Category Archives: Appellate Monitor

Omnicare Argued

On Monday, the U.S. Supreme Court heard oral argument in the Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund case, which addresses the pleading standard for a claim under Section 11 of the Securities Act alleging a false or misleading opinion in a registration statement.  While the Second, Third, and Ninth Circuits have held that the plaintiff must allege the statement was both objectively and subjectively false – requiring allegations that the speaker’s actual opinion was different from the one expressed – in Omnicare the Sixth Circuit held that if a defendant “discloses information that includes a material misstatement [even if it is an opinion], that is sufficient and a complaint may survive a motion to dismiss without pleading knowledge of falsity.”

At oral argument, the focus was on what role the speaker’s basis, or lack thereof, for the opinion should play in evaluating falsity.  Omnicare argued that the “ultimate legal inquiry is whether the speaker did not possess the stated belief,” but “if it’s a case where the speaker truly has no basis for the opinions, we believe it will be quite possible for a plaintiff to include all of these underlying allegations about the basis as a way of showing subjective disbelief.”  The Court appeared concerned, however, about situations where a defendant could avoid liability even though the speaker either (a) had not done any due diligence to support the stated opinion (Justice Breyer), or (b) knew, but failed to disclose, that the basis for the opinion was weak (Justice Kagan).  Justice Kagan, in particular, suggested that if a registration statement contained an opinion that a transaction was legal, “a reasonable reader would look at that statement and say two things actually: Both, he’s done something to try to check as to whether the transaction is legal, and he doesn’t know anything that’s very dispositive going the other way.”

At the same time, the Court did not appear noticeably more sympathetic to the position taken by the plaintiffs (and the Sixth Circuit), who argued that even if an opinion had a reasonable basis, it could be actionable if it turned out to be objectively false.  Justice Ginsburg noted that the effect of that position is “there is no such thing as an opinion versus a fact, that it’s just the same as if they left out ‘we believe.'”

Ultimately, the Court spent most of the argument discussing the government’s proposed “middle ground,” which is that an opinion should be actionable if “[e]ither they didn’t believe what they were saying, or there was no reasonable basis for what they were saying.”  Justice Alito expressed concern that the Court needed “some more concrete guidance as to what is reasonable.”  For example, if a CEO plans to state his opinion that nobody in the company was paying bribes, “[d]oes he have to hire an outside firm to do an investigation to see if maybe somebody is paying bribes?”  Both plaintiffs and the government suggested that reasonableness is a “context-specific inquiry,” but Justice Alito countered that if the opinion turned out to be inaccurate, “it’s not going to be very hard” for the plaintiff to assert that a “reasonable investigation” would have revealed that the opinion was false or misleading.  Omnicare, for its part, argued that “an amorphous liability standard like the reasonable basis standard will really have a chilling effect” by encouraging companies not to offer their opinions about the company’s prospects.

The Court will issue its opinion by next June.


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Middle Ground

How to evaluate corporate scienter continues to be an unresolved issue in securities litigation.  Some courts, notably the Fifth Circuit (and arguably the Eleventh Circuit), have taken the position that a court can only “look to the state of mind of the individual corporate official or officials who make or issue the statement (or order or approve it or its making or issuance, or who furnish information or language for inclusion or the like).”  Conversely, the Second, Seventh, and Ninth Circuits have suggested that under some circumstances plaintiffs should be allowed to plead collective corporate scienter, i.e., that some corporate officer knew the statement was false even if the plaintiff is unable to adequately allege that any particular corporate officer knew the statement was false.

In In re Omnicare, Inc. Sec. Litig., 2014 WL 5066826 (6th Cir. Oct. 10, 2014), the court addressed this circuit split and concluded that “a middle ground is necessary.”  On the one hand, the court found that the Fifth Circuit’s approach might encourage companies to engage in “tacit encouragement and willful ignorance.”  On the other hand, a broad application of collective scienter (which the Sixth Circuit itself had seemed to endorse in an earlier decision) creates the possibility “that a company could be liable for a statement made regarding a product so long as a low-level employee, perhaps in another country, knew something to the contrary.”

