Category Archives: Appellate Monitor

As predicted, the U.S. Supreme Court has issued a narrow decision in the Halliburton case rejecting the Fifth Circuit’s requirement that securities fraud plaintiffs must prove loss causation to obtain class certification. The unanimous (and short) opinion authored by Chief Justice Roberts holds that loss causation is not a precondition for invoking the fraud-on-the-market presumption of reliance and, therefore, is not necessary to establish that reliance is capable of resolution on a common, classwide basis.

While the Court endorsed the majority position adopted by the Second Circuit, Third Circuit, and Seventh Circuit, it focused entirely on the nature of the fraud-on-the-market presumption and did not address the scope of Federal Rule of Civil Procedure 23 (governing class certification). Moreover, the Court gave short shrift to the defendants’ argument that although the Fifth Circuit specifically said “loss causation,” it really was imposing a “price impact” test designed to determine whether the alleged misrepresentation had affected the company’s stock price in the first place. The Court noted that “loss causation is a familiar and distinct concept in securities law; it is not price impact” and declined to do anything other than take the Fifth Circuit “at its word.”

Holding: Judgment vacated and remanded to district court for further proceedings consistent with opinion.

Quote of note: “According to the Court of Appeals, however, an inability to prove loss causation would prevent a plaintiff from invoking the rebuttable presumption of reliance. Such a rule contravenes Basic’s fundamental premise—that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction. The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively through the fraud-on-the-market theory. Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.”

In its Tellabs and Matrixx decisions, the Supreme Court emphasized that whether a plaintiff has adequately plead a strong inference of scienter is subject to a holistic review (i.e., the allegations in the complaint must be considered in their entirety). This approach conflicts with the more traditional judicial approach of reviewing each scienter allegation separately and then coming to an overall conclusion as to whether the plaintiff has met its pleading burden.

In Frank v. Dana Corp., 2011 WL 2020717 (6th Cir. May 25, 2011), the court addressed this issue and held that in light of the Supreme Court’s decisions it must adopt a new, more efficient approach to evaluating scienter allegations. Exactly how efficient, however, may have come as a surprise to the parties. In just one page of analysis, the court concluded that in light of such factors as overall industry problems, rising prices for a key commodity, and the quick collapse of the company, it was “difficult to grasp the thought that [the defendants] really had no idea that Dana was on the road to bankruptcy.” Accordingly, the court found that the plaintiffs had adequately plead a strong inference of scienter because “the inference that [the defendants] recklessly disregarded the falsity of their extremely optimistic statements is at least as compelling to us as their excuse of failed accounting systems.”

Holding: Dismissal reversed. (The 10b-5 Daily has previously posted about an earlier, related appellate decision in the case.)

Quote of note: “[In Matrixx] the Court provided for us a post-Tellabs example of how to consider scienter pleadings ‘holistically’ in section 10(b) cases. Writing for the Court, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis. This is the only appropriate approach following Tellabs’s mandate to review scienter pleadings based on the collective view of the facts, not the facts individually. Our former method of reviewing each allegation individually before reviewing them holistically risks losing the forest for the trees. Furthermore, after Tellabs, conducting an individual review of myriad allegations is an unnecessary inefficiency.”

Mortgage pass-through certificates entitle the investor to distributions from underlying pools of mortgages. A key aspect of these securities are the credit ratings given to them by the ratings agencies. In In re Lehman Brothers Mortgage-Backed Securities Litigation, 2011 WL 1778726 (2d Cir. May 11, 2010), the court considered whether these ratings agencies, by allegedly helping to “determine the composition of loan pools, the certificates’ structures, and the amount and kinds of credit enhancement of particular tranches” could be liable under Section 11 of the ’33 Act for misstatements in the certificates’ offering documents.

