The 10b-5 Daily

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.”

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 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.” In the intervening years, however, the Second Circuit has not directly addressed this inconsistency, to the benefit of plaintiffs.

George v. China Automotive Systems, Inc., 2012 WL 3205062 (S.D.N.Y. Aug. 8, 2010) is a “Chinese reverse merger” case alleging that the company engaged in accounting fraud. In their motion to dismiss, the defendants argued that the plaintiffs had failed to adequately plead scienter. The court, citing Second Circuit precedent, noted that the “requisite ‘strong inference’ of scienter can be established by alleging facts showing (a) defendants’ ‘motive and opportunity’ to commit the alleged fraud, or (b) strong circumstantial evidence of conscious misbehavior or recklessness.” After examining the complaint, the court held that the plaintiffs’ insider trading allegations, by themselves, were sufficient to establish motive and opportunity. In particular, four of the seven individual defendants “sold over 50% of their CAAS stock during the class period” and the individual defendants collectively made a net profit of nearly $42 million on their class period sales.

The defendants offered two counterarguments, both of which were rejected by the court. First, the defendants noted that the individual defendants had entered into Rule 10b5-1 stock trading plans. As a result “more than two-thirds of [their] sales were made pursuant to the 10b5-1 plans and the remaining sales are too small a fraction of total sales to establish ‘unusual’ trading.” The court held that because the 10b5-1 trading plans were entered into during the class period, they could not be invoked “to disarm any inference of scienter raised by the Individual Defendants’ sales of CAAS stock.” Second, the defendants asserted that “the alleged accounting errors and misstatements regarding internal controls are insufficient to sustain a securities fraud claim.” The court found that this assertion was “immaterial at this stage” because the plaintiffs had “sufficiently plead motive and opportunity.”

It is difficult, in the wake of Tellabs, to see how a lower court can engage in the required weighing of competing inferences of scienter if it stops the exercise after finding that there has been “unusual” insider trading. The Second Circuit needs to sort this out.

Holding: Motion to dismiss denied (except as to an auditor defendant).