Category Archives: Appellate Monitor

When a district court within the Fourth Circuit dismisses a securities class action, it usually stays dismissed. But past performance is no guarantee of future results. In In re Mutual Funds Investment Litig. 2009 WL 1241574 (4th Cir. May 7, 2009), the U.S. Court of Appeals for the Fourth Circuit has reversed the dismissal of a market timing case brought against Janus Capital Group. Moreover, the decision contains some significant legal holdings.

(1) Pleading of Loss Causation – While the Fifth Circuit recently held that loss causation is only subject to notice pleading, the Fourth Circuit is standing tough. The court reaffirmed that, pursuant to Fed. R. Civ. P. 9(b), loss causation must be plead with particularity.

(2) Making of a Misrepresentation – To satisfy the fraud-on-the-market theory, the defendant must have made “a misrepresentation that is public and attributable to the defendant.” There is an ongoing circuit split over how to evaluate whether a statement can be attributed to a particular defendant. Some courts (e.g., the Second and Eleventh Circuits) have adopted a “bright line” rule requiring that the misstatement must be attributable on its face to the defendant. Other courts (e.g., the Ninth Circuit) have concluded that substantial participation in the making of the misstatement is sufficient.

The Fourth Circuit declined to fully adopt either approach, instead offering this compromise: it is sufficient for a plaintiff to “alleg[e] facts from which a court could plausibly infer that interested investors would have known that the defendant was responsible for the statement at the time is was made, even if the statement on its face is not directly attributable to the defendant.” Applying its new standard to the instant case, the court found that Janus Funds investors would have attributed to Janus Capital Management, the investment advisor to the funds, “a role in the preparation or approval of the allegedly misleading prospectuses. ” Janus Funds investors would have been unlikely to come to the same conclusion about Janus Capital Group, however, which was the parent company of the investment advisor.

(3) Scheme Liability – The court found that it did not have to separately evaluate the possible existence of scheme liability. Under Stoneridge, “the existence of a fraudulent scheme does not permit a plaintiff to avoid proving any of the traditional elements of primary liability, such a scienter and reliance.” Since the court had already evaluated these elements in connection with the misrepresentation claims, it did not have to go any further.

Holding: Reversed and remanded.

In Institutional Investors Group v. Ayaya, Inc., 2009 WL 1151943 (3rd Cir. April 30, 2009), the U.S. Court of Appeals for Third Circuit has issued a comprehensive opinion that addresses a number of important pleading topics.

(1) Safe Harbor for Forward-Looking Statements – Whether the first prong of the PSLRA’s safe harbor, which states that a defendant shall not be liable with respect to any forward-looking statement if it is accompanied by “meaningful cautionary statements,” insulates the defendant from liability for false statements made with actual knowledge of their falsity is an open issue (see this post). The Third Circuit found that Avaya’s cautionary language was “extensive and specific.” In particular, the company had warned against the adverse effects of “price and product competition,” which was exactly what the plaintiffs asserted “was responsible for Avaya’s missing its projections.” The court declined, however, to decide whether the cautionary language on its own was sufficient to avoid liability, instead finding that the plaintiffs had, in any event, failed to adequately plead actual knowledge of the projections’ falsity.

(2) Confidential Witnesses – The Third Circuit considered whether, as some courts have held, the Tellabs decision requires a court to discount allegations attributed to confidential witnesses. The court found that its earlier decision on the issue remained good law. To wit, confidential witness allegations must be evaluated by examining “the detail provided by the confidential sources, the sources’ basis of knowledge, the reliability of the sources, the corrobative nature of other facts alleged, including from other sources, the coherence and plausibility of the allegations, and similar indicia.” The statements should only be “discounted” if they are “found wanting with respect to these criteria.”

(3) Holistic Approach to Scienter Allegations – As predicted by The 10b-5 Daily following the Tellabs decision, the Third Circuit found that it can no longer allow plaintiffs to plead scienter by either alleging facts establishing motive and opportunity or by alleging facts that constitute evidence of reckless or conscious behavior. Instead, all of the plaintiffs’ scienter allegations must be considered collectively. (Along the same lines, the court rejected the Ninth Circuit’s recent embrace of a dual inquiry in which scienter allegations are evaluated individually and then, if insufficient on their own, collectively.)

Holding: Reversed in part, affirmed in part, and remanded.

Quote of note: “Our conclusion that ‘motive and opportunity’ may no longer serve as an independent route to scienter follows also from Tellabs’s general instruction to weigh culpable and nonculpable inferences. Individuals not infrequently have both strong motive and ample opportunity to commit bad acts-and yet they often forbear, whether from fear of sanction, the dictates of conscience, or some other influence. It cannot be said that, in every conceivable situation in which an individual makes a false or misleading statement and has a strong motive and opportunity to do so, the nonculpable explanations will necessarily not be more compelling than the culpable ones. And if that is true, then allegations of motive and opportunity are not entitled to a special, independent status.”

