The 10b-5 Daily

Does the fraud-on-the-market presumption, pursuant to which reliance by investors on a material misrepresentation is presumed if the company’s shares were traded on an efficient market, apply in suits alleging misrepresentations by analysts (and other non-issuers)?

The U.S. Court of Appeals for the Second Circuit was poised to answer that question in 2004, but Citigroup’s settlement of the claims against it in the WorldCom litigation rendered its appeal moot. Based on the order granting the appeal, issued a day after the agreement to settle was reached, it appeared that the court was inclined to limit the reach of the fraud-on-the-market presumption. Four years later, before a completely different panel, the plaintiffs’ bar has a significant win on the same issue.

In In re Salomon Analyst Metromedia Litigation, No. 06-3225 (2nd Cir. Sept. 30, 2008), the court found that nothing in Basic, the Supreme Court case creating the fraud-on-the-market presumption, limited the presumption’s application to misrepresentations by issuers. Indeed, the “logic” of the Basic decision, which is based on the economic theory that share prices reflect all publicly available information in an efficient market, suggests “it does not matter, for purposes of establishing entitlement to the presumption, whether the misinformation was transmitted by an issuer, an analyst, or anyone else.”

In the alternative, the defendants argued that to establish the materiality of the misrepresentations, and thereby invoke the fraud-on-the-market presumption, the plaintiffs had the burden of proving that the misrepresentations had a quantifiable effect on the company’s stock price. The court disagreed, holding that inherent in the fraud-on-the-market theory is the presumption that material misrepresentations have an effect on stock price. Therefore, it was the defendants’ burden to rebut the presumption by demonstrating the absence of a price impact.

A couple of notes on the decision:

(1) The Second Circuit cited the Supreme Court’s recent Stoneridge decision in support of its holding. In Stoneridge, however, the Court found that the fraud-on-the-market presumption was inapplicable to the non-issuer defendants based on the fact that their “deceptive acts” were not communicated to the public. The issue of the scope of the fraud-on-the-market presumption was not squarely before the Court. Moreover, the Court expressed grave reservations about expanding securities fraud liability, something the Second Circuit’s decision arguably does.

(2) The Second Circuit brushed aside the defendants’ arguments concerning the expansion of liability (see full quote below), but offered an interesting codicil in a footnote. The court noted that “the identity of the speaker may be significant, because a court may determine that the reasonable investor would only rely on misrepresentations made by some speakers, but not by others.”

Holding: Vacate order of class certification and remand for further proceedings (including providing the defendants with an opportunity to rebut the presumption of a price impact).

Quote of note: “Defendants worry that if no heightened test is applied in suits against non-issuers, any person who posts material misstatements about a company on the internet could end up a defendant in a Rule 10b-5 action. The worry is misplaced. The law guards against a flood of frivolous or vexatious lawsuits against third-party speakers because (1) plaintiffs must show the materiality of the misrepresentation, (2) defendants are allowed to rebut the presumption, prior to class certification, by showing, for example, the absence of a price impact, and (3) statements that are ‘predictions or opinions,’ and which concern ‘uncertain future event[s],’ such as most statements made by research analysts, are generally not actionable.”

The recent string of appellate decisions involving securities class actions includes Ley v. Visteon Corp., 2008 WL 3905469 (6th Cir. Aug. 26, 2008), which contains a couple of interesting holdings.

Comparisons to Competition – The plaintiffs alleged that Visteon failed to disclose how high its costs were relative to its competition. The court declined to “advocate a rule that requires companies to draw such comparisons.” Quoting from an older Third Circuit opinion, the court found that “it is precisely and uniquely the function of the prudent investor, not the issurer of securities, to make such comparisons among investments.”

Discounting Confidential Witnesses – The Seventh Circuit has held that in evaluating the pleading of scienter (i.e. fraudulent intent), allegations from confidential witnesses must be “discounted” and that discount will usually be “steep.” Although there is some confusion as to whether that holding remains good law, the Sixth Circuit cited it favorably in concluding that the confidential witness allegations in the Visteon complaint were insufficient to establish any inference of scienter.

Holding: Dismissal affirmed.

There is a recent appellate trend of finding “must have known” allegations sufficient to establish a strong inference of scienter in situations where the underlying events are deemed to be highly important to the corporation (e.g., Dynex Capital (2nd Cir.), Tellabs II (7th Cir.), and Applied Signal (9th Cir.)).

In South Ferry LP v. Killinger, 2008 WL 4138237 (9th Cir. Sept. 9, 2008), the court examined exactly when “a scienter theory that infers that facts critical to a business’s ‘core operations’ or an important transaction are known to a company’s key officers” establishes a strong inference of scienter. The court found that these allegations may help to satisfy the pleading standard in three circumstances.

(1) “[T]he allegations may be used in any form along with other allegations that, when read together, raise an inference of scienter that is ‘cogent and compelling, thus strong in light of other explanations.'” (citing Tellabs)

(2) The “allegations may independently satisfy the [scienter pleading standard] where they are particular and suggest that defendants had actual access to the disputed information.”

(3) The “allegations may conceivably satisfy the [scienter pleading] standard in a more bare form, without accompanying particularized allegations, in rare circumstances where the nature of the relevant fact is of such prominence that it would be ‘absurd’ to suggest that management was without knowledge of the matter.”

Although the first two tests are uncontroversial, the “absurdity” test appears difficult to apply in a consistent fashion. The court cited the Applied Signal case, where the defendants allegedly failed to disclose stop-work orders from the company’s largest customers even though they had a devastating effect on revenues, as one of the “exceedingly rare” cases where the core operations inference, without more, was sufficient. But whether lower courts will find that the core operations inference is sufficient only in “exceedingly rare” cases remains to be seen.
Holding: Remanded for further proceedings consistent with the opinion.

