Bohai Oil Spills: CNOOC’s Motion to Dismiss Survives Second Circuit Scrutiny 

In Sinay v. CNOOC Ltd., No. 13‒2240, 2014 WL 350055 (2d Cir. Feb. 3 2014), the Second Circuit affirmed the district court’s dismissal of a putative class action for failure to plead scienter with particularity.

A putative class alleged that CNOOC Ltd. (Defendant) made false and fraudulent statements to investors relating to: (i) the safety of an oilfield it owned and developed with another oil producer and (ii) two major oil spills off the northeastern coast of China. The class brought claims under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b‒5 of the Exchange Act. Prior to the oil spills, Defendant lauded its commitment to safety in multiple press statements. After the spills, Defendant reassured investors that it and its partner had the spills under control. At the trial-court level, Defendant moved to dismiss both claims. The district court granted the motion to dismiss, finding that the class had not adequately pleaded scienter.

The Private Securities Litigation Reform Act requires that parties bringing securities fraud claims plead facts that “giv[e] rise to a strong inference that the defendant acted with the required state of mind.” This may be shown by pleading facts that the defendant had “motive and opportunity,” or that there was “circumstantial evidence of conscious misbehavior or recklessness.”

On appeal, the class argued that the district court erred in concluding that the facts as pleaded did not show Defendant “must have known” of the falsity of its statements—which would have satisfied the scienter requirement. Specifically, the class pointed to a State Oceanic Administration Report that found the spills were derivative of “flaws in the system and management” and Defendant’s partner’s violation of a development plan.

In affirming the district court’s finding, the Second Circuit agreed that the report was insufficient to meet the required pleading standards. The court held that, even if the report was true, the facts did not “establish a ‘strong inference’ of scienter.” Simply, the facts as pleaded did not establish that the problems that caused the spills were “so obvious” that Defendant must have been aware of them. 

Based on the facts pleaded, the court was left with no choice but to affirm the lower court’s dismissal of the putative class action.

The primary materials for this case may be found on the DU Corporate Governance website.    


WM High Yield Fund v. O’Hanlon: Court grants Motion for Summary Judgment dismissing securities fraud claims, including claims under scheme liability

In WM High Yield Fund v. O’Hanlon, No. 04-3423, 2013 BL 172104 (E.D. Pa. June 23, 2013), the United States District Court for the Eastern District of Pennsylvania granted a Motion for Summary Judgment for failure to provide evidence of deceptive conduct or investor reliance under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”).

According to the allegations, Defendant Matthew Colasanti (“Colasanti”) was an internal consultant who managed the loan workout group for Diagnostic Ventures, Inc. (“DVI”), a financial services firm operating in twenty countries. Plaintiffs are six institutional funds that invested in DVI debt securities through the New York Stock Exchange from August 10, 1999 to August 13, 2003. On August 13, 2003, DVI filed for Chapter 11 bankruptcy protection, DVI was subsequently delisted, and the debt securities lost substantially all of their value.  

The DVI loan workout group was responsible for recovering on delinquent loans made by the company. Colasanti, among others at DVI, approved accruals of income on delinquent loans for the DVI financial statements. Colasanti was not a member of DVI’s Board of Directors, did not otherwise participate in any of DVI’s accounting or financial reporting, and did not sign any of DVI’s public filings.

Plaintiffs’ complaint averred that Colasanti, in conjunction with other DVI officers and directors, intentionally deceived investors by overstating DVI’s earnings to artificially inflate the market price of DVI securities in violation of Section 10(b) of the Exchange Act and Rule 10b-5. Section 10(b) prohibits “any manipulative or deceptive device” in connection with the purchase or sale of a security. Rule 10b-5(b) specifically prohibits misleading statements. Subsections (c) and (a) make it unlawful to employ any “scheme” to defraud or engage in any conduct which operates as fraud. The Court had previously found that the complaint contained no averments of any misleading statements and therefore dismissed claims against Colasanti under Subsection (b) but left open the possibility of scheme liability under Subsections (a) and (c).

Plaintiffs alleged that Colasanti engaged in “actionable conduct.”  The Court, however, found that the allegations were insufficient to establish reliance, one of the elements of Rule 10b-5.  The allegedly deceptive conduct had not been specifically attributed to Colasanti.  As the Court noted:  “The record does not establish that the Plaintiff Funds knew about or otherwise relied on anything said or done by Colasanti at the time that they purchased or sold DVI’s securities.”   

Plaintiffs further contended that Colasanti owed a duty to disseminate accurate information about the company’s financial condition. An affirmative duty arises when there has been a misleading prior disclosure. However, Plaintiffs never pled an affirmative duty to disclose on the part of Colasanti. The Court commented that absent a duty to disclose, silence is not misleading under Rule 10b-5.

Because the record failed to provide triable disputes as to deceptive conduct or reliance on the alleged conduct by the Plaintiffs, the Defendant’s Motion for Summary Judgment was granted.

The primary materials for this post may be found on the DU Corporate Governance website.


Prime Mover v. Elixir Gaming Technologies: Fraud Claims Dismissed For “Implausibility”

In Prime Mover v. Elixir Gaming Technologies, the Prime Mover Capital Partners and Strata Fund (“Plaintiffs”) appealed the judgment granting Elixir Gaming Technologies’ (“Defendant”) motion to dismiss Plaintiffs’ Second Amended Complaint for failure to state a claim. 2013 BL 349784 (2d Cir. Dec. 18, 2013). The United Stated Court of Appeals for the Second Circuit affirmed the district court’s dismissal of Plaintiffs’ Second Amended Complaint.

Plaintiffs are hedge funds that invested in Defendant, which owned and placed electronic gaming machines in Asia. Plaintiffs alleged that Defendant overstated the number of electronic gaming machines it placed in Asia and represented that such placements were pursuant to binding agreements when in fact they were not. Plaintiffs further alleged that Defendant misled them into believing the electronic gaming machines were equipped with a software called CasinoLink that tracked data and prevented theft and that Defendants deceptively told them that each electronic gaming machine would produce $125 of daily profit.

To adequately plead securities fraud, a plaintiff must sufficiently allege loss causation or, put another way, allege that the misconduct by the defendant caused the plaintiff's economic harm. A plaintiff can adequately plead loss causation by showing that the security's value declined in response to a disclosure that corrected a defendant’s fraudulent statements.

