BY ALL ACCOUNTS, 2010 promises more noteworthy developments in the securities enforcement and litigation area. The newly constituted SEC Enforcement Division, now headed and staffed by former criminal prosecutors, has signaled a more aggressive approach. In addition to hedge funds—which the Enforcement Division has singled out as one of its most important priorities—the Division’s other areas of focus include: insider trading (by hedge funds and others), market manipulation, valuation, investor communications, violations of the Foreign Corrupt Practices Act, Ponzi schemes and Sarbanes-Oxley Section 304 “clawback” actions involving executive compensation. In the class action and private securities litigation arena, pending decisions from the Supreme Court addressing questions of jurisdiction, statutes of limitations and the proper role of courts in evaluating “excessive” compensation, among others, are sure to have a substantial impact on the business community and investors alike. The following are some of the more notable cases to watch in the upcoming year.
SEC v. Bank of America
The SEC had pledged to increase the capacity and willingness of its trial unit to try cases against those it believes have violated the securities laws. Still, few would have predicted that 2010 would start off with not one, but two, SEC cases against Bank of America before the same judge arising out of its merger with Merrill Lynch.
In September 2009, Southern District of New York Judge Jed. S. Rakoff rejected a $33 million settlement between the SEC and Bank of America to resolve the SEC’s charge that Bank of America failed to disclose its prior agreement authorizing Merrill to pay year-end bonuses of up to $5.8 billion to its employees. Judge Rakoff’s decision presented the SEC with several choices: drop the case, renegotiate the terms of the settlement, pursue the action administratively or fight the case in court.
The SEC chose to continue to litigate. On Jan. 12, 2010, the SEC filed a second action charging Bank of America with violations of the federal proxy rules by failing to disclose extraordinary financial losses that Merrill sustained prior to a shareholder vote to approve the merger.34 The filing followed a ruling by Judge Rakoff the day before that the charges be brought separately from the SEC’s pending case against Bank of America, which challenges the bank’s disclosures about bonuses paid to Merrill executives.35
Most recently, the SEC announced a second settlement, again subject to Judge Rakoff’s approval, that attempts to resolve both cases against Bank of America. The current settlement will impose a $150 million fine to be paid to Bank of America shareholders who allegedly were harmed by the disclosures at issue. It also will also require Bank of America to take specified steps designed to strengthen its corporate governance and disclosure practices.
This new settlement responds to much of Judge Rakoff’s prior criticism, but the matter is not over yet. The same day the SEC settlement was announced, New York Attorney General Andrew Cuomo filed new fraud charges against Bank of America and its former CEO, Kenneth Lewis, and former CFO, Joseph Price, alleging that they lied to government officials and investors regarding the losses at Merrill. Just why the NYAG and the SEC—which acknowledged the NYAG’s support and cooperation when announcing its settlement—reached different conclusions regarding the executives may be a question Judge Rakoff will pose to the SEC.
SEC v. Rorech
The coming year also may see an expansion of the SEC’s enforcement authority in the insider-trading arena. In December 2009, the SEC won an early skirmish in its first insider-trading case involving credit default swaps (“CDSs”) when Judge John Koeltl denied defendants’ motion for judgment on the pleadings in SEC v. Rorech.36 This case—along with the establishment of a new unit in the Enforcement Division focused on derivatives and new products—signals the SEC’s resolve to expand its horizon beyond the equities markets and into more complex products. The SEC brought its insider-trading claim in this case in May 2009 against Renato Negrin, a former hedge fund portfolio manager, and Jon-Paul Rorech, a salesman at Deutsche Bank Securities, Inc. The SEC alleged that the defendants had engaged in insider trading in the CDSs of VNU N.C., a Dutch media conglomerate that owns Nielsen Media and other companies. According to the complaint, Rorech learned from investment bankers at Deutsche Bank, which was serving as lead underwriter for a proposed bond offering by VNU, about a change to the structure of the offering that was expected to increase the price of the CDSs on VNU bonds. Rorech allegedly tipped Negrin about the contemplated change, and Negrin then purchased CDSs on VNU for the fund. Following the public announcement of the restructured offering, the price of VNU CDSs increased, earning the fund a $1.2 million profit.
In August 2009, both defendants moved to dismiss the SEC’s complaint on the pleadings, arguing, most notably, that Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) did not provide the SEC with the authority to regulate the CDSs at issue because they were not “securities-based swap agreements.”37 Specifically, the defendants argued that because the price term in the CDS contracts specified a particular number (383 basis points), and did not instead refer to the price, yield, value, or volatility of the underlying securities (in this case, bonds), the price of the CDSs could not have been “based on” those characteristics of the securities.
