Securities litigation year in review 2013

Securities Litigation Year in Review 2013 ©2014 Haynes and Boone, LLP Nicholas Even is Chair of the firm’s Securities Litigation practice. In 2013, he won a dismissal for alleged controlling shareholders in Brown Foundation v. Frazier Healthcare V, 2013 WL 4046412 (5th Cir. Aug. 12, 2013), successfully argued against an injunction of a merger, Herrley v. Frozen Food Express Indus., Inc., 2013 WL 4417699 (N.D. Tex. Aug. 19, 2013), and was the senior securities litigation partner representing the Board of Directors of AT&T, Inc., winning dismissal of a shareholder derivative suit in Texas state court. He is AV® Peer Review Rated Preeminent by Martindale-Hubbell® Law Directory. Thad Behrens is Chair of the firm’s Class Action Defense practice. He has successfully defended companies, directors and officers in securities class actions, derivative suits, M&A litigation, and proxy contests. He has scored major victories for clients in other class actions, including significant wins this year for the National Football League in a consumer class action and for BP Products North America, Inc. in an environmental class action. 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 practices. In 2013, among other matters, he obtained summary judgment in a fraud, fiduciary duty and breach of contract lawsuit brought against Hillwood by Mark Cuban companies, continued to serve as lead counsel for defendants in a putative class action arising out of the collapse of a hedge fund, obtained dismissal of claims by a bankruptcy trusteee, and played a leading role in significant victories for the NFL, AT&T and Frozen Food Express Industries. Odean L. Volker is a Co-Chair of the firm’s Litigation Department. His practice includes securities and complex litigation, as well as 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 and was named a Texas Super Lawyer, 2012-2013. Kit Addleman is a member of the firm’s White Collar Defense and Investment Funds Practice groups and also co-head of the firm’s Crisis Management Practice group. Kit defends companies, executives and directors against charges of civil and criminal misconduct, particularly investigations and litigation by the SEC 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. 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 2009-2013. 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 20 years of experience in class actions and shareholder litigation. She is Co-Chair of the firm’s Fiduciary L itigation group. In 2013, she played a signification role in defeating the plaintiffs’ motion for preliminary injunction to halt the announced acquisition of a target corporation and obtaining the dismissal of all actions. A major part of Carrie’s practice is advising attorneys on ethics issues and she assisted in affirming an order disqualifying opposing counsel in the Dallas Court of Appeals. She also continued to represent the trustees of two family trusts involved in a highprofile, multi-court dispute. Special thanks to the following attorneys and staff for their contributions: Emily Westridge Black, Amelia Cardenas, David Dodds, Scott Ewing, Richard Guiltinan, Andrew Guthrie, Taryn McDonald, Matt McGee, Casey McGovern, Sarah Mallett, Bonnelle Martin, Tim Newman, Christopher Quinlan, John Tancabel. Meet the Authors This paper is for informational purposes only and is not intended to be legal advice. Transmission is not intended to create and receipt does not establish an attorneyclient relationship. Legal advice of any nature should be sought from legal counsel. haynesboone.com 2 Clients and Friends, Our 2013 Securities Litigation Year in Review comments on significant decisions in the areas of class certification, loss causation, scienter, duty to disclose, pleading falsity, use of confidential witnesses, federal preemption, standing, and statutes of limitations and repose among others. It also notes key developments in SEC enforcement as well as several significant rulings in state law fiduciary litigation against directors and officers of public companies. We begin in Section I with a discussion of the Court’s February 2013 Amgen decision and a preview of the Halliburton case, set for the Supreme Court’s 2014 term. The Court has become increasingly active in class litigation in recent terms (see Section II’s discussion of other class-related decisions from the Court’s 2013 term). After the Court’s Amgen decision, in which a number of Justices expressed skepticism over the vitality of the “efficient market theory” underlying a presumption of class reliance on public company disclosures (enunciated by the Court 25 years ago in Basic Inc. v. Levinson), there was speculation that a majority of the Court might be ready to jettison that presumption entirely. Whether that is true, and whether Halliburton will be the vehicle for such a seismic shift in securities class action practice, remains to be seen. In the interim, the shareholder plaintiffs’ bar is surely holding its collective breath. In 2013, among other wins, Haynes and Boone’s securities litigation docket included (i) a Fifth Circuit victory in a minority shareholder action alleging improper dilution, (ii) dismissal of a shareholder derivative suit against the Board of Directors of AT&T, Inc. in Texas state court, (iii) denial of a preliminary injunction in an M&A suit in the Northern District of Texas, and (iv) dismissal of 1933 Act claims against an alleged controlling shareholder in a shareholder class action. We also advised companies, boards and special committees on disclosure and fiduciary matters and annual meeting issues. Members of our group also defeated class certification in significant non-securities cases, as we continued the expansion of our class action experience into other arenas. (See Meet the Authors). The firm was honored to be noted in BTI Consulting Group’s Litigation Outlook 2013 in the area of Securities and Finance Related Litigation. If you have any questions about the issues covered in this 2013 Review, or about our practice, please let us know. We look forward to working with our friends and clients in 2014. Nicholas Even Chair—Securities Litigation Practice Group Table of Contents I. Fraud-on-the-Market at 25 Years: Judgment Day for Securities Class Actions?........................................... 4 II. Other Class Certification Issues ................................. 7 III. Loss Causation........................................................11 IV. Scienter................................................................ 14 V. “Confidential Witnesses”......................................... 15 VI. Duty to Disclose .................................................... 17 VII. Pleading Alleged Misstatements............................... 18 VIII. Post-Morrison Extraterritoriality ............................... 19 IX. SLUSA Preemption ................................................. 20 X. Statute of Limitations and Statute of Repose .............. 22 XI. Standing .............................................................. 25 XII. PSLRA Stay on Discovery........................................ 26 XIII. Trials .................................................................... 27 XIV. SEC Enforcement Actions and Other Activities .......... 27 XV. Section 16(b) Short-Swing Profits.............................. 32 XVI. Notable Developments in State Law Actions and Fiduciary Litigation................................................. 33 haynesboone.com 3 Fraud-on-the-Market at 25 Years: Judgment Day for Securities Class Actions? This past year marked the 25th anniversary of the Supreme Court’s landmark Basic v. Levinson decision, 485 U.S. 224 (1988), which allowed plaintiffs alleging securities fraud to establish class-wide reliance through the fraud-on-themarket presumption. By removing individualized issues of reliance from the class certification analysis, the presumption ushered in a new era of class action cases involving securities traded on public markets. Since Basic, securities defendants have attempted to rebut the fraud-on-the-market presumption at the class certification stage through various methods. Although the Supreme Court rejected one approach this past year, in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184, 568 U.S. __ (2013), members of the Court also indicated that the time may be ripe to revisit the viability of the fraud-on-the-market presumption itself. Amgen: Proof of Materiality Not Required to Invoke Fraud-on-the-Market Presumption The Supreme Court addressed two fraud-on-the-market issues in the Amgen case. First, the Court held that securities fraud class action plaintiffs need not prove materiality at the class certification stage to invoke the presumption. Second, the Court held that a district court need not consider a defendant’s rebuttal evidence submitted in an effort to prove the absence of materiality and therefore rebut the presumption of reliance. Together, these holdings remove materiality from the class certification battleground in securities fraud cases. The Amgen plaintiffs sought to certify a class of all Amgen stock purchasers between the date of the company’s alleged misrepresentations and the date of its corrective disclosures. Amgen argued that the plaintiffs needed to prove the materiality of the alleged misrepresentations to establish that the information had been incorporated in the purchase price of the stock, but the district court rejected this argument. Amgen then sought an opportunity to rebut the materiality allegation by introducing evidence that the truth behind the alleged misstatement had already entered the market. If Amgen could show that the truth had previously entered the market, the fraud-on-the-market presumption would be inapplicable because none of the alleged misstatements could have artificially inflated the company’s stock price. The district court declined to consider such evidence at class certification, holding that rebuttal of the fraud-on-the-market presumption should be resolved at trial. On appeal, the Ninth Circuit affirmed as to both holdings, and Amgen sought Supreme Court review. With respect to the first issue, the Supreme Court recognized that materiality is an essential predicate of the fraud-on-the-market theory. The Court nonetheless held that proof of materiality is not required to show that common questions predominate over individual issues at the certification stage. The Court observed that the materiality analysis—whether omitted or misrepresented information would have been significant to a reasonable investor—is an objective standard that applies equally to all members of the class. The Court reasoned that the failure to prove materiality would not leave individual issues predominating because materiality is an essential element of a Rule 10b-5 claim. Accordingly, plaintiffs who cannot establish the materiality of an alleged misstatement or omission cannot prevail in a securities fraud suit as a matter of law. A failure to prove materiality at the class certification stage would, the Court reasoned, extinguish the claim on its merits. There would be no remaining claim and likewise no The Supreme Court’s Amgen decision removes materiality from the class certification battleground. haynesboone.com 4 risk that individual issues would predominate. Consequently, the Court held that proof of a statement’s materiality does not bear on a court’s class certification predominance analysis under Rule 23(b)(3). For the same reasons, the Supreme Court upheld the decision not to allow Amgen to rebut the allegations that the misstatements were material. “[J]ust as a plaintiff class’s inability to prove materiality creates no risk that individual questions will predominate, so even a definitive rebuttal on the issue of materiality would not undermine the predominance of questions common to the class.” Justices Thomas, Scalia and Kennedy dissented and would have required that plaintiffs prove materiality—as a predicate of the fraud-on-the-market presumption—to show that individual issues of reliance do not preclude class certification. In his concurring opinion, Justice Alito joined with the majority, noting that Amgen had not asked the Court to revisit the fraud-on-the-market presumption adopted by the Court in Basic. Citing questions that have been raised regarding the viability of the theory’s underlying economic premise, Justice Alito wrote that “reconsideration of the Basic presumption may be appropriate.” Halliburton: Revisiting the Fraud-on-the-Market Presumption Nine months after Amgen, in November 2013, the Supreme Court granted certiorari in Halliburton v. Erica P. John Fund Inc., Docket No. 13-317 (“Halliburton II”), in which the Court will have an opportunity to consider whether to overrule or substantially modify the Basic decision, as suggested by Justice Alito. This is the second time Halliburton has reached the Supreme Court. The Halliburton plaintiffs allege that the company made false and misleading statements about various aspects of its business to inflate its stock price. The plaintiffs further allege that shareholders were harmed when the “truth” was revealed to the market and the stock price declined. In 2011, the Supreme Court held in a unanimous decision that securities fraud plaintiffs do not need to establish loss causation to invoke the fraud-on-the-market presumption. Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179, 563 U.S. __ (2011) (“Halliburton I”). After Halliburton I, the district court certified the class upon finding that the requirements for invoking the fraud-on-the-market presumption of class-wide reliance were met. Halliburton appealed to the Fifth Circuit and argued that it should be allowed to rebut the fraud-on-the-market presumption by showing that the alleged misrepresentations did not impact the stock price. The Fifth Circuit affirmed the certification ruling. The Fifth Circuit noted that Amgen limits the issues that may be addressed at class certification to those that bear on common question predominance and the propriety of class resolution. With respect to Halliburton’s price impact argument, the Fifth Circuit applied Amgen’s reasoning and concluded that price impact rebuttal evidence would be common to the entire class and would negate the claims of the individual plaintiffs if class certification was denied. Accordingly, the Fifth Circuit rejected price impact as an issue for consideration at class certification. Halliburton again appealed to the Supreme Court. Halliburton II presents two questions: (1) whether the Court should overrule or substantially modify Basic’s fraud-on-the-market presumption of class-wide reliance; and (2) whether a defendant may rebut the presumption by introducing evidence that the alleged misrepresentations did not distort the market price of the stock. Though both questions may have significant ramifications for securities litigation, Will Halliburton II mark the end of the fraud-on-the-market presumption or will Basic survive? haynesboone.com 5 the first issue implicates the potential viability of securities fraud class actions as a whole. Outside of the securities context, putative class actions premised on fraud typically cannot satisfy Rule 23(b) (3)’s predominance requirement due to the need for individualized proof of reliance on alleged misrepresentations. The fraud-on-the-market presumption allows plaintiffs to avoid proving actual individual reliance, thereby allowing them to meet the predominance requirement. Was Basic wrong? Halliburton argues that the theoretical justification for the fraud-on-the-market presumption—the efficient capital markets hypothesis—has been repudiated in the twenty-five years since Basic. To support its argument, Halliburton cites economic literature and studies that show that public information is not always incorporated into a stock price immediately or that markets do not always behave rationally. Halliburton contrasts this research against Basic’s view of market efficiency as a binary question. According to Halliburton, the fraud-on-the-market theory oversimplifies the issue of whether an alleged misrepresentation affected a stock’s price, and thus the presumption of class-wide reliance does not necessarily correlate to the effects of the alleged misrepresentation on the investors in the putative class. Halliburton also suggests a tension between Basic and the Supreme Court’s more recent class certification jurisprudence which emphasizes that plaintiffs must “affirmatively demonstrate compliance” with the requirements in Rule 23 (quoting Wal-Mart Stores, Inc. v. Dukes, 131 S. Ct. 2541, 2551 (2011)). Basic, by contrast, allows courts to presume reliance to certify classes in cases where individual issues would otherwise predominate. According to Halliburton, because the fraud-on-the-market presumption was created when courts required a less rigorous certification showing, the Supreme Court should reconcile Basic’s holding with more recent class certification decisions. If the Supreme Court were to overturn or substantially modify Basic’s central holding, Halliburton II would have a monumental impact on securities litigation. Without a presumption of class-wide reliance, class certification would pose an insurmountable hurdle to nearly all putative securities fraud class actions. Absent congressional intervention restoring a mechanism for courts to find class-wide reliance, most securities class actions would likely be replaced by individual actions filed by large investors or groups of investors (akin to the “opt out” litigation seen in some class actions). The plaintiffs’ bar may also focus more heavily on omissions cases (which may qualify for a distinct Affiliated Ute presumption of reliance) and/or public offering-related claims that do not require reliance. Must Defendants Wait Until Trial to Rebut Price Impact? If the Supreme Court does not overturn Basic, the second question in Halliburton II may have significant ramifications for securities fraud class action defendants. This issue presents the Court with the opportunity to clarify whether and how defendants may rebut the fraud-on-the-market presumption at class certification. On the one hand, the Court may limit defendants from introducing price impact rebuttal evidence at the certification stage. In this outcome, the Court would presumably conclude that a showing of no price impact would foreclose any remaining individual claims (applying Amgen’s reasoning). Class certification would remain a focal point in securities fraud litigation, but defendants would have fewer options to rebut the fraud-on-the-market theory at class certification. Because many such cases settle after certification of a class, such a ruling would practically foreclose any opportunity for defendants to rebut the presumption of reliance. Alternatively, the Court may distinguish Halliburton II from Amgen and Halliburton I by noting that, unlike materiality and loss causation, price impact is not one of the merits elements in a securities haynesboone.com 6 fraud suit under Rule 10b-5. The Court could conclude that price impact rebuttal evidence would not extinguish the individual claims of the named plaintiffs, even if a district court denied class certification on the basis of that evidence. Such an outcome would provide a mechanism for defendants to rebut the fraud-on-the-market theory at class certification while leaving the Basic framework intact. Regardless of the outcome in Halliburton II, one thing remains clear: class certification will continue to be a major battleground in securities fraud class actions. For that reason, securities defendants should take note of the other class-related holdings discussed below. Although not Rule 10b-5 cases, principles at issue in these decisions may prove important to securities fraud defendants challenging class certification. Other Class Certification Issues A number of other 2013 decisions in class actions, in the Supreme Court and elsewhere, have potential ramifications for parties to securities suits. Comcast: Failure to Show Damages Are Susceptible to Class-Wide Proof Can Preclude Class Certification In Comcast Corp. v. Behrend, 133 S. Ct. 1426 (2013), the Supreme Court made clear that a plaintiff’s inability to show that damages are susceptible to class-wide proof can be a basis for denial of class certification. The Court also held that a plaintiff may not rely on arbitrary or speculative expert models in order to establish that damages are susceptible to class-wide measurement. Rather, any damages model offered must be tethered to the plaintiff’s liability theory. The plaintiffs in Comcast filed an antitrust suit alleging that the defendant cable company attempted to monopolize the cable market in Philadelphia. In their motion for class certification, the plaintiffs proposed four different theories of antitrust impact, but the district court held that only one of the theories was capable of class-wide proof. The expert damages model the plaintiffs had proffered in support of their motion, however, did not attempt to isolate the damages resulting from the individual theory of antitrust impact that the court had held was capable of class-wide proof. The district court nonetheless certified the class, holding that the plaintiffs’ expert’s damages model addressing the four antitrust theories together had served to demonstrate that there was a methodology by which damages theoretically could be measured on a class-wide basis. The Third Circuit affirmed the district court’s decision. Although Comcast argued that the plaintiffs’ damages model did not correlate to their remaining theory of antitrust liability, the Third Circuit refused to consider the argument because such an “attac[k] on the merits of the methodology [had] no place in the class certification inquiry.” In the Third Circuit’s view, the plaintiffs were not required to “tie each theory of antitrust impact to an exact calculation of damages” at the class certification stage of the case. The Supreme Court reversed. The Court emphasized that certification is only proper where, after a rigorous analysis, the trial court is satisfied that all of Rule 23’s requirements have been met. The Court faulted the district court and Court of Appeals for refusing to entertain arguments against the plaintiffs’ damages model “that bore on the propriety of class certification, simply because those arguments A plaintiff’s class-wide damages methodology must correlate to the alleged theory of liability. haynesboone.com 7 would also be pertinent to the merits determination,” as this approach “ran afoul of [the Court’s] precedents requiring precisely that inquiry.” The Court also disagreed with the lower courts’ conclusion that it was unnecessary to decide whether the expert’s methodology was a “just and reasonable inference or speculative,” so long as the expert provided some theoretical “method to measure and quantify damages on a class-wide basis.” The Court noted that, under that logic, district courts could accept any method of measuring damages that could be applied class-wide no matter how arbitrary, which would reduce the “predominance requirement to a nullity.” The Court then held that the class should not have been certified because the plaintiffs’ damages model did not correlate to their theory of liability. Given that the district court had held that the plaintiffs could only proceed on one theory of antitrust impact, the plaintiffs were required to proffer a model that would “measure only those damages attributable to that theory.” Because the plaintiffs’ damages model made no attempt to identify the damages attributable to that theory, it could not “possibly establish that damages [were] susceptible of measurement across the entire class” for purposes of class certification. It was therefore inappropriate to certify the class. In the aftermath of Comcast, courts have struggled with how far the holding extends. On the one hand, some courts have emphasized that Comcast has enhanced plaintiffs’ burden at class certification to show how damages can be calculated on a class-wide basis. See, e.g., In re Rail Freight Surcharge Antitrust Litig., 725 F.3d 244, 255 (D.C. Cir. 2013) (vacating class certification order based on faulty damages model). On the other hand, courts have also attempted to limit Comcast’s holding and emphasized that a common damages methodology is not always necessary for certification of a class. See In re Whirlpool Corp. Front-Loading Washer Prods. Liab. Litig., 722 F.3d 838, 860 (6th Cir. 2013); Butler v. Sears, Roebuck & Co., 727 F.3d 796, 800 (7th Cir. 2013). Ultimately, these divergent approaches to interpreting Comcast may require further guidance from the Supreme Court. Class Action Waivers In 2013, the United States Supreme Court issued its third decision in four years addressing class action waivers in arbitration agreements, American Express Company v. Italian Colors Restaurant, 133 S. Ct. 2304 (2013), and once again emphasized that such provisions will be enforced even when they render proving a federal statutory claim economically impractical. In addition, a Financial Industry Regulatory Authority (“FINRA”) arbitration panel ruled that class action waivers in investor arbitration agreements likewise were enforceable. Dep’t of Enforcement v. Charles Schwab, FINRA No. 201102976010201 (Feb. 21, 2013). Italian Colors Restaurant. In 2013, the Supreme Court held that arbitration agreements containing class action waivers are enforceable even if the result is that it becomes economically unfeasible for a plaintiff to assert a federal statutory claim such as one under U.S. antitrust laws or federal securities laws. The decision marked an extension of the Court’s decision in AT&T v. Concepcion, 131 S. Ct. 1740 (2011), in which the Court had held that class action waivers in arbitration agreements could not be invalidated by contravening state law. In the years following Concepcion, class action waivers in arbitration agreements have remained a topic of judicial and regulatory review. haynesboone.com 8 In Italian Colors, the plaintiffs were merchants who accepted American Express cards. According to plaintiffs, American Express used its alleged monopoly power in the charge card market to force merchants to accept credit cards at excessive rates in violation of the antitrust laws. The plaintiffs sued in federal district court and American Express moved to compel arbitration pursuant to an arbitration clause in its form merchant contract. The contract contained a class action waiver stating that the merchant would “not have the right to participate in a representative capacity or as a member of any class of claimants pertaining to any claim subject to arbitration.” The plaintiffs presented evidence that the cost of an economic study to prove an antitrust violation would vastly exceed the recovery sought by any individual plaintiff. After the district court granted the motion to compel, the Second Circuit reversed, concluding that “the cost of plaintiffs’ individually arbitrating their dispute with Amex would be prohibitive, effectively depriving plaintiffs of the statutory protections of the antitrust laws.” Accordingly, the Second Circuit held that “as the class action waiver in this case precludes plaintiffs from enforcing their statutory rights, we find the arbitration provision unenforceable.” The Supreme Court reversed, holding that the arbitration agreement was enforceable even if the cost of proving a claim in individual arbitration exceeded its potential recovery. The Court emphasized that arbitration is a matter of contract and, therefore, that the courts must “rigorously enforce” arbitration agreements according to their terms. Against this baseline, the Court’s holding turned on three rationales. First, the Court concluded that “the antitrust laws do not guarantee an affordable procedural path to the vindication of every claim.” While Congress has facilitated antitrust lawsuits by provisions such as treble damages, the Court reasoned that no legislation “pursues its purposes at all costs” and noted that the antitrust statutes were originally enacted before the advent of the class device. Second, the Court rejected the application of an “effective vindication” exception to the enforceability of arbitration agreements. It noted that several of its prior decisions had indicated a willingness, in dictum, to invalidate on public policy grounds arbitration agreements that operate as a prospective waiver of a party’s right to pursue statutory remedies. However, the Court concluded that “the fact that it is not worth the expense involved in proving a statutory remedy does not constitute the elimination of the right to pursue that remedy.” Finally, the Court concluded on a practical note, observing that the process of weighing, on a case-by-case basis, the costs of proving each claim against the damages recoverable would “destroy the prospect of speedy resolution that arbitration in general and bilateral arbitration in particular was meant to secure.” It observed that the Federal Arbitration Act would not “sanction such a judicially created superstructure.” Charles Schwab. In Charles Schwab, FINRA’s Department of Enforcement challenged an arbitration provision in an investor agreement that “waive[d] any right to bring a class action, or any type of representative action” and further stipulated that “the arbitrators shall have no authority to consolidate more than one parties’ [sic] claims” in arbitration. A FINRA hearing panel determined that both aspects of the waiver violated FINRA arbitration rules (i) which prohibit provisions that eliminate a party’s right to participate in a judicial class action and (ii) which prohibit attempts to limit the authority of FINRA arbitrators. The panel then addressed whether those FINRA rules were preempted by the Supreme Court’s interpretation of the Federal Arbitration Act. The panel first looked to the contract clause mandating arbitration and prohibiting judicial class action. It held that the FAA precludes application of the FINRA rule prohibiting waivers of the right to pursue judicial class action relief. Accordingly, contractual haynesboone.com 9 clauses restricting rights to pursue judicial class actions cannot serve as a basis of liability for violating FINRA rules. The panel reached a different conclusion concerning the FINRA rule prohibiting limitations on arbitrator authority. It stated that “the FAA is focused on requiring those who have agreed in advance to resolve their disputes by arbitration to go to arbitration after a dispute arises and enforcing any decision the arbitrators may reach, not on regulating the governance of arbitration forums or arbitration procedures.” Therefore, the panel reasoned that the FAA did not preempt “FINRA Rules governing the powers of FINRA arbitrators [or] the procedures for FINRA arbitration.” It held that the provision preventing consolidation constituted a violation of FINRA rules that warranted invalidation of the provision as well as a $500,000 fine. The Department of Enforcement has appealed the hearing panel’s ruling on the enforceability of class action waivers in investor agreements to the National Adjudicatory Council. That appeal is currently pending. Ascertainability An important, but sometimes overlooked, argument in the arsenal of any company defending itself against potentially devastating class litigation is the requirement that the class be “ascertainable.” Before a class can be certified, a plaintiff must demonstrate by a preponderance of the evidence that the members of the class are currently and readily identifiable based on objective criteria. Unless class members can be identified without “extensive and individualized fact-finding or mini-trials,” a class action is inappropriate. In Carrera v. Bayer Corp., 727 F.3d 300 (3d Cir. 2013), the Third Circuit addressed a district court class certification order that permitted members of the class to be ascertained through “affidavits of class members.” In Carrera, the named plaintiff brought a class action against Bayer Corporation and Bayer Healthcare claiming that Bayer deceptively advertised its product One-A-Day WeightSmart by falsely claiming that it enhanced metabolism. Bayer sold WeightSmart to retail stores, but it did not sell the product directly to consumers. At issue was the ascertainability of the class—whether members of the putative class, limited to those individuals who purchased WeightSmart, could be identified. The plaintiff conceded that class members were unlikely to have documentary proof of purchase, such as packaging or receipts. And because Bayer did not sell WeightSmart directly to consumers, it had no list of purchasers. The plaintiff argued that the class could nevertheless be ascertained either by retailer records of online sales and sales made with store loyalty cards or through affidavits of class members, attesting that they had, in fact, purchased the product. The trial court agreed and certified the class, concluding that ascertainability was manageable in light of the relatively small amount of the claims and the plaintiff’s proposed methods for verifying the claims. The Third Circuit reversed, holding that if class members cannot be ascertained from a defendant’s records, there must be a reliable, administratively feasible alternative—and affidavits from absent members of the putative class are not enough. The court reasoned that a defendant in class litigation “has a similar, if not the same, due process right to challenge the proof used to demonstrate class membership as it does to challenge the elements of a plaintiff’s claim.” Because Bayer would not have the opportunity to challenge the affidavits, the affidavits could not satisfy the plaintiff’s burden to show the class was ascertainable. haynesboone.com 10 In securities cases where the identity of the purchaser of the security is not readily ascertainable, Bayer could prove to be a useful decision for defendants. Loss Causation In private federal securities actions, a plaintiff must plead and prove loss causation, i.e., “a causal connection between the material misrepresentation and the loss.” Dura Pharms., Inc. v. Broudo, 544 U.S. 336, 342 (2005). This connection is typically proven through evidence of a corrective disclosure that revealed the falsity of prior misrepresentations or omissions, thus causing a decline in the company’s stock price and resultant loss to the plaintiff. Federal decisions in 2013 demonstrate not only that proof of loss causation depends on the facts of each case, but also that the contours of loss causation may vary by Circuit. What Constitutes a Corrective Disclosure? Massachusetts Retirement Systems v. CVS Caremark Corporation. In this case, the First Circuit held that alleged corrective disclosures were sufficient to plead loss causation even though the disclosures were not direct admissions that prior representations were false. 