Here, the court concluded that Plaintiffs’ allegations about the placement of the EGMs did not create a plausible inference that Defendant’s statements were false.  As a result, “any subsequent clarification of the number of operational EGMs did not constitute a ‘corrective disclosure’ for loss causation purposes because that clarification‘d[id] not reveal to the market the falsity of the prior [statements].’”, Nor was there loss causation with respect to the non-binding nature of the agreements since the complaint did not include allegations that the information had been “made public.” 

As for the allegations about the CasinoLink software, the court noted that the relevant disclosure did not “expressly reveal any information about the installation, or lack of installation” about the software.  The court therefore characterized Plaintiffs’ claims of “corrective disclosure” as “speculative and qualified.” 

Last, the court upheld the finding that Defendant’s projected $125 profit per day from each electronic gaming machine was forward looking and therefore protected by the safe harbor in the Private Securities Litigation Reform Act (“PSLRA”).  Plaintiffs did not sufficiently allege that Defendants had actual knowledge that their statements were false or misleading.

The court affirmed the decision of the district court, which found that Plaintiffs had inadequately pled loss causation.

The primary materials for this case may be found on the DU Corporate Governance Site.


In re L&L Energy Securities Litigation: Motion to Dismiss Amended Complaint Denied

In In re L&L Energy Securities Litigation, investors filed a class action lawsuit on behalf of all persons who bought L&L Energy common stock between August 13, 2009 and August 2, 2011 (“Plaintiffs”). No. C11-1423RSL, 2013 BL 335037 (W.D. Wash. Dec. 3, 2013). Plaintiffs filed a complaint against L&L Energy and individual defendants Dickson Lee (CEO), Jung Mei Wang (CFO 2009-2011), and Ian Robinson (CFO 2011) (collectively, “Defendants”). The complaint alleged that Defendants overstated the company’s revenues and misled the public regarding ownership of particular mines in China. The purported misrepresentations allegedly caused a decline in share price, resulting in damage to the Plaintiffs. The Defendants moved to dismiss the amended complaint and the motion was denied.

According to the complaint, L&L Energy, a U.S. coalmining corporation, operates related mining ventures in China through its subsidiaries. Plaintiffs alleged that Defendants falsely reported the company’s 2009, 2010, and 2011 consolidated revenue in each respective 10-K filing submitted to the SEC. Allegedly, Defendants did not have ownership or control over two of its claimed assets in China--the DaPuAn Mine and the SuTong Mine. According to the complaint, however, L&L Energy reported revenues from both mines. Purportedly, under Chinese law, legal ownership remained with the son and brother of the original mine owner, who died in 2008, not L&L Energy. Furthermore, Plaintiffs alleged that the individual defendants were aware that these reports were false at the time they were made and that defendants profited from the disposition of L&L stock during the class period.

“In order to state a claim under § 10b of the Exchange Act and Rule 10b-5 plaintiffs must allege: (1) a material misrepresentation (or omission), (2) made with scienter, (3) on which plaintiff relied, (4) that proximately caused (5) economic loss, (6) in connection with the purchase or sale of a security.” A complaint must “as to each act or omission alleged to violate the securities laws, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” To establish scienter, the plaintiff must allege that the defendant “engaged in knowing or intentional conduct.” Lastly, to substantiate a claim under the Private Securities Litigation Reform Act, a plaintiff must allege a causal connection between the defendant’s material misrepresentations and the plaintiff’s loss.

The court first determined that Plaintiffs had adequately alleged loss causation by identifying the three specific false or misleading financial statements. The court noted the publication of a 2011 report by Glaucus Research Group that compared L&L Energy with a larger Chinese competitor and found that L&L’s claims were “ridiculous” and “suspicious” in comparison. The effect of the report was sufficient to show causation. “The Glaucus Report can therefore be construed as a corrective disclosure regarding the allegedly false statements, the immediate effect of which was a significant drop in share price.” The court also determined that Plaintiffs sufficiently alleged particularized facts regarding the falsity of the statements in L&L Energy’s 2009, 2010, and 2011 10-Ks due to the misstatements over the ownership and control of the DaPuAn and SuTong Mines.

Accordingly, the court turned to the element of scienter to determine if these misrepresentations were committed knowingly or recklessly. In light of the significant business interest at stake regarding the revenue reported for the two mines, Plaintiffs argued that Defendants “must have known” that the statements were false due to their individual positions within the company.

Although defendants Lee and Robinson allegedly signed the 2009 10-K, the court found this insufficient to establish scienter. “Merely signing a financial statement does not necessarily give rise to a strong inference that the signer had knowledge of all of the underlying facts . . . .” On the other hand, scienter was adequately plead by allegations that gave rise to an inference that Mr. Lee “was involved in the day-to-day operations of L&L Energy and participated in the business deals related to the contested mines” was sufficient. There were, however, no similar indications “that Mr. Robinson was involved in the operations of the company, that he would have had any reason to suspect the continuing validity of the 2008 agreement and the 2009 supplemental agreements, or that he was familiar with Chinese corporate law.”    

Finally, the court addressed Section 20(a) of the Exchange Act, which “imposes secondary liability on persons who ‘control’ persons or entities that have violated the securities laws.” Plaintiffs argued that if the individual defendants had a supervisory role in the day-to-day operations of L&L Energy, then they were controlling persons under the Exchange Act. Defendants’ sole argument was that because there was no primary violation under Section 10b, there could be no violation under Section 20(a). Because the court had already found that the Section 10b claims could proceed, the court denied the motion to dismiss the control-person liability claims.

For the aforementioned reasons, the court denied the Defendants motion to dismiss the class action complaint.

The primary materials may be found on the DU's Corporate Governance Site.


Halliburton v. Erica P. John Fund: The Likely Reaffirmation of Basic (Fraud Insensitive Investors)

We are discussing the oral argument in Halliburton from Wednesday, March 5. The transcript is here. 

Perhaps one of the most unusual observations was by Justice Alito. He seemed to suggest that there were a meaningful number of investors who knew about the possibility of fraud but purchased the shares anyway.   

  • JUSTICE ALITO: I didn't understand what you just said. Are you saying there are not categories of investors who might say to themselves, "You know what? There is a possibility that the price of this stock on this particular day might be artificially inflated by some statement that was made in the past that isn't true, but I'm going to buy it anyway because I still think it's either, it's undervalued or because there are some other statistics regarding the market that tell me that this price is going to go up." You tell me that there are--there are not large categories of investors who think that way?  