Accordingly, the court adopted the following formulation for evaluating corporate scienter, which it took from a law review article on the topic.

The state(s) of mind of any of the following are probative for purposes of determining whether a misrepresentation made by a corporation was made by it with the requisite scienter under Section 10(b): . . .

a. The individual agent who uttered or issued the misrepresentation;

b. Any individual agent who authorized, requested, commanded, furnished information for, prepared (including suggesting or contributing language for inclusion therein or omission therefrom), reviewed, or approved the statement in which the misrepresentation was made before its utterance or issuance;

c. Any high managerial agent or member of the board of directors who ratified, recklessly disregarded, or tolerated the misrepresentation after its utterance or issuance . . . .

The court concluded that this formulation was consistent with the Sixth Circuit’s earlier decision, would properly create potential liability for “corporations that willfully permit or encourage the shielding of bad news from management,” and would “protect corporations from liability – or strike suits – when one individual unknowingly makes a false statement that another individual, unrelated to the preparation or issuance of the statement, knew to be false or misleading.”

Although the Sixth Circuit describes its formulation as a “middle ground,” critics may question whether it is really different than the Fifth Circuit’s standard, and, if it is, whether it will accomplish the court’s stated goals.  Notably, sections (a) and (b) of the formulation are simply a restatement of the Fifth Circuit’s formulation – agents who made, approved, or directly contributed to the misstatement.  So the key difference is section (c), but the court offers no guidance as to how lower courts are supposed to determine whether a plaintiff has adequately plead that an agent “ratified, recklessly disregarded, or tolerated” the misstatement after it was made.  Section (c) also goes beyond the stated goal of describing which agent’s state of mind should be examined.  Finally, what does the court see as the significance of a corporate officer recklessly disregarding or tolerating the misstatement after it was issued?  Scienter is usually assessed as of the time of the alleged misstatement.  If a corporate officer later discovers that a corporate statement is false, he may have a duty to correct that misstatement (which could provide a separate basis for securities liability), but that does not establish the misstatement was made with scienter.  Stay tuned.

Holding: Dismissal affirmed (among other pleading deficiencies, the plaintiffs failed to adequately plead corporate scienter under the new formulation).

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Confirmatory Information

In its Halliburton II decision, the Supreme Court held that a securities fraud defendant can overcome the fraud-on-the-market presumption of reliance at the class certification stage of a case “through evidence that the misrepresentation did not in fact affect the stock price.”  Some defendants have argued that this means that if the company’s stock price did not increase when the alleged misrepresentations were made, the fraud-on-the-market presumption is not applicable.

Two recent decisions have questioned this line of reasoning.  In Local 703, I.B. of T. Grocery and Food Employees Welfare Fund v. Regions Financial Corp., 2014 WL 3844070 (11th Cir. Aug. 6, 2014), the court remanded the case so that the district court could consider evidence that the company’s “stock price did not change in the wake of any of the alleged misrepresentations.”  The court noted, however, that this evidence might not be sufficient to overcome the fraud-on-the-market presumption because the misrepresentations could have been “confirmatory information” that the market had already incorporated into the stock price.

Similarly, in McIntire v. China Mediaexpress Holdings, Inc., 2014 WL 4049896 (S.D.N.Y. Aug. 15, 2014), the court granted class certification as to certain claims because a “material misstatement can impact a stock’s value either by improperly causing the value to increase or by improperly maintaining the existing stock price.”  The court was “not persuaded” that the auditor defendant had demonstrated no stock price impact as the result of its allegedly false audit opinion because (a) only days before the audit opinion was issued the company’s “stock price increased based on its release of unaudited financial statements,” and (b) “it is reasonable to infer that this increase included the market’s expectation that [the] audit opinion would later confirm the accuracy of [the company’s] financial statements.”