716 F.3d 229 (1st Cir. 2013). In their complaint, the plaintiffs alleged that, following the merger of CVS and Caremark, company executives misrepresented the merger’s success, making misstatements regarding integrated systems, service quality, and maintenance of its client base. Later, in a November 2009 earnings call, the CEO disclosed the loss of several key clients, including the loss of a client due to “service issues,” and the sudden retirement of a chief architect of the company’s “integrated model.” The price of the company’s stock dropped 20 percent. The district court dismissed the complaint on loss causation grounds, but the First Circuit reversed. The First Circuit held that several aspects of the earnings call plausibly revealed the falsity of prior representations regarding the purported success of merger integration. First, the call revealed that service issues had led to the loss of a key client, and the plaintiffs’ allegations supported the conclusion that these issues resulted from poor integration. Second, the market’s alarm following disclosure of the magnitude of CVS Caremark’s lost business likely reflected an understanding that a systemic integration failure had occurred. Third, an earnings release issued the same day as the earnings call had not disclosed the magnitude of the losses; the discrepancy between these contemporaneous disclosures led analysts to question the company’s credibility. Fourth, the unexpected retirement of an architect of the “integrated model” alerted the market to problems with the company’s business. The public’s knowledge prior to the November 5 earnings call—that the company had lost clients that would negatively impact its revenues—did not change the Court’s conclusion that the plaintiffs had pled loss causation. It was the alleged reason for the loss of clients (failed integration) that was at the heart of the plaintiffs’ claims, and this underlying reason was allegedly not revealed until the earnings call. The First Circuit also relied on analyst reports of the earnings call as plausibly supporting the market’s understanding that the merger had failed to produce value. In other words, “[w]hen a plaintiff alleges corrective disclosures that are not straightforward admissions of a defendant’s previous haynesboone.com 11 The First Circuit finds loss causation may be pled through market reaction to disclosures “that are not straight-forward admissions” of prior misstatements. misrepresentations, it is appropriate to look for indications of the market’s contemporaneous response to those statements.” Meyer v. Greene. In this case, the Eleventh Circuit held that disclosure of an SEC inquiry was not a corrective disclosure and that the plaintiffs had failed to plead loss causation through other alleged corrective disclosures based on public sources that did not reveal fraud. 710 F.3d 1189 (11th Cir. 2013). The plaintiffs alleged that a real estate company had overstated the value of its holdings by failing to take impairment charges despite knowledge that the real estate market had deteriorated and that the carrying value of the holdings could never be recovered. The Eleventh Circuit affirmed dismissal, holding that a presentation by a third party hedge fund investor suggesting that the company’s assets should be impaired was not a corrective disclosure. The presentation was a repackaging of public information, and did not reveal new facts. Accordingly, the decline in the company’s share price following the presentation “was not due to the fact that the presentation was revelatory of any fraud, but was instead due to ‘changed investor expectations’ after an investor who wielded great clout in the industry voiced a negative opinion about the [c]ompany.” The court also determined that the company’s disclosure of an informal SEC inquiry, and its later disclosure that the informal inquiry had ripened into a private order of investigation, were not to be a corrective disclosures. Although stock prices may drop following the announcement of an SEC investigation, “that is because the investigation can be seen to portend an added risk of future corrective action. That does not mean that…investigations, in and of themselves, reveal to the market that a company’s previous statements were false or fraudulent.” After Meyer, district courts have highlighted lack of uniformity in the case law regarding whether the announcement of a government investigation can qualify as a corrective disclosure for purposes of loss causation. In In re Gentiva Securities Litigation, 932 F. Supp. 2d 352 (E.D.N.Y. 2013), a district court in the Second Circuit noted “several conflicting decisions in the various circuits” but held that “until the Second Circuit or the Supreme Court dictate otherwise, an announcement regarding a governmental investigation into the precise subject matter which forms the basis of the fraudulent practices at issue can qualify as a partial corrective disclosure.” In contrast, a district court in the Fourth Circuit held in Caplin v. TranS1, Inc., 2013 WL 5309743 (E.D.N.C. Sept. 19, 2013), that the plaintiff’s allegations were insufficient to plead loss causation under a corrective disclosure theory because the disclosed government investigation did not relate to the subject matter of the alleged scheme, nor did the investigation call into question the defendant’s prior public statements. Losses Coinciding With a Marketwide Phenomenon In Central States, Se. & Sw. Areas Pension Fund v. Federal Home Loan Mortg. Corp., No. 12-4353- cv, 2013 WL 5911476 (2d Cir. Nov. 5, 2013) (Summary Order), the Second Circuit affirmed the dismissal of a complaint that failed to allege facts sufficient to show that the plaintiff’s loss was caused by the defendants’ alleged misstatements as opposed to the bursting of the housing bubble in 2008. The plaintiff, who represented purchasers of securities issued by the Federal Home Loan Mortgage Company (“Freddie”), alleged that the defendants misrepresented that Freddie was adequately capitalized and had sufficient internal controls. At the beginning of the class period, Freddie reported a loss of over $2 billion, and it disclosed its involvement in nontraditional mortgage markets and the “greater credit risks” associated with haynesboone.com 12 such markets. As the housing bubble burst accelerated during the class period, Freddie’s stock price substantially declined before the plaintiff alleged that corrective disclosures began to leak the truth about Freddie’s financial condition. Because the plaintiff’s loss coincided with a marketwide phenomenon—the housing bubble burst—the Second Circuit stated that “the plaintiff must plead facts sufficient to show ‘that its loss was caused by the alleged misstatements as opposed to intervening events.’” Viewed in this context, the Second Circuit cited several reasons why the plaintiff had not plausibly alleged loss causation. For example, the plaintiff did not identify how the alleged corrective disclosures revealed “some thenundisclosed fact with regard to the specific misrepresentations alleged in the complaint.” And even assuming that the alleged corrective disclosures contained these undisclosed “facts,” the plaintiff “[did] not plausibly allege a causal connection between the drop of the share price and the information revealed in the corrective disclosures.” In addition, the plaintiff failed to connect the defendants’ alleged misrepresentations regarding Freddie’s subprime mortgage exposure to the events that were alleged to have caused the relevant stock price decline, i.e., the federal government’s takeover of Freddie. Absent this connection, the plaintiff’s subprime exposure allegations were unavailing to plead loss causation. “But For” Causation Theory In Nuveen Municipal High Income Opportunity Fund v. City of Alameda, 730 F.3d 1111 (9th Cir. 2013), the Ninth Circuit affirmed summary judgment for the defendant in an action involving a “but for” theory of loss causation. The case arose from the defendant city’s notes offering in 2004 to refinance and expand its electrical system to include telecommunications. The telecom system performed poorly in ensuing years, and the notes were scheduled to mature in 2009. The city determined in June 2008 that refinancing the notes was not a viable option, and that it would instead sell the telecom system. A third party bought the system in November 2008 for a price below the notes’ par value. The notes were secured by the net proceeds from the sale, which were paid to noteholders. The plaintiff’s share of the net proceeds was substantially less than the principal amount paid for its notes. The plaintiff alleged that the 2004 notes offering misrepresented risks and contained inflated projections of the telecom system’s future performance. The plaintiff argued that the city knew in 2004 that it would not be able to refinance the notes at maturity, and thus the notes were preordained to fail. The plaintiff argued that, “but for” the city’s purported inflated projections, the notes would not have been marketable in the first instance. The Ninth Circuit held that this “but for” theory was insufficient to show a triable issue of fact on the element of loss causation. The Court observed that “but for” causation is akin to reliance (also known as “transaction causation”) but not loss causation. The plaintiff’s “but for” theory failed to make the necessary link between the claimed misrepresentations and the alleged economic loss. In other words, loss did not result from the city’s sale of the telecom system, but instead from “the decline in value of the [n]otes, as reflected in the sale price.” In addition, there was no evidence that the allegedly misrepresented risks “materialized” over time and caused the plaintiff’s loss. Rather, the plaintiff’s evidence targeted the reasonableness of the city’s projections when the notes were issued, thus leaving a gap between these projections and the city’s later inability to refinance the notes. The Ninth Circuit rejects a plaintiff’s attempt to employ a “but for” theory of loss causation. haynesboone.com 13 The Ninth Circuit also rejected the contention that the 2008 telecom sale price reflected the reduction in value attributable to the alleged 2004 fraud. The evidence did not distinguish the allegedly misrepresented risks from other non-fraud economic factors as the cause of the plaintiff’s loss. Moreover, the plaintiff’s argument that the notes were “inefficiently traded” was unavailing because the loss causation requirement “is no less urgent in inefficient markets.” 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. The Supreme Court recognized in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), that all circuits had held that it was sufficient to demonstrate that a defendant acted with “deliberate recklessness.” Additionally, securities fraud complaints are subject to a heightened pleading standard requiring particular facts giving rise to a “strong inference” that the defendant acted with the requisite state of mind. Tellabs held that the inference must be “cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” In 2013, a number of decisions applying Tellabs turned on whether the facts pled gave rise to an inference of recklessness or mere negligence. Where the more compelling inference was negligence, courts found that the scienter element was not met. Standard for Recklessness as “Scienter” The Third Circuit examined this issue in Belmont v. MB Investment Partners, Inc., 708 F.3d 470 (3d Cir. 2013), affirming the dismissal of a Rule 10b-5 claim against an MB Investment Partners executive. At issue was the executive’s role in marketing an allegedly fraudulent investment fund managed and controlled by a different employee. The plaintiffs brought securities fraud claims against the executive who marketed the fund (among others) for alleged misrepresentations. The Third Circuit found that investors failed to show that the marketing executive knew that the fund at issue was fraudulent. At most, investors had shown simply that the executive “touted” the fund. The Court rejected any attempt to satisfy the scienter requirement by arguing that the executive’s “praise” of the fund “without sufficient investigation” gave rise to a “strong inference that [the executive was] reckless.” The Court explained that for purposes of a securities fraud claim, a reckless statement must be more than a statement involving simple or inexcusable negligence, but must be an “extreme departure from the standards of ordinary care.” Further, a defendant must either know the danger of misleading buyers or sellers with the reckless statement, or the danger must be so obvious that a defendant “must have been aware of it.” Because the colleague who set up and controlled the fund had a successful investment track record, the Court found that there was no evidence that the executive knew or should have known the danger of misleading the investors. Thus, the plaintiffs failed to sufficiently plead that his statements about the fund were knowingly false or reckless. The Ninth Circuit’s decision in Hemmer Group v. SouthWest Water Co., No. 11-56154, 2013 U.S. App. LEXIS 11517 (9th Cir. June 7, 2013), also balanced facts that gave rise to an inference of recklessness against those that gave rise to an inference of negligence and affirmed the dismissal of a Section 10(b) claim. At issue were alleged misrepresentations concerning SouthWest Water’s failure to maintain proper internal accounting controls, resulting in restated financials and a downward adjustment of operating income. The Ninth Circuit applied Tellabs and affirmed dismissal because the more likely inference from the facts alleged was that SouthWest Water was negligent rather than reckless. While most alleged facts were consistent with both theories, a few facts were consistent only haynesboone.com 14 with the non-fraudulent theory. The court held that “the inference of scienter [was] therefore not as compelling as the inference of negligence.” In Ross v. Lloyds Banking Group, PLC, Nos. 12-4600-cv(L), 13-729-cv(Con), 2013 U.S. App. LEXIS 19303 (2d Cir. Sept. 19, 2013), the Second Circuit also applied Tellabs in affirming the dismissal of Section 10(b) and Rule 10b-5 claims because the plaintiff failed to adequately plead scienter. At issue were alleged misstatements and one omission in connection with Lloyds’ acquisition of Halifax Bank of Scotland. The Court considered whether the facts alleged, taken collectively, gave rise to a strong inference of scienter—not whether any individual allegation