The Sixth Circuit continues to be a source of interesting opinions regarding corporate scienter. In 2014, the court held in its Omnicare decision that only a limited set of corporate officers (including officers who had either made or approved the alleged misstatements) could have their state of mind imputed to the company. But what about lower corporate officers who know about undisclosed problems and fail to report them?
In Doshi v. General Cable Corp., 2016 WL 2991006 (6th Cir. 2016), the court addressed a case arising out of General Cable’s financial restatement, which was the result of a “complex theft scheme in Brazil and, to a somewhat lesser extent, accounting errors, primarily in Brazil.” The plaintiffs alleged that the head of the company’s “Rest of World” (ROW) division, which included Brazil, knew about these issues but failed to report them to the executive management. Moreover, the plaintiffs argued, his knowledge could be imputed to General Cable because he “furnished information used in General Cable’s false public financial statements.”
The court found that even if the head of the ROW division had acted recklessly, in the absence of any allegations that he had “drafted, reviewed, or approved” the alleged misstatements, “only his knowledge of the theft and accounting errors – not his state of mind – imputes to General Cable.” The court then applied its normal “scienter factors” to determine whether the plaintiffs had adequately plead that the company, with that knowledge, had acted with a fraudulent intent. Ultimately, the court found that the more compelling inference was that “a theft scheme racked General Cable’s operations in Brazil where local managers overrode accounting procedures, which, when coupled with the legitimate freedom afforded ROW to report its financial data, led General Cable to issue materially false public financial statements.” Accordingly, the plaintiffs’ allegations failed “to create a strong inference that General Cable acted with scienter.”
Holding: Dismissal affirmed.
In Halliburton II, the U.S. Supreme Court held that defendants can rebut the fraud-on-the-market presumption of reliance at the class certification stage with evidence of a lack of stock price impact. In a typical case, where the plaintiff alleges that a misrepresentation artificially inflated the company’s stock price, the defendant can satisfy this requirement by providing evidence that there was no stock price increase as a result of the misrepresentation.
At least two circuit courts (Seventh and Eleventh), however, have recognized an alternative “price maintenance theory” of artificial inflation. Under the price maintenance theory, a misrepresentation can artificially inflate a stock’s price by improperly maintaining the existing price (e.g., by repeating prior falsehoods and preventing the stock’s price from falling to its true value). But how does a defendant provide evidence to establish a lack of stock price impact under these circumstances?
Perhaps because of the inherent tension between Halliburton II and the price maintenance theory, two recent circuit court decisions appear to question the theory’s use in securities class actions.
In IBEW Local 98 Pension Fund v. Best Buy Co., Inc., 2016 WL 1425807 (8th Cir. April 12, 2016), the court held that the district court had improperly certified a class based on statements made in an earnings call. According to experts for both sides, the statements were merely confirmatory and did not cause the company’s stock price to increase. While the plaintiffs argued that a price increase was not necessary under their price maintenance theory, the court found that the “theory provided no evidence that refuted defendants’ overwhelming evidence of no price impact.”
In In re Pfizer Inc. Sec. Litig., 2016 WL 1426211 (2nd Cir. April 12, 2016), the court addressed the issue more indirectly. The district court granted summary judgment for the defendants after excluding the plaintiffs’ loss causation and damages expert from testifying. On appeal, the court found that the plaintiffs were relying on a price maintenance theory and that the expert’s testimony would be helpful to the jury in that context. As to the theory itself, however, the court went out of its way to note that it was not deciding whether it was “either legally or factually sustainable” and that it “might be that Plaintiffs’ inflation-maintenance theory is deficient under Rule 10b-5.”
As noted by the dissent in the Best Buy case, “[n]either the Supreme Court nor any circuit court has however discussed the type of showing needed to rebut  a presumption of reliance in a price maintenance case.” Until that issue is addressed, the price maintenance theory appears to be on shaky ground.
Plaintiffs often establish the existence of loss causation by pointing to a “corrective disclosure” that allegedly revealed the fraud and led to a stock price decline. What a disclosure must contain to be deemed “corrective,” however, has been the subject of extensive debate.
In Rand-Heart of New York v. Dolan, 2016 WL 521075 (8th Cir. Feb. 10, 2016), the plaintiffs alleged that Dolan, a professional services company, had failed to adequately disclose that a major customer had stopped sending new work to the company in early 2013. It was not until November 2013 that Dolan told securities analysts about the problem. Although the company’s stock price declined based on that announcement, the plaintiffs argued that the fraud was not fully revealed until January 2014, when the company also announced that it had hired a new restructuring officer and the stock price declined again.
