2014 YEAR IN REVIEW – SECURITIES LITIGATION January 2015 © 2015 Haynes and Boone, LLPNICHOLAS EVEN is Chair of the firm’s Securities Litigation Group. He currently represents the Board of AT&T, Inc. in shareholder derivative litigation pending in Texas state court. In 2014, among multiple merger litigation matters in Texas, Delaware and Maryland, he represented a special litigation committee of Hastings Entertainment, successfully argued against an injunction of its merger with affiliates of National Entertainment Collectibles Association, and gained dismissal of the suit. He also successfully advocated for a zero fee award to plaintiffs’ counsel in merger litigation filed against FirstCity Financial and Värde Partners. He is AV® Peer Review Rated Preeminent by Martindale-Hubbell® Law Directory. KIT ADDLEMAN chairs the firm’s Government Investigations and Litigation Practice Group and is a member of the Investment Funds Practice Group. Kit defends companies, executives and directors against government charges of misconduct, particularly investigations and litigation by the Securities and Exchange Commission and Department of Justice. Many of her matters involve allegations of accounting and financial fraud, insider trading, hedge fund and advisor fraud, and Foreign Corrupt Practices Act violations. Prior to joining Haynes and Boone in 2009, Kit was the regional director of the Atlanta Regional Office of the SEC and spent more than 20 years prosecuting matters at the SEC. THAD BEHRENS is Chair of the firm’s Class Action Defense Practice Group. He has successfully defended companies, directors and officers in securities class actions, derivative suits, M&A litigation, and proxy contests. In 2014, he again scored major victories for his clients, including a dismissal in the Delaware Chancery Court of a shareholder derivative suit involving an exploration and production company, and a partial summary judgment for the National Football League in a consumer action arising from Super Bowl XLV. Thad is a past president of the Dallas Federal Bar Association, and has been recognized as a Texas Super Lawyer. DAN GOLD is a partner in the firm’s Class Action and Securities and Shareholder Litigation Practice Groups. In 2014, among other matters, he obtained a denial of class certification and voluntary dismissal of the remaining individual claims in a putative class action arising out of the collapse of a hedge fund, succesfully resolved his clients’ counterclaims for attorneys’ fees in a fiduciary duty and breach of contract case, and played a leading role in obtaining partial summary judgment for the NFL. In December 2014 Dan was honored as Young Attorney of the Year by the Cardozo Society of the Attorney’s Division of the Jewish Federation of Greater Dallas. ODEAN VOLKER is Chair of the firm’s International Arbitration Practice Group, and previously served as CoChair of the Litigation Department. His practice includes securities and complex litigation, and domestic and international commercial arbitration. He has extensive experience in conducting internal investigations and addressing governance issues for public and private companies. Odean is AV® Peer Review Rated Preeminent by Martindale-Hubbell® Law Directory, was named a Texas Super Lawyer, 2012-2014 and recognized as a Best Lawyer in America in Arbitration in 2015. GEORGE W. BRAMBLETT, JR. has been involved in high stakes litigation with significant experience in securities and shareholder litigation. He was named in Best Lawyers of America for Commercial Litigation, Securities Law, and “Bet–the-Company” Litigation in 2009-2014. He was named Best Lawyers’ Dallas Litigation Lawyer of the Year for 2013. He has been recognized by Chambers USA as a leading practitioner for General Commercial Litigation. In 2013, he was awarded the Luther (Luke) H. Soules Award for Outstanding Service to the Practice of Law by the Litigation Section of the State Bar of Texas. CARRIE HUFF is a partner with more than 25 years of experience in class action, shareholder and fiduciary litigation. A major part of her practice is advising lawyers on ethics issues, and in 2014, Carrie became an assistant general counsel of the firm. She also has continued to represent the trustees of family trusts involved in a high-profile, multi-court dispute, and in 2014, secured favorable rulings by the Fifth Circuit affirming the comprehensive settlement of the dispute. Carrie is AV® Peer Review Rated Preeminent by Martindale-Hubbell® Law Directory. MEET THE AUTHORS This paper is for informational purposes only. It is not intended to be legal advice. Transmission is not intended to create and receipt does not establish an attorney-client relationship. Legal advice of any nature should be sought from legal counsel. SPECIAL THANKS to the following attorneys and staff for their contributions and assistance: Michael Dill, David Dodds, Scott Ewing, Richard Guiltinan, Andrew Guthrie, Kathy Gutierrez, David Harper, Hazel Leung, Taryn McDonald, Matt McGee, Casey McGovern, Sarah Mallett, William Marsh, Tim Newman, Scott Wallace, and Jennifer Wisinski.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 1 Clients and Friends, Our annual Year in Review comments on significant securitiesrelated decisions by the Supreme Court, federal appellate courts and district courts, notes key developments in SEC enforcement, and summarizes significant rulings in state law fiduciary litigation against directors and officers of public companies. We begin with a discussion of the Supreme Court’s 2014 decision in Halliburton II, which did not jettison the “efficient market theory” and the “fraud-on-the-market” presumption of class reliance on public disclosures which it supports, as some had speculated that it might. Nevertheless, the decision was important, confirming that securities class action defendants have the opportunity to rebut the presumption of reliance at the class certification stage by showing alleged misrepresentations did not impact the issuer’s stock price. When and how this can be done, and who ultimately bears the burden of persuasion on the issue of class reliance, remains to be seen. In 2015, the Supreme Court will rule in the Omnicare case, expected to clarify the standards of liability under Section 11 of the Securities Act for expressions of opinion in connection with stock issuances. Beyond the Supreme Court, there was notable activity at the Circuit Courts of Appeals, including the Fifth Circuit – a court viewed for a number of years as skeptical and demanding in shareholder class actions, but which issued two “plaintiff friendly” rulings on loss causation, scienter and other issues in Houston American Energy and Amedisys II. Last year also saw shareholder suits over cyber security, Delaware decisions on forum selection and fee-shifting bylaws, and a key Texas Supreme Court decision rejecting a common law theory of minority shareholder oppression. These rulings and more are discussed in our 2014 Year in Review. In 2014 at Haynes and Boone, our litigation docket included these notable successes, among others: (i) defeat of class certification in a suit arising from a hedge fund collapse, (ii) dismissal of shareholder derivative claims in Delaware challenging the fairness of an oil and gas transaction, (iii) denial of a preliminary injunction of a merger, and subsequent voluntary dismissal of that federal suit, and (iv) an award of zero fees to shareholder plaintiffs’ counsel in another merger litigation filed in Texas state court. We also defended SEC enforcement matters, continued to defend ongoing shareholder suits, and advised companies, boards and special committees on a variety disclosure and fiduciary matters. If you have any questions about the issues covered in this 2014 Review, or about our practice, please let us know. We look forward to working with our friends and clients in 2015. Haynes and Boone — Securities Litigation Practice Group MEET THE AUTHORS / page 2 I. SUPREME COURT SUMMARY: HALLIBURTON II AND BEYOND / page 2 II. LOSS CAUSATION / page 5 III. SCIENTER / page 7 IV. DUTY TO DISCLOSE AND MATERIALITY / page 9 V. PLEADING ALLEGED MISSTATEMENTS / page 10 VI. CIVIL LIABILITY FOR INSIDER TRADING / page 13 VII. EXTRATERRITORIALITY/ POST-MORRISON / page 13 VIII. CLASS CERTIFICATION ISSUES / page 16 IX. SEC AND OTHER REGULATORY MATTERS / page 16 X. NOTABLE DEVELOPMENTS IN STATE LAW ACTIONS AND FIDUCIARY LITIGATION / page 21 TABLE OF CONTENTSHAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 2 Foremost among the past year’s securities decisions was the Supreme Court’s highly anticipated opinion in Halliburton Co. v. Erica P. John Fund, Inc., 134 S.Ct. 2398 (2014) (Halliburton II). In this case, the Court considered whether to abandon the fraud-on-themarket theory in securities fraud class actions, a presumption that makes it easier for shareholder plaintiffs to prove class-wide reliance and obtain class certification. Although the Court declined to take such a drastic step, which would have effectively ended securities fraud litigation as we know it, the Court held that defendants may rebut the presumption at the class certification stage by showing that the alleged misrepresentations did not impact the stock price. Halliburton II ensures that class certification will remain a major battleground in securities fraud cases as defendants try to refute the foundational premise of class-wide reliance. BACKGROUND AND PROCEDURAL HISTORY The plaintiffs filed a putative class action suit alleging that Halliburton made false and misleading statements about various aspects of its business. The district court denied class certification in 2008 after finding that plaintiffs had not established loss causation, as required by then-binding Fifth Circuit authority, and the Fifth Circuit affirmed. However, the Supreme Court reversed and vacated that ruling, holding that securities fraud plaintiffs do not need to prove loss causation at the class certification stage. Erica P. John Fund, Inc. v. Halliburton Co., 131 S.Ct. 2179 (2011) (Halliburton I). On remand, the district court certified a class of shareholders after finding that plaintiffs satisfied the requirements for invoking the fraud-on-the-market theory. On appeal, Halliburton argued that it should have been allowed to rebut the fraud-on-the-market presumption at the class certification stage by showing that the alleged misrepresentations did not impact the stock price. The Fifth Circuit rejected this argument and affirmed the district court. Halliburton appealed. Halliburton II presented two questions to the Supreme Court: (1) whether the Court should overrule or substantially modify Basic v. Levenson’s long-standing fraud-on-the-market presumption of class-wide reliance; and (2) whether defendants may rebut that presumption at class certification by introducing evidence that the alleged misrepresentations did not distort the market price of the stock. THE SUPREME COURT UPHOLDS BASIC AND THE FRAUD-ON-THE-MARKET PRESUMPTION With respect to the first question, the Court declined to overturn Basic or modify the prerequisites for invoking the fraud-on-the-market presumption. Justice Roberts, writing for the majority, noted that “overturning a long-settled precedent” requires “‘special justification,’ not just an argument that the precedent was wrongly decided.” The Court found that the criticisms of Basic and the presumption did not reach that standard. The Court further rejected Halliburton’s argument that plaintiffs should be required to show price impact at class certification to invoke the fraud-on-the-market presumption. By refusing to overrule the fraud-on-the-market theory, the Court preserved the mechanism used by most securities fraud plaintiffs to seek class certification. DEFENDANTS MAY REBUT THE FRAUD-ON-THEMARKET PRESUMPTION AT CLASS CERTIFICATION Although the Court sided with the plaintiffs on the first question, the Court ruled in Halliburton’s favor on the second question, holding that defendants may rebut the presumption of reliance at the class certification stage by showing that the alleged misrepresentations did not impact the company’s stock price. Justice Roberts recognized that the prerequisites for invoking the fraud-on-the-market theory – namely, the alleged misrepresentations were publicly known and material, and I. SUPREME COURT SUMMARY: HALLIBURTON II AND BEYOND Halliburton Co. v. Erica P. John Fund, Inc.