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Last month, the U.S. Court of Appeals for the Ninth Circuit held, in a securities class action brought against BofI (In re BofI Securities Lit.), that the filing of a judicial complaint can form the basis for loss causation if the market reasonably perceived the allegations in the complaint as true and acted upon them accordingly.

It turns out, however, that there are two different securities class actions pending against BofI. And this month, the Ninth Circuit is back with a new decision (by a different panel of judges) on loss causation in the second case.

In Grigsby v. BofI Holding, Inc., 2020 WL 6438912 (9th Cir. Nov. 3, 2020), the plaintiffs alleged that BofI engaged in securities fraud by falsely denying that the company was the subject of a DOJ/SEC money laundering investigation. According to the plaintiffs, this denial was revealed to be false when information received from the SEC pursuant to a Freedom of Information Act (FOIA) request uncovered the existence of an ongoing SEC investigation into BofI.

The district court held that information obtained through a FOIA request could not act as a corrective disclosure for purposes of establishing loss causation because the information was “publicly available to an information-hungry market.” While the plaintiffs alleged that the SEC had granted (in full or in part) only five other BofI-related FOIA requests during the relevant time period, and there was no reason to believe that any of these requests had revealed the existence of the investigation, the district court concluded that this did not plausibly establish that market participants had not already learned about the investigation

On appeal, the Ninth Circuit disagreed. First, the panel held “there must be some indication that the relevant information was requested and produced before the information contained in a FOIA response can be considered publicly available for purposes of loss causation.” Second, the panel held that plaintiffs were not required to disprove that this had taken place. To the extent that it was not clear from the earlier FOIA requests whether the public had learned of the existence of the investigation, the “record does not allow the conclusion that any of the other BofI-related FOIA requests resulted in the disclosure of information about an SEC investigation of BofI.”

The panel also found that (a) BofI’s denial of the existence of a DOJ/SEC money laundering investigation was sufficiently revealed to have been false by the disclosure of a SEC investigation into related topics, and (b) the district court correctly held that a Seeking Alpha article about BofI did not act as a separate corrective disclosure because the article stated that it was based on public information and the “article’s analysis did not require any expertise or specialized skills beyond what a typical market participant would possess.”

Holding: Reversing dismissal in part and remanding for further proceedings.

Additional note: The two BofI decisions from the Ninth Circuit arguably conflict on the issue of the plaintiffs’ pleading burden as to whether the information in the alleged corrective disclosure was already known to the market. In In re BofI Securities Lit., the panel held that “[t]o rely on a corrective disclosure that is based on publicly available information, a plaintiff must plead with particularity facts plausibly explaining why the information was not yet reflected in the company’s stock price.” In Grigsby, however, the panel suggested (without citation to the earlier decision) that this is an inappropriately “elevated” pleading standard and it is enough for a plaintiff to plausibly allege that the corrective disclosure revealed the fraud. Stay tuned.

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The Other Shoe Hasn’t Dropped

Can the filing of a judicial complaint against a company constitute a revelation of the alleged fraud sufficient to establish loss causation? Courts have found that it can, but usually where there is some later, independent confirmation of the allegations in the complaint.

In Norfolk County Retirement Systems v. Community Health Systems (6th Cir. 2017), for example, the Sixth Circuit considered a case where the plaintiffs alleged that a healthcare company’s overcharging of Medicare was revealed by a rival company’s lawsuit. The court found that the stock price drop that occurred after the filing of the lawsuit could form the basis for loss causation, but specifically noted that the CEO of Community Health Systems had “promptly admitted the truth of one of the complaint’s core allegations.”

But what if no such admission ever occurs? In In re BofI Securities Lit., 2020 WL 5951150 (9th Cir. Oct. 8, 2020), the plaintiffs alleged that the defendant bank had made false or misleading statements about its loan underwriting standards, internal controls, and compliance infrastructure. The fraud supposedly was revealed by “a whistleblower lawsuit filed by a former company insider and a series of blog posts offering negative reports about the company’s operations.” The district court found that neither of these items were “corrective disclosures” because (a) the complaint contained only unsubstantiated allegations that had not been subsequently confirmed, and (b) the blog posts were based entirely on existing public information.