While the U.S. Court of Appeals for the Eighth Circuit was willing to allow claims based on the early 2013 to November 2013 time period to proceed, it found that the plaintiffs had inadequately plead loss causation as to any claims based on the November 2013 to January 2014 time period. The court agreed with the Fourth Circuit and Eleventh Circuit that a “corrective disclosure” must contain “new facts” about the alleged fraud to provide a basis for establishing loss causation. In contrast, “the appointment of a restructuring officer on January 2 does not correct a misrepresentation; it elaborates on the previously disclosed plan to restructure.”
Holding: Dismissal affirmed in part, reversed in part, and case remanded for further proceedings.
An announcement that a company is the target of a government investigation is likely to lead to a stock price decline. The mere fact of an investigation, however, does not tell the market anything about the existence of prior corporate misstatements. Accordingly, some appellate courts have concluded that this type of announcement is not a “corrective disclosure” that can be used to establish loss causation. But what if the company later issues a corrective disclosure revealing that there were prior corporate misstatements related to the subject matter of the investigation? Given that factual scenario, those same appellate courts appear inclined to reverse field and find that the government investigation was a “partial corrective disclosure” that was later confirmed by the company.
In Lloyd v. CVB Financial Corp., 2016 WL384773 (9th Cir. Feb. 1, 2016), the court addressed what appears to be a paradigmatic fact pattern. In August 2010, CVB announced that it had received a SEC subpoena concerning its lending practices. Analysts speculated that the subpoena related specifically to loans made to a certain property company. Following the announcement, CVB’s stock price dropped by 22%. A month later, CVB announced that the property company was unable to pay its loans as scheduled and the bank took a large impairment charge related to the loans. The company’s stock price did not move significantly following this announcement, but at least one analyst speculated that this was because “further deterioration in credit quality and uncertainly surrounding the SEC investigation [were] already reflected in the share price.”
The Ninth Circuit concluded that the investigation announcement standing alone was insufficient to establish loss causation. Once CVB disclosed that it was charging off millions of dollars in loans, however, it was reasonable to conclude that the plaintiffs had plead a sufficient causal connection between the earlier stock price decline and the alleged fraud.
The problem with decisions based on paradigmatic fact patterns is that they leave room for interpretation if the facts are less clear. What if the market had not connected the SEC investigation to the particular loans at issue? What if the company’s decision to take a charge had been announced a year, rather than a month, after the disclosure of the SEC investigation? What if the company’s stock price had moved significantly after the company took its charge? All questions for another day.
Holding: Dismissal affirmed in part, reversed in part, and remanded.
Quote of note: “Under the facts of this case, loss causation is sufficiently pleaded. Indeed, any other rule would allow a defendant to escape liability by first announcing a government investigation and then waiting until the market reacted before revealing that prior representations under investigation were false.”
The scienter (i.e., fraudulent intent) of an officer who makes a false or misleading statement can be imputed to the company based on the law of agency, but that rule potentially is subject to an “adverse interest exception” in cases where the officer acted purely out of self-interest and his conduct did not benefit the company. Earlier this year, The 10b-5 Daily discussed a decision from the Northern District of California where the court, in a case involving improperly claimed expenses, applied the adverse interest exception and found that the plaintiffs had failed to adequately plead that the company acted with scienter. Accordingly, the case was only allowed to proceed against the officer who had engaged in the bad conduct.
In a decision issued last week, however, the Ninth Circuit considered the same issue and has rejected the application of the “adverse interest exception” as a pleading matter. In In re ChinaCast Education Corp. Sec. Litig., 2015 WL 6405680 (9th Cir. Oct. 23, 2015), there was no dispute that the company’s CEO had embezzled millions of dollars of corporate assets and made false statements to investors while his fraudulent activities were ongoing. The district court, however, invoked the “adverse interest exception” and refused “to impute scienter [to the company] from the fraud of a rogue agent.”
