The 10b-5 Daily

There are two prongs to the PSLRA’s safe harbor for forward-looking statements. First, a defendant is not liable with respect to any forward-looking statement that is identified as forward-looking and is accompanied by “meaningful cautionary statements” alerting investors to the factors that could cause actual results to differ. Second, a defendant is not be liable with respect to any forward-looking statement, even in the absence of meaningful cautionary statements, if the plaintiff cannot establish that the statement was made with “actual knowledge” that it was false or misleading.

Although the circuit courts agree that the two prongs operate separately, they are split as to whether the defendant’s state of mind should be considered in determining whether the cautionary statements are sufficiently “meaningful.” The Sixth, Ninth, and Eleventh Circuits have held that the defendant’s state of mind is irrelevant. The Seventh and Second Circuits, however, have suggested that it might be necessary to inquire into what the defendant knew about the risks facing the company before making that determination.

In In re Harman Int’l Indus., Inc. Sec. Litig., 2014 WL 197919 (D.D.C. Jan. 17, 2014), the district court agreed with the majority position and found that the defendant’s state of mind is irrelevant. First, the plain text and the legislative history of the PSLRA make it clear that the first prong should be considered without reference to the defendant’s state of mind. Second, considering the defendant’s state of mind would improperly collapse the two prongs together, essentially making it impossible for a defendant to invoke the first prong at the pleadings stage of the case.

Holding: Motion to dismiss granted.

If an SEC rule states that certain information does not have to be disclosed in a public filing, does that mean a company cannot act recklessly in failing to disclose that information? In In re Hi-Crush Partners L.P. Sec. Litig., 2013 WL 6233561 (S.D.N.Y. Dec. 2, 2013), the defendants noted that under the SEC’s Form 8-K rules, they were not required to disclose that a major customer had terminated its contract with the company because the purported termination was invalid. In support of their argument that the plaintiffs had failed to adequately plead scienter, the defendants cited a different district court, addressing a similar set of facts, which held that “defendants’ compliance with [SEC regulations] suggests that Lead Plaintiff has failed to show defendants acted recklessly in omitting such information.”

The Hi-Crush court agreed that the Form 8-K rules did not require the disclosure, but disagreed that this meant the defendants had not acted recklessly. First, the court found that even in the absence of an affirmative disclosure obligation, the defendants could have a duty to disclose the information to avoid misleading investors. Second, given that the contract was supposed to generate 18.2% of Hi-Crush’s revenue stream, it was “imperative” that investors be told about the threat of termination.

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

The Gentiva securities class action is based on allegations that the company violated Medicare rules and artificially inflated the Medicare payments it received. In a previous post, The 10b-5 Daily discussed the motion to dismiss decision in the case, where the court found that the plaintiffs had adequately plead a strong inference of scienter against the company and two of its officers based solely on alleged suspicious insider trading. The defendants moved for reconsideration.

In In re Gentiva Sec. Litig., 2013 WL 6486326 (Dec. 10, 2013), the court reevaluated the trading and came to some different conclusions. As to the former CFO’s trading, the court found “that trades under a Rule 10b5-1 plan do not raise a strong inference of scienter.” If those type of trades were removed from the CFO’s trading, all that would remain was a sale of 20,000 shares (or 12% of his holdings) that “occured more than six months before the announcement of the government investigation.” Under these circumstances, the trading was not sufficiently suspicious and the court dismissed the securities fraud claim against the CFO.

But what did that mean for the two remaining defendants in the case – the former CEO and the company? As to the CEO, the court found that he sold 99% of his shares during the class period for approximately $2.14 millon and those sales were not made pursuant to a Rule 10b5-1 trading plan. The fact that no other officers were adequately alleged to have engaged in suspicious trading did not alter the court’s conclusion that the CEO’s trading created a strong inference of scienter as to him. When it came to the company, however, the court reversed field and found that the suspicious sale of stock by only one officer – as opposed to two officers – could not support a finding of corporate scienter and dismissed the securities fraud claim against the company.

So, after reconsideration, the case apparently will move forward against a single individual defendant – the former CEO.

Holding: Motion for partial reconsideration granted in part and denied in part.

