The 10b-5 Daily

The Janus opinion, which holds that primary liability for securities fraud is limited to the person or entity with ultimate authority over the alleged false statements, has had its first impact. Earlier this week, the U.S. Supreme Court denied cert in a case alleging that a law firm and one of its former partners were liable for false statements made by Refco in its public filings. The Second Circuit had dismissed the claims, finding that under its “bright line” test the attorneys could not be liable because they were not identified to investors as the makers of the statements. In the wake of Janus, the Court left the Second Circuit’s decision undisturbed. Law360 has an article on the cert denial.

In the Janus Capital Group v. First Derivative Traders case, the U.S. Supreme Court has held that for purposes of primary liability under Rule 10b-5, the “maker” of a statement is the person or entity with ultimate authority over the statement. The 5-4 decision authored by Justice Thomas rejects the government’s proposed “creation” test, which would have extended primary liability to a person who provides false or misleading information that another person puts into a statement. Justice Breyer penned a vigorous dissent.

Oral argument does not always point the way to the ultimate decision in a case. Here, however, the justices split along the same lines, and for the same reasons, as publicly discussed back in December. At issue in Janus was whether a fund’s investment advisor had “made” the alleged misstatements in the prospectuses issued by the fund. The Court concluded that “the maker of a statement is the entity with authority over the content of the statement and whether and how to communicate it.” Because the fund (and not its investment advisor, which was a separate corporate entity) possessed the “ultimate authority” to determine what would go into its prospectuses, it was the “maker” of the alleged misstatements.

Although the Court recognized that an investment advisor acts as the manager of a fund and exercises significant influence over the contents of any prospectus, it concluded that “[a]ny reapportionment of liability in the securities industry in light of the close relationship between investment advisers and mutual funds is properly the responsibility of Congress and not the courts.” Moreover, the Court found that its bright-line definition of “maker” was consistent with its past rejections of secondary liability in private securities fraud suits.

Holding: Judgment reversed.

Quote of note: “[T]he maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it. Without control, a person or entity can merely suggest what to say, not ‘make’ a statement in its own right. One who prepares or publishes a statement on behalf of another is not its maker. And in the ordinary case, attribution within a statement or implicit from surrounding circumstances is strong evidence that a statement was made by—and only by—the party to whom it is attributed. This rule might best be exemplified by the relationship between a speechwriter and a speaker. Even when a speechwriter drafts a speech, the content is entirely within the control of the person who delivers it. And it is the speaker who takes credit—or blame—for what is ultimately said.”

Notes on the Decision:

(1) In dissent, Justice Breyer argues that the “English language does not impose upon the word ‘make’ boundaries of the kind the majority finds determinative.” It is more reasonable to conclude that several different individuals or entities can “‘make’ a statement that each has a hand in producing.” Here, according to the dissent, the “special relationships” alleged between the fund, its investment advisor, and the prospectus statements “warrant the conclusion that [the investment advisor] did ‘make’ those statements.”

(2) The Court is notably silent on the exact scope of its decision. Is it limited to cases involving separate corporate entities or does it also extend to disputes over who, within a corporation, can be said to have “made” an alleged misstatement? The dissent appears to suggest that it covers both situations, noting (as part of its criticism of the decision) that “[e]very day, hosts of corporate officials make statements with content that more senior officials or the board of directors have ‘ultimate authority’ to control.”

(3) One of the key issues at the oral argument was whether a limited interpretation of “make a statement” would allow a corporate entity to avoid liability by duping another corporate entity into making misstatements. A possible solution is the application of Section 20(b) of the Exchange Act, which makes it unlawful for a person to effect a securities fraud through another person. The Court declined to address the issue (see Note 10), but will we now see an increase in Section 20(b) claims as plaintiffs attempt to limit the impact of the decision?

As predicted, the U.S. Supreme Court has issued a narrow decision in the Halliburton case rejecting the Fifth Circuit’s requirement that securities fraud plaintiffs must prove loss causation to obtain class certification. The unanimous (and short) opinion authored by Chief Justice Roberts holds that loss causation is not a precondition for invoking the fraud-on-the-market presumption of reliance and, therefore, is not necessary to establish that reliance is capable of resolution on a common, classwide basis.

