The 10b-5 Daily

Oral argument took place in the Matrixx case this morning. The case addresses the issue of materiality, in particular whether adverse event reports (i.e., reports by users of a drug that they experienced an adverse event after using the drug) are material information even if they are not statistically significant. Also, there was a lot of talk about Satan. Seriously.
A few highlights (based on the transcript):

(1) Petitioner (Matrixx) argued that the key issue is whether the plaintiff has plead facts from which “you can draw a reliable inference that the product is the cause” of the adverse events. In the case of adverse event reports, that reliable inference exists if the adverse event reports are statistically significant. The justices were aggressively skeptical of that position right from the outset. First, a number of justices (Sotomayor, Kennedy, Ginsburg, Scalia, Roberts) wondered if the real issue is whether the company knew about information that could affect its stock price, even if that information was not credible. Second, Justices Kagan and Breyer disagreed that a reasonable investor would only want to know about adverse effects that were statistically significant. As Justice Breyer put it – “look, Albert Einstein had the theory of relativity without any empirical evidence . . . So I can’t see how we can say this statistical evidence always works or always doesn’t work.”

(2) Respondent (investors) had a somewhat easier time, with Justice Breyer even inviting counsel to draft a disclosure rule for drug companies. Counsel responded that he would start with the “total mix of information” test for materiality and “where there is credible medical professionals describing the harms based on credible scientific theories to back up the link, a very serious health effect risk for products with many substitutes, and the effect in on a predominant line, then the company ought to disclose that information.”

(3) The argument took a bit of a turn for Respondent, however, when counsel stated that even irrational information – such as a group of people believing that a product “has some link to satanic influences” – might need to be disclosed. Chief Justice Roberts wondered how companies could determine what should be disclosed under that standard and asked if it would matter whether the “product has particular satanic susceptibility”? In response to Respondent’s argument that the scienter requirement might limit a company’s liability for failing to disclose material, yet irrational, information, Justice Scalia noted that there was no difference between scienter and materiality in that “scienter is withholding something that is material that is known to be material and once . . . Satan is material, if the company thinks Satan is involved here, it has to put it in its report.”

All of the briefs and other background materials can be found here. Bloomberg and the Washington Post have coverage of the argument.

Disclosure: The author of The 10b-5 Daily submitted an amicus brief on behalf SIFMA and the U.S. Chamber of Commerce in support of petitioner.

The U.S. Supreme Court continues to take an interest in securities litigation cases. Earlier today, the Court granted cert in the Erica P. John Fund, Inc. v. Halliburton Co. case.

In Halliburton, the Fifth Circuit declined to certify a class because the plaintiffs had failed to adequately demonstrate loss causation. At issue on appeal is whether the Fifth Circuit’s requirement that plaintiffs establish loss causation at class certification by a preponderance of admissible evidence (but without the benefit of merits discovery) exceeds what is required by Federal Rule of Civil Procedure 23.

The Court asked for the government’s views on the case. In a brief filed early last month, the government urged the Court to take the case and overturn the Fifth Circuit’s decision. Among other things, the government noted that the Seventh Circuit has expressly rejected the Fifth Circuit’s approach.

As always, SCOTUSblog has all of the relevant background materials.

The Apollo Group securities class action has turned out to be far more interesting than anyone could have predicted. The case is based on the company’s alleged failure to disclose the existence of a government report finding that its wholly-owned subsidiary, the University of Phoenix, had violated Department of Education regulations.

After a jury trial, the plaintiffs won a $277.5 million verdict. The trial court, however, held that the plaintiffs had failed to prove loss causation and overturned the verdict. In its decision, the court found that the two analyst reports relied upon by the plaintiffs as “corrective disclosures” that led to a stock price decline “did not provide any new, fraud-revealing analysis.” Instead, the reports merely repeated information about the government report already known to the market or provided information about the University of Phoenix that was factually wrong (and therefore could not have been corrective).

The plaintiffs appealed to the Ninth Circuit and, in a summary, unpublished opinion, the appellate court held that “the jury could have reasonably found that the [analyst] reports following various newspaper articles were ‘corrective disclosures’ providing additional or more authoritative fraud-related information that deflated the stock price.”

So it is on to the Supreme Court, where the question will be whether the justices are ready to revisit the issue of loss causation a mere five years after their Dura decision. Commentators are making a strong argument that the court should grant cert. The Ninth Circuit’s decision appears to suggest that the efficient market hypothesis, which forms the basis for the presumption of reliance in securities class actions, somehow does not really apply when examining loss causation. In other words, the market rapidly absorbs information for the purpose of allowing investors to argue that they relied on false information incorporated into the stock price, but once that information is disclosed, these same investors can argue that it was only when the media or analysts more widely broadcast the information that their loss occurred.

In a New York Law Journal column, the authors discuss the case and the related circuit splits over the necessary timing and nature of a “corrective disclosure.”SCOTUSblog has the cert petition. According to the docket, a number of amicus briefs have already been filed (e.g., a brief from the National Association of Manufacturers supporting the granting of the cert petition).

Oral argument in the Janus case took place this morning. The early verdict is that the U.S. Supreme Court may be headed toward a split decision on whether the investment manager of a fund can be subject to primary liability for securities fraud based on alleged misstatements in the fund’s prospectuses.