met that standard. Additionally, the Court noted that “plausible, nonculpable explanations for the defendant’s conduct” must be considered. Addressing each misstatement in turn, the Court found that a strong inference of scienter could not be shown through conclusory allegations, unsupported factual assertions, or speculative inferences. Turning to the alleged omission, the Second Circuit held that the plaintiff could not establish scienter through recklessness. Although Lloyds did not specifically disclose the source of its government funding, Lloyds had disclosed that Halifax depended on government assistance to meet its funding obligations. Given such evidence, the Court found that the plaintiff could not show that defendants “should have known that they were misrepresenting material facts” when they did not specifically identify the funding source. The Court found more compelling the plausible, nonculpable explanation that Lloyds thought that its disclosure was sufficient. Such a view did not rise to “an extreme departure from the standards of ordinary care” required to establish scienter through recklessness. These 2013 opinions demonstrate courts’ increasing willingness under Tellabs to consider possible negligent explanations for misstatements or omissions, and scrutinize the facts alleged to determine whether they truly establish the “extreme departure from the standards of ordinary care” required to establish recklessness in a securities case. “Confidential Witnesses” Because of the PSLRA’s stringent scienter requirements, in 2013 plaintiffs continued to resort to allegations derived from confidential sources allegedly in a position to know the defendants’ state of mind. This tactic is not always successful. For example, courts have rejected the sufficiency of such allegations where they are too broad or generic. Rahman v. Kid Brands, Inc., 736 F.3d 237 (3d Cir. 2013). Moreover, where plaintiffs survive a motion to dismiss by resorting to such allegations, defendants can compel the disclosure of “confidential witness” names and depose these individuals. Two decisions in 2013 provide lessons on how defendants may use discrepancies between pleading allegations attributed to confidential sources and these witnesses’ subsequent testimony and other evidence to their advantage. The plaintiffs in City of Livonia Employees’ Ret. Sys. & Local 295/Local 851 v. Boeing Co., 711 F.3d 754 (2d Cir. 2013) alleged Section 10(b) claims based on statements by Boeing in May 2009 that the 787-8 Dreamliner was set for its first flight in late June 2009. The 787-8 Dreamliner had failed wing stress tests in April and May 2009, and the plaintiffs alleged that the employees who made the statements knew that the first flight could not occur by late June 2009. When Boeing later announced an indefinite delay of the first flight, its stock dropped more than 10%. The district court dismissed the resulting securities complaint for failure to plead a strong inference of scienter. The The Seventh Circuit suggests potential sanctions over so-called “confidential witness” allegations in Boeing. haynesboone.com 15 plaintiffs filed an amended complaint including particular facts alleged to be derived from a confidential source later revealed as Bishnujee Singh. The plaintiffs alleged that Singh was a senior Boeing engineer who had worked on the 787-8 Dreamliner wing stress tests and had access to and knowledge of the stress test files, including communications alerting relevant employees that the first flight would likely be delayed. On the basis of these allegations, the district court denied a renewed motion to dismiss. Discovery, however, showed that many of the allegations concerning Singh were false: he was never a Boeing employee (rather he was employed by a Boeing contractor), and he did not work on the 787-8 Dreamliner but on a different model. Nor did Singh have access to the 787-8 Dreamliner stress test results or related communications. Moreover, in his deposition, Singh denied almost every statement that plaintiffs’ counsel’s investigator had reported about him. Armed with this information, the Boeing defendants filed a motion to reconsider the court’s denial of the motion to dismiss, on the basis that the court made a manifest error in fact by relying on the false allegations concerning Singh. The court granted the motion to reconsider and dismissed the complaint with prejudice, but declined to make a ruling on the defendants’ arguments that plaintiffs’ counsel had violated Rule 11. In affirming dismissal, the Seventh Circuit rejected plaintiffs’ argument that granting such a motion to reconsider was procedurally improper. The Seventh Circuit further held that the district court had erred in failing to rule on possible Rule 11 violations, because the PSLRA requires district courts, after entering a final judgment, to make such findings. The appellate court remanded the case for that determination. In remanding, however, the Seventh Circuit suggested that it thought plaintiffs’ counsel did violate Rule 11 and indicated that failure to verify investigator notes may have amounted to a “fraud on the court.” The Seventh Circuit also faulted plaintiffs’ attorneys for relying solely on investigator notes and not speaking with Singh themselves until six months after the amended complaint was filed. Moreover, the Court noted that the names Singh allegedly gave about the Boeing chain of command were inconsistent with what the investigator had heard from other sources. The Seventh Circuit characterized plaintiffs’ counsel’s failure to attempt to verify as “ostrich tactics.” City of Livonia paves the way for courts to reconsider a previously denied Rule 12(b)(6) motion where the complaint rested on confidential witness statements later shown to be false. It also shows the power of undercutting confidential witness allegations through evidence independent of that individual’s testimony. Singh had denied most of the statements attributed to him in the complaint, but it was also important that evidence beyond his testimony proved that the pleading statements attributed to him could not be true. With this independent evidence, it was easier to conclude that the district court committed a manifest error of fact in denying the motion to dismiss (the court did not need to determine whether Singh was simply recanting under pressure). Moreover, the fact that plaintiffs’ counsel could have verified some of these objective facts caused the appellate court to suggest a possible Rule 11 violation. The district court’s decision on sanctions in pending. In City of Pontiac General Employees’ Retirement System v. Lockheed Martin Corp., __ F. Supp. __, 2013 WL 3389473 (S.D.N.Y. July 9, 2013), the plaintiffs made use of confidential witnesses to bolster scienter allegations related to statements Lockheed made about the financial performance of one of its divisions. When defendants deposed these witnesses, they denied having made the statements attributed to them. The defendants filed a motion for summary judgment, arguing that there was no longer evidence supporting allegations of scienter. The district court ordered the five confidential witnesses to appear at a hearing at which they were questioned. Three of the witnesses denied ever making the statements attributed to them. But they each had credibility problems. Two claimed very short conversations with plaintiffs’ investigator, but phone records showed the calls were much longer. The third did not recall having told Lockheed’s counsel, as recorded in that counsel’s notes, that if he were called to testify he would respond “I don’t know” or say nothing. The other two confidential witnesses who had allegedly recanted instead confirmed the substance of the allegations attributed to them (though noting that selective snippets did not always haynesboone.com 16 convey the nuances of their conversations with the investigator). After this hearing, the court denied the defendants’ summary judgment motion, and the case soon settled. City of Pontiac illustrates potential perils of trying to capitalize on confidential witnesses who later “recant,” particularly without a very clear record. Moreover, unlike in City of Livonia, the defendants in City of Pontiac were not able to undercut the confidential witness allegations with independent evidence. Duty to Disclose The lower federal courts issued several notable decisions in 2013 involving allegations that a defendant violated securities laws by failing to disclose required information to investors. In the following cases, a key question was whether and when a legal duty to disclose arose. In re Proshares Trust Securities Litigation, 728 F.3d 96 (2d Cir. 2013) involved claims by investors in certain exchange-traded funds (ETFs) that purported to deliver a multiplied return on a given index through aggressive investment techniques. Notably, the ETFs pursued no long-term objectives, and registration statements warned that if held over time, the value of the ETFs could “diverge significantly” from the overall movement of the underlying index. Nevertheless, plaintiffs filed suit under Section 11 of the Securities Act, claiming that defendants failed to disclose the magnitude and probability of loss for “beyond-a-day” investments in these ETFs. The Second Circuit affirmed dismissal. It held that defendants warned of the very risks that ultimately materialized, i.e., that the investor could experience an “actual loss” even while generally guessing the correct movement of the underlying index. The registration statements consistently disclosed the effect that market volatility could have on these ETFs, and the Second Circuit held that this was sufficient. Defendants were not “expected to predict and disclose all possible negative results across any market scenario.” In another Section 11 case, Silverstrand Investments v. AMAG Pharmaceuticals, 707 F.3d 95 (1st Cir. 2013), the First Circuit found that the defendant plausibly violated Items 303 and 503 of SEC Regulation S-K by not disclosing reports of adverse drug reactions. Because these negative reports could qualify as a “known trend[] or uncertaint[y]” that would have a material, unfavorable impact on the sales of this new drug or as a “material risk to an investment” in the company, the First Circuit found that plaintiffs had stated a claim for violations of Items 303 and 503. Notably, the Court seemed to hold that a Section 11 claim premised on Items 303 & 503 need not establish that the omission was otherwise material under Basic, Inc. v. Levenson, 485 U.S. 224 (1988) and Matrixx Initiatives, Inc. v. Siracusano, 131 S.Ct. 1309 (2011). Such a holding arguably conflicts with five other Circuits which have found that a plaintiff must plead both a duty to disclose under Item 303 and materiality under Basic/Matrixx. See, e.g., Hutchison v. Deutsche Bank Securities, Inc., 647 F.3d 479, 485-89 (2d Cir. 2011). The Supreme Court denied a petition for writ of certiorari that could have potentially resolved this Circuit split. Finally, the Tenth Circuit in Slater v. A.G. Edwards & Sons, Inc., 719 F.3d 1190 (10th Cir. 2013), held that a publiclytraded residential mortgage lender adequately disclosed its exposure to certain mortgage backed securities (MBSs) in the midst of the recent financial crisis. While most of the lender’s business focused on prime loans, it also originated and acquired loans and MBSs backed by sub-prime and Alt-A mortgages (loans that are riskier than prime, but not as risky as subprime). In 2007, as the housing market declined, the lender sought to raise capital through public stock offerings. Plaintiffs invested and then filed suit as the price of the lender’s stock plummeted, claiming that the lender failed to disclose its exposure to the Alt-A market. Plaintiffs’ primary claim was that the lender misled investors by commenting on concerns and trends in the Alt-A market while not explicitly revealing its holdings in that market. The district court dismissed for failure to state a claim and the Tenth Circuit affirmed, holding that none of the allegedly actionable statements was, in fact, misleading. Instead, the lender had painted a truthful, unvarnished picture of its haynesboone.com 17 finances and MBS holdings in the offering documents, and was not required to provide any more specific disclosures about Alt-A exposure. Pleading Alleged Misstatements Post-Janus Pleading of Statement “Makers” The Supreme Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011) held that only the person or entity that communicates the misrepresentation—the statement’s “maker”—is liable in private actions under Section 10(b). Since Janus, courts have continued to address the distinction between primary and secondary liability as it relates to cases involving corporate entities and officers. Fezzani v. Bear, Stearns & Co., 716 F.3d 18 (2d Cir. 2013) involved an alleged fraudulent scheme by a brokerdealer which included false representations that stocks were sold to customers at prices established in an arms-length market, independent of his artificial trading. The purported scheme also involved “parking” stock with investors, including the defendant custodian. In Fezzani, though the plaintiffs sufficiently alleged that the custodian had knowledge of the artificial trades, participated in them, and actively facilitated the broker-dealer’s fraudulent business, the court found that was not enough to support a Section 10(b) claim for damages against the custodian. To survive a motion to dismiss as to the custodian, plaintiffs had to allege that the custodian made a pertinent misrepresentation. The Second Circuit explained that “an allegation of acts facilitating or even indispensable to a fraud is not sufficient to state a claim if those acts were not the particular misrepresentations that deceived the investor.” Section 11 Misrepresentations Based on Opinions: a Circuit Split In Indiana State District Council of Laborers & Hod Carriers Pension & Welfare Fund v. Omnicare, Inc., 2013 WL 2248970 6th Cir. May 23, 2013), the Sixth Circuit declined to extend to Section 11 claims a rule that a plaintiff must plead a defendant’s knowledge of falsity regarding a statement of opinion or belief. The Second and Ninth Circuits had previously held, citing the Supreme Court’s opinion in Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991), that a Section 11 plaintiff must allege with particularity that statements of opinion are both objectively and subjectively false or misleading to avoid dismissal. See Fait v. Regions Financial Corp., 655 F.3d105 (2d Cir. 2011); Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156 (9th Cir. 2009). The Sixth Circuit expressly refused to similarly impose a knowledge of falsity requirement on Section 11 claims for two reasons: (1) Section 11 is a strict liability statute without a scienter requirement, and (2) the Supreme Court’s reasoning in Virginia Bankshares addressing Section 14(a) claims has limited application to Section 11 claims. Materiality The PSLRA’s safe harbor provision provides that “forward-looking statements ‘accompanied by meaningful cautionary statements’ explaining the risks that may preclude a forward-looking projection from coming to fruition are immaterial as a matter of law.” The Eleventh Circuit in Miyahira v. Vitacost.com, Inc., Strict application of the Janus decision requires dismissal of Section 10(b) claims against all but the statement “makers.” haynesboone.com 18 715 F.3d 1257 (11th Cir. 2013), upheld the dismissal of a securities class action alleging a vitamin manufacturer and internet retailer failed to disclose its plans to oust key personnel and relocate its Las Vegas distribution center in its pre-IPO prospectus, finding that the plaintiffs failed to allege material omissions. Investors argued that the omissions were material because a reasonable investor would have wanted to know (1) that the CEO and VP of Manufacturing would be terminated shortly after the IPO and (2) that the Las Vegas facility was to be relocated (as opposed to the opening of a new facility altogether). The court found the omissions immaterial. First, the Court of Appeals found that the omission of the pending terminations was immaterial as a matter of law. It rejected investors’ attempt to demonstrate materiality by pointing to insider opinions that the two individuals were pivotal to the company’s success and by pointing to the eventual drop in stock prices due to manufacturing and distribution issues following their terminations. The