Working Backwards

Securities class actions based on corporate financial disclosures, which used to form the backbone of securities litigation, have been declining.  Instead, in recent years the plaintiffs’ bar has turned its focus to “event-driven” securities litigation, bringing securities class actions based on external events that drive down a company’s stock price.  These external events have included data security breaches, sexual harassment allegations, commercial litigation, allegations that a product has caused injury, and regulatory investigations or enforcement actions.  The frequent challenge for the plaintiffs’ bar, however, is to find corporate statements that can be adequately alleged to have been rendered false or misleading by the external event.

In In re Marriott International, Inc., 2022 WL 1178526 (4th Cir. April 21, 2022), investors brought a securities class action based on a data breach that impacted approximately 500 million guest records in the Starwood guest reservation database.  The plaintiffs alleged that Marriott’s failure to disclose severe vulnerabilities in Starwood’s IT systems rendered various public statements false or misleading.  The district court dismissed the case, finding that the complaint failed to adequately allege falsity, scienter, and loss causation.

On appeal, the Fourth Circuit found that the challenged statements fell into three categories: “statements about the importance of protecting customer data; privacy statements on Marriott’s website; and cybersecurity-related risk disclosures.”

(1) As to the statements about the importance of data protection to Marriott’s business, the court held that “the investor’s whole theory of the case turns on those statements being true.”  In other words, data protection was important to Marriott and the fact that the company said this “basic truth is neither misleading nor creates the false impression the investor suggests.”  Moreover, Marriott also disclosed the “key risks that the investor alleges made Starwood’s systems vulnerable.”

(2) Marriott’s privacy statements on its website were inactionable for similar reasons.  The company stated that it seeks to protect personal data, but also noted that no data system “can be guaranteed to be 100% secure.”  The complaint conceded that “Marriott devoted resources and took steps to strengthen the security of Starwood’s systems.”  Therefore, the court held, the fact that Marriott suffered a security breach “does not demonstrate that the company did not place significant emphasis on maintaining a high level of security.”

(3) Finally, the court concluded that Marriott’s risk factors were accurate when issued.  The plaintiffs argued that “Marriott twice warned generally about cybersecurity breaches that could occur when it knew those events had in fact already occurred.”  The court found, however, that the first alleged cybersecurity breach was “not supported by the investor’s own allegations” and after the Starwood breach the company updated its risk disclosures to specifically state that it had “experienced cyber-attacks.”

Holding: Dismissal affirmed.

Quote of note: “Marriott certainly could have provided more information to the public about its experience with or vulnerability to cyberattacks, but the federal securities laws did not require it to do so.  Indeed, the SEC advises companies against ‘mak[ing] detailed disclosures that could compromise [their] cybersecurity efforts – for example by providing a ‘roadmap’ for those who seek to penetrate a company’s securities protections.’  Even as alleged here, Marriott provided sufficient information to ensure its statements were neither false nor misleading.”

Additional note: On the related issue of whether risk disclosures are material to investors, some courts (notably the Sixth Circuit in its Bondali decision) have held that investors do not rely upon risk disclosures because they are not meant to educate investors on what harms are currently affecting the company.   In Marriott, the Fourth Circuit drops a footnote stating that “risk disclosures generally also lack materiality” and favorably quotes the Bondali decision.

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Thanks To Twitter

A key issue in securities fraud litigation is when, and under what circumstances, a company has a duty to tell investors about material corporate developments.

In Weston Family Partnership LLP v. Twitter, 2022 WL 853252 (9th Cir. March 23, 2022), the plaintiffs alleged that Twitter had misled investors about problems with its Mobile App Promotion (MAP) product.  In August 2019, Twitter announced that software bugs in the MAP product had caused the sharing of the cell phone location data of its users and that it had “fixed these issues.”  Several months later, the company disclosed that software bugs continued to exist and reported a $25 million revenue shortfall.

The district court dismissed the claims.  On appeal, the Ninth Circuit found that “fixed these issues” referred to no longer sharing the cell phone location data, not the software bugs.  Moreover, Twitter had no duty to update investors about the progress of its MAP product and the plaintiffs had not plausibly alleged that the software bugs had materialized and impacted revenue prior to August 2019.

