Category Archives: Appellate Monitor

The recent string of appellate decisions involving securities class actions includes Ley v. Visteon Corp., 2008 WL 3905469 (6th Cir. Aug. 26, 2008), which contains a couple of interesting holdings.

Comparisons to Competition – The plaintiffs alleged that Visteon failed to disclose how high its costs were relative to its competition. The court declined to “advocate a rule that requires companies to draw such comparisons.” Quoting from an older Third Circuit opinion, the court found that “it is precisely and uniquely the function of the prudent investor, not the issurer of securities, to make such comparisons among investments.”

Discounting Confidential Witnesses – The Seventh Circuit has held that in evaluating the pleading of scienter (i.e. fraudulent intent), allegations from confidential witnesses must be “discounted” and that discount will usually be “steep.” Although there is some confusion as to whether that holding remains good law, the Sixth Circuit cited it favorably in concluding that the confidential witness allegations in the Visteon complaint were insufficient to establish any inference of scienter.

Holding: Dismissal affirmed.

There is a recent appellate trend of finding “must have known” allegations sufficient to establish a strong inference of scienter in situations where the underlying events are deemed to be highly important to the corporation (e.g., Dynex Capital (2nd Cir.), Tellabs II (7th Cir.), and Applied Signal (9th Cir.)).

In South Ferry LP v. Killinger, 2008 WL 4138237 (9th Cir. Sept. 9, 2008), the court examined exactly when “a scienter theory that infers that facts critical to a business’s ‘core operations’ or an important transaction are known to a company’s key officers” establishes a strong inference of scienter. The court found that these allegations may help to satisfy the pleading standard in three circumstances.

(1) “[T]he allegations may be used in any form along with other allegations that, when read together, raise an inference of scienter that is ‘cogent and compelling, thus strong in light of other explanations.'” (citing Tellabs)

(2) The “allegations may independently satisfy the [scienter pleading standard] where they are particular and suggest that defendants had actual access to the disputed information.”

(3) The “allegations may conceivably satisfy the [scienter pleading] standard in a more bare form, without accompanying particularized allegations, in rare circumstances where the nature of the relevant fact is of such prominence that it would be ‘absurd’ to suggest that management was without knowledge of the matter.”

Although the first two tests are uncontroversial, the “absurdity” test appears difficult to apply in a consistent fashion. The court cited the Applied Signal case, where the defendants allegedly failed to disclose stop-work orders from the company’s largest customers even though they had a devastating effect on revenues, as one of the “exceedingly rare” cases where the core operations inference, without more, was sufficient. But whether lower courts will find that the core operations inference is sufficient only in “exceedingly rare” cases remains to be seen.
Holding: Remanded for further proceedings consistent with the opinion.

Can the sheer number of accounting errors negate an inference of fraud? In In re Ceridian Corp. Sec. Litig., 2008 WL 4163782 (8th Cir. Sept. 11, 2008), the U.S. Court of Appeals for the Eighth Circuit had an opportunity to address that question.

Between February 2004 and April 2005, Ceridian announced three financial restatements. The restatements were based on a variety of apparently unrelated accounting errors over a number of years. The district court found that the sheer number of accounting errors, which involved dozens of employees, made it “almost inconceivable that there could have been any unifying intent behind the errors, much less an intent to defraud.”

The Eighth Circuit agreed. Even in conjunction with the plaintiffs’ other scienter allegations – including insider trades, SOX certifications, confidential witness statements about pre-class period conduct, and an ongoing SEC investigation – the court found that “the opposing inference that Ceridian and the controlling officer defendants should have known about the many accounting errors” was more compelling than the inference that they knew about the errors. The court concluded that the plaintiffs had “a viable claim of negligence, but not of fraud.”

Holding: Dismissal affirmed.