Court noted that investors were told pre-IPO that the CEO would not continue in the same policy-making role, so they could not have based their decisions on such continued involvement. Similarly, there were no statements in the prospectus indicating that the VP of Manufacturing was “critical” and so investors had no indication that manufacturing would struggle without him. Therefore, the omissions in the prospectus were not materially misleading as a matter of law. Next, the Eleventh Circuit found that the misstatement or omission regarding the Las Vegas facility’s relocation was not materially misleading. The prospectus addressed the possibility of expanding the old facility or building a new facility, and the Court determined that such a statement put investors on notice that the company would soon need to invest in its distribution facilities. The Court also rejected the argument that false statements about Vitacost’s growth projections were materially misleading because Vitacost “must have known”—given the changes within the company—that such projections were unrealistic. Because the prospectus contained “appropriate cautionary language” about the future risks that could impact its projections, the Court held that Vitacost was protected by the safe harbor provision. Post-Morrison Extraterritoriality In 2013, courts continued to explore the contours of the Supreme Court’s 2010 decision in Morrison v. National Australia Bank Ltd. In Morrison, the Court held that Section 10(b) of the Exchange Act applies in a private civil case only where the security at issue is listed on a domestic exchange or, if not listed on a domestic exchange, where its purchase or sale is made in the United States. Morrison repudiated the longstanding “conduct” and “effects” tests, which focused on (1) whether the wrongful conduct occurred in the U.S. and (2) whether the wrongful conduct had a substantial effect in the U.S. or upon U.S. citizens. Since Morrison, courts have grappled with the scope of its reach—does it apply to criminal liability under Section 10(b)? Does it apply to claims brought under other similar federal statutes? Does it apply to civil suits brought by the SEC in light of Congress’s enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act? Courts this year provided guidance to many of these questions. In United States v. Villar, 729 F.3d 62 (2d Cir. 2013), the Second Circuit considered whether criminal liability under Section 10(b) extends to conduct in connection with an extraterritorial purchase or sale of securities. In 2008, a jury convicted Alberto Villar and Gary Tanaka of securities and investment adviser fraud for lying to investors about how their funds would be invested. Relying on Morrison, haynesboone.com 19 Courts continue to grapple with the extraterritorial reach of federal securities laws. Villar and Tanaka argued on appeal that their misrepresentations to foreign investors occurred outside of the U.S. The government responded that Morrison applied only in the civil context and therefore did not bar the convictions. The Second Circuit disagreed and held that Morrison’s transactional test does apply to criminal cases brought pursuant to Section 10(b) and Rule 10b-5. The Court of Appeals held that the presumption against extraterritoriality applies to all criminal statutes, except in situations where the law at issue is aimed at protecting the right of the government to defend itself. Because the purpose of Section 10(b) and Rule 10b-5 is not related to the government’s right to defend itself, the presumption against extraterritoriality applied to criminal cases brought under those sections. Moreover, the Second Circuit held that “[t]o permit the government to punish extraterritorial conduct when bringing criminal charges under Section 10(b)” would establish “the dangerous principle that judges can give the same statutory test different meanings in different cases.” Adopting Morrison’s test, the Second Circuit held that a criminal defendant may be convicted of securities fraud under Section 10(b) or Rule 10b-5 only if engaged in fraud in connection with (1) a security listed on a U.S. exchange or (2) a security purchased or sold in the U.S. The Court, however, found that there was no plain error in these convictions because a jury could have found beyond a reasonable doubt that their fraud occurred in connection with a domestic purchase or sale of securities. Courts also extended Morrison’s transactional test beyond the Exchange Act. In two cases from the Southern District of New York, Starshinova v. Batratchenk, 931 F. Supp. 2d 478 (S.D.N.Y. 2013) and Loginovskaya v. Batratchenk, 936 F. Supp. 2d 357 (S.D.N.Y 2013), separate courts held that Morrison applies with equal force to claims brought under the Commodities Exchange Act (CEA). The cases were brought by Russian citizens who sought to recover money they had contributed to programs managed by a series of related domestic and foreign companies that invested in U.S. and foreign stocks, commodities, and real estate. The courts held that the scope of the CEA is the same as the Exchange Act and therefore, under Morrison, the CEA only applies to transactions involving entities listed on domestic exchanges or to domestic purchases and sales of commodities. Another issue addressed in 2013 was whether Morrison’s transactional test applies to civil lawsuits brought by the SEC. Section 929P(b) of Dodd-Frank—entitled “Extraterritorial Jurisdiction of the Antifraud Provisions of the Federal Securities Laws”—sought to supersede Morrison by reviving the “conducts and effects” test for transnational securities fraud actions brought by the DOJ or SEC. The issue arose in SEC v. Chicago Convention Ctr., LLC, 2013 WL 4012638 (N.D. Ill. Aug. 6, 2013). The SEC alleged that the defendant limited liability companies fraudulently sold over $145 million in securities to Chinese investors who hoped to obtain U.S. citizenship by investing in “target employment areas” under the Immigration and Nationality Act of 1990. The defendants argued that Morrison’s transactional test necessitated dismissal because the transactions were not “domestic transactions.” The SEC argued that the transactional test was not the proper inquiry because Section 929(b) superseded Morrison and revived the previously applied “conduct and effects” test for SEC actions. Calling it a “complex interpretation issue,” the district court held that it did not need to answer the question because the SEC had satisfied both the transactional and “conduct and effects” tests. It thus remains to be seen whether courts will continue to apply Morrison to civil actions brought by the SEC. SLUSA Preemption In 2013, courts continued to grapple with the scope of the preclusive effect of the Securities Litigation Uniform Standards Act (“SLUSA”) on state-law class actions. SLUSA was enacted to stem the tide of state-law class actions seemingly designed to avoid the heightened pleading requirements of the PSLRA. Under SLUSA, “[n]o covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging 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 question whether an alleged fraud is “in haynesboone.com 20 connection with the purchase or sale of a covered security” continues to be complex, leading to multiple appellate court rulings and a Supreme Court argument this year. Second Circuit In In re Herald, 730 F.3d 112 (2d Cir. 2013), investors in feeder funds that suffered heavy losses in the collapse of Bernie Madoff’s elaborate Ponzi scheme sued JPMorgan Chase & Co. and the Bank of New York Mellon for allegedly aiding and abetting Madoff’s fraud. The Southern District of New York dismissed the claims as precluded by SLUSA, and the Second Circuit affirmed. Although the Court of Appeals acknowledged (and all parties conceded) that the plaintiffs’ interests in feeder funds were not “covered securities” under SLUSA, it held that the allegations against JPMorgan and BNY were predicated on the banks’ assistance to Madoff’s scheme. Because that scheme “indisputably engaged in purported investments in covered securities on U.S. exchanges,” the banks’ alleged assistance was “in connection with the purchase or sale of a covered security.” The claims, as a result, had been properly dismissed as precluded by SLUSA, according to the Second Circuit. Ninth Circuit In Freeman Investments, L.P. v. Pacific Life Insurance Co., 704 F.3d 1110 (9th Cir. 2013), the plaintiffs had purchased variable universal life insurance policies. Pursuant to the policies, a portion of the plaintiffs’ premiums were allocated to a separate investment account, and Pacific Life Insurance Company invested the funds at the direction and for the benefit of the plaintiffs. Pacific Life also levied a monthly “cost of insurance” charge, which it collected by redeeming units of (i.e., selling securities from) the plaintiffs’ separate investment accounts. The plaintiffs brought a class action suit against Pacific Life, alleging an unfairly inflated “cost of insurance” fee. The complaint asserted claims for breach of contract, breach of the duty of good faith and fair dealing, and unfair competition under the California Business and Professions Code. The district court dismissed the claims as precluded by SLUSA. The Ninth Circuit affirmed in part and reversed in part. The Court of Appeals held that the claims for breach of contract and breach of the duty of good faith and fair dealing were not precluded by SLUSA because they did not require an alleged misrepresentation or omission by Pacific Life. “[Plaintiffs] need only persuade the court that theirs is the better reading of the contract term.” Conversely, the unfair competition claim was precluded by SLUSA because it required a showing of an “unlawful, unfair or fraudulent business act or practice.” Moreover, the Ninth Circuit found that because the alleged fraud “coincided” with Pacific Life’s sale of securities in the plaintiffs’ accounts, the fraud was “in connection with the purchase or sale of a covered security.” Fifth Circuit and Supreme Court The Supreme Court will soon weigh in on the scope of SLUSA preclusion. In October 2013, the Court heard consolidated arguments in Chadbourne & Parke LLP v. Troice, Willis of Colorado, Inc., v. Troice, and Proskauer Rose LLP v. Troice (collectively, “Chadbourne & Parke”), three cases arising from the Ponzi scheme allegations against R. Allen Stanford. The plaintiffs alleged that various defendants participated in Stanford’s scheme by selling certificates of deposit (“CDs”) issued by Stanford International Bank haynesboone.com 21 The extent of federal preemption of class claims related to securities continues to be tested. (“SIB”) while fraudulently 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 allege, the CDs were backed by illiquid investments or no investments at all. The district court dismissed. Although it acknowledged that the CDs purchased by the plaintiffs were not “covered securities” under SLUSA, the court held the claims were nevertheless precluded by SLUSA because the defendants had allegedly induced the plaintiffs to purchase the CDs by fraudulently misrepresenting that they would be backed by “covered securities.” On appeal, the Fifth Circuit reversed. Roland v. Green, 675 F.3d 503, 521 (5th Cir. 2012). The Court adopted the Ninth Circuit formulation of the “in connection with” requirement from Madden v. Cowen & Co., 576 F.3d 957 (9th Cir. 2009), and held: “[W]e find 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.” Accordingly, the “in connection with” requirement was not satisfied, and the plaintiffs’ claims were not precluded by SLUSA. The defendants appealed the Fifth Circuit’s ruling, and the Supreme Court heard oral arguments in October 2013. When asked to provide a standard for deciding the case, counsel for the defendantpetitioners stated, “[t]he simplest, narrowest way to decide this case is to say that when there is a misrepresentation and a false promise to purchase covered securities for the benefit of the plaintiffs, then the ‘in connection with’ standard is [satisfied].” Under this test, SLUSA would apply and preclude the plaintiffs’ claims because SIB “promised to purchase” various types of marketable securities to back the CDs. Conversely, counsel for the plaintiff-respondents suggested that the Court should adopt the following test: “[A] false promise to purchase securities for one’s self in which no other person will have an interest is not a material misrepresentation in connection with the purchase or sale of covered securities.” Under this test, SLUSA would not preclude the plaintiffs’ claims because the CD purchasers were to have no direct interest in the purported “covered securities” backing the CDs. The Court’s decision in Chadbourne & Parke will be an important one. A ruling for the defendantpetitioners will further limit the scope of claims that can be brought in state court and will subject many class action claims to the PSLRA’s strict requirements. A ruling for the plaintiff-respondents, on the other hand, could lead to more creative class action filings in state court. Statute of Limitations and Statute of Repose Limits on the Government’s Ability to Seek Civil Penalties on Stale Claims Many government actions—including SEC and DOJ civil enforcement actions—are subject to 28 U.S.C. § 2462, the “catch-all” statute of limitations. Section 2462 provides that “[e]xcept as otherwise provided by Act of Congress, an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued if, within the same period, the offender or the property is found within the United States in order that proper service may be made thereon.” In Gabelli v. SEC, 133 S. Ct. 1216 (2013), the Supreme Court addressed the critical question of when a claim “first accrue[s].” The Court held that Section 2462’s five-year limitations period begins when the underlying violation occurred—not when the government discovered the violation. This ruling significantly limits the government’s ability to bring an action for civil penalties more than five years after alleged misconduct occurred. haynesboone.com 22 In Gabelli, the SEC alleged that from 1999 until 2002, the COO and manager of Gabelli Funds had allowed an investor to engage in undisclosed “market timing,” and brought suit for civil penalties. However, the SEC did not file its complaint until 2008—more than five years after the alleged misconduct. The defendants moved to dismiss, arguing that the claims were barred by Section 2462. The district court agreed, but the Second Circuit reversed, adopting the SEC’s position that the discovery rule applies to extend the limitations period in cases “that sound in fraud.” As the Second Circuit noted, “[u]nder the discovery rule, the statute of limitations for a particular claim does not accrue until that claim is discovered, or could have been discovered with reasonable diligence, by the plaintiff.” A unanimous Supreme Court reversed, holding that in all cases, including those involving fraud allegations, claims accrue under Section 2462 when the alleged misconduct occurs. The Court noted that this is “the most natural reading” of Section 2462 and is consistent with the “standard rule” that a claim accrues when the plaintiff has a complete cause of action. In addition, the rationale underlying the discovery rule—preserving the claims of victims “who do not know they are injured and who reasonably do not inquire as to any injury”—is inapplicable in enforcement actions where injury is often irrelevant. A discovery rule, moreover, would leave defendants exposed to punishment for an uncertain and lengthy period. The Court found this not only “repugnant to the genius of our laws,” but unworkable because it would require courts to determine when “the Government” knew or should have known of a violation. The Court did not foreclose the government from relying upon equitable tolling in appropriate situations. However, Gabelli should still impose significant limits on the government’s ability to bring stale claims. To successfully invoke equitable tolling, a plaintiff must show (at least) that the defendant fraudulently concealed misconduct and that plaintiff was diligent in discovering and bringing claims. Accordingly, Gabelli will likely impact government enforcement actions in a number of ways, including by incenting agencies to: 1) investigate and decide to file or decline cases within five years of the alleged misconduct; 2) seek tolling agreements more frequently; and 3) choose not to pursue cases based upon stale conduct. Fifth Circuit: American Pipe Tolling Ceases When Class Certification is Vacated Nearly forty years ago, the Supreme Court established the American Pipe tolling doctrine, which provides that the commencement of a putative class action suspends the applicable limitations period as to all asserted members of the class during the pendency of the class action. Am. Pipe & Constr. Co. v. Utah, 414 U.S. 538 (1974). American Pipe tolling ceases after class certification is denied or when a class is decertified. In Hall v. Variable Annuity Life Ins. Co., the Fifth Circuit held that tolling also ceases after vacatur of certification. 