Category Archives: Motion To Dismiss Monitor

An interesting issue, which has generated a district court split, is whether securities class actions can be brought against a mutual fund based on misstatements about the fund’s investment objective and holdings. Mutual funds have argued that it is impossible for plaintiffs to establish loss causation. The price of mutual fund shares is not determined by market securities trading, but rather is based on the fund’s net asset value (NAV). The NAV is a statutorily defined formula that depends on the value of the underlying securities held by the fund. Accordingly, the NAV can only decline in response to a change in the value of those securities, not as a result of the disclosure of hidden facts about the fund.

Courts have been reluctant to embrace this argument, with several courts noting that as a matter of public policy mutual funds should not be allowed to escape securities liability. In In re State Street Bank and Trust Co. Fixed Income Funds Investment Litigation, 2011 WL 1206070 (S.D.N.Y. March 31, 2011), however, the court examined claims brought under Section 11 and 12 of the ’33 Act and found that this policy rationale cannot trump the required legal analysis.

Under the Lentell (2d Cir.) decision, plaintiffs must show “that the misstatement or omission concealed something from the market that, when disclosed, negatively affected the value of the security.” Moreover, the damages provisions in Sections 11 and 12 both “tie the recovery of a potential plaintiff to the value of the security.” Given that “the NAV does not react to any misstatements [about the fund’s investment objective and holdings], no connection between the alleged material misstatement and a diminution in the security’s value had been or could be alleged.” The court therefore granted the defendants’ motion to dismiss.

Holding: Case dismissed with prejudice.

Quote of note: “In this case, however, the Court is constrained by the plain language of Section 11(e) and 12(a)(2), which requires a connection between the alleged material misstatements and a diminution in the security’s value. It seems likely that Congress never considered that it might be creating a loophole for fraudulent misrepresentations by mutual fund managers when enacting these provisions. But if this is so, closing the loophole requires legislative action.”

A trial verdict that results in $9.3 billion in potential damages is likely to engender a slew of post-trial motions. The court’s decision on those motions in the Vivendi securities class action was made public this week.

The media focus has been on the court’s application of the National Australia Bank (NAB) decision to dismiss the fraud claims by purchasers (including U.S. purchasers) of Vivendi shares on foreign exchanges. The dismissal was in line with other post-NAB cases, although the Vivendi court was quick to point out that the Supreme Court’s decision contains imprecise language. In particular, on the issue of whether the decision permits, based on the existence of a dual listing (U.S. and foreign exchange), a U.S. cause of action for investors who purchased their shares on the foreign exchange, the court suggested that “perhaps Justice Scalia simply made a mistake.” That is to say, “[Scalia] stated the test as being whether the alleged fraud concerned the purchase or sale of a security ‘listed on an American stock exchange,’ when he really meant to say a security ‘listed and traded’ on a domestic exchange.” In any event, there was no indication that the Supreme Court “read Section 10(b) as applying to securities that may be cross-listed on domestic and foreign exchanges, but where the purchase and sale does not arise from the domestic listing.”

The Vivendi court’s other rulings are at least as interesting and two of them stand out.

(1) Corporate scienter – The court addressed how the jury could have found that Vivendi acted with scienter in committing securities fraud, while dismissing the claims against Vivendi’s former CEO and CFO. The court agreed that to prove corporate scienter, the plaintiffs needed to establish that a Vivendi agent committed a culpable act with scienter. However, the court found, the “fact that the jury absolved [the former officers] of liability does not negate the fact that there was sufficient evidence in the record in the first instance to enable a reasonable jury to find against all three defendants on the issue of scienter, thereby foreclosing judgment as a matter of law in Vivendi’s favor.” As to whether the verdicts were inconsistent, which is a possible ground for a new trial, the court concluded that “significant evidence admitted against Vivendi, but not against [the former officers], could have led the jury to find that plaintiffs proved that Vivendi violated Section 10(b) based on the scienter of [the former officers], even if the jury was unable to conclude the plaintiffs had met their burden of proof against [the former officers].”

(2) Reliance – The court noted that “certain means of rebutting the presumption of reliance require an individualized inquiry into the buying and selling decisions of particular class members.” Vivendi should have the opportunity to make this rebuttal as to individual class members, perhaps even through separate jury trials if necessary, although the exact procedures for the “individual reliance phase” would have to be determined. As a result, the court declined to enter a final judgment in the case.

Holding: Dismissed claims brought by purchasers of ordinary shares (as opposed to American Depositary Shares). Denied Vivendi motion for judgment as a matter of law or, in the alternative a new trial, except as to one statement. Denied entry of final judgment.

