Extract taken from 'The Securities Ligation Review – edition 5'
Private enforcementi Forms of action
Nearly all private US securities enforcement is through class-action litigation in the federal courts. Where a corporation is itself the entity that suffered injury under the securities laws, derivative actions can be pursued. This litigation is usually 'lawyer-driven', relying on plaintiffs' lawyers to enforce the rights of absent class members. Class-action lawyers typically derive their fees from settlements, or through recovery obtained at the end of the action.
Most private securities class actions are brought under Sections 11 and 12 of the Securities Act and Sections 10 and 14 of the Exchange Act – with Section 14 claims gaining increasing prominence over the past three years, as merger-related litigation has shifted from state to federal courts. Plaintiffs' burden of proof and the defences available to a defendant will vary depending on which statutory provision is invoked. These provisions can also be civilly enforced by the public authorities, or support criminal prosecution if a violation was wilful.
One notable impediment to private claimants seeking remedies under the US securities laws is the frequent absence of a private right to sue. While the right for individual buyers and sellers to bring suit to recover actual losses is well established for claims of fraud under Section 10 of the Exchange Act and some other statutory provisions, it should not be assumed that private plaintiffs can sue to redress conduct that violated the securities laws. In recent years, federal courts have been generally unwilling to imply new private rights of action where Congress has not explicitly provided one – a trend that is unlikely to subside following the appointment of conservative jurists by the current presidential administration. As such, certain areas of enforcement are exclusively in the hands of government authorities.
An additional barrier that plaintiffs must surmount is the need to show 'standing' to sue. The contours of the standing requirement vary from one statutory provision to the next, but in general a plaintiff must show that he or she is the type of party who is authorised to sue under the statute. For example, the Supreme Court has held that to bring an action under Rule 10b-5, a plaintiff must show that he or she purchased or sold securities in the transaction complained of. These standing requirements are reviewed where relevant in the discussion below. Note, however, that these obstacles to suit – standing and a private right of action – do not apply to the Securities and Exchange Commission, which can bring an action on behalf of the government under all provisions of the securities laws.
Because the federal securities laws are generally disclosure-based (rather than contract-based), a complaining plaintiff will usually bear the burden of establishing that an issuer, seller, or buyer traded securities on the basis of a 'material' misstatement or omission. Indeed, the requirement that any misstatement be material recurs throughout US securities law and applies to most private and government enforcement actions. The leading case on materiality is TSC Industries, Inc v. Northway, Inc, in which the Supreme Court defined a material fact as one to which there is a substantial likelihood that a reasonable investor would attach importance in making a decision because the fact would significantly alter the 'total mix' of available information. In a recent demonstration of how broadly this definition can sweep, the Second Circuit held that a misrepresentation as to price could be found material even in a negotiating context where such misleading statements were common. However, some courts have held that false statements or omissions are not materially misleading as long as the market possessed the correct information. Additionally, courts have held that actionable statements must be sufficiently 'concrete' and 'specific', as opposed to 'single, vague statement[s] that are essentially mere puffery'. For example, the Second Circuit recently held that where a defendant insurance company had been cited for non-compliance with certain healthcare regulations, prior public statements about its commitment to behave ethically and comply with applicable regulations were 'too general to cause a reasonable investor to rely upon them'.
Under SLUSA, plaintiffs are barred from bringing class actions asserting certain securities fraud claims under state law. Specifically, SLUSA bars state-law claims alleging 'a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security'. This provision of SLUSA was enacted to block plaintiffs from using state law to evade the PSLRA's restrictions on federal securities class actions. To effect that purpose, the Supreme Court has interpreted the provision broadly to apply to any alleged misrepresentation that 'coincides with a securities transaction – whether by the plaintiff or by someone else'. Despite this guidance, the courts have long struggled with delineating precisely which state-law class actions involving securities are precluded by SLUSA. This has resulted in a framework that varies somewhat from one federal circuit to the next, although in recent years, the Second and Ninth Circuits – whose courts are prime venues for federal securities litigation – have held that SLUSA precludes state-law claims that can succeed only through proof of conduct that is specified in the SLUSA preclusion statute (i.e., misrepresentations or omissions of material fact in connection with the purchase or sale of a covered security).