On appeal, the Ninth Circuit disagreed with the district court’s imposition of “bright line rules” in its decision.

(1) Whistleblower Complaint – The Ninth Circuit held (citing Norfolk County) that the relevant question for loss causation purposes is “whether the market reasonably perceived [the whistleblower’s] allegations as true and acted upon them accordingly.” It was not necessary for there to be any subsequent confirmation of the allegations so long as “the market treats allegations in a lawsuit as sufficiently credible to be acted upon as truth, and the inflation in the stock price attributable to the defendant’s misstatements is dissipated as a result.” Given that the whistleblower complaint was brought by an insider and the company’s stock price dropped significantly after it was filed, the court concluded that this standard was met.

(2) Blog Posts – The Ninth Circuit agreed with the district court that a corrective disclosure “must by definition reveal new information to the market that has not yet been incorporated into the price.” However, the court found that this new information could include an analysis of the company’s operations, based on existing public information, that the market had not yet seen. The court found that the blog posts “required extensive and tedious research involving the analysis of far-flung bits and pieces of data” and, as result, provided new information to the market. Because they were written by short sellers and expressly disclaimed their own accuracy, however, the court concluded that “it is not plausible that the market reasonably perceived these posts as revealing the falsity of BofI’s prior misstatements, thereby causing the drops in BofI’s stock price on the days the posts appeared.”

(3) Dissent – In a strongly-worded dissent, Judge Lee disagreed with the panel’s reasoning. Judge Lee noted that there have been multiple government investigations of BofI, but “so far, we have not seen any external evidence corroborating [the whistleblower’s] allegations.” The majority’s decision, in Judge Lee’s view, would have “the unintended effect of giving the greenlight for securities fraud lawsuits based on unsubstantiated assertions that may turn out to be nothing more than wisps of innuendo and speculation.” Nor does it help to say that the allegations in the judicial complaint must be plausible, because “the plausibility standard will likely stave off only lawsuits based on insider accounts that even Mulder and Scully would find unbelievable.” As to the blog posts, Judge Lee concluded that he would base the decision “on the grounds that the [blog posts] contain public information only, and that we should not credit anonymous posts on a website notorious for self-interested short-sellers trafficking in rumors for their own pecuniary gain.”

Holding: Reversing dismissal and remanding for further proceedings.

Quote of note (majority decision): “[The whistleblower] is a former insider of the company who had personal knowledge of the facts he alleged. Those facts revealed that a number of BofI’s alleged misstatements were false. If the market regarded his factual allegations as credible and acted upon them on the assumption that they were true, as the shareholders have plausibly alleged here, [the whistleblower’s] allegations established fire and not just smoke.”

Quote of note (dissent): “[The whistleblower’s] allegations are certainly ominous, and may in fact be true. But at this time, the drop in BofI’s share price can only be attributed to market speculation about whether fraud has occurred. And this type of speculation cannot form the basis of a viable loss causation theory. Before plaintiffs can establish loss causation based on an unsubstantiated whistleblower complaint, another shoe has to drop. It has not yet.”

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Check Your Disbelief At the Door

Securities class actions brought against drug development and medical device companies often are based on alleged misrepresentations related to the regulatory approval process.  Plaintiffs assert that the company’s officers must have known that the drug or device would not be approved, because the product was key to the company’s success.  But is that a plausible way of looking at how companies interact with their investors and regulators?

In Ngyuen v. Endologix, Inc., 962 F.3d 405 (9th Cir. 2020), the plaintiff alleged that Endologix misled its investors about whether the Food and Drug Administration (FDA) would approve Nellix, the company’s aneurysm sealing product.   In particular, Endologix supposedly knew the device had encountered development problems in Europe that would manifest again in U.S. clinical trials, which would in turn lead the FDA to deny pre-market approval.  The district court dismissed the complaint, finding that the plaintiff had failed to adequately plead a strong inference of scienter (i.e., fraudulent intent).