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 3 the stock traded in an efficient market – serve as an indirect proxy for price impact. Under Basic, that indirect showing of price impact provides the requisite causal connection between the alleged misrepresentations and the plaintiff’s transaction in the stock. That presumed causal connection is severed where a defendant shows that the alleged misstatements did not actually impact the stock price. “In the absence of price impact, Basic’s fraud-on-themarket theory and presumption of reliance collapse,” and the “suit cannot proceed as a class action” because “[e]ach plaintiff would have to prove reliance individually.” Although Halliburton II makes any existential challenges to the fraud-on-the-market theory unlikely in the near future, securities fraud defendants nevertheless will use the decision as another basis to oppose class certification. Even after Halliburton’s two trips to the Supreme Court, there are class certification issues that remain to be clarified in the lower courts. Most notably, although defendants bear some burden to show no price impact, Halliburton II did not specify which party bears the ultimate burden of persuasion on the issue of class-wide reliance. Going forward, this may become a major point of contention in securities fraud cases. On February 26, 2014, the Supreme Court held that state-law fraud class actions brought against attorneys, insurance brokers and others arising from Ponzi-scheme claims involving R. Allen Stanford could proceed. In a 7-2 decision in Chadbourne & Parke LLP v. Troice, 134 S. Ct. 1058, (2014), the Court held that such claims were not prevented by the Securities Litigation Uniform Standards Act (“SLUSA”), a federal law that precludes certain state-law securities class actions in which the alleged fraud was perpetrated “in connection with” the purchase or sale of covered securities. The Court’s decision narrowed the extent of the preclusive effect of SLUSA on state-law fraud claims that bear some relationship to nationally traded securities. The plaintiffs in Chadbourne & Parke alleged that the defendants participated in Stanford’s alleged Ponzi scheme through the sale of certificates of deposit (“CDs”) issued by Stanford International Bank (“SIB”) while misrepresenting that those CDs would be backed by investments in “highly marketable securities issued by stable governments, strong multinational companies and major international banks.” In reality, the plaintiffs alleged, the CDs were backed by illiquid investments or no investments at all. The district court dismissed these claims as precluded by SLUSA, acknowledging that the CDs purchased by the plaintiffs were not themselves “covered securities” under SLUSA, but nevertheless finding SLUSA preclusion appropriate because the defendants allegedly induced the purchase of the CDs by misrepresenting that the CDs were backed by “covered securities” acquired by SIB. On appeal, the Fifth Circuit reversed, Roland v. Green, 675 F.3d 503, 521 (5th Cir. 2012), finding “the references to SIB’s portfolio being backed by ‘covered securities’ to be merely tangentially related to the heart, crux, or gravamen of the defendants’ fraud.” The Supreme Court affirmed the Fifth Circuit’s decision. First, the Court noted that its holding was consistent with SLUSA’s focus on “transactions in covered securities.” The plaintiffs in Chadbourne & Parke purchased only uncovered securities (CDs not traded on any national exchange). Second, the Court found that SLUSA’s language suggested a “connection that matters” – meaning the alleged misrepresentation “makes a significant difference to someone’s decision to purchase or to sell a covered security, not to purchase or to sell an uncovered security, something about which [SLUSA] expresses no concern.” Third, the Court noted that its prior interpretations of the “in EVEN AFTER HALLIBURTON’S TWO TRIPS TO THE SUPREME COURT, THERE ARE CLASS CERTIFICATION ISSUES THAT REMAIN TO BE CLARIFIED IN THE LOWER COURTS. Chadbourne & Parke LLP v. TroiceHAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 4 connection with” language involved “victims’” “ownership interest in financial instruments that fall within the relevant statutory definition,” as contrasted with the plaintiffs in Chadbourne & Parke whose direct ownership of securities was outside SLUSA’s scope. Fourth, the Court found that SLUSA and its underlying regulatory statutes (the Securities Act of 1933 and the Securities Exchange Act of 1934) were intended to protect persons who actually “buy” or “sell” “statutorily relevant securities,” not persons with a “more remote” connection to such securities. Finally, the Court expressed concern that a broader interpretation of the “in connection with” requirement would “interfere with state efforts to provide remedies for victims of ordinary state law frauds,” such as a suit by creditors against a small business that had claimed credit-worthiness due to its stock investments. The Court’s decision resolved inconsistencies in lower courts’ interpretations of the “in connection with” requirement and could lead to an increase in creative class action filings under state laws against third parties involved indirectly, peripherally or tangentially in securities transactions. Such state-law claims remain attractive to plaintiffs’ attorneys because they are not subjected to the heightened pleading requirements of the PSLRA. However, the effect of Chadbourne & Parke should be limited to cases involving so-called “uncovered securities” not traded on a national exchange. For “covered securities,” state-law claims against third parties should remain subject to SLUSA’s preclusive effect. In addition to deciding Halliburton II and Chadbourne & Parke, the Supreme Court held oral argument this past year in Omnicare Inc. v. Laborers District Council Construction Industry Pension Fund (Docket No. 13-435), which involves Section 11 of the Securities Act of 1933. Section 11 subjects companies to virtually strict liability for material misrepresentations of fact in registration statements for initial public offerings, even if the misstatements were innocently made. The Omnicare decision, which is expected later this year, will clarify the extent to which statements of opinion can lead to liability under Section 11 of the Securities Act of 1933. The registration statement at issue in Omnicare included management’s opinions that the company’s contracts were in compliance with federal and state law. The plaintiffs in Omnicare claimed these opinions were materially misleading because, according to the plaintiffs, the company had engaged in various illegal activities such as kickback arrangements with pharmaceutical manufacturers and the submission of false Medicare claims. The defendants moved to dismiss, and the district court granted the motion after finding that the plaintiffs had not satisfied the heightened pleading requirements for fraud claims. The Sixth Circuit reversed on appeal, holding that because Section 11 provides for strict liability, it is irrelevant whether the defendants subjectively believed the opinion when it was published, and thus it was unnecessary for plaintiffs to plead knowledge of falsity. Under the Sixth Circuit’s holding, even a genuinely held opinion may result in liability if it was a material misrepresentation. The Sixth Circuit’s decision conflicts with the holdings of the Second and Ninth Circuits, which require plaintiffs to show that an opinion was both objectively untrue and that the speaker did not believe the opinion when it was made. The Supreme Court granted the defendants’ petition for certiorari to resolve the split. At oral argument, many of the Court’s questions focused on the reasonableness of a defendant’s belief in the opinion at the time it was made. Although Supreme Court outcomes are often difficult to predict, the Court may be considering a middle ground approach. Under such a standard, a statement of opinion could be actionable under Section 11 either if it was not genuinely believed by the speaker or if it was made without any reasonable basis. Pending in the Supreme Court: Omnicare Inc. THE OMNICARE DECISION, WHICH IS EXPECTED LATER THIS YEAR, WILL CLARIFY THE EXTENT TO WHICH STATEMENTS OF OPINION CAN LEAD TO LIABILITY UNDER SECTION 11 OF THE SECURITIES ACT OF 1933.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 5 II. LOSS CAUSATION Loss causation generally refers to the causal relationship between an alleged material misrepresentation and a shareholder’s economic loss when the truth is revealed to the market through a corrective disclosure. Although the Supreme Court did not address loss causation in 2014, the issue may be ripe for such review in the near future after decisions in the Ninth and Fifth Circuits broadened an existing circuit split related to loss causation pleading standards. In Spitzberg v. Houston American Energy Corp., 758 F.3d 676 (5th Cir. 2014), the Fifth Circuit reversed a district court’s dismissal of a 10b-5 action for failure to allege loss causation. The district court had dismissed because the plaintiffs did not allege specifically “whether the alleged misstatements or omissions were the actual cause of their economic loss as opposed to other explanations, e.g., changed economic circumstances or investor expectations or industryspecific facts.” However, the Fifth Circuit pointed out that it previously held in Lormand v. U.S. Unwired, Inc., 565 F.3d 228 (5th Cir. 2009) that courts are “not authorized or required to determine whether the plaintiff’s plausible inference of loss causation is equally or more plausible than other competing inferences, as we must in assessing allegations of scienter under the PSLRA.” The Fifth Circuit issued another decision favorable to securities fraud plaintiffs by holding that partial disclosures, taken collectively, may constitute a corrective disclosure for loss causation. In Public Employees’ Retirement System of Mississippi v. Amedisys, Inc. (Amedisys II), 769 F.3d 313 (5th Cir. 2014), the plaintiffs alleged that the defendant company and its board concealed a Medicare fraud scheme. The plaintiffs further alleged that the truth was revealed to the market through a series of five partial corrective disclosures over an almost two-year span. The partial corrective disclosures consisted of: a report by a third-party research firm about billing practices; a company announcement that two executives were resigning; an article in the Wall Street Journal about the company’s Medicare reimbursements; the combination of three announcements of government investigations; and the announcement of disappointing quarterly operating results. In Amedysis II, the Fifth Circuit reaffirmed its view that loss causation allegations need only satisfy the basic principles of pleading under Federal Rule of Civil Procedure 8(a)(2): a “short and plain statement” providing “fair notice” of the claim and the grounds upon which it rests. The Court held that, collectively, the five partial disclosures constituted a corrective disclosure that adequately pled loss causation sufficient to survive a motion to dismiss. Although the Fifth Circuit suggested that most of the partial disclosures would not alone qualify as corrective disclosures, it indicated its “holding can best be understood by simply observing that the whole is greater than the sum of its parts.” The Fifth Circuit vacated and remanded the district court’s dismissal order for further consideration. Loss Causation Decisions in the Fifth Circuit IN AMEDYSIS II, THE FIFTH CIRCUIT REAFFIRMED ITS VIEW THAT LOSS CAUSATION ALLEGATIONS NEED ONLY SATISFY THE BASIC PRINCIPLES OF PLEADING UNDER RULE 8(A)(2): A “SHORT AND PLAIN STATEMENT” PROVIDING “FAIR NOTICE” OF THE CLAIM AND THE GROUNDS UPON WHICH IT RESTS.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 6 Under Amedisys II, even statements by outside parties, such as research reports or newspaper articles, may contribute to the formation of a collectively corrective disclosure alleged against the defendant. Particularly in the Fifth Circuit, securities fraud defendants may find it harder to obtain dismissal, at least on loss causation grounds, for complaints that rely on numerous partial disclosures. On the other end of the spectrum, in Oregon Public Employees Retirement Fund v. Apollo Group Inc., 2014 WL 7139634 (9th Cir. Dec. 16, 2014), the Ninth Circuit made it harder for securities fraud plaintiffs and loss causation allegations to survive early dismissal. The plaintiffs in Apollo alleged that the defendant company and its officers and directors made material misrepresentations about the company’s revenue growth, financial condition, and other business factors to the detriment of shareholders. The district court dismissed the suit for failure to state a claim, and the plaintiffs appealed. One of the key appellate issues was whether the heightened pleading standards of Rule 9(b) apply to the loss causation element in securities fraud actions, an issue that the Supreme Court declined to decide in its 2005 Dura Pharmaceuticals opinion. While Rule 8(a) requires only a “short and plain statement of the claim,” Rule 9(b) requires a plaintiff to plead allegations of fraud “with particularity.” The Ninth Circuit held that “Rule 9(b) applies to all elements of a securities fraud action, including loss causation.” Although it noted that the plaintiffs’ claims would have failed under either pleading standard, the Ninth Circuit found that the plaintiffs had not adequately pled a material misrepresentation or omission, scienter, and/or loss causation for their various claims. With respect to loss causation, the Ninth Circuit faulted the plaintiffs for not alleging “specific statements by the Defendants that were made untrue or called into question by subsequent public disclosures.” Based on these findings, the Ninth Circuit affirmed the dismissal of the case. With the Apollo decision, the Ninth Circuit joins the Fourth and Seventh Circuits in holding that the heightened pleading standards of Rule 9(b) apply to the loss causation element in securities fraud actions. The Ninth Circuit also affirmed a dismissal order in Loos v. Immersion Corporation, 762 F.3d 880 (9th Cir. 2014), holding that the announcement of an investigation, standing alone, is insufficient to establish loss causation. In Loos, the plaintiffs alleged that the defendants had made material misrepresentations regarding the company’s revenue, which later resulted in having a restatement of its earnings for three years and a fiscal quarter. Like the Amedisys II plaintiffs in the Fifth Circuit, the Loos plaintiffs claimed that the fraudulent scheme was revealed to the market through a series of partial disclosures consisting of disappointing earnings results for four quarters and the company’s subsequent announcement of an internal investigation into its revenue transactions. Unlike the Fifth Circuit in Amedisys II, the Ninth Circuit found that plaintiffs had not pled loss causation. On the first alleged partial disclosure, the court noted that the disappointing earnings results did not reveal any information from which the market could reasonably infer accounting fraud. On the second alleged partial disclosure, the court held that the announcement of an investigation, without anything more, does not reveal fraudulent practices to the market. The Ninth Circuit reasoned that when an investigation is announced, “the market cannot possibly know what the investigation will ultimately reveal” and any stock price decline “can only be attributed to market speculation” that “cannot form the basis of a viable loss causation theory.” Without a corrective disclosure, the Ninth Circuit found that plaintiffs could not satisfy the pleading requirements for loss causation and affirmed the dismissal. Loss Causation Decisions in the Ninth Circuit WITH THE APOLLO DECISION, THE NINTH CIRCUIT JOINS THE FOURTH AND SEVENTH CIRCUITS IN HOLDING THAT THE HEIGHTENED PLEADING STANDARDS OF RULE 9(B) APPLY TO THE LOSS CAUSATION ELEMENT IN SECURITIES FRAUD ACTIONS.