December 14, 2012 · 4:34 pm

They Can’t Both Be Right

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.

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November 30, 2012 · 4:02 pm

Not Sufficiently Colorful

An interesting motion to dismiss decision in the S.D.N.Y. – Dobina v. Weatherford Int’l Ltd., 2012 WL 5458148 (S.D.N.Y. Nov. 7, 2012) – touches upon several scienter pleading issues.

(1) Corporate Acquisitions – Does the artificial inflation of the company’s stock price to facilitate acquisitions establish a “motive” that can contribute to a demonstration of scienter (i.e., fraudulent intent)? The Second Circuit has held that there must be a “unique connection between the fraud and the acquisition,” but has “provided little guidance as to what this ‘unique connection’ must be.” The court found that, at a minimum, this requirement “demands more than alleging simply that the Company acquired companies during the class period with the use of stock.” Moreover, it is arguable that “any such motive to raise the stock price in order to fund acquisitions more cheaply would inure to the benefit of all shareholders, and thus would not demonstrate intent to defraud.”

(2) Core Operations Theory – Should knowledge of the falsity of statements about the “core operations” of a company be imputed to its key officers? The court noted that “it remains an open question whether the theory has survived the passage of the PSLRA.” Even if it applied the core operations theory, however, the court found that because it “may make such an inference does not mean that such an inference necessarily would be the most compelling [as required by the S. Ct.’s Tellabs decision].” As to the Weatherford defendants, the more compelling inference of scienter was “that the Company made an error in its tax accounting treatment in 2007 that persisted on its books, compounding over time, and leading to incorrect financial reporting that propagated up to management.”

(3) Auditor Scienter – Auditor scienter in the Second Circuit “turns on alleging that the auditor repeatedly failed to scrutinize serious signs of fraud” (i.e., ignored red flags). The court found that the plaintiffs’ allegations about what E&Y (Weatherford’s auditor) ignored, however, were either “not red flags at all” or “not sufficiently colorful.” In particular, the mere “size and nature of the fraud” could not establish that “E&Y should have found it.”

Holding: Complaint dismissed, except for claims against two officers based on statements about the quality of internal controls (and related control claims).

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November 19, 2012 · 11:49 am

Giant Bodies and Evil Minds

Summary judgment decisions are usually fact specific and do not provide a lot of insight into how other cases will be decided. The recent decision in In re Federal National Mortgage Association Sec., Derivative, and “ERISA” Lit., 2012 WL 4888506 (D.D.C. Oct. 16, 2012), however, contains some interesting lessons.

The case against Fannie Mae is one of the longest-running securities class actions in the country, with the first complaint having been filed in Sept. 2004. The case arises out of accounting issues that ultimately resulted in a massive restatement. As detailed in the court’s decision, there have been numerous reports and findings of regulators relating to the events in question. During the relevant period, J. Timothy Howard was the CFO of Fannie Mae.

Following prolonged discovery in the case, Howard moved for summary judgment, arguing that the plaintiffs had failed to establish he acted with scienter. The court agreed, finding that despite all of the smoke around Howard’s activities as CFO, there was no evidence of an actual fire. A few key points:

(1) Stretching the Evidence – The court appeared annoyed at what it viewed as the plaintiffs’ attempt to “stich[] together a patchwork quilt of evidence that they allege presents a disputed issue of material facts as to Howard’s scienter.” The plaintiffs had no direct evidence of Howard’s knowledge of any accounting fraud and, in the court’s view, frequently resorted to overstating the circumstantial evidence.

(2) Outside Reports – The court rejected the plaintiffs’ use of “post-hoc reports and litigation documents, which were uniformly prepared after the relevant events in this case, and some of which were explicitly prepared in preparation for litigation, as ‘evidence’ of Howard’s scienter.” Not only were these materials likely inadmissible, but none of them specifically demonstrated how Howard had acted with scienter.

(3) Relying on Motion to Dismiss Arguments – The plaintiffs argued that the magnitude and duration of the accounting fraud was evidence of Howard’s scienter. The court’s response was (a) “as Shakespeare might have noted: a giant body doth not portend an evil mind,” and (b) “the time for simply presenting allegations that give rise to a strong inference of scienter has long since passed.”

Holding: Individual defendant’s motion for summary judgment granted.

