Category Archives: Appellate Monitor

Big Verdicts and Big Appeals

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.

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Not Congress’s Concern

The Securities Litigation Uniform Standards Act (“SLUSA) is designed to limit the ability of plaintiffs to avoid the heightened pleading standards (and other procedural and substantive protections) applicable to federal securities class actions by pleading their cases as violations of state law.  Accordingly, the statute precludes certain class actions based upon state law that allege a misrepresentation or deceptive conduct in connection with the purchase or sale of nationally traded securities.  Although SLUSA was enacted in 1998, the exact scope of its preclusive effect continues to be a hot topic, with a recent Supreme Court decision addressing the “in connection with” requirement.

In In re Kingate Management Ltd. Litigation, 2015 WL 1839874 (2d Cir. April 23, 2015), the court considered a different interpretive question: what does SLUSA mean when it proscribes the “main[tenance]” of a covered class action “alleging . . . [false conduct] in connection with the purchase or sale of a covered security”?  The Second Circuit concluded that “alleging” must be interpreted narrowly to only cover “conduct by the defendant falling within SLUSA’s specifications of conduct prohibited by the anti-falsity provisions” of the federal securities laws.  A broader application – e.g., to claims where the requisite falsity is a “necessary predicate of the plaintiffs’ claim” but “the falsity is not chargeable to the defendant and the claim could not have been brought against the defendants under the federal securities laws” – would improperly “bar state law claims in a manner unrelated to SLUSA’s purposes.”

The Second Circuit, however, did add some important caveats to its holding.  First, plaintiffs cannot engage in artful pleading to avoid SLUSA preclusion.  Any time “the success of a class action claim depends on a showing that the defendants committed false conduct conforming to SLUSA’s specifications, the claims will be subject to SLUSA,” even if the plaintiffs choose to invoke a state law theory that does not include false conduct as an element.  Second, consistent with the Supreme Court’s Dabit decision, SLUSA preclusion may apply even if the alleged conduct could not lead to a private claim (as opposed to an enforcement action by the SEC).  Finally, even if the plaintiffs do not specifically allege that the requisite false conduct was in connection with the purchase or sale of nationally traded securities, “the court may nonetheless ascertain those facts independently of the plaintiffs’ allegations and apply SLUSA.”

Holding: District court’s dismissal of complaint vacated; case remanded to district court for claim-by-claim assessment of whether SLUSA preclusion applies.

Quote of note: “Interpreting SLUSA to apply more broadly to state law claims that are altogether outside the prohibitions of the federal securities laws, and could not be subject to the PSLRA, would . . . construe ambiguous provisions of SLUSA in a highly improbable manner – as prohibiting state law claims involving matters that were not Congress’s concern in passing SLUSA, that have never been a subject of congressional concern, and that in a number of instances might even lie outside the powers of Congress.”

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Omnicare Decided

The U.S. Supreme Court has issued a decision in the Omnicare case holding that opinions presented in registration statements can be subject to Section 11 liability if either (a) the opinion was not genuinely held, or (b) the registration statement omitted material facts about the issuer’s inquiry into, or knowledge concerning, the opinion.  It is a 9-0 decision authored by Justice Kagan, although Justices Scalia and Thomas filed separate concurring opinions that effectively function as dissents.

The decision addresses an existing split in the circuit courts.  While the Second, Third, and Ninth Circuits had held that the plaintiff must allege the opinion 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 found 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.”  The Supreme Court rejected both positions and, as was extensively discussed at the oral argument, endorsed a middle ground approach.

In Omnicare, the relevant opinions related to the company’s compliance with applicable law.  The plaintiffs failed to allege that the company did not believe it was legally compliant or that the opinions contained some false statement of underlying fact.  As a result, the Court held, the first prong of its liability analysis was inapplicable.