There are no doubt investors of all stripes who acquire shares under every set of circumstances, not all of them rational. The group of investors posited by Justice Alito would either have to know the extent of the fraud, in which case there would be insider trading implications, or would have to believe the stock was undervalued absent any knowledge of the extent of the fraud.  

In those circumstances, there could be no way of knowning that the anticipated gain would exceed the fraud. What the investor would know, however, was that once the fraud was exposed, shares would likely fall. In other words, the strategy would amount to a gamble that any gain would be greater than the inevitable fall.  

Counsel for Respondent had this to say: 

  • MR. BOIES: I think there are not large categories of investors that think that way, and I think there is absolutely no empirical evidence at all that there are large categories of investors that think that way. Could there be somebody who says, "I know this is fraudulent, but I think I can buy; I know it's artificially inflated, but I think I can buy and ride it up and I can get out before the market knows that there is an artificial inflation." There might be somebody like that and that's why Basic provides for a rebuttable presumption. 

Experiences with companies such as Enron suggest that when the accuracy of the disclosure, particularly the financial disclosure, becomes uncertain because of fraud, the approach does not attract investors but drives them away.  


Halliburton v. Erica P. John Fund: The Likely Reaffirmation of Basic (Event Studies and Omissions)

We are discussing the oral argument in Halliburton from Wednesday, March 5. The transcript is here. What will happen if the Court essentially requires an event study to show that misrepresentations distorted the market price? Presumably it will require an event study for each alleged misrepresentation.   
  • MR. BOIES: You could, Your Honor, and with respect to December 7th, I think that would not be so difficult. But there are nine dates and with respect to five of those nine dates when there was news revealed, they claim confounding factors. So what you have to do is you have to separate out the confounding factors, the allegedly confounding factors, with respect to each one of those dates, and you've got to do a detailed event study and in addition­­--
  • JUSTICE KENNEDY:  For each one of--of-- ­­
  • MR. BOIES:  For each­­ for--each day--
  • JUSTICE KENNEDY:  --Oh, each day-- 
  • MR. BOIES: --you've got to look at what the confounding factors are and you have to try to separate them. That's very complicated. It takes a lot of time. It's very expensive. It's a lot of expert testimony. It is why these things, for example, at the summary judgment stage, are very complicated. Now, an event study that demonstrates the efficiency of the market is far simpler. Halliburton conceded the efficiency of this market. This is not a case in which there is any doubt about the efficiency of the market. Halliburton has repeatedly conceded the efficiency of this market. And I think that when you are trying to prove market efficiency, all you have to do is demonstrate that the basic premise that generally markets take into account, well­ developed markets, take into account publicly available news, and you can do that relatively simply. Trying to separate out all of the factors that you need to separate out in order to determine whether a culpable misrepresentation was the cause of a price change and how much of that price change was due to that culpable information is very complicated. All of that will add cost and complication.   

Nonetheless, the Respondent received a boost on this issue from the Government. The Government seemed to suggest that requiring event studies at the class certification stage would not be a big deal. Indeed, it was described as a "net gain" to investors.   

  • JUSTICE KENNEDY: Can you get to part two of Justice Kagan's question? Which is what is your view of  the ­­ of the consequences if we adopt the law professors' view? 
  • MR. STEWART: I understand the law professors, there were a few law professors' briefs. I understand the one you're referring to be the one that basically advocated a shift away from analyzing the general efficiency of the market and focusing only on the effect or lack of effect on the ­­ the particular stock. I don't think that the consequences would be nearly so dramatic. In fact if anything, that would be a net gain to plaintiffs, because plaintiffs already have to prove price impact at the end of the day.  

The discussion did not address how to show that an omission affected share prices. That can presumably be demonstrated at the time of corrective disclosure when the market learned the truth. But what about ab initio? The brief suggesting that event studies should be used focused on misrepresentations. See Amicus Brief of Law Professors, at 28 ("Event studies can examine market effects of particular affirmative misstatements by looking to the effect at the time of disclosure; in cases involving omissions, they can look to the date the information was corrected.").  


Halliburton v. Erica P. John Fund: The Likely Reaffirmation of Basic (The Costs of Showing Market Efficiency)

We are discussing the oral argument in Halliburton from Wednesday, March 5. The transcript is here

In assessing whether to require shareholders to show that the material misstatements were absorbed into the market price at class certification, rather than later as part of the merit determination process, Justice Kennedy focused on a proposal by law professors that shareholders be required to conduct an event study demonstrating the impact of the disclosure. Justice Kennedy wanted to know how involved such a requirement would be.    

  • JUSTICE KENNEDY: Can you tell me, based on your experience, compare the--the cost, the extent of time, the difficulty of showing under Basic the efficient--that there is an efficient market, and compare and contrast that with the undertaking of an event study? Is the latter much more costly, much more time consuming?

The response back from Respondent was that it would not impose significant additional burdens.

  • MR. STREETT: No, Your Honor. They're about the same. And, in fact, plaintiffs are commonly using event studies right now as part of their market efficiency showing, because one of the factors courts are requiring for market efficiency is showing a reaction between price and unexpected corporate information throughout the class period. So, in fact, they're running these events studies for the entire class period, where all our position would do is require them to look at the alleged misrepresentations in the case, that is to say what really matters, and look at whether they distorted the market price as opposed to --

That would have remained the answer in the record but for the intervention of the Chief Justice.  

  • CHIEF JUSTICE ROBERTS: Well, how hard is it to show that the New York Stock Exchange is an efficient market?
  • MR. STREETT: Well, the courts look at several factors. Now, admittedly, virtually all of the time, those lead to a finding of yes, but--­­
  • CHIEF JUSTICE ROBERTS: So I would think the event study they are talking about would be a lot more difficult and laborious to demonstrate than market efficiency in a typical case. 

To the extent that the Court imposes this requirement at the class certification stage, it will not be able to avoid the conclusion that at least in some cases the result will be a significant added expense for Plaintiffs.   


Halliburton v. Erica P. John Fund: The Likely Reaffirmation of Basic (Fraud on the Market and the PSLRA)

We are discussing the oral argument in Halliburton from Wednesday, March 5. The transcript is here

One of the key arguments in favor of preserving fraud on the market (and a factor not present when
Basic was decided) was, paradoxically, the adoption of the PSLRA and SLUSA, both actions designed to limit suits by investors. These statutes clearly assumed fraud on the market. Some of the Justices viewed this as effective ratification of the theory.    

  • JUSTICE GINSBURG: Whatever it might have been at the beginning, given the most recent legislation, Congress took a look at the 10(b)(5) action and it made a lot of changes. It made pleading requirements. It's difficult to say that this­­ Congress would have legislated all these constraints if it thought there was no action to begin with.  