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 7 III. SCIENTER An essential element of a securities fraud claim under Section 10(b) and Rule 10b-5 is scienter — the mental state to deceive, manipulate, or defraud. All circuits have held that in order to sufficiently plead scienter, plaintiffs must allege with particularity facts giving rise to a “strong inference” that a defendant acted with at least “deliberate recklessness.” In pleading scienter as to a corporate defendant, courts have disagreed as to under what circumstances scienter may be imputed to the corporation. Some circuits have taken a more restrictive approach, holding that scienter may be imputed to the corporation only where the person who made the alleged misstatement did so with knowledge of its falsity (the “respondeat superior” approach to corporate scienter). In contrast, other circuits have adopted a more expansive view of scienter, requiring only that plaintiffs allege facts creating a strong inference that at least some corporate officials knew of the falsity. The Sixth Circuit in KBC Asset Mgmt. N.V. v. Omnicare, Inc., 769 F.3d 455 (6th Cir. 2014), adopted a “middle ground” approach for determining when a corporation made false or misleading statements with the requisite scienter. At issue were various material misrepresentations and omissions made “in public and SEC filings regarding Omnicare’s compliance with Medicare and Medicaid regulations.” Specifically, plaintiff’s allegations involved internal audits performed by Omnicare’s former VP of internal audit who was not a defendant in the case. The Sixth Circuit laid out the following three categories of individuals whose states of mind are probative for purposes of demonstrating corporate scienter: (a) the individual agent who issued the misrepresentation; (b) any individual agent who authorized, requested, commanded, furnished information for, prepared (including suggesting or contributing language for inclusion therein or omission therefrom), reviewed, or approved the statement in which the misrepresentation was made before its utterance or issuance; and (c) any high managerial agent or member of the board of directors who ratified, recklessly disregarded, or tolerated the misrepresentation after its utterance or issuance. The Sixth Circuit stated that it formulated its “middle ground” approach in an effort to strike a balance between the more restrictive approach to corporate scienter (imputing scienter to the corporation only where the individual making the statement knew it was false) and the more liberal approach to corporate scienter (imputing scienter to the corporation where there is a strong inference that at least some corporate officials knew of the statement’s falsity – even if the individual making it did not). This “middle ground” approach still holds corporations liable, but also protects corporations from liability in situations where an individual unknowingly makes a false statement that another individual knew to be false. Scienter Decisions in the Sixth Circuit IN PLEADING SCIENTER AS TO A CORPORATE DEFENDANT, COURTS HAVE DISAGREED AS TO UNDER WHAT CIRCUMSTANCES SCIENTER MAY BE IMPUTED TO THE CORPORATION.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 8 In contrast to the Sixth Circuit’s “middle ground” approach in Omnicare, the Ninth Circuit has adopted a broader, more liberal view of corporate scienter, requiring only that plaintiffs allege facts creating a strong inference that an individual whose intent could be imputed to the corporation acted with the requisite scienter, even if that individual is not a named defendant. This year, the Ninth Circuit reiterated its broader view, but also tightened the “core operations” theory of scienter. The Ninth Circuit reiterated its broader view of corporate scienter in Reese v. Malone, 747 F.3d 557 (9th Cir. 2014). At issue were a Senior Vice President’s (SVP) public comments regarding the condition of the pipeline that eventually caused the March 2, 2006 oil spill. The SVP who made the comments was directly responsible for the relevant pipeline operations during the class period. Weighing competing inferences, the lower court found a stronger non-culpable inference – that the SVP misunderstood or did not have access to BP’s data. But the Ninth Circuit disagreed, emphasizing that the court has a duty to weigh plausible competing inferences, and stating that the possibility that the SVP misunderstood the data or did not have access to it, despite her position and the fact that she specifically addressed the corrosion data in her statement, was unlikely under the circumstances. Despite its broader approach, the Ninth Circuit rejected the “core operations” theory of scienter in Police Ret. Sys. v. Intuitive Surgical Inc., 759 F.3d 1051 (9th Cir. 2014), holding that plaintiff did not allege facts sufficient to raise a strong inference that the individual defendants had knowledge of the alleged fraud. At issue were allegedly false and misleading statements regarding the company’s growth and financial health. The court explained that the “core operations” theory of scienter relies on the principle that corporate officers have knowledge of the critical core operation of their companies. Proof under this theory requires either (1) specific admissions by one or more corporate executives of involvement, or (2) witness testimony demonstrating that executives had actual involvement. Plaintiff relied on witnesses who lacked direct access to executives and failed to link specific reports and their contents to the executives. Accordingly, the court held that at best, the complaint only supported an inference of the executives’ knowledge of all core operations, not scienter. Importantly, the court noted that this was not the rare instance in which it would be absurd to suggest management did not know of the reports’ contents. The court concluded that “[m]ere access to reports containing undisclosed sales data is insufficient to establish a strong inference of scienter.” Notably, this year the Fifth Circuit in Spitzberg v. Houston Am. Energy Corp., 758 F.3d 676 (5th Cir. 2014), found relevant the size of the company at issue when deciding whether a complaint plausibly alleged scienter. At issue were statements made in a company’s Form 8-K and other various filings in 2011 and 2012. The Fifth Circuit had previously taken a more restrictive view and rejected the idea that corporate scienter could stem from the collective knowledge of all the corporation’s officers and employees. Nevertheless, the court in Spitzberg found, considering the “extremely small size of the company” and the positions held by defendants, that defendants had actual knowledge of the materially false and misleading statements and omissions alleged, or at least acted with reckless disregard for the truth. The court emphasized that “[a]s the senior managers and/ or directors of Houston American, the Individual Defendants had knowledge of the details of Houston American’s internal affairs.” These varied 2014 opinions emphasize the complicated analysis courts face when deciding under what circumstances scienter may be imputed to the corporation defendant, and some courts’ willingness to strike more of a middle ground going forward. Scienter Decisions in the Fifth Circuit Scienter Decisions in the Ninth CircuitHAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 9 IV.DUTY TO DISCLOSE AND MATERIALITY This past year saw several notable decisions regarding whether a defendant had gone far enough to satisfy its disclosure obligations to shareholders. Among those decisions, the Ninth Circuit addressed actionable omissions under Section 10(b) of the Securities Act in In re NVIDIA Corporation Securities Litigation., 768 F.3d 1046 (9th Cir. 2014). Generally, Section 10(b) prohibits materially untrue statements and omissions of information that would be necessary to avoid misleading investors, but does not create an affirmative duty to disclose any and all material information. Nevertheless, the plaintiffs in NVIDIA attempted to prove their Section 10(b) claims by relying on the defendant’s alleged failure to comply with the general disclosure obligations found in Item 303 of SEC Regulation S-K. The Ninth Circuit rejected this argument and held, for the first time, that Item 303’s disclosure duties are not actionable in a Section 10(b) claim. Simply put, Section 10(b) and Item 303 impose different duties. While Item 303 does require the disclosure of certain information — omission of which might be brought as a claim under Section 11 of the Securities Act — the type of securities fraud governed by Section 10(b) only arises where omission of certain information would cause the other information disclosed to be misleading. In short, the Ninth Circuit refused to convert the general obligations in Item 303 into an actionable claim under Section 10(b). In another case under Section 10(b) — Dalberth v. Xerox Corporation, 766 F.3d 172 (2d Cir. 2014) — the Second Circuit affirmed a lower court finding that Xerox had made no actionable misstatements or omissions related to its 1998 global restructuring plan. Plaintiffs alleged that Xerox misled investors by representing that the global restructuring plan would be financially beneficial to the corporation when, in fact, one specific component of the restructuring was causing significant economic duress. In affirming summary judgment in favor of Xerox, the Second Circuit first held that Xerox had truthfully represented the overall financial benefits of the global restructuring — despite the financial difficulties of one particular aspect of the plan. And as for plaintiffs’ claim that Xerox should have said more about those financial difficulties, the court found that Xerox had been sufficiently forthright. In doing so, it rejected plaintiffs’ argument that Xerox should have used stronger language to describe those difficulties. The court found that is simply not what the law requires: “Corporations are not required to phrase disclosures in pejorative terms. . . . Rather, what is required is the disclosure of material objective factual matters.” Because Xerox satisfied that standard, the court found no violation of Section 10(b). Conversely, the Second Circuit in Meyer v. Jinkosolar Holdings Co., Ltd., 761 F.3d 245 (2d Cir. 2014), held that shareholders had adequately alleged materially misleading statements regarding pollution prevention and compliance measures for the company’s Chinese production plants in a public offering prospectus. The plaintiffs alleged that these prophylactic steps were actually failing to prevent serious, ongoing pollution problems and thus, rendered the statements misleading under Section 11 of the Securities Act of 1933. Reversing the lower court’s dismissal of the case, the Second Circuit found that the plaintiffs had adequately alleged materially misleading statements. The court found that the company’s description of the pollution-prevention efforts gave comfort to investors that reasonable steps were being taken to comply with environmental regulations and that investors would be misled by such statements if, in fact, the measures described were then failing to prevent violations. The court also found the misleading statements were not cured by the additional statements regarding risks of “CORPORATIONS ARE NOT REQUIRED TO PHRASE DISCLOSURES IN PEJORATIVE TERMS. . . . RATHER, WHAT IS REQUIRED