Holding: Dismissal affirmed.

Quote of note: “While society may have become accustomed to being instantly in the loop about the latest news (thanks in part to Twitter), our securities laws do not impose a similar requirement. . . . Put another way, companies do not have an obligation to offer an instantaneous update of any internal developments, especially when it involves the oft-tortuous path of product development.  Indeed, to do so would inject instability into the securities markets, as stocks may wildly gyrate based on even fleeting developments.”

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Compare And Contrast

NERA Economic Consulting and Cornerstone Research have released their respective 2021 annual reports on federal securities class action filings.  As usual, the different methodologies employed by the two organizations have led to slightly different numbers, although they both identify the same general trends.

The findings for 2021 include:

(1) The reports agree that there was a significant decline in filings, primarily driven by a sharp drop in the number of M&A-related filings (down over 80%).   NERA finds that there were 205 filings (compared with 321 filings in 2020), while Cornerstone finds that there were 218 filings (compared with 333 filings in 2020).

(2) Both NERA and Cornerstone analyzed the number of filings with COVID-19 related claims: NERA identifies 20 filings with COVID-19-related claims (less than in 2020), while Cornerstone identified 17 filings with COVID-19-related claims (the same as in 2020, but with fewer filings in the second half of the year).

(3) Filings related to special purpose acquisition companies (SPACS) rose significantly, constituting more than 10% of all filings.  NERA identified 24 SPAC-related cases, while Cornerstone identified 32 SPAC-related cases.

(4) The Second Circuit (New York) and Ninth Circuit (California) traditionally have been the locations with the most filings, but that peaked this past year.  According to Cornerstone, 72% of all standard filings were brought in those courts, the highest combined proportion of any two circuits since tracking began in 1997.

(5) NERA finds that if settlements related to merger objections, settlements with no cash payment to the class, and individual cases with settlements of $1 billion or greater are removed, the annual average settlement value in 2021 was $21 million.  That is the lowest annual average within the most recent 10 years.

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

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Sticking To The Plan

SEC Rule 10b5-1, put into place in 2000, establishes that a person’s purchase or sale of securities is not “on the basis of” material nonpublic information if, before becoming aware of the information, the person enters into a binding contract, instruction, or trading plan (as defined in the rule) covering the securities transaction at issue.  To take advantage of this potential affirmative defense, many executives have implemented trading plans for their sales of company stock.

Insider trading, of course, is often used by plaintiffs in securities class actions to create an inference of scienter (i.e., fraudulent intent).  The plaintiffs allege that the individual corporate defendants profited from the alleged fraud by selling their company stock at an artificially inflated price.  Even as the SEC is considering amendments to Rule 10b5-1, courts continue to grapple with when and how a stock trading plan can help shield corporate executives from securities fraud liability.

In KBC Asset Management NV v. DXC Technology Co., 19 F.4th 601 (4th Cir. 2021), the Fourth Circuit examined the various categories of scienter allegations made by the plaintiffs, including allegations that the company’s CEO and CFO sold shares during the nine-month class period.  The CEO sold 17% of his holdings, for proceeds of over $10 million, and the CFO sold 77% of his holdings, for proceeds of over $9.5 million.  The sales were concentrated in the time period shortly before the company revised its revenue projections downward (i.e., the alleged “corrective disclosure” at the end of the putative class period).

The Fourth Circuit held that despite the large amounts involved and the arguably suspicious timing, the sales could not support a strong inference of scienter.  First, the court found that the CEO’s sale of 17% of his holdings was similar to percentages that the court previously had held to be “nearly de minimus.”  Second, while the CFO’s sales were far more significant on a percentage basis, during the nine-month period prior to the class period the CFO had sold nearly $15 million worth of shares.  The court declined to “draw a strong inference of scienter from the fact that [the CFO] sold much less stock during the period in which he was allegedly defrauding investors than during the period in which he is not alleged to have done so.”