Moreover, the Court in Amgen v. Connecticut Retirement Plan expressly stated that Congress effectively reaffirmed the fraud on the market theory when adopting the PSLRA. See Amgen (“While taking these steps to curb abusive securities-fraud lawsuits, Congress rejected calls to undo the fraud-on-the-market presumption of classwide reliance endorsed in Basic.”). The Amgen decision was by a vote of 6-3, with Justice Alito concurring and Justices Scalia, Thomas, and Kennedy dissenting.  

In Halliburton, however, Justice Alito (with help from Justice Scalia) appeared to retreat from this position. He noted specific language in the PSLRA regarding the impact on private rights of action. This exchange occurred during oral argument:   

  • JUSTICE ALITO: [W]hat do you make of Section 203 of the PSLRA, which says that "Nothing in this Act or the amendments made by this Act shall be deemed to create or ratify any implied private right of action"? Do you think that was ratification of Basic  
  • MR. BOIES: Well, Your Honor, what this Court said in Amgen afterwards is that what the [sic] what Congress did was it did ratify the private cause of action. And whether that was right or wrong, that is what this Court held in Amgen just a year or so ago. 
  • JUSTICE SCALIA: Did we refer to Section 203--
  • MR. BOIES: You did not. 
  • JUSTICE SCALIA: --in connection with that dictum?
  • MR. BOIES: I do not I do not believe that you did, Your Honor. 
  • JUSTICE SCALIA: I think maybe we didn't know about it, as the parties here seemingly did not know about it. I don't think it was cited in the briefs. 
  • MR. BOIES: But whether or not you conclude that that was ratified or not, Your Honor, I think what--what you must conclude is that when Congress acted both with respect to the PSLRA and even more  so with respect to SLUSA, it acted on the assumption that they were legislating on the backdrop of the fraud­on ­the ­market theory. The SLUSA ­­decision the SLUSA legislation makes no sense without the fraud on the market.  
  • JUSTICE SCALIA: Of course. But--but to act on the assumption that the courts are going to do what they’ve  been doing is quite different from approving what the courts have been doing. As I understand the history of these things, there was one side that wanted to overrule Basic and the other side that wanted to endorse Basic, and they did neither one. They simply enacted a law that   assumed that the courts were going to continue Basic. I don't see that that is--is necessarily a   ratification of it. It's just an acknowledgment of reality.    
  • MR. BOIES: I think, obviously, the Court will decide. But I think that when you look at what Congress has done, and they have legislated based on the assumption of what the law is and they   have made a decision that, as I think the Court recognizes, would never have been made in SLUSA if--if they did not ­­if Congress did not believe that the fraud ­on ­the ­market theory exists. 

So for these Justices, the adoption of the PSLRA (and the reasoning in Amgen) does not appear to be a barrier to overturning the fraud on the market theory.  


Halliburton v. Erica P. John Fund: The Likely Reaffirmation of Basic (One way or Another)

The current Supreme Court has a fascination with all things surrounding Rule 10b-5. The Court has taken more cases in this area in a short period of time than any other. Moreover, the opinions sometimes reflect wild swings. 

In  some instances, the Court made decisions that were almost liberal in their interpretation of the anti-fraud provision. In a couple of cases, however, a majority of Justices announced a strong dislike for the Rule, particularly the existence of a private right of action. While not willing to entirely upend the private right of action, this cluster of Justices decreed that the reach of the provision would no longer be "expanded" and promised something approaching a scorched earth approach to future efforts to do so. Janus is perhaps the best example of this type of opinion. 

The approach meant that every time the Court took another case interpreting the Rule (or the class certification requirements for the Rule), there was a fear that the scorched earth majority would take the opportunity to further rewrite and narrow the provision. But truth be told, that scorched earth majority has rarely shown up. If anything, the general approach by the Court to cases in this area has been very functional, well within the realm of stare decisis, and, as such an approach would suggest, has resulted in decisions that sometimes narrow but sometimes even broaden the scope of actions under Rule 10b-5. 

Matrixx, for example, was a case that had the potential to rewrite the standard for materiality. Instead, the majority reaffirmed the traditional test in Basic. In Tellabs, the Court had a chance to use the PSLRA to restrict the standards for fraud suits under the securities laws through a narrow interpretation of the scienter pleading requirement but instead adopted a largely benign interpretation. Amgen, Merck, and Chadbourne were out and out shareholder/investor victories.

All of this suggests that the scorched earth majority doesn’t really exist, at least in any meaningful sense. That’s not to say that a majority can’t sometimes come together and, lacking any ameliorating influence of moderates, interpret the requirements of Rule 10b-5 in a harsh way. But by all appearances, this is only a significant risk where there is little direct Supreme Court authority on the particular matter at issue. Where precedent exists, the proclivity of the Court in the 10b-5 area is to modify around the edges but otherwise leave precedent in place.  

All of this brings us back to Halliburton. Oral arguments were on Wednesday, March 5. The transcript is here

Halliburton has raised alarms because it involves a frontal assault on a traditional element of Rule 10b-5, the "fraud on the market" presumption of reliance. To overturn that standard, however, the Court would have to reverse Basic and impose an actual reliance standard. Repondents have asked for this. See Transcript ("Basic v. Levinson should be overruled  because it was wrong when it was decided and it is even more clearly clearly erroneous today. Basic substitutes economic theory for the bedrock common law requirement of actual reliance that Congress embraced in the most analogous express cause of action.").   

Nonetheless, the scorched earth approach to Rule 10b-5 is not likely to find majority support in this case. While predicting an outcome is not easy from oral argument, it seems that the Court as a whole has little appetite for doing what Respondents asked. Instead, the Court will take one of two approaches. Either the majority will basically reaffirm the fraud on the market standard in Basic--perhaps with a few tweaks--and some of the Justices (mostly likely Justices Scalia and Alito and perhaps Justice Thomas) will dissent, arguing for an actual reliance standard.   

Alternatively, a majority will find that the impact on the market of any alleged misrepresentation can be raised at the class certification stage. This will effectively force shareholders to conduct event studies to show that the alleged misrepresentations in fact influenced share prices. This will also likely engender a dissent, this time from at least some of the moderates (most likely Justice Sotomayor) who will object to the transformation of the class certification process into a merits determination.    