While the Court endorsed the majority position adopted by the Second Circuit, Third Circuit, and Seventh Circuit, it focused entirely on the nature of the fraud-on-the-market presumption and did not address the scope of Federal Rule of Civil Procedure 23 (governing class certification). Moreover, the Court gave short shrift to the defendants’ argument that although the Fifth Circuit specifically said “loss causation,” it really was imposing a “price impact” test designed to determine whether the alleged misrepresentation had affected the company’s stock price in the first place. The Court noted that “loss causation is a familiar and distinct concept in securities law; it is not price impact” and declined to do anything other than take the Fifth Circuit “at its word.”

Holding: Judgment vacated and remanded to district court for further proceedings consistent with opinion.

Quote of note: “According to the Court of Appeals, however, an inability to prove loss causation would prevent a plaintiff from invoking the rebuttable presumption of reliance. Such a rule contravenes Basic’s fundamental premise—that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction. The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively through the fraud-on-the-market theory. Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.”

In its Tellabs and Matrixx decisions, the Supreme Court emphasized that whether a plaintiff has adequately plead a strong inference of scienter is subject to a holistic review (i.e., the allegations in the complaint must be considered in their entirety). This approach conflicts with the more traditional judicial approach of reviewing each scienter allegation separately and then coming to an overall conclusion as to whether the plaintiff has met its pleading burden.

In Frank v. Dana Corp., 2011 WL 2020717 (6th Cir. May 25, 2011), the court addressed this issue and held that in light of the Supreme Court’s decisions it must adopt a new, more efficient approach to evaluating scienter allegations. Exactly how efficient, however, may have come as a surprise to the parties. In just one page of analysis, the court concluded that in light of such factors as overall industry problems, rising prices for a key commodity, and the quick collapse of the company, it was “difficult to grasp the thought that [the defendants] really had no idea that Dana was on the road to bankruptcy.” Accordingly, the court found that the plaintiffs had adequately plead a strong inference of scienter because “the inference that [the defendants] recklessly disregarded the falsity of their extremely optimistic statements is at least as compelling to us as their excuse of failed accounting systems.”

Holding: Dismissal reversed. (The 10b-5 Daily has previously posted about an earlier, related appellate decision in the case.)

Quote of note: “[In Matrixx] the Court provided for us a post-Tellabs example of how to consider scienter pleadings ‘holistically’ in section 10(b) cases. Writing for the Court, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis. This is the only appropriate approach following Tellabs’s mandate to review scienter pleadings based on the collective view of the facts, not the facts individually. Our former method of reviewing each allegation individually before reviewing them holistically risks losing the forest for the trees. Furthermore, after Tellabs, conducting an individual review of myriad allegations is an unnecessary inefficiency.”

Mortgage pass-through certificates entitle the investor to distributions from underlying pools of mortgages. A key aspect of these securities are the credit ratings given to them by the ratings agencies. In In re Lehman Brothers Mortgage-Backed Securities Litigation, 2011 WL 1778726 (2d Cir. May 11, 2010), the court considered whether these ratings agencies, by allegedly helping to “determine the composition of loan pools, the certificates’ structures, and the amount and kinds of credit enhancement of particular tranches” could be liable under Section 11 of the ’33 Act for misstatements in the certificates’ offering documents.

The plaintiffs’ argued that the ratings agencies activities made them “underwriters” of the securities and therefore subject to Section 11 liability. The court disagreed, finding that “to qualify as an underwriter under the participation prongs of the statutory definition, a person must participate, directly or indirectly, in purchasing securities from an issuer with a view to distribution, in offering or selling securities for an issuer in connection with a distribution, or in the underwriting of such an offering.” The fact that the ratings agencies played a role in “structuring or creating” the securities was insufficient to find that they acted as underwriters. Nor had the plaintiffs adequately alleged that the ratings agencies controlled the primary violators. The court found that “allegations of advice, feedback, and guidance fail to raise a reasonable inference that the Ratings Agencies had the power to direct, rather than merely inform, the banks’ ultimate structuring decisions.”

Holding: Dismissal of claims against ratings agencies affirmed.

Can a corporate 401(k) profit-sharing plan claim a share of the settlement proceeds from a securities class action brought against the company? In In re Motorola Securities Litigation, 2011 WL 1662838 (7th Cir. May 4, 2011) the court held that Motorola’s plan, despite being a purchaser of Motorola common shares during the relevant period, could not participate in the settlement because it was an “affiliate” of the issuer.

The Motorola 401(k) Profit-Sharing Plan (the “Plan”) is “a participant-directed, defined-contribution retirement plan established for the benefit of current and former Motorola employees.” The Plan was controlled by a committee appointed by Motorola’s board. One of the plan’s investment options was a fund that allowed participants to acquire beneficial ownership of Motorola common stock.

