Category Archives: Appellate Monitor

In a typical securities class action, the dismissal of the claims against the individual defendants leads to the dismissal of the claims against the company. In the absence of an underlying Rule 10b-5 violation, there also can be no control person liability. But consider this scenario: the suit is stayed against the controlled entity because it is in bankruptcy. Can the control person claims continue against the individual defendants even if the Rule 10b-5 claims against them have been dismissed? The U.S. Court of Appeals for the First Circuit says yes, but how the district court is supposed to implement the decision is unclear.

In In re Stone & Webster, Inc. Sec. Litig., 414 F.3d 187 (1st Cir. 2005), the court affirmed the dismissal of the Rule 10b-5 claims against the CEO and CFO of Stone & Webster (the only individual defendants in the case) based on the failure to adequately plead scienter (i.e., fraudulent intent). The Section 20(a) claims for control person liability against the CEO and CFO, however, were allowed to continue. The CEO and CFO petitioned for rehearing on this issue, arguing that the dismissal of the underlying Rule 10b-5 claims necessitated the dismissal of the Section 20(a) claims.

In a separate opinion, the court denied the petition. See In re Stone & Webster, Inc. Sec. Litig., 2005 WL 2216319 (Sept. 13, 2005). The claims against the company had not been dismissed. Instead, they had been stayed when the company filed for bankruptcy protection. The court held that the dismissal of the Rule 10b-5 claims against the CEO and CFO “is in no way incompatible with the establishment of their secondary liability under Sec. 20(a) as controlling persons of Stone & Webster, predicated on Stone & Webster having violated Rule 10b-5.”

On remand, however, the district court appears to be presented with a difficult puzzle. Whether a defendant corporation has acted with scienter is normally 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.” Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353 (5th Cir. 2004). The CEO and CFO were the only individual defendants in the case. If the case is not going to proceed against them, how can the corporation be found to have acted with scienter? The opinion refers to the possibility that “the acts of other agents might also serve as predicates for the Sec. 20(a) liability,” but this seems like merely a theoretical assertion if all of the individual defendants have been dismissed. Stay tuned.

The Securities Litigation Uniform Standards Act of 1998 (“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 defendants are permitted to remove the case to federal district court for a determination on whether the case is preempted 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.

Earlier this year, the U.S. Court of Appeals for the Seventh Circuit held in the Putnam Funds cases that the “in connection with” language in SLUSA merely “ensures that the fraud occurs in securities transactions rather than some other activity.” Accordingly, plaintiffs could not avoid SLUSA by limiting their proposed class to investors in the funds who merely held their shares, rather than purchased or sold them, during the class period.

The Seventh Circuit has now confirmed that holding under slightly different factual circumstances. In Disher v. Citigroup Global Markets Inc., 2005 WL 1962942 (7th Cir. Aug. 17, 2005), the court found that a class action suit brought in state court on behalf of customers of Salomon Smith Barney alleging that they were mislead by false stock ratings was subject to preemption. The proposed class definition “of all SSB customers who retained certain securities in reliance on SSB’s misrepresentations is no more narrowly drawn than the class definitions discussed in [the Putnam Funds decision].” Accordingly, the court ordered that the case be dismissed.

Holding: Reversed and remanded with instructions to vacate the remand order and dismiss the claims.

The U.S. Court of Appeals for the Fourth Circuit has decided to publish its opinion in the PEC Solutions securities class action. As discussed in this post from last March, the opinion is the first post-PSLRA decision by the Fourth Circuit to address the common scienter allegations of insider stock sales and violations of generally accepted accounting principles (“GAAP”).

Disclosure: The author of The 10b-5 Daily argued the case before the appellate court on behalf of the defendants.

The PSLRA created a safe harbor for forward-looking statements to encourage companies to provide investors with information about future plans and prospects. Under the first prong of the safe harbor, a defendant is not liable with respect to any forward-looking statement if it is identified as forward-looking and is accompanied by “meaningful cautionary statements” that alert investors to the factors that could cause actual results to differ.

Some commentators have described this provision as a “license to lie,” because it arguably protects companies from liability based on even deliberately false forward-looking statements. The U.S. Court of Appeals for the First Circuit agrees. In In re Stone & Webster, Inc., Sec. Litig., 2005 WL 1654040 (1st Cir. July 14, 2005), the court evaluated an allegedly misleading statement that the company “has on hand . . . sufficient sources of funds to meet its anticipated [needs].” The district court found the statement to be forward-looking based on its reference to an anticipated futher need for funds and dismissed the claim based on the PSLRA’s safe harbor. On appeal, the First Circuit found “that the meaning of this curious statute, which grants (within limits) a license to defraud, must be somewhat more complex and restricted.”

