Category Archives: Appellate Monitor

The “group pleading” doctrine creates the presumption that the senior officers of a company are collectively responsible for misrepresentations or omissions contained in public statements made by the company (e.g., press releases, SEC filings). District courts are divided over whether a plaintiff’s ability to plead in this manner has survived the enactment of the PSLRA with its heightened pleading standards for securities fraud.

Last week, the U.S. Court of Appeals for the Fifth Circuit made a strong statement against the use of group pleading. In Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 2004 WL 626721 (5th Cir. March 31, 2004), the court held that group pleading “cannot withstand the PSLRA’s specific requirement that the untrue statements be set forth with particularity as to ‘the defendant’ and that scienter be pleaded with regard to ‘each act or omission sufficient to give rise to a strong inference that the defendant acted with the required state of mind.'” As a result of the PSLRA’s repeated references to “the defendant,” the court found that Congress intended plaintiffs to inform each defendant of his or her particular role in the alleged fraud.

Holding: Affirmed in part, reversed in part (the decision also contains an interesting, if relatively uncontroversial, discussion on determining scienter for a corporate defendant).

Quote of note: “[C]orporate officers may not be held responsible for unattributed corporate statements solely on the basis of their titles, even if their general day-to-day involvement in the corporation’s affairs is pleaded. However, corporate documents that have no stated author or statements within documents not attributed to any individual may be charged to one or more corporate officers provided specific factual allegations link the individual to the statement at issue.”

Similar to the Merrill Lynch cases, a securities class action was filed against First Union in May 2001 accusing the financial services company of inflating the price of Ask Jeeves stock by issuing “strong buy” recommendations while acting under an undisclosed conflict of interest. In LaGrasta v. First Union Securities, 2004 WL 178937 (11th Cir. Jan. 30, 2004), the U.S. Court of Appeals for the 11th Circuit reversed the lower court’s decision to dismiss the case based based on the statute of limitations. The lower court had found that the sharp decline in the price of Ask Jeeves stock in April 2000, even though First Union was continuing to make “strong buy” recommendations, was sufficient to put the plaintiffs on inquiry notice of fraud, thus making the filing of their complaint more than a year later untimely.

On appeal, the 11th Circuit held that a stock price decline is insufficient to create inquiry notice of fraud. The court laid out five reasons: (1) stock price fluctuations are always possible; (2) Ask Jeeves stock was highly volatile; (3) the stock price decline may have resulted from reasons other than fraud; (4) the investors may have been looking for a speculative investment and therefore expected large fluctuations; and (5) the investors are suing First Union, not Ask Jeeves, so a stock price drop would not necessarily have alerted them to First Union’s misconduct. The court also rejected First Union’s argument that its disclosure of the possibility of a conflict in its analyst reports was sufficient to put investors on notice of the possibility of fraud. Based on the record, the court found that the most it could conclude as a matter of law was that the plaintiffs were on inquiry notice as of June 2000 (less than a year before the complaint was filed) when a Smart Money article expressly disclosed that First Union was in the running to be selected as the underwriter for Ask Jeeves’ secondary stock offering.

Holding: Dismissal on statute of limitations ground reversed. Case remanded for district court to consider loss causation argument.

Quote of note: “[T]he district court’s orders [in the Merrill Lynch cases finding the claims in those cases time-barred] were based only partially on the dramatic decline in the price of the shares. In fact, most of the discussion on inquiry notice by the district court concerns the newspaper articles about the conflict of interest and similar information in the public domain. We view the Merrill Lynch orders as consistent with our own conclusion that, on the face of the complaint, the publication of the Smart Money article exposing the conflict of interest of First Union and Ms. Trabuco was the event which put the La Grastas on inquiry notice.”

Section 11 and Section 12(a)(2) of the Securities Act of 1933 impose liability, under various circumstances, for untrue or misleading statements in registration statements. The statute does not require a plaintiff to establish that the defendant acted with scienter (i.e., fraudulent intent). Nevertheless, a number of federal circuits (3rd, 5th, 7th, and 9th – with only the 8th disagreeing) have found that Federal Rule of Civil Procedure 9(b)’s particularity pleading requirement applies to these claims if they “sound in fraud.”

In Rombach v. Chang, 2004 WL 77928 (2d Cir. Jan. 20, 2003), the Second Circuit addressed the issue for the first time. The court noted that Rule 9(b) applies to “all averments of fraud” and “is not limited to allegations styled or denominated as fraud or expressed in terms of the constituent elements of a fraud cause of action.” Although fraud is not an element of Sections 11 and 12(a)(2) claims, these claims are often predicated on the same course of conduct that would support a Rule 10b-5 claim. Accordingly, “while a plaintiff need allege no more than negligence to proceed under Section 11 and Section 12(a)(2), claims that do rely upon averments of fraud are subject to the test of Rule 9(b).”