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Duties to Disclose

Item 303 of Regulation S-K requires issuers to disclose known trends or uncertainties “reasonably likely” to have a material effect on operations, capital, and liquidity.  Plaintiffs often contend that if the disclosure required under Item 303 involves material information, then a company’s failure to disclose that information constitutes a material omission for purposes of securities fraud liability.

In In re NVIDIA Corp. Sec. Litig., 2014 WL 4922264 (9th Cir. Oct. 2, 2014), the Ninth Circuit considered this issue, but declined to find that the disclosure duty created by Item 303 can form the basis for an actionable securities fraud claim.  First, companies do not have “an affirmative duty to disclose any and all material information.”  Second, the “duty to disclose under Item 303 is much broader that what is required under” the general materiality standard for securities fraud.  As a result, plaintiffs cannot rely on the duty of disclosure created by Item 303 to form the basis of a securities fraud claim, but must separately demonstrate that the company had a duty to disclose because the omission of the information rendered the company’s statements false or misleading.

Holding: Dismissal affirmed.

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Standing Alone

Can the announcement of an investigation act as a “corrective disclosure” sufficient to support the existence of loss causation?  Last year, the Eleventh Circuit concluded that investigations do not “in and of themselves, reveal[] to the market that a company’s previous statements were false or fraudulent.”

In Loos v. Immersion Corp., 2014 WL 3866084 (9th Cir. Aug. 7, 2014), the Ninth Circuit has agreed with the Eleventh Circuit’s reasoning.  In particular, the court noted that because the disclosure of an investigation “simply puts investors on notice of a potential future disclosure of fraudulent conduct . . . any decline in a corporation’s share price following the announcement of an investigation can only be attributed to market speculation about whether fraud has occurred.”  Accordingly, “the announcement of an investigation, without more, is insufficient to establish loss causation.”

Holding: Dismissal affirmed.

Addition: Interestingly, this month the Ninth Circuit added a footnote to the decision clarifying that it did not “mean to suggest that the announcement of an investigation can never form the basis of a viable loss causation theory.”  Instead, the court was merely adopting the Eleventh Circuit’s position that the announcement of an investigation “standing alone and without any subsequent disclosure of actual wrongdoing, does not reveal to the market the pertinent truth of anything, and therefore does not qualify as a corrective disclosure.”

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Fervent Beliefs

Next term, the U.S. Supreme Court will hear argument in the Omnicare case.  The issue in Omnicare is the pleading standard for a claim under Section 11 of the Securities Act alleging a false or misleading opinion.  While the Second, Third, and Ninth Circuits have held that the plaintiff must allege the statement was both objectively and subjectively false – requiring allegations that the speaker’s actual opinion was different from the one expressed – in Omnicare the Sixth Circuit held that if a defendant “discloses information that includes a material misstatement [even if it is an opinion], that is sufficient and a complaint may survive a motion to dismiss without pleading knowledge of falsity.”

While Omnicare is pending, the Tenth Circuit has provided its own views on the subject.  In MHC Mutual Conversion Fund, L.P. v. Sandler O’Neill & Partners, L.P., 2014 WL 3765717 (10th Cir. Aug. 1, 2014), the court identified at least three possible conclusions that could be drawn from Section 11 and relevant legal precedent.  First, the court noted that “many common law authorities took a dim view of opinion liability” and one could find that Section 11 liability simply does not extend to opinions (as opposed to misstatements of fact).  Second, “an opinion can qualify as a factual claim by the speaker regarding his current state of mind.”  In that case, the opinion might be actionable if the plaintiff shows “both that the defendant expressed an opinion that wasn’t his real opinion (sometimes called ‘subjective disbelief’) and that the opinion didn’t prove out in the end (sometimes called ‘objective falsity’).”  Finally, there is support in the law for the view that “at least some subset of opinions about future events contain within them an implicit factual warranty that they rest on an objectively reasonable basis – and providing an opinion without an objectively reasonable foundation, at least without disclosing that deficiency, can give rise to a claim for negligent misrepresentation.”