In the instant case, the statement was “composed of elements that refer to estimates of future possibilities and elements that refer to present facts.” The court found that the specific claim of fraud related to whether the defendants were “lying about the Company’s present access to funds,” not whether the defendants “were underestimating the amount of their future cash needs.” Under these circumstances, the “mere fact that a statement contains some reference to a projection of future events cannot sensibly bring the statement within the safe harbor.”

Holding: Judgment affirmed in part and vacated in part. (The decision contains holdings on a number of other pleading issues. It also creates an interesting bit of nomenclature, referring to the PSLRA’s heightened pleading standards for false statements as the “clarity-and-basis” requirement.)

The IPO allocation cases (brought against the underwriters of over 300 initial public offerings) generally allege that the defendants ramped up trading commissions in exchange for providing access to IPO shares and required investors allocated IPO shares to buy additional shares in the after-market to help push up the share price. Last year, Judge Scheindlin (S.D.N.Y.) granted class certification in six “focus” cases that have been used to test the sufficiency of the overall allegations.

A reader points out that the Second Circuit has agreed to hear an appeal from that grant (by order dated June 30, 2005). Moreover, the court has specifically asked for briefing on two hot-button issues:

(1) Whether the Second Circuit’s previous position that plaintiffs are only required to make “some showing” that the proposed class comports with all of the elements of Federal Rule of Civil Procedure 23 is consistent with the 2003 amendments to that rule.

(2) Whether the presumption of reliance established in Basic v. Levinson, 485 U.S. 224 (1988) (i.e., the fraud-on-the-market theory) was properly extended to plaintiffs’ claims against the non-issuer defendants and to the market manipulation claims.

The Second Circuit has come close to addressing the scope of the fraud-on-the-market theory before, but was thwarted by a settlement. The resolution of this issue has wide-ranging implications for securities fraud litigation. Take a look, for example, at The 10b-5 Daily’s discussion of two opposing district court decisions in cases brought against research analysts. Stay tuned.

In the first circuit court decision to apply the Supreme Court’s holding in the Dura case, the Sixth Circuit has affirmed the dismissal of a securities class action based on the plaintiffs’ failure to adequately plead loss causation. The case was brought against several former Kmart executives and PricewaterhouseCoopers. The plaintiffs alleged that the defendants misled Kmart’s investors in 2000 and 2001 prior to the company’s bankruptcy.

In D.E. & J. Limited Partnership v. Conaway, 2005 WL 1386448 (6th Cir. June 10, 2005) (unpublished), the Sixth Circuit found that the plaintiffs “did not plead that the alleged fraud became known to the market on any particular day, did not estimate the damages that the alleged fraud caused, and did not connect the alleged fraud with the ultimate disclosure or loss.” In the end, the plaintiffs relied entirely on allegations that they had paid artificially inflated prices for their Kmart stock and that Kmart’s stock price declined after the company announced its bankruptcy. The Sixth Circuit held that price inflation had been expressly rejected by the Supreme Court as an adequate basis for pleading loss causation. As for the bankruptcy filing, the plaintiffs “never alleged that Kmart’s bankruptcy announcement disclosed any prior misrepresentations to the market.”

Holding: Dismissal affirmed.

The National Law Journal has a review (via law.com – free regist. req’d) of the Second Circuit’s major securities law cases over the past year. Click on the case name for The 10b-5 Daily’s take on the featured decisions – Dabit, Rombach, and Enterprise Mortgage.

The Sarbanes-Oxley Act of 2002 (“SOX”) extends the statute of limitations for federal securities fraud to the earlier of two years after the discovery of the facts constituting the violation or five years after the violation. Although the legislation clearly provides that it “shall apply to all proceedings addressed by this section that are commenced on or after the date of enactment of this Act [July 30, 2002],” left unresolved is whether Congress intended to revive claims that had already expired under the earlier one year/three years statute of limitations.

Two circuit courts (the 2nd and 7th) have declined to apply the new statute of limitations to revive time-barred claims. In the past week, the Eleventh and Eighth Circuits have also issued opinions addressing the question.

In its long-awaited decision in Tello v. Dean Witter Reynolds, Inc., 2005 WL 1279130 (11th Cir. June 1, 2005), the Eleventh Circuit held that it could not decide “the statutory-interpretation issue of whether previously time-barred claims are revived by the [SOX] statute of limitations” until the district court determined if the plaintiffs were on inquiry notice of their claims prior to the passage of the legislation.

In contrast, the Eight Circuit’s opinion in In re ADC Telecommunications, Inc. Sec. Litig., 2005 WL 1322576 (8th Cir. June 6, 2005) simply follows the earlier appellate holdings in finding that SOX did not revive time-barred claims. The opinion (in a footnote) and concurrence clarify that the issue of the retroactivity of the new statute of limitations (i.e., its application to “causes of action that had already accrued at the time of the change in law”) is separate from the issue of whether Congress intended to revive time-barred claims.