Category Archives: Appellate Monitor

The U.S. Court of Appeals for the Fourth Circuit has issued its first opinion applying the Tellabs decision on the pleading of scienter (i.e., fraudulent intent). Those who follow the Fourth Circuit’s jurisprudence in this area will be unsurprised to learn that the decision creates good law for defendants.

In Cozzarelli v. Inspire Pharmaceuticals, Inc., 2008 WL 5194311 (4th Cir. Dec. 12, 2008), the plaintiffs alleged that Inspire made false statements regarding a drug trial. The court found that in defining the PSLRA’s “strong inference” pleading standard for scienter, the Supreme Court “gave that standard teeth, using adjectives like ‘cogent,’ ‘compelling,’ ‘persuasive,’ ‘effective,’ and ‘powerful.'” Moreover, an inference of scienter “can only be strong – and compelling, and powerful – when it is weighed against the opposing inferences that may be drawn from the facts in their entirety.”

Based on the facts before it, the court found the inference that any allegedly omitted information about the drug trial was withheld “to protect [Inspire’s] competitive advantage” more “powerful and compelling than the inference that defendants acted with an intent to deceive.” Moreover, the plaintiffs’ motive allegations based on the company’s need to raise capital, the CEO’s performance-based compensation, and a limited amount of stock sales were “conclusory” and “lack[ed] merit.”

The court also joined a number of other circuit courts in holding (a) the signing of allegedly false SOX certifications does not contribute to an inference of scienter, and (b) Section 11 and 12(a)(2) claims that “sound in fraud” must be plead with particularity pursuant to Fed R. Civ. P. 9(b).

Holding: Dismissal affirmed.

Quote of note: “All investments carry risk, particularly in a field like biopharmaceuticals. If we inferred scienter from every bullish statement by a pharmaceutical company that was trying to raise funds, we would choke off the lifeblood of innovation in medicine by fueling frivolous litigation-exactly what Congress sought to avoid by enacting the PSLRA. Furthermore, the fact that some analysts relied on defendants’ hopeful statements to speculate-as the analysts admitted they were doing-that Study 109 would succeed adds little to an inference of scienter. Speculation by investors and subsequent buyers’ remorse cannot support an Exchange Act suit alone.”

Disclosure: The author of The 10b-5 Daily has previously represented the defendants in this case.

What triggers the running of the statute of limitations for a securities fraud action is suddenly a hot topic, thanks to a possible Supreme Court case and a recent Second Circuit decision.

In Staehr v. Hartford Financial Services Group, Inc., 2008 WL 4899445 (2d Cir. Nov. 17, 2008), the court considered whether the plaintiffs had been put on inquiry notice of their claims based on the “cumulative effect” of news articles, public filings, and lawsuits referring to an industrywide fraudulent scheme. The court found that the news articles mostly did not mention Hartford and were in specialty publications, the company’s public filings did not offer enough information about the subject of the fraud, and the lawsuits either did not mention Hartford or were not sufficiently publicized so as to be “reasonably accessible” to an ordinary investor. The New York Law Journal has a column (Dec. 10 edition – subscrip. req’d) on the decision.

Holding: Dismissal based on statute of limitations vacated.

Quote of note (decision): “Given the objective standard for inquiry notice, there is an inherent sliding scale in assessing whether inquiry notice was triggered by information in the public domain: the more widespread and prominent the public information disclosing the facts underlying the fraud, the more accessible this information is to plaintiffs, and the less company-specific the information must be.”

The U.S. Court of Appeals for the Ninth Circuit has issued an opinion on pleading scienter that includes new law (sort of) on the issues of collective scienter, SOX certifications, and profit motive.

In Glazer Capital Management LP v. Magistri, 2008 WL 5003306 (9th Cir. Nov. 26, 2008) the Ninth Circuit considered a case based on alleged misstatements in a merger agreement attached to an SEC filing. The district court found that the complaint failed to adequately plead falsity or scienter. On appeal, the Ninth Circuit made the following rulings (among others) regarding scienter:

(1) Collective scienter – The decision appears to open the door for collective scienter arguments in the Ninth Circuit, but it is far from clear on this point. The collective scienter theory holds that it is possible to raise the required inference of scienter about a corporate defendant without doing so with regard to a specific individual defendant. Although there is a published (and an additional unpublished) Ninth Circuit decision that appear to reject the collective scienter theory, in Glazer the panel found that the earlier published decision had “not foreclose[d] the possibility that, in certain circumstances, some form of collective scienter might be appropriate.” In the instant case, however, the alleged misstatements were not susceptible to the theory because they were broad legal warranties contained in a single document. Accordingly, the panel did not need to decide whether the collective scienter theory was viable.

