Category Archives: Motion To Dismiss Monitor

Following the Dura decision by the Supreme Court, lower courts continue to grapple with what constitutes a sufficient pleading of loss causation. In In re Cree, Inc. Sec. Litig., 2005 WL 1847004 (M.D.N.C. Aug. 2, 2005), Cree’s stock price dropped after its former CEO filed an individual lawsuit generally alleging that the company had engaged in securities fraud. The court found: (a) the individual lawsuit “did not disclose anything about transactions with five of the six companies Plaintiffs now claim were the subject of numerous misstatements and omissions;” and (b) as to the one transaction it did address, the complaint “merely attribute[d] an improper purpose to the previously disclosed facts.” In the absence of the disclosure of new facts, the court found that the transaction could not be the “proximate cause of the complained-of loss.”

Holding: Dismissed with prejudice. (The court also adopted the rigorous First Circuit standard for evaluating confidential witness statements and held that the plaintiffs failed to plead falsity with sufficient particularity.)

Quote of note: “It is doubtful that a general averment of fraud with no specific factual allegations could be deemed a ‘disclosure’ for purposes of determining whether some act or omission, previously concealed by a false representation, caused, upon revelation, a shareholder’s loss. While it is clear that a disclosure need not conform to any prescribed format, in must nevertheless satisfy at least a minimum standard of content. A disclosure must reveal new facts; a bald assertion of fraud is not sufficient.”

Disclosure: The author of The 10b-5 Daily represents the defendants in the Cree securities litigation.

Whether trading under a Rule 10b5-1 trading plan can help shield corporate executives from securities fraud liability is a topic that courts continue to explore.

Rule 10b5-1, put into place in 2000, establishes that a person’s purchase or sale of securities is not “on the basis of” material nonpublic information if, before becoming aware of the information, the person enters into a binding contract, instruction, or trading plan (as defined in the rule) covering the securities transaction at issue. To take advantage of this potential affirmative defense, many executives have implemented trading plans for their sales of company stock.

Insider trading, of course, is often used by plaintiffs in securities class actions to create an inference of scienter (i.e., fraudulent intent). The plaintiffs allege that the individual corporate defendants profited from the alleged fraud by selling their company stock at an artificially inflated price. In the latest decision to consider the impact of Rule 10b5-1 trading plans on insider trading scienter allegations, the court in In re Netflix, Inc. Sec. Litig., 2005 WL 1562858 (N.D. Cal. June 28, 2005) found that the fact that the trading in question took place pursuant to a trading plan mitigated against a finding of an inference of scienter.

The author of The 10b-5 Daily has written an article (with one of his colleagues) on this topic.

In an interesting opinion released yesterday in the Parmalat securities class action, Judge Kaplan (S.D.N.Y.) addresses some important topics.

(1) Parmalat’s primary auditors were the Italian affiliates of two multinational accounting firms – Grant Thornton and Deloitte & Touche. The court found that the plaintiffs sufficiently alleged an agency relationship between the global umbrella organizations, Grant Thornton International (“GTI”) and Deloitte Touche Tohmatsu (“DTT”), and their Italian member firms so as to allow the claims against the global entities to go forward.

(2) GTI and DTT argued that the plaintiffs had failed to adequately plead loss causation “because they do not allege that any misrepresentation by them was the proximate cause of the decline in the value of the price of Parmalat securities or that a corrective disclosure about their prior misrepresentations caused the company’s collapse.” The court disagreed, holding that under Second Circuit precedent the plaintiffs’ allegations that the risks concealed by Parmalat and its auditors caused the decline in investor value were sufficient.

(3) Section 20(a) of the ’34 Act creates a cause of action against defendants alleged to have been “control persons” of those who engaged in securities fraud. There is a split within the Second Circuit over whether a plaintiff must allege culpable participation to state a legally sufficient claim under this provision. The court found that allegations of culpable participation are not necessary.

(4) The defendants evidently also moved to dismiss the 368-page complaint as failing to comply with F.R.C.P. 8 (“short and plain statement” of the claim). The court noted that it was in “substantial sympathy” with this position: “The requirement of pleading fraud with particularity does not justify a complaint longer than some of the greatest works of literature.” Nevertheless, the court declined to dismiss the complaint on this basis.

