Category Archives: Appellate Monitor

Whether secondary actors who did not prepare or substantially participate in preparing corporate financial misstatements can still be held liable for them under Rule 10b-5 as scheme participants is a hot topic in the courts. In Simpson v. AOL Time Warner, Inc., 2006 WL 1791042 (9th Cir. June 30, 2006), the U.S. Court of Appeals for the Ninth Circuit has issued an opinion in the Homestore securities litigation that addresses the issue.

In Simpson, the court held that “to be liable as a primary violator of Sec. 10(b) for participation in a ‘scheme to defraud,’ the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme.” It is not sufficient, the court concluded, “that a transaction in which a defendant was involved has a deceptive purpose and effect; the defendant’s own conduct contributing to the transaction or overall scheme must have had a deceptive purpose and effect.” The court rejected the defendants’ argument that Sec. 10(b) liability is limited to those who make material misstatements or omissions, but ultimately found that the district court had correctly dismissed the claims against them.
Held: Dismissal affirmed.

The U.S. Court of Appeals for the Tenth Circuit has issued an opinion in the Qwest securities litigation on the issue of selective waiver. See In re Qwest Communications Int’l Inc. Sec. Litig., 2006 WL 1668246 (10th Cir. June 19, 2006). In particular, the court considered whether the company could withhold documents from the plaintiffs on the grounds of attorney-client privilege or the work-product doctrine even though those documents had previously been produced to the SEC.

After an exhaustive survey of related decisions, revealing that circuit courts generally have rejected the concept of selective waiver, the court held that the record in the case did “not establish a need for a rule of selective waiver to assure cooperation with law enforcement, to further the purposes of the attorney-client privilege or work-product doctine, or to avoid unfairness to the disclosing party.” In the court’s view, Qwest was seeking “the substantial equivalent of an entirely new privilege, i.e., a government-investigation privilege,” which the court was disinclined to create. (Note that the production of opinion work product was not an issue in the case.)

The Rocky Mountain News has an article on the decision.

Quote of note: “At least to the degree exhorted by amici, ‘the culture of waiver’ appears to be of relatively recent vintage. Whether the pressures facing corporations in federal investigations present a hardened, entrenched problem suitable for common-law intervention or merely a passing phenomenon that may soon be addressed in other venues is unclear.”

In the Kircher v. Putnam Funds case, the U.S. Supreme Court has held that a district court’s decision to remand a case to state court pursuant to the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) is not subject to appellate review. The 9-0 decision authored by Justice Souter (with a separate concurrence by Justice Scalia) resolves a circuit split between the Second Circuit (not appealable) and the Seventh Circuit (appealable) on the issue.

SLUSA generally prohibits the bringing of a securities class action based on state law in state court. The defendants are permitted to remove the case to federal district court for a determination on whether the case is precluded by the statute. If so, the district court must dismiss the case; if not, the district court must remand the case back to state court.

As a matter of federal procedural law, a remand based on a district court’s decision that it does not have subject-matter jurisdiction over a case cannot be reviewed on appeal. In Kircher, however, the Seventh Circuit found that this general proposition is inapplicable to a case removed and remanded under SLUSA because the district court is making a substantive decision of no preclusion, as opposed to a procedural decision of no subject-matter jurisdiction.

The Supreme Court disagreed. Based on SLUSA’s text, the Court found that “removal and jurisdiction to deal with removed cases is limited to those precluded” by the statute. Under these circumstances, “a motion to remand claiming the action is not precluded must be seen as posing a jurisdictional issue.” The district court’s exercise of its “adjudicatory power” is “jurisdictional, as is the conclusion reached and the order implementing it.” Accordingly, the remand decision is not subject to appellate review.

Interestingly, the Supreme Court also addressed the Seventh Circuit’s assumption that SLUSA gives federal courts exclusive jurisdiction to decide the preclusion issue, so that “a remand order based on a finding that the action is not precluded would arguably be immune from review.” The Court found that nothing in SLUSA creates this exclusive jurisdiction and on remand the state court would be “perfectly free to reject the remanding court’s reasoning” and make its own determination as to preclusion. Moreover, any error in that decision could “be considered on review by this Court.” The issue was of particular importance in the instant case, because the Court had recently held that holder claims, arguably like those brought by Kircher, are precluded under SLUSA.

Holding: Judgment vacated and case remanded with instructions to dismiss the appeal for lack of jurisdiction.

There is a district court split over whether secondary actors who did not prepare or substantially participate in preparing corporate financial misstatements can still be held liable for them under Rule 10b-5 as scheme participants. Last week, the U.S. Court of Appeals for the Eighth Circuit weighed in on the issue and flatly rejected this theory of liability.