The U.S. Court of Appeals for the Third Circuit has issued a notable decision on the application of the statute of limitations in securities cases. In In re Merck & Co., Inc. Sec., Derivative & ERISA Lit., Nos. 07-2431, 07-2432 (3rd Cir. Sept. 9, 2008), the court considered whether Merck investors were on inquiry notice of their securities claims relating to Vioxx disclosures more than two years before the case was filed. If so, the plaintiffs’ claims would be barred by the statute of limitations. The decision has a number of interesting holdings:

(1) There has been some ambiguity in the Third Circuit over whether inquiry notice is triggered by evidence alerting an investor to the “possibility” or the “probability” of wrongdoing. The decision clarified that the Third Circuit’s standard is: “whether the plaintiffs, in the exercise of reasonable diligence, should have knows of the basis for their claims depends on whether they had sufficient information of possible wrongdoing to place them on inquiry notice or to excite storm warnings of culpable activity.” Although the court adopted the lower “possibility” standard, it emphasized that the evidence must be substantial, especially in light of the PSLRA’s heightened pleading standards.

(2) The district court found the existence of inquiry notice based upon a public FDA warning letter stating that Merck was misrepresenting the safety profile of Vioxx, press and scholarly articles about the risk of heart attack associated with the drug, and various lawsuits filed against Merck over Vioxx safety issues. On appeal, however, the court found that these “storm warnings” were dissipated by Merck’s reassuring statements to the market or undermined by the failure of the disclosures to have any significant impact on Merck’s stock price or projections by analysts. In particular, the court focused on the fact that Merck put forward an alternative hypothesis as to why the relevant clinical study showed increased heart attack risks associated with Vioxx that may have led to the limited stock price reaction. Also, none of the lawsuits alleged securities fraud.

(3) In a vigorous dissent, Judge Roth argued that the FDA warning letter, by itself, was a sufficient storm warning that Merck had engaged in misrepresentations concerning Vioxx. Moreover, the subsequent press coverage and consumer lawsuits should have led investors to an awareness “of the possibility that Merck had been fraudulently misrepresenting the cardiovascular safety of Vioxx.”

(4) The majority’s footnote response to the dissent appears ill-considered: “It is ironic that the dissent, although noting what might be viewed as Merck’s misrepresentations, would apply the statute of limitations to deprive plaintiffs of the opportunity to prove a viable case against Merck for such misrepresentations.” Bad facts make for bad law? After all, as The 10b-5 Daily has noted before, an inquiry notice argument presupposes the possibility of misrepresentations and the statute of limitations can limit liability even where misconduct has occurred.

Holding: Reversed and remanded.

Quote of note (majority opinion): “Merck’s stock price dipped slightly following the disclosure of the FDA warning letter before closing higher than it did before that disclosure just a week and a half later. Although the lack of significant movement in Merck’s stock price following the FDA warning letter is not conclusive, it supports a conclusion that the letter did not constitute a sufficient suggestion of securities fraud to trigger a storm warning of culpable activity under the securities laws. This conclusion is also supported by the fact that more than a half-dozen securities analysts continued to maintain their ratings for Merck stock and/or project increased future revenues for Vioxx after the warning letter was made public.”

Quote of note (dissent): “In applying the above inquiry notice standard to the instant case, I am reminded of a classic fairytale: The Emperor’s New Clothes, by Danish author and poet, Hans Christian Anderson. As the child in The Emperor’s New Clothes saw – that the Emperor walked naked down the street – any reasonable investor reading the FDA’s September 17, 2001, warning letter could see the problem with Vioxx – the misrepresentation of its safety profile and the ‘possibility’ that Merck had fraudulently misrepresented the cardiovascular safety of its ‘blockbuster’ product.”

Does the PSLRA require courts to find the attorneys’ fees agreed upon by the lead plaintiff presumptively reasonable? In In re Nortel Networks Corp. Sec. Litig., 2008 WL 3840916 (2d Cir. Aug. 19, 2008), the lead counsel made this argument on appeal after the district court reduced its fee request from the negotiated 8.5% of the settlement amount to 3% of the settlement amount. The Second Circuit found that the lead counsel had waived the argument, which was based on Third Circuit precedent, by failing to raise it before the district court. The appellate court nevertheless made it clear that while district courts should give “serious consideration” to negotiated fee arrangements, “the only PSLRA provision related to attorneys’ fees places an obligation on district courts to ensure independently that fees are reasonable.” As for the 3% fee award (resulting in a 2.04 lodestar multiplier), the appellate court found that it was “toward the lower end of reasonable fee awards,” but the district court had not abused its discretion in setting the award at that level.

Holding: Fee award affirmed.