That said, the plaintiffs also alleged that Omnicare omitted to state facts that necessary to make its opinions on legal compliance not misleading.  The Court held that this was a potentially viable claim, because a reasonable investor “expects not just that the issuer believes the opinion (however irrationally), but that it fairly aligns with the information in the issuer’s possession at the time.” While it is not enough that some fact cuts against the stated opinion, if the investor can “identify particular (and material) facts going to the basis for the issuer’s opinion – facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have – whose omission makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context,” there can be Section 11 liability.  In the case of a legal opinion, for example, “if the issuer made the statement in the face of its lawyers’ contrary advice, or with the knowledge that the Federal Government was taking the opposite view,” the investor has “cause to complain.”

The Omnicare plaintiffs claimed the company received some contrary advice from an attorney about the legal risks associated with a particular contract.  The Court remanded the case for the lower court to determine whether (a) the excluded fact would have been material to a reasonable investor and (b) in light of the overall context, including other disclosures that Omnicare made about its legal compliance and risks, “the excluded fact shows that Omnicare lacked the basis for making those statements that a reasonable investor would expect.”

Holding: Judgment vacated and remanded for further proceedings.

Quote of note: “Section 11’s omissions clause, as applied to statements of both opinion and fact, necessarily brings the reasonable person into the analysis, and asks what she would naturally understand a statement to convey beyond its literal meaning.  And for expressions of opinion, that means considering the foundation she would expect an issuer to have before making the statement.  All that, however, is a feature, not a bug, of the omissions provision.”

Notes on the Decision

(1) The Court concluded that it will be “no small task for an investor” to adequately demonstrate that an omission has rendered an opinion misleading.  At the same time, it also found that to avoid exposure to liability “an issuer need only divulge an opinion’s basis, or else make clear the real tentativeness of its belief.”  Whether this judicial advice will change how opinions are presented in registration statements remains to be seen.

(2) As perhaps to be expected when the Court adopts a middle ground approach, both the plaintiffs and defense bars will have reason to be satisfied with the decision.  While the Court struck down the Sixth Circuit’s purely objective standard, it also arguably provided a new basis for opinion liability in the Second, Third, and Ninth Circuits (and those circuits are where the majority of securities class actions are filed).

(3) Justice Scalia’s concurrence took issue with the majority’s omissions analysis, arguing that “[t]he objective test proposed by the Court – inconsistent with the common law and common intuitions about statements of opinion – invites roundabout attacks upon expressions of opinion.”

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The Streak Is Over

Plaintiffs in securities class actions often point to insider trades as evidence that the individual defendants had a pecuniary motive to commit fraud.   But if the plaintiffs do not make any allegations related to insider trades, can defendants conversely use SEC filings to show, at the motion to dismiss stage, that there was no suspicious trading (and, accordingly, no pecuniary motive)?

In Zak v. Chelsea Therapeutics Int’l, Ltd., 2015 WL 1137142 (4th Cir. March 16, 2015), the district court took judicial notice of certain SEC filings concerning insider sales and the individual defendants’ stock holdings.  It then “concluded that the defendants’ purported failure to sell Chelsea stock during the class period ‘tip[ped] the scales’ of the competing inferences of scienter” in favor of the defendants.  The Fourth Circuit held that this analysis was improper.  First, the district court should not have considered the SEC filings because they “were not explicitly referenced in, or an integral part of, the plaintiff’s complaint,” which did not contain any allegations related to insider trades.   Second, the SEC filings the district court considered did not conclusively establish that none of the individual defendants sold any Chelsea stock during the class period.

Holding: Dismissal vacated.

Addition:  One of the panel members dissented from the decision, but stated that he agreed with the majority’s “determination that the district court misused the challenged SEC documents.”  Interestingly, the dissent notes that prior to the instant case, the Fourth Circuit had never overturned, in the post-PSLRA era, a district court decision holding that the plaintiffs had failed to plead facts supporting a strong inference of scienter (eight total cases).

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Give and Take

To what extent does a company have to anticipate that its actions could result in a negative regulatory outcome?  In Fire and Police Pension Association of Colorado v. Abiomed, Inc., 2015 WL 500748 (1st Cir. Feb. 6, 2015), the plaintiffs asserted that the company’s alleged off-label drug marketing rendered false or misleading its (a) financial statements, and (b) disclosures about its interaction with the Food and Drug Administration (FDA) on the issue of marketing.  On appeal, the court held that the plaintiffs had failed to plead the requisite “strong inference” of scienter as to any of the defendants.