In In re Charter Communications, Inc. Sec. Litig., 2006 WL 925354 (8th Cir. April 11, 2006), the court addressed allegations that the vendor defendants entered into sham transactions with Charter knowing that the company “intended to account for them improperly and that analysts would rely on the inflated revenues and operating cash flow in making stock recommendations.” The plaintiffs argued (relying primarily on a district court decision in the Parmalat case) that the vendors violated Rule 10b-5(a) and (c) by participating in a fraudulent scheme or course of business.

The court found, however, that “any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under Sec. 10(b) or any subpart of Rule 10b-5.” Since the plaintiffs did not allege that the vendor defendants made or approved Charter’s financial misrepresentations, the claims against them were properly dismissed.

Holding: Dismissal affirmed.

Quote of note: “To impose liability for securities fraud on one party to an arm’s length business transaction in goods or services other than securities because that party knew or should have known that the other party would use the transaction to mislead investors in its stock would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings. Decisions of this magnitude should be made by Congress.”

The respondents’ brief in the Kircher case before the U.S. Supreme Court is now available online. The docket reveals that an amicus brief in support of Kircher has been filed by four law professors. Putnam Funds, in turn, is supported by amicus briefs from the Washington Legal Foundation, the Securities Industry Association and the Bond Market Association, and the U.S. Chamber of Commerce. Oral argument is scheduled for April 24.

It turns out that sometimes you can tell what the justices are thinking by the questions they ask. As was predicted by some observers following oral argument in the Dabit case, the U.S. Supreme Court has held that the Securities Litigation Uniform Standards Act (“SLUSA”) pre-empts state-law class actions brought on behalf of persons who were induced to hold (but not purchase or sell) securities. The 8-0 decision authored by Justice Stevens resolves a circuit split between the Second Circuit and the Seventh Circuit on the issue.

SLUSA preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. The primary goal of SLUSA was to prevent plaintiffs from using state law claims to avoid the heightened pleading standards imposed on federal securities class actions. The issue before the Supreme Court in Dabit was the meaning of SLUSA’s “in connection with” requirement.

Dabit is a former Merrill Lynch broker who filed a class action in federal court claiming, under Oklahoma state law, that Merrill Lynch breached its fiduciary duty to its brokers by disseminating misleading analyst research. Dabit asserted that this practice caused the brokers to hold onto overvalued securities too long and lose commission fees when their clients took their business elsewhere. The Second Circuit found that Dabit’s claims were not pre-empted by SLUSA to the extent that he “alleged that brokers were fraudulently induced, not to sell or purchase, but to retain or delay selling their securities.”

The Supreme Court previously had held that only purchasers and sellers of securities have standing to bring a private securities fraud action pursuant to Rule 10b-5. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). In Dabit, however, the Court clarified that its earlier decision to limit the potential plaintiffs in Rule 10b-5 cases was based on policy considerations, not on an attempt to define the phrase “in connection with the purchase or sale.” Indeed, the Court has generally “espoused a broad interpretation” of that phrase, holding that “it is enough that the fraud alleged ‘coincide’ with a securities transaction – whether by the plaintiff or by someone else.”

The Court found that this broad interpretation must have been known to Congress when it drafted SLUSA and used the “in connection with” language. Given that “class actions brought by holders pose a special risk of vexatious litigation,” it would be “odd, to say the least, if SLUSA exempted that particularly troublesome subset of class actions from its pre-emptive sweep.” Moreover, allowing state class actions brought by holders “would give rise to wasteful, duplicative litigation” if parallel state court (holders) and federal court (purchasers) class actions were brought based on the same facts.

Holding: Judgment vacated and case remanded for further proceedings consistent with opinion.

Quote of note: “The holder class action that respondent tried to plead, and that the Second Circuit envisioned, is distinguishable from a typical Rule 10b–5 class action in only one respect: It is brought by holders instead of purchasers or sellers. For purposes of SLUSA pre-emption, that distinction is irrelevant; the identity of the plaintiffs does not determine whether the complaint alleges fraud ‘in connection with the purchase or sale’ of securities. The misconduct of which respondent complains here—fraudulent manipulation of stock prices—unquestionably qualifies as fraud ‘in connection with the purchase or sale’ of securities as the phrase is defined in Zandford, 535 U. S., at 820, 822, and O’Hagan, 521 U. S., at 651.”

Oral argument in the Kircher case before the U.S. Supreme Court will be held on April 24. The case addresses whether a party may appeal a district court’s decision to remand a case to state court pursuant to the Securities Litigation Uniform Standards Act of 1998.

An interesting appellate decision from late last year illustrates the double-edged nature of the efficient market hypothesis for securities fraud litigants. In In re Merck & Co. Sec. Litig., 432 F.3d 261 (3rd Cir. 2005), the Third Circuit addressed whether Merck’s failure to disclose certain accounting practices of a wholly-owned subsidiary was a material omission.

