Category Archives: Motion To Dismiss Monitor

In its Tellabs decision, the U.S. Supreme Court held that a court must assess a plaintiff’s scienter (i.e., fraudulent intent) allegations “holistically” in determining whether the plaintiff has met the requisite “strong inference” pleading standard. The 10b-5 Daily noted at the time of the Tellabs decision that this holding “would appear to alter the evaluation of scienter in the Second Circuit and Third Circuit, both of which have held that a court can examine allegations of motive or knowledge/recklessness separately.” The Second Circuit has failed to address this inconsistency, however, leading to decisions that are arguably at odds with binding precedent.

In In re Gentiva Sec. Litig., 2013 WL 5291297 (E.D.N.Y. Sept. 19, 2013), the court addressed allegations that the company violated Medicare rules and artificially inflated the Medicare payments it received. In its first motion to dismiss decision, the court found that the plaintiffs had failed to adequately plead either motive and opportunity to commit fraud or sufficient circumstantial evidence of conscious misbehavior.

As to the amended complaint, the court again concluded that there were insufficient allegations to establish that the “Individual Defendants knew or had access to information showing that Gentiva was pressuring its staff to provide as many therapy visits as possible to receive extra Medicare payments without consideration of patients’ needs.” On the issue of motive, however, the court found that two of the individual defendants had exercised stock options and sold a significant amount of shares during the class period. It also found that corporate scienter could be “inferred from the ‘suspicious’ insider stock sales.” Accordingly, the court denied the motion to dismiss “to the extent the Plaintiff seeks to establish scienter of the Defendants Malone, Potapchuk, and Gentiva based on a theory of ‘motive and opportunity.'”

What does it mean to “holistically” examine the complaint’s scienter allegations if they are divided into two categories? The court offers no explanation, but the responsibility ultimately lies with the Second Circuit, which needs to address this question.

Holding: Motion to dismiss denied, with the court curiously stating the plaintiff would “not be permitted to present . . . at trial” a theory of scienter based on circumstantial evidence of misbehavior or recklessness.

Under the PSLRA’s safe harbor for forward-looking statements, such statements cannot form the basis for securities fraud liability unless (a) the statements were not accompanied by “meaningful cautionary statements” and (b) the defendants had “actual knowledge” of their falsity. A company’s forward-looking statements, however, often contain some reference to present facts. Does that make these statements ineligible for the safe harbor?

In IBEW Local 98 Pension Fund v. Best Buy Co., Inc., 2013 WL 3982629 (D. Minn. Aug. 5, 2013), the court considered this question in evaluating whether the company’s statements that it was “on track to deliver and exceed our annual EPS guidance” and that its earnings were “essentially in line” with expectations were forward-looking. Although the defendants argued that these statements were simply affirmations of the projected guidance, and therefore forward-looking, the court concluded that they really were statements of present condition. Accordingly, the statements were not subject to the safe harbor.

Holding: Motion to dismiss granted in part and denied in part.

Are a company’s ethical guidelines material (i.e., important to the investment decision of a reasonable investor)? In Cement & Concrete Workers District Council Pension Fund v. Hewlett Packard Co., 2013 WL 4082011 (N.D. Cal. Aug. 9, 2013), the plaintiffs alleged that the CEO’s undisclosed relationship with an independent consultant (which lead to his firing and a significant stock price drop) caused the company’s ethical guidelines to be misleading “because in light of [the CEO’s] endorsement of these tenets, there was an implication that [he] was in fact in compliance with them.” In addition, the company’s public filings contained a disclosure about the risk to HP’s operations associated with the need to retain key executives, which the plaintiffs claimed was rendered misleading by the omission of the CEO’s “actual, fraudulent, and noncompliant business practices.”

The court concluded that both sets of statements were immaterial. As to the ethical guidelines, the court found that they were “not specific, nor do they suggest that [the CEO] was in compliance with them at the time they were published.” Indeed, no reasonable investor would “depend on [them] as a guarantee that [HP] would never take a step that might adversely affect its reputation.” Similarly, the plaintiffs’ argument that the risk factor about executive retention was material improperly conflated “the materiality of statements concerning whether [the CEO] would, in fact, remain at HP with the materiality of vague and routine statements concerning the retention of executives in general.”

Holding: Motion to dismiss granted (without prejudice).

The use (and potential abuse) of confidential witnesses continues to be a controversial topic in securities class actions. Some court decisions, particularly in the Boeing securities litigation, have been sharply critical of how the plaintiffs’ bar conducts its pre-filing investigations and decides what statements to include in its complaints. A recent decision from Judge Rakoff (S.D.N.Y), however, suggests that at least some of the problems may arise from witness “indiscretions.”

