The 10b-5 Daily

When Judge Easterbrook of the U.S. Court of Appeals for the Seventh Circuit writes a securities law opinion, it is invariably going to be worth talking about. His latest is no exception.

The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. The defendants are permitted to remove the case to federal district court for a determination on whether the case is preempted by the statute. If so, the district court must dismiss the case; if not, the district court must remand the case back to state court.

In an earlier opinion in the Putnam Fund cases, Judge Easterbrook found that the district court’s decision to remand the actions back to state court was appealable. This week’s opinion, Kircher v. Putnam Funds Trust, 2005 WL 757255 (7th Cir. April 5, 2005), addressed the merits of that remand decision. In particular, Judge Easterbrook grappled with the question that has confronted the Second and Third Circuits recently: what is the scope of SLUSA’s “in connection with the purchase or sale of securities” requirement?

In contrast to the Second Circuit, the Seventh Circuit found that SLUSA preemption is not limited to actions where the plaintiffs are purchasers or sellers of securities. One of the complaints filed in the Putnam Fund cases defined its class as “all investors who held the fund’s securities during a defined period and neither purchased or sold shares during that period.” The court held that the “in connection with” language in SLUSA merely “ensures that the fraud occurs in securities transactions rather than some other activity.” Although private actions under Rule 10b-5 (from which SLUSA adopted the “in connection with” requirement) can only be brought by purchasers or sellers, it “would be more than a little strange” if this judicially-created limitation on private actions “became the opening by which that very litigation could be pursued under state law, despite the judgment of Congress (reflected in SLUSA) that securities class actions must proceed under federal securities laws or not at all.” Accordingly, the complaint was subject to dismissal under SLUSA.

Holding: Cases remanded with instructions to undo the remand orders and dismiss plaintiffs’ state-law claims.

Quote of note: “[M]ost of the approximately 200 suits filed against mutual funds in the last two years alleging that the home-exchange-valuation rule can be exploited by arbitrageurs have been filed in federal court under Rule 10b-5. Our plaintiffs’ effort to define non-purchaser-non-seller classes is designed to evade PSLRA in order to litigate a securities class action in state court in the hope that a local judge or jury may produce an idiosyncratic award. It is the very sort of maneuver that SLUSA is designed to prevent.”

Two appellate decisions from earlier this year that are worth noting:

(1) In Barrie v. Intervoice-Brite, Inc., 2005 WL 57928 (5th Cir. Jan. 12, 2005), the Fifth Circuit considered a securities fraud claim based on revenue recognition issues at a software company. The defendants argued that a charge the company took against its revenues was caused by the SEC’s issuance of new revenue recognition guidance. To counter this argument, the plaintiffs apparently attached a sworn expert analysis to their amended complaint stating that “Intervoice’s reversal of revenue in the first quarter fiscal 2001 was not a result of SAB 101, but rather was required because Intervoice’s prior revenue recognition practice did not comply with GAAP, specifically SOP 97-2.” The Fifth Circuit reversed the dismissal of the revenue recognition claims, finding that the “accounting questions in this case are disputed” and that plaintiffs’ position “was adequately supported by expert opinion.”

(2) In In re Daou Systems, Inc. Sec. Litig., 2005 WL 237645 (9th Cir. Feb. 2, 2005), the Ninth Circuit clarified its position on confidential witnesses (by adopting the pleading standard used in the First and Second Circuits) and muddied its position on loss causation.

Confidential witnesses – The court held that “[n]aming sources is unnecessary so long as the sources are described ‘with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged’ and the complaint contained ‘adequate corroborating details.'”

Loss causation – The court found that “if the improper accounting did not lead to the decrease in Daou’s stock price, plaintiffs’ reliance on the improper accounting in acquiring the stock would not be sufficiently linked to their damages.” This position is the exact opposite of the one adopted by the Ninth Circuit in the Dura case and recently reviewed by the U.S. Supreme Court. Curious.

Although the U.S. Court of Appeals for the Fourth Circuit established its pleading standards for scienter (i.e., fraudulent intent) in securities fraud cases over a year ago, it has not had a subsequent opportunity to apply these standards. Moreover, the Hanger Orthopedic decision did not address the common scienter allegations of insider stock sales and violations of generally accepted accounting principles (“GAAP”).

The Fourth Circuit’s decision in In re PEC Solutions, Inc. Sec. Litig., 2005 WL 646070 (March 18, 2005), although unpublished, offers some guidance on how the court will evaluate the existence of a “strong inference” of scienter as required under the PSLRA. In PEC Solutions, plaintiffs alleged that scienter was demonstrated by, among other things, the stock trading of the individual defendants and a failure of the company to take a reserve against non-payment of a contract in violation of GAAP.

As to the stock sales, the court found that they were “nearly de minimus” given that the individual defendants only sold between 1.17% and 13% of their holdings during the class period. Moreover, the individual defendants exercised stock options during the class period, but did not sell the underlying stock, and actually lost hundreds of millions of dollars in stock value due to the price drop. The court concluded that “[i]f this all give rise to a ‘strong inference’ of anything, it is that no scienter exists.”

Turning to the alleged GAAP violation, the court noted that “it is certainly possible that some egregious GAAP violations may help support an inference of scienter for pleading purposes.” The supposed lack of a reserve, however, added “nothing new” to the scienter allegations because the complaint had failed to plead facts establishing that PEC believed it would not be paid for its work.

Holding: Dismissal affirmed.

Quote of note: “”But this alleged GAAP violation adds nothing new; rather it simply rides around in circles on the inadequate coattails of the scienter pleading. For if PEC was to take a reserve only when it believed non-payment was ‘probable’ . . . and that ‘the amount of the loss can be reasonably estimated,’ we are brought back to Appellants’ previous problem that they have not pled facts that give rise to a strong inference that PEC ever believed it would not get paid by Pearson while making the public statements that the [Complaint] challenges.”

Disclosure: The author of The 10b-5 Daily argued the case before the appellate court on behalf of the defendants. Note that the case has also received some attention for the results of the court’s spell-checking.