IS THE DISCLOSURE OF MATERIAL OBJECTIVE FACTUAL MATTERS.”HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 10 non-compliance. The court stated “[a] generic warning of risk will not suffice when undisclosed facts... would substantially affect a reasonable investor’s calculations of probability.” The Jinkosolar opinion signals to potential defendants the possible need to disclose known flaws, defects, and risks when making statements regarding compliance measures and efforts. Cautionary language, however specific, may not be enough. In United Food and Commercial Workers Union Local 880 Pension Fund v. Chesapeake Energy Corporation, 762 F.3d 1158 (10th Cir. 2014), the Tenth Circuit analyzed a Section 11 claim and found that Chesapeake Energy had adequately disclosed its hedging strategy in a stock offering just before the onset of the 2008 financial crisis. The court first held that Chesapeake had sufficiently disclosed the general nature of its hedging strategy, either in the body of its Registration Statement or the SEC filings incorporated therein. While plaintiffs claimed that Chesapeake had adopted — and failed to disclose — a more volatile hedging strategy, the court noted certain disclosures about the historic variability in Chesapeake’s hedging activities. Moreover, the court found that almost all of the “change” in strategy that plaintiffs complained about had been disclosed in an SEC filing prior to the offering date. While this filing was not incorporated into the initial offering materials, the court found it was relevant to the “total mix” of information available to a reasonable investor. As a result, Chesapeake had made no actionable omission under Section 11. V. PLEADING ALLEGED MISSTATEMENTS Rule 10b-5(b) prohibits “mak[ing] any untrue statement of a material fact . . . in connection with the purchase or sale of a security.” In Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), the Supreme Court adopted a narrow definition of who may qualify as the “maker” of an untrue statement of material fact. Specifically, in private suits, the Court held that the maker of an untrue statement is limited to “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” Under that definition, those who contribute to an untrue statement but do not ultimately control the statement are not subject to private 10b-5 liability. Although Janus was a private securities case, it has often been cited as a defense in government investigations brought by the Department of Justice (DOJ) and the SEC. In Prousalis v. Moore, 751 F.3d 272 (4th Cir. 2014), the Fourth Circuit held that Janus does not apply in a criminal prosecution for federal securities fraud. Prousalis, a securities lawyer, pled guilty to violations of Section 10(b) and Rule 10b-5 in connection with his orchestration of a scheme to defraud investors in a client’s initial public offering. Following Prousalis’s guilty plea, the Supreme Court issued its decision in Janus. Prousalis then filed a habeas petition with the district court and argued, based on Janus, that the conduct for which he had been convicted was no longer criminal. The district court denied the petition and the Fourth Circuit affirmed. The Fourth Circuit observed that Janus is premised on, and “meshes seamlessly with,” other recent Supreme Court cases that limit the availability of a private right of action under Rule 10b-5. The Fourth Circuit stated that Janus evinces a general desire to circumscribe judicially-created private causes of action that Congress has not expressly authorized. The court concluded that “[t]hese concerns are specific to the dangers of judicially implied causes of action. Nowhere is there the suggestion that criminal sanctions for security [sic] fraud violations would be similarly imperiled.” Moreover, given that the statutes Post-Janus Pleading: Criminal Enforcement is not Limited to “Makers” HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 11 to which Prousalis pled guilty fell within “the acknowledged powers of Congress,” the Fourth Circuit observed that its interpretation of Janus was further supported by “considerations of judicial restraint and legislative primacy.” In sum, “[e]xplicit congressional prohibitions simply operate in a different universe than the one inhabited by Janus.” In SEC v. Monterosso, 756 F.3d 1326 (11th Cir. 2014), the Eleventh Circuit similarly declined to apply Janus in a civil enforcement action and affirmed the district court’s grant of summary judgment in favor of the SEC. Unlike Janus, which addressed what it means to “make” a statement under Rule 10b-5(b), the Eleventh Circuit observed that the defendants in Monterosso were liable for violations that do not require the “making” of a statement — i.e., Section 17(a) of the Securities Act, and subsections (a) and (c) of Rule 10b-5. The SEC’s case relied not on the defendants “making” false statements, but on their commission of deceptive acts as part of an overall fraudulent scheme to generate false corporate revenues. Thus, Janus had no bearing on Monterosso. The Prousalis and Monterosso decisions illustrate that the federal government may aggressively prosecute individuals who assist issuers in preparing false SEC filings and other public statements, or who are peripheral to false and misleading statements made by others. By way of further example, and as discussed in a concurring opinion in Prousalis, the DOJ may charge a defendant under 18 U.S.C. § 2(b), which provides for criminal liability as a principal for anyone who “willfully causes an act to be done which if directly performed by him or another” would be a federal offense. Also, the SEC has indicated that it may bring enforcement actions against individuals under Section 20(b) of the Securities Exchange Act, which makes it unlawful for anyone to violate the Exchange Act through or by means of another person. See 15 U.S.C. § 78t(b). Each of these options remains available to criminal and civil prosecutors. The Tenth Circuit in MHC Mutual Conversion Fund v. Sandler O’Neill & Partners, 761 F.3d 1109 (10th Cir. 2014), widened the circuit split on the standards for Section 11 liability for statements of opinion in registration statements. The Tenth Circuit joined the Second and Ninth Circuits in holding that a defendant cannot be liable for a false opinion, unless he or she knew it was false at the time it was made. This holding stands in contrast with the Sixth Circuit’s view that a defendant can be liable under Section 11 for a materially false opinion even if the opinion was honestly held and the speaker believed it to be true when it was made. The Supreme Court is scheduled to resolve this split in the Indiana State District Council v. Omnicare Inc. case, discussed above. Section 11 of the Securities Act of 1933 creates a cause of action for investors when a public statement contains an untrue or misleading statement of material fact. Plaintiffs generally need not show knowledge of falsity, fraudulent intent, reliance, or loss causation for liability to attach. A circuit split has developed on whether objective falsity — that the opinion was objectively untrue when made — is enough to establish liability. This is the standard adopted by the Sixth Circuit in Omnicare. The Tenth Circuit, in the MHC Mutual decision, held that both objective and subjective falsity is required – the standard applied by the Second and Ninth Circuits. A plaintiff must plead both that the opinion was false and that the speaker knew the opinion was false when made or did not honestly hold the opinion. THE PROUSALIS AND MONTEROSSO DECISIONS ILLUSTRATE THAT THE FEDERAL GOVERNMENT MAY AGGRESSIVELY PROSECUTE INDIVIDUALS WHO ASSIST ISSUERS IN PREPARING FALSE SEC FILINGS AND OTHER PUBLIC STATEMENTS, OR WHO ARE PERIPHERAL TO FALSE AND MISLEADING STATEMENTS MADE BY OTHERS. Misrepresentations Based On Opinions: Section 11 of the 1933 ActHAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 12 In MHC Mutual, the plaintiffs challenged the company’s opinion that it expected the market for its mortgagebacked securities portfolio to rebound soon. That expectation did not come to fruition. The Tenth Circuit affirmed the dismissal of the suit because the plaintiffs did not show both that the company did not subjectively believe the opinion and that there was no objectively reasonable basis for the opinion. The Tenth Circuit also found it significant that in expressing its opinion about the future market rebound, the company warned that if the housing market did not improve soon the company would incur additional charges. Therefore, the court failed to see how a reasonable investor could have been misled. Section 11 has long been thought of as a “strict liability” statute. Thus, defendants have much to gain if the Supreme Court accepts the joint objective/ subjective falsity standard adopted by the Tenth, Second, and Ninth Circuits. Such a ruling would allow public company officers and directors to continue to express sincere opinions without fear of liability for opinions on future events that ultimately do not occur. In Spitzberg v. Houston American Energy Corp., 758 F.3d 676 (5th Cir. 2014), the Fifth Circuit considered alleged misstatements by a small energy company regarding oil and gas reserves and drilling progress on a well. The Fifth Circuit rejected the defendants’ characterization of reports regarding the well drilling as inactionable statements of opinion. The Fifth Circuit quoted earlier precedent that “[a]n opinion or prediction is actionable if there is a gross disparity between prediction and fact.” Citing statements attributable to confidential witnesses that directly contradicted the defendants’ challenged reports, the Fifth Circuit found that such statements did not indicate disagreements between the parties over the validity of an opinion or prediction. Without deciding whether or not any of the plaintiffs’ allegations could be proven during later stages of the litigation, the Fifth Circuit found that the plaintiffs had sufficiently alleged the falsity of the challenged statements in order to survive dismissal. The Second Circuit in Carpenters Pension Trust Fund of St. Louis v. Barclays PLC, 750 F.3d 227 (2d Cir. 2014), in the context of a Section 10(b) claim under the Securities Exchange Act of 1934 found that plaintiff investors failed to plead with specificity false and misleading statements regarding internal controls. Plaintiffs alleged that Barclay’s statement that “minimum control requirements have been established for all key areas of identified risk” was materially false because, at the time it was made, Barclays had no specific systems or controls for its LIBOR submissions process. Barclays had previously announced its agreement to pay fines to the DOJ, CFTC, and other agencies in connection with allegedly false LIBOR rates. The Second Circuit affirmed the lower court’s dismissal opinion which, among other things, found that the internal control statements were mere puffery. The Second Circuit found the statements to be general and not specifically tied to Barclay’s LIBOR controls and practices. Thus, the plaintiffs failed to demonstrate with specificity that the internal control statements were false and misleading. This decision is significant because it suggests that in cases involving alleged misconduct, plaintiffs cannot successfully plead falsity under Section 10(b) by citing to commonplace, general statements in public filings that a company is taking reasonable steps regarding internal controls or risk management. Misrepresentations Based On Opinions: Section 10(b) of the 1934 Act Specificity Requirements for Pleading Misrepresentations SECTION 11 DEFENDANTS HAVE MUCH TO GAIN IF THE SUPREME COURT ACCEPTS THE JOINT OBJECTIVE/SUBJECTIVE FALSITY STANDARD ADOPTED BY THE TENTH, SECOND, AND NINTH CIRCUITS.