Although the Tenth Circuit – in line with the majority view – appeared inclined to require allegations of both objective and subjective falsity, it found that it did not have to resolve the issue.  Even under the “objectively reasonable basis test,” the plaintiffs had failed to undermine the conclusion that the company had “a reasonable (if not universally shared) basis for the opinion it expressed.”  Moreover, the company had clearly disclosed that its “opinion about the prospects for its securities wasn’t unqualified – that an essential premise of the opinion rested on a judgment about near-term economic trends, a judgement that could well fail to bear out.”

Holding: Dismissal affirmed.

Quote of note:  “For centuries legions accepted Newtonian physics without qualification.  Last year some of us fervently believed the Broncos would win the Super Bowl.  In 2008, no doubt there were those who genuinely thought the market for mortgage backed securities would rebound.  Events have disproved each of these opinions, but that hardly means the opinions were anything other than honestly offered – true opinions at the time made.”

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No Bright Line

In its Morrison decision, the U.S. Supreme Court addressed the extraterritorial application of Section 10(b) and held that the statute only applies to “transactions in securities listed on our domestic exchanges, and domestic transactions in other securities.” While this formulation clearly excludes foreign transactions, does it conversely mean that any “domestic transaction” in a foreign security can be subject to potential Section 10(b) liability?

The Second Circuit had the opportunity to address this question in a case involving an unusual fact pattern. In Parkcentral Global Hub Ltd. v. Porsche Automobile Holdings SE, 2014 WL 3973877 (2d Cir. August 15, 2014) , the plaintiffs had entered into “securities based-swap agreements pegged to the price of VW [Volkswagen] shares, which trade on European stock exchanges, to bet that VW stock would decline in value.” The plaintiffs alleged that VW “made various fraudulent statements and took various manipulative actions to deny and conceal Porsche’s intention to take over VW.” When it became public that Porsche would take over VW, “the price of VW shares rose dramatically, causing the plaintiffs to suffer large losses.”

While the Second Circuit assumed, for purposes of its decision, that the swap agreements were “executed and performed in the United States,” it found that this was not sufficient under Morrison to justify the application of Section 10(b). First, the Supreme Court “never said that an application of § 10(b) will be deemed domestic whenever such a transaction is present.” Second, applying the statute “to wholly foreign activity clearly subject to regulation by foreign authorities solely because a plaintiff in the United States made a domestic transaction” would “inevitably place § 10(b) in conflict with the regulatory laws of other nations.” As to the VW-related swap agreements, the court held “that the relevant actions in this case are so predominately German as to compel the conclusion that the complaints fail to invoke § 10(b) in a manner consistent with the presumption against extraterritoriality.”

Holding: Dismissal affirmed and case remanded for proceedings consistent with decision.

Quote of note: “We have neither the expertise nor the evidence to allow us to lay down, in the context of the single case before us, a rule that will properly apply the principles of Morrison to every future § 10(b) action involving the regulation of securities-based swap agreements in particular or of more conventional securities generally. Neither do we see anything in Morrison that requires us to adopt a ‘bright-line’ test of extraterritoriality when deciding every § 10(b) case. . . . It is enough to say that we think our decision in this case is compelled by the text of the Exchange Act and the principles underlying the Supreme Court’s decision in Morrison, as applied to our facts.”

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Too Tangential

In its recent Chadbourne decision, the U.S. Supreme Court held that to be “in connection with” the purchase or sale of a security, an alleged securities fraud must involve “victims who took, who tried to take, who divested themselves of, who tried to divest themselves of, or who maintaned an ownership interest in financial instruments that fall within the relevant statutory definition.” Whether that requirement is met, of course, depends heavily on the particular facts at issue.