The defendants also argued that any inference of scienter should be negated by the fact that all of the trades were done pursuant to Rule 10b5-1 trading plans.  The Fourth Circuit concluded that it could not consider the impact of the trading plans because the record was “silent as to when [the CEO and CFO] entered their plans.”  If the plans had been entered into during the class period, they would not “mitigate a suggestion of motive for suspicious trading.”  Interestingly, the court also noted in a footnote that it was not clear whether it could consider the trading plans “as an affirmative defense at the motion-to-dismiss stage.”  Rule 10b5-1 trading plans, however, are an affirmative defense to a claim of insider trading, which is different than a claim of securities fraud based on material misrepresentations.  There does not appear to be any reason why a court could not consider the existence of trading plans in assessing whether trading by corporate insiders has raised an inference of scienter.

The SEC’s proposed amendments to Rule 10b5-1 place additional restrictions on how trading plans are structured and create extensive corporate disclosure requirements around the creation and use of trading plans.  If adopted, these amendments are likely to have a significant impact on the defense of securities class actions.  Stay tuned.

Holding: Dismissal affirmed.

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And Then There Was One

In securities class actions, plaintiffs often take a shotgun approach and allege that the defendants made numerous false statements throughout the putative class period.  Whether that helps avoid dismissal, however, is an open question.

In City of Plantation Police Officers Pension Fund v. Meredith Corp., 16 F.4th 553 (8th Cir. 2021), the plaintiffs alleged that Meredith Corp. – during a 19-month class period – made 138 false statements relating to its acquisition and integration of Time, Inc. (the owner of Time, People, Sports Illustrated, and other magazines).  On appeal, the court found that 137 of the 138 statements were not actionable because they “were clearly either (1) statements identified as forward-looking and accompanied by meaningful cautionary statements, (2) corporate puffery, or (3) forward-looking statements that the complaint’s allegations do not imply by strong inference were made with actual knowledge of their falsity.”  But what about that 138th statement?

Meredith’s CEO claimed that the company had “fully integrated [its ]HR, finance, legal and IT functions.”  According to a former Meredith employee, however, at that time the legacy Meredith employees and legacy Time employees were still operating on different finance software systems.  The court found that this was a bit of a closer call, but concluded that nothing in the complaint provided “any insight” into what the CEO actually knew about the integration of the finance departments.  A more plausible inference than fraudulent intent was that the CEO made the statement because he had limited information.

Holding: Dismissal affirmed.

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A Business Problem, Not A Securities Problem

A securities opinion written by Judge Easterbrook of the U.S. Court of Appeals for the Seventh Circuit is bound to be noteworthy.  And his latest effort – City of Taylor Police and Fire Retirement System v. Zebra Technologies Corp., 8 F. 4th 592 (7th Cir. 2021) – does not disappoint.

In City of Taylor, the plaintiffs alleged that Zebra made misstatements in connection with its acquisition of a division of Motorola Solutions.  In particular, Zebra predicted that the acquisition would yield substantial recurring savings and was “progressing as planned,” but the costs of the acquisition turned out to be higher than expected.  While the consolidation was occurring, Zebra also missed its projected gross profit margin for the second quarter of 2015 by about 1%.

The district court dismissed the complaint.  On appeal, the Seventh Circuit had little difficulty affirming the dismissal.

Falsity – The Seventh Circuit found that the plaintiffs had failed to adequately plead the existence of any material misstatements.

(1) Cost-savings estimates – The plaintiffs contended that the estimates were “misleading when not coupled with more information about the ongoing costs of consolidation.”  The Seventh Circuit was unimpressed with the attempt to link these items, noting that “[j]ust as stocks and flows differ, the one-time expenses of integration are categorically distinct from recurring savings gained by melding similar businesses.”  The court concluded that a “corporation need not couple each piece of good news with disclosure of some tangential difficulty.”

(2) “Progressing as planned” – The district court found that this statement was immaterial corporate puffery.  The Seventh Circuit agreed, but also noted that “it could not be called false” because “the consolidation continued throughout the class period,” even if the costs proved higher than expected.