Item 303(a) of Regulation S-K, which requires issuers to disclose known trends or events “reasonably likely” to have a material effect on operations, capital, and liquidity, has been referred to as the “sleeping tiger” of securities litigation. Item 303(a) certainly has two attributes that are attractive to plaintiffs: it requires the issuer to offer a prediction on the effects of a known trend, but the disclosure arguably is not subject to the PSLRA’s safe harbor for forward-looking statements (other than two subsections dealing with off-balance sheet arrangements and contractual obligations). The use of Item 303(a) in securities litigation has a mixed history, but the Second Circuit may have woken the tiger last week.

In Litwin v. The Blackstone Group, L.P., 2011 WL 447050 (2d Cir. Feb. 10, 2011), the court considered whether the plaintiffs had adequately alleged that Blackstone failed to make required disclosures under Item 303(a) related to two portfolio companies and its real estate investment funds. The claims were brought pursuant to Section 11 and 12 of the ’33 Act, based on omissions in Blackstone’s registrations statement and prospectus, so the applicable pleading standard was notice pleading (i.e., enough facts that the claim is plausible on its face). Moreover, there was no dispute that there was a downturn in the real estate market at the time of Blackstone’s IPO. Accordingly, the sole issue was the pleading of materiality.

The court made the following key holdings.

First, the court rejected Blackstone’s argument that it was not required to make an Item 303(a) disclosure because the downturn in the real estate market was already part of the “total mix” of information available to the market. While investors knew about the downturn, the “potential future impact [on Blackstone’s investments] was certainly not public knowledge.”
Second, the court declined to find that Blackstone was not required to disclose information about particular portfolio companies because the investments were relatively small and the gains or losses from the investments were aggregated at the fund level. To hold otherwise, the court found, would “effectively sanction misstatements in a registration statement or prospectus related to particular portfolio companies so long as the net effect on the revenues of a public private equity firm like Blackstone was immaterial.” Moreover, the portfolio company investments were in key sectors of Blackstone’s business.

Finally, the court held that the plaintiffs were not required to identify specific real estate investments that had been adversely effected by the downturn. Indeed, that was the exact information, along with potential effect of the downturn, that the plaintiffs claimed was omitted. In any event, the plaintiffs had alleged enough facts connecting the real estate downturn with potential adverse effects on Blackstone’s real estate investments to state a plausible claim.

So what impact will the Blackstone decision have? At a minimum, the decision seems likely to encourage the use of Item 303(a) as a vehicle for private securities litigation, although obviously not every case is amenable to an allegation that there was a known, undisclosed trend. Second, the decision can be read to create a low materiality threshold (although this case did not allege fraud and therefore was not subject to the heightened pleading standard of Rule 9(b)). While the district court relied heavily on the fact that the investment losses did not have a significant impact on Blackstone’s overall financial results, the Second Circuit applied a more holistic, “what would a reasonable investor want to know,” standard. Of course, the Supreme Court soon will be weighing in on the issue of materiality. Stay tuned.

Holding: Dismissal vacated and remanded for further proceedings.

While defendants have had the better of the post-NAB decisions to date, a court in the S.D.N.Y. may have gone a step too far this week. In In re Societe Generale Sec. Litig., 08 Civ. 2495 (S.D.N.Y. Sept. 29, 2010), the court found that NAB‘s prohibition on claims based on the purchase of securities on foreign exchanges also extends to claims based on the purchase of American Depository Receipts in the U.S. Because Societe Generale’s ADRs “were not traded on an official American securities exchange,” the court held that trading in them was a “predominately foreign securities transaction” and Section 10(b) was inapplicable. The D&O Diary has a lengthy post on the decision and expresses some skepticism about the court’s reasoning.

No one should pack their bags for Shangri-La quite yet. The defendants in the UBS case have received a huge boost from another S.D.N.Y. court regarding the scope of the National Australia Bank (NAB) decision.

At issue is whether a foreign issuer listed on both a foreign exchange and a U.S. exchange can be subject to suit in the U.S. by investors who purchased their shares on the foreign exchange. In In re Alstom SA Sec. Litig., 03 Civ. 6595 (VM) (S.D.N.Y. Sept. 14, 2010), the court found that NAB‘s use of the phrase “listed on domestic exchanges” did not, based on the existence of a dual listing (U.S. and France), create a U.S. cause of action for investors who purchased their Alstom shares on the French exchange.

The court also declined to exercise supplemental jurisdiction over the claims of the foreign purchasers and apply French law to adjudicate them. Among other things, the court noted that “Plaintiffs have not given any indication that the French claims were unavailable when they began this action and the Court is not now persuaded they should be allowed to press the reset button here, particularly where, by Plaintiffs’ own reckoning, France’s ten-year statute of limitations allows the claims to be brought in France.”