In Hidalgo-Velez v. San Juan Asset Management, Inc., 2014 WL 3360698 (1st Cir. July 9, 2014) the court addressed whether SLUSA preemption, which applies only to cases involving the purchase or sale of securities traded on a national exchange (“covered securities”), could be invoked if the plaintiffs were investors in a fund that promised to invest at least 75% of its assets “in certain specialized notes offering exposure to North American and European bond indices.” As a threshold matter, the fund shares were not covered securities. The court found, however, that “the analysis does not invariably end there.” To the extent that “the primary intent or effect of purchasing an uncovered security is to take an ownership interest in a covered security,” the “in connection with” requirement could still be met.

The court held that in analyzing this issue, the “relevant questions include (but are not limited to) what the fund represents its primary purpose to be in soliciting investors and whether covered securities predominate in the promised mix of investments.” In the instant case, it was clear the fund was marketed “principally as a vehicle for exposure to uncovered securities” (i.e., the specialized notes). Accordingly, the “in connection with” requirement was not met and SLUSA preemption did not apply.

Holding: Judgment of dismissal vacated, reversal of order denying remand, and remittal of case with instructions to return it to state court.

Quote of note: “As pleaded, the plaintiffs’ case depends on averments that, in substance, the defendants made misrepresentations about uncovered securities (namely, those investments that were supposed to satisfy the 75% promise); that the plaintiffs purchased uncovered securities (shares in the Fund) based on those misrepresentations; and that their primary purpose in doing so was to acquire an interest in uncovered securities. Seen in this light, the connection between the misrepresentations alleged and any covered securities in the Fund’s portfolio is too tangential to justify bringing the SLUSA into play.”

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Doubling Down

In Spitzberg v. Houston American Energy Corp., 2014 WL 3442515 (5th Cir. July 15, 2014), the Fifth Circuit reversed the dismissal of a securities class action based on alleged false statements concerning oil and gas reserves. The decision contains a few interesting holdings.

(1) Scienter – The district court found, among other things, that the company’s decision to spend $5 million on more testing of one of its wells “would not make sense” if the defendants had believed that no oil or gas would be found. The Fifth Circuit noted, however, that this testing took place after the company had been “heavily criticized” for making optimistic statements regarding its reserves. Accordingly, it was just as plausible that the defendants “may have felt the need to substantiate the allegedly irresponsible statements they had made previously.”

(2) Loss Causation – The district court held that the complaint “warranted dismissal because it did not allege specifically whether the alleged misstatements or omissions were the actual cause of [the plaintiffs’] economic loss as opposed to other explanations, e.g., changed economic circumstances or investor expectations or industry-specific facts.” The Fifth Circuit disagreed with this pleading standard. Instead, the court concluded that “the PSLRA does not obligate a plaintiff to deny affirmatively that other facts affected the stock price in order to defeat a motion to dismiss.”

(3) Forward-looking Statements – The Fifth Circuit joined “the First Circuit, Third Circuit, and Seventh Circuit in concluding that a mixed present/future statement is not entitled to the [PSLRA safe harbor for forward-looking statements] with respect to the part of the statement that refers to the present.” In particular, while the company’s statements concerning the commercial productability of its wells were forward-looking, to the extent that its statements about “reserves” communicated information on past testing of the wells, those statements were actionable.

Holding: Reversed and remanded for further proceedings.

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Halliburton Decided

The U.S. Supreme Court has issued a decision in the Halliburton case holding 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. It is a 9-0 decision authored by Chief Justice Roberts, although Justice Thomas (joined by Justices Alito and Scalia) concurred only in the judgment. As discussed in a February 2010 post on this blog, Halliburton has a long history that now includes two Supreme Court decisions on class certification issues. A summary of the earlier Supreme Court decision can be found here.

Under the fraud-on-the-market presumption, reliance by investors on a misrepresentation is presumed if the misrepresentation is material and the company’s shares were traded on an efficient market that would have incorporated the information into the stock price. The fraud-on-the-market presumption is crucial to pursuing a securities fraud case as a class action – without it, the proposed class of investors would have to provide actual proof of its common reliance on the alleged misrepresentation, a daunting task for classes that can include thousands of investors.