(2) SOX certifications/Profit motive – Following precedent from other circuits, the panel found that neither the signing of SOX certifications nor allegations that the individual defendant “was positioned to profit personally from the proposed merger” were sufficient to raise a strong inference of scienter.

Holding: Dismissal affirmed.

Quote of note: “If the doctrine of collective scienter excuses Glazer from pleading individual scienter with respect to these legal warranties, then it is difficult to imagine what statements would not qualify for an exception to individualized scienter pleadings. In fact, because the merger agreement warranted that the company was in compliance ‘with all laws,’ then under the collective scienter theory urged by Glazer, so long as any employee at InVision had knowledge of the violation of any law, scienter could be imputed to the company as a whole. This result would be plainly inconsistent with the pleading requirements of the PSLRA. We are thus not faced with whether, in some circumstances, it might be possible to plead scienter under a collective theory.”

As discussed in The 10b-5 Daily before, whether the Tellabs decision on pleading scienter (i.e., fraudulent intent) can best be described as a victory for plaintiffs or defendants has to be evaluated on a circuit-by-circuit basis. In the U.S. Court of Appeals for the Sixth Circuit, for example, the pleading standard has been lowered.

In Frank v. Dana Corp., 2008 WL 4923012 (6th Cir. Nov. 19, 2008), the lower court found that it was “required to accept plaintiff’s inferences of scienter only if those inference are the most plausible of competing inferences.” On appeal, the Sixth Circuit noted that although its earlier decisions applied a “most plausible” standard, that standard was no longer good law. Instead, under Tellabs, the plaintiffs only needed to demonstrate an inference of scienter that was “at least as compelling” as any opposing inference one could draw from the facts alleged.

Holding: Dismissal vacated and case remanded to district court for reconsideration.

When only some of the defendants settle a securities class action, the extent to which they can avoid related litigation with non-settling defendants through the imposition of a judicial bar order is limited. In In re Heritage Bond Litig., 2008 WL 4415172 (9th Cir. Oct. 1, 2008), the court, agreeing with Second Circuit precedent, held that a permissible bar order “may only bar claims for contribution and indemnity and claims where the injury is the non-settling defendant’s liability to the plaintiff.” Non-settling defendants should still be able to bring “genuinely independent” claims against settling defendants, even if the claims arise out of the same facts as those underlying the securities class action.

Holding: Vacated challenged bar orders and remanded to district court for modification.

Will the next U.S. Supreme Court securities case be about the statute of limitations? It is a strong possibility, given that the Court has asked the Solicitor General to weigh in on the cert petition filed in a Ninth Circuit case.

At issue in Betz v. Trainer Wortham & Co., Inc., 519 F.3d 863 (9th Cir. 2008) is when the two-year statute of limitations for a securities fraud begins to run. It is well-settled that if an investor has sufficient knowledge concerning the possibility or probability of fraud (courts have differed on the exact wording), he is deemed to have “inquiry notice” and must begin an investigation into the underlying facts. There is a conflict between the circuits, however, on whether the statute of limitations begins to run when the investor is put on inquiry notice, or later when a reasonably diligent investigation would have revealed the fraud.

The Ninth Circuit went even further then the existing case law and held that inquiry notice is triggered not by mere evidence of a misrepresentation (as in other circuits), but only by evidence of the defendant’s fraudulent intent. It also adopted the more rigorous notice-plus-reasonable-diligence standard and found that even fairly mild reassurances from the defendant in response to a plaintiff’s inquiries may require a jury determination as to whether a reasonably diligent investigation would have revealed the fraud. In a vigorous dissent from the denial of en banc review, Judge Kozinski described the court as being “out in left field again” and argued that “the panel effectively writes the statute of limitations off the books.”