In City of Pontiac General Employees’ Retirement System v. Lockheed Martin Corp., 2013 WL 3389473 (S.D.N.Y. July 9, 2013), the court denied the defendants’ motion to dismiss. The defendants subsequently deposed the confidential witnesses cited in the complaint and filed a “limited motion for summary judgment” arguing that these witnesses had either recanted their statements or never made them in the first place. The court held an evidentiary hearing, denied the motion, and the parties settled. Nevertheless, the court decided to issue a memorandum on the issue of the confidential witness statements.

In its memorandum, the court noted that the testimony presented by the five confidential witnesses suggested “that some, though not all, of the CWs had been lured by the [plaintiff’s] investigator into stating as ‘facts’ what were often mere surmises, but then, when their indiscretions were revealed, felt pressured into denying outright statements they had actually made.” The court took particular issue with two of the confidential witnesses claiming that they only had short calls with the investigator when the plaintiffs’ phone records revealed that the main calls were both around an hour long. Moreover, two of the witnesses “confirmed the substance of the statements attributed to them in the Amended Complaint, while noting that such snippets did not always convey the nuances of what they had told [the investigator].” The fact that these witnesses testified to the accuracy of what the investigator had reported created an inference that the investigator’s report “was accurate in all material respects.”

Holding: Motion for summary judgment denied.

Quote of note: “It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate ‘private eyes’ who would entice naive or disgruntled employees into gossip sessions that might help support a federal lawsuit. Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate. But, as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.”

Securities class actions alleging that a company issued false or misleading earnings guidance are frequently dismissed. Among other things, to overcome the PLSRA’s safe harbor for forward-looking statements a plaintiff must adequately plead (a) the guidance was not accompanied by “meaningful cautionary statements” and (b) the company had “actual knowledge” of its falsity. Given the vagaries of business performance, courts generally find that one or the other pleading burden has not been met.

With that background, the decision in City of Providence v. Aeropostale, Inc., 2013 WL 1197755 (S.D.N.Y. March 25, 2013) is interesting because the court found that the plaintiffs successfully plead an “earnings guidance” claim, albeit with the help of a unique fact pattern and (arguably) a misreading of the law. Aeropostale is a clothing retailer. In the second half of 2010, the company decided to change the design of its women’s fashion line and placed orders for the new styles that would provide inventory through the fall of 2011. The new styles sold poorly and, in December 2010, the company fired the officer who led the change.

In response to the poor sales, Aeropostale provided 2011 earnings guidance that was below its 2010 results. According to the complaint, however, this guidance still understated the sales and inventory problems and failed to disclose that the unpopular new styles had been pre-ordered and would continue to be stocked for the next several quarters. The defendants argued that its earnings guidance (and other statements about the company’s future performance) were protected by the PSLRA’s safe harbor, but the court disagreed.

First, the court found that Aeropostale had failed to provide “meaningful cautionary statements.” While the company disclosed risks concerning “consumer spending patterns,” “fashion preferences,” and “inventory management,” its failure to disclose that the new styles would continue to be sold throughout most of 2011 meant that these risks were not hypothetical. Accordingly, the cautionary statements were inadequate because they did not “disclose hard facts critical to appreciating the magnitude of the risks described.”

Second, the court found that the “safe harbor does not apply to material omissions” and, as a result, the failure to dislose the pre-ordering of the unpopular new styles was “unprotected by the safe harbor, regardless of whether the statements thereby rendered misleading were forward-looking.” Because the court “declined to find that the misleading nature of the statements rests on the forward-looking aspects of the statements,” it also declined to find that the safe harbor’s “actual knowledge” requirement was applicable.

The court’s interpretation of the scope of the safe harbor is questionable (and perhaps unnecessary, given the court’s general view of the strength of the complaint’s allegations). The PSLRA expressly states that the safe harbor applies “in any private action that is based on an . . . omission of a material fact necessary to make the statement not misleading.” While the safe harbor does not apply to statements of current fact (whether they are alleged to be misstatements or rendered misleading by a material omission), that is different than concluding that the safe harbor does not apply to forward-looking statements that are alleged to be misleading because of the omission of a current fact. Indeed, reading the statute in this manner would severely limit its application. Plaintiffs routinely allege that a company’s projections were misleading based on its failure to disclose certain current facts.

Holding: Motion to dismiss denied.