What's our guess?  Amgen saw a dissent from Justices Thomas, Kennedy, and Scalia. These three, therefore, had few qualms about turning class certification into a merits determination. In the same case, Justice Alito concurred. These four Justices will likely support requiring plaintiffs, in order to show reliance, to establish at the class certification stage that the market was affected by the alleged misstatement. To the extent that the four moderates see it the other way (they were all in the majority in Amgen), the Chief Justice will be the deciding vote.  

We will add some additional observations about oral arguments in the next few posts. 


Chadbourne & Parke v. Troice: A Haliburton Preview?  

Yesterday, the Court issued a case interpreting SLUSA.  The case, Chadbourne & Parke v. Troice, arose out of the fraud involving Allen Stanford.  By a vote of 7-2, the Court found that SLUSA did not preempt class actions brought under state law against a cluster of tertiary players, including law firms, insurance brokers and persons who allegedly provided "Stanford-related companies with trust, insurance, accounting, or reporting services."

From an investor perspective, this was a victory.  SLUSA generally cuts off actions at state court that would be difficult to bring at the federal level.  Moreover, Justice Breyer, the author of the opinion, noted that an alternative outcome would have interfered with state efforts to prevent fraud.   

  • to interpret the necessary statutory "connection" more broadly than we do here would interfere with state efforts to provide remedies for victims of ordinary state law frauds. A broader interpretation would allow   Act to cover, and thereby to prohibit, a lawsuit brought by creditors of a small business that falsely represented it was credit worthy, in part because it owns or intends to own exchange-traded stock. It could prohibit a lawsuit brought by homeowners against a mortgage broker for lying about the interest rates on their mortgages—if, say, the broker (not the homeowners) later sold the mortgages to a bank which then securitized them in a pooland sold off pieces as "covered securities.".

Intriguingly, however, the dissent written by Justice Kennedy (and joined by Justice Alito) pitched themselves as the true friends of investors. 

The narrow legal issue was whether the class actions involved "misrepresentation or omission of amaterial fact in connection with the purchase or sale of a covered security." §78bb(f)(1)(A).  Covered securities include those traded on a national stock exchange.  See15 USC §78bb(f)(5)(E).   The securities at issue were certificates of deposit and therefore not "covered securities"   Ordinarily that would be the end of the analysis. 

The alleged misrepresentations, however, touched on covered securities.  As the Court described:   

  • But each complaint in one way or another alleged that the fraud included misrepresentations that the Bank maintained significant holdings in "‘highly marketable securities issued by stable governments [and] strong multinational companies,’" and that the Bank’s ownership of these "covered" securities made investments in the uncovered certificates more secure.

The Court, therefore, had to decide whether the "in connection with" language extended to misstatements about covered securities when the investors were otherwise purchasing uncovered securities.  The majority said it did not.  The majority mostly relied on the statute and the intent of Congress.  The Court also, however, addressed the line of cases that held the "in connection with" language should be broadly construed and found that they did not interfere with its interpretation of SLUSA. 

The government and the dissent saw it otherwise.  Tthe government warned that "a narrow interpretation of 'in connection with' here threatens a similarly narrow interpretation there [under Rule 10b-5], which could limit the SEC’s enforcement capabilities." The dissent, written by Justice Kennedy (and joined by Justice Alito) had this to say about the majority opinion:

  • And, as a consequence, today’s decision, to a serious degree, narrows and constricts essential protection for our national securities markets, protection vital for their strength and integrity. The result will be a lessened confidence in the market, a force for instability that should otherwise be countered by the proper interpretation of federal securities laws and regulations.

The bottom line is that the majority does arguably narrow the reach of "in connection with" under Rule 10b-5.  In doing so, however, it frees a significant number of plaintiffs who want to bring actions under state law.  Moreover, the "narrowing" appears shall we say, academic.  The majority noted that "despite the Government’s and the dissent’s handwringing, neither has been able to point to an example of any prior SEC enforcement action brought during the past 80 years that our holding today would have prevented the SEC from bringing."  So its a narrowing without any actual effect. 

Most importantly, however, the language used by Justice Kennedy in dissent suggests that he recognizes the need for broad language under Rule 10b-5 as a means of ensuring the integrity of the securities markets.  Since he is a likely 5th vote in Haliburton, this may suggest that he will not favor a repeal of the "fraud on the market" theory of reliance.  This would, however, be a significant change.  Justice Kennedy has been very hostile to private actions under Rule 10b-5 (one need only read Stoneridge to see an example).  So perhaps the decision in Haliburton will clarify whether Justice Kennedy really is the friend of investors that he claims in this case.       


Another Teaching Moment: Facebook, WhatsApp and Liquid Capital Markets

Teaching moments abound these days.

In teaching corporations or securities, there is always a certain amount of black letter law to cover (with large doses of judicial interpretation).  But in relating what students learn to what actually goes on in the real world, there needs to be discussions about the capital markets and the capital raising process.

This always leads to a discussion about the unique nature of the markets in the U.S.  They are deeper and more efficient than any other in the world.  The truly unique strength can be seen from the ability of the capital markets to fund the next generation of innovative companies.  This is harder than it sounds.  A disruptive technology or a novel strategy may ultimately prevail but there is no way to know which one will be the one to do so.  As a result, capital has to be available to thousands of companies, with most failing and most investments lost.  But out of the debris a new generation of companies will arise.

So what makes this happen?  Some of it is likely that U.S. investors often have, as a matter of culture, a higher tolerance for risk.  As a result, they are more willing to part with their hard earned funds to invest in risky ventures.  But the other part of the equation is that there has to be a possibility of a payoff that, if successful, provides incredible wealth.    

Under this system of risk taking and rich rewards, private equity trolls for appropriate investments. Sometimes they will be wrong and either lose their investment or obtain sub-par returns.  If a few are successful, however, private equity will be repaid multiples of their investment.  Private equity, however, eventually wants to cash out.  The company can be sold or engage in a public offering.  

If the company goes public, it can raise prodigious amounts of capital on a good story, even if it is unprofitable or barely profitable.  Investors will buy shares hoping that the story will come true.  Often it doesn't.  But when it does, the returns can be extraordinary.  Google went public at $85 with a good story.  Today its trading at around $1200.  

The system, therefore, thrives on uncertainty, risk and the promise of huge returns.  All of which brings up back to the acquisition of WhatsApp.  The transaction involved a $19 billion acquisition of a five year old company with 50 employees.  The sole private equity firm in the company invested $60 million and will receive somewhere around $2.5 billion for its interest, or a return between 40 and 50 fold.  