On appeal, the Ninth Circuit noted that the “adverse interest exception” is itself subject to an exception. Under the relevant common law principles, “the adverse interest rule collapses in the face of an innocent third party who relies on the agent’s apparent authority.” As set forth in the ChinaCast complaint, “third-party shareholders understandably relied on [the CEO’s] representations, which were made with the imprimatur of the corporation that selected him to speak on its behalf and sign SEC filings.” Moreover, the court found, “imputation [of the CEO’s scienter to the company] also comports with the public policy goals of both securities and agency law – namely, fair risk allocation and ensuring close and careful oversight of high-ranking officials to deter securities fraud.” Accordingly, at least as a pleading matter, the court found the adverse interest exception could not be invoked and the case against the company should proceed.
Holding: Dismissal reversed.
Quote of note: “Assuming a well-pled complaint, we recognize that, as a practical matter, having a clean hands plaintiff eliminates the adverse interest exception in fraud on the market suits because a bona fide plaintiff will always be an innocent third party. The gymnastic exercise of imposing a general rule of imputation followed by analyzing the applicability of the exception to the exception becomes unnecessary. Of course, as the litigation proceeds, whether the plaintiff is an innocent third party and whether the presumption of reliance is rebutted remain open questions.”
Does the fact that an individual defendant’s stock trading took place pursuant to a pre-determined Rule 10b5-1 trading plan undermine any inference that the trades were “suspicious”? Courts continue to be split on this issue, with the answer often depending on the exact circumstances surrounding the plan’s formation and execution.
One recurring issue, which appellate courts have begun to weigh in on, is whether it makes a difference if the trading plan was entered into before or after the outset of the alleged class period (i.e., before or after the fraud allegedly began). Last year, the Fourth Circuit held that because one of the trading plans relied on by a defendant was instituted during the class period, it did “less to shield [that defendant] from suspicion.” The Second Circuit now has issued a more emphatic holding on this topic.
In Employees’ Retirement System of Govt. of the Virgin Islands v. Blanford, 2015 WL 4491319 (2d Cir. July 24, 2015), the defendants argued that their stock trading did not support any inference of scienter because it was done entirely pursuant to Rule 10b5-1 trading plans. The court found that this argument “ignores that [the defendants] entered this trading plan in May after the second quarter investor call, long after the Complaint alleges that Green Mountain’s fraudulent growth scheme began.” Indeed, “[w]hen executives enter into a trading plan during the Class Period and the Complaint sufficiently alleges that the purpose of the plan was to take advantage of an inflated stock price, the plan provides no defense to scienter allegations.”
Holding: Reversing dismissal of complaint and remanding for further proceedings.
Securities class actions rarely go to trial. When they do, as in the Household International case where the plaintiffs won a $2.46 billion verdict, they make the news. But it is axiomatic that big verdicts lead to big appeals. Last month, the Seventh Circuit agreed with the defendants that a new trial was warranted, at least as to certain determinations.
In Glickenhaus & Co. v. Household Int’l, Inc., 2015 WL 2408028 (7th Cir. May 21, 2015), the court offered guidance on two interesting issues.
(1) Loss causation – The jury applied a “leakage model” to determine damages, apparently concluding that information about Household’s alleged fraud had become available to market participants before the relevant disclosures. This model “calculates every difference, both positive and negative, between the stock’s predicted return [using a regression analysis] and the stock’s actual return during the disclosure period.” All of these residual returns are then added up and this amount is “assumed to be the effect of the disclosures.” While the Seventh Circuit agreed that the leakage model of loss causation was legally sufficient, it also found that the expert’s “conclusory opinion that no firm-specific, nonfraud related information affected the stock price during the relevant time period” was subject to challenge. It ordered a new trial on the issue of loss causation to allow the defendants an opportunity to rebut the accuracy of that opinion.
(2) Maker of the statements – The jury was instructed that the defendants could be held liable if they “made, approved, or furnished information to be included in a false statement of fact.” The Supreme Court subsequently issued its Janus decision, holding that liability is limited to “the person or entity with ultimate authority over the statements, including its content and whether or how to communicate it.” When the defendants moved for a new trial based on Janus‘s holding, the district court denied the motion, “reasoning that the Court’s holding applied only to legally independent third parties.” On appeal, the Seventh Circuit found that this was error because “[t]he Court’s interpretation applies generally, not just to corporate outsiders.” Accordingly, it ordered a new trial as to which of the false statements were “made” by the individual officer defendants (this would include, for example, a jury determination as to whether Household’s CEO actually exercised control over the company’s press releases).
Holding: Defendants are entitled to a new trial on loss causation and whether the individual officer defendants “made” certain of the false statements.