Notably, while SLUSA restricts plaintiffs' ability to circumvent federal law, the Supreme Court recently held in Cyan Inc v. Beaver County Employees' Retirement Fund that the statute does not restrict plaintiffs from pursuing Securities Act class actions in the state courts. In addition, the Cyan Court held that defendants may not remove Securities Act class actions to federal court. Cyan thus preserves plaintiffs' ability to pursue Securities Act class actions outside the federal forum.Securities Act: Section 11
To bring a securities claim under Section 11(a) of the Securities Act, a plaintiff must show that a registration statement 'contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading'. Once a plaintiff satisfies this burden, then Section 11(a) makes liable the issuer, the directors of the issuer, anyone named in the registration statement as about to become a director of the issuer, every person who signed the registration statement, every expert (e.g., accountant or appraiser) who was named as having certified or prepared the misleading part of the registration statement, and every underwriter of the security. The plaintiff need not show that he or she relied upon the misstatements or that any defendant acted in bad faith.
Several courts have held that to establish standing, a Section 11 plaintiff must 'plead that [his or her] stock was issued pursuant to the public offering[s] alleged to be defective'. However, most courts have held that stock purchased in a secondary market is 'issued pursuant to the public offering' if the plaintiffs can trace their securities to the challenged registration.
An issuer has virtually no defence under Section 11; it is effectively strictly liable for material misstatements and omissions in registration statements. Assuming a material misstatement, an issuer's only hope of avoiding liability is to prove that the plaintiff knew of the misstatements or omissions when the trade occurred. However, other defendants have a variety of defences under Section 11(b). Thus, a party named in a registration statement can avoid liability if he or she resigns and informs the SEC of the false or misleading statement before the registration statement becomes effective. In addition, under Section 11(b)(3), a non-issuer defendant can avoid liability if he or she can show reasonable grounds for believing that the alleged misstatements were true. The degree of investigation sufficient to serve as 'reasonable grounds' varies by category of defendant – while accountants are largely governed by professional standards, underwriters are subject to much stricter due diligence obligations.
In Omnicare, Inc v. Laborers District Council Construction Industry Pension Fund, the Supreme Court rejected a lower court holding that an issuer's sincerely held opinion could constitute an 'untrue statement of a material fact' under Section 11. The Court reasoned that accurately disclosing a belief cannot amount to an untrue statement. But the Court also held that some genuinely held opinions could still be actionable, because Section 11 also proscribes statements that have 'omitted to state a material fact . . . necessary to make statements not misleading'. Omitted facts could render a genuinely held opinion misleading where investors expect that the opinion 'fairly aligns with the information in the issuer's possession at the time'. Accordingly, 'if a registration statement omits material facts about the issuer's inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from [the issuer's statement of opinion], then Section 11's omissions clause creates liability'. The Court counselled that 'to avoid exposure for omissions under Section 11, an issuer need only divulge an opinion's basis, or else make clear the real tentativeness of its belief'. In applying Omnicare, the Second Circuit has held that a securities claim may fail even where defendants were aware of significant information that undermined their public statements. Significantly, the principles of Omnicare have gained purchase on other areas of federal securities law, including claims brought under Section 10(b) of the Exchange Act.Securities Act: Section 12
Under Section 12(a)(1), any person who offers or sells a security required to be registered under the Securities Act but not registered is liable to the person purchasing the security. Under Section 12(a)(2), any person who by the use of any means of interstate commerce offers or sells a security on the basis of a materially false or misleading prospectus or materially false or misleading oral statements is liable to the person purchasing from him or her, unless he or she can show that he or she did not know, and could not in the exercise of reasonable care have known, of the falsehood or omission. Unlike Section 11 and Section 12(a)(1), which apply only to securities that must be registered under the Securities Act, Section 12(a)(2) applies to all securities except those specifically exempted.
To succeed in a Section 12 claim, a plaintiff need not show that he or she relied on the misstatements or that the defendant acted in bad faith. However, no liability will attach in a private action – under Section 12 or other provisions of the Securities Act or the Exchange Act – based on certain statutorily defined 'forward-looking statements' unless the plaintiff proves actual knowledge of the false or misleading nature of the statement on the part of a natural person making the statement or on the part of an executive officer approving the statement made on behalf of a business entity. In addition, a defendant can avoid Section 12(a)(2) liability by showing that any claimed depreciation in a security's value was not caused by the defendant's misstatements or omissions.Exchange Act: Section 10
Section 10 authorises the SEC to prescribe rules addressing prohibited securities trading practices. Under Section 10(a), the SEC is empowered to prohibit short sales and the use of stop-loss orders for securities registered under the Exchange Act or traded on national security exchanges. Under Section 10(b), the SEC is empowered to prohibit 'the use of a manipulative or deceptive device or contrivance' in connection with the purchase or sale of any securities or in connection with security-based swap agreements. While there are currently 11 SEC-promulgated rules in force under Section 10(b), the most important by far is the general anti-fraud rule, Rule 10b-5. Rule 10b-5 prohibits use of any means of interstate commerce to (a) employ any device, scheme or artifice to defraud; (b) make material misstatements or omissions; or (c) engage in any course of business that operates as a fraud against any person, in connection with the purchase or sale of any security or securities-based swap agreement. This rule is the great engine of private securities enforcement in the United States.
