specifically allege that the requisite false conduct was in connection with the purchase or sale of nationally traded securities, “the court may nonetheless ascertain those facts independently of the plaintiffs’ allegations and apply SLUSA.”

Holding: District court’s dismissal of complaint vacated; case remanded to district court for claim-by-claim assessment of whether SLUSA preclusion applies.

Quote of note: “Interpreting SLUSA to apply more broadly to state law claims that are altogether outside the prohibitions of the federal securities laws, and could not be subject to the PSLRA, would . . . construe ambiguous provisions of SLUSA in a highly improbable manner – as prohibiting state law claims involving matters that were not Congress’s concern in passing SLUSA, that have never been a subject of congressional concern, and that in a number of instances might even lie outside the powers of Congress.”

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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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