The Rombach plaintiffs brought Section 11, Section 12(a)(2), and Rule 10b-5 claims based on the same course of conduct. Although they asserted that their Section 11 claims did not sound in fraud, the court held that “the wording and imputations of the complaint are classically associated with fraud: that the Registration statement was ‘inaccurate and misleading;’ that it contained ‘untrue statements of material facts;’ and that ‘materially false and misleading written statements’ were issued.” Having found that the particularity requirement of Rule 9(b) was applicable, the court then affirmed the lower court’s decision that the plaintiffs’ had failed to adequately plead that the statements at issue were false or misleading.

Holding: Affirm grant of motion to dismiss.

Quote of note: “The particularity requirement of Rule 9(b) serves to ‘provide a defendant with fair notice of a plaintiff’s claim, to safeguard a defendant’s reputation from improvident charges of wrongdoing, and to protect a defendant against the institution of a strike suit.’ These considerations apply with equal force to ‘averments of fraud’ set forth in aid of Section 11 and Section 12(a)(2) claims that are grounded in fraud.”

The New York Law Journal has an article (via law.com – free regist. req’d) on the decision.

The Ninth Circuit has issued an opinion in Employee Teamsters Local Nos. 175 and 505 Pension Trust Fund v. Clorox Co., 2004 WL 32963 (9th Cir. Jan. 7, 2004) that addresses discovery, the PSLRA’s safe harbor for forward-looking statements, and scienter issues.

An interesting part of the opinion deals with the plaintiff’s contention that the lower court “incorrectly held that knowingly false statements made by [an officer defendant] during her April 22 conference call are not actionable as long as they are short, and that it improperly relied on limited and general cautions to protect Clorox under the PSLRA’s safe harbor and the ‘bespeaks caution’ doctrine.” The Ninth Circuit disagreed, finding the basis for the district judge’s holding was that the forward-looking statements were accompanied by meaningful cautionary language, not the relative length of the statements. Although plaintiffs argued that the lower court should not have considered cautionary language contained in Clorox’s Form 10-K filing in making this determination, the appellate court found that the officer defendant had referenced the risk factors in the Form 10-K during the call and “the PSLRA does not require that the cautions physically accompany oral statements.”

Holding: Affirming grant of partial summary judgment and judgment on the pleadings.

Quote of note: “It is with respect to these statements that the court observed that [the officer defendant] ‘spoke only a couple of sentences and provided an approximate timetable.’ Investors submit that the court’s holding that ‘short whoppers don’t count’ is error, but we read its decision as turning on context rather than word count.”

To survive a motion to dismiss, the PSLRA requires plaintiffs bringing a securities fraud claim to plead facts establishing a “strong inference” that the defendants acted with scienter (i.e., fraudulent intent). There are two components to this analysis: (1) what is the substantive standard for scienter; and (2) what must a plaintiff allege to meet the “strong inference” pleading requirement. Until last week, the U.S. Court of Appeals for the Fourth Circuit had declined to take a position on either of these issues. Not anymore.

In Ottmann v. Hanger Orthopedic Group, 2003 WL 22992292 (4th Cir. Dec. 22, 2003), the court joined every other circuit in holding that scienter may be established by pleading not only intentional misconduct, but also recklessness (although it must be “severe recklessness [that] is, in essence, a slightly lesser species of intentional misconduct”). Having established the substantive standard, the court turned to what a plaintiff must plead to meet the PSLRA’s “strong inference” pleading requirement.

The court found that “Congress ultimately chose not to specify particular types of facts that would or would not show a strong inference of scienter [as part of the PSLRA].” As a result, the court concluded that a “flexible, case-specific analysis is appropriate in examining scienter pleadings.” Although facts establishing “motive and opportunity to commit fraud (or lack of such facts) may be relevant to the scienter inquiry, the weight accorded to those facts should depend on the circumstances of each case.”

In applying this flexible analysis to the instant case, the court found that there were insufficient facts demonstrating that any of the alleged misstatements were the product of reckless or intentional conduct (as opposed to negligence). Moreover, the court noted that the plaintiffs failed to allege that the individual defendants had any personal motive to make the alleged misstatements, “such as to facilitate personal sales of Hanger stock.” Instead, plaintiffs argued that the defendants were motivated to misrepresent Hanger’s financial situation so as to maintain the company’s positive relationships with its creditors, avoid additional interest payments, and promote future acquisitions. The court concluded that other courts “have repeatedly rejected these types of generalized motives — which are shared by all companies — as insufficient to plead scienter under the PSLRA.”

