Category Archives: Appellate Monitor

Less than many other circuit courts have required, is the answer from the U.S. Court of Appeals for the Tenth Circuit in Adams v. Kinder-Morgan, Inc., 2003 WL 21906117 (10th Cir. August 11, 2003). Pursuant to the PSLRA, plaintiffs attempting to plead securities fraud based on information and belief (as opposed to personal knowledge) must “state with particularity all facts” supporting their belief that the specified statements were misleading. Courts have routinely grappled with the meaning of the words “all facts.”

The Second Circuit, in Novak v. Kasaks, 216 F.3d 300 (2d Cir. 2000), concluded that interpreting the text literally would lead to absurd results, including requiring dismissal “where the complaint pled facts fully sufficient to support a convincing inference if any known facts were omitted.” The Second Circuit tempered its holding, however, by finding that it is not enough for plaintiffs to baldly allege facts in support of their allegations, they must provide “documentary evidence and/or a sufficient general description of the personal sources of the plaintiffs’ beliefs.” (The Fifth Circuit has also adopted this approach, while the First and Ninth Circuits have required detailed source information.)

In Adams, the Tenth Circuit agreed with the Second Circuit that “all facts” should not be interpreted literally, but declined to impose a requirement that plaintiffs state the source of their facts. Noting that the PSLRA did not “purport to move up the trial to the pleadings stage” and does not mention the pleading of sources, the court held that it will “apply a common-sense, case-by-case approach in determining whether a plaintiff has alleged securities fraud with the particularity required by [the PSLRA] without adding a per se judicial requirement that the source of facts must always be alleged to support substantive allegations of fraud in an information and belief complaint.” The court did note, however, that in the absence of source information, the facts in the complaint “will usually have to be particularly detailed, numerous, plausible, or objectively verifiable by the defendant before they will support a reasonable belief that the defendant’s statements were false or misleading.”

Holding: Reversed in part (dismissal based on a lack of particularity, and other grounds, as to all defendants), affirmed in part (dismissal based on insufficient scienter allegations and lack of control as to one defendant).

Quote of note: “While the PSLRA certainly heightened pleading standards for securities fraud lawsuits, we believe that if Congress had intended in securities fraud lawsuits to abolish the concept of notice pleading that underlies the Federal Rules of Civil Procedure, Congress would have done so explicitly.”

The McKesson HBOC securities fraud cases have generated a number of interesting legal developments over the years. The cases are based on the 1999 merger between McKesson and HBO & Co. After the merger was closed, McKesson announced that HBOC had improperly recorded certain software sales as revenues and that HBOC’s financial results would have to be restated. Several securities class actions were filed and the New York State Common Retirement Fund was eventually selected as the lead plaintiff.

In January 2001, McKesson filed a complaint and compulsory counterclaim against the Fund and former HBOC shareholders who exchanged more than 20,000 shares of HBOC stock for McKesson stock. The theory was that the investors were unjustly enriched by trading inflated HBOC shares for properly-valued McKesson shares. The district court dismissed the claim.

On Wednesday, the U.S. Court of Appeals for the Ninth Circuit weighed in on the case, holding that McKesson cannot sue its own investors on an unjust enrichment theory. First, the court held that an equitable remedy for McKesson was unnecessary given that there are legal remedies available to the company for the same alleged wrong. “McKesson has potential legal claims against any number of parties who, unlike the former shareholders, actually played a substantial role in the decision to enter the Merger Agreement; the former HBOC shareholders are not the only targets for recovery.” Second, the court declined to pierce the corporate veil to create liability for HBOC’s shareholders, noting that “there is no allegation that the HBOC shareholders exercised – or even had the ability to exercise – domination or control over HBOC.” Finally, the court concluded that the expansion of liability to the shareholders, who were unaware of the risk that they could be personally liable for corporate acts, would be unjust.

The Recorder has a story on the case (via law.com) and the decision can be found here. The case certainly highlights the difficulties in determining the winners and losers in securities fraud.

The Salt Lake Tribune reports today that the U.S. Court of Appeals for the Tenth Circuit has partially reversed the earlier dismissal of a securities class action against Novell. The appellate court held that claims alleging that Novell and certain of its officers “created a fictional ‘in transit’ category and improperly recorded shipments to OEMs (or original equipment manufacturers, companies that incorporated Novell products into retail computers, or acted as resellers) as sales revenue” could proceed. The suit is based on conduct that allegedly occurred in 1996 and 1997.