In general, to prevail on a Rule 10b-5 claim, a plaintiff must prove that the defendant: (1) made a false statement or an omission of material fact (2) with scienter (3) in connection with the purchase or sale of a security (4) upon which the plaintiff justifiably relied and (5) that proximately caused (6) the plaintiff's economic loss. The most important violations of Rule 10b-5 fall into three categories:
- common fraud in transactions by sellers, purchasers, brokers, and others;
- false or misleading statements of material fact by corporate insiders or others that affect the prices in which securities trade; and
- trading on material non-public information by corporate insiders and their tippees (insider trading).
There has been substantial debate and disagreement in the courts over how to construe the reliance element of Rule 10b-5 in the context of class actions. The difficulty is that to proceed as a class under the Federal Rules of Civil Procedure, plaintiffs must show that common questions of law or fact 'predominate over any questions affecting only individual members'. But whether a particular buyer or seller relied on an alleged misstatement is typically an individualised question. Thus, if Rule 10b-5 were interpreted to require proof of individual reliance on defendants' misstatements, it would be more challenging for plaintiffs' lawyers to bring claims on a class basis.
The Supreme Court rode to the rescue of plaintiffs in Basic Inc v. Levinson, endorsing a 'fraud-on-the-market' theory under which courts may presume that '[a]n investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price'. This theory obviates the need for proof of individual reliance and facilitates class certification. However, the fraud-on-the-market presumption is only available if a plaintiff can allege and prove that the market was 'efficient' – which is to say that market prices were responsive to new, material news. To establish (or refute) the claim of market efficiency, parties present economists armed with event studies analysing how the relevant market reacted to new information.
More recently, in Halliburton Co v. Erica P John Fund, Inc, the Supreme Court clarified that Rule 10b-5 defendants can defeat class certification by demonstrating that alleged misstatements had no effect on price. Based on this holding, defendants can now rebut the Basic presumption by citing news and analyst reports and other public information that shows how the supposedly undisclosed truth was already known to the market. Courts continue to grapple with the application of this standard. The Second Circuit has held that defendants must 'demonstrate a lack of price impact by a preponderance of the evidence' under Halliburton, diverging from the Eighth Circuit, which has suggested that defendants can defeat Basic by simply 'com[ing] forward with evidence showing a lack of price impact'. And courts across the country have struggled with plaintiffs pursuing a 'price maintenance' theory of liability – under which an alleged misstatement's lack of price impact can be overlooked so long as the misstatement 'maintained' an inflated share price by reinforcing or failing to correct a preexisting market misapprehension. That theory has been accepted by a number of circuit courts.
The Supreme Court has also clarified that courts should not presume that a misstatement caused an inflated purchase price in Rule 10b-5 cases. In Dura Pharm Inc v. Broudo, the Court unanimously held that 'an inflated purchase price will not itself constitute or proximately cause the relevant economic loss'. Following Dura, plaintiffs in fraud-on-the-market and other Rule 10b-5 cases must prove that their economic losses were actually attributable to a defendant's misrepresentations.
In addition, the Supreme Court has repeatedly examined the impact that Section 10(b)'s 'in connection with' requirement has on plaintiff standing. As noted above, the Court has generally required that a Section 10 plaintiff demonstrate that he or she was misled into purchasing or selling securities. More recently, the Court has clarified this standard, holding in Wharf (Holdings) Ltd v. United Int'l Holdings, Inc, that the sale of an option to buy stock while secretly intending never to honour it also falls within the 'in connection with' language. The Court again revisited the scope of Section 10(b) in SEC v. Zandford, holding that the provision reached a defendant broker who, by selling a client's securities and transferring the proceeds to his own account, stole money from a discretionary account. Most recently, the Court held that not only is a Section 10 plaintiff not permitted to sue under a theory that false or misleading statements led them not to buy or sell shares, but that such 'holder' transactions are nevertheless pre-empted by SLUSA and barred in state court as well.Insider trading in violation of Section 10
Since the decision of the SEC in Cady, Roberts & Co, insider trading – trading on material non-public information – by both corporate insiders and their tippees has been viewed by the SEC and the courts as a violation of Rule 10b-5. As such, a range of defendants can be held liable: insiders who trade on insider information; insiders who disclose material non-public information to others who may then trade (tippers); and the third-party traders who are tipped off by insiders (tippees).