The plaintiffs’ argued that the ratings agencies activities made them “underwriters” of the securities and therefore subject to Section 11 liability. The court disagreed, finding that “to qualify as an underwriter under the participation prongs of the statutory definition, a person must participate, directly or indirectly, in purchasing securities from an issuer with a view to distribution, in offering or selling securities for an issuer in connection with a distribution, or in the underwriting of such an offering.” The fact that the ratings agencies played a role in “structuring or creating” the securities was insufficient to find that they acted as underwriters. Nor had the plaintiffs adequately alleged that the ratings agencies controlled the primary violators. The court found that “allegations of advice, feedback, and guidance fail to raise a reasonable inference that the Ratings Agencies had the power to direct, rather than merely inform, the banks’ ultimate structuring decisions.”

Holding: Dismissal of claims against ratings agencies affirmed.

Can a corporate 401(k) profit-sharing plan claim a share of the settlement proceeds from a securities class action brought against the company? In In re Motorola Securities Litigation, 2011 WL 1662838 (7th Cir. May 4, 2011) the court held that Motorola’s plan, despite being a purchaser of Motorola common shares during the relevant period, could not participate in the settlement because it was an “affiliate” of the issuer.

The Motorola 401(k) Profit-Sharing Plan (the “Plan”) is “a participant-directed, defined-contribution retirement plan established for the benefit of current and former Motorola employees.” The Plan was controlled by a committee appointed by Motorola’s board. One of the plan’s investment options was a fund that allowed participants to acquire beneficial ownership of Motorola common stock.

In 2007, a securities class action brought against Motorola was settled for $190 million. (The 10b-5 Daily also has posted about the lead plaintiff and motion to dismiss decisions in the case.) The settlement specifically excluded any “affiliate” of Motorola from making a claim. The Plan filed a claim with the claims administrator for the benefit of its participants, which the district court eventually rejected.

On appeal, the Seventh Circuit found that the district court’s rejection of the Plan’s claim was correct. The key issue was whether, pursuant to the securities-law meaning of “affiliate,” the Plan was controlled by or under common control with Motorola. Motorola’s board appointed the Plan committee, which in turn had managerial control over the Plan’s policies and operations. The court held that “[t]his degree of control is sufficient to make the Plan an affiliate of Motorola, and as an affiliate of Motorola, the Plan is specifically excluded from the class.”

Holding: Order disallowing the Plan’s claim to a share of the Motorola settlement proceeds affirmed.

Oral argument took place in the Halliburton case earlier this week. The case addresses whether the Fifth Circuit’s requirement that plaintiffs establish loss causation at the class certification stage of a case exceeds what is required by Federal Rule of Civil Procedure 23. The transcript of the argument can be found here.

The defendants faced an uphill battle: other circuit courts have rejected the Fifth Circuit’s approach and the government also weighed in against the decision. As a result, the defendants argued that the real import of the Fifth Circuit’s decision was not that the plaintiffs must establish loss causation (as that term is generally understood in securities fraud cases), but rather that the plaintiffs must establish that the alleged misstatements resulted in a “price impact” so as to allow for a presumption of reliance based on the existence of an efficient market. To the extent that the defendants can successfully rebut the presumption and demonstrate that common issues will not predominate, they should be able to do so at the class certification stage. As the the transcript strongly suggests, the key question for the Court will be whether the predominance analysis under Federal Rule of Civil Procedure 23 allows for this extensive an inquiry (as opposed, for example, to just requiring plaintiffs to generally show that the market for the company’s securities was efficient).

For a summary of the oral argument, the D&O Diary has a comprehensive guest post. In addition, The Conglomerate Blog has an academic roundtable that does an admirable job of analyzing the various considerations before the Court and offers some predictions about the Court’s eventual decision (hint: it will be narrow).

It can be difficult for plaintiffs to adequately allege that an outside auditor acted with scienter when issuing its audit opinion. Accordingly, the Ninth Circuit’s decision last week to reverse the dismissal of the securities fraud claims against an outside auditor is worth examining.