The U.S. Court of Appeals for the Fifth Circuit has offered some guidance on how to analyze allegations of loss causation. In Lormand v. US Unwired, Inc., 2009 WL 941505 (5th Cir. April 9, 2009), the plaintiffs alleged that the truth about the fraud “leaked” to the market in a series of partial disclosures and led to stock price declines

The Fifth Circuit made two holdings of note.

(1) In contrast to some other courts (including a recent Ninth Circuit decision), the court found that under Supreme Court precedent loss causation is only subject to a notice pleading requirement. In the court’s lengthy formulation, a plaintiff must allege either a “facially ‘plausible’ causal relationship between the fraudulent statements or omissions and plaintiff’s economic loss, including allegations of a material misrepresentation or omission, followed by the leaking out of relevant or related truth about the fraud that caused a significant part of the depreciations of the stock and plaintiff’s loss” (citing Dura) or “enough facts to give rise to a reasonable hope or expectation that discovery will reveal evidence of the foregoing elements of loss causation” (citing Twombley).

(2) The disclosures that constitute the leaking out of the truth about the fraud may come from third parties.

Applying these legal standards, the Fifth Circuit held the plaintiffs had alleged, at least as to some of their claims, both a “plausible nexus” between the fraud and the cited disclosures and enough factual allegations to raise a reasonable expectation that discovery would reveal evidence of loss causation.

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

A visit to the U.S. Supreme Court does not necessarily mean the end of a securities class action, even if the defendants win their legal argument. The defendants in the Tellabs case successfully overturned the Seventh Circuit’s interpretation of the “strong inference” pleading standard for scienter (i.e., fraudulent intent). On remand, however, the Seventh Circuit found that the plaintiffs had adequately plead scienter even under the Supreme Court’s more rigorous interpretation and sent the case back to the district court for further proceedings.

A mere eight years after the case was filed, the issue of class certification has been decided. In Makor Issues & Rights, Ltd. v. Tellabs, Inc., 2009 WL 448895 (N.D. Ill. Feb. 23, 2009), the court rejected the defendants’ attempts to limit the class period and class members. Among other rulings, the court found that in-and-out traders, members of the class in a related ERISA class action, and Tellabs employees should not be excluded from the class. However, the court did exclude one of the proposed representative plaintiffs because, under a last-in, first-out (“LIFO”) analysis of his stock trading, his gains during the class period outweighed any losses.

Holding: Class certification granted.

In In re Williams Sec. Litig. – WCG Subclass, 2009 WL 388048 (10th Cir. Feb. 18, 2009), the court considered whether the plaintiffs’ expert was able to “reliably link the class’s losses to the revelation of the alleged misrepresentations.” In examining the validity of the expert’s methodology, the court also provided its views on the application of the Supreme Court’s Dura decision on loss causation.

(1) Although loss causation “is easiest to show when a corrective disclosure reveals the fraud to the public and the price subsequently drops,” a “leakage theory that posits a gradual exposure of the fraud rather than a full and immediate disclosure” is permissible under the Dura decision.

(2) To be a corrective disclosure, “the disclosure need not precisely mirror the earlier representation, but it must at least relate back to the misrepresentation and not to some other negative information about the company.”

(3) The plaintiffs must be able to demonstrate that the stock price decline was due “to the revelation of the fraud and not to another significant piece of negative information that was released” at the same time.

As to the plaintiffs’ expert, the court found that his “leakage theory” failed to adequately identify when the “materialization of the concealed risk” occurred. The expert’s alternative theory – that there was a series of corrective disclosures at the end of the class period – was inadequate because he failed to show “that it was the revelation of the fraud, and not other factors, that caused the subsequent declines in price.”

Holding: Affirmed district court’s exclusion of expert testimony and grant of summary judgment in favor of defendants.

Addition: Note that the plaintiffs did not appeal the district court’s rejection of the “constant percentage” method of calculating damages.

There is now an official circuit split over the issue of whether a ’33 Act securities class action that is not removable to federal court under the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) is nevertheless subject to the removal provisions of the Class Action Fairness Act of 2005 (“CAFA”) (see this post for more background). In Katz v. Gerardi, 2009 WL 18137 (7th Cir. Jan. 5, 2009), the court held, in contrast to the Ninth Circuit, that the ’33 Act’s general grant of state court jurisdiction is modified by CAFA, which clearly provides for the removal of certain securities class actions not otherwise covered by SLUSA.

Holding: Judgment of district court vacated and remanded for further proceedings.

The U.S. Court of Appeals for the Third Circuit has issued two interesting decisions.

(1) The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) pre-empts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. In In re Lord Abbett Mutual Funds Fee Litig., 2009 WL 117002 (3rd Cir. Jan. 20, 2009), the court considered whether Congress intended SLUSA to pre-empt the entire case or just the offending state-law claim(s). The court found that that nothing in the language or legislative history of SLUSA “mandate[s] dismissal of an action in its entirety where the action includes only some pre-empted claims.” Moreover, interpreting SLUSA in this manner would have little practical effect: “plaintiffs could simply bring two or more actions in order to avoid having all of their claims dismissed – one action with the potentially pre-empted state law claims and one or more with the remaining claims.”

