Category Archives: Motion To Dismiss Monitor

The SEC has created an affirmative defense to allegations that a person engaged in insider trading while in possession of material nonpublic information. 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 been implementing 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. Since the implementation of Rule 10b5-1, however, it has been an open question whether this inference can be refuted by the fact that the trading was done pursuant to a previously established trading plan. A partial answer may be found in the decision in Wietschner v. Monterey Pasta Co., No. C 03-0632 (N.D. Cal. Nov. 4, 2003) (will add Westlaw cite and link when available).
In Wietschner, the court held that the individual defendants’ stock sales were not sufficiently unusual or suspicious to raise a strong inference of scienter. In addition to evaluating the size and timing of the transactions, the court noted: “Plaintiffs state that both Defendants sold shares under individual SEC Rule 10b5-1 trading plans, which allows corporate insiders to set a schedule by which to sell shares over a twelve to fifteen month period. This could raise an inference that the sales were pre-scheduled and not suspicious.”
Holding: Motion to dismiss granted.
Addition: The opinion is now available on Westlaw – Weitschner v. Monterey Pasta Company, 2003 WL 22889372 (N.D. Cal. Nov. 4, 2003).

Those who believe that courts, in the post-Enron environment, should be more willing to temper the heightened pleading requirements of the PSLRA will be encouraged by a recent decision from the N.D. of Ill.
In In re Sears, Roebuck and Co. Sec. Litig., 2003 WL 22454021 (Oct. 24, 2003 N.D. Ill.), the court addressed allegations that the defendants made misstatements “about the risk level of balances in accounts in Sears’ credit card portfolio, the delinquencies in those accounts, and the amount of ‘charge-offs’ of unpaid accounts.” The plaintiffs argued that they had established a strong inference of scienter (i.e., fraudulent intent) because the individual defendants were executive officers of Sears and therefore must have known the information that made the alleged misstatements false and misleading. The court agreed, holding: “Officers of a company can be assumed to know of facts ‘critical to a business’s core operations or to an important transaction that would affect a company’s performance.'”
It is difficult to reconcile this decision with the PSLRA. The PSLRA requires plaintiffs to “state with particularity facts giving rise to a strong inference that the defendant acted with the required stated of mind.” The mere pleading of a defendant’s official corporate title and responsibilities would not appear to be sufficient.
Moreover, the case cited (and quoted!) by the court in support of this proposition, Stavros v. Exelon Corp., 266 F. Supp. 2d 833 (N.D. Ill. 2003) says no such thing. Stavros is a case based on allegedly false financial projections and merely notes, after a discussion of the need to plead scienter with particularity, that a “plaintiff might also plead that key officers knew of facts critical to a business’s core operations or to an important transaction that would affect a company’s performance.” There is no suggestion that this knowledge can be assumed based on the officers’ positions with the company. There are cases finding that this assumption is enough to establish a strong inference of scienter (although a significant majority of post-PSLRA cases appear to go the other way – see, e.g., In re Advanta Corp. Sec. Litig., 180 F. 3d 525, 539 (3rd. Cir. 1999)), but Stavros just does not happen to be one of them.
Holding: Motion to dismiss denied.
Quote of note: “Plaintiffs specifically allege that the positions held by each of the individual defendants during the class period gave them knowledge of the specific information in question. . . Logically, defendants in their positions would be expected to have knowledge of the facts regarding the credit card portfolio at the time they were making statements about the portfolio or signing off on SEC filings.”

Pediatrix Medical Group, Inc. (NYSE: PDX) announced yesterday that the plaintiffs have voluntarily dismissed, without prejudice, the securities class actions currently pending against the company in the S.D. of Fla.

Pediatrix is a Fort Lauderdale-based provider of maternal-fetal and newborn physician services. The suits were brought following Pediatrix’s June 24 announcement that a U.S. attorney’s office is conducting an investigation into the company’s nationwide Medicaid billing practices. In 2002, Pediatrix settled an earlier securities class action, also based on allegedly fraudulent billing practices, for $12 million.

Judge Pollack of the S.D.N.Y. has dismissed, with prejudice, an additional eight class actions against Merrill Lynch alleging the brokerage committed securities fraud by publishing overly optimistic research reports. The companies discussed in the relevant reports include eToys Inc., Homestore.com, and Pets.com Inc. The decision follows the reasoning laid down in Judge Pollack’s earlier ruling on two related cases a few months ago. The court focuses on the plaintiffs’ inability to adequately plead loss causation because of the absence of an alleged connection between the analyst reports and the companies’ financial troubles or the collapse of the overall market. As has become expected, Judge Pollack also manages to provide some colorful turns of phrase.

As of July, there were 27 similar consolidated class actions, each involving a different company’s stock, pending in the S.D.N.Y. It appears likely that none will survive the motion to dismiss stage. The Associated Press has a story on the new decision and the Securities Litigation Watch has this post.

Quote of note: Loss causation – “The burst of the bubble and the attendant market chaos are not chargeable to the defendants and represent intervening causes for which defendants are not responsible in the sequence of responsible causation.”

Quote of note II: Statute of limitations – On the issue of whether plaintiffs were on inquiry notice of their fraud claims, thus triggering the statute of limitations, the court concludes that “[t]he plethora of public information would have required even a blind, deaf, or indifferent investor to take notice of the purported alleged ‘fraud.'”