Stay tuned for whether the Court takes the case. In the interim, the amicus brief filed by the Organization for International Investment and the Chamber of Commerce of the United States of America in support of a cert grant can be found here. Thanks to LawyerLinks for noting the Court’s invitation to the Solicitor General’s office to express the government’s views.

“Foreign-cubed” cases are actions brought against a foreign issuer, on behalf of a class that includes not only investors who purchased the securities in question on a U.S. securities exchange, but also foreign investors who purchased the securities on a foreign securities exchange. These cases raise a number of jurisdictional issues.

In Morrison v. National Australia Bank Ltd., 2008 WL 4660742 (2nd Cir. Oct. 23, 2008), the court considered whether it should exercise subject matter jurisdiction over the claims brought by the foreign purchasers of the bank’s ordinary shares (the lower court had dismissed the domestic purchasers’ claims on other grounds). The court declined to impose a “bright-line ban” on foreign purchaser claims, expressing concern that “securities cheaters . . . should not be given greater protection from American securities laws because they carry a foreign passport or victimize foreign shareholders.”

Instead, the court applied its existing “conduct test” for subject matter jurisdiction. Under the conduct test, the plaintiffs needed to adequately allege that “activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad.” The court found that this test was not met: “the fact that the fraudulent statements at issue emanated from NAB’s corporate headquarters in Australia, the complete lack of any effect on America or Americans, and the lengthy chain of causation between [the false numbers communicated to NAB by its U.S. subsidiary] and the statements that reached investors – add up to a determination that we lack subject matter jurisdiction.”

Holding: Dismissal affirmed (note that the Second Circuit did not address a related issue that was recently raised in a S.D.N.Y. case – whether the fraud-on-the-market theory is applicable to foreign purchasers).

Quote of note: “[W]e are leery of rigid bright-line rules because we cannot anticipate all the circumstances in which the ingenuity of those inclined to violate the securities laws should result in their being subject to American jurisdiction. That being said, we are an American court, not the world’s court, and we cannot and should not expend our resources resolving cases that do not affect Americans or involve fraud emanating from America. In our view, the ‘conduct test’ balances these competing concerns adequately and we decline to place any special limits beyond the ‘conduct test’ on ‘foreign-cubed’ securities fraud actions.”

The latest application of the Tellabs decision on the pleading of scienter (i.e., fraudulent intent) comes from the U.S. Court of Appeals for the Eleventh Circuit. In Mizzaro v. Home Depot, Inc., 2008 WL 4498940 (11th Cir. Oct. 8, 2008), the court considered two controversial issues.

Confidential Witnesses – The court declined to embrace the Seventh Circuit’s position that statements by confidential witnesses should be “heavily discounted.” On the other hand, the court acknowledged that there were reasons to be “skeptical of confidential sources cited in securities fraud complaints,” including that there are no harsh consequences if a witness lies to a plaintiff’s attorney. The court concluded: “Confidentiality . . . should not eviscerate the weight given if the complaint otherwise fully describes the foundation of the confidential witness’s knowledge, including the position(s) held, the proximity to the offending conduct, and the relevant time frame.”

Collective Scienter – The court agreed with the Fifth Circuit’s position that a defendant corporation’s scienter is determined by looking “to the state of mind of the individual corporate official or officials who make or issue the statement . . . rather than generally to the collective knowledge of all the corporation’s officers and employees acquired in the course of their employment.” (For more on the circuit split over collective scienter, see this post.) The plaintiffs did “not argue that any Home Depot officials were responsible for the company’s financial statements other than the named individual defendants.” Accordingly, the court found that it “need not pursue this issue further.”

Holding: Dismissal affirmed.

Quote of note: “To begin with, we indulge at least some skepticism about allegations that hinge entirely on a theory that senior management ‘must have known’ everything that was happening in a company as large as Home Depot, which operates over 2000 stores. The amended complaint, therefore, must at least allege some facts showing how knowledge of the fraud would or should have percolated up to senior management. The amended complaint does not come close to accomplishing that task. In particular, [plaintiff’s] ‘must have known’ theory fails because the alleged amount of the fraud is wholly speculative, the type of fraud alleged would be very difficult for senior management to detect, [plaintiff] alleges no suspicious stock sales by management, and Home Depot’s 2004 overhaul of its RTV processing system does not suggest knowledge of widespread fraud.”