On appeal, the Ninth Circuit questioned whether the plaintiff’s version of events was the most likely.  As the court explained, the “plaintiff’s core theory—that the company invested in a U.S. clinical trial and made promising statements about FDA approval, yet knew from its experience in Europe that the FDA would eventually reject the product—has no basis in logic or common experience.”  The court found that was especially true given that the complaint did not allege the existence of suspicious insider stock sales.  Moreover, the complaint’s reliance on statements from a former Endologix officer could not fill this gap because the information attributable to the officer “lack[ed] any detail about the supposed device migration problems that Nellix encountered in the European channel.”  Without those details, the plaintiff could not establish “a strong inference that defendants’ later statements about FDA approval were intentionally false or made with deliberate recklessness.”

Holding: Dismissal affirmed.

Quote of note: “[W]e are asked to accept the theory that defendants were promising FDA approval for a medical device application they knew was ‘unapprovable,’ misleading the market all the way up to the point that defendants were ‘unable to avoid the inevitable.’  The allegation does not resonate in common experience.  And the PSLRA neither allows nor requires us to check our disbelief at the door.”

Additional note: Interestingly, the confidential witness relied upon by the plaintiff apparently “submitted a declaration in the district court disavowing the plaintiff’s allegations, denying having ‘ma[de] many of the statements attributed to me,’ and stating that ‘most of the factual assertions attributed to me … are contrary to my understandings of fact and my opinions.'”  Neither the district court nor the appellate court, however, considered this declaration in rendering their decisions.

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What Lower-Level Employees Know

A corporation’s scienter (i.e., fraudulent intent) may be imputed in a securities fraud case, under Second Circuit precedent, from (a) the scienter of an individual defendant who made the alleged misstatement, (b) the scienter of officers or directors who were involved in the dissemination of the fraud, or (c) in rare circumstances, from a statement that is so obviously incorrect that it can be inferred that the makers must have known that it was false.

In Jackson v. Abernathy, 960 F.3d 94 (2d Cir. May 27, 2020) (per curiam), the plaintiffs alleged that the company told investors that its surgical gowns were highly-rated for their protectiveness, but in fact the gowns had failed numerous quality control tests. The plaintiffs argued that the company’s scienter could be imputed based on (a) the knowledge of three lower-level employees, who testified in a different litigation that they were aware that the surgical gowns had failed quality control tests, and/or (b) the surgical gowns were a key company product, so senior management must have known about the test failures. The Second Circuit found that these allegations were insufficient to adequately plead the company’s scienter.

First, as to the lower-level employees, the Second Circuit concluded that the employees did not act with scienter because they took steps to raise warnings about problems with the gowns. Moreover, the complaint failed to plead any facts establishing that these employees were involved with the misstatements or had adequately conveyed their warnings to senior management. The court therefore was left to “only guess what role those employees played in crafting or reviewing the challenged statements and whether it would otherwise be fair to charge the [company] with their knowledge.”

Second, as to the allegation that the gowns were a key product, the Second Circuit found that this “naked assertion, without more, is plainly insufficient to raise a strong inference of collective corporate scienter.”

Holding: Affirming lower court decision that amended complaint would be futile.

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The Need for New News

To adequately plead loss causation, a plaintiff must establish the existence of a corrective disclosure that reveals to the market the pertinent truth that was previously concealed or obscured by the company’s fraud.  Determining whether an alleged corrective disclosure actually provides “new news” or is merely a restatement of previously-disclosed information, however, has proven difficult for courts.

In Luczak v. National Beverage Corp., 2020 WL 2111947 (11th Cir. May 4, 2020) (per curiam), the plaintiffs alleged that the company (a) made misleading statements regarding two sales metrics the Company purportedly touted as an important measure of growth and sales, and (b) failed to disclose that its CEO had engaged in a pattern of sexual misconduct.

