The 10b-5 Daily

In what is shaping up to be a blockbuster term for securities litigation cases, the U.S. Supreme Court will address the issue of primary liability.

On Monday, the Court granted cert (over the objection of the government) in the Janus Capital Group v. First Derivative Traders case. In Janus, the Fourth Circuit found that to establish primary liability it is sufficient for a plaintiff to adequately allege (a) the defendant “participated” in the making of a false statement, 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.” The defendants argued in their cert peition, apparently with some success, that both prongs of this holding created or exacerbated circuit splits.

SCOTUSBlog has links to the cert petition papers.

In the Morrison v. National Australia Bank (“NAB”) case, the U.S. Supreme Court has held that Section 10(b) of the Exchange Act applies only to transactions in securities listed on U.S. exchanges and to U.S. transactions in other securities. The 8-0 decision (Justice Sotomayor did not participate) authored by Justice Scalia thus rejects the use of the conduct/effects test to determine the extraterritorial application of the U.S. anti-fraud securities laws.

In NAB, the court considered a so-called “foreign-cubed” securities case – i.e., a securities class action brought against a foreign issuer by foreign investors who purchased their securities on a foreign exchange. The Second Circuit applied its existing “conduct test” for determining the extraterritorial application of Section 10(b) and held that the plaintiffs needed to adequately allege that “activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad.” The court found that this test was not met in NAB because the locus of the fraudulent activity, including the issuance of the false statements, was in Australia.

On appeal, the Supreme Court reached the same result, but took a notably different approach.

First, the Court found (contrary to the Second Circuit and other lower federal courts) that the extraterritorial application of Section 10(b) does not “raise a question of subject-matter jurisdiction.” Instead, it is an issue of “what conduct Section 10(b) prohibits, which is a merits question.”

Second, it is a longstanding principle that Congressional legislation, “unless a contrary intent appears, is meant to apply only within the territorial jurisdiction of the United States.” The fact that the “Exchange Act is silent as to the extraterritorial application of Section 10(b)” does not give courts license to speculate as to what Congress would have wanted. In the absence of any “affirmative indication” that Section 10(b) applies extraterritorially, the Court concluded “that it does not.”

Finally, the Court addressed the plaintiffs’ contention that even if Section 10(b) does not apply extraterritorially, there was sufficient deceptive conduct in the U.S. to make it a “domestic” case. Although the Court agreed that applying the presumption against extraterritorial application may require analysis, the presumption “would be a craven watchdog indeed if it retreated to its kennel whenever some domestic activity is involved in the case.” The Court found that the focus should be on the location of the securities transaction, not “the place where the deception originated.” Accordingly, it is “only transactions in securities listed on our domestic exchanges, and domestic transactions in other securities, to which Section 10(b) applies.”

Holding: Affirmed.

Notes on the Decision

(1) Although technically a unanimous decision, the concurrence written by Justice Stevens (and joined by Justice Ginsburg) effectively acted as a dissent. The justices urged affirmance on the grounds set forth in the Second Circuit’s opinion.

(2) The Court’s bright-line rule would appear easy to apply. One can envision fact patterns, however, that might make it difficult to assess whether a securities transaction is “domestic” (i.e., has taken place within the United States).

(3) While the decision does not discuss whether it applies to the SEC, there is no principled reason why the Court’s construction of Section 10(b) would not extend beyond private plaintiffs. Congress has been considering a codification of the extraterritorial application of Section 10(b). By indirectly limiting the scope of the SEC’s authority, the Court may have improved the prospects for such legislation.

(4) The Court showed some sympathy for the argument that the extraterritorial application of Section 10(b) will encourage suits of questionable merit and compromise the ability of foreign countries to regulate their own securities markets. To wit: “While there is no reason to believe that the United States has become the Barbary Coast for those perpetrating frauds on foreign securities markets, some fear that it has become the Shangri-La of class action litigation for lawyers representing those allegedly cheated in foreign securities markets.”

The U.S. Supreme Court is going to address the issue of materiality in securities fraud cases, albeit in the limited context of actions based on a drug company’s nondisclosure of “adverse event” reports.

Yesterday, the Court granted cert in the Matrixx Initiatives, Inc. v. Siracusano (9th Circuit) case. In Matrixx, the Ninth Circuit found that a drug company can be liable for failing to disclose adverse event reports (i.e., reports by users of a drug that they experienced an adverse event after using the drug) even if those reports were not statistically significant. The First, Second, and Third Circuits, however, have held that statistical significance is required to make the nondisclosure of the reports material. The Court will resolve the circuit split.

SCOTUSBlog has links to the cert petition papers. Although the question presented is narrow, the case may have wider ramifications if the Court offers guidance on its general materiality standard. Matrixx will be heard in the October term.

Surprisingly, the U.S. Court of Appeals for the Second Circuit has never issued an opinion analyzing the PSLRA’s safe harbor for forward-looking statements. It filled in that gap this week.