(3) Gross profit margin – The Seventh Circuit found that the “Securities Exchange Act does not demand perfection from forecasts, which are inevitably inaccurate.”  A miss on gross profit margin of just over 1% “is a long way from fraud.”

Scienter – The Seventh Circuit found that two competing inferences could be drawn from the alleged facts.  In the plaintiffs’ version, Zebra’s management “chose to hoodwink investors into thinking that integration was seamless” when it was actually “costlier and more difficult than anticipated.”  Another inference, however, was that Zebra’s management “only had limited information about the inner workings of Motorola” when consolidation began and the difficulties came to light over time and were disclosed.  The court found that the second inference was a “better fit” with the facts alleged in the complaint, which included statements during the class period where Zebra warned about increasing costs related to the acquisition.

Moreover, the Seventh Circuit went on to note that the “plausibility of potential inferences depends on context.”  While an executive may be “privy to good historical information about the inner workings of her own corporation,” she possesses “only limited information about the internal operations of other corporations.”  If companies were required to provide a “complete accounting of difficulties as they emerged during a merger or acquisition,” they might either “guess too high” and drive down their stock price or “guess too low” and be accused of securities fraud.  The court concluded that “[s]ecurities law does not force corporations into this sort of no-win circumstance.”

Holding: Dismissal affirmed.

Quote of note: “Retrospective disclosures can and should be precise because corporations generally possess good information about completed operations.  The law tolerates greater imprecision from forecasts because predicting the future is an uncertain enterprise. . . . The fatal flaw of the Retirement System’s suit is that it seeks to apply rules covering retrospective statements to ongoing developments.  Unexpected difficulties that crop up in any corporate consolidation are a business problem, not a securities problem.”

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Learning The Alphabet

A recent decision by the U.S. Court of Appeals for the Ninth Circuit offers potential lessons for both companies and their securities defense counsel. 

In In re Alphabet, Inc. Sec. Lit., 1 F.4th 687 (9th Cir. 2021), the plaintiffs alleged that Alphabet – Google’s parent company – failed to disclose that a securities glitch in the Google+ social network had left the private data of hundreds of thousands of users exposed to third-party developers and that Google+ was plagued by other security vulnerabilities.  Google discovered these issues in early 2018 and remediated them.  In October 2018, however, the Wall Street Journal published a lengthy story about the Google+ issues and how the company had decided not to tell the public about them during a time when technology companies were under regulatory scrutiny for their handling of customer data.  Google responded with a blog post acknowledging what had happened and announcing that it was shutting down the Google+ social network.  Alphabet’s stock price fell following these disclosures and a securities class action was filed shortly thereafter.

The district court dismissed the case, finding that the plaintiffs failed to adequately plead the existence of material misstatements and scienter.  On appeal, however, the Ninth Circuit reversed the decision as to some of the claims.

Most importantly, the panel considered whether Alphabet’s Form 10-Qs issued in April 2018 and July 2018 were materially misleading.  The risk disclosures incorporated into those filings “warned, among other things, that even unfounded concerns about Alphabet’s ‘practices with regard to the collection, use, disclosure, or security of personal information or other privacy related matters’ could damage the company’s ‘reputation and adversely affect [its] operating results.'”  While some courts have questioned whether risk disclosures can ever form the basis for a securities fraud claim because they are inherently prospective in nature, the Ninth Circuit previously has held that if risk disclosures do not alert the reader that the described risks already have come to fruition they may be actionable. 

Alphabet argued that there was a key factual difference between its case and the Ninth Circuit precedent: by the time the Form 10-Qs were issued, Google already had remediated the problem.  Therefore, the company had no affirmative duty to disclose a problem that no longer existed.  The panel disagreed, finding that because “Google’s business model was based on trust, the material implications of a bug that improperly exposed user data for three years were not eliminated merely by plugging the hole in Google+’s security.”  Moreover, Google also had discovered other security vulnerabilities that led to the decision to shut down the whole platform.  Under these circumstances, the panel held that Google needed to update its risk factors if they wanted to avoid making materially misleading statements.  (The panel also found that the plaintiffs had adequately alleged the defendants’ scienter as to these risk factors.)