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 13 VI.CIVIL LIABILITY FOR INSIDER TRADING In Steginsky v. Xcelera, Inc., 741 F.3d 365 (2d Cir. 2014), the Second Circuit held that the duty of corporate insiders to either disclose material nonpublic information or to abstain from trading applies to unregistered securities is defined by federal common law. The plaintiff, a minority shareholder of Xcelera, alleged that Xcelera’s stock price fell from $110 per share in 2000 to about $1 per share in 2004. Thereafter, Xcelera stopped making its filings with the SEC. In response, the American Stock Exchange delisted Xcelera stock, and the SEC revoked the registration of Xcelera securities. Xcelera then told its investors that they could sell their stock back to the company. In December 2010, OFC Ltd. (“OFC”) made a tender offer for Xcelera stock at $0.25 per share. No information about Xcelera’s financial condition was disclosed in the tender offer. The plaintiff sold all of her Xcelera stock in the tender offer. In February 2012, the plaintiff filed a private federal securities fraud action alleging insider trading claims, among others. Specifically, the plaintiff alleged that Xcelera insiders purchased Xcelera stock by making a tender offer through a shell corporation, OFC, without disclosing to potential sellers any information about Xcelera’s financial condition. The district court granted the defendants’ motion to dismiss. The Second Circuit vacated the dismissal, holding that Section 10(b) of the Securities Exchange Act applies to both registered and unregistered securities, and thus the defendants had a duty to disclose material nonpublic information before purchasing unregistered Xcelera securities. The Second Circuit observed that, although the defendants did not have an affirmative duty to disclose information regarding the financial state of Xcelera when its securities were deregistered, they nevertheless had a duty to abstain from trading in Xcelera securities if they possessed undisclosed material inside information. The Second Circuit also held that the duty against insider trading under Section 10(b) is defined by federal common law. Thus, the law of the jurisdiction of Xcelara’s incorporation, the Cayman Islands, was inapplicable even though Cayman law did not impose a duty to abstain from insider trading. The Second Circuit noted that prior cases “have implicitly assumed that the relevant duty springs from federal law,” and looking to “idiosyncratic differences in state law would thwart the goal of promoting national uniformity in securities markets.” In 2014, courts continued to confront questions regarding the domestic transaction requirement for private securities litigation under Section 10(b) of the Exchange Act announced in Morrison v. National Australia Bank, Ltd., 561 U.S. 247 (2010). In Morrison, the Supreme Court held that Section 10(b) applies in private civil securities cases only when the security at issue is listed on a domestic exchange or was purchased or sold in the United States. To determine whether the purchase or sale of the security occurred in the United States, many courts have adopted the “irrevocable liability/passage of title” test. Under this test, a transaction is “domestic” if: (1) title to the underlying interest was transferred within the United States or (2) the parties incurred “irrevocable liability” within the United States, meaning the parties incurred an obligation to transfer or pay for the interest in the United States. Courts this year continued to develop the contours of this test. VII.EXTRATERRITORIALITY/ POST-MORRISONHAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 14 In Loginovskaya v. Batratchenko, 764 F.3d 266 (2d Cir. 2014), the Second Circuit held that claims brought under Section 22 of the Commodities Exchange Act (which allows for a private right of action for certain transactions) must be based on domestic transactions, and a direction to wire transfer money to the United States was insufficient to demonstrate a domestic transaction. The plaintiff in Loginovskaya was a citizen and resident of Russia. The defendant, the CEO of an international financial services organization, solicited the plaintiff in Russia to invest in a real estate and commodities fund offered by Thor United, a New York corporation. The plaintiff invested $720,000 via wire transfer to Thor United’s account in New York. After being denied access to her funds, and learning that the defendant had made risky investments in a real estate investment entity in which he had a personal financial interest, the plaintiff brought fraudulent inducement claims under the Commodities Exchange Act. The district court held that the claim failed Morrison’s domestic transaction test and dismissed the case. On appeal, the question before the Second Circuit was whether the underlying transaction occurred in the United States. After determining that Morrison’s domestic transaction test applied to claims brought under Section 22 of the CEA, the Second Circuit affirmed the district court’s holding that the transaction occurred outside of the United States. Applying the “irrevocable liability/passage of title” test, the Second Circuit held that the plaintiff failed to allege that title to her shares in the defendant fund was transferred within the United States. The plaintiff had also failed to show that the defendant incurred irrevocable liability within the United States. The defendant solicited the plaintiff’s investment while in Russia using investment materials written in Russian, and the investment contracts were negotiated and signed in Russia. Russia, the court held, was where the plaintiff and defendant reached a “meeting of the minds.” Although the defendant fund was incorporated in New York, the Second Circuit noted that the state of incorporation was irrelevant in evaluating where the transaction took place. Moreover, the court held that the wire transfer of funds to a bank account in New York was an action needed to carry out the transaction — not the transaction itself. In City of Pontiac Policemen’s and Firemen’s Ret. Sys. v. UBS AG, 752 F.3d 173 (2d Cir. 2014), the Second Circuit rejected a “listing theory” of liability as a work-around to Morrison. The plaintiffs brought actions against UBS and its officers and directors alleging violations of the Exchange Act arising from purchases of UBS shares on a foreign exchange. Relying on Morrison, the district court dismissed the claims. On appeal, the plaintiffs argued that Morrison was limited to claims for securities not listed on a domestic exchange, and, because UBS shares were also listed on the New York Stock Exchange, Morrison should not apply. The Second Circuit rejected this so-called “listing theory,” holding that Morrison focuses on whether the purchase or sale of the securities occurred in the United States, not whether the security was listed on a domestic exchange. The Second Circuit also held that placing a buy order in the U.S. for the foreign-listed UBS shares was insufficient to establish that “irrevocable liability” had attached in the United States. In ParkCentral Global Hub, Ltd. v. Porsche Automobile Holdings SE, 763 F.3d 198 (2d Cir. 2014), the Second Circuit held that the plaintiffs could not bring a claim for losses incurred in securities-based swap agreements made in the United States against a foreign defendant on the basis of foreign conduct. The plaintiffs entered into a series of swap agreements pegged to the price of Volkswagen (VW) stock. The plaintiffs accused the defendant, a German MORRISON FOCUSES ON WHETHER THE PURCHASE OR SALE OF THE SECURITIES OCCURRED IN THE UNITED STATES, NOT SIMPLY WHETHER THE SECURITY WAS LISTED ON A DOMESTIC EXCHANGE.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 15 corporation, of making fraudulent statements from Germany and taking manipulative actions to conceal its intention to take over VW. The swap agreements were executed by large hedge funds in New York and contained New York choice of law clauses, but the referenced VW shares were traded on a foreign exchange. On review, the Second Circuit held that while a domestic transaction under Morrison was a necessary condition for application of Section 10(b), that alone was not a conclusive factor. The court stated that any other reading of Morrison would require the courts to apply Section 10(b) to wholly extraterritorial activity solely because the plaintiff transacted in the security domestically — a concept inconsistent with the insistence in Morrison that section 10(b) not have extraterritorial application. Thus, the Second Circuit did not limit its analysis to whether the swap agreements in question were domestic transactions. Instead, the court analyzed all aspects of the claim, including that the claims were brought against foreign defendants with no alleged involvement in the plaintiffs’ transactions, on the basis of the defendants’ largely foreign conduct, for losses incurred by the plaintiffs in securities-based swap agreements based on the price movements of foreign securities. The Second Circuit held that the claims were so “predominantly foreign” that Section 10(b) did not apply. The court clarified that the presence of a foreign element in the transaction does not preclude Section 10(b) coverage, but a court may find that a claim is so overwhelmingly foreign that the claim is precluded by the presumption against extraterritorial application of law. The court stopped short of announcing a test, noting instead that it would adopt a fact-intensive, case-by-case approach. The ParkCentral decision provides an escape route to courts that are uncomfortable deciding cases that involve mostly foreign conduct but nevertheless satisfy Morrison’s domestic transaction requirement. In a recent decision in the Southern District of Texas, Avalon Holdings, Inc.et al. v. BP, PLC et al, the district court held that the Securities Litigation Uniform Standards Act (SLUSA) did not apply to English common law deceit claims brought by institutional investors in federal court against BP executives for statements made in the wake of the Deepwater Horizon disaster. SLUSA precludes a securities action if the action is (1) a “covered class action;” (2) based on “State” law; (3) involves a “covered security;” and (4) alleges a misrepresentation or omission of a material fact “in connection with the purchase or sale of a covered security.” 15 U.S.C. § 78bb(f)(1)(A). The plaintiffs argued that their English law claims were not “state” law claims as required for SLUSA preclusion based on the plain language of the Exchange Act, which defines “state” as “any State of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, or any other possession of the United States.” The defendants argued that SLUSA was intended to preclude foreign law fraud claims because Congress intended that federal securities laws be the only law through which plaintiffs could bring fraud claims on covered securities. Although the district court agreed with the defendants that perhaps SLUSA should preclude foreign law claims, the court relied on the plain language of the statute and held that SLUSA does not preclude foreign law claims. Because the claims were brought under foreign law, the court was not concerned with extraterritorial application of Section 10(b), even though the securities at issue in Avalon Holdings were purchased on the London Stock Exchange. This Avalon Holdings decision demonstrates how foreign plaintiffs could pursue foreign law claims regarding their losses in foreign-traded securities in federal court to avoid extraterritorial application issues of Section 10(b). IN AVAION HOLDINGS, BECAUSE THE CLAIMS WERE BROUGHT UNDER FOREIGN LAW, SLUSA DID NOT PRECLUDE A CLASS SUIT IN STATE COURT.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 16 VIII. CLASS CERTIFICATION ISSUES A noteable class certification ruling in 2014 was In re Kosmos Energy Ltd. Securities Litigation, 299 F.R.D. 133 (N.D. Tex. 2014). The lead plaintiff sued under Section 11 of the Securities Act based on alleged false and misleading statements in Kosmos Energy Ltd.’s IPO documents and then moved for class certification. The lead plaintiff seemed to believe that class certification was a mere formality. The court, however, applied Supreme Court precedent and undertook a “rigorous” review of the evidence in denying class certification on two independent grounds. First, the court denied class certification because the lead plaintiff failed to satisfy its burden of proving that it could be an adequate class representative. The court noted that the only evidence submitted in support of adequacy was “little more than formulaic, boiler-plate assertions.” By contrast, the defense submitted evidence showing that the lead plaintiff’s representative knew little about the case. Among other reasons, the lead plaintiff did not realize it had allegedly been damaged until notified by plaintiff’s counsel pursuant to a “securities monitoring service,” a common method employed by the shareholder plaintiffs’ bar that the court heavily criticized. Second, the court also denied class certification upon finding that common questions did not predominate over questions affecting individual class members. The court was troubled that the lead plaintiff relied almost exclusively on briefing — rather than evidence — to try to meet its burden of establishing predominance. The defense had also submitted unrefuted evidence of individualized investor knowledge regarding Kosmos’ alleged misstatements. The court therefore found that common questions did not predominate and denied class certification. The Kosmos decision demonstrates that class certification in securities suits remains a high bar for plaintiffs to attain. Defendants should be attuned to the evidence that plaintiffs submit in support of each requirement for class certification and should not hesitate to present their own evidence and to oppose certification where that evidence supporting plaintiff is lacking. As required by the Dodd-Frank Act, the SEC established its Office of the Whistleblower (the “OWB”) in 2011 to receive and investigate whistleblower tips and complaints. The OWB and the SEC encourage and incentivize individuals to provide information relating to a violation of the securities laws by offering financial awards in some instances. The SEC’s whistleblower program will reward “high-quality, original information” that results in enforcement actions exceeding $1 million. Awards can range from 10 to 30 percent of the sanctions collected. The SEC gave out its first whistleblower award in 2012, awarded four whistleblowers in 2013, and awarded nine whistleblowers in 2014. On September 22, 2014, the SEC announced the largest payout since the inception of the whistleblower program — an