Category Archives: Motion To Dismiss Monitor

Whether a defendant corporation has acted with scienter (i.e., fraudulent intent) is determined by looking “to the state of mind of the individual corporate official or officials who make or issue the statement . . . rather than generally to the collective knowledge of all the corporation’s officers and employees acquired in the course of their employment.” Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353 (5th Cir. 2004). In other words, courts reject a “collective scienter” theory.

Eager to get at corporate wrongdoing, however, some courts have been ignoring this principle. In In re NUI Sec. Litig., 314 F.Supp.2d 388 (D.N.J. 2004), the court found that the plaintiffs had adequately alleged a strong inference of scienter for the corporate defendant because NUI’s associate general counsel (who was not a defendant in the case and made none of the alleged misstatements) was alleged to have actual knowledge of the company’s fraudulent conduct. As to the individual defendants (the CEO and CFO of NUI), however, the court held that there were insufficient allegations concerning their motive to commit fraud and knowledge of the alleged fraudulent conduct.

Similarly, in the recent decision in In re Motorola Sec. Litig., 2004 WL 2032769 (N.D. Ill. Sept. 9, 2004), the court held that the plaintiffs had alleged a strong inference that Motorola “through its various officials, sought to mislead the investing public” about its vendor financing to a Turkish company. The direct fraud claims against the individual defendants (the CEO, CFO, and COO of Motorola) were dismissed, however, because the plaintiffs made no allegations that the individual defendants “had specific knowledge of the details concerning Motorola’s loan” and the plaintiffs’ motive allegations were insufficient.

In both cases, the claims against the individual defendants were not fully dismissed. Since the individual defendants controlled NUI and Motorola, and the courts found that a Rule 10b-5 claim was adequately pled against these companies, the Section 20(a) claims against the individual defendants based on control person liability for fraud still remained. By analyzing the scienter of NIU and Motorola separately, the courts, in essence, held that the companies acted with fraudulent intent, but their controlling officers or directors did not. This result both defies common sense (after all, a corporation can only act through its officers and directors) and, given that the individual defendants still have potential Section 20(a) liability, provides an end run around the PSLRA’s requirement that scienter be adequately plead as to each defendant.

Following its enormous settlement in the WorldCom case, Citigroup received a bit of relief last week when Judge Swain (S.D.N.Y.) dismissed a related securities class action against the company. In In re Citigroup, Inc. Sec. Litig., 2004 WL 1794465 (S.D.N.Y. August 10, 2004), the court addressed claims that Citigroup had failed, with respect to transactions with Enron, Dynegy, and WorldCom, to conduct its business in accordance with its risk management policies. The plaintiffs also alleged that Citigroup had permitted Solomon Smith Barney (a Citigroup subsidiary) analysts to color their public assessments of those companies to aid Citigroup’s investment banking business.

In its decision, the court found that the claims regarding the transactions with Enron, Dynegy, and WorldCom merely alleged “that Citigroup’s business would have been conducted differently had the company adhered to the management principles disclosed in its public filings.” The court held that under established law, “allegations of mismanagement, even where a plaintiff claims that it would not have invested in the an entity had it known of the management issues, are insufficient to support a securities fraud claim under section 10(b).”

As to the claims based on analyst statements, the court noted that the plaintiffs had failed to allege that any misleading statements were made “in connection with the market for Citigroup’s own securities.” The allegation that Citigroup’s failure to disclose the false nature of the analyst statements had the effect of misleading investors concerning the profitability of Citigroup’s investment banking activities was summarily rejected. First, the court found the “securities laws do not require a company to accuse itself of wrongdoing.” Second, the court found that to the extent the claims were “premised on the assertion that Citigroup breached a duty to disclose that its revenues were ‘unsustainable,” no such duty existed in the absence of any projections concerning those revenues.

Holding: Motion to dismiss granted with leave to amend.

One way to rebut the fraud-on-the-market theory is to demonstrate that the alleged misrepresentations could not have affected the market price of the stock because the truth of the matter was already known to investors. The “truth-on-the-market” defense is fact-specific, and courts have only rarely found it to be an appropriate basis for dismissing a securities fraud complaint for failure to adequately plead that the alleged misrepresentations were material.