In denying the defendant’s motion, Judge Koeltl acknowledged that the face of CDS contracts did not reveal whether a material term of the CDSs was “based on” a security. He added, however, that “it cannot be that traders can escape the ambit of Section 10(b) and Rule 10b-5 by basing a CDS’s material term on a security, but simply omitting reference to the security from the text of the CDS contract.” The defendants conceded that the CDSs at issue could be bought and sold on the secondary market, and therefore, according to Judge Koeltl, the amount at which they could be bought and sold would “‘normally’ be described as the ‘price’ of the instrument.” The court found that whether the price of the CDSs was actually based on the value of the underlying bond presented a question of fact that could not be resolved at that stage of the proceedings.
Just what facts will prove dispositive on the issue of whether the CDSs at issue fall under the prohibitions of Section 10(b) and Rule 10b-5 remains to be seen. What is clear from Judge Koeltl’s decision is that courts will take a flexible approach in determining whether novel financial instruments are securities and look to “the ‘economic reality’ of the instruments and the public’s expectations of their nature.” This, in turn, may embolden the SEC to bring similar cases seeking to expand the scope of its enforcement authority in this area.
SEC v. Cuban
Another high-profile insider-trading case on appeal to the Fifth Circuit calls into question the scope of the SEC’s ability to bring such cases under the so-called “misappropriation theory.” In July 2009, a federal district court in the Northern District of Texas dismissed the SEC’s insider-trading case against Dallas Mavericks owner Mark Cuban involving his sale of 600,000 shares of Mamma.com stock after he was advised by the company’s CEO of the company’s efforts to raise capital through a PIPE offering.38
Under the misappropriation theory, which the Supreme Court adopted in United States v. O’Hagan, a person violates Section 10(b) of the Exchange Act and Rule 10b-5 when he “misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”39 Rule 10b5-2, adopted by the SEC in 2000, delineates certain circumstances giving rise to a “duty of trust or confidence” for purposes of the misappropriation theory,” including “[w]henever a person agrees to maintain information in confidence.”
In its complaint, the SEC had alleged that Cuban misappropriated confidential information when he sold Mamma.com stock after agreeing to maintain the confidentiality of the material nonpublic information about the offering. The court disagreed that this was sufficient to constitute insider trading under the misappropriation theory, rejecting the SEC’s long-held position, as reflected in Rule 10b5-2, that third parties who agree to accept nonpublic information on a confidential basis may not trade on the information. The court reasoned that, while the SEC adequately pled that Cuban entered into a confidentiality agreement (a point that Cuban disputed), it did not allege that he agreed to refrain from trading on, or using for his own benefit, the information the CEO was about to share and, therefore, there was no “deception”.
A ruling in favor of Cuban could impede the SEC’s ability to bring similar cases in the future, though its potential impact should not be overstated given its limited precedential value outside of the Fifth Circuit. The case does suggest, however, that companies interested in sharing information with potential investors will need to be specific if they do not want the recipient of the information to trade.
Merck & Co., Inc. v. Reynolds
In the case of Merck & Co., Inc. v. Reynolds (08-905), the Supreme Court will decide whether the two-year statute of limitations period to bring a lawsuit under the Exchange Act begins when the plaintiff has obtained knowledge that the defendant acted with the intent to defraud, or simply when the plaintiff obtained general knowledge of facts pointing to potential fraud. The statute provides, in relevant part, that a complaint alleging “fraud, deceit, manipulation, or contrivance” under the Exchange Act “may be brought not later than the earlier of . . . 2 years after the discovery of the facts constituting the violation or . . . 5 years after such violation.”40
Purchasers of Merck stock initially brought the action in November 2003 in the District of New Jersey alleging that the company had misrepresented the safety risks and commercial viability of its anti-inflammatory painkiller Vioxx. The suit followed an October 2003 article published in The Wall Street Journal describing the results of a study that found an increased incidence of heart attack associated with the use of Vioxx. Merck moved to dismiss the claim as time-barred, arguing that the plaintiffs were on “inquiry notice” of the claim before November 2001 (and thus outside of the two-year statute of limitations period). Specifically, Merck cited a September 2001 warning letter from the FDA to Merck stating that the company’s marketing of Vioxx had been misleading, as it had downplayed the risks of heart attack associated with the drug. The warning was covered extensively by the media and investment analysts at the time.
The district court granted the motion, but the Third Circuit reversed on appeal, holding that the statute of limitations did not begin to run until the plaintiffs had knowledge of facts suggesting that Merck had acted with scienter. The Third Circuit found that prior to November 2001, the plaintiffs lacked sufficient knowledge of the facts constituting their claim. Publication of the FDA’s warning letter had little effect on the market, according to the court, with Merck’s stock price falling briefly following its publication, then quickly rebounding, as investors and analysts remained bullish on the future of Vioxx. On the other hand, according to the Third Circuit’s decision, the study published in 2003 was sufficient notice to investors that Merck had fraudulently marketed the drug. The holding—that, under the “inquiry notice” standard applicable to federal securities claims, the statute of limitations does not begin to run until the plaintiff has evidence of scienter—is in accord with the Ninth Circuit, but departs from other courts of appeals, which have adopted the more stringent standard.