A few highlights (based on the transcript):

(1) Petitioner (Janus) conceded that its in-house counsel had drafted the prospectuses on behalf of the fund, but argued that the fund was governed by its trustees who were responsible for the contents and issuance of the prospectuses. The court spent a considerable amount of time exploring the nature of the relationship between an investment advisor and a fund. In particular, various members of the court (J. Breyer, J. Kennedy, J. Sotomayor) probed as to whether an investment advisor should be viewed as the equivalent of a corporate manager who can be held liable for the corporation’s misstatements.

(2) Justice Sotomayor and Justice Ginsburg both suggested that under Petitioner’s theory, a corporate entity could avoid liability by duping another corporate entity into making the misstatements. Petitioner responded that a “dupe case” is addressed in Section 20(b) of the Exchange Act (“the ventriloquist dummy statute”), which makes it unlawful for a person to effect a securities fraud through another person.

(3) Respondent (investors) argued that the Court should adopt the SEC’s interpretation of what it means to “make” a statement, i.e., “to create or compose or to accept as one’s own.” Justice Scalia was skeptical, suggesting that if Respondent was “talking about making heaven and earth, yes, that means to create, but if you’re talking about making a representation, that means presenting the representation to someone, not drafting it for someone else to make.”

(4) As to whether an investment advisor was the equivalent of a corporate manager, despite the fact that it is an independent entity, Respondent asserted that “contractually outsourc[ing] the management function should not alleviate the securities fraud that is alleged here.” Moreover, the investment advisor had “substantive control over the content of the message” and, therefore, was not a mere aider and abettor. In response, Justice Kagan questioned the relevance of “control” given that Respondent had not brought its case under Section 20 of the Exchange Act and presumably could not have done so because of the nature of the relationship between a fund and its investment advisor.

All of the briefs and other background materials can be found here. Bloomberg has coverage of the argument.

Can a plaintiff adequately allege or prove loss causation by pointing to a corrective disclosure that reveals the company’s financial results and condition, even if the disclosure does not directly reveal any alleged misrepresentations? Courts have been reluctant to apply this “true financial condition theory,” especially at the proof stage of a case. The U.S. Court of Appeals for the Ninth Circuit is the latest court to find that an earnings miss, or similar adverse financial result, is by itself insufficient to establish loss causation.

In In re Oracle Corp. Sec. Litig., 2010 WL 4608794 (9th Cir. Nov. 16, 2010), the Ninth Circuit reviewed a grant of summary judgment for the defendants. The district court held that plaintiffs failed to identify sufficient evidence as to loss causation for their non-forecasting claims. In particular, plaintiffs relied on an earning miss rather than any actual disclosure about defects in a key product.

On appeal, the Ninth Circuit agreed that the “overwhelming evidence produced during discovery indicates the market understood Oracle’s earnings miss to be a result of several deals lost in the final weeks of the quarter,” not “that customers did not buy [the product] as a result of defects.” The fact that two analyst reports questioned this explanation for the earnings miss could not overcome the “market’s consensus.” Moreover, Oracle continued to sell large amounts of the product during the following quarter, suggesting that there was no public knowledge of the supposedly concealed defects.

Holding: Grant of summary judgment affirmed.

Quote of note: “Plaintiffs take issue with our opinion in Metzler. Specifically, they assert that they should be able to prove loss causation by showing that the market reacted to the purported ‘impact’ of the alleged fraud—the earnings miss—rather than to the fraudulent acts themselves. We reject that assertion. Loss causation requires more than an earnings miss.”

There is a circuit split on the issue of primary vs. aiding-and-abetting liability. Under the “bright line” test adopted by the Second Circuit, primary liability for securities fraud (as opposed to aiding-and-abetting liability, which is not available in private actions) only exists if the alleged misstatement is attributable on its face to the defendant.

Other circuit courts, however, have applied a more relaxed standard. The Fourth Circuit has found that it is sufficient for a plaintiff to adequately allege that (a) the defendant “participated” in the making of the misstatement, and (b) “interested investors would have known that the defendant was responsible for the statement at the time it was made, even if the statement on its face is not directly attributable to the defendant.” Earlier this year, the Supreme Court granted cert in that case – Janus Capital Group v. First Derivative Traders – and presumably will resolve the circuit split.

In the interim, the Fifth Circuit has issued a decision expressly agreeing with the Second Circuit and adopting the “bright line” test. In Affco Investments 2001 LLC v. Proskauer Rose, L.L.P., 2010 WL 4226685 (5th Cir. Oct. 27, 2010), the court considered whether a law firm could have primary liability based on its provision of tax opinions that were alleged to be part of a fraudulent scheme. The company that promoted the scheme informed investors that “several major national law firms” had vetted the investments. Although plaintiffs claimed to have relied on the tax opinions, the court found that they failed to allege “that they ever saw or heard any Proskauer work product before making their decision, nor do they explicitly allege that the promoters identified Proskauer as one of the ‘major national law firms.'” Accordingly, the plaintiffs “failed to show reliance on Proskauer” and the law firm could not be a primary violator.

Holding: Dismissal affirmed.

Quote of note: “Knowing the identity of the speaker is essential to show reliance because a word of assurance is only as good as its giver. Clients engage ‘name-brand’ law firms at premium prices because of the security that comes from the general reputations of such firms for giving sound advice, or for winning trials. Specific attribution to a reputable source also induces reliance because of the ability to hold such a party responsible should things go awry.”