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November 5, 2012 · 9:25 pm

Amgen Argued

Oral argument took place in the Amgen case in the U.S. Supreme Court this morning. The case involves the issue of whether, to obtain class certification, a plaintiff must prove that an alleged misstatement was material and therefore can support a fraud-on-the-market presumption (reliance by investors on the misstatement is presumed if the misstatement is material and the company’s shares were traded on an efficient market that would have incorporated the information into the stock price).

The argument focused heavily on whether it was appropriate to decide the issue of materiality at the class certification stage given that it is both a predicate for the use of the fraud-on-the-market presumption and a substantive element of the securities fraud claim.

A few highlights:

(1) The parties agreed that materiality was a “common issue” for all the class members, but not on whether that fact should preclude it being examined at the class certification stage of the case. Petitioner (Amgen) had some difficulty persuading the Court that a distinction could be drawn between determining materiality at the class certification stage for purposes of the fraud-on-the-market presumption and determining materiality on the merits. A few justices pressed whether it was Petitioner’s position, as Justice Kagan put it, “that a judge who has just ruled that a statement is immaterial is going to keep the case in his court litigated by an individual plaintiff, even though he’s just ruled that the statement is immaterial?” Petitioner insisted that this was possible, because the judge would not be able to resolve disputed facts at the summary judgment stage of a case brought by an individual plaintiff. Justice Breyer questioned whether this established too much, because why not “try out everything [at class certification], because we could always think of a few examples where, despite the fact that, you know, it’s only a common issue 99 percent of the time, we can dream up a situtation where it’s not a common issue.”

(2) More broadly, Petitioner argued that the purpose of FRCP 23 “is for a court to determine whether all of the preconditions for forcing everyone into a class action are present before you certify.” Because materiality is “an essential predicate of the fraud-on-the-market theory” and that theory is necessary to certify a securities fraud class, it follows that the court must determine the existence of materiality at class certification.

(3) In turn, Respondent (investors) was asked numerous questions about why the Court should draw a distinction between market efficiency (another predicate for the fraud-on-the-market presumption that can be rebutted at the class certification stage) and materiality. Justice Scalia noted that market efficiency also is a common issue that, if decided by the judge at class certification, might preclude individual investors from bringing a suit because they could not say “that’s why I got cheated, because the market reflected this false statement and I paid more money for the stock than I should have.” Respondent – with some assistance from Justice Breyer – argued that the difference was that market efficiency is merely a “gate-keeping function[] to determine whether or not the answer for indirect reliance on the market is a common question,” while materiality is a traditional element of a fraud.

(4) For its part, the government argued in support of Respondent, stating that “materiality in a fraud-on-the-market case serves two purposes . . . . And what Petitioners would have this Court do is isolate the two inquiries when they’re really the same question.” Justice Scalia’s response: “If you have the same question, then maybe we shouldn’t have this fraud-on-the-market theory . . . . So maybe we should overrule Basic [the Supreme Court case endorsing the fraud-on-the-market presumption] because it was certainly based upon a theory that simply collapses once you remove the materiality element.”

All of the briefs and other background materials can be found here. Reuters has an article on the argument.

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November 2, 2012 · 9:56 pm

Amgen Preview

On Monday, the Supreme Court will hear oral argument in the Amgen case. The official questions presented are:

1. Whether, in a misrepresentation case under SEC Rule 10b-5, the district court must require proof of materiality before certifying a plaintiff class based on the fraud-on-the-market theory.

2. Whether, in such a case, the district court must allow the defendant to present evidence rebutting the applicability of the fraud-on-the-market theory before certifying a plaintiff class based on that theory.

The court will be addressing a circuit split on these issues. Three circuit courts (Second, Fifth and, to a lesser extent, the Third) previously have held that materiality is a required part of the fraud-on-the-market analysis when evaluating whether a class should be certified. The Ninth Circuit joined a decision from the Seventh Circuit, however, in rejecting that position and holding that materiality is a merits question that does not affect whether class certification is appropriate.

Scotusblog has links to all of the relevant background materials, including the merits and amicus briefs, and an argument preview. Thomson Reuters and Forbes also have columns on the case.

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October 19, 2012 · 8:32 pm

Who Knew The Truth?

Should a securities class action defendant be able to get discovery from absent class members to support its defenses? In Garden City Employees’ Retirement System v. Psychiatric Solutions, Inc., 2012 WL 4829802 (M.D. Tenn. Oct. 10, 2012), the defendants issued subpoenas to 14 institutional investors in a case where the class had already been certified. In their motion for leave to conduct this discovery, the defendants contended that the discovery was necessary on “individual issues” and to further their “truth on the market defense.”