Whether another transaction of this nature will emerge anytime soon is unclear.  Nonetheless, the message to the capital markets and entrepreneurs is very clear.  Those with good ideas can form a business and in a relatively short time become rich.  Private equity firms, if they pick right, can make unheard of multiples of their investments.  

As a result, smart individuals with interesting ideas are, right now, throwing away their applications to law school or that phd program in political science and starting a small business.  Private equity firms are redoubling their efforts to find the next WhatsApp making it easier and easier for these start ups to raise the necessary seed capital.  Pension plans and other institutional investors are throwing money at private equity firms, looking for a WhatsApp level of return.

In short, whatever happens to WhatsApp in its relationship with Facebook, the most profound impact has been its sale and the message it is sending to entrepreneurs and intermediaries in the capital raising process. There is some Steve Jobs or Bill Gates or Jan Koum that, but for that acquisition, would have done something entirely different but is now about to form a company that will dominate its industry sometime over the next five to ten years. 


Securities Class Action Law Suits: 2013 Edition

The statistics on securities class action suits are in for 2013 and, according to NERA, there were some interesting shifts.  The total number of cases was more or less stable, at 234.  This was a slight increase from 2012 (213 actions) but consistent with the overall number since 2008 (245 in 2008; 207 in 2009; 232 in 2010; 225 in 2011; 213 in 2012).  

The interesting thing to note is that the numbers remained stable during a period of significant stock market volatility.  Thus, the numbers did not change much whether the market was going up or down. Given the amount of work that must now be done to prepare a securities class action law suit, this potentially indicates a plateau of capacity on the plaintiffs side.  

This is also suggested by the mix of cases.  Foreign companies were sued 35 times in 2013, with almost half (16) involving Chinese companies.  This was down from 62 cases against foreign companies in 2011. Thus, either 2011 had less detectable domestic fraud and 2013 had more--or firms have a capacity to bring a certain number of cases, irrespective of the particular mix.    

At the same time, average "ordinary" settlements (excluding, for example, the $2.4 billion settlement by BofA) rose a significant 53% to $55 million, but the median took a substantial dip of 26% to $9.1 million.  The difference arose from the number of large settlements (there were 9 that exceeded $100 million).  Indeed, 51% of the settlements were below $10 million.  Thus, the report described 2013 as "a year in which large settlements got larger and small settlements got smaller."  

The study does not separate out the settlements by law firms.  Thus, it is unclear whether the industry is dividing itself into firms that bring large suits, something more resource intensive, and firms that bring smaller suits or whether each firm does a balance of large and small cases.  There is at least a possibility, therefore, that firms are dividing into the haves and the have nots.  

The data also provided some insight into the percentage of cases dismissed on motion since 2000. According to the report, motions to dismiss were filed in 95% of the cases.  In 20% of those instances, there was no resolution (cases were settled or withdrawn).  Where there was a court determination, however, almost half (48%) of the motions were granted.  In addition, 25% were granted in part and only 21% were denied.

Moreover, the dismissal rate has been increasing.  As the report stated: 

  • Dismissal rates have increased from 32%-36% for cases filed in 2000-2002 to 43%-47% for cases filed in 2004-2006. Remembering the caveat above, dismissal rates appear to have continued to increase, given that 44%-51% of cases filed in 2007-2009 have been dismissed.  

The increase in dismissals also coincides with a decline in the number of suits that allege both fraud and insider sales.  In 2005, allegations of insider sales occurred in 48.6% of the cases, a number that had fallen to 25.2% in 2013.  Since insider sales are generally used as evidence of scienter, one possible explanation for the increase in the number of dismissals is that, absent allegations of insider sales, efforts to establish a "strong inference" of scienter is more difficult.  

The apparent stability could change.  In the past, a precipitous drop in the market had the potential to cause an upswing in the number of suits.  That, however, may be less likely.  While the financial crisis struck at the end of 2008, securities class actions actually fell in 2009 (to 207).  Moreover, the slight increase in suits filed in 2013 occurred in a year when the market was up around 25%.  

Change could, however, result for the Supreme Court's determination to revisit fraud in the market. With scienter already substantially harder to allege as a result of the PSLRA, the Supreme Court could effectively do the same thing to the reliance element.  If that happens, the number of cases will most likely fall.   

The full NERA report is here.   


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 5B)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

In dismissing the claim by Red Oak that the election was unfair because of its lack of knowledge about Digirad's treasury shares, the court put a great deal of weight on the fact that the error was unintentional.  Id. ("As Red Oak conceded, the voting was "accidental[],'" and no evidence contradicts this conclusion."). 

What the court did not do was give any weight to the unusual nature of the error and the fact that it was caused by, and provided an advantage to, the company.  Nor did the court put any weight on the fact that there were plenty of ways to remedy the problem short of selective disclosure to Red Oak.

First, the fact that Digirad had a large block of shares in a street name account was viewed by its own solicitor as something he "would never have expected to see."   See Transcript, at 162 ("In this particular case--first of all, the fact that treasury shares were in street name was something that I would never have expected to see.  So it's something that I never would just assume were there or assume that to be true."). 

Second, the voting error was made by the Digirad.  It was ultimately the result of an accidental decision by an accounting manager.  Nevertheless, the error was company induced.  Moreover there was at least some opportunity to prevent the errant vote.  Before voting the shares, the account manager sent an email to the CFO asking about the reason for the request.  See Id. n. 45 ("On April 22, [the employee] emailed [the CFO] to check and see if he knew why [the employee] might have received the email").  The CFO "did not recall receiving the email" and testified that he was "extremely busy" during the relevant time period.

Third, and most importantly, the problem could have been fixed.  The Digirad could have simply changed the vote from favoring management to abstain.  The following colloquy occurred at the trial:  

  • Digirad Solicitor:  You can't call Broadridge and tell them "I don't want to vote anymore," or "I choose not to vote." At least it's my experience. So you can't unvote a proxy.
  • THE COURT: So you can't change your vote to abstain?
  • THE WITNESS: You can change your vote, but you cannot unvote.
  • THE COURT: Well, wouldn't changing a vote to abstain have the same effect?
  • THE WITNESS: It potentially could.  But even during--if that were the case, and if that was a course of action that I thought needed to be taken, there would not have been a person at Raymond James that I would have contacted to execute that vote. Because at that time, there wasn't--there was no knowledge of who at Raymond James or who anywhere had voting authority over those shares.  Transcript, 163-164. 