It has been a big summer for loss causation cases. A clear split in authority has developed between courts that believe plaintiffs must demonstrate a causal connection between the misrepresentations and a subsequent decline in the stock price (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 allege that the misrepresentations artificially inflated the stock price (Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824 (8th Cir. 2003)).

In Broudo v. Dura Pharmaceuticals, 2003 WL 21789028 (9th Cir. Aug. 5, 2003), the Ninth Circuit clarified that it will not require plaintiffs to establish a causal connection between the misrepresentations and a decline in the stock price: loss causation “merely requires pleading that the price at the time of purchase was overstated and sufficient identification of the cause.” The facts of the case, however, underline the problems with this reasoning. Broudo is a securities class action on behalf of investors who purchased Dura stock between April 15, 1997 and February 24, 1998. The defendants allegedly made misleading statements during that time period about, among other things, the clinical trials necessary to obtain new drug approval from the FDA for Dura’s Albuterol Spiros delivery device for asthma medication. On February 24, 1998, Dura revealed that it expected lower-than-forecast 1998 revenues and 1998 earnings per share, but did not make any disclosures about its Albuterol Spiros delivery system. The February 24 announcement caused Dura’s stock price to decline by 47%. It was not until November 1998, nearly nine months after the end of the class period, that Dura announced the FDA had “found the Albuterol Spiros device not approvable due to electro-mechanical reliability issues and chemistry, manufacturing, and control concerns.” The district court found that the plaintiffs had failed to properly plead loss causation for his claims based on misleading statements concerning the Albuterol Spiros device because the complaint did “not contain any allegations that the FDA’s non-approval [of the Albuterol Spiros device] had any relationship to the February price drop.”

The 9th Circuit reversed. The court did not address the logical inconsistency of the plaintiffs’ argument that statements revealed to be misleading in November caused them to suffer losses the previous February. Instead, the court found that it was unnecessary for the plaintiffs to plead “that a disclosure and subsequent drop in the market price of the stock have actually occurred, because the injury occurs at the time of the transaction.”

The decision improperly conflates transaction causation and loss causation. Plaintiffs may have purchased on the basis of the alleged misrepresentations, but any loss requires the stock they purchased to decline in value. The practical problems created by the Broudo opinion are significant. As noted by Judge Pollack in the Merrill Lynch cases, “allowing plaintiffs in a fraud on the market case to satisfy loss causation simply by alleging that a misrepresentation caused the price to be artificially inflated without having to allege any link between the conduct and the decline in price would undoubtedly lead to speculative claims and procedural intractibility.” Moreover, the PSLRA expressly states that plaintiffs have the burden of establishing that their losses were caused by the defendants’ acts or omissions. How can plaintiffs’ claims be plead with particularity if they do not connect the alleged fraudulent conduct to any loss?

Holding: Reversed and remanded with leave to amend.

The Securities Law Beacon reports that the Ninth Circuit has affirmed the dismissal of the securities class action against Read-Rite Corp. The court agreed with the lower court’s determination that the plaintiffs failed to adequately plead scienter.

The Eighth Circuit’s decision in the ConAgra case (Gebhardt v. ConAgra Foods, Inc., (8th Cir. June 30, 2003)) highlights how difficult it can be to establish the immateriality of alleged fraudulent statements at the motion to dismiss stage of a securities class action.

In ConAgra, plaintiffs alleged that the company had engaged in fraud by permitting its United Agri Products subsidiary to prematurely recognize revenue from sales where the delivery of the goods had not yet taken place. The Eighth Circuit found that “the problem was mostly one of having the money attributed to the wrong year, as opposed to not having ever made the money at all.” As a result, “ConAgra’s income, before taxes, was reduced by $111 million for the years 1998 through 2000, while its income for 2001 was increased by $127 million.” When the restatement was announced in May 2001, the stock price dropped from $20.61 to $20.07. It quickly recovered, however, and began to trend higher.

The district court dismissed the case on two bases. First, the lower court noted that the amount of earnings misrepresented was merely .4% of ConAgra’s total revenues during the years in question. The lower court concluded that “[a] reasonable investor with complete knowledge of the UAP accounting issues would have realized that ConAgra’s overall earnings were basically unaffected by any of those issues.” Second, the lower court held that the plaintiffs’ pleadings failed to allege loss causation. The alleged misrepresentations were immaterial and the company’s stock price was barely affected by the announcement of the restatement.