The court noted that, as a general matter, discovery of absent class members is disfavored. The defendants “bear the burden of showing necessity and the absence of any motive to take undue advantage of the class members.” In the instant case, the court concluded that mere “speculation” that absent class members might have invested even knowing of the alleged misstatements was insufficient to satisfy the defendants’ burden. Moreover, any discovery related to individual reliance on the alleged misstatements could be done after a trial on the common issues.

Holding: Motion for leave to conduct discovery of absent class members denied.

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October 5, 2012 · 8:06 pm

SLUSA Is On Deck

As the U.S. Supreme Court begins its October term, a securities litigator’s thoughts turn to what cases the court might take next. A leading indicator (although far from a guarantee) is a cert petition where the Court asks the government to provide its input. On Monday, the Court made this request in three related cases arising out of an alleged Ponzi scheme.

The Securities Litigation Uniform Standards Act (“SLUSA”) precludes certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. In determining what is meant by “in connection with,” the Supreme Court has held that it is sufficient that the alleged misrepresentation “coincide” with a covered securities transaction. The circuit courts have had difficulty, however, in expanding upon this requirement to form a consistent standard (see, e.g., decisions from the Second Circuit, Sixth Circuit, and Seventh Circuit).

In the Ponzi scheme cases, the Fifth Circuit held that the “best articulation of the ‘coincide’ requirement” is that the fraud allegations must be “more than tangentially related to (real or purported) transactions in covered securities.” The court concluded that the relationship between the alleged Ponzi scheme, which centered around the sale of certificates of deposit, and any transactions in covered securities was too attenuated to trigger SLUSA preclusion.

Will the Supreme Court revisit SLUSA? Stay tuned.

Addition: Bloomberg has an article on the Supreme Court’s request.

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September 28, 2012 · 11:43 pm

Merck Again

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.”

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September 21, 2012 · 10:13 pm

Facebook Begins

One of the first decisions in the Facebook securities litigation addresses a Securities Litigation Uniform Standards Act of 1998 (SLUSA) issue that has been the subject of a longstanding district court split.

Private actions under the Securities Act of 1933 (’33 Act) may be brought in federal or state court. SLUSA was designed, however, to prohibit the bringing of securities class actions based on misrepresentations or deception in state court and provides for the removal of these cases to federal court. In doing so, however, SLUSA specifically limits itself to class actions “based upon the statutory or common law of any State.” Which leaves open the question: can plaintiffs bring a ’33 Act class action in state court and prevent its removal?

In Lapin v. Facebook, Inc., 2012 WL 3647409 (N.D. Cal. Aug. 23, 2012), the court held that ’33 Act class actions are removable. The court found that SLUSA amended the jurisdiction section of the ’33 Act by inserting an “except as provided in” SLUSA provision that exempts covered class actions from concurrent jurisdiction (presumably even though ’33 Act class actions are brought under federal, not state or common, law). Moreover, this interpretation of the amendment to the jurisdiction section is supported by SLUSA’s legislative history, which broadly states that SLUSA’s purpose “is to prevent plaintiffs from seeking to evade the protections that Federal law provides against abusive litigation by filing suit in State, rather than in Federal, court.”

Holding: Motion to remand denied.

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September 7, 2012 · 9:01 pm

Competing Methodologies

Determining whether a pharmaceutical company has made a false statement about a clinical trial can raise technical issues. In In re Rigel Pharmaceuticals, Inc. Sec. Litig., 2012 WL 3858112 (9th Cir. Sept. 6, 2012), the plaintiffs alleged that the company misstated the results of a clinical trial for a drug designed to treat rheumatoid arthritis. The district court found that the plaintiffs “had failed to adequately plead a false statement regarding efficacy [of the drug] because disagreements over statistical methodology and study design are insufficient to allege a materially false statement.”

On appeal, the Ninth Circuit agreed with that analysis. The court found that the plaintiffs were really “alleging that Defendants should have used different statistical methodologies, not that Defendants misrepresented the results they obtained from the methodologies they employed.” Even if another statistical methodology would have been better or more accurate, accepting the plaintiffs’ argument “would suggest that a company should announce statistical results that are obtained using a statistical methodology that is adopted after the study data is made available to the researchers and that is different from the methodology used as part of the clinical trial.” Any company that took this approach “could raise concerns regarding reliability, biased scientific methods, or even fraud.”

Holding: Dismissal affirmed (both on falsity and scienter grounds).

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