727 F.3d 372 (5th Cir. 2013). The plaintiffs in Hall brought a class action alleging misrepresentations about prospective tax benefits of certain annuities. The Hall complaint was identical to a class action lawsuit filed in 2001 by two other plaintiffs, James Drnek and Maureen Tiernan (the “Drnek action”). The Drnek court certified a class that included the Halls (as absent members). However, the Drnek plaintiffs failed to timely designate expert witnesses and were barred from submitting expert testimony. The Drnek court vacated its certification haynesboone.com 23 Limits on enforcement actions begin to run at the time of the violation, not the government’s discovery. order because it found that, without expert testimony, the Drnek plaintiffs would be unable to prove class-wide damages. The Hall plaintiffs filed the instant case more than five years later. On a motion to dismiss, the district court found that tolling under American Pipe ceased—and the statute of repose had resumed running— when the Drnek court vacated its certification order. It ruled that the claims were extinguished by the statute of repose and dismissed the case. The Fifth Circuit affirmed, holding that “a vacatur of certification is no different than a decertification or a denial of certification” because it is “tantamount to a declaration that only the named plaintiffs [are] parties to the suit.” Accordingly, “those putative class members who have officially lost their status as a class” bear the onus of filing their own claims. The Court explained that “a contrary rule would allow non-class members to sit on their rights indefinitely while awaiting full appellate review of a decision that does not legally apply to them.” The Court noted that “there is some debate” about whether a statute of repose can be extended by tolling under the American Pipe rule. Generally, a statute of repose begins to run once a specified action has occurred, whereas a statute of limitations begins to run once an injury has occurred. As discussed further below, the Tenth Circuit has held that a statute of repose may be extended by American Pipe, but in a recent case the Second Circuit held that it cannot. The Fifth Circuit reserved judgment on this issue because it had not been briefed in Hall. Second Circuit: American Pipe Does Not Apply to Securities Act’s Statute of Repose Whether the American Pipe rule also tolls a “statute of repose” is “an unsettled question of law.” In Police & Fire Retirement System of Detroit v. IndyMac MBS, Inc., 721 F.3d 95 (2d Cir. 2013), the Second Circuit held that the rule did not toll the three-year statute of repose in Section 13 of the Securities Act. In IndyMac, the lead plaintiffs asserted class claims arising out of 106 different offerings. The district court dismissed all claims related to offerings in which the lead plaintiffs did not personally purchase shares, due to lack of standing. Other members of the putative class then moved to intervene to pursue the dismissed claims. The court denied the motion, finding that the claims had been extinguished by the statute of repose, which it held had not been tolled under American Pipe. The Second Circuit affirmed. It noted controversy regarding whether the American Pipe rule is an equitable or a legal tolling doctrine, but held that it was inapplicable in any case. If the rule is equitable, the Court posited, then application to the repose period of the Securities Act is barred by the Supreme Court’s decision in Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilberston, 501 U.S. 350 (1991), which held that equitable “tolling principles do not apply to that period.” On the other hand, if the tolling rule is “legal,” then it cannot be applied to toll the repose period because of the Rules Enabling Act, 28 U.S.C. § 2072(b),which provides that courts “shall not” use procedural rules to “abridge, enlarge, or modify any substantive right.” The Second Circuit found that “the statute of repose in Section 13 creates a substantive right, extinguishing claims after a three-year period,” and that application of American Pipe tolling would “necessarily enlarge or modify” that right in violation of the Act. The attempted intervenors argued that this ruling would disrupt class action litigation and burden the courts, but the Second Circuit noted that if such problems arise they must be resolved by Congress. The IndyMac decision creates a split between the Second Circuit and the Tenth Circuit, which previously held that the statute of repose for the Securities Act is subject to tolling under American Pipe in Joseph v. Wiles, 223 F.3d 1155 (10th Cir. 2000). The plaintiffs in IndyMac recently filed a petition for certiorari on this issue. haynesboone.com 24 Standing There were two important rulings from Courts of Appeals in 2013 concerning standing issues in securities cases. Trustee Standing In In re Bernard L. Madoff Investment Securities LLC, 721 F.3d 54 (2d Cir. 2013), the Second Circuit weighed in on whether a trustee could pursue claims against alleged aiders and abettors of Bernie Madoff’s multi-billion dollar Ponzi scheme. Irving Picard, appointed as a trustee under the Securities Investor Protection Act (“SIPA”), was tasked with distributing money to investors following the collapse of Madoff’s firm. Picard sued several financial institutions in effort to recover over $20 billion, alleging that the institutions enabled Madoff’s fraud, ignoring warning signs so that they could continue to collect large fees. Picard argued that as a trustee essentially standing in Madoff’s shoes, he could recover from third parties on behalf of Madoff’s estate. The Second Circuit quickly disposed of this argument, holding that the doctrine of in pari delicto—which prohibits one wrongdoer from recovering from another—barred the trustee from suing on this basis. Second, Picard contended that he could pursue claims against third parties on behalf of Madoff’s customers. The court ruled that Picard lacked standing to sue on behalf of customers, as Congress has not permitted bankruptcy trustees to collect money owed to creditors. Picard relied on a previous Second Circuit case to argue that a trustee under SIPA should be treated differently, but the Court held that the prior case was drained of any precedential force because the Supreme Court had reversed it (although on other grounds). The Court noted that more recent cases had not permitted SIPA trustees to bring claims against third parties. Picard also advanced common law theories to argue that he had standing, but the Court rejected those theories as well. The decision confirms that, unless Congress revises the law, defrauded investors in bankrupt institutions will have to bring claims themselves and cannot rely on a trustee. Section 11 Standing Section 11 of the Securities Act of 1933 provides a strict liability cause of action to buyers who purchase securities issued under a false or misleading registration statement. To have standing to sue under Section 11, however, buyers must be able to trace their purchase to the registration statement that contained a false or misleading statement. In 2005, the United States Court of Appeals for the Fifth Circuit ruled in Krim v. pcOrder.com, Inc., 402 F.3d 489, 496 (5th Cir. 2005), that purchasers of a company’s securities in an aftermarket comprised of shares from multiple issuances could not rest on statistical probability to prove Section 11 standing for a specific offering. In In re Century Aluminum Co. Securities Litigation, 729 F.3d 1104 (9th Cir. 2013), the Ninth Circuit addressed the interplay between Section 11 standing and the “plausibility” pleading standards articulated by the Supreme Court in its Twombly and Iqbal decisions in 2007 and 2009, post-Krim. The issue before the Ninth Circuit concerned what Section 11 plaintiffs must plead regarding tracing to survive a motion to dismiss under Twombly and Iqbal. The court found that barebones allegations of tracing—such as those made by the plaintiffs in the case before it—were insufficient to state a claim for relief. A complaint must Section 11 plaintiffs must allege plausible—not merely possible— facts tracing their shares to the challenged offering. haynesboone.com 25 include allegations that support the plausibility that a buyer can trace its shares to a false or misleading registration statement rather than including allegations that suggest only a possibility of tracing. In its decision, the Ninth Circuit noted that more than 49 million shares of Century Aluminum common stock were in the market at the time of the company’s challenged secondary offering, that plaintiffs’ shares could have come from the secondary offering, but further noted the “obvious alternative explanation” is that they could instead have come from the pool of previously issued shares. Citing Iqbal, the Court held that “[w]hen faced with two possible explanations, only one of which can be true and only one of which results in liability, plaintiffs cannot offer allegations that are ‘merely consistent with’ their favored explanation but are also consistent with the alternative explanation.” In line with the Fifth Circuit’s Krim decision, the Ninth Circuit’s Century Aluminum opinion continues the strict enforcement by federal courts on Section 11 standing and access to that statute’s strict liability regime. PSLRA Stay on Discovery A key feature of the PSLRA is its stay of “all discovery and other proceedings” prior to the resolution of a motion to dismiss. There are narrow exceptions to the PSLRA stay, and in 2013, plaintiffs continued to press the scope of those exceptions, with differing results. Both cases arose in the context of a pending M&A transaction. In Pension Trust Funds for Operating Engineers v. Assisted Living Concepts, Inc., 943 F. Supp. 2d 913 (E.D. Wis. 2013), the plaintiff fund successfully moved to lift the PSLRA stay, approximately one month after the issuance of the court’s scheduling order. The plaintiff sought certain documents provided to the SEC pursuant to subpoena, and documents produced in discovery in a separate proceeding among the defendants. The court noted that the PSLRA stay was intended to prevent defendants from incurring substantial discovery costs until the sufficiency of plaintiff’s allegations is determined. However, the court found “such burden is slight when a defendant has already found, reviewed and organized the documents.” The court also found the discovery sought to be “particularized”—a “relatively limited amount of materials.” The court further found that the plaintiff fund had shown the discovery was necessary because the defendant company “is in the midst of being acquired by a private equity group, is being federally investigated by the SEC, and is facing other lawsuits (including a contract suit filed against them by their co-defendant in this case . . .).” The court found that the plaintiff “is fighting this lawsuit in a rapidly shifting landscape, at an informational disadvantage when compared to the many other interested parties” and therefore “would face undue prejudice” if the PSLRA stay was not lifted. The district court’s decision to lift the stay on these grounds is disturbingly broad, as public companies frequently face regulatory scrutiny, or find themselves engaged in strategic transactions, or become tangled in collateral litigation when securities class actions are filed. Moreover, a plaintiff will almost always be “at an informational disadvantage” compared to defendants prior to the commencement of discovery. Such is the nature of litigation. If such grounds routinely satisfy the lifting of the PSLRA stay, then it becomes meaningless. In a second reported decision in 2013, a federal magistrate judge declined to lift the PSLRA stay in an acquisition context. In Herrley v. Frozen Food Express Industries, Inc., 2013 WL 4417699 (N.D. Tex. Aug. 19, 2013), the plaintiff filed a motion for expedited discovery and sought a lifting of the PSLRA stay in a suit asserting claims for violations of Section 14 of the Exchange Act, as well as derivative claims for breaches of fiduciary duty, arising from a tender offer for shares of the defendant company. Plaintiff sought multiple categories of documents and three depositions. Defendants filed motions to dismiss and separately opposed expedited discovery and the lifting of the stay on the grounds that (1) plaintiff had asserted no colorable federal claim, (2) plaintiff had a disabling conflict, (3) plaintiff’s derivative claims were stayed under state law, (4) no irreparable harm was presented as money damages were an adequate remedy, and (5) plaintiff had failed to demonstrate good cause. The judge agreed with defendants, finding that plaintiff had “not shown that his discovery requests are sufficiently ‘particularized,’” noting that “the fact haynesboone.com 26 haynesboone.com 27 that defendants may have much of the requested discovery on hand is not the test for determining whether the stay should be lifted.” The magistrate judge further noted that undue prejudice was not at issue “especially” where plaintiff had recently failed to succeed in extending the tender offer deadline “because he failed to demonstrate a substantial likelihood of success on the merits regarding any of his claims.” Trials This year saw a post-verdict trial judgment of $2.46 billion—reportedly the largest judgment ever in a securities fraud trial. Lawrence E. Jaffe Pension Plan v. Household International, Inc. was filed over ten years ago in 2002 alleging that Household International had engaged in illegal practices and misrepresented the quality of its loans. In 2009, after several months of trial, the jury returned a verdict finding in favor of the plaintiff with regard to 17 of the 40 alleged misstatements. While the jury made findings about the inflation of Household International’s stock price during the relevant time period, it did not make a specific determination of damages at that time. The Court then spent the next four years considering challenges to the verdict and other post-trial motions that could have drastically affected the final damages award. One major focus of these motions was the reliance of institutional and individual investors on the misstatements. This October, after denying the defendants’ remaining post-trial motions, the court entered the $2.46 billion judgment. Of that judgment, nearly $1 billion was prejudgment interest. Defendants have appealed the judgment to the Seventh Circuit. SEC Enforcement Actions and Other Activities Insider Trading The past year saw big developments in insider trading enforcement. The Justice Department and SEC continued to focus on the investment fund industry and alleged improper use of confidential information to boost trading profits. Illustrative of that emphasis, SAC Capital Advisors LP pled guilty in November 2013 to securities fraud and wire fraud charges and agreed to pay $1.2 billion in penalties, the largest ever paid in an insider trading case, to settle the government’s charges of insider trading. At the same time, the SEC suffered high profile trial losses this year including a loss in what could be the most expensive individual insider trading lawsuit the SEC has tried, the action against billionaire and Dallas Mavericks owner Mark Cuban. SAC Capital Advisors LP. In November 2013, following years of investigation by both the SEC and the US Attorney’s Office, hedge fund SAC Capital Advisors LP (“SAC”) pled guilty to federal insider trading charges. In a July 2013 indictment, prosecutors in the Southern District of New York alleged that SAC “encouraged the widespread solicitation and use of illegal inside information” and exhibited “institutional indifference” to the unlawful conduct of its employees. SAC allegedly sought to hire portfolio managers that had existing networks of public company insiders and failed to create an effective