The court found that it was not clear that the alleged off-label drug marketing had materially impacted Abiomed’s financial results, which “weighs against an argument that defendants here possessed the requisite scienter.”  Moreover, the company promptly disclosed when the FDA sent it a “warning letter” about its marketing and explicitly told investors that the FDA might conclude that it had engaged in improper marketing.  Abiomed also took corrective actions and the FDA “eventually closed out its investigation of Abiomed without taking any action adverse to the company.”  Finally, the alleged insider trading “was neither unusual nor suspicious.”  Indeed, one of the individual defendants actually increased his holdings of Abiomed stock during the class period.

Holding: Dismissal affirmed.

Quote of note: “Under plaintiffs’ theory of the case, Abiomed should have affirmatively admitted widespread wrongdoing rather than stating that the outcome of its regulatory back-and-forth with the FDA was uncertain.  That would be a perverse result; such an admission would have been misleading, since the off-label marketing issues had the potential to be resolved with no adverse action from the FDA. . . . There must be some room for give and take between a regulated entity and its regulator.”

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Domestic Status

Under the Morrison test for extraterritoriality, a Section 10(b) claim for securities fraud may only be brought if the transaction involved “the purchase or sale of a security listed on an American stock exchange” or “the purchase or sale of any other security in the United States.”  Although nominally a bright-line test, it can be difficult to apply.  In United States v. Georgiou, 2015 WL 241438 (3rd Cir. Jan. 20, 2015), the court considered whether either prong was applicable to the purchase, by a foreign entity, of securities listed on the OTCBB or Pink Sheets.

First, the court examined whether the OTCBB or Pink Sheets were “stock exchanges.”  The court found that the Securities Exchange Act of 1934 draws a clear distinction between “securities exchanges” and “over-the-counter markets” and, moreover, the OTCBB and Pink Sheets are not on the SEC’s list of registered national securities exchanges.  Accordingly, it was “persuaded that those exchanges are not national securities exchanges within the scope of Morrison.”

Second, the court examined whether the purchases were nevertheless “domestic” securities transactions.  In doing so, the court adopted the Second Circuit’s approach and held that “a securities transaction is domestic when the parties incur irrevocable liability to carry out the transactions within the United States or when title is passed within the United States.”  Because there was evidence that the trades were facilitated by U.S. market makers and that in specific instances the securities were bought or sold from entities located in the United States, the court held that they met the “irrevocable liability” standard and could be the subject of a Section 10(b) claim.

Holding: Judgment of conviction affirmed.

 

 

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That Escalated Quickly

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 October, the Ninth Circuit rejected that position, holding that the disclosure duty created by Item 303 cannot form the basis for an actionable securities fraud claim.  This week, the Second Circuit disagreed.

In Stratte-McClure v. Morgan Stanley, 2015 WL 136312 (2d Cir. Jan. 12, 2015), the Second Circuit addressed claims that Morgan Stanley, in 2007, failed to disclose a negative trend in a large credit default swap position.  Noting that its position is “at odds with the Ninth Circuit,” the court held that Item 303’s “affirmative duty to disclose in Form 10-Qs can serve as the basis for a securities fraud claim under Section 10(b).”  The court described it as a two-part test: (1) the “plaintiff must first allege that the defendant failed to comply with Item 303,” thereby “establish[ing] that the defendant had a duty to disclose;” and (2) the “plaintiff must then allege that the omitted information was material under Basic’s probability/magnitude test.”  In addition, of course, the plaintiff must sufficiently plead the other elements of a Section 10(b) claim.

As to Morgan Stanley and its credit default swap position, the court concluded the plaintiffs had adequately alleged both that “Defendants breached their Item 303 duty to disclose that Morgan Stanley faced a deteriorating subprime mortgage market” and that the omission was material.  However, the court found that the complaint was “silent about when employees realized that the more pessimistic assessments of the market were likely to come to fruition and they would be unable to reduce [the credit default swap position].”  As a result, the complaint did not create a strong inference of scienter as to the Item 303-based claims.

Holding: Dismissal affirmed.

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