The 10b-5 Daily

Rules 10b-5(a) and (c) establish securities fraud liability for deceptive devices, schemes, and acts. One issue courts have considered is whether “scheme liability” requires a defendant to have engaged in fraudulent conduct beyond the making of material misrepresentations or omissions (which is specifically prohibited by Rule 10b-5(b)).

In Public Pension Group v. KV Pharmaceutical Co., 2012 WL 1970226 (8th Cir. June 4, 2012), the court found that the only non-conclusory “scheme liability” allegations were based on the defendants’ supposed knowledge of misstatements concerning the company’s FDA compliance and earnings. The court held that these allegations were deficient, “join[ing] the Second and Ninth Circuits in recognizing a scheme liability claim must be based on conduct beyond misrepresentations or omissions actionable under Rule 10b-5(b).”

Holding: Dismissal affirmed in part and reversed in part.

The Second Circuit and Seventh Circuit have issued recent notable decisions.

(1) Item 303(a) of Regulation S-K requires issuers to disclose known trends or uncertainties “reasonably likely” to have a material effect on operations, capital, and liquidity. While it has been referred to as the “sleeping tiger” of securities litigation, it may soon be the star of the circus. In Panther Partners Inc. v. Ikanos Communications, Inc., 2012 WL 1889622 (2nd Cir. May 25, 2012), the Second Circuit added to its Item 303(a) jurisprudence, finding that the plaintiffs had plausibly alleged that the company, at the time of its securities offering, “was aware of the ‘uncertainty’ that it might have to accept returns of a substantial volume, if not all, of the chips it had delivered to its major customers.”

Holding: Denial of leave to file an amended complaint (based on futility) reversed.

(2) He’s back and so soon! Following up on last month’s decision, Judge Easterbrook of the Seventh Circuit has authored another securities litigation opinion. In Plumbers and Pipefitters Local Union 719 Pension Fund v. Zimmer Holdings, Inc., 2012 WL 1813700 (7th Cir. May 21, 2012) (Easterbrook, J.), the court addressed whether the plaintiffs had adequately plead scienter (i.e., fraudulent intent) in a case alleging that the company downplayed the significance of product problems. Among other things, the plaintiffs pointed to the CEO’s failure, in response to a question posed during an analyst call, to reveal that the company had received verbal notice from an FDA inspector of “significant objectionable conditions” at one of its plants. The court concluded that the CEO’s answer was technically accurate and the “worst one could say about [the] answer is that it was evasive, which is short of fraudulent.”

Holding: Dismissal affirmed.

There is rarely a dull moment when Judge Frank Easterbrook writes a securities litigation opinion. In Fulton County Employees Retirement System v. MGIC Investment Corp., 675 F.3d 1047 (7th Cir. April 12, 2012) (Easterbrook, J.) the court addressed a credit crisis case in which a mortgage loan insurer allegedly made misstatements about the liquidity of an affiliated company. The decision includes a few interesting holdings.

(1) MGIC stated in a press release that the affiliated company (in which MGIC held a 46% interest) had “substantial liquidity,” but eleven days later announced that its investment in the affiliated company was “materially impaired.” The court concluded that the liquidity statement was inactionable both because it was true when made and because the press release contained specific warnings about the liquidity risk at the affiliated company.

(2) Moreover, the court noted that the events that led to the material impairment of the investment were known to the market. To the extent that the “whole world knew that firms that had issued, packaged, or insured subprime loans were in distress,” MGIC was in no better position to foresee what would happen to its investment than anyone else.

(3) The plaintiffs also alleged that certain statements made by officers of the affiliated company during MGIC’s earnings call were fraudulent. The court held that (a) MGIC’s ownership interest in the affiliated company was insufficient to establish that it “controlled” the affiliate (especially given that another company also had a 46% stake) for purposes of control person liability, and (b) pursuant to the recent Janus decision, MGIC could not be held liable as a “maker” of the affiliated company’s statements and had no duty to correct them.

Holding: Dismissal affirmed.

Quote of Note: “The press release went on to detail problems that MGIC was encountering, including the liquidity risk at [the affiliated company]. The goal of this paragraph was to let investors know about the trouble without painting too gloomy a picture. A balancing act of that nature cannot sensibly be described as fraud.”

The efficient market hypothesis can be a double-edged sword for plaintiffs. While it is necessary to support a presumption of reliance in securities class actions, it also makes courts skeptical of any theory of fraud that is based on the corporate defendant failing to inform the market about the impact of known events.

In City of Omaha, Nebraska Civilian Employees’ Retirement System v. CBS Corp., 2012 WL 1624022 (2d Cir. May 10, 2012), the plaintiffs alleged that CBS should have performed an impairment test on its goodwill and disclosed the results several months before it actually did so in October 2008. The Second Circuit affirmed the dismissal of the case on two grounds.

First, the court held, based on on its prior Fait decision, that estimates of goodwill are statements of opinion. The plaintiffs’ failure to allege “that defendants did not believe in their statements of opinion regarding CBS’s goodwill at the time they made them” was fatal to their securities fraud claims.

Second, the court found that “all of the information alleged to constitute ‘red flags’ calling for interim impairment testing . . . were matters of public knowledge.” Given the efficiency of the market for CBS stock, the price therefore “would at all pertinent times have reflected the need for, if any, or culpable failure to undertake, if any, interim impairment testing.” Under these circumstances, the complaint did not allege in a plausible fashion that “the market price of CBS stock was inflated by a fraud” and that the plaintiffs relied upon that fraudulently inflated price.

Holding: Dismissal affirmed.