Holding: Affirm the dismissal of complaint.

Quote of note: “We therefore conclude that courts should not restrict their scienter inquiry by focusing on specific categories of facts, such as those relating to motive and opportunity, but instead should examine all of the allegations in each case to determine whether they collectively establish a strong inference of scienter.”

Addition: Note that the facts of the case do not allow the Fourth Circuit to address an important issue. Based on the analysis in the opinion, it appears clear that the court could have affirmed the dismissal of the complaint based on the lenient Second Circuit pleading standard, as it has in other cases. See Phillips v. LCI Int., Inc. 190 F.3d 609 (4th Cir. 1999). Instead, the court chose to adopt and apply a new pleading standard in a case where the plaintiffs did not allege any personal motive to commit securities fraud (e.g., stock sales by the individual defendants). District courts in the Fourth Circuit are left with no practical guidance on what “weight” the appellate court thinks should be given to those types of allegations in determining whether a strong inference of scienter has been plead.

Many courts have declined to appoint a group of unrelated investors as the lead plaintiff in a securities class action, concluding that a group of this nature will be unable to effectively direct the litigation as envisioned by the PSLRA. See, e.g., In re Milestone Scientific Sec. Litig., 183 F.R.D. 404 (D.N.J. 1998) (“Where multiple lead plaintiffs have divergent interests, the leadership of the class may be divided, and rendered factious.”). If it did not agree with this reasoning before, the U.S. Court of Appeals for the Eighth Circuit probably does now.

In In re BankAmerica Corp. Sec. Litig., 2003 WL 22844301 (8th Cir. Dec. 2, 2003), the court addressed what weight a district court must give to “a fraction of a fractured lead plaintiff group” that objected to the settlement terms agreed to by lead counsel. The plaintiffs alleged losses caused by misrepresentations and omissions surrounding the 1998 merger of NationsBank and BankAmerica to form Bank of America. After the consolidation of numerous actions, the district court appointed a seven-member lead plaintiff group to represent the NationsBank classes and a six-member lead plaintiff group to represent the BankAmerica classes. According to the appellate court, “[n]o members of the lead plaintiff groups were institutional investors nor did they have relationships with one another prior to this litigation.”

Shortly before trial, there was a mediation that led to the signing of a memorandum of understanding with the defendants for a $490 million global settlement of all claims. Three members of the NationsBank lead plaintiff group objected to the settlement. In particular, “[t]hey alleged that class counsel instructed them to leave the mediation because it was futile, but that class counsel remained and reached the proposed global settlement for an amount far below that which they had authorized.” The district court found that the PSLRA is silent on what to do under these circumstances. In the absence of legislative guidance, it held a fairness hearing and determined to approve the settlement despite the objections.

On appeal, the Eight Circuit noted that while the PSLRA “is explicit on the lead plaintiff’s authority to select and retain counsel, it is silent on the other responsibilities and rights that lead plaintiffs have to control, direct, and manage class action securities litigation.” It certainly does not address whether a group of lead plaintiffs have to agree on a proposed settlement before it can be reviewed and approved by the district court. In any event, the appellate court limited itself to the narrower question of “what weight a district court must give to objections from a fraction of a fractured lead plaintiff group” and held that the district court did not abuse its discretion under Fed.R.Civ.P. 23 in approving the settlement despite the objections.

Holding: Judgment of district court is affirmed.

Quote of note: “We leave for another day a determination of how much control over litigation the [PSLRA] confers on a singular lead plaintiff or unified lead plead plaintiff group.”

In Roberts v. Dean Witter Reynolds Inc., 2003 WL 1936116 (M.D. Fla. March 31, 2003), the court found that the legislative history of the Sarbanes-Oxley Act of 2002, which extended the statute of limitations for federal securities fraud claims to the earlier of two years after the discovery of the facts constituting the violation or five years after such violation, revealed Congress’s intent to revive claims that had already expired as of the date of the legislation’s enactment (July 30, 2002). The court, however, primarily relied on floor statements made by a single senator and a few sentences in a congressional analysis of the legislation in reaching this conclusion. It also certified an interlocutory appeal.
The Fulton County Daily Report has coverage of the oral argument in Roberts before the U.S. Court of Appeals for the 11th Circuit. The panel apparently expressed skepticism about the lower court decision, including Chief Judge Edmonson’s comment that to establish Congress meant to revive time-barred claims: “You’re going to have to show me something with neon light and underlined by Congress.” The 11th Circuit will be the first federal court of appeals to rule on this issue.
Quote of note: “[Visiting 9th Circuit Senior Judge] Farris later chimed in that Congress knows how to use the word ‘revive,’ suggesting that if Congress had wanted Sarbanes-Oxley to be able to revive previously expired claims, it could have done so. ‘They didn’t,’ Farris added.”
The 10b-5 Daily has previously posted about the recent district court decisions (including Roberts) addressing the retroactivity of the new statute of limitations.