In 2007, a securities class action brought against Motorola was settled for $190 million. (The 10b-5 Daily also has posted about the lead plaintiff and motion to dismiss decisions in the case.) The settlement specifically excluded any “affiliate” of Motorola from making a claim. The Plan filed a claim with the claims administrator for the benefit of its participants, which the district court eventually rejected.

On appeal, the Seventh Circuit found that the district court’s rejection of the Plan’s claim was correct. The key issue was whether, pursuant to the securities-law meaning of “affiliate,” the Plan was controlled by or under common control with Motorola. Motorola’s board appointed the Plan committee, which in turn had managerial control over the Plan’s policies and operations. The court held that “[t]his degree of control is sufficient to make the Plan an affiliate of Motorola, and as an affiliate of Motorola, the Plan is specifically excluded from the class.”

Holding: Order disallowing the Plan’s claim to a share of the Motorola settlement proceeds affirmed.

Oral argument took place in the Halliburton case earlier this week. The case addresses whether the Fifth Circuit’s requirement that plaintiffs establish loss causation at the class certification stage of a case exceeds what is required by Federal Rule of Civil Procedure 23. The transcript of the argument can be found here.

The defendants faced an uphill battle: other circuit courts have rejected the Fifth Circuit’s approach and the government also weighed in against the decision. As a result, the defendants argued that the real import of the Fifth Circuit’s decision was not that the plaintiffs must establish loss causation (as that term is generally understood in securities fraud cases), but rather that the plaintiffs must establish that the alleged misstatements resulted in a “price impact” so as to allow for a presumption of reliance based on the existence of an efficient market. To the extent that the defendants can successfully rebut the presumption and demonstrate that common issues will not predominate, they should be able to do so at the class certification stage. As the the transcript strongly suggests, the key question for the Court will be whether the predominance analysis under Federal Rule of Civil Procedure 23 allows for this extensive an inquiry (as opposed, for example, to just requiring plaintiffs to generally show that the market for the company’s securities was efficient).

For a summary of the oral argument, the D&O Diary has a comprehensive guest post. In addition, The Conglomerate Blog has an academic roundtable that does an admirable job of analyzing the various considerations before the Court and offers some predictions about the Court’s eventual decision (hint: it will be narrow).

It can be difficult for plaintiffs to adequately allege that an outside auditor acted with scienter when issuing its audit opinion. Accordingly, the Ninth Circuit’s decision last week to reverse the dismissal of the securities fraud claims against an outside auditor is worth examining.

In New Mexico State Investment Council v. Ernst & Young LLP, 2011 WL 1419642 (9th Cir. April 14, 2011), the court addressed E&Y’s alleged role in Broadcom’s options backdating scheme. At issue was a 2005 unqualified audit opinion that covered three years of Broadcom’s financial statements (2003–05). The court found that each of the following three allegations, whether taken individually or viewed collectively, were sufficient to find a strong inference that E&Y had acted with scienter:

(1) E&Y knew the material consequences of a May 2000 backdated option grant that would have resulted in a $700 million charge to Broadcom’s financial results but, despite violations of GAAS, signed off on the grant without obtaining documentation;

(2) E&Y knew that several significant option grants in 2001 were approved on dates when Broadcom’s compensation committee was not legally constituted due to the death of one of the two committee members; and

(3) E&Y presided over corrective reforms in 2003 to prevent and detect any future instances of improper stock option awards without questioning the integrity of Broadcom’s accounting for options granted prior to the corrective reforms.
The court also examined several other factual allegations related to scienter, including allegations of insufficient documentation, weak internal controls, and red flags related to Broadcom’s stock option grants.

Of particular concern to auditor defendants, however, may be the court’s rejection of E&Y’s argument that the plaintiffs had failed to show that any of the E&Y personnel who participated in the 2005 audit were aware of the earlier alleged backdating that impacted Broadcom’s 2005 consolidated financial statements. E&Y described this as an attempt to apply “roving scienter” over a long time period. The court disagreed, concluding that “EY, despite serving continuously as Broadcom’s auditor from 1998 until 2008, during which it attested to the accuracy of Broadcom’s financial statements for the multiple years noted in the 2005 Opinion, cannot now disclaim those prior opinions simply because the same individuals were not involved.”

Holding: Dismissal of claims against outside auditor reversed.