As to the sales metrics statements, the plaintiffs alleged that the truth was revealed to the market by a March 2018 SEC letter questioning the company’s use of the metrics and a subsequent June 2018 media report discussing the issue.  The lower court, however, found that neither of these items were “corrective disclosures” because the SEC letter “merely confirm[ed] the SEC’s already established doubt of the veracity” of the sales metrics and the media report was just a summary of the SEC correspondence.  As to the sexual misconduct claims, the plaintiffs argued that a July 2018 Wall Street Journal article had revealed the misconduct, but the lower court found that the article only repeated allegations that had been made in publicly-filed lawsuits.

On appeal, the Eleventh Circuit rendered a split decision.  The panel found that the lower court had read the March 2018 SEC letter and the June 2018 media report too narrowly.  Although the SEC’s interest in the sales metrics was publicly known, the SEC letter and media report arguably provided “new news” that the company was failing to cooperate with the SEC in its inquiry by not providing additional information about the metrics.  Moreover, the media report could be read to suggest that this conclusion came from sources beyond the SEC correspondence.  As to the sexual misconduct claims, however, the panel agreed that the 2018 Wall Street Journal article did not provide any additional information that could not be found in the lawsuits.

Holding: Affirmed in part, reversed in part, and vacated in part.

Additional note:  The decision points out that the Eleventh Circuit has never decided whether the heightened pleading standards of the PSLRA or FRCP 9(b) apply to the pleading of loss causation.  The panel declined to address the issue, however, holding that its decision would not be affected by which pleading standard was used.

 

 

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Playing Chicken

If a securities fraud claim is based on the nondisclosure of an illegal act, what is the plaintiff required to plead about the existence of that act?  In Gamm v. Sanderson Farms, Inc., 2019 WL 6704666 (2d Cir. Dec. 10, 2019), the plaintiffs alleged that Sanderson Farms, a poultry processing company, had failed to disclose an anti-competitive conspiracy to inflate the price of chicken by coordinating supply reductions and manipulating a chicken price index.  After a series of antitrust complaints were filed against Sanderson Farms and other chicken producers, the company’s stock price fell.

The district court dismissed the complaint based on the plaintiffs’ failure to adequately plead the existence of “a chicken supply reduction conspiracy with particularized facts.”  On appeal, the Second Circuit agreed.  To support their contention that Sanderson Farms’ financial disclosures were rendered misleading by the failure to disclose the anti-competitive conduct, the plaintiffs were required “to have alleged the basic elements of an underlying antitrust conspiracy” with particularity.   Those elements included “collusive conduct,” but the securities complaint provided “no facts alleging that Sanderson or its peers actually reduced supply, and that those reductions were the result of an agreement, or were even interrelated.”  Accordingly, the complaint was deficient.

Holding: Dismissal affirmed.

Quote of note: “A stock-issuing company like Sanderson cannot be required, whenever accused of illegal activity, to simultaneously defend itself in an accompanying securities fraud suit based on facts not alleged with the level of particularity required by the statute [PSLRA].  Such a reality would harm the company’s stock and contravene the purpose of the securities laws – to protect shareholders’ interests.”

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Compare and Contrast

NERA Economic Consulting and Cornerstone Research have released their respective 2019 annual reports on federal 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 2019 include:

(1) The reports agree that there continue to be a record or near-record number of filings, with an increase in “standard” filings alleging violations of Rule 10b-5, Section 11, and/or Section 12 offsetting a decline in M&A-related cases.  NERA finds that there were 433 filings (the same as the 433 filings in 2018), while Cornerstone finds that there were 428 filings (compared with 420 filings in 2018).

(2) Over the last few years, the Second Circuit and Ninth Circuit have had a similar number of standard filings.  In 2019, however, both NERA and Cornerstone report that the number of Second Circuit standard filings was nearly double the number of Ninth Circuit standard filings (NERA – 103 (2d) v. 52 (9th); Cornerstone 108 (2d) v. 56 (9th)).  The Third Circuit had the next highest number of filings (NERA – 28; Cornerstone – 32).