compliance program designed to detect illegal trading. According to prosecutors, SAC’s elaborate insider trading scheme spanned more than ten years and involved the securities of more than 20 publicly traded companies. SAC’s record settlement consisted of a $900 million criminal fine and a $900 million civil forfeiture judgment. SAC will receive a $600 million credit for a settlement reached with the SEC in March 2013. Eight individual employees of SAC were also charged in connection with the SAC investigation; six have pled guilty while one portfolio manager, Michael Steinberg, was convicted in December 2013, and another portfolio manager, Matthew Martoma, began trial this month. As a result of prosecutors’ success against SAC and its managers, successful investment funds and others should expect continued emphasis on insider trading and aggressive allegations in the face of circumstantial facts. SEC v. Cuban. In October 2013, a federal jury in the Northern District of Texas exonerated Mark Cuban of insider trading charges in a civil enforcement action. The Commission sued Cuban in 2008, alleging that the billionaire sold his stock in Mamma.com, Inc. in 2004 after learning from an inside source that the company would soon announce a private investment in public equity (“PIPE”) offering. Cuban allegedly avoided $750,000 in losses when he sold his 6% stake in the company prior to the announcement. The SEC sued Cuban under the misappropriation theory of insider trading, which posits that a non-insider may be held liable for trading on material, non-public information when the trade is executed in breach of a duty of confidentiality to the source of the information. Central to the SEC’s allegations was a telephone call that took place between Cuban and Mamma.com CEO Guy Fauré in 2004. Fauré—who was not subject to the court’s subpoena power and refused to appear— testified by video-recorded deposition that during the call, he told Cuban that he had confidential information to share, to which Cuban allegedly responded, “Okay, uh-huh, go ahead.” Fauré testified that he then informed Cuban of the PIPE offering, and Cuban became upset, ending the telephone call by saying, “Well now I’m screwed. I can’t sell.” The Commission alleged that this conversation was evidence that Cuban knew the PIPE offering was confidential, knew that he could not lawfully trade on the information, and agreed not to sell his Mamma.com stock prior to the announcement of the PIPE offering. Cuban denied the SEC’s allegations, asserting that the PIPE offering was public information, that he never acknowledged that the information regarding the offering was confidential, and that he never agreed not to sell his Mamma.com stock. The jury agreed that Cuban did not owe a duty which would prevent him from trading and then ruled in favor of Cuban. Following the loss against Cuban, the SEC lost a smaller insider trading case involving the friend of a public company CEO (SEC v. Ladislav “Larry” Schvacho). The SEC alleged that Schvacho either received confidential information communicated directly from his friend or obtained the information indirectly by overhearing communications with others or accessing his friend’s briefcase. The federal district court in the Northern District of Georgia held that “potential access” to material, non-public information was not sufficient to prove actual possession of information. While numerous excuses can be cited for the SEC’s loss in the Cuban matter, such as trying a high profile business man and NBA team owner on his home “court” or having the disputed testimony of a single witness who could not be produced for trial, the SEC’s losses will generate more trials as others who are charged seek to replicate a defense win. At the same time, the SEC likely will exercise caution in the future, strengthening its position to improve its win tally in insider trading matters. A widely publicized insider trading action against Mark Cuban ends in a jury verdict in his favor after a three-week trial. haynesboone.com 28 haynesboone.com 29 Whistleblowers and the SEC As required by the Dodd-Frank Act, the SEC established in 2011 its Office of the Whistleblower (the “OWB”) 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. According to the OWB’s 2013 Annual Report, whistleblower reports are increasing annually. In 2013, the OWB received more than 3,000 tips from individuals in all 50 states and from 55 foreign countries. The three most common categories of whistleblower tips were Corporate Disclosures and Financials, Offering Fraud, and Manipulation. Since whistleblower activity is on the rise, public companies should take steps to leverage the incentives provided in the Act and implement procedures that encourage internal reporting. By designing a system of internal controls and processes to handle internal complaints, companies can quickly discover and halt ongoing violations, avoid external reporting of frivolous complaints through an effective investigation and feedback system, and benefit from SEC rules that give credit to companies with effective compliance procedures. Whistleblower Awards The need for companies to design a system of internal controls and processes to handle and resolve internal whistleblower complaints became even more obvious in the wake of this year’s largest-ever whistleblower award. After two years of operations, the SEC’s whistleblower program announced its first multimillion dollar award on October 1, 2013—a record $14 million payment to an anonymous tipster. The award is the largest since the program’s inception and emphatically signals the SEC’s continuing emphasis on its whistleblower program. The $14 million award went to an unidentified whistleblower whose information led to an SEC enforcement action that recovered substantial investor funds. The whistleblower provided original information and assistance that enabled the SEC to bring an enforcement action more quickly than it could have otherwise -- less than six months after receiving the whistleblower’s tip. This award is expected to draw increased attention to the whistleblower program and will likely increase the number of whistleblower tips. In fact, SEC Chair Mary Jo White has stated that the SEC “hope[s] an award like this encourages more individuals with information to come forward.” As a result, public companies should evaluate their own compliance programs to ensure that they have effective processes and procedures in place that support regulatory training, internal reporting, and appropriate investigation of complaints. While the Dodd-Frank Act does not require internal reporting, it provides incentives to potential whistleblowers who first report internally. Thus, given the incentives for internal reporting and the large awards the SEC is prepared to give for external reporting, companies should be prepared to quickly and effectively respond to any internal reports of a potential securities violation. Whistleblower Protection Another provision of the Dodd-Frank Act, 15 U.S.C. §78u-6(h), protects whistleblowers from retaliation by creating a private right of action against employers. This is referred to as the “whistleblowerprotection provision.” In the Asadi v. G.E. Energy (USA), LLC, 720 F.3d 620 (5th Cir. 2013), the Fifth Circuit analyzed this provision and held that the Act “unambiguously requires individuals to provide information relating to a violation of the securities laws to the SEC” to qualify as a whistleblower and thus pursue a claim for retaliation under the whistleblower-protection provision. The court heavily relied on the Act’s plain language, which defines a whistleblower as “any individual…who provide[s] information relating to a violation of the securities laws to the Commission….” §78u-6(a)(6). Unlike other courts, the Fifth Circuit did not find this definition conflicting or ambiguous. The court stated that this definition is not in conflict with §78u-6(h)(1)(A), which provides three categories of protected activity in a whistleblower-protection claim, but does not define which individuals qualify as whistleblowers. Therefore, based on the statute’s “plain language and structure,” the Fifth Circuit found that a GE Energy employee, who made only internal reports regarding potential FCPA violations to the company and not to the SEC, did not qualify as a “whistleblower” under the Dodd-Frank Act. Because the employee was not a whistleblower, he did not have a claim against the company under the whistleblower-protection provision for terminating him after he made the internal reports. Thus, the Fifth Circuit affirmed the 12(b) (6) dismissal of the employee’s claim. The Southern District of New York in Liu v. Siemens A.G., 2013 WL 5692504 (S.D.N.Y. Oct. 21, 2013) also analyzed which individuals may pursue a claim for retaliation under the whistleblowerprotection provision. The Liu case involved complaints from a Taiwanese employee of Siemens, a German corporation, concerning its Chinese subsidiary and allegations relating to corruption and kickback activity in China and North Korea. The primary question analyzed by the court was whether Dodd-Frank’s whistleblower-protection provision had extraterritorial effect, thus permitting the Siemens employee to pursue his private action for retaliation under the provision. While some Dodd-Frank Act provisions do have extraterritorial application, the language of the whistleblower-protection provision at issue is silent in this regard. Moreover, the court relied on various Supreme Court rulings stating that unless there is the affirmative intention to give a statute extraterritorial effect, the presumption is that it is purely domestic. Thus, the court found that the provision’s silence invoked a strong presumption against extraterritoriality. Because there was no indication that the provision applied extraterritorially, the employee’s complaint was dismissed. These rulings and strict construction of the term whistleblower and extraterritorial application may seem favorable to employers, but companies should remain cautious when dealing with internal reports. For instance, the Asadi ruling may discourage whistleblowers from reporting potential violations internally first, if at all. Case law involving whistleblower-protection and retaliation claims is still evolving. Thus, it is imperative that a company implement and support internal structures and safeguards that encourage, manage and resolve internal reports while at the same time avoid potential retaliatory actions. Admissions of Wrongdoing in Settlements This year the U.S. Securities and Exchange Commission (the “SEC”) announced that it will seek more admissions of wrongdoing from defendants as a condition of settling enforcement cases. In 2012, the SEC made a first step in this regard by requiring certain admissions in SEC settlements with parties that had pled guilty in a related criminal action. In 2013, SEC Chair Mary Jo White said the change in policy would extend even further. Chair White specifically identified four triggering factors that might require admissions by corporate or individual defendants: (1) cases where a large number of investors have been harmed or the conduct was otherwise egregious; (2) cases where the conduct posed a significant risk to the market or investors; (3) cases where admissions would aid investors deciding The Fifth Circuit finds that to qualify as a protected “whistleblower,” an employee must do more than make an internal report. haynesboone.com 30 haynesboone.com 31 whether to deal with a particular party in the future; and (4) cases where reciting unambiguous facts would send an important message to the market about a particular case. An example of this new policy was seen in two high profile matters by the SEC in 2013—a settlement in June with Philip A. Falcone and his advisory firm, Harbinger Capital Partners, and a settlement in September with JPMorgan Chase & Co. In the Falcone/Harbinger settlement, the SEC alleged that Falcone and his firm improperly used $113.2 million in fund assets, through a low-interest loan from the Harbinger Capital Partners Special Situations Fund, to pay Falcone’s personal taxes, secretly granted favorable redemption and liquidity terms to certain large investors, and conducted an improper “short squeeze” on bonds of a Canadian manufacturer. Falcone and Harbinger agreed to a settlement in which: (a) they must pay more than $18 million in disgorgement and penalties; (b) Falcone would be barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization for five years; and (c) they must admit to wrongdoing. In September 2013, JPMorgan Chase settled a matter with the SEC and other regulators in the US and United Kingdom involving trading losses in a series of transactions involving credit default swaps booked in its London branch. The SEC alleged that JPMorgan Chase failed to establish and implement effective internal accounting controls regarding the valuation of its portfolio, misstated its financial results, and failed to involve the firm’s audit committee of the board regarding the actions by traders to fraudulently overvalue investments and conceal hundreds of millions of dollars in trading losses. In its settlement, JPMorgan Chase agreed to: (a) pay a $200 civil penalty to the SEC in addition to penalties to other regulators; (b) cease and desist from future violations of the securities laws; and (c) admit the underlying facts and publicly acknowledge the violations of the securities laws. The SEC’s longstanding settlement practice of permitting defendants to settle on a “neither admit nor deny basis” continued to be the rule for most enforcement actions in 2013. The SEC’s new policy to require admissions, a change designed almost entirely to appease concerns from the judges, Congress, and the press about the “optics” of the SEC settlement, was reserved for the exceptional, large and highly impactful matters noted. In 2014, companies involved in SEC investigations should be ready for demands from individual SEC staff members for admissions in many investigations, including smaller matters not clearly meeting the factors articulated by Chair White where an admission will not ultimately be required. However, companies should also note that the SEC will be working over the next year to better illustrate, through the announcement of key enforcement settlements, the types of conduct which will require a company or individual to admit violations. Covered Securities In SEC v. Thompson, 2013 WL 5498133 (10th Cir. Oct. 4, 2013), the Tenth Circuit cited longstanding authority to hold that, at least in the context of civil suits, whether an instrument is a security under the Securities Exchange Act is a question of law, not fact. It applied a four-part test articulated by the Supreme Court in Reves v. Ernst & Young, 494 U.S. 56 (1990), to affirm a determination that unsecured promissory notes sold by the defendant were securities as a matter of law. The SEC had What qualifies as a “covered security” under federal law is a legal question for the court, not a fact determination. filed a civil enforcement action against the defendant in connection with unsecured promissory notes he issued and sold through his company. The defendant used the funds to invest in various alleged Ponzi schemes. Each note stated on its face that it was not a security, but the district court found otherwise and granted summary judgment to the SEC. The defendant appealed, arguing (i) he was entitled to have a jury determination on whether the instruments were securities, and (ii) the court erred in deciding the instruments were securities. The Tenth Circuit affirmed, finding first that in arguing the determination was for the jury, the defendant “all but ignore[d] authority in this circuit and elsewhere suggesting that the opposite was true.” The Court cited holdings from the Ninth, Tenth, and D.C. Circuits that the determination is a question of law. It noted that the complexity of the Supreme Court’s four-part test in Reves suggested the question was one for the courts. The Court acknowledged “rare” cases in which courts may be unable to apply the test without first resolving factual disputes, but found this was not one of them. The Court then applied Reves, under which notes are generally presumed to be securities. That presumption can be rebutted by showing that the note bears a “family-resemblance” to notes issued in a commercial or consumer context, which are not securities. The Tenth Circuit held that the defendant failed to rebut