Quote of note III: Scienter – “Often lost in the enormous muddle of securities litigation is this most basic of facts: not every knowing misrepresentation creates a legal cause of action under the securities laws. The requisite state of mind, or scienter, in an action under Section 10(b) and Rule 10b-5, that the plaintiff must allege is a purpose to harm by intentionally deceiving, manipulating or defrauding.”

When a court grants a motion to dismiss a securitites class action based on the failure to meet the heightened pleading standards of the PSLRA, the plaintiffs often seek to file an amended complaint addressing the identified deficiences. At least one court has found, however, that plaintiffs cannot take a wait-and-see-what-happens approach if they are aware of additional facts.

In In re Stone & Webster, Inc. Sec. Litig., 217 F.R.D. 96 (D. Mass. 2003), the court addressed whether to grant a motion for leave to file a second consolidated and amended complaint after dismissing most of the claims in the case because they were not plead with the required specificity. The plaintiffs premised their motion “on the theory that the facts that would allegedly remedy the pleading defects identified in the [court’s] order were ‘newly discovered,’ [but] conceded at the scheduling conference that much of this information was in fact available to them during the pendency of the motions to dismiss.” The court found that the plaintiffs’ failure to provide these additional facts while the court considered the motion to dismiss was “precisely the sort of ‘undue delay’ that should result in a denial of leave to amend.”

Holding: Motion for leave to amend denied.

Quote of note: “The fact that the plaintiffs chose to oppose the motions to dismiss on the grounds that their complaint was, in their view, sufficiently pleaded, rather than providing the additional information known to them during the necessarily lengthy period during which the motions to dismiss were being considered, smacks of gamesmanship bordering on bad faith.”

Securities Litigation Watch notes that the recent decision in the K-Mart case (see this post) addresses loss causation and appears to follow the line of cases holding that merely alleging the stock was purchased at an artificially inflated price does not adequately plead a “causal nexus” between the misstatement and any economic harm. The 10b-5 Daily recently summarized the current split of appellate authority on this issue.

According to Second Circuit precedent, for a court to determine on a motion to dismiss in a securities fraud case that the alleged misstatement or omission is immaterial, it must be “so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of [its] importance.” Judges in the S.D.N.Y. recently have been exploring what “obviously unimportant” means, with favorable results for defendants. (See this post in The 10b-5 Daily for a discussion of the Allied Capital case.)

In re Duke Energy Corp. Sec. Litig., 2003 WL 22170716 (S.D.N.Y. September 17, 2003), involved allegations that Duke Energy had failed adequately to disclose that its revenues were overstated due to “round trip” or “wash transactions,” involving simultaneous sales and purchases of energy at the same prices and in the same amounts. The stock price dropped over the time period that the company made announcements concerning the discovery of these trades. Finally, in August 2002, the company confirmed that it had engaged in $217 million of these transactions.

The court found that the concealment of these transactions could not have been material. An inflation of $217 million in Duke Energy’s revenues over a two-year period amounted to about 0.3% of the company’s total revenues — a total that the court found immaterial as a matter of law. The plaintiffs made two counterarguments that were rejected by the court as insufficient.

First, the plaintiffs argued that the fall in share price after the announcement of the discovery of these transactions demonstrated that they were material to investors. The court found: (a) the plaintiffs’ allegations of a connection between the company’s disclosures and the stock price decline were too vague (really a loss causation argument); and (b) “bare allegations of stock price declines cannot cure the immateriality of an overstatement as small as the one here at issue.”

Second, the plaintiffs argued that the nondisclosure was qualitatively material because it involved illegal activity. The court found that even assuming that the transactions were illegal, the failure to disclose them did “not give rise to a securities claims if their only effect in terms of what was disclosed to the public was a miniscule 0.3% inflation of revenues.”

Holding: Motion to dismiss with prejudice granted.

Quote of note: “Plaintiffs are vague about what constituted this underlying ‘illegality,’ as ‘wash sales’ and ’round-trip trading’ are not necessarily illegal per se. But even assuming they were, illegality of a financial nature (as opposed, say, to rape or murder) must still be assessed, for disclosure purposes, by its economic impact. Otherwise, every time a giant corporation failed to disclose a petty theft in its mailroom, it would be liable under the securities laws.”

The E.D. of Mich. has dismissed the securities class action against several former Kmart executives and PricewaterhouseCoopers. The complaint alleged that the defendants misled Kmart investors in 2000 and 2001 prior to the company’s bankruptcy.

According to an article in yesterday’s Detroit News, the case was dismissed by Judge Gerald Rosen on pleading grounds, despite his determination that the plaintiffs had established a strong inference of fradulent intent for two of the individual defendants. The article also reports that a related ERISA class action on behalf of former Kmart employees has survived a motion to dismiss.

Quote of note: “Rosen said he dismissed the lawsuit strictly on technical legal grounds. Congress may have set ‘a virtually unreachable’ standard for lawsuits that charge private companies with securities fraud, he said. But his decision ‘by no means should be construed as giving defendants a completely clean bill of health,’ Rosen wrote in the 65-page opinion issued Friday.”

Intervoice, Inc. (Nasdaq: INTV) has announced the dismissal, with prejudice, of the securities class action pending against the company in the N.D. of Tex. Intervoice is a Dallas-based maker of call automation systems.

According to the Dallas Business Journal, the suit was filed in June 2001 and alleged “some of Intervoice’s executives issued false and misleading statements concerning the financial condition of the company, the results of the company’s merger with Brite Voice Systems Inc. in 1999 and the company’s business projections.” The suit was originally dismissed a year ago, but the plaintiffs were given leave to amend.