Had the votes been changed to "abstain," the preliminary voting data would presumably have shown a 6% decline in support for management, eliminating the informational asymmetry that the company caused.

Fourth, the company could have simply disclosed the location of the treasury shares to Red Oak's solicitor.  The decision to hold treasury shares in a street name account was, as the record indicated, unusual.  Presumably the solicitor for Red Oak, had he known the location of the treasury shares, could have--like the solicitor for Digirad--figured out that the shares had been voted.  Moreover, the Red Oak solicitor asked at least twice, including during the time period when Digirad was figuring out the matter. 

Fifth, the company could have informed Broadridge.  The issue came up in the hearing during the testimony of the proxy solicitor for Digirad.

  • Q. You did not tell Broadridge that Broadridge was counting shares that were ineligible, did you? 
  • A. Broadridge would have had nothing to do with that. 
  • Q. You didn't tell them, did you? 
  • A. No. Broadridge will only report a vote on share positions for their clients who are the banks and brokers based on what those banks and brokers report.  So if Raymond James tells Broadridge that they have 1.3 million shares, telling Broadridge that those 1.3 million shares, or a million of those shares, whatever the number is, is not the correct way, and would not lead to resolving the problem in any way.  Transcript, 190-191. 

Perhaps.  Broadridge is dealing with a high volume process when tabulating voting instructions.  The record does not indicate that Broadridge had a system for correcting erroneous tallies.  Yet Digirad could have requested that Broadridge include a note on the tally that there was a dispute as to the votes cast by Raymond James because of the belief that they were treasury shares.  In that case, anyone receiving the tally would have been alerted to the dispute.  Whether Broadridge could have done this is unclear because the company did not try. 

Sixth, the reliance on the "speculative" nature of the information is cramped and conflicts with the record.  To the extent material (which the court did not dispute), the ability of a significant error to impact a shareholder engaging in a solicitation seems common sense.  Moreover, it was the testimony. 

  • Red Oak:  Well, there's a cost benefit. We run a business. This is one of many companies that we're invested into. And again it's a fluid process. If we are winning by 50 percent, we're probably not going to spend a heck of a lot of time soliciting. If we're losing by 50 percent, we're probably not going to spend a heck of a lot of time soliciting. But we make the judgments based on where we are in the election, what votes we think we can sway, and it's a cost benefit. Transcript, at 24. 
  • We didn't give the solicitor the full green light to call every shareholder five times. And that's not uncommon. We may say, "Call everyone. Find me another couple percent." We may say certain shareholders that we, frankly, didn't chase down after the fact, including [shareholder], who had flip flopped, and, frankly, was fairly--seemed to be wavering a fair bit from our perspective. We didn't chase them down because even if we won them, that doesn't make up the 12 percent. So, yeah, it had an impact.  Transcript, at 33-34. 

Red Oak called the information a "game changer."  Transcript, at 51.  As Red Oak explained: 

  • A. As I mentioned earlier, 12 percent--when we assessed what votes we thought we could bring our way, 12 percent at that stage seemed an unrealistic hurdle. 6 percent is entirely different.  6 percent means we only had to change votes of 3 percent or just achieve 6 percent in total.  A whole new slew of options would become available to us. I could go to the solicitor and say, "Make those calls. We held back. We didn't go for quite the same iterations of calls for shareholders. Let's make them. Get me 250 or 500,000 more votes."  Transcript, at p. 52

The testimony was also quite specific about the steps Red Oak might have taken. 

  • Red Oak:  Ensign Peak [a shareholder] we didn't chase down. We were of the belief--.  Transcript, at 51
  • Q. Let me interrupt you. How big was Ensign Peak? Id.
  • A. They were two and a half percent, so just switching them would have made it a 1 percent vote.
  • Q. By that you mean switching two and a half percent is a 5 percent swing?
  • A. Yes. They had voted for management slate, and we believed that they would have voted for us.
  • Q. You talked before about how you had had some discussions with Mr. Cuesta about Ensign Peak, but you never contacted them directly, correct?  
  • A. Correct. 
  • Q. If you had known that you were within 6 percent, would you have reevaluated whether it was worth the additional effort to contact Ensign Peak and track down that vote? 
  • A. Well, there's no question--I would have reevaluated, but there's no question we would have made every effort to track that down because at that point, we were quite confident that if we did track that down--and during proxy season, many firms deal with a lot of votes.  It's a busy time. Sometimes administrative delays and what-have-you do occur.  Id. at 52
  • Q. Can you think of other specific examples of where you might have had the most opportunity to invest more effort in that last week had you known you were really only within 6 percent? 
  • A. Sure.  There were a lot of--towards the tail end of the top 20 holders, there were a lot of holders that were between point two or point three to one percent, and I was not very active trying to call them because, again, in aggregate, they could not have swung a 12 percent deficit we saw. I absolutely would have been reaching out actively to them.  And in addition, Perkins Capital had already flip flopped twice, and I never tried to contact them after they switched back to management because, again, with a 12 percent differential, I couldn't get there. That's an easy call for me to try and make at that stage.  Transcript, at pp. 53-54.   

The import of the decision is clear.  As more and more matters are contested, courts in Delaware intend to take a management friendly approach in resolving any controversies.  For this to be changed, there will need to be a solution at the federal level. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site.



Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 5A)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

The other disclosure issue concerned preliminary voting tallies provided by Broadridge.  Unknown to Broadridge or Red Oak but eventually known to Digirad, the tallies included over 1 million treasury shares voted in favor of management.  The shares would ultimately be exclued from the final tally. 

Digirad had a stock buy back program.  Apparently the repurchased shares were in an account at Raymond James.  On the record date, the account contained 1,073,641 treasury shares, about 6% of the vote.  Because they were treasury shares, they could not be voted.

When DTC disclosed the number of shares on deposit, the figure conflicted with the number of shares revealed in the proxy statement.  The difference was, apparently, the treasury shares in the Raymond James account.  Described as an "overhang," proxy solicitors for Red Oak and Digirad noticed the difference.  See Id. ("An overhang meant that the DTC list of Digirad stock held in street name included more stock than the number of shares that Digirad identified in its proxy as eligible to vote."). 

In early April, the solicitor for Red Oak asked whether the difference was a result of treasury shares.  The proxy solicitor for Digirad indicated that it was.  At least twice, the solicitor for Red Oak asked about the location of the treasury shares and received no answer.  As a result, Red Oak did not know the shares were in the account at Raymond James. 