The Eighth Circuit disagreed with both conclusions. On the issue of materiality, the appellate court found that focusing on the percentage of total revenues misstated was insufficient. As a result of its revenue recognition problems, ConAgra overstated its net income for 1999 and 2000 by 8%. A discrepancy of that magnitude is not immaterial as a matter of law. The appellate court also found that it was inappropriate for the lower court to rely on the fact that ConAgra was eventually able to receive the revenues it prematurely recognized. The company “could not know for certain it would receive the profits it had booked.” Accordingly, a reasonable investor, at the time of the misrepresentation, may have found information about the premature revenue recognition to be material.

As for loss causation, the Eighth Circuit found that because the alleged misrepresentations were material, the plaintiffs can “invoke the fraud-on-the-market theory and assume that the misrepresentations inflated the stock’s price.” Even though the stock price did not decline when the restatement was announced, the appellate court declined “to attach dispositive significance to the stock’s price movements absent sufficient facts and expert testimony, which cannot be considered at this procedural juncture, to put this information in its proper context.”

The Eighth Circuit’s opinion leaves little room for a materiality argument to succeed on a motion to dismiss. Here, the amount of the restatement was relatively small (even for net income), the company’s overall finances were unaffected, and the stock market had virtually no reaction upon being told of the problem. Nevertheless, the appellate court goes out of its way to justify a finding that materiality and loss causation were adequately plead, including dismissing the lack of a negative stock market reaction by holding that “stockholders can be damaged in ways other than seeing their stocks decline. If a stock does not appreciate as it would have absent the fraudulent conduct, investors have suffered harm.” The allegations in the case, however, were that the company’s stock price was artificially inflated, not lowered, as a result of the misrepresentations.

Holding: Judgment of the district court reversed.

Quote of note: “A reasonable investor might be concerned about one of ConAgra’s subsidiaries reporting earnings not yet received, especially if this was done under orders from ConAgra’s senior management. The fraud-on-the-market theory then would allow the fact finder to presume that the stock’s price reflected the inflated earnings, and it makes sense to conclude that the plaintiffs were harmed when they paid more for the stock than it was worth.”

Addition: Note that the Eighth Circuit comes to virtually the opposite conclusion on materiality as the S.D.N.Y in the Allied Capital case. A discussion of Allied Capital can be found here.

Addition: Note also that other courts have expressly rejected the idea that the fraud on the market theory supports a presumption of loss causation. See, e.g., Robbins v. Koger Props, Inc., 116 F.3d 1441, 1448 (11th Cir. 1997).

The Associated Press reports that the 8th Circuit has overturned the district court’s dismissal of the securities class action against ConAgra Foods, Inc. Plaintiffs allege that ConAgra overstated the earnings of its subsidiary, UAP, by recognizing sales when the delivery of the goods had not yet taken place. As a result, ConAgra prematurely recognized revenue in the years 1998 through 2000. The case was originally filed in the D. of Neb.

The court’s opinion can be found here and contains an interesting discussion of materiality. More to follow.

The U.S. Court of Appeals for the Fourth Circuit has upheld the dismissal of a securities class action against Duratek, Inc., a Columbia, Md.-based company that disposes of radioactive waste materials for nuclear facililties. The opinion can be found here.

Any securities litigation opinion from the Fourth Circuit has the potential to be big news, because the court has never decided whether recklessness suffices to meet the scienter requirement for 10b-5 actions and, correspondingly, what a plaintiff must plead to satisfy the PSLRA’s heightened pleading standards for scienter. But no luck today. Duratek is a per curiam opinion and simply holds that “even under the lenient Second Circuit standard” the complaint failed to adequately plead scienter.

In Cantrell v. Cal-Micro, Inc. (9th Cir. May 28, 2003), the Ninth Circuit addressed whether a corporate officer who is personally liable for corporate fraud can discharge such a debt in bankruptcy. The panel held that the directors or officers of a California corporation are not fiduciaries within the meaning of the federal bankruptcy code. As a result, the judgment against Cantrell, for breach of his fiduciary duties, was dischargeable in bankruptcy. The Recorder has an article on the opinion and its potential impact on collecting judgments.
Note, however, that the Ninth Circuit�s ruling should not affect the ability of plaintiffs to collect judgments based on securities fraud claims. Section 803 of the Sarbanes-Oxley Act has amended the federal bankruptcy code to make judgments and settlements that result from a violation of federal and state securities laws (or common law securities fraud) non-dischargeable.