Category Archives: Appellate Monitor

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).

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.”

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.

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.

Federal Rule of Civil Procedure 9(b) states that “[i]n alleging fraud or mistake, a party must state with particularity the circumstances  fraud or mistake.”  Whether FRCP 9(b) applies to the pleading of loss causation in securities fraud cases, however, has been an open question.

In the Dura case, the Supreme Court heard argument on the issue.  The Court ultimately punted, however, noting in its 2005 decision that it would “assume, at least for argument’s sake, that neither the Rules nor the securities statutes impose any special further requirement [beyond FRCP 8’s notice pleading standard] in respect to the pleading of proximate causation or economic loss.”  Perhaps not surprisingly, this quickly lead to a split in the lower courts, with some courts requiring notice pleading and other courts requiring particularity.  Moreover, this split has continued at the appellate level with, at a minimum, the Fifth Circuit (FRCP 8 applies) and the Fourth Circuit (FRCP 9(b) applies) taking opposite positions.

In Oregon Public Employees Retirement Fund v. Apollo Group, Inc., 2014 WL 7139634 (Dec. 16, 2014), the Ninth Circuit has addressed the split and come down firmly in favor of FRCP 9(b)’s particularity requirement applying to the pleading of loss causation (and, by extension, to every element of a securities fraud claim).  The court gave three reasons for its decision.  First, because FRCP 9(b) “applies to all circumstances of common law fraud, and since securities fraud is derived from common law fraud, it makes sense to apply the same pleading standard.”  Second, FRCP 9(b) applies on its face because loss causation, as an element of the claim, is “part of the ‘circumstances’ constituting fraud.”  Finally, applying FRCP 9(b) “creates a consistent standard through which to assess pleadings in 10(b) actions.”

Holding: Dismissal affirmed.

Quote of note: “We are persuaded by the approach adopted in the Fourth Circuit and hold today that Rule 9(b) applies to all elements of a securities fraud action, including loss causation.”

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.

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).

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.

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.”