Addition: The complaint also contained “opinion evidence from an expert in the retail and wholesale industry,” who concluded that the “Defendants had no reasonable basis to believe that Aeropostale could meet the guidance they issued.” Although the court summarized this opinion evidence in its decision, it also stated that it “did not consider any of the ‘expert testimony’ that was included – inappropriately in the Court’s view – in the pleading.”

Pursuant to 28 U.S.C. Sec. 1658(b), a private securities fraud action “may be brought not later than the earlier of (1) 2 years after the discovery of the facts constituting the violation; or (2) 5 years after such violation.” While there are a number of cases that have explored what triggers the 2-year period (the statue of limitations), fewer courts have examined what triggers the 5-year period (the statute of repose).

In Intesa Sanpaolo, S.p.A. v. Credit Agricole Corporate and Investment Bank, 2013 WL 525000 (S.D.N.Y. Feb. 13, 2013), the plaintiff argued that its securities fraud claim was not time-barred under the 5-year deadline “because a ‘violation’ for 1658(b) purposes is the transaction that forms the basis of the Sec. 10(b) claim at issue (rather than the alleged misrepresentation).” Alternatively, the plaintiff argued that even if the misrepresentation triggered the time period, its claim was still timely because the defendants had concealed the truth until less than five years before the complaint was filed. The court rejected both arguments.

First, the court found that the majority of courts have held that the “violation” is the misrepresentation, not the securities transaction, and there was no dispute that the last alleged misrepresentation took place more than five years before the plaintiff brought its suit. Second, the court rejected the “continuing omission” theory proposed by the plaintiff. The court noted that “applying the concept of a continuing omission to the five-year deadline would essentially render that element of 1658(b) a nullity with respect to any securities fraud case that does not involve a corrective disclosure.”

Holding: Federal claims time-barred.

Quote of note: “For example, if it is assumed that an individual purchased a company’s stock in February 2007 in reliance upon an offering memorandum that contained a material omission that was never subsequently acknowledged or corrected, under the continuing omission theory urged by Inesta, not only would a claim based on that omission be timely even today, six years after the omission, despite 1658(b)’s five-year deadline, but the five-year deadline would not have even begun running on the claim.”

The federal securities laws have statutes of repose (suit barred after a fixed number of years from the time the defendant acts in some way) and statutes of limitations (establishing a time limit for a suit based on the date when the claim accrued). There is a growing district court split, however, over whether the existence of a class action tolls the statute of repose for a federal securities claim.

Under what is known as American Pipe tolling, “the commencement of a class action suspends the applicable statute of limitations as to all asserted members of the class who would have been parties had the suit been permitted to continue as a class action.” American Pipe & Construction Co. v. Utah, 414 U.S. 538, 554 (1974). The Supreme Court found that its rule was “consistent both with the procedures of [Federal Rule of Civil Procedure] 23 and with the proper function of limitations statutes.” Id. at 555. In a later case, however, the Supreme Court also found that federal statutes of repose are not subject to equitable tolling. Lampf, Pleva, Lipkind, Prupis & Pettigrow v. Gilbertson, 501 U.S. 350, 364 (1991). In attempting to reconcile these two cases, the majority of lower courts have concluded that American Pipe tolling applies to the statute of repose for federal securities claims because it is based on FRCP 23 and, therefore, is a type of legal (as opposed to equitable) tolling. Other recent decisions, however, have concluded that because FRCP 23 does not expressly create a class action tolling rule, American Pipe tolling is best understood as a judicially-created rule based on equitable considerations and, as a result, cannot extend a statute of repose.

In New Jersey Carpenters Health Fund v. Residential Capital, LLC, 2013 WL 55854, (S.D.N.Y. Jan. 3, 2013), the court surveyed this case law and sided with the majority position. In particular, the court found that failing to toll the statute of repose would undermine the purpose of FRCP 23 and its endorsement of class actions. Indeed, the court noted that “in a securities case, the risk that potential class members would flood the courts is particularly serious, since class certification is a lengthy, uncertain process.” Moreover, any former class members would have effectively been a party to an action against the defendant already. Tolling their individual claims therefore would not be “contrary to the purpose of the repose period that the right to initiate suit against a defendant be within a legislatively determined time period.”

Holding: Denying motion to dismiss claims.

Addition: On the Case has a post on the decision and notes that the Second Circuit is considering the tolling issue in a pending appeal.

Let’s say a company provides a financial statement to a government regulator, but then provides a different (and significantly more favorable) financial statement to investors. The financial statement given to the investors has to be false, right? Not so fast.