In New Mexico State Investment Council v. Ernst & Young LLP, 2011 WL 1419642 (9th Cir. April 14, 2011), the court addressed E&Y’s alleged role in Broadcom’s options backdating scheme. At issue was a 2005 unqualified audit opinion that covered three years of Broadcom’s financial statements (2003–05). The court found that each of the following three allegations, whether taken individually or viewed collectively, were sufficient to find a strong inference that E&Y had acted with scienter:

(1) E&Y knew the material consequences of a May 2000 backdated option grant that would have resulted in a $700 million charge to Broadcom’s financial results but, despite violations of GAAS, signed off on the grant without obtaining documentation;

(2) E&Y knew that several significant option grants in 2001 were approved on dates when Broadcom’s compensation committee was not legally constituted due to the death of one of the two committee members; and

(3) E&Y presided over corrective reforms in 2003 to prevent and detect any future instances of improper stock option awards without questioning the integrity of Broadcom’s accounting for options granted prior to the corrective reforms.
The court also examined several other factual allegations related to scienter, including allegations of insufficient documentation, weak internal controls, and red flags related to Broadcom’s stock option grants.

Of particular concern to auditor defendants, however, may be the court’s rejection of E&Y’s argument that the plaintiffs had failed to show that any of the E&Y personnel who participated in the 2005 audit were aware of the earlier alleged backdating that impacted Broadcom’s 2005 consolidated financial statements. E&Y described this as an attempt to apply “roving scienter” over a long time period. The court disagreed, concluding that “EY, despite serving continuously as Broadcom’s auditor from 1998 until 2008, during which it attested to the accuracy of Broadcom’s financial statements for the multiple years noted in the 2005 Opinion, cannot now disclaim those prior opinions simply because the same individuals were not involved.”

Holding: Dismissal of claims against outside auditor reversed.

The U.S. Court of Appeals for the Third Circuit has weighed in on two controversial issues concerning loss causation and scheme liability. In In re DVI, Inc. Sec. Litig., 2011 WL 1125926 (3rd Cir. March 29, 2011), the court examined the lower court’s decision to grant class certification, except as to the claims against the company’s outside law firm. The key holdings are:

(1) Loss causation – The court addressed the issue currently before the U.S. Supreme Court in the Halliburton case, i.e., does a plaintiff have to establish loss causation to obtain class certification. In agreement with the Second Circuit and Seventh Circuit (but contrary to the Fifth Circuit), the court held that “a plaintiff need not demonstrate loss causation as a prerequisite to invoking the fraud-on-the-market presumption of reliance.” Instead, the burden is on the defendant to introduce evidence “demonstrating an allegedly corrective disclosure did not move the market – that there was no market impact and therefore no loss causation” which “may in some circumstances rebut the presumption of reliance.”

(2) Scheme liability – The plaintiffs argued that the Stoneridge decision created a “remoteness test” for assessing whether investors had relied on the fraudulent conduct of secondary actors. The remoteness test allegedly requires courts to assess: (a) the defendant’s level of involvement in the fraudulent scheme, (b) whether the misrepresentation was the “necessary or inevitable” result of the defendant’s conduct, and (c) whether the defendant’s conduct took place in the “investment sphere.” Like the Second Circuit, the court rejected this argument, finding that the only issue was whether the deceptive conduct “has been publicly disclosed and attributed to the actor.” In the instant case, because the plaintiffs did “not contend that the outside law firm’s role in masterminding the fraudulent 10-Q was disclosed to the public, they cannot invoke the [fraud-on-the-market presumption of reliance].”

Holding: Judgment affirmed.

In the Matrixx Initiatives v. Siracusano case, the U.S. Supreme Court has held that the plaintiffs were not required, in a case alleging that Matrixx failed to disclose reports of a possible link between its leading drug product and the loss of smell, to plead that these reports were statistically significant. The unanimous decision authored by Justice Sotomayor rejects the use of statistical significance as a “bright-line rule” for the assessment of materiality in this type of case.