This does not mean that corporate insiders have a duty to disclose all material information to the public. Rather, their duty is to disclose or to abstain from trading until disclosure takes place. The duty to disclose material non-public information or abstain from trading has been held to apply not only to registered securities, but to unregistered and delisted securities as well. Since this liability is rooted in Rule 10b-5, it is subject to the purchaser–seller standing requirements discussed above.
To succeed on an insider-trading claim under Rule 10b-5, a plaintiff generally must establish five basic elements: (1) the buying or selling of a security or the tipping thereof (2) on the basis of information about the security that is (3) non-public, (4) material, and (5) where trading without disclosure constitutes a breach of a fiduciary duty or other relationship of trust and confidence owed to the source of the information.
Other than materiality (discussed under 'Forms of action'), the most complex of these elements is the last – the rule that insider-trading liability can attach only if the trading constitutes a breach of a duty. This element is generally satisfied under one of two established theories. Under the 'classical' theory, a corporate insider or 'temporary insider' working for the benefit of a corporation breaches his duty to the corporation and its shareholders by using confidential corporate information to trade in the corporation's stock for his or her personal benefit. Under the 'misappropriation' theory, a tipper or trader who has no duty to the issuer or to shareholders may nevertheless be liable where he or she obtains confidential information in breach of a duty owed to the source of the information. The misappropriation theory was approved by the Supreme Court in United States v. O'Hagan, where the defendant was a lawyer who traded based on the information that one of his law firm's clients was planning a tender offer. In Rule 10b5-2, the SEC has enumerated broad categories that give rise to a duty of trust or confidence to a source of information under the misappropriation theory.
Insider-trading tippees can also be sued or prosecuted under Section 10 and Rule 10b-5. Under the standard established by the Supreme Court in Dirks v. SEC, a tippee is liable where: (1) an insider receives a 'direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings'; and (2) the tippee knew or had reason to know of the tipper's breach of duty to an issuer. As the Supreme Court recently reaffirmed in United States v. Salman, insider-trading liability extends to circumstances where an insider gifts non-public information to a 'trading relative or friend'.Rule 14a-9
Rule 14a-9 prohibits any proxy solicitation made pursuant to Section 14 of the Exchange Act that 'contain[s] any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication . . . which has become false or misleading'. To succeed on a Rule 14a-9 claim, a plaintiff must establish that a proxy statement contained a material misrepresentation or omission that caused the plaintiff injury and that the proxy solicitation itself was an essential link in accomplishing the transaction. In recent years, this provision has increasingly been invoked by plaintiffs seeking to challenge merger disclosures.
Unlike Section 10(b), Section 14(a) does not require a showing of manipulative or deceptive conduct. As a result, most courts require proof of negligence, not scienter. However, some courts have adopted a more nuanced approach to the scienter requirement. For example, the Eighth Circuit has held that while proof of negligence suffices for corporate officer defendants, scienter must be shown where the defendant is an accountant or an outside director.Rule 14e-3
In the context of a tender offer, Rule 14e-3(a) prohibits any person 'who is in possession of material information relating to such tender offer which information he knows or has reason to know is non-public and which he knows or has reason to know has been acquired directly or indirectly from' the tender offeror, the issuer, or any officer, director, partner, employee, or any other person acting on behalf of the offeror to trade in the affected securities unless the information and its source are 'publicly disclosed' 'within a reasonable time' before the trade. Subsection (d) of the Rule prohibits tipping in the tender-offer context, barring certain persons from communicating material non-public information relating to the tender offer where it is reasonably foreseeable that such communication is likely to result in a violation of Rule 14e-3. Rule 14e-3 has the effect of broadening the scope of insider-trading liability in the tender-offer context by dispensing with the requirement that a breach of fiduciary duty be shown.Exchange Act: Section 16
Section 16 of the Exchange Act provides another important source of liability for insider trading. Section 16(a) requires certain insiders to report their transactions and positions in their employers' securities. Section 16(c) bars insiders from shorting their employers' equity securities. Section 16(b) permits a corporation (or derivative plaintiff) to recover short-swing profits from insider trades within a six-month period.
By its terms, the liability created under Section 16(b) is sharply circumscribed, affecting only 'short-swing' profits enjoyed by a defined class of insiders, a category defined to include beneficial owners or groups of owners holding 10 per cent or more of an issuer's shares. However, where an insider runs afoul of the provision, he or she must disgorge all profits.ii Procedure
In general, plaintiffs bringing a complaint in federal court must allege facts sufficient to render their claim plausible on its face, but must allege fraud with particularity. The PSLRA codifies a heightened pleading standard imposed for securities fraud claims brought under the Exchange Act. Under the PSLRA, a securities fraud claim must specify each statement alleged to have been misleading, identify the speaker, state when and where the statement was made, plead with particularity the elements of the false representation, plead with particularity what the person making the representation obtained, and explain the reason or reasons why the statement is misleading. In addition, where scienter is an element of the securities claim, plaintiffs must 'state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind'. Often, a defendant will test the adequacy of a private securities complaint by bringing a motion to dismiss soon after filing.
