The 10b-5 Daily

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.

The U.S. Court of Appeals for the Third Circuit has weighed in on two controversial issues concerning loss causation and scheme liability. In In re DVI, Inc. Sec. Litig., 2011 WL 1125926 (3rd Cir. March 29, 2011), the court examined the lower court’s decision to grant class certification, except as to the claims against the company’s outside law firm. The key holdings are:

(1) Loss causation – The court addressed the issue currently before the U.S. Supreme Court in the Halliburton case, i.e., does a plaintiff have to establish loss causation to obtain class certification. In agreement with the Second Circuit and Seventh Circuit (but contrary to the Fifth Circuit), the court held that “a plaintiff need not demonstrate loss causation as a prerequisite to invoking the fraud-on-the-market presumption of reliance.” Instead, the burden is on the defendant to introduce evidence “demonstrating an allegedly corrective disclosure did not move the market – that there was no market impact and therefore no loss causation” which “may in some circumstances rebut the presumption of reliance.”

(2) Scheme liability – The plaintiffs argued that the Stoneridge decision created a “remoteness test” for assessing whether investors had relied on the fraudulent conduct of secondary actors. The remoteness test allegedly requires courts to assess: (a) the defendant’s level of involvement in the fraudulent scheme, (b) whether the misrepresentation was the “necessary or inevitable” result of the defendant’s conduct, and (c) whether the defendant’s conduct took place in the “investment sphere.” Like the Second Circuit, the court rejected this argument, finding that the only issue was whether the deceptive conduct “has been publicly disclosed and attributed to the actor.” In the instant case, because the plaintiffs did “not contend that the outside law firm’s role in masterminding the fraudulent 10-Q was disclosed to the public, they cannot invoke the [fraud-on-the-market presumption of reliance].”

Holding: Judgment affirmed.

In the Matrixx Initiatives v. Siracusano case, the U.S. Supreme Court has held that the plaintiffs were not required, in a case alleging that Matrixx failed to disclose reports of a possible link between its leading drug product and the loss of smell, to plead that these reports were statistically significant. The unanimous decision authored by Justice Sotomayor rejects the use of statistical significance as a “bright-line rule” for the assessment of materiality in this type of case.

The core of the defendants’ argument was that in the absence of statistical significance, adverse event reports suggesting that a drug has caused a loss of smell do not “reflect a scientifically reliable basis for inferring a potential causal link” that would be material to a reasonable investor. The Court declined to hold, however, that “statistical significance is the only reliable indication of causation.” For example, the FDA relies on a wide range of evidence of causation and “sometimes acts on the basis of evidence that suggests, but does not prove, causation.” If “medical professionals and regulators act on the basis of evidence that is not statistically significant, it stands to reason that in certain cases reasonable investors would as well.”

Having rejected the proposed bright line rule, the Court found that the complaint adequately alleged “Matrixx received information that plausibly indicated a reliable causal link” between the drug and the loss of smell. The information included the adverse event reports and studies suggesting a causal link. In turn, investors would have viewed this information as material because it suggested there was “a significant risk to the commercial viability of Matrixx’s leading product,” especially because the risk associated with the drug (possible loss of smell) substantially outweighed the benefit of using the drug (alleviate cold symptoms). The omitted material information rendered Matrixx’s statement that its “revenues were going to rise 50 and then 80 percent” misleading.

Holding: Reversal of dismissal affirmed (the court also found that the plaintiffs had adequately plead scienter).

Notes on the Decision:

(1) The decision is quite narrow. Perhaps most importantly, the Court did not offer any redefinition of the Basic materiality standard (so the forests are safe). Nor did the Court make any broad pronouncements on the appropriateness of evaluating materiality at the motion to dismiss stage of a case.

(2) In line with its Tellabs decision on the issue of pleading scienter, the Court emphasized a holistic approach to evaluating the plaintiffs’ materiality allegations (e.g., “Viewing the allegations of the complaint as a whole . . .”).