award of more than $30 million to a IX. SEC AND OTHER REGULATORY MATTERS Whistleblower BountyHAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 17 foreign national who provided information about an ongoing fraud “that would have been very difficult to detect.” In reaching the award determination, the SEC considered the significance of the information, the assistance provided, and the law enforcement interests at issue. Despite the record-breaking award, the SEC admonished the tipster’s delay in reporting the violations, which it found to be unreasonable. Because of the delay, the SEC said the award was below the average percentage amount paid to other whistleblowers. The OWB has seen consistent growth in the annual numbers of tips received and awards made since the inception of its program. The award of more than $30 million, which is the fourth to a whistleblower living in a foreign country, shows the international breadth of the whistleblower program. The SEC has signaled it will continue to incentivize whistleblowers from all over the world to come forward with credible information about potential securities violations. With whistleblower complaints on the rise, companies should be sensitive to the various protections whistleblowers are afforded under both the SarbanesOxley Act of 2002 (“SOX”) and the Dodd-Frank Wall Street Reform and Consumer Protection Act (“DoddFrank”). On March 4, 2014, in a 6 to 3 decision, the U.S. Supreme Court in Lawson v. FMR LLC, 134 S. Ct. 1158 (2014), considerably expanded the number of employees who may seek to bring suit under the SOX whistleblower provision. The Court held that SOX whistleblower protection extends to the employees of a public company’s private contractors and subcontractors. Plaintiffs in Lawson were employees of mutual fund investment advisers, non-public companies that had contractual relationships with public mutual funds. They sued their employers under Section 806 of SOX, alleging that they had been retaliated against after they reported supposed shareholder fraud at the mutual funds. Section 806 provides, in part, that: “No [public] company . . . or any officer, employee, contractor, subcontractor, or agent of such company, may discharge, demote, suspend, threaten, harass, or in any other manner discriminate against an employee . . . because of [whistleblowing or other protected activity].” 18 U.S.C. § 1514A(a). The question for the Court was whether § 1514A shields only those employed by the public company itself, or whether it extends to protect employees of privately-held contractors and subcontractors who perform work for the public company. In a decision authored by Justice Ginsberg, the Court held SOX whistleblower protection does extend to private contractor employees. To reach this holding, the Court analyzed the statutory text, legislative history, and Congress’s intent “to ward off another Enron debacle” when it enacted SOX. Additionally, the Court rejected as hypothetical the dissent’s concern that broadly interpreting § 1514A would open the floodgates for claims beyond its purpose. Nor did the Court see evidence of a narrower meaning in subsequent legislative events like Dodd-Frank. With the expansive Lawson decision, there may be a significant increase in the volume of whistleblower litigation against public and private companies under both SOX’s Section 806 and Dodd-Frank’s whistleblower-protection provision. A contested issue under Dodd-Frank is whether employees suing under its whistleblower-protection provision must have made Whistleblower Protection Expanded IN LAWSON, THE SUPREME COURT HELD THAT SOX WHISTLEBLOWER PROTECTION EXTENDS TO EMPLOYEES OF A PUBLIC COMPANY’S PRIVATE CONTRACTORS AND SUBCONTRACTORS. HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 18 a report to the SEC versus internal reports. In 2013, the Fifth Circuit held in Asadi v. G.E. Energy (USA), LLC, 720 F. 3d 620 (5th Cir. 2013), that the Dodd-Frank provision unambiguously requires individuals to provide information to the SEC to qualify as a whistleblower and pursue a claim for retaliation. The SEC’s amicus brief in Lawson, however, indicated the SEC views internal complaints protected by SOX as protected under Dodd-Frank as well. Regardless, private and public companies should continue to bolster their internal processes and procedures for reporting and investigating internal complaints so that such complaints are handled effectively and in compliance with the applicable whistleblower protection laws. The Dodd-Frank Act in 2011 gave power to the SEC to prosecute companies that engaged in retaliation against whistleblowers and, in 2014, the SEC brought the first enforcement action using this authority. On June 16, 2014, the SEC charged hedge fund Paradigm Capital Management with, among other things, retaliating against an employee who reported violative trading activity to the SEC. According to the SEC’s order, Paradigm’s former head trader made a whistleblower submission to the SEC that revealed undisclosed principal transactions by Paradigm. The SEC alleged that after learning that the trader had reported potential violations to the SEC, Paradigm immediately engaged in a series of retaliatory actions including removing the individual from his head trader position, tasking him with investigating the very conduct he reported to the SEC, changing his job function from head trader to a full-time compliance assistant, stripping him of his supervisory responsibilities, and otherwise marginalizing him. The Paradigm action is the first of what is expected to be an ongoing SEC program to exercise its anti-retaliation authority. In 2013, SEC Chairwoman Mary Jo White announced that the Commission would be increasing its focus on “control failures, negligence-based offenses, and even violations of prophylactic rules with no intent requirement” as part of its “Broken Windows” initiative. The SEC continued the initiative in 2014. In September, the SEC announced actions against 19 firms for Exchange Act Rule 105 violations (a rule designed to prevent firms from participating in public stock offerings after short selling the same stock during a restricted period). The announcement followed a similar enforcement action in 2013 against 23 firms for Rule 105 violations. In the 2014 settlement, the SEC secured disgorgement, interest, and penalties ranging from $70,000 to more than $3.6 million (one firm attested to the SEC that it was financially unable to pay a penalty). Total recovery by the Commission exceeded $9 million. Almost simultaneously, the Commission announced charges against 18 individuals, 10 investment firms, and 6 publicly traded companies for violating or contributing to violations of Exchange Act Rules 13d-1 and 16(a), requiring prompt reporting of holdings and transactions in company stock by officers, directors, or major shareholders. According to the SEC, the individuals, firms, and companies they charged were “repeatedly filing late,” in some cases delaying their filings by weeks, months, or even years (although some filings were late by as little as one or two days). ThirtyWhistleblower Retaliation Actions SEC Continues its “Broken Windows” Initiative THE SEC CONTINUED THE BROKEN WINDOWS INITIATIVE IN 2014, INCREASING ITS FOCUS ON CONTROL FAILURES, NEGLIGENCE-BASED OFFENSES, AND VIOLATIONS OF RULES WITH NO INTENT REQUIREMENT.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 19 three of the 34 individuals and companies settled the Commission’s charges and paid penalties ranging from $25,000 to $150,000. With Chairperson White’s announcement that the Commission is focused on pursuing “all types of wrongdoing,” we can expect to see more enforcement actions targeted at arguably minor violations in the near future. For example, the SEC has been increasingly focused on the reasonableness of issuers’ efforts to verify potential investors’ accredited status under the new Rule 506(c) (which allows for general solicitation of offerings), and many issuers are currently responding to Commission inquiries in this regard. In Goldman, Sachs & Co. v. Golden Empire Schools Financing Authority, 764 F.3d 210 (2d Cir. 2014), the Second Circuit widened a potentially burgeoning circuit split over whether a contractual forumselection clause can supersede FINRA rules requiring arbitration. It joined the Ninth Circuit in holding that where parties have contractually agreed to resolve any disputes in federal court, that agreement supersedes the arbitration clause embodied in FINRA Rule 12200. The agreement in the Golden Empire matter called for “all actions and proceedings” between the parties to be brought in federal court. In another matter, the Fourth Circuit had previously compelled arbitration in the face of a similar clause because it did not specifically mention arbitration. The court in Golden Empire was not persuaded by the Fourth’s Circuit’s reasoning. Instead, it held that where a forumselection clause is “all-inclusive and mandatory,” that clause overcomes the presumption of arbitrability in the Federal Arbitration Act, even where the clause does not specifically mention arbitration. In United States SEC v. Citigroup Global Mkts., 752 F.3d 285 (2d Cir. 2014), the Second Circuit vacated the trial court’s order rejecting a settlement between the SEC and Citigroup Global Markets Inc. (Citigroup), holding that the trial court applied an incorrect legal standard in assessing the consent decree. The underlying dispute involved allegations that Citigroup negligently misrepresented its role in marketing a billion-dollar fund (Class V Funding III) by exercising substantial influence over the selection of $500 million of the fund’s assets. The trial court rejected Citigroup’s proposed settlement with the SEC on the basis that the settlement was not reasonable, fair, adequate, or in the public’s interest. The trial court objected to the settlement terms largely because Citigroup did not admit or deny wrongdoing as part of the settlement. The Second Circuit vacated the trial court’s order, finding that it was an abuse of discretion for the trial court to require that the SEC establish the “truth” of the allegations against Citigroup. Further, the Second Circuit clarified that the proper standard for reviewing a proposed consent judgment involving an enforcement agency is “whether the proposed settlement is fair and reasonable, with the additional requirement that the ‘public interest would not be disserved’ in the event that the consent decree includes injunctive relief,” omitting “adequacy” from the standard. The court laid out the following factors which should be considered by courts evaluating proposed SEC settlements for fairness and reasonableness, noting the primary focus should be on procedural soundness, taking care not to impose on the SEC’s discretionary authority to settle: Forum Selection Clauses May Supersede FINRA Arbitration Rules Second Circuit Vacates Rejection of Citigroup/ SEC Settlement WE CAN EXPECT TO SEE MORE SEC ENFORCEMENT ACTIONS TARGETED AT ARGUABLY MINOR VIOLATIONS IN THE NEAR FUTURE. HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 20 (1) the basic legality of the decree; (2) whether the terms of the decree, including its enforcement mechanism, are clear; (3) whether the consent decree reflects a resolution of the actual claims in the complaint; and (4) whether the consent decree is tainted by improper collusion or corruption of some kind. Because the trial court in Citigroup has not been the only court to reject SEC settlements in an attempt to elicit stronger sanctions, the Second Circuit’s decision likely will have significant impact on future SEC settlements. The Second Circuit decision provides the SEC wide discretion in fashioning settlements and narrows a trial court’s ability to influence terms by rejecting such a settlement. Going forward, courts may be less inclined to reject settlements and more likely to accept the SEC’s determination of whether to require admissions of wrongdoing as a part of any settlement. In a landmark opinion released on December 10, 2014, the Second Circuit clarified the scope of tippee liability for insider trading by requiring a tippee to have knowledge that a tipper gained a personal benefit from the disclosure of material nonpublic information. The court also clarified the personal benefit test to require evidence of “a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the latter.” In United States v. Newman, 2014 WL 6911278 (2d Cir. 2014), the Second Circuit overturned the insider trading convictions of two portfolio managers who were alleged downstream tippees three to four steps removed from corporate insiders/tippers. At trial, the two defendants asked the district court to instruct the jury that the government — in order to obtain a conviction for insider trading — had to prove that the defendants had knowledge of a personal benefit obtained by the tipper. The district court declined, however, and gave the jury an alternate instruction that required that the defendants only “know that [the inside information] was originally disclosed by the insider in violation of a duty of confidentiality.” The jury convicted both defendants, but the Second Circuit reversed. The court observed that a tippee’s liability is derived from the insider’s fiduciary breach, an