In Slayton v. American Express Co., 2010 WL 1960019 (2d Cir. May 18, 2010), the court considered whether the safe harbor shielded American Express from liability for a statement it made in its May 15, 2001 Form 10-Q. As paraphrased by the court, American Express had disclosed “that while it had lost $182 million from its high-yield debt investments in the first quarter of 2001, it expected futher losses from those investments to be substantially lower for the remainder of 2001.” It turned out, however, that in July 2001 the company took a large write-down on those investments.

The court’s decision contains a number of interesting holdings.

(1) Plain Language – Contrary to some other courts, the Second Circuit found that the safe harbor is “written in the disjunctive.” Therefore, “a defendant is not liable if the forward-looking statement is identified and accompanied by meaningful cautionary language or is immaterial or the plaintiff fails to prove that it was made with actual knowledge that it was false or misleading.”

(2) Scope of Financial Statement Exclusion – The safe harbor excludes forward-looking statements “included in a financial statement prepared in accordance with generally accepted accounting principles.” The Second Circuit held that the Management’s Discussion and Analysis (“MD&A”) section of the Form 10-Q, which contained the alleged misstatement, was not part of the financial statement portion of the filing. As a result, the safe harbor could be applied.

(3) Meaningful Cautionary Language – The Second Circuit noted that it was difficult to follow Congress’s instructions concerning the application of the safe harbor. To determine whether a defendant has identified the risks that realistically could cause results to differ, “the most sensible reference is the major factors that the defendants faced at the time the statement was made.” But it is clear from the relevant Conference Report that Congress did not want courts to inquire into the defendant’s knowledge of those risks.

The Second Circuit concluded that it did not have to “decide that thorny issue,” however, because American Express’s cautionary statement was too vague to satisfy the “meaningful” standard. While the company warned of the possibility of “potential deterioration in the high-yield sector,” it did not warn of the risk that rising defaults on the bonds underlying its investments would cause that deterioration. Moreover, American Express’s cautionary statement remained the same even as the problems related to its investments changed.

(4) Actual Knowledge – The Second Circuit held that the relevant pleading standard for actual knowledge is whether a reasonable person, based on the facts alleged, would “deem an inference that the defendants (1) did not genuinely believe the May 15 statement, (2) actually knew they had no reasonable basis for making the statement, or (3) were aware of undisclosed facts tending to seriously undermine the accuracy of the statement, ‘cogent and at least as compelling as any opposing inference.'” In this case, the plaintiffs failed to allege sufficient facts to meet this standard.

Holding: Dismissal based on PSLRA’s safe harbor affirmed.

Quote of note: “Congress may wish to give further direction on how to resolve this tension, and in particular, the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections. May an issuer be protected by the meaningful cautionary language prong of the safe harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement? In this case, however, we need not decide that thorny issue because we conclude that at any rate the cautionary statement the defendants point to here was vague.”

The U.S. Court of Appeals for the Second Circuit has rejected creationism, at least when it comes to determining whether a secondary actor has “made” a statement for purposes of securities fraud liability. In Pacific Investment Management Co. LLC v. Mayer Brown LLP, 2010 WL 1659230 (2d Cir. April 27, 2010), the plaintiffs and the SEC urged the court to reconsider its “bright line” test for determining whether a defendant can be liable for a misstatement.

Under the “bright line” test, primary liability (as opposed to aiding and abetting liability, which is not available in private securities fraud actions) only exists if the misstatement is attributable on its face to the defendant. In other words, the defendant must have been identified to investors as the maker of the statement. The plaintiffs and the SEC argued that public attribution is unnecessary. Instead, a court should be able to find primary liability where the defendant “creates” the statement, even if investors are unaware of the defendant’s involvement.

The Second Circuit disagreed. First, the panel found that an “attribution requirement is more consistent with the Supreme Court’s guidance on the question of secondary actor liability.” In particular, the Supreme Court’s Stoneridge decision suggests that attribution is necessary to establish the existence of reliance on the defendant’s deceptive acts. Second, the panel noted that the Second Circuit has consistently favored a “bright line” test to distinguish “primary violations of Rule 10b-5 from aiding and abetting.” The attribution requirement makes it clear that secondary actors “who sign or otherwise allow a statement to be attributed to them expose themselves to liability,” while “[t]hose who do not are beyond the reach of Rule 10b-5’s private right of action.”

As for the case at hand, the panel found that none of the alleged misstatements in Refco’s public filings were attributed to Mayer Brown or any of its attorneys. Without this attribution, “plantiffs cannot show reliance on any statements of Mayer Brown.” Moreover, plaintiffs’ “scheme liability” claims failed because plaintiffs admitted that “they were unaware of defendants’ deceptive conduct or ‘scheme’ at the time they purchased Refco securities.”

In an interesting concurrence, one of the judges noted that the Second Circuit’s decisions on the “attribution” issue have been somewhat inconsistent (including rejecting an attribution requirement for corporate insiders) and there is a split among the circuits. Accordingly, he opined that it might be appropriate for the full Second Circuit, as well as the Supreme Court, to consider the case.

Holding: Dismissal of the claims against Mayer Brown and its attorney affirmed.