As the court in White v. H.R. Block, Inc., 2004 WL 1698628 (S.D.N.Y. July 28, 2004) recently noted, however, “‘rarely appropriate’ is not the same as ‘never appropriate.'” In that case, the plaintiffs alleged that H.R. Block had concealed important facts about more than 20 class action lawsuits filed against the company over its refund anticipation loan program. The court found that the “litigation involved public lawsuits brought by public filings in public courts, and the litigation was the subject of extensive press coverage . . . as well as press releases and SEC filings from Block itself.” Not surprisingly, the court rejected the plaintiffs’ argument that this information did not enter the market with sufficient intensity to counter-balance any alleged misrepresentations. “In short, the truth was all over the market.”

Holding: Motion to dismiss granted with prejudice.

Quote of note: “Plaintiffs claim that investors should not be obligated to ‘scour county court houses across the country.’ But, as defendants point out, the market is comprised of more than ordinary investors; it is also comprised of market professionals, such as Avalon, and Avalon apparently had little trouble scouring those courthouses to gather information for its report on the RAL litigation which sparked this lawsuit against Block.”

While the U.S. Court of Appeals for the Eleventh Circuit continues to consider whether the new statute of limitations in the Sarbanes-Oxley Act of 2002 revives time-barred claims, the district court split on the issue remains unresolved. Two recent decisions from the S.D.N.Y., in prominent cases, come to different conclusions.

In In re Worldcom, Inc. Sec. Litig., 2004 WL 1435356 (S.D.N.Y. June 28, 2004), Judge Cote found that “there is no explicit language in the statute” that would operate to revive time-barred claims and lengthening the statute of limitations in this manner “would affect the substantive rights of the defendants by depriving them of a defense on which they were entitled to rely.” Accordingly, the court held that “Sarbanes-Oxley does not revive previously time-barred private securities fraud claims” and dismissed certain claims in the case that had expired in June 2002 (a month before Sarbanes-Oxley was passed).

In In re AOL Time Warner, Inc. Sec. and “ERISA” Litig., 2004 WL 992991 (S.D.N.Y. May 5, 2004), Judge Kram went in another direction. In that case, the first class action was filed on July 18, 2002 (two weeks before Sarbanes-Oxley was passed). The court held that the plaintiffs’ otherwise time-barred claims would have been revived if the plaintiffs had filed after the passage of Sarbanes-Oxley. Although “in most cases, class actions or otherwise, the date of the first filing is the operative one for statute of limitations purposes,” the court decided that the filing date of the consolidated complaint, September 16, 2002, should be the operative date in the instant case. As a result, the longer statute of limitations in Sarbanes-Oxley applied and the otherwise time-barred claims could proceed. The court justified this rather extraordinary decision by arguing that any other result would punish the plaintiffs for filing too early and lead to a mass opt-out from the class.

The PSLRA created a safe harbor for forward-looking statements to encourage companies to provide investors with information about future plans and prospects. Under the first prong of the safe harbor, a defendant is not liable with respect to any forward-looking statement if it is identified as forward-looking and is accompanied by “meaningful cautionary statements” that alert investors to the factors that could cause actual results to differ.

In the case of oral forward-looking statements, the PSLRA specifically provides that the meaningful cautionary statements can be incorporated by reference in a readily available written document. The statute is silent, however, about whether this is also true for written forward-looking statements. Surprisingly, only a few courts have addressed this issue.

In In re Blockbuster Inc., Sec. Litig., 2004 WL 884308 (N.D. Tex. April 24, 2004), the court noted that the PSLRA’s safe harbor is based on the judicially-created bespeaks caution doctrine, which provides that statements must be analyzed in context. The court therefore concluded that “as long as the reference is clear and explicit so that the referenced cautionary language can fairly be viewed as part of the ‘context’ surrounding the written forward-looking statement, the PSLRA safe harbor for written forward-looking statements can be satisfied by meaningful cautionary language that is incorporated by reference.” The court found that its holding was supported by the “illogic” of allowing incorporation by reference for oral statements, where the location of the cautionary statements is likely to be misheard or forgotten, but not allowing it for easily followed written statements.