On April 17, 2002, in connection with the initial public offering of the subsidiary, Merck filed a Form S-1 that disclosed for the first time that the subsidiary had recognized as revenue the co-payments paid by consumers. The Form S-1 did not disclose, however, the total amount of co-payments recognized. On the day the Form S-1 was filed, Merck’s stock price went up. Two months later, the Wall Street Journal reported that the subsidiary had been recognizing the co-payments as revenue and estimated the total amount of this revenue in 2001 at over $4 billion. Merck’s stock price dropped two dollars.

On appeal, the Third Circuit held that in an efficient market the materiality of disclosed information may be measured by looking at the movement of the company’s stock price immediately following the disclosure. Since Merck’s stock price did not decline when the Form S-1 was filed, the court found that the revenue recognition information was immaterial as a matter of law. In response to the plaintiffs’ argument that the real disclosure took place when the Wall Street Journal made public the estimated magnitude of the co-payment recognition, the court found that the “minimal, arithmetic complexity of the calculation” made by the reporter “hardly undermines faith in an efficient market.” The court noted that this was especially true given how closely Merck was followed by analysts.

Holding: Dismissal affirmed.

Quote of note: “[Plaintiff] is trying to have it both ways: the market understood all the good news that Merck said about its revenue but was not smart enough to understand the co-payment disclosure. An efficient market for good news is an efficient market for bad news. The Journal reporter simply did the math on June 21; the efficient market hypothesis suggests that the market made these basic calculations months earlier.”

Addition: One of the panel judges was Samuel Alito, who has since become Justice Alito.

For readers interested in more analysis of the Securities Litigation Uniform Standards Act (SLUSA) issues before the U.S. Supreme Court this term, the New York Law Journal (via law.com – regist. req’d) has two recent columns on the cases.

It took ten years, but the U.S. Court of Appeals for the Seventh Circuit has finally issued an opinion that comprehensively interprets the PSLRA’s heightened pleading standards. In Makor Issues & Rights, Ltd. v. Tellabs, Inc., 2006 WL 172142 (7th Cir. Jan. 25, 2006) (Wood, J.), the court addressed the following issues:

(1) Pleading of all facts – Although the PLSRA requires a complaint based on information and belief to state “all facts on which that belief is formed,” courts generally have held that this requirement should not be applied literally. The Seventh Circuit agreed with the Second Circuit that the relevant question is “whether the facts alleged are sufficient to support a reasonable belief as to the misleading nature of the statement or omission.”

(2) Confidential witnesses – In accord with a number of other circuit courts, the Seventh Circuit found that plaintiffs are not required to provide the identify of their confidential sources. It is enough for plaintiffs to describe the sources with sufficient particularity to support the probability that the person would “have access to, or knowledge of, the facts underlying the allegations.”

(3) Substantive scienter standard – The Seventh Circuit found that the PSLRA did not raise the substantive scienter standard for securities fraud, which continues to be knowledge or recklessness. (Only the Ninth Circuit has reached a different conclusion.)

(4) Pleading scienter – Under the PSLRA, a plaintiff must plead sufficient facts to create a “strong inference” of scienter or the complaint shall be dismissed. The key issue has been whether motive and opportunity allegations (e.g., insider stock trading), by themselves, can meet this pleading burden. The Second and Third Circuits say yes. The Ninth and Eleventh Circuits disagree. A number of other circuit courts, however, have taken a more holistic approach and require that all of the allegations in the complaint be collectively examined to determine whether the requisite strong inference of scienter is demonstrated. The Seventh Circuit adopted this middle ground, finding that motive and opportunity allegations may be “useful indicators.”

(5) Competing inferences – Although the Sixth Circuit has found that the “strong inference” requirement creates a situation in which plaintiffs are only entitled to the most plausible of competing inferences when a court evaluates their scienter allegations, the Seventh Circuit disagreed. Instead, the Seventh Circuit stated that it “will allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.”

(6) Group pleading for scienter – The Seventh Circuit found that the PSLRA requires a strong inference of scienter to be pled for each defendant. Accordingly, scienter allegations made against one defendant cannot be imputed to other defendants on the theory that the officers of the company acted collectively.

For all of the legal windup, the application of the law to the facts in Makor is surprisingly brief. The district court had found that the plaintiffs failed to adequately allege scienter for any of the defendants. On appeal, the Seventh Circuit held that the allegations concerning marketing, sales, and production information available to the CEO were sufficient to establish a strong inference that he acted with fraudulent intent. The CEO’s scienter could then be imputed to the company. As for the other individual defendant, the company’s Chairman, the scienter allegations appeared to be of the “must have known” variety, and he only sold 1% of his stock holdings during the class period. Accordingly, the Rule 10b-5 claim against the Chairman was dismissed.

Holding: Affirmed in part, reversed in part. (The court also evaluated whether falsity and materiality was adequately pled for all of the statements and whether the forward-looking statements were protected by the PSLRA’s safe harbor, but its holdings on these issues were not dispositive of the overall claims against any of the defendants.)