Holding: Claims of plaintiffs who purchased securities on foreign exchanges dismissed.

Quote of note: “That the transactions themselves must occur on a domestic exchange to trigger application of Sec. 10(b) reflects the most natural and elementary reading of [the NAB decision].”

The scope of the National Australia Bank (NAB) decision on the extraterritorial application of Section 10(b) continues to be tested in the lower courts. A case to keep an eye on is In re UBS AG Sec. Litig. (S.D.N.Y.), where the issue is what the Supreme Court meant when it stated that Section 10(b) applies to “the purchase of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.” To wit, does it mean that if a foreign issuer is listed on both a foreign exchange and a U.S. exchange it can be subject to suit in the U.S. by investors who purchased their shares on the foreign exchange?

The AmLaw Litigation Daily has a post (subscrip. req’d) on the case, which includes a link to UBS’s recent motion to dismiss. Not surprisingly, UBS argues that reading “listed” to authorize U.S. securities class actions based on the purchases of securities on a foreign exchange would “fly in the face” of the Supreme Court’s conclusion that Section 10(b) does not regulate foreign exchanges. Stay tuned.

Quote of note (UBS brief): “Over 850 foreign issuers, including NAB and UBS, list and register their shares on both a foreign exchange and a U.S. exchange. It defies logic to believe that Justice Scalia, without explanation and contrary to the rest of his majority opinion, included the word ‘listed’ to expand Section 10(b) in a way that will discourage foreign issuers from listing their shares on U.S. exchanges and make the United States the ‘Shangri-La’ for worldwide securities class actions.”

In Freudenberg v. E*TRADE Financial Corp., 2010 WL 1904314 (S.D.N.Y. May 11. 2010), the plaintiffs alleged that E*TRADE had fraudulently concealed the high risk nature and deterioration of the company’s mortgage portfolio. The court’s decision, which denies the defendants’ motion to dismiss, addresses a couple of interesting topics.

(1) Rule 10b5-1 stock trading plans – The utility of a Rule 10b5-1 stock trading plan in defeating the inference of scienter caused by large stock sales varies widely. (The 10b-5 Daily’s most recent post on the topic, with links to other relevant posts, can be found here.) In the E*TRADE case, the individual defendants had entered into their plans during the class period. In other words, they allegedly “were already aware of the Company’s mortgage exposure time bombs” when they decided to sell shares. Under these circumstances, the court declined to find that any inference of scienter created by the stock sales was dispelled.

(2) Announcement of SEC investigation – On the last day of the class period, E*TRADE announced additional mortgage losses , withdrew its guidance, and disclosed that the SEC has commenced an investigation. The company’s stock price declined significantly. The court found that the announcement of the SEC investigation, which was “linked to the purportedly fraudulent misconduct,” was within the “zone of risk” concealed by E*TRADE’s alleged misrepresentations. As a result, it was “akin to a corrective disclosure” and could be used to adequately plead loss causation. (A post by The 10b-5 Daily on a contrary decision can be found here.)

Holding: Motion to dismiss denied.

Under the collective scienter theory, it is possible for a plaintiff to adequately plead scienter with respect to a corporate defendant even where the plaintiff is unable to adequately plead scienter with respect to any individual corporate employee who made a false statement. There is a circuit split on the issue, with the Second Circuit and Seventh Circuit adopting the theory and the Fifth Circuit rejecting the theory. That leaves a lot of room for district courts in other circuits to come to their own conclusions.

In City of Roseville Employees’ Retirement System v. Horizon Lines, Inc., 2010 WL 1994693 (D. Del. May 18, 2010), the court considered the potential liability of the corporate defendants (Horizon and a wholly-owned subsidiary) for making false statements related to a price fixing conspiracy. Certain of the corporate defendants’ officers had already plead guilty to price fixing. The court declined to apply the collective scienter theory, finding that the Third Circuit’s rejection of group pleading (i.e., the presumption that the senior officers of a company are collectively responsible for any misrepresentations contained in the company’s public statements) made the appellate court unlikely to adopt collective scienter. Instead, the court followed the Fifth Circuit’s requirement that there must be “a showing that at least one individual officer who made, or participated in the making of, a false or misleading statement did so with scienter.”

The officers who had plead guilty to criminal charges were not alleged to have made any public statements on behalf of the corporate defendants. Nevertheless, the plaintiffs argued that these officers “participated” in the making of the statements because the corporations must have obtained the false data from them. As a result, the plaintiffs argued, the scienter of these officers should be imputed to the corporations. The plaintiffs provided no facts to support their assertion about the source of the false data and the court declined to find that corporate scienter had been adequately established.

Holding: Complaint dismissed with prejudice as to certain defendants.