Holding: Motion to dismiss granted.

Whether and how to apply the fraud-on-the-market theory (i.e., reliance by investors on an alleged misrepresentation is presumed if the company’s shares were traded on an efficient market) to research analyst statements is a controversial issue. It was the subject of a recent appeal by Citigroup in the WorldCom litigation, but the appeal was mooted by the settlement of the case just before the scheduled oral argument.

The 10b-5 Daily has argued that the Second Circuit, in its opinion granting Citigroup’s request for interlocutory appeal, appeared favorably disposed to finding that the fraud-on-the-market theory was not generally applicable to research analyst statements. Judge Rakoff of the S.D.N.Y. apparently agrees with this reading of the opinion.

In DeMarco v. Lehman Brothers, 2004 WL 1506242 (S.D.N.Y. July 6, 2004), a case alleging that a Lehman analyst made buy recommendations for RealNetworks, Inc. stock while secretly holding negative views of the stock, the court has denied the motion for class certification. The court noted that there is a “qualitative difference” between a statement of fact from an issuer and a statement of opinion by a research analyst. In particular, a “well-developed efficient market can reasonably be presumed to translate the former into an effect on price, whereas no such presumption attaches to the latter.” As a result, the court held that the fraud-on-the-market doctrine can apply to a case based on research analyst statements “only where the plaintiff can make a prima facie showing that the analyst’s statements materially impacted the market price in a reasonably quantifiable respect.”

The plaintiffs relied on Lehman Brothers’ promotional materials touting its analyst’s abilities and influence and an expert report (largely based on general studies of the effect of analyst recommendations on stock prices) in arguing that the analyst’s statements inflated the market price for RealNetworks’ stock. The court found that this evidence was insufficient to “warrant invocation of the fraud-on-the-market presumption.”

Holding: Motion for class certification denied.

Quote of note: “[A] statement of opinion emanating from a research analyst is far more subjective and far less certain, and often appears in tandem with conflicting opinions from other analysts as well as new statements from the issuer. As a result, no automatic impact on the price of a security can be presumed and instead must be proven and measured before the statement can be said to have ‘defrauded the market’ in any material way that is not simply speculative.”

The New York Law Journal has an article (via law.com – free regist. req’d) on the decision. Thanks to Adam Savett for sending in a copy of Judge Rakoff’s opinion.

The decision in the Fogarazzo research analyst case in the S.D.N.Y. (previously posted about in The 10b-5 Daily) is controversial on a number of pleading issues. Not only does the court apply a loss causation standard that, in contravention of the Second Circuit, appears to remove the need to draw any actual connection between the misrepresentations and the loss, it also runs roughshod over other S.D.N.Y. decisions on how to analyze the falsity and scienter (i.e., fraudulent intent) requirements for securities fraud claims based on statements of opinion.

In the research analyst cases, the issue is whether the defendants deliberately misrepresented their truly held opinion that the stock was not a good investment. Judges in the S.D.N.Y. (e.g., Judge Lynch in the Podany decision) have found that under these circumstances the falsity and scienter requirements are essentially identical. Since the statement (unlike a statement of fact) cannot be false at all unless the speaker is knowingly misstating his truly held opinion, the plaintiffs must allege inconsistent statements or actions by the defendants from which a factfinder could infer that a knowing misstatement was made. For example, the plaintiffs might allege that the defendants’ made statements to others that the stock was overvalued or engaged in personal sales of the stock.

In Forgarazzo, Judge Scheindlin rejected this approach. After finding that falsity must be examined separately from scienter, the court held that the falsity of the analysts’ buy recommendations was adequately plead based on allegations that the defendants: (1) wanted to obtain investment banking business from the underlying company; (2) had analysts that were subject to financial conflicts of interest; and (3) failed to maintain adequate controls to protect the objectivity of their public research. None of these allegations, however, suggests that the analyst reports were false (i.e., that the defendants actually regarded the underlying stock as a poor investment). In essence, the court found that the existence of a motive to commit fraud is enough to demonstrate that the opinions were false.