insider’s fiduciary breach requires that the insider obtain some personal benefit, and a tippee is liable only if he knows or should have known of the breach. Thus, it must be the case that a tippee’s conviction for insider trading “requires knowledge that the insider disclosed confidential information in exchange for personal benefit.” The court also clarified what the government must prove to satisfy the “personal benefit” requirement, rejecting the notion that such a benefit could be inferred from the mere existence of a personal relationship between insider and tip recipient: “we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” In light of these holdings in Newman, the court reversed the convictions and remanded with instructions to dismiss the indictments with prejudice. Moving forward, this opinion will make it more difficult for prosecutors to secure insider trading convictions against downstream tippees. Tippee Liability for Insider Trading: United States v. Newman A TIPPEE’S CONVICTION FOR INSIDER TRADING “REQUIRES KNOWLEDGE THAT THE INSIDER DISCLOSED CONFIDENTIAL INFORMATION IN EXCHANGE FOR PERSONAL BENEFIT.” HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 21 In 2013, the Delaware Court of Chancery upheld a forum selection bylaw that required litigation involving the internal affairs of a Delaware corporation to be brought only in Delaware courts. In 2014, the holding was extended further in City of Providence v. First Citizens BancShares, Inc., 99 A. 3d 229 (Del. Ch. 2014), when the court upheld a forum selection bylaw that required litigation involving a Delaware corporation to be brought only in North Carolina courts. First Citizens, incorporated in Delaware and headquartered in North Carolina, adopted a forum selection bylaw requiring that litigation be brought only in North Carolina. A shareholder challenged the bylaw as invalid. The Delaware Court of Chancery held that corporate bylaws are a binding contract among directors, officers, and stockholders and that the First Citizens’ bylaws facially permitted the amendment. After analyzing a previous Delaware case that upheld a Delaware forum selection bylaw, the court concluded that there was no principled reason to reach a different result merely because the designated forum was in a different state. Applying business judgment review to the board’s adoption of the forum selection bylaw, the court disposed of the plaintiff’s argument that the forum selection bylaw was facially invalid. The court also held that it “did not discern an overarching public policy of this State that prevents boards of directors of Delaware corporations from adopting bylaws to require stockholders to litigate intra-corporate disputes in a foreign jurisdiction.” The court stressed the importance of judicial comity, observing that if Delaware expects courts of other states to enforce bylaws that designate Delaware as the exclusive forum for intra-corporate disputes, then Delaware courts must be willing to enforce similar bylaws that require disputes to be brought in other states. Decisions such as City of Providence provide powerful grounds to permit companies and directors to steer litigation to a forum that comports with the company’s location or other business needs. With the advice of counsel, companies should consider adopting such forum selection bylaws. In 2014, the Delaware Supreme Court provided a framework for how a transaction with a controlling stockholder could be structured to obtain the protections of the business judgment rule. In Kahn v. M&F Worldwide Corp. (“MFW”), 88 A.3d 635 (Del. 2014), the Delaware Supreme Court adopted a new standard that allows the “business judgment” standard of review, rather than “entire fairness,” to apply to controlling-party takeovers where it is established that certain protections exist. X. NOTABLE DEVELOPMENTS IN STATE LAW ACTIONS AND FIDUCIARY LITIGATION “Forum selection” Bylaw Provisions: Valid and Enforceable Delaware Courts Adopts and Apply Standards in Controlling-Party Takeover THE DELAWARE CHANCERY COURT HELD THAT IT “DID NOT DISCERN AN OVERARCHING PUBLIC POLICY OF THIS STATE THAT PREVENTS BOARDS OF DIRECTORS OF DELAWARE CORPORATIONS FROM ADOPTING BYLAWS TO REQUIRE STOCKHOLDERS TO LITIGATE INTRA-CORPORATE DISPUTES IN A FOREIGN JURISDICTION.”HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 22 Where a transaction involving a controlling stockholder takeover is challenged — such as a going-private transaction — the standard of judicial review traditionally applied under Delaware law is “entire fairness,” an onerous standard that requires a defendant to demonstrate both fair dealing and fair price. The demands of “entire fairness” review make it difficult for a defendant to prevail on a motion to dismiss before having to engage in costly discovery or to obtain summary judgment. In MFW, the Delaware Supreme Court held that the far more deferential business judgment review standard applies to controlling stockholder mergers if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say “no” definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority. Then, under the business judgment standard, breach of fiduciary claims must be dismissed unless no rational person could have believed that the merger was favorable to the minority stockholders. After MFW, however, it was unclear whether and how the business judgment rule would be applied at the pleading stage in cases where defendants sought to rely on the new framework. In Swomley v. Schlecht, C.A. No. 9355-VCL (Del. Ch. Aug. 27, 2014), Vice Chancellor Laster applied the business judgment standard of review at the pleading stage to dismiss a complaint challenging a cash-out merger involving a controlling stockholder. Vice Chancellor Laster held that the plaintiffs had failed to adequately plead facts undermining the six factors required for application of the business judgment rule in the controlling stockholder merger context. The Vice Chancellor rejected the argument that it was procedurally inappropriate to dismiss under MFW because the defendants should have to establish that the requirements of MFW were met. The Vice Chancellor reasoned that “MFW contemplates that one can establish a structure where, at the pleading stage, it would stand up, and the plaintiff would have the burden to attack it by pleading facts that would undermine each of its elements.” Perhaps most importantly, the Vice Chancellor held that the plaintiffs had not pled facts sufficient to call into question whether the Special Committee had met its duty of care, despite allegations that the Special Committee should have negotiated for a higher price. Vice Chancellor Laster held that the “[d]uty of care is measured by a gross negligence standard,” which “really requires recklessness” and is “a very tough standard to satisfy.” That the committee could have negotiated differently, or that there were bases to disagree with the committee’s strategy or tactics, were not enough to plead a duty of care violation. Swomley provides a useful roadmap. There are tangible litigation benefits to structuring a controlling stockholder transaction to comply with the MFW structural requirements for obtaining business judgment rule review. Moreover, the case demonstrates that the court will hold plaintiffs to the stricter gross negligence standard when evaluating the Special Committee’s efforts to achieve a higher price. A determination as to whether a single shareholder or a group of shareholders acting together “controls” a corporation often affects the legal analysis for claims involving shareholder disputes. Shareholders ordinarily do not owe fiduciary duties to other shareholders, but will owe fiduciary duties if they have majority THERE ARE TANGIBLE LITIGATION BENEFITS TO STRUCTURING A CONTROLLING STOCKHOLDER TRANSACTION TO COMPLY WITH THE MFW STRUCTURAL REQUIREMENTS FOR OBTAINING BUSINESS JUDGMENT RULE REVIEW. Determination of Controlling Stockholder StatusHAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 23 ownership or exercise control over the company’s business. Two decisions from the Delaware Court of Chancery in 2014 helped further draw the boundaries for when a shareholder or group of shareholders will be deemed controllers. In Hamilton Partners, L.P. v. Highland Capital Management, L.P., 2014 WL 1813340 (Del. Ch. May 7, 2014), the court considered a challenge by a shareholder (“Hamilton”) to a merger involving a company that was alleged to have been controlled by Highland Capital Management, L.P. (“Highland”). The merger was a complex transaction involving multiple steps. At the time the merger was agreed to, Highland was a 48% shareholder. It argued that it owed no fiduciary duties to other shareholders because it was not a majority owner and did not exercise control over the company. The court analyzed Hamilton’s complaint and concluded that it had adequately alleged that Highland was a controlling shareholder and therefore owed fiduciary duties. The court emphasized that whether a minority shareholder controls a company is a highly contextualized inquiry and that there is no bright-line ownership percentage to determine that a minority shareholder does or does not exercise control. In addition to being a 48% shareholder, Highland also owned 82% of the company’s debt, which was in default. Highland’s ability to withhold its consent to prevent the company from refinancing defaulted debt supported an inference that Highland controlled the company and ultimately used that control to facilitate the merger and its terms. Therefore, the court denied Highland’s motion to dismiss. In In re Crimson Exploration Inc. Stockholder Litigation, 2014 WL 5449419 (Del. Ch. Oct. 24, 2014), the court analyzed at the pleading stage whether a group of affiliated defendants could collectively be considered controlling shareholders. The plaintiffs challenged a completed merger and argued that several shareholders who were affiliated with Oaktree Capital Management, L.P. (“Oaktree”) and collectively held 33.7% of the company’s stock constituted a controlling bloc and breached fiduciary duties by allegedly selling the company for below its market value. The plaintiffs also attempted to buttress their control allegations by claiming that Oaktree’s 33.7% should be aggregated with an additional 15% of the shares there were owned by other shareholders alleged to have interests that were “aligned” with Oaktree’s. The court assessed whether the plaintiffs had adequately alleged that Oaktree was a controlling stockholder and began its analysis by cataloging numerous cases where Delaware courts have considered whether a sub-50% shareholder exercised control. The examples cited by the court reflect that — depending on context — a 46% shareholder had been held not to be a controller, while a 35% shareholder had been held to be a controller. From the cases, the court gleaned that “a large blockholder will not be considered a controlling stockholder unless they actually control the board’s decisions about the challenged transaction.” In applying the law to the facts alleged in the complaint, the court first rejected plaintiff’s effort to lump Oaktree’s 33.7% ownership in with another 15% of the shares held by others, emphasizing that “mere concurrence of self-interest among certain stockholders” is insufficient to aggregate multiple owners’ interests for purposes of establishing a controlling bloc. Second, the court then found that — among other pleading deficiencies — the plaintiffs failed adequately to allege that Oaktree actually controlled the company regarding the challenged transaction. Accordingly, Oaktree owed no fiduciary duties and the claims against it were dismissed. Taken together, Hamilton Partners and Crimson Exploration demonstrate the fact-specific nature of whether a significant shareholder will be deemed to owe fiduciary duties to others. WHETHER A MINORITY SHAREHOLDER CONTROLS A COMPANY IS A HIGHLY CONTEXTUALIZED INQUIRY AND THERE IS NO BRIGHT-LINE OWNERSHIP PERCENTAGE TO DETERMINE THAT A MINORITY SHAREHOLDER DOES OR DOES NOT EXERCISE CONTROL.