(3) Filings against foreign issuers had steadily increased from 2013-2017, with these companies facing a disproportionate (as compared to their percentage of listings) risk of securities class action litigation.  In 2018, the numbers took a dip, but they have rebounded to a record high.  Cornerstone finds that there were 57 standard filings against foreign issuers in 2019, representing 24.3% of all standard filings.

(4) NERA reports a sharp increase in standard filings based on missed earnings guidance (from an average of 20% of filings over the past four years to 32% of filings in 2019).

(5) NERA finds that the average settlement value ($30 million) held steady and the median ($12.8 million) settlement value increased slightly.  However, the median settlement values in 2018 and 2019 were more than 25% higher than the median settlement values in the previous three years, reflecting a downward trend in the proportion of cases settled for less than $10 million.

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

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Congress At Work

The author of The 10b-5 Daily (Lyle Roberts) had an op-ed in the Wall Street Journal last month on the Insider Trading Prohibition Act.  A link to the op-ed can be found here (no paywall).

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Southern District for the Inquisition

Investors frequently bring securities class actions against drug development companies, typically asserting that the company failed to adequately disclose information about its clinical trials.  In Lehmann v OHR Pharmaceutical, Inc.,  2019 WL 452765 (S.D.N.Y. Sept. 20, 2019), the company was developing a drug for the treatment of a degenerative eye disease called Wet Age-Related Macular Degeneration (“Wet AMD”).  The plaintiffs claimed that OHR, in disclosing the results of its Phase II clinical trial, failed to disclose that its control arm results were inconsistent with previous trials (which allegedly made the Phase II trial appear more successful than it really was).  Ultimately, the company announced disappointing results for its subsequent Phase III clinical trial and the stock price declined 81%.

The court found that OHR’s disclosures were accurate and the company was not required to provide more context around its Phase II trial results.  Indeed, the court questioned the entire premise of the case, noting that “[o]n Plaintiffs’ account, it is unclear whether the Company should have embarked on the phase III study after the success of the phase II study – should the Company have ignored what Plaintiffs say were aberrant results, or should it have investigated further?”  The court came down firmly on the side of further investigation, noting “that the law does not abide attempts at using the judiciary to stifle the risk-taking that undergirds scientific achievement and human progress.”

Holding: Motion to dismiss granted (also based on the plaintiffs’ failure to adequately plead scienter).

Quote of note:  “This Court will not adopt a rule that discourages free scientific inquiry in the name of shielding investors from the risks of failure.  Science is risky.  Science advances through those willing to take those risks and break with consensus.  With science suffering from a replication crisis, this Court is happy to report that the law does not abide attempts to use the judiciary to stifle the risk-taking that undergirds scientific advancement and human progress.  The answer to bad science is more science, not this Court’s acting as the Southern District for the Inquisition.”

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Expert Opinion

To what extent can plaintiffs use allegations from a retained expert in a securities fraud complaint?  In Sgarlata v. Paypal Holdings, Inc., 2019 WL 4479562 (N.D. Cal. Sept. 18, 2019), the plaintiffs claimed that PayPal had failed to adequately disclose a cybersecurity breach.  To bolster their scienter (i.e., fraudulent intent) allegations, the plaintiffs engaged a cybersecurity expert to determine what information about the breach likely was available to the company at the time the breach was discovered and provided the expert’s opinions in the complaint.

In its motion to dismiss decision, the court found that it could consider the expert’s statements, but only if they satisfied the same standard applied to confidential witnesses, i.e., (1) the statements must be described with sufficient particularity to establish the expert’s reliability and personal knowledge; and (2) the statements must themselves be indicative of scienter.  The cybersecurity expert had extensive experience in the field and opined that the company must have known more about the breach than it disclosed.

The court noted, however, that there was no allegation in the complaint that the expert “was familiar with, much less had knowledge of, the specific security architecture of Defendants’ privacy network.”  Moreover, the expert “did not actually talk to employees . . . nor did he review documents that – in and of themselves – demonstrate inconsistencies that were available” to the company at the time of its disclosure.  Even considered holistically with the entire complaint, the court found that the expert’s opinions did not support a finding of scienter.

Holding: Motion to dismiss granted.

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