Rule 15(a) of the Federal Rules of Civil Procedure provides that leave to amend a complaint “should be freely given when justice so requires.” The PSLRA, on the other hand, states “[i]n any private action arising under this chapter, the court shall, on the motion of any defendant, dismiss the complaint if the [pleading] requirements . . . are not met.” It is a tension-packed clash leading to the inevitable question: how many bites at the apple are too many in a securities class action?

The U.S. Court of Appeals for the Sixth Circuit does not give an exact answer in Miller v. Champion Enterprises, Inc., 2003 WL 22298649 (6th Cir. Oct. 8, 2003), but it does conclude that repeated amendments should not be permitted. In Miller, the plaintiffs moved for leave to file a second amended complaint (the fourth complaint in the action) after their first amended complaint was dismissed for failure to meet the PSLRA’s pleading requirements. The district court denied the motion for two reasons: (1) the PSLRA was designed to prevent strike suits and “could not achieve this purpose if plaintiffs were allowed to amend and amend until they got it right;” and (2) the proposed amended complaint was futile because it did not correct the earlier pleading deficiencies.

In affirming the decision, the Sixth Circuit states that the “district court also correctly held that allowing repeated filing of amended complaints would frustrate the purpose of the PSLRA.” The appellate court expressly rejects the argument that courts should be lenient in allowing amendments to pleadings in securities fraud cases because plaintiffs do not have discovery available to them.

Holding: Dismissal affirmed.

Quote of note: “In light of [the PSLRA’s heightened pleading] requirements, we think it is correct to interpret the PSLRA as restricting the ability of plaintiffs to amend their complaint, and thus as limiting the scope of Rule 15(a) of the Federal Rules of Civil Procedure.”

Just when you thought there could not possibly be another appellate loss causation pleading case this summer, along comes the Second Circuit to clarify its position on the issue.

To recap the current scorecard, a clear split in authority has developed between courts that believe plaintiffs must demonstrate a causal connection between the alleged misrepresentations and a subsequent decline in the stock price to establish loss causation (Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir. 2000); Robbins v. Koger Props, Inc., 116 F.3d 1441 (11th Cir. 1997)) and courts that believe plaintiffs merely need to demonstrate that the alleged misrepresentations artificially inflated the stock price (Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824 (8th Cir. 2003); Broudo v. Dura Pharmaceuticals, Inc., 339 F.3d 933 (9th Cir. 2003)). (The 10b-5 Daily has discussed the Gebhardt and Broudo cases, both decided in the last few months, in previous posts.)

Breaking the apparent tie is the Second Circuit’s opinion in Emergent Capital Investment Management, LLC v. Stonepath Group, Inc., 2003 WL 22053957 (2d Cir. Sept. 4, 2003), which clarifies some confusion over the Second Circuit’s approach to loss causation. Several courts, including the Ninth Circuit in the Broudo decision, have concluded that the Second Circuit finds allegations of artificial price inflation sufficient to plead loss causation (relying on a 2001 opinion in the Suez Equity case). Not so fast.

In Emergent Capital, the court found that the plaintiff’s “pump-and-dump” allegations were sufficient to establish loss causation. Judge Cardamone, however, took exception to the plaintiff’s attempt to cite his earlier decision in Suez Equity for the position that a “purchase-time value disparity” can satisfy the loss causation pleading requirement. Devoting an entire section of the opinion to the question, Judge Cardamone clarifies:

“We did not mean to suggest in Suez Equity that a purchase-time loss allegation alone could satisfy the loss causation pleading requirement. To the contrary, we emphasized that the plaintiffs had ‘also adequately alleged a second, related, loss–that [the executive’s] concealed lack of managerial ability induced [the company’s] failure.’ Moreover, we expressly distinguished that case from one where the ultimate decline in the market price of a company’s securities would be unrelated to that company’s manager’s concealed negative history.”

The court goes on to conclude that Suez Equity did not undermine the Second Circuit’s “established requirement that securities fraud plaintiffs demonstrate a causal connection between the content of the alleged misrepresentations or omissions and ‘the harm actually suffered.'”

So now we know where the Second Circuit stands. Anybody else? There’s still a week of summer left!

Holding: Judgment of the district court is affirmed, in part, and vacated, in part, and remanded to the district court.

Many thanks to Colin Wrabley for pointing The 10b-5 Daily to this case.