Holding: Motion to dismiss denied.

The argument that loss causation must be plead by showing a stock price decline related to the alleged fraud, articulated in the Second Circuit by the Emergent Capital decision, is meeting with increased resistance by the S.D.N.Y. judges handling the research analyst cases. Judges have argued that the stock market crash that occured between the issuance of the allegedly biased research and the revelation of the analysts’ conflicts of interest (and, therefore, arguably caused any loss) was irrelevant, either because of allegations that the research analyst directly participated in a fraudulent scheme perpetrated by the issuer of the underlying stock or because the revelation of the analysts’ conduct caused a subsequent stock price drop. (See these posts on the WorldCom and Robertson Stephens cases).

In Fogarazzo v. Lehman Brothers, Inc., 2004 WL 1151542 (S.D.N.Y. May 21, 2004), however, the entire concept of the price decline approach to pleading loss causation comes under attack. The complaint, brought by shareholders of RSL Communications, Inc. (“RSL”), alleged that analysts at three firms had falsified their opinions of RSL. Specifically, while RSL issued a series of negative announcements in 1999 and 2000 – and its stock price dropped – the analysts continued to provide RSL with positive ratings. Ultimately, RSL’s stock declined to the point that it was delisted, and each of the three firms then dropped analyst coverage. The court was careful to note that there were no allegations that the defendants concealed any facts concerning RSL. Instead, the plaintiffs merely alleged that despite publicly available negative information, the analysts expressed falsely positive opinions.

Although the facts are similar to those in the Merrill Lynch cases, Judge Scheindlin appears to create a new loss causation standard and concludes that loss causation was adequately plead. The court explained that loss causation is shown when “(1) the misrepresentation artificially inflated the value of the security, or otherwise misrepresented its investment quality, and (2) the subject of the misrepresentation causedthe decline in the value of the security.” Here, the subject of the misrepresentations was “the financial health and future prospects of RSL,” and though no facts were concealed, that subject still caused plaintiffs’ losses. “[E]ven though the true facts were available to the world to see, by affirmatively opining on the meaning of those facts, the Banks obscured the logical conclusion that RSL was failing.” This standard would appear to remove the need to draw any actual connection between the misrepresentations and the loss; the mere fact that the company’s stock price declined creates liability for anyone who issued false statements about the company into the market.

Moreover, although Judge Scheindlin expressed uncertainty as to whether the Second Circuit’s price decline approach requires a corrective disclosure, the court concluded that dropping analyst coverage of RSL was a corrective disclosure. “[W]hen the Banks dropped coverage, they essentially conceded (in the eyes of the investing public) that their previous recommendations were mistaken.” Even accepting this characterization of the banks’ actions (and it is hard to see how dropping coverage can be equated with a disclosure about the previous recommendations), the court did not find that there was a price decline after coverage was dropped.

As noted previously, clarification of these issues may come in the near future. The Second Circuit is scheduled to hear the appeal of the first few Merrill Lynch decisions on August 12, 2004.

Holding: Motion to dismiss denied. (The 10b-5 Daily may do an additional post about the other holdings in the opinion.)

As noted in The 10b-5 Daily’s discussions of the Intergroup and NUI decisions, the idea that corporate acquisitions for stock are a sufficient motive for securities fraud is controversial. A contrary view can be found in the recent decision in In re Corning Sec. Litig., 2004 WL 1056063 (W.D.N.Y. April 9, 2004).

In the Corning case, the plaintiffs alleged that the defendants were motivated to artificially inflate the company’s stock price so that they could use it as currency for the acquisition of Tropel Corporation. The court found that “[p]aying a smaller price for the acquisition of Tropel [by using inflated stock] benefited Corning’s common shareholders.” Moreover, the desire to have a high stock price to be used in the purchase of Tropel “is a motive that could be attributed to virtually every company seeking to acquire another through the use of its own stock as part of the purchase.” As a result, the court held that the acquisition failed to create a strong inference of scienter.

Holding: Motion to dismiss granted.