Centene Corporation requires all insider stock transactions by its senior executives to be executed under pre-authorized Rule 10b5-1 stock trading plans. That policy turns out to have been helpful in obtaining the dismissal of a securities class action against the company.

In Elam v. Neidorff, 2008 WL 4587310 (8th Cir. Oct. 16, 2008), the Eighth Circuit reviewed the dismissal of the securities class action against Centene and certain individual officers. The plaintiffs argued that scienter (i.e., fraudulent intent) was demonstrated, among other things, by insider stock sales during the class period. The court, however, found that the stock sales could not support an inference of scienter because they were (a) done pursuant to Rule 10b5-1 trading plans, and (b) represented only a small portion of each seller’s overall holdings. Interestingly, the court discussed the terms of the trading plans, suggesting that the trading plans were publicly disclosed. (For more on this issue and related posts, click here.)

Holding: Dismissal affirmed (for failure to adequately plead falsity and scienter).

Does the fraud-on-the-market presumption, pursuant to which reliance by investors on a material misrepresentation is presumed if the company’s shares were traded on an efficient market, apply in suits alleging misrepresentations by analysts (and other non-issuers)?

The U.S. Court of Appeals for the Second Circuit was poised to answer that question in 2004, but Citigroup’s settlement of the claims against it in the WorldCom litigation rendered its appeal moot. Based on the order granting the appeal, issued a day after the agreement to settle was reached, it appeared that the court was inclined to limit the reach of the fraud-on-the-market presumption. Four years later, before a completely different panel, the plaintiffs’ bar has a significant win on the same issue.

In In re Salomon Analyst Metromedia Litigation, No. 06-3225 (2nd Cir. Sept. 30, 2008), the court found that nothing in Basic, the Supreme Court case creating the fraud-on-the-market presumption, limited the presumption’s application to misrepresentations by issuers. Indeed, the “logic” of the Basic decision, which is based on the economic theory that share prices reflect all publicly available information in an efficient market, suggests “it does not matter, for purposes of establishing entitlement to the presumption, whether the misinformation was transmitted by an issuer, an analyst, or anyone else.”

In the alternative, the defendants argued that to establish the materiality of the misrepresentations, and thereby invoke the fraud-on-the-market presumption, the plaintiffs had the burden of proving that the misrepresentations had a quantifiable effect on the company’s stock price. The court disagreed, holding that inherent in the fraud-on-the-market theory is the presumption that material misrepresentations have an effect on stock price. Therefore, it was the defendants’ burden to rebut the presumption by demonstrating the absence of a price impact.

A couple of notes on the decision:

(1) The Second Circuit cited the Supreme Court’s recent Stoneridge decision in support of its holding. In Stoneridge, however, the Court found that the fraud-on-the-market presumption was inapplicable to the non-issuer defendants based on the fact that their “deceptive acts” were not communicated to the public. The issue of the scope of the fraud-on-the-market presumption was not squarely before the Court. Moreover, the Court expressed grave reservations about expanding securities fraud liability, something the Second Circuit’s decision arguably does.

(2) The Second Circuit brushed aside the defendants’ arguments concerning the expansion of liability (see full quote below), but offered an interesting codicil in a footnote. The court noted that “the identity of the speaker may be significant, because a court may determine that the reasonable investor would only rely on misrepresentations made by some speakers, but not by others.”

Holding: Vacate order of class certification and remand for further proceedings (including providing the defendants with an opportunity to rebut the presumption of a price impact).

Quote of note: “Defendants worry that if no heightened test is applied in suits against non-issuers, any person who posts material misstatements about a company on the internet could end up a defendant in a Rule 10b-5 action. The worry is misplaced. The law guards against a flood of frivolous or vexatious lawsuits against third-party speakers because (1) plaintiffs must show the materiality of the misrepresentation, (2) defendants are allowed to rebut the presumption, prior to class certification, by showing, for example, the absence of a price impact, and (3) statements that are ‘predictions or opinions,’ and which concern ‘uncertain future event[s],’ such as most statements made by research analysts, are generally not actionable.”