(2) In Alaska Electrical Pension Fund v. Pharmacia Corp., 2009 WL 213095 (3rd Cir. Jan. 30, 2009), the court had an opportunity to apply its Merck decision on inquiry notice and the statute of limitations. The court found that “investors are not put on inquiry notice of fraud when, in the context of this case, an apparently legitimate scientific dispute arises between the FDA and a pharmaceutical company.” Instead, to find the existence of inquiry notice the court required “some reason to suspect that defendants did not genuinely believe the accuracy of their statements.”

JP Morgan Chase was willing to settle with Enron’s investors over its alleged complicity in the energy company’s financial scandal, but not with its own investors. That turned out to be a prudent decision when the U.S. Court of Appeals for the Second Circuit affirmed the dismissal of the JP Morgan Chase investors’ securities class action last week.

In ECA v. JP Morgan Chase Co., 2009 WL 129911 (2d Cir. Jan. 21, 2009), the court found that the plaintiffs’ scienter allegations suffered “from a basic problem concerning plausibility.” The plaintiffs argued that JP Morgan “concealed its transactions with Enron in return for excessive fees.” The court held, however, that it was “implausible to have both an intent to earn excessive fees for the corporation and also an intent to defraud Plaintiffs by losing vast sums of money [through loans to Enron that JP Morgan could not recover].”

Holding: Dismissal affirmed (on both scienter and materiality grounds).

Addition: The court considered whether Chase was motivated to artificially inflate its stock price via the Enron fraud so that it could use the stock as currency for its acquisition of JP Morgan. Whether this type of motive allegation can contribute to a strong inference of scienter has been an unsettled question. The court found that “a generalized desire to achieve a lucrative acquisition proposal” is common to all companies seeking to make an acquisition and fails “to establish the requisite scienter.”

The U.S. Court of Appeals for the Ninth Circuit issued two decisions this week affirming dismissals based on a failure to adequately plead scienter (i.e., fraudulent intent). The decisions – Zucco Partners, LLC v. Digimarc Corp., 2009 WL 57081 (9th Cir. Jan. 12, 2009) and Rubke v. Capitol Bancorp LTD, 2009 WL 69278 (9th Cir. Jan. 13, 2009) – are notable because they appear to tweak the court’s approach to evaluating scienter allegations.

The panels found that the U.S. Supreme Court’s decision in Tellabs meant that they could no longer dismiss a complaint because the individual scienter allegations were insufficient. Instead, as the Zucco panel held, the court needed to “conduct a dual inquiry: first, we will determine whether any of the plaintiff’s allegations, standing alone, are sufficient to create a strong inference of scienter; second, if no individual allegations are sufficient, we will conduct a ‘holistic’ review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or deliberate recklessness.” The Rubke panel agreed with this two-step approach, finding that it was required to perform a “second holistic analysis to determine whether the complaint contains an inference of scienter that is greater than the sum of its parts.”

Whether this dual inquiry, which appears to afford plaintiffs a second bite at the apple, will have any practical effect is difficult to say. Both panels held that scienter was inadequately plead in the respective complaints (even when evaluated holistically), with the Zucco panel noting that “a comprehensive perspective of Zucco’s complaint cannot transform a series of inadequate allegations into a viable inference of scienter.” To put it another way, can zero plus zero plus zero ever add up to something? Stay tuned.

Last month, the U.S. Court of Appeals for the Fourth Circuit issued its first post-Tellabs decision on the pleading of scienter (i.e., fraudulent intent). The court is back this month with another scienter decision, this time in a case against an accounting firm.

In Public Employees’ Retirement Assoc. of Col. v. Deloitte & Touche LLP, 2009 WL 19134 (4th Cir. Jan. 5, 2009), the court considered the alleged role of two Deloitte entities in the Royal Ahold fraud. (The corporate defendants settled for $1.1 billion in 2005.) The court found that “to establish a strong inference of scienter,” the plaintiffs needed to “demonstrate that the Deloittes were either knowingly complicit in the fraud, or so reckless in their duties as to be oblivious to malfeasance that was readily apparent.” The plaintiffs, however, could not “escape the fact that Ahold . . . went to considerable lengths to conceal the frauds from the accountants and it was the defendants that ultimately uncovered the frauds.” The “strong inference to be drawn from this fact” is that the Deloitte entities “lacked the requisite scienter.”

Holding: Dismissal affirmed.

Quote of note: “It is not an accountant’s fault if its client actively conspires with others in order to deprive the accountant of accurate information about the client’s finances. It would be wrong and counter to the purposes of the PSLRA to find an accountant liable in such an instance.”