In In re L&L Energy, Inc. Sec. Litig., 2012 WL 6012787 (W.D. Wash. Dec. 3, 2012), the court addressed a securities class action brought against a U.S. company engaged in coal mining and related operations in China. The plaintiffs alleged that L&L Energy’s revenue and income for FY2009, as disclosed in its SEC filings, was grossly overstated. The allegation was “based primarily on the fact that L&L Energy’s subsidiaries in China reported much lower revenue and income to the PRC State Administration for Industry and Commerce (‘SAIC’) over a comparable period.” Moreover, the plaintiffs asserted, it was clear that the SAIC numbers reflected L&L Energy’s true financial performance because “there are strict penalties, including the revocation of an entity’s business license, for filing false statements with the SAIC.”

The court was less sure about which numbers to believe. As a threshold matter, the court found that it was difficult to determine whether the plaintiffs were actually comparing apples to apples, given that the SAIC data appeared to “differ[] in material ways from the information provided to the SEC, and not just in amounts.” Even if one of the filings must be incorrect, however, the court held that the plaintiffs had failed to adequately plead it was the SEC numbers that were false. Willful misstatements in an SEC filing can also result in significant penalties and, therefore, the “only reasonable inference is that corporations make false statements to both the SAIC and the SEC at their peril.”

Holding: Motion to dismiss granted with leave to amend.

A recent decision in the long-running Merck securities litigation contains a pair of interesting holdings. In In re Merck & Co., Inc. Securities, Derivative & ERISA Litigation, 2012 WL 3779309 (D.N.J. Aug. 29, 2012), the court considered the impact of its rulings in a related individual suit on the securities class action.

(1) False or Misleading Statements – Can accurate financial statements be rendered false or misleading because the company fails to disclose ongoing business problems? Plaintiffs frequently bring claims based on these types of allegations, with mixed results in the courts. In Merck, the court found that this theory of liability “would expose a company to liability every time it reported previous successes without disclosing any and every reason, established or not, the company had for second-guessing the reported performance, be it a contemplated change in business strategy, dissension among company management or adverse information about a key product.” Accordingly, the court declined to find that the company’s earnings statements could have been rendered inaccurate by the company’s failure to disclose drug safety issues.

(2) Control Person Liability – Does a plaintiff have to adequately plead that the defendant was a “culpable participant” to move forward with a control person claim? The Merck court noted that other judges in the District of New Jersey have held that it is not necessary to provide factual support for this element. The court held that this position is no longer tenable, however, following the Supreme Court’s Iqbal decision, which clarified that a claim cannot survive a motion to dismiss unless “the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” Moreover, because pleading “culpable participation” is akin to pleading scienter, it is subject to the PSLRA’s heightened pleading standard. A plaintiff asserting a control person claim therefore “must plead with particularity facts giving rise to a strong inference that the controlling person knew or should have known that the primary violator, over whom the person had control, was engaging in fraudulent conduct.”

While the Morrison decision limits Section 10(b) liability to securities transactions that take place in the United States, the complexity of the global securities market can lead to transactions that are difficult to define geographically. As a result, lower courts have struggled to consistently apply Morrison to different fact patterns.

In Phelps v. Stomber, 2012 WL 3276969 (D.D.C. Aug. 13, 2012), the court addressed whether there could be Section 10(b) liability for “Class B Shares” and “Restricted Depositary Shares (RDS)” issued by a closed-end investment fund. The Class B Shares were sold only outside the U.S. to foreign investors. The RDSs were sold to investors in the U.S.

As to the Class B Shares, the court held it was of no significance that Euronext, the exchange upon which the shares were traded, is owned by a Delaware company. Euronext was still a “foreign exchange” for purposes of the Morrison analysis and there could be no Section 10(b) liability. In contrast, the RDSs were clearly bought and sold in the U.S., but the defendants argued that the purchase of a RDS also should be considered a foreign transaction because it represented the shareholder’s ownership of a Class B Share traded on Euronext. Among other precedent, the defendants cited the Societe Generale decision, which held that American Depository Receipts were the “functional equivalent” of trading a company’s shares on a foreign exchange. The court rejected this view, finding that while the contention that “an investor could not purchase an RDS in the United States without a corresponding overseas transaction may be true, it does not change the fact that a purchase in the United States still took place.” Accordingly, Morrison did not bar the RDS claims.

Holding: Motion to dismiss granted (on other grounds as to the RDS claims).

Quote of note: “[P]laintiffs’ efforts to label everything “Made in America” to get around Morrison requires the Court to ignore allegations in the complaint and information contained in the Offering documents referenced in the complaint.”