the Reves presumption. The first Reves factor “clearly favor[ed]” a finding that the instruments were securities because the defendant admitted he sold them to raise money for his company and because the high interest rate (annual returns of 36% to 60%) was evidence that holders were drawn to invest for the profit the notes were expected to generate. As to the second Reves factor, the court noted that “the sale of the notes on an exchange is not necessary” to establish “common trading.” The Court noted the defendant had targeted a broad segment of the public via shopping mall seminars, conference calls, and a website advertising the notes. The third factor—“reasonable expectations” of investors—was “a closer call.” Though the notes stated that they were not securities and bore other features not usually associated with securities, the Court was persuaded by other countervailing facts such as defendant’s comments about the notes at seminars in terms associated with investments. Finally, the Court decided the fourth Reves factor cut toward characterizing the notes as securities because they would escape federal regulation entirely if the Securities Acts were held not to apply. The decision underscores that the SEC may regulate investments, even when called by a name other than “security,” and that scope of that the term “security” remains a question for courts not juries. Section 16(b) Short-Swing Profits Section 16(b) of the 1934 Securities Exchange Act provides for the disgorgement of profits that corporate insiders realize “from any purchase and sale, or any sale and purchase, of any equity security of such [corporate] issuer… within any period of less than six months.” In Gibbons v. Malone, 703 F.3d 595 (2d Cir. 2013), the Second Circuit concluded that purchasing one class of a company’s stock and selling another class—the only difference being the existence of voting rights—within a six month period was not prohibited by the statute. A shareholder sought to disgorge the profits from a director of Discovery Communications, Inc. who had sold almost a million shares of “Series A” Discovery stock and sold over half a million shares of “Series B” Discovery stock within six months. The district court dismissed because these two types of stock, which were separately registered and traded separately on NASDAQ, did not fit within Section 16(b)’s “any equity security” language. The use of the singular “any security” rather than “any securities” implied that the statute covered purchases and sales of a single type of security. The Second Circuit affirmed and adopted the district court’s construction. A line of cases allowed different types of securities to be treated as the same for purposes of Section 16(b) if the securities were “economically equivalent.” However, the Second haynesboone.com 32 haynesboone.com 33 Circuit held that the Series A and C stock could not be treated as economically equivalent, because one series had voting rights and the other did not, the two series of stock were not convertible, and their market prices fluctuated relative to one another, albeit slightly. The court also rejected the plaintiff’s suggestion that it adopt a “substantial similarity” test for assessing whether two different types of securities should be paired for purposes of Section 16(b). The Second Circuit reasoned that a nebulous “similarity” test would run counter to Congress’s intent that Section 16(b) be capable of easy administration. The Court expressly noted the absence of SEC guidance on the issue, possibly leaving the door open to a different holding in the future. Notable Developments in State Law Actions and Fiduciary Litigation Delaware Rejects Expansion of Fraud Exception to the “Continuous Ownership Rule” In Lewis v. Anderson, 477 A.2d 1040 (Del. 1984), the Delaware Supreme Court held that in order for a shareholder to have standing to pursue a derivative action on behalf of the company in which shares are held, the plaintiff must be a stockholder (i) at the time of the alleged wrong, (ii) when the action is filed, and (iii) continuously throughout the suit. In Arkansas Teacher Retirement System v. Countrywide Financial Corp., 2013 WL 4805725 (Del. Sept. 10, 2013), the Delaware Supreme Court responded to a certified question from the United States Court of Appeals for the Ninth Circuit, inquiring “[w]hether, under the ‘fraud exception’ to Delaware’s continuous ownership rule, shareholder plaintiffs may maintain a derivative suit after a merger that divests them of their ownership interest…by alleging that the merger…was necessitated by, and inseparable from, the alleged fraud that is the subject of their derivative claims.” In short, the Delaware Supreme Court “answer[ed] that question in the negative.” The Court further noted that “any injury flowing from the ‘inseparable fraud’ would be suffered by the shareholders rather than the corporation and any recovery would go to the shareholders rather than the corporation,” which would be a direct, not derivative, cause of action. Delaware Derivative Suit is Collaterally Estopped by Dismissal in California In Pyott v. Louisiana Municipal Police Employees’ Retirement System, 74 A.3d 313 (Del. 2013), the Delaware Supreme Court held that a Delaware derivative complaint should have been dismissed after a California federal court earlier dismissed essentially the same suit brought by different stockholders for failure to plead demand futility. The Delaware Supreme Court ruled that once the California federal court had issued its final judgment, the “successive case is governed by the principles of collateral estoppel, under the full faith and credit doctrine, and not by demand futility law.” The Delaware Chancery Court had been unwilling to give preclusive effect to the California judgment because it believed that the California plaintiffs had not adequately investigated their claims before filing suit, whereas the Delaware plaintiffs alleged more particularized facts developed through a “books and records” request. The Delaware Supreme Court found no support “for the trial court’s premise that stockholders who file quickly, without bringing a § 220 books and records action” are acting on behalf of their law firms instead of the corporation. While empathizing with the Chancery Court’s attempt to curb a “race to the courthouse” by the shareholder plaintiffs’ bar, the opinion made clear that such attempts cannot come at the expense of well-settled principles of federalism, comity, and finality associated with final judgments. The Delaware Supreme Court reiterated that “the undisputed interest that Delaware has in governing the internal affairs of its corporations must yield to the stronger national interests that all state and federal courts have in respecting each other’s judgments.” This decision should help corporate defendants and boards minimize the burdens of duplicative derivative litigation in different jurisdictions. Delaware Chancery Court Upholds Board-Adopted “Forum Selection” Bylaw Provisions In Boilermakers Local 154 Ret. Fund v. Chevron Corp., 2013 WL 3191981 (Del. Ch. June 25, 2013), a consolidated ruling affecting shareholder challenges to forum selection provisions adopted by the boards of Chevron Corporation and FedEx Corporation as bylaw amendments, the Delaware Chancery Court (Strine, C.), found that such provisions are statutorily and contractually valid and enforceable. The forum selection bylaws governed (a) shareholder derivative suits, (b) breach of fiduciary duty claims, (c) claims under the Delaware General Corporation Law, and (d) suits asserting claims “governed by the internal affairs doctrine.” The court noted (i) that the certificates of incorporation permitted directors to adopt bylaws under 8 Del. C. § 109(a), and further (ii) that 8 Del. C. § 109(b) provides board-adopted bylaws “may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.” The court held that the forum selection bylaws “easily” satisfied these statutory requirements. The court further found that “an essential part of the contract stockholders assent to when they buy stock [in these Delaware corporations] is one that presupposes the board’s authority to adopt binding bylaws consistent with 8 Del. C. § 109.” The court also held open the possibility that stockholders could not only vote to repeal such provisions but also could file suit in their favored forum and challenge their application as “unreasonable” within the meaning of The Bremen v. Zapata Off-Shore Co., 407 U.S. 1 (1972), or as unenforceable if “used for improper purposes inconsistent with the directors’ fiduciary duties.” Business Judgment Rule Applied to Controlling Shareholder Transactions, Where Conditioned on Independent Committee and Majority-of-Minority Approval In May 2013, the Delaware Chancery Court ruled that the business judgment rule standard of review should apply (instead of “entire fairness”) to a challenged going-private transaction for M&F Worldwide (“MFW”) initiated by its controlling stockholder MacAndrews & Forbes. Chancellor Strine’s ruling noted that the controlling shareholder’s offer to purchase the rest of MFW’s equity was “conditioned upfront… on approval by both a properly empowered, independent committee and an informed, uncoerced majority-of-the-minority vote.” In re MFW S’holders Lit., 2013 WL 2436341 (Del. Ch. May 29, 2013). The defendants successfully moved for summary judgment, arguing that these “two key procedural protections…together, replicate[d] an arm’s-length merger,” while plaintiffs unsuccessfully urged that the “entire fairness” standard should apply but with a shifting of the burden of proof to plaintiffs. The Chancery Court found that the two procedures “are complementary and effective in tandem” and that applying the more relaxed business judgment standard of review would create “an across-the-board incentive…to provide minority stockholders with the best procedural protections in all going private transactions.” In August 2013, the business judgment standard was applied by Vice Chancellor Noble to a third-party’s merger with a company with controlling shareholder where “the transaction [was] recommended by a disinterested and independent special committee and (2) approved by stockholders in a non-waivable vote of the majority of all the minority stockholders.” Southeastern Pennsylvania Trans. Auth. v. Volgenau, 2013 WL 4009193 (Del. Ch. Aug. 5, 2013). The MFW and Volgenau matters are currently on appeal to the Delaware Supreme Court. A Delaware court upholds a board-adopted bylaw requiring derivative and fiduciary claims to be filed in the state. haynesboone.com 34 haynesboone.com 35 Does the Business Judgment Rule Apply to Bank Directors? On November 25, 2013, a federal district judge in Georgia suggested that bank officers and directors may not be entitled to the protection of the “business judgment rule” in cases brought by the FDIC as a receiver. In FDIC v. R. Charles Loudermilk, Sr., 2013 U.S. Dist. LEXIS 166924 (N.D. Ga. Nov. 25, 2013), the agency asserted ordinary and gross negligence claims against former officers and directors of a community bank that failed because of alleged loan portfolio mismanagement. The officers and directors moved to dismiss, arguing the business judgment rule precluded ordinary negligence claims. Though the court acknowledged that “[f]ederal courts in this district…have uniformly applied the business judgment rule to protect bank officers and directors,” it “respectfully disagree[d].” The court opined that bank officers and directors should be treated differently than their corporate counterparts because the former’s financial fortunes are not tied to the bank’s fortunes. Instead, “when a bank, instead of a business corporation fails, the FDIC and ultimately the taxpayer bear the pecuniary loss.” The Georgia district court also suggested that the fact the FDIC, as a receiver appointed during a financial crisis, was the plaintiff, provided further support to denying business judgment rule protection to bank officers and directors in similar cases. Ultimately, the federal court determined it was an open question, and certified it for decision by the Georgia Supreme Court. Should the state supreme court agree, the decision would have profound implications for officers and directors of Georgia banks. (The Loudermilk court is not the first to suggest that a different standard of care should be applied to bank directors. In 2006, for example, a federal court in Texas noted that banks may entail “special treatment” in terms of the applicable standard of care, citing an 1888 Texas Supreme Court decision requiring bank directors to be more diligent than directors of other corporations. See Floyd v. Hefner, 2006 WL 2844245, at *28 (S.D. Tex. Sept. 29, 2006). Texas M&A Settlements: Frontier Oil The Houston (14th Dist.) Court of Appeals dealt a powerful blow to the ability of plaintiffs’ counsel to collect fees in the settlement of class cases that do not involve monetary relief to the class members. In Kazman v. Frontier Oil Corp., 398 S.W.3d 377 (Tex. App. – Houston [14th Dist.] 2013, no pet.), the court addressed a class settlement that involved only equitable relief to the class. Several shareholders of Frontier Oil brought putative class actions to enjoin a proposed merger with Holly Corporation. The parties ultimately agreed to a settlement that provided for supplemental disclosures about the transaction to the class of Frontier Oil shareholders and over $600,000 in fees to class counsel. The settlement did not provide any monetary relief to the class. The trial court approved the settlement over the objection of a Frontier shareholder, who appealed the fee award to class counsel. The appellate court followed in the steps of the Dallas Court of Appeals (Rocker v. Centex Corp., 377 S.W.3d 907 (Tex. App.—Dallas [5th Dist.] 2012, pet. granted, judgm’t vacated w.r.m.), and held that Texas Rule of Civil Procedure 42(i)(2) unambiguously precludes the award of attorneys’ fees to class counsel in cases where the class receives no cash. In so holding, the court rejected class counsel’s argument that Rule 42(i)(2) only applied to coupon settlements and not to other forms of non-cash settlements such as injunctive relief. Although the court rejected the award of attorneys’ fees, it otherwise approved the underlying settlement, leaving class counsel with nothing. Another Texas appellate court denies a fee award to plaintiff’s counsel in a disclosure-only settlement. Majority/Minority Shareholders and Dilution In Joe W. and Dorothy Dorsett Brown Foundation v. Frazier Healthcare V, L.P., 2013 WL 4046412 (5th Cir. Aug. 12, 2013), the Fifth Circuit affirmed a dismissal of claims stemming from the 2011 acquisition of Ascension Orthopedics, Inc. (“Ascension”) by Integra LifeSciences. In a case of first impression for the Fifth Circuit, applying Delaware law, the Court of Appeals affirmed the derivative (as opposed to direct) nature of claims primarily grounded in shareholder dilution. Plaintiffs had filed suit in the Western District of Texas against members of Ascension’s board of directors and three Frazier funds, who were alleged to have controlled the board. Plaintiffs alleged claims for breach of fiduciary duty and minority shareholder oppression. The trial court granted defendants’ motions to dismiss, finding that plaintiffs’ claims (sounding primarily in shareholder dilution) were derivative rather than direct under Delaware law. Central to the court’s ruling was the fact that plaintiffs could have participated in the challenged preferred stock transaction, but declined. Because the allegedly dilutive issuance was not for the “exclusive benefit” of defendants, the suit did not fall under Delaware’s narrow exception for direct pursuit of shareholder dilution claims. See Gentile v. Rossette, 906 A.2d 91 (Del. 2006). The trial court also found that Delaware does not recognize a cause of action for minority shareholder oppression and dismissed plaintiffs’ claims under that theory as well. See Joe W. & Dorothy Dorsett Brown Found. v. Frazier Healthcare V, L.P., 889 F. Supp.2d 893, 897 (W.D. Tex. 2012). The Fifth Circuit affirmed the dismissal of all claims in a per curiam opinion. The affirmance reinforces that would-be minority shareholders considering investing in Delaware corporations should bargain for the protections they desire prior to investing rather than expecting courts to craft rules to protect them. See Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993). haynesboone.com 36