The Supreme Court heard oral argument on Dec. 1, 2009. How it resolves this question of statutory construction could have significant implications for defendants’ ability to defeat claims on statute of limitations grounds. The Court’s adoption of the more stringent standard also might encourage plaintiffs to bring actions earlier in order to avoid dismissal.
Jones v. Harris Associates
The Supreme Court’s pending decision in Jones v. Harris Associates (08-586), argued in November 2009, could have broad implications for fund industry participants and the question as to what constitutes “excessive” advisory fees under the Investment Company Act of 1940 (“ICA”). The petitioners—shareholders in several mutual funds formed and advised by Harris—brought a claim in federal district court alleging that the company breached its fiduciary duty to the shareholders under Section 36(b) of the ICA by charging them “excessive” fees and failing to provide material facts relating to compensation to the funds’ board members and shareholders.
The district court rejected that claim, relying on the bedrock 1982 decision in Gartenberg v. Merrill Lynch Asset Management, Inc.,41 in which the Second Circuit held that a breach of fiduciary duty occurs only when an adviser “charge[s] a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” In granting Harris’s motion for summary judgment, the court concluded that because the fees paid by petitioners were comparable to those paid by other mutual funds, no breach of fiduciary duty for purposes of Section 36(b) had occurred.
On appeal, the Seventh Circuit affirmed the district court’s decision but rejected the Gartenberg approach as relying “too little on markets.” Because there was no evidence that Harris had misled the mutual fund’s board about the facts material to its decision, the court held, the board’s approval of the fee precluded any claim that the advisor had breached its fiduciary duty.
At oral argument before the Supreme Court in November, the parties—as well as the United States, which filed an amicus brief—generally agreed (in line with Gartenberg) that under Section 36(b), an advisory fee should fall within a range of fees that could result from arm’s-length negotiations, but disagreed on how to apply that standard. According to the petitioners, the best gauge of whether the fee was excessive was to compare it to the fees the advisor charged to its institutional clients. The respondents, on the other hand, pointed to the fact that the fee must be approved by independent members of the board, and that Congress, noting this, did not intend to put courts in the position of effectively reviewing the fees de novo. The respondents added that, even if the Seventh Circuit had applied the wrong test, it was inappropriate to compare the fee to non-mutual fund fees because of the different and more extensive services provided to mutual funds. The United States, for its part, endorsed the existing Gartenberg approach, acknowledging the role of the courts as an additional check on advisor compensation.
It is difficult to predict how this case will be decided. While it appears the Court does not have a majority of votes to adopt the Seventh Circuit’s market-based approach, neither is it eager to place the judiciary in the position of making fee determinations. Regardless, the decision may offer broader lessons on how the courts might go about evaluating claims of excessive compensation, currently a hot-button issue.
Morrison et al. v. National Australia Bank Ltd.
In November 2009, the Supreme Court agreed to hear its first “foreign-cubed” case (i.e., where (1) foreign plaintiffs (2) sue a foreign issuer in a U.S. court for (3) violations of the anti-fraud provisions of the U.S. securities laws, based on securities transactions in a foreign country). In Morrison v. National Australia Bank Ltd. (08-1191), the central issue facing the Court is what standard to use to determine whether or not there is a sufficient nexus with the U.S. to support jurisdiction over a private claim of transnational securities fraud.
The plaintiffs in Morrison were foreign shareholders of National Australia Bank (“NAB”), an Australian corporation, who sued NAB for allegedly defrauding its shareholders by overvaluing the mortgage holdings in its wholly owned subsidiary HomeSide Lending Inc. (“HomeSide”), a Florida-based corporation. The plaintiffs contended that the fraud primarily occurred in Florida because, among other things, HomeSide was located there and the false numbers at issue were created there. The district court disagreed and dismissed the action for lack of subject matter jurisdiction, finding that HomeSide’s conduct “amounted to, at most, a link in the chain of a scheme that culminated abroad.”42
The Second Circuit affirmed that decision,43 holding that the appropriate test for subject matter jurisdiction is whether the “activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad.” Stated another way, the issue “boils down to what conduct comprises the heart of the alleged fraud.” Applying that standard, the court concluded that NAB’s actions and omissions (e.g., overseeing operations, including those of its subsidiaries; and reporting to shareholders and the financial community) were “significantly more central to the fraud and more directly responsible for the harm to investors than the manipulation of the numbers in Florida.”
The Supreme Court’s decision could resolve the conflict among circuits as to the standard for determining whether there is a sufficient connection to the US to permit a private action under Rule 10b-5 in transnational fraud cases. The District of Columbia Circuit, for example, has held that jurisdiction will not be met unless all elements of the alleged fraud occurred domestically. The Third, Eighth and Ninth Circuits require only “some activity designed to further a fraudulent scheme.”
Where the Supreme Court comes out on this issue holds great interest for the business community, given the increasingly transnational nature of our economy.