The fraud-on-the-market presumption, however, is not part of the federal securities laws. It was judicially created by the Supreme Court in a 1988 decision (Basic v. Levinson). In Halliburton, the Court agreed to revisit that decision, but ultimately decided that there was an insufficient “special justification” for overturning its own precedent.

The Court rejected the following key arguments. First, Halliburton argued that the fraud-on-the-market presumption was no longer tenable because (a) there is substantial empirical evidence that capital markets are not fundamentally efficient, and (b) investors do not always invest in reliance on the integrity of a stock’s price. The Court found, however, that the Basic decision was not undermined by either of these arguments because it was based “on the fairly modest premise that market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.” Accordingly, “[d]ebates about the precise degree to which stock prices accurately reflect public information are . . . largely beside the point” and it is sufficient that most investors do rely, either directly or indirectly, on the accuracy of stock prices.

Second, Halliburton argued that the fraud-on-the-market presumption could not be reconciled with more recent Court decisions making it clear that plaintiffs must prove that their proposed class meets all of the certification requirements imposed by the Federal Rules of Civil Procedure. The Court disagreed, noting that plaintiffs who invoke the fraud-on-the-market presumption must still prove certain prerequisites for that presumption – publicity, market efficiency, and market timing – before class certification.

Finally, Halliburton argued that the fraud-on-the-market presumption, by facilitating securities class actions, “allow[s] plaintiffs to extort large settlements from defendants from meritless claims; punish innocent shareholders, who end up having to pay settlements and judgments; impose excessive costs on businesses; and consume a disproportionately large share of judicial resources.” The Court found that these “concerns are more appropriately addressed to Congress, which has in fact responded, to some extent, to many of the issues raised by Halliburton and its amici.” Moreover, the fact that Congress “may overturn or modify any aspect of our interpretations of the reliance requirement, including the Basic presumption itself” supports the notion that the principle of stare decisis should be applied to the Basic decision.

Although the Court was unwilling to overturn Basic, it did agree with Halliburton that defendants should be able to rebut the fraud-on-the-market presumption with evidence that the alleged misrepresentation did not actually affect the stock price. Notably, price impact evidence is already used at the class certification stage “for the purpose of countering a plaintiff’s showing of market efficiency” by establishing that the stock price did not react to publicly reported events. If it can be used to rebut this prerequisite for the fraud-on-the-market presumption (which is nothing more than “an indirect showing of price impact”), the Court found that it also should be available to directly rebut the presumption as to the specific misrepresentation.

Holding: Vacated judgment and remanded for further proceedings consistent with opinion.

Notes on the Decision:

(1) There are two concurrences, which go in radically opposite directions. A concurrence authored by Justice Ginsburg (joined by Justices Breyer and Sotomayor) simply states that she joins the opinion because she understands that it “should impose no heavy toll on securities-fraud plaintiffs with tenable claims.” In contrast, Justice Thomas (joined by Justices Scalia and Alito) concurs only in the judgment and forcefully argues that the Basic decision should be overturned, noting that “[t]ime and experience have pointed up the error of that decision, making it all too clear that the Court’s attempt to revise securities law to fit the alleged new realities of financial markets should have been left to Congress.”

(2) Missing from the fray is Justice Kennedy, who joined Justice Thomas’ dissent in the recent Amgen decision. In that dissent, Justice Thomas expressed skepticism about the continued vitality of the fraud-on-the-market presumption. A number of commentators therefore assumed that Justice Kennedy was interested in overturning the Basic decision. Apparently not.

Disclosure: The author of The 10b-5 Daily submitted an amicus brief on behalf of the Washington Legal Foundation in support of petitioner. The amicus brief primarily argued that the Court should permit defendants to rebut the fraud-on-the-market presumption with price impact evidence.

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