In addition, the plaintiffs brought claims under all three subsections of Rule 10b-5.  That is to say, the plaintiffs alleged the defendants (a) made material misstatements under Rule 10b-5(b), and (b) disseminated and approved material misstatements and engaged in a course of conduct to conceal the truth from investors under under Rule 10b-5(a) and Rule 10b-5(c) (often referred to as “scheme liability”).  On appeal, the plaintiffs argued that the district court failed to address their scheme liability claims and therefore erred in dismissing them.  Alphabet countered that the plaintiffs had waived those claims by not raising them in their opposition to Alphabet’s motion to dismiss and, in any event, the scheme liability claims were duplicative of the material misstatement claims.

The panel disagreed.  It noted that Alphabet’s motion to dismiss had not specifically targeted the scheme liability claims, so the plaintiffs could not have waived those claims in its opposition.  Moreover, the scheme liability claims were not merely duplicative.  Under Lorenzoa 2019 decision by the U.S. Supreme Court – it was possible for the plaintiffs to bring separate “scheme liability” claims even if the underlying conduct involved material misstatements.  Accordingly, the panel reversed the dismissal of all of the plaintiffs’ claims brought under Rule 10b-5(a) and (c).

Holding: Reversed in part, affirmed in part, judgment vacated, remanding for further proceedings.

Notes:  (1) Companies headquartered in the Ninth Circuit will need to think carefully about the scope of their disclosures.  Merely by disclosing the risk of data security issues, Alphabet apparently also was required to disclose any material data security issues that had arisen in the past and were already resolved.  The panel’s view of a company’s duty of disclosure arguably goes well beyond what other courts have found Section 10(b) and Rule 10b-5 to require.

(2) Securities defense counsel are now on notice that they must separately and specifically address scheme liability claims in the motion to dismiss or risk the court finding that they were unopposed.

(3) The defendants moved for rehearing or rehearing en banc, which was denied on July 23, 2021.  Then, last week, the defendants filed a motion to stay mandate pending the filing of a petition for writ of certiorari to the U.S. Supreme Court.  Stay tuned.

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Goldman Decided

The U.S. Supreme Court has issued a decision in the Goldman Sachs v. Arkansas case.  As predicted, it is a narrow opinion (a) clarifying that courts can and should take the generic nature of the alleged misstatements into account when assessing price impact for purposes of class certification, and (b) holding that defendants have the burden of persuasion in rebutting the Basic presumption of reliance.  The majority opinion was authored by Justice Barrett.  It is a 8-1 decision on the issue of taking the generic nature of the alleged misstatements into account (with Justice Sotomayor dissenting only as to whether a remand of the case was necessary) and a 6-3 decision on the issue of the burden of persuasion (with Justices Gorsuch, Thomas, and Alito concluding in dissent that defendants should have only a burden of production).

As way of background, to certify a class on behalf of all investors who purchased shares during a class period, plaintiffs usually invoke a presumption of reliance created by the Court in the Basic case.  Under the Basic presumption, plaintiffs can establish class-wide reliance by showing (1) that the alleged misrepresentations were publicly known, (2) that they were material, (3) that the stock traded in an efficient market, and (4) that the plaintiff traded the stock between the time that the misrepresentations were made and when the truth was revealed.  These requirements are based on the efficient market hypothesis, which, as relevant here, posits that in an efficient market any material statements will impact a stock’s price.  If all four elements are met, any investor trading in such a market can be presumed to have relied upon the stock’s price and all material statements (or misstatements) about the stock.  Accordingly, the Court has held that the Basic requirements are merely an “indirect proxy for price impact,” which is the true underpinning of the presumption of reliance. 

Without the Basic presumption, individualized issues of reliance would normally prevent any attempt to certify a class in a securities fraud class action.  Defendants have the ability to rebut the Basic presumption, and defeat class certification, by demonstrating that the alleged misrepresentations did not have a price impact. 