Two recent decisions from the U.S. Court of Appeals for the Ninth Circuit demonstrate that a fair amount of judicial discretion goes into determining whether the inference of loss causation created by a complaint’s factual allegations is either “unreasonable” or “facially plausible.”

(1) In Metzler Investment GMBH v. Corinthian Colleges, Inc., 2008 WL 2853402 (9th Cir. July 25, 2008), the court examined whether a news story and a press release that lead to stock price declines could “be reasonably read to reveal widespread financial aid manipulation by Corinthian.” The court found that the news story only discussed a Department of Education investigation into improper financial aid practices at one of Corinthian’s schools and, therefore, could not have revealed the supposed fraud. As for the later press release, the plaintiffs alleged that the announcement of higher than anticipated student attrition was understood by the market as the company’s “euphemism for an admission that they had enrolled students who should not have been signed up at all, resulting in a 45% stock price drop.” The court was unwilling to credit this inference, holding that although the corrective disclosure does not have to be an admission of fraud, “that does not allow a plaintiff to plead loss causation through ‘euphemism.'”

Holding: Dismissal affirmed.

Quote of note: “So long as there is a drop in a stock’s price, a plaintiff will always be able to contend that the market ‘understood’ a defendant’s statement precipitating a loss as a coded message revealing the fraud. Enabling a plaintiff to proceed on such a theory would effectively resurrect what Dura discredited – that loss causation is established through an allegation that a stock was purchased at an inflated price. Loss causation requires more.”

(2)In In re Gilead Sciences Sec. Litig., 2008 WL 3271039 (9th Cir. Aug. 11, 2008), the court examined whether loss causation was adequately plead where the market was alerted to the company’s off-label marketing efforts by an FDA warning letter in August 2003 (no decline in stock price), but the alleged financial impact to the company of the FDA warning letter was not announced until October 2003 (12% decline in stock price). The lower court found that it was unreasonable to infer that the August 2003 revelation caused a stock price decline nearly three months later and that the October 2003 announcement of a slowing increase in demand for the relevant product was too speculative a basis for finding loss causation. On appeal, the court held that “a limited temporal gap between the time a misrepresentation is publicly revealed and the subsequent decline in stock value does not render a plaintiff’s theory of loss causation per se implausible.” Moreover, the warning letter’s effect on product demand may not have been understood by the market until the October 2003 announcement.

Holding: Dismissal reversed.

Quote of note: “It is true that the court need not accept as true conclusory allegations, nor make unwarranted deductions or unreasonable inferences. But so long as the plaintiff alleges facts to support a theory that is not facially implausible, the court’s skepticism is best reserved for later stages of the proceedings when the plaintiff’s case can be rejected on evidentiary grounds.”

The Shaw Group is on a roll. Following the recent dismissal of the securities class action against the company in the S.D.N.Y., it has obtained an unusual victory in an earlier, unrelated securities class action filed in the D. of La. As noted in The 10b-5 Daily nearly two years ago, the D. of La. court denied Shaw’s motion to dismiss in the case, but certified its denial for appeal. The court found that “reasonable minds might disagree on the issue of whether the Plaintiffs have satisfied their pleading burden under the heightened standards for securities claims.” Apparently so.

In Indiana Electrical Workers’ Pension Trust Fund IBEW v. Shaw Group, Inc., 2008 WL 2894793 (5th Cir. July 29, 2008), the court held that the plaintiffs had failed to allege a strong inference of scienter. Interestingly, the court agreed with the Seventh Circuit that “[f]ollowing Tellabs, courts must discount allegations from confidential sources.” In the absence of any financial restatement, the court found that the complaint’s circumstantial allegations of scienter (based largely on confidential sources) were insufficient and there were plausible, non-fraudulent explanations for the officer stock sales during the class period.

Holding: Reversed and remanded with instructions to dismiss.