Can the sheer number of accounting errors negate an inference of fraud? In In re Ceridian Corp. Sec. Litig., 2008 WL 4163782 (8th Cir. Sept. 11, 2008), the U.S. Court of Appeals for the Eighth Circuit had an opportunity to address that question.

Between February 2004 and April 2005, Ceridian announced three financial restatements. The restatements were based on a variety of apparently unrelated accounting errors over a number of years. The district court found that the sheer number of accounting errors, which involved dozens of employees, made it “almost inconceivable that there could have been any unifying intent behind the errors, much less an intent to defraud.”

The Eighth Circuit agreed. Even in conjunction with the plaintiffs’ other scienter allegations – including insider trades, SOX certifications, confidential witness statements about pre-class period conduct, and an ongoing SEC investigation – the court found that “the opposing inference that Ceridian and the controlling officer defendants should have known about the many accounting errors” was more compelling than the inference that they knew about the errors. The court concluded that the plaintiffs had “a viable claim of negligence, but not of fraud.”

Holding: Dismissal affirmed.

The U.S. Court of Appeals for the Third Circuit has issued a notable decision on the application of the statute of limitations in securities cases. In In re Merck & Co., Inc. Sec., Derivative & ERISA Lit., Nos. 07-2431, 07-2432 (3rd Cir. Sept. 9, 2008), the court considered whether Merck investors were on inquiry notice of their securities claims relating to Vioxx disclosures more than two years before the case was filed. If so, the plaintiffs’ claims would be barred by the statute of limitations. The decision has a number of interesting holdings:

(1) There has been some ambiguity in the Third Circuit over whether inquiry notice is triggered by evidence alerting an investor to the “possibility” or the “probability” of wrongdoing. The decision clarified that the Third Circuit’s standard is: “whether the plaintiffs, in the exercise of reasonable diligence, should have knows of the basis for their claims depends on whether they had sufficient information of possible wrongdoing to place them on inquiry notice or to excite storm warnings of culpable activity.” Although the court adopted the lower “possibility” standard, it emphasized that the evidence must be substantial, especially in light of the PSLRA’s heightened pleading standards.

(2) The district court found the existence of inquiry notice based upon a public FDA warning letter stating that Merck was misrepresenting the safety profile of Vioxx, press and scholarly articles about the risk of heart attack associated with the drug, and various lawsuits filed against Merck over Vioxx safety issues. On appeal, however, the court found that these “storm warnings” were dissipated by Merck’s reassuring statements to the market or undermined by the failure of the disclosures to have any significant impact on Merck’s stock price or projections by analysts. In particular, the court focused on the fact that Merck put forward an alternative hypothesis as to why the relevant clinical study showed increased heart attack risks associated with Vioxx that may have led to the limited stock price reaction. Also, none of the lawsuits alleged securities fraud.

(3) In a vigorous dissent, Judge Roth argued that the FDA warning letter, by itself, was a sufficient storm warning that Merck had engaged in misrepresentations concerning Vioxx. Moreover, the subsequent press coverage and consumer lawsuits should have led investors to an awareness “of the possibility that Merck had been fraudulently misrepresenting the cardiovascular safety of Vioxx.”

(4) The majority’s footnote response to the dissent appears ill-considered: “It is ironic that the dissent, although noting what might be viewed as Merck’s misrepresentations, would apply the statute of limitations to deprive plaintiffs of the opportunity to prove a viable case against Merck for such misrepresentations.” Bad facts make for bad law? After all, as The 10b-5 Daily has noted before, an inquiry notice argument presupposes the possibility of misrepresentations and the statute of limitations can limit liability even where misconduct has occurred.

Holding: Reversed and remanded.

Quote of note (majority opinion): “Merck’s stock price dipped slightly following the disclosure of the FDA warning letter before closing higher than it did before that disclosure just a week and a half later. Although the lack of significant movement in Merck’s stock price following the FDA warning letter is not conclusive, it supports a conclusion that the letter did not constitute a sufficient suggestion of securities fraud to trigger a storm warning of culpable activity under the securities laws. This conclusion is also supported by the fact that more than a half-dozen securities analysts continued to maintain their ratings for Merck stock and/or project increased future revenues for Vioxx after the warning letter was made public.”

Quote of note (dissent): “In applying the above inquiry notice standard to the instant case, I am reminded of a classic fairytale: The Emperor’s New Clothes, by Danish author and poet, Hans Christian Anderson. As the child in The Emperor’s New Clothes saw – that the Emperor walked naked down the street – any reasonable investor reading the FDA’s September 17, 2001, warning letter could see the problem with Vioxx – the misrepresentation of its safety profile and the ‘possibility’ that Merck had fraudulently misrepresented the cardiovascular safety of its ‘blockbuster’ product.”

Does the PSLRA require courts to find the attorneys’ fees agreed upon by the lead plaintiff presumptively reasonable? In In re Nortel Networks Corp. Sec. Litig., 2008 WL 3840916 (2d Cir. Aug. 19, 2008), the lead counsel made this argument on appeal after the district court reduced its fee request from the negotiated 8.5% of the settlement amount to 3% of the settlement amount. The Second Circuit found that the lead counsel had waived the argument, which was based on Third Circuit precedent, by failing to raise it before the district court. The appellate court nevertheless made it clear that while district courts should give “serious consideration” to negotiated fee arrangements, “the only PSLRA provision related to attorneys’ fees places an obligation on district courts to ensure independently that fees are reasonable.” As for the 3% fee award (resulting in a 2.04 lodestar multiplier), the appellate court found that it was “toward the lower end of reasonable fee awards,” but the district court had not abused its discretion in setting the award at that level.

Holding: Fee award affirmed.