The impact of a Rule 10b5-1 trading plan on a court’s scienter analysis depends largely on the overall facts and circumstances surrounding the trading. In Koplyay v. Cirrus Logic, Inc., 2013 WL 6233908, (S.D.N.Y. Dec. 2, 2013), the court considered allegations that during the class period the individual defendants sold 14%, 11%, 46% and 10% of their stock holdings (for profits ranging from less than $1m to $4m). In surveying the case law, the court found that this trading was not “suspicious” for the following reasons:

(1) The timing of the sales, which allegedly took place at the “height” of the class period, “actually weighs against a finding of scienter, as the majority of the sales were neither at the beginning of the Class Period, soon after the misleading statements, nor clustered at its end, when insiders theoretically would have rushed to cash out before the fraud was revealed and stock prices plummeted.”

(2) The court declined to adopt a rule that an insider’s sale of more than 10% of his holdings is suspicious. Instead, the court noted that “courts have found scienter based on sales similar to these only where the volume of sales and total profit is overwhelming or where some other factor, such as the timing of the sales, further tips the balance.”

(3) The court found that all but one of the sales were made pursuant to Rule 10b5-1 trading plans that “were entered into months before the class period.” Although the plaintiffs argued that the defendants could have “timed the release of good and bad news to maximize insider trading profits based on triggers in the plan,” the court found that “this argument effectively reduced to a claim that Defendants had scienter because they were motivated to raise the price of Cirrus stock.”

Holding: Motion to dismiss granted.

If the judge likens the events surrounding the collapse of your company to a “massive train wreck,” is moving to dismiss the related securities class action worthwhile? That was the question facing the defendants in the MF Global Holdings case and the court did not like their answer.

In In re MF Global Holdings Ltd. Sec. Litig., 2013 WL 5996426 (S.D.N.Y. Nov. 12, 2013), the court started out by noting that its “train wreck” analogy “was meant as a hint giving a form of guidance.” The case involved the alleged disappearance of $1.6 billion from customer accounts that was later found to have been “improperly commingled and used to cover questionable company transactions.” Under these circumstances, the court believed that the parties would “turn to the search for relevant evidence,” but instead was surprised to find that the defendants “seem convinced that no one named in this lawsuit could possibly have done anything wrong.” Indeed, the defendants’ contention that all twenty-three claims against them should be dismissed must mean that MF Global’s collapse was “the fateful work of supernatural forces, or else that the explanation for a spectacular multi-billion dollar crash of a global corporate giant is simply that ‘stuff happens.'”

The court went on to reject the motion to dismiss in its entirety. However, the court did make at least one legal ruling in favor of the defendants. A key issue in the case is whether MF Global’s statements about its deferred tax assets were false or misleading. Deferred tax assets are losses, credits and other tax deductions that may be used to offset taxable income in the future, but they can only be recorded as assets on a company’s balance sheet to the extent the company determines it is “more likely than not” they will be realized. The court found that under Second Circuit precedent, “statements about the realization of the DTA are statements of opinion, not of fact.” Accordingly, the plaintiffs ultimately will need to prove that these statements were both false and not honestly believed at the time they were made.

Holding: Motion to dismiss denied.

Quote of note: “In evaluating the application of law that Defendants argue would allow the outcome that they seek at this stage of the litigation, the Court’s assessment may be simply stated: It cannot be.”

Does the fact that an individual defendant’s stock trading took place pursuant to a pre-determined Rule 10b5-1 trading plan undermine any inference that the trades were “suspicious”? Courts continue to be split on this question, with the answer often depending on the exact circumstances surrounding the plan’s formation and execution.

In In re Questor Sec. Litig., 2013 WL 5486762 (C.D. Cal. Oct. 1, 2013), the court examined a plan that was created around the beginning of the class period and lead to periodic sales of 30,000 shares each until July 2012. When the plan terminated, however, the defendant “made two additional sales of 40,000, more than his usual 30,000 sales, in August and September 2012 [just prior to the end of the class period].” Based on this fact pattern, the court found that while the sales could have been innocent, it was “equally as plausible that, after observing the success of Questcor’s aggressive and misleading marketing strategies, [the defendant] set up the plan to avoid the appearance of improper sales.”

More generally, the decision contains an extensive analysis of the scienter implications of the defendants’ stock trading. The court holds, inter alia, that (a) even where the percentage of stock sold is not suspicious, the sales can support an inference of scienter if the profits are “substantial,” and (b) a company’s implementation of a stock repurchase plan during the class period can be inconsistent with scienter, because it is illogical for a company to buy shares if it knows the price will fall.

Holding: Motion to dismiss denied.