The core of the defendants’ argument was that in the absence of statistical significance, adverse event reports suggesting that a drug has caused a loss of smell do not “reflect a scientifically reliable basis for inferring a potential causal link” that would be material to a reasonable investor. The Court declined to hold, however, that “statistical significance is the only reliable indication of causation.” For example, the FDA relies on a wide range of evidence of causation and “sometimes acts on the basis of evidence that suggests, but does not prove, causation.” If “medical professionals and regulators act on the basis of evidence that is not statistically significant, it stands to reason that in certain cases reasonable investors would as well.”

Having rejected the proposed bright line rule, the Court found that the complaint adequately alleged “Matrixx received information that plausibly indicated a reliable causal link” between the drug and the loss of smell. The information included the adverse event reports and studies suggesting a causal link. In turn, investors would have viewed this information as material because it suggested there was “a significant risk to the commercial viability of Matrixx’s leading product,” especially because the risk associated with the drug (possible loss of smell) substantially outweighed the benefit of using the drug (alleviate cold symptoms). The omitted material information rendered Matrixx’s statement that its “revenues were going to rise 50 and then 80 percent” misleading.

Holding: Reversal of dismissal affirmed (the court also found that the plaintiffs had adequately plead scienter).

Notes on the Decision:

(1) The decision is quite narrow. Perhaps most importantly, the Court did not offer any redefinition of the Basic materiality standard (so the forests are safe). Nor did the Court make any broad pronouncements on the appropriateness of evaluating materiality at the motion to dismiss stage of a case.

(2) In line with its Tellabs decision on the issue of pleading scienter, the Court emphasized a holistic approach to evaluating the plaintiffs’ materiality allegations (e.g., “Viewing the allegations of the complaint as a whole . . .”).

Oral argument took place in the Matrixx case this morning. The case addresses the issue of materiality, in particular whether adverse event reports (i.e., reports by users of a drug that they experienced an adverse event after using the drug) are material information even if they are not statistically significant. Also, there was a lot of talk about Satan. Seriously.
A few highlights (based on the transcript):

(1) Petitioner (Matrixx) argued that the key issue is whether the plaintiff has plead facts from which “you can draw a reliable inference that the product is the cause” of the adverse events. In the case of adverse event reports, that reliable inference exists if the adverse event reports are statistically significant. The justices were aggressively skeptical of that position right from the outset. First, a number of justices (Sotomayor, Kennedy, Ginsburg, Scalia, Roberts) wondered if the real issue is whether the company knew about information that could affect its stock price, even if that information was not credible. Second, Justices Kagan and Breyer disagreed that a reasonable investor would only want to know about adverse effects that were statistically significant. As Justice Breyer put it – “look, Albert Einstein had the theory of relativity without any empirical evidence . . . So I can’t see how we can say this statistical evidence always works or always doesn’t work.”

(2) Respondent (investors) had a somewhat easier time, with Justice Breyer even inviting counsel to draft a disclosure rule for drug companies. Counsel responded that he would start with the “total mix of information” test for materiality and “where there is credible medical professionals describing the harms based on credible scientific theories to back up the link, a very serious health effect risk for products with many substitutes, and the effect in on a predominant line, then the company ought to disclose that information.”

(3) The argument took a bit of a turn for Respondent, however, when counsel stated that even irrational information – such as a group of people believing that a product “has some link to satanic influences” – might need to be disclosed. Chief Justice Roberts wondered how companies could determine what should be disclosed under that standard and asked if it would matter whether the “product has particular satanic susceptibility”? In response to Respondent’s argument that the scienter requirement might limit a company’s liability for failing to disclose material, yet irrational, information, Justice Scalia noted that there was no difference between scienter and materiality in that “scienter is withholding something that is material that is known to be material and once . . . Satan is material, if the company thinks Satan is involved here, it has to put it in its report.”

All of the briefs and other background materials can be found here. Bloomberg and the Washington Post have coverage of the argument.

Disclosure: The author of The 10b-5 Daily submitted an amicus brief on behalf SIFMA and the U.S. Chamber of Commerce in support of petitioner.