In Goldman, the Court considered whether defendants can, at least in part, demonstrate a lack of price impact by pointing to the generic nature of the alleged misrepresentations.  The Court held that “a court cannot conclude that Rule 23’s requirements are satisfied without considering all evidence relevant to price impact.”  That is the true even if the evidence – like the generic nature of the alleged misrepresentations – “is also relevant to a merits question like materiality.”  The inquiry into the nature of the alleged misrepresentations is especially relevant in cases like Goldman where the plaintiffs, invoking the “inflation maintenance theory,” argued that the misrepresentations did not increase Goldman’s stock price, but instead merely prevented it from falling.  The Court found that it had some “doubt” as to whether the Second Circuit had “properly considered the generic nature of Goldman’s alleged misrepresentations” and remanded with instructions for the lower court to “take into account all record evidence relevant to price impact.”

While Goldman won a clear victory on that issue, it was not as fortunate on the question of the burden of persuasion.  The Court noted that under applicable law, it has “the authority to assign defendants the burden of persuasion to prove a lack of price impact.”  Accordingly, the only question was whether the Court had already done so in its previous decisions addressing the Basic presumption.  The Court found that the “best reading” of its precedents is “that the defendant bears the burden of persuasion to prove a lack of price impact.”  In any event, the Court noted, “the allocation of the burden is unlikely to make much difference on the ground” because the district court’s task is “to determine whether it is more likely than not that the alleged misrepresentations had a price impact.”  Unless the district court finds that the evidence is in “equipoise,” a situation the Court stated “should rarely arise,” there is no negative impact on defendants from having this burden.

Holding: Judgment vacated and case remanded for further proceedings consistent with the opinion.

Additional notes on the decision:

(1) There arguably is a circuit split on the issue of whether the inflation maintenance theory is legally cognizable under the federal securities laws and the Court’s prior decisions.  In Goldman, the Court stated that it was not expressing any “view on [the theory’s] validity or its contours.”  As a result, that issue remains one for a future case.

(2) Justice Gorsuch, in a vigorous dissent (joined by Justices Thomas and Alito) on the issue of the burden of persuasion, stated that the “hard truth is that in the 30-plus years since Basic this Court has never (before) suggested that plaintiffs are relieved from carrying the burden of persuasion on any aspect of their own causes of action.”  Addressing the majority’s insistence that shifting the burden of persuasion would have little practical effect, Justice Gorsuch noted that the “whole reason we allocate the burden of persuasion is to resolve close cases by providing a tie breaker where the burden does make a difference.”  The fact that close cases may be uncommon “is no justification for indifference about how the law resolves them.”

Disclaimer: The author of The 10b-5 Daily assisted with the submission of an amicus brief by the Washington Legal Foundation in support of the petitioner.

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The No Good, Very Bad Insider Trading Prohibition Act

The author of The 10b-5 Daily (Lyle Roberts) wrote an op-ed last year arguing that the Insider Trading Prohibition Act passed by the House of Representatives was severely flawed. The bill went to the Senate, but died from deserved inaction. Last month the bill was passed again and its sponsors hope it will receive a more favorable reception now. Unfortunately, the legislation has not gotten any better in the interim.

Lyle Roberts and Professor M. Todd Henderson (U. of Chicago Law School) have published a new op-ed in The Hill discussing how the Senate could fix what the House has wrought. Stay tuned.

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Please Take This Case!

It has been over fifteen years since the U.S. Supreme Court’s decision in Dura Pharmaceuticals v. Broudo, where the Court held that plaintiffs in securities fraud cases must plead and prove loss causation. In the interim, the lower courts have gone in a number of different directions on crucial loss causation questions

The author of The 10b-5 Daily (Lyle Roberts) has written an article for Law360 urging the Court to grant cert in the In re BofI Securities Litigation case. In that case, the U.S. Court of Appeals for the Ninth Circuit created a clear circuit split on the issue of whether a third-party judicial complaint, standing alone, can be a “corrective disclosure” for purposes of loss causation. Here is a link to the article (may require subscription).

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