Federal discovery procedures are liberal, coupling broad mandatory disclosures with invasive depositions, subpoenas, and interrogatories. Under the PSLRA, however, in any private action brought under the Acts, all discovery is stayed while a motion to dismiss is pending unless the court finds that particularised discovery is necessary to preserve evidence or prevent prejudice. As such, the federal courts often weigh defendants' motions to dismiss on a thin factual record, drawing solely from the facts alleged in the complaint, documents that the complaint incorporates by reference, and public information that is available for judicial notice. While the courts have typically been permissive in applying incorporation by reference and judicial notice to expand the record on motions to dismiss, a recent Ninth Circuit decision could signal a retrenchment of this approach. The Ninth Circuit emphasised that judicial notice of public documents is only available for facts 'not subject to reasonable dispute', and cautioned that a complaint's 'mere mention of the existence of a document' is insufficient to support incorporation by reference. If that panel's sceptical approach is adopted more broadly by the Ninth and other federal circuits, it could complicate the efforts of defendants to achieve early dismissal of complaints that rely upon cherry-picked quotations and selective narratives.iii Settlements
Far more often than not, securities suits that survive a motion to dismiss are settled rather than litigated to trial. Since securities lawsuits are typically brought as class actions, their settlement can bind absent class members and judicial review of such settlements must comply with Federal Rule of Civil Procedure 23 (Rule 23). Rule 23 requires the court to conduct a hearing and to approve a settlement only after a finding that it is 'fair, reasonable, and adequate'. In applying this standard, the courts look to a range of factors, including:
- the complexity, expense, and likely duration of the litigation;
- the reaction of the class to the settlement;
- the stage of the proceedings and the amount of discovery completed;
- the risks of establishing liability;
- the risks of establishing damages;
- the risks of maintaining the class action through trial;
- the ability of the defendants to withstand a greater judgment;
- the range of reasonableness of the settlement fund in light of the best possible recovery; and
- the range of reasonableness of the settlement fund to a possible recovery in light of all the attendant risks of litigation.
Under Federal Rule of Civil Procedure 23(e)(5), '[a]ny class member may object to [a proposed settlement subject to judicial review]'.
Attorneys' fees are also subject to judicial review in the securities class action context. Under the PSLRA, '[t]otal attorneys' fees and expenses awarded by the court to counsel for the plaintiff class' in an Exchange Act lawsuit cannot 'exceed a reasonable percentage of the amount of any damages and prejudgment interest actually paid to the class'. More generally, Federal Rule of Civil Procedure 23(h) permits a court to award class counsel 'reasonable attorney's fees and non-taxable costs that are authorized by law or by the parties' agreement'. This 'reasonableness' determination can be guided by retainer agreements, fee stipulations embodied in settlement agreements, and other fee agreements entered into between lead plaintiffs and class counsel.iv Damages and remedies
Different remedies are available for the common securities claims described above. For claims brought under Section 11 of the Securities Act, the measure of a plaintiff's damages is the decline in the value of his or her securities, quantified as the difference between purchase price and sale price. For Section 12 of the Securities Act, the remedy is rescission – the plaintiff tenders his or her securities to the defendant and receives his or her purchase price with interest. Where appropriate, a court can also order injunctive relief for a Securities Act plaintiff.
Remedies available under Section 10, Rule 10b-5, Rule 14a-9, and Rule 14e-3 include both injunctive relief and damages. However, the measure of damages in all Exchange Act claims is limited to 'actual damages'. In the context of a Rule 10b-5 claim, the Supreme Court has held that this imposes an 'out-of-pocket' measure, which is the difference between the price paid or received for the security and its true value at the time of purchase. In insider-trading cases brought under Rule 10b-5, a disgorgement remedy is often available, under which defendants are liable for the profits that they and their tippees obtained. Finally, at least where the plaintiff dealt face-to-face with the defendant and the securities purchased or sold have not been re-transferred, the plaintiff may elect to sue for rescission rather than damages. In a Rule 14a-9 claim, courts have allowed both out-of-pocket and disgorgement damages, as well as fashioning damages designed to give the plaintiff the benefit of the bargain they would have received had the misrepresentations been true.