In Berson v. Applied Signal Tech., Inc., 527 F.3d 982 (9th Cir. 2008), the company allegedly misled investors into believing it was likely to perform contracted work. According to the plaintiffs, however, the work had actually ceased pursuant to “stop-work” orders and was not likely to be resumed. On appeal, the U.S. Court of Appeals for the Ninth Circuit reversed the dismissal of the case. A couple of interesting holdings in the decision:

(1) Scienter – The plaintiffs did not allege particular facts indicating that the individual defendants knew about the stop-work orders. Instead, they argued that Applied Signal’s CEO and CFO must have known about the stop-work orders because of the devastating effect of the orders on the corporation’s revenue. The court agreed and found that the stop-work orders “were prominent enough that it would be ‘absurd to suggest’ that top management was unaware of them.” The decision continues a recent appellate trend of finding “must have known” allegations sufficient in situations where the underlying events are deemed to be highly important to the corporation.

(2) Loss Causation – The Supreme Court’s Dura decision left open the question of whether loss causation is subject to a heightened pleading standard. A number of courts have held that notice pleading pursuant to F.R.C.P. 8(a)(2) is sufficient (see, e.g., Greater Penn. Carpenters Pension Fund v. Whitehall Jewellers, Inc., 2005 WL 1563206 (N.D. Ill. June 30, 2005)), while a few others have required pleading with particularity pursuant to F.R.C.P. 9(b) (see, e.g., In re The First Union Corp. Sec. Litig., 2006 WL 163616 (W.D.N.C. Jan. 20, 2006)). The Applied Signal court noted that this is still an open question in the Ninth Circuit, but declined to decide it because the loss causation allegations in the case met the more stringent standard.

Whether a plaintiff can establish the scienter of a defendant corporation based on the collective knowledge of the corporation’s employees, commonly referred to as the “collective scienter” theory, is a topic that is getting increased attention in the courts. The author of The 10b-5 Daily wrote a New York Law Journal column (with a colleague) on collective scienter earlier this year.

The main case discussed in that column was decided by the Second Circuit last week. In Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital, Inc., 2008 WL 2521676 (2nd Cir. June 26, 2008), the court drew a distinction between the pleading and proving of corporate scienter. Although to prove corporate liability “a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation,” the court found that at the pleading stage a plaintiff is only required to create a strong inference that “someone whose intent could be imputed to the corporation acted with the requisite scienter.” This pleading burden can be met “with regard to a corporate defendant without doing so with regard to a specific individual defendant.” The court went on to hold, however, that the generic allegations of knowledge and motive in the complaint failed to meet this standard.

Practitioners, especially in the defense bar, are likely to find the decision disappointing. First, the court did not address what type of factual allegations would be sufficient to find the existence of a strong inference of corporate scienter (in the absence of sufficient factual allegations concerning an individual defendant). The only hint is a quote from the Seventh Circuit’s decision in Tellabs II discussing a hypothetical in which “General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero.” Although General Motors now knows one situation to avoid, that fact pattern offers limited guidance for the lower courts. Second, the court provided no legal basis for its announced pleading standard (other than the citation to Tellabs II) and did not address the growing circuit split on this issue.

Disclosure: The author of The 10b-5 Daily submitted an amicus brief in the Dynex Capital case on behalf of the Washington Legal Foundation.

One of the concerns raised by Congress, as part of the PSLRA, was that the application of traditional joint and several liability in securities cases may be unfair, given the enormous potential damages. To combat this problem, the PSLRA replaced joint and several liability with a proportionate liability scheme for defendants who are not found to have knowingly violated the securities laws. An unanswered question, however, is whether this proportionate liability scheme also applies to defendants who are found to have controlling person liability. Section 20(a) of the ’34 Act, which creates controlling person liability, specifically states that the controlling person shall be liable “jointly and severally with and to the same extent” as the primary violator.

In Laperriere v. Vesta Ins. Group, Inc., 2008 WL 1883482 (11th Cir. April 30, 2008), the Eleventh Circuit has held that the proportionate liability provisions of the PSLRA also apply to controlling persons. In the comprehensive decision, which discusses the relevant statutory provisions at length, the court found that both the plain language and legislative history suggest that Congress intended to include controlling persons.

Quote of Note: “We ought to avoid any interpretation of the statute that would treat controlling persons more harshly than the primary violator – that would put derivatively liable controlling persons on the hook for all damages, but let primary violators off the hook for any damages that their actions did not cause. That result would be contrary to common sense, to what the committee that drafted the PSLRA said it intended to do, and to what Congress actually did in the plain language of the PSLRA.”