Speaking of confidential sources, it has not taken long for the Third Circuit’s decision in Chubb to have an effect in the lower courts. In Freed v. Universal Health Services, Inc., 2005 WL 1030195 (E.D.Pa. May 3, 2005), the plaintiffs relied on confidential sources in alleging that UHS improperly accounted for its receivables and deliberately understated its bad debt reserves.

The confidential sources included numerous unnamed former employees of UHS, but all of them worked in individual hospitals owned by the corporation. The court, citing the Chubb decision, found that the statements could not be relied upon because “the Amended Complaint fails to allege how [the confidential sources] would have access to information regarding UHS’s operations nationwide.” The Legal Intelligencer has an article (via law.com – free regist. req’d) on the decision.

Holding: Dismissed with leave to amend.

Quote of note: “[C]omplaints that rely heavily on confidential sources to establish the ‘true facts’ must contain information describing the time period during which the confidential sources were employed by the defendant corporation, the dates on which they acquired the information they purportedly possess, and the manner in which they had access to such information.”

Is it fraudulent to pay analysts to promote your company’s stock? In a break from the run-of-the-mill securities class action, investors in Diomed Holdings, Inc. alleged that, in 2002, the company and its chairman “devised a plan to artificially inflate the price of Diomed’s stock by secretly paying stock analysts to tout Diomed to unsuspecting investors.” The plaintiffs argued that this was part of a “pump and dump” scheme and and unlawful pursuant to Rule 10b-5.

The court disagreed. In Garvey v. Arkoosh, 2005 WL 273135 (D. Mass. Feb. 4, 2005), the court held that “nothing in the securities laws bars the issuer of a regulated security from paying an analyst for a stock recommendation.” While the applicable regulatory scheme requires the person who publishes the report to disclose a conflict of interest (see Section 17(b) of the ’33 Act), there is no similar duty imposed on the issuer who paid for the promotion. Moreover, the analysts had clearly stated in their reports that they were being paid to tout the stock, even if the disclosures did not directly connect Diomed to the payments.

Holding: Motion to dismiss granted.

Quote of note: “Any reasonable investor told that the publisher of an investment report had received $700,000, $100,000, or even $50,000 to tout a particular stock would give the analyst’s recommendation the proverbial grain of salt regardless of the source of the funds.”

The 11th Circuit and 2nd Circuit are continuing to ponder whether the Sarbanes-Oxley Act of 2002, which extended the statute of limitations for securities fraud claims, revived claims that were time-barred prior to the Act’s passage. Meanwhile, a growing majority of district courts are holding that these time-barred claims must be dismissed. In the past two months, three courts have come to this conclusion: Zurich Capital Mkts. v. Coglianese, 2004 WL 2191596 (N.D. Ill. Sept. 23, 2004); Zouras v. Hallman, 2004 WL 2191031 (D.N.H. Sept. 30, 2004); Milano v. Perot Systems Corp., 2004 WL 2360031 (N.D. Tex. Oct. 19, 2004). Given that the frequency of these cases is bound to decrease over time, the appellate courts better act quickly if they plan to reverse the tide.

As the U.S. Supreme Court prepares to take on the issue of loss causation in securities fraud cases, the lower court split continues. In Swack v. Credit Suisse First Boston, 2004 WL 2203482 (D. Mass. Sept. 21, 2004), a case alleging that the defendants committed fraud by disseminating research reports that they knew to be overly optimistic, the court held that loss causation could be adequately plead even though the corrective disclosure did not lead to a stock price decline.

The court noted that “stock prices sometimes self-correct in advance of the final overt disclosure.” In the case of a misleading analyst report, data that is inconsistent with the rating may lead the market to devalue the rating to the point that the corrective disclosure fails to move the stock price. As a result, the court found that it could not resolve the issue of loss causation on a motion to dismiss. (Note that the court’s decision is similar to the Fogarazzo opinion from earlier this year.)

Holding: Motion to dismiss denied.