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 24 Many entities choose to incorporate in Delaware as a result of the abundance of case law on corporate matters and the willingness and ability of the Delaware legislature to adapt to changing times. The Delaware Supreme Court’s opinion in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014) held that fee-shifting provisions contained in a non-stock corporation’s bylaws that required the losing party of intra-corporate litigation to pay both parties’ legal fees, were facially valid. The decision allows a Delaware non-stock corporation to draft around the traditional “American Rule,” which is the prevailing policy throughout the United States for determining whether a losing party is responsible for another party’s court costs and attorneys’ fees. The “American Rule” requires each party to a lawsuit, regardless of whether winner or loser, plaintiff or defendant, to pay its respective court costs and attorneys’ fees. Feeshifting provisions similar to the one at issue in the litigation have historically not garnered widespread adoption in corporate bylaws. ATP Tour, Inc. (“ATP”) is a Delaware non-stock membership corporation that operates professional men’s tennis tournaments. Deutscher Tennis Bund, a German tennis federation and member of ATP, is the host of an ATP tournament that filed a lawsuit alleging antitrust violations and breach of fiduciary duty that challenged ATP’s decision to change the date and the significance of the tennis tournament that Deutscher hosted. Following a ruling by a federal trial court in favor of ATP, ATP pointed to its bylaws to seek recovery of its court costs and attorneys’ fees incurred in defending itself in the litigation. Specifically, ATP cited Article 23 of its bylaws, which stated in part that “[i]n the event … the Claiming Party does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the League and any such member or Owner for all fees, costs, and expenses of every kind and description.” The federal court certified the question for the Delaware Supreme Court’s consideration of whether the board of a Delaware non-stock corporation can lawfully adopt such a provision. After examining relevant statutes and previous court precedent, the Delaware Supreme Court determined that a fee-shifting bylaw, like the one at issue in the litigation, is facially valid under Delaware law when authorized by the Delaware General Corporation Law (the “DGCL”) and consistent with a corporation’s certificate of incorporation and the enactment is not otherwise prohibited. The court discussed the importance of the circumstances surrounding the adoption of such a provision when examining the legality of corporate bylaws. Specifically, the court noted that “[b]ylaws that may otherwise be facially valid will not be enforced if adopted or used for an inequitable purpose.” Depending upon whether proposed amendments to the DGCL are adopted, the ATP Tour decision might lay the foundation for the future adoption and enforcement of similar feeshifting provisions by for-profit corporations. In response to the ATP Tour decision, the Delaware legislature has considered prohibiting fee-shifting bylaws. It remains to be seen whether the legislature will act and if so, how courts will treat fee-shifting bylaws that were implemented prior to the legislative change. If the legislature does not act, it also remains to be seen whether Delaware courts will extend the holding of ATP Tour to permit fee-shifting bylaws by for-profit public companies. With the advice of counsel, Delaware corporations should consider Delaware Supreme Court Speaks on Fee-Shifting Bylaws THE ATP TOUR DECISION MIGHT LAY THE FOUNDATION FOR THE FUTURE ADOPTION AND ENFORCEMENT OF SIMILAR FEE-SHIFTING PROVISIONS BY FOR-PROFIT CORPORATIONS.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 25 adopting fee-shifting bylaws as a means to deter shareholder litigation but should recognize the possibility that such provisions could be rendered invalid by the Delaware legislature and/or the courts. In February 2014, a shareholder of Wyndham Worldwide Hotels filed a derivative suit against several of the company’s officers and directors alleging they violated their fiduciary duties, wasted corporate assets, and were unjustly enriched in connection with three separate data breaches between 2008 and 2010. Palkon v. Holmes, No. 2:14-cv-1234 (D.N.J. Oct. 20, 2014). In his suit, the plaintiff alleged that the defendants failed to take reasonable steps to secure customers’ personal and financial information and failed to timely disclose the breaches of payment card data in the company’s financial filings. Hackers had allegedly gained entry to the company’s network through a brute force attack and used memory-scraping malware to collect hotel guests’ credit card data. The plaintiff also alleged that the defendant directors failed to independently and in good faith consider a pre-suit demand that they investigate the data breaches and cause the company to file a lawsuit against company personnel allegedly responsible for allowing the breaches to occur. Notably, the plaintiff relied on documents produced by the company in response to a books-and-records demand in an effort to show that the directors’ investigation was inadequate. The federal district court in New Jersey dismissed the derivative suit in October 2014, holding that the plaintiffs presented no evidence that the board’s refusal to bring suit constituted bad faith. The court also rejected the plaintiff’s contention that the company’s general counsel (who the plaintiff alleged could face personal liability for the breaches) and the board’s outside counsel (who was defending the company in a lawsuit by the Federal Trade Commission related to the breaches) had conflicts of interest that influenced their advice that the board not take action on the plaintiff’s demand. The plaintiff has appealed the decision to the United States Court of Appeals for the Third Circuit. A similar suit is pending against directors and officers of Target Corporation, although the plaintiffs in that lawsuit are claiming that a pre-suit demand would have been futile. See Amended Verified Consolidated Shareholder Derivative Complaint, In re Target Corp. S’holder Derivative Litig., No. 0:14-cv-00203 (D. Minn. July 18, 2014). These lawsuits illustrate the recent expansion of data breach litigation and the importance of involving company executives, officers, and directors in decisions regarding data security. In Wal-Mart Stores v. Indiana Elec. Workers Pension Trust Fund IBEW, 95 A.3d 1264 (Del. 2014), the Delaware Supreme Court adopted the so-called “fiduciary exception” to a corporation’s attorney-client privilege as articulated in the Fifth Circuit’s decision issued many years ago in Garner v. Wolfinburger, 430 Dismissal of Cyber BreachRelated Fiduciary Claims Delaware Adopts Fiduciary Exception to Corporate Attorney-Client Privilege RECENT LAWSUITS ILLUSTRATE THE EXPANSION OF DATA BREACH LITIGATION INVOLVING COMPANY EXECUTIVES, OFFICERS, AND DIRECTORS.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 26 F.2d 1093 (5th Cir. 1970). In the Wal-Mart case, a shareholder plaintiff, through a Delaware Section 220 demand for books and records, sought Wal-Mart’s privileged documents relating to an internal FCPA investigation by the company. By applying the Garner fiduciary exception, the Delaware Supreme Court held that a shareholder may show “good cause” to invade a corporation’s attorney-client privilege in order to prove fiduciary breaches by those running the corporation. To meet Garner’s “good cause” burden requires a fact-specific analysis of numerous factors, such as the “bona fides” of the shareholders, the nature of the shareholders’ claim and whether it is colorable, and whether the privileged communications are identified with particularity or whether the shareholders are “blindly fishing.” The Delaware Supreme Court stated that the Garner fiduciary exception is “narrow, exacting, and intended to be very difficult to satisfy.” Whether and under what circumstances the Garner fiduciary exception results in companies being forced to produce privileged documents to shareholder plaintiffs remains to be seen; however, the Delaware Supreme Court’s recognition of Garner illustrates the importance of Section 220 books and records actions as a tool for shareholder plaintiffs to acquire information in support of their claims. In a significant decision affecting Texas corporate law, in which Haynes and Boone, LLP represented the defendant company, the Texas Supreme Court decided in 2014 that there is no common law claim for shareholder oppression in Texas; the court also set the standards and remedies available for oppression claims brought pursuant to the rehabilitative receiver statute in the Texas Business Organizations Code. Several Texas intermediate courts of appeal had previously allowed shareholders to bring oppression claims, but the supreme court had never directly addressed oppression claims. By declining to recognize a common law claim, Texas law conforms to Delaware corporate law, which also does not recognize such a common law cause of action. In the case, Ritchie v. Rupe, 443 S.W.3d 856 (Tex. 2014), the supreme court reviewed an appeal from the Dallas Court of Appeals regarding whether a failure of representatives of a privately held corporation to meet with prospective buyers of a minority shareholder’s interest in the company constituted oppression. At the minority shareholder’s request, the company had previously made an offer to buy her shares for an amount she rejected as too low and had also met her requests for corporate information. However, based on advice of the company’s lawyers that the meeting might put the company at risk for securities fraud liability, the company representatives declined to meet with buyers proffered by the minority shareholder. The minority shareholder then sued the company and its representatives alleging as the basis for claims of oppression and breach of fiduciary duty, among other things, the failure to meet with the prospective buyers. After trial, the trial court ordered that the company buy the minority shareholder’s interest for more than $7 million as the remedy for the alleged oppression. In so doing, the trial court considered both a “fair dealing” test (submitted to the jury) and a “reasonable expectation” test. The share buyout valuation did not include any discounts for marketability or lack of control. The Dallas Court of Appeals upheld the oppression finding but remanded to the trial court to apply discounts to reduce the buyout remedy from the interest’s alleged “fair value” to its “fair market value.” Texas Supreme Court Rejects Common Law Shareholder Oppression THE TEXAS SUPREME COURT HELD IN 2014 THAT THERE IS NO COMMON LAW CLAIM FOR SHAREHOLDER OPPRESSION IN TEXAS.HAYNESBOONE.COM 2014 YEAR IN REVIEW: SECURITIES LITIGATION 27 Upon reviewing the claim, the supreme court determined there is a statutory claim for oppression under the Texas rehabilitative receivership statute for corporations, Texas Business Organizations Code section 11.404; however, the court limited the available relief to appointment of a rehabilitative receiver and adopted standards for “oppressive” conduct higher than the “fair dealing” and “reasonable expectations” tests previously used by the lower courts. Under the new standard, oppression occurs only if a corporation’s directors or managers “abuse their authority over the corporation with the intent to harm the interests of one or more of the shareholders, in a manner that does not comport with the honest exercise of their business judgment, and by doing so create a serious risk of harm to the corporation.” In arriving at this standard, the court reviewed the purposes of the receivership and other statutes and noted that oppression always included the abuse of power that harms the interests of another person in a way that disserves the authorization of such power, that the statute was only to allow a temporary receivership to relieve exigent circumstances, and that all of the possible grounds for a receivership posed a serious risk of harm to the corporation. The court also held that the statute contemplates that the “business judgment” rule be considered in a claim for oppression. The court held that the cases that had applied only a “fair dealing” or “reasonable expectations” test did not comport with those statutory requirements. The court concluded that the refusal to meet with potential buyers in Ritchie did not constitute oppressive action. In addition, the court held that a temporary rehabilitative receivership cannot be appointed unless a trial court has determined that all other lesser available remedies based on other claims or other provisions of the statute would not be adequate. In Ritchie, the court noted that the minority shareholder had not requested a rehabilitative receivership or shown that lesser remedies would not be sufficient based on other successful claims. The court rejected the argument that the statute allowed lesser remedies other than a short term, rehabilitative receivership. The court then examined whether Texas should recognize a common law claim for shareholder oppression, applying a cost-benefit analysis. In particular, the court reviewed the various forms of conduct often alleged in oppression claims, including the denial of access to books and records, the withholding of dividends, termination of employment, misapplication of funds, diversion of corporate opportunities, and manipulation of stock price. For each of these types of wrongs, the court found that other available causes of action adequately addressed the wrongdoing and no additional cause of action was necessary to protect minority shareholders’ interests. Ritchie should bring greater certainty to Texas law and allow companies and majority shareholders to plan their business activities without being concerned about potential liability for amorphous “oppressive” conduct. It also aligns Texas more fully with Delaware and other states in recognizing the importance of the business judgment rule in these contexts. The ruling could thus make Texas a more attractive state for business entities to incorporate. Would-be minority shareholders should take a lesson from the opinion and make sure that they negotiate the protections they want before investing. RITCHIE SHOULD BRING GREATER CERTAINTY TO TEXAS LAW AND MAKE TEXAS A MORE ATTRACTIVE STATE FOR BUSINESS ENTITIES TO INCORPORATE.