Raymond James eventually received a voting request for the shares and sent it to Digirad (through Broadridge).  On April 9, an employee at the company mistakenly executed the instruction in favor of management.  As a result, Broadridge received instructions for the 1 million shares and listed them as votes for management.  The result was to overstate management's support by 6%. 

By April 15, a bit less than three weeks before the meeting, the proxy solicitors began receiving preliminary voting data from Broadridge. The data included the Raymond James shares and, as a result, overstated management's support by 6%.    

Sometime in late April (the meeting was scheduled for May 3), the solicitor for Digirad "was starting to have some luck in discovering who owned the Raymond James stock."  See Id.  ("In an April 27 email to Keyes, [the solicitor for Digirad] seems to have concluded that Raymond James did vote Digirad's treasury stock.").  The court described the solicitor as "fairly confident" that treasury shares had been voted.  Indeed, the CFO sent a letter dated May 1 (the meeting was on May 3) to the inspector of elections stating that "Digirad had 1,073,641 shares of treasury stock held at Raymond James that 'should not be considered outstanding for purposes of [Digirad's] 2013 Annual Meeting.'"

The information was not conveyed to Red Oak or Broadridge.  Indeed, this apparently continued through the date of the meeting when Red Oak informed its candidates that they had lost by a 46%-34% margin.  Only when the final results were certified and the treasury shares backed out, was the final tally closer:  40%-34%.  See Id.  ("On May 10, Digirad announced the final results of the Election. The independent inspector certified that the Board had been reelected over Red Oak's slate by a vote of 40% to 34%. The 6% difference between Sandberg's May 3 email listing a result of 46%-34% and the May 10 final vote tally of 40%-34% is the Digirad treasury stock that may not lawfully be counted in a stockholder vote."). 

Digirad, therefore, knew of the inaccuracy but did not tell Broadridge or Red Oak.  The solicitor for Red Oak had asked at least twice about the location of the treasury shares but received no response.  Moreover, evidence in the record indicated that the information was important.  Red Oak testified that its strategy in large part depended upon the preliminary tallies.  Id. (Red Oak solicitation strategy described "as a 'fluid process' and a 'cost[’s-]benefit' analysis that depended in large part on the preliminary results").  Red Oak asserted that knowledge of the inaccuracy would have have been a "game changer." 

The issue put the court in a tough spot.  The error (voting the treasury shares) was caused by the company, even if unintentional.  The error benefited the company.  The evidence showed that the company knew about the error. 

The court hinted that the risk of faulty data was assumed by Red Oak.  With Red Oak receiving data that was  "preliminary," the information by its "very terms" was "subject to change and thus possibly inaccurate."  But the error that occurred in this case was not typical, not expected, and caused by the company.  The court did not rely on this analysis.

Instead, the court framed the issue as "novel" and described Red Oak as seeking selective disclosure of information to a single shareholder. 

  • The argument for a duty to disclose such information to one stockholder to use in its proxy contest strategy is unpersuasive. It clashes with the well-established principles that teach that disclosure of material information, when required under Delaware law because the directors seek stockholder action, must be to all stockholders to inform their voting decisions. Thus, if the Board owed Red Oak a duty to disclose that the Broadridge reports were inaccurate, it would have to have been a duty the Board owed to all stockholders.

The court was "loath" to find "a breach of fiduciary duty under the circumstances for such a customary and inoffensive practice without an exceedingly compelling argument rooted in Delaware law, which Red Oak has not presented."  The court described the "asymmetry of information" as "an honest and unfortunate mistake, not anything approaching intentional misconduct." 

The court conceded that Red Oak was disadvantaged but this was not, apparently, enough.  See  Id.  ("Red Oak has not demonstrated by a preponderance of the evidence how a proxy solicitation strategy based on preliminary Broadridge reports inaccurately listing Digirad's inadvertently submitted treasury stock proxy amounts to an unfair election process for the stockholders at large, even if the information asymmetry disadvantaged Red Oak."). For Red Oak to prevail, it would have to show something like "intentional misconduct or self-initiated disclosure to the stockholders".    

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 4B)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

Management of Digirad and its agents had information indicating the progress of the proxy contest.  This came in the form of preliminary voting tallies provided by Broadridge.  Red Oak, in challenging the election, essentially alleged that management overstated its position in the contest by using words like "landslide" (although use of the term was disputed).

The court found that the alleged statements were immaterial.  In other words, the court did not conclude that the statements by Digirad and its agents were inaccurate.  The court found that the information was not important to a reasonable investor. 

While the court provided a confusing analysis as to the immateriality of the statement (rarely actually analyzing whether the information was important to a reasonable investor), the main concern seemed to be the court viewed as the speculative consequences of the allegedly inaccurate information. 

  • Because the integrity of the election process is an essential part of the foundation of Delaware corporate law, the Court takes very seriously claims of an unfair election process because of misleading or inadequate disclosures. But, the Court also does not take lightly either finding an election invalid or imposing the equitable remedy of ordering a new one. Fair elections should be based on the disclosure of all material information to stockholders, but the Court here cannot find the Election invalid for want of adequate disclosure based on speculation about alleged misstatements that is unsupported by a preponderance of the evidence. These alleged misstatements do not render the Election invalid.

Yet the record reflects that the claims made by Red Oak were hardly speculative.  The testimony at the one-day trial ndicated that access to management for investors was extremely important:  

  • You have to make decisions responsibly and after real diligence, learning about companies that you have not learned about before. And the only way to get that information when you're a smaller company is by understanding through management.  You typically don't have any outside banks or firms that cover you for research. So if I'm  investing in Microsoft, I don't need to speak to the CEO because there's a lot of ways to learn about that company.  But after 17 years, I've been doing only small companies, and I would say less than 5 percent of my companies have any research coverage.  So it is very important to speak to management.  Transcript at 43-44.

Management, however, could refuse to communicate with shareholders for any reason:

  • The problem here is that management -- there's no rules that say that they have to speak to everybody. They get to choose who they want to speak to and who they don't. That is common for them to  freeze people out on conference calls if they don't like them and don't want them to ask questions.  They can frequently not reply.  Companies that I've contested or simply argued with, they don't contact me back, and that affects how I will act with them. This is really a very well known thing within the industry and amongst small company investors.  Transcript, at 44. 

This was a particular concern where shareholders demonstrated a lack of support for management:

  • If you don't support them, they have no reason or obligation to want to spend their time speaking with you, and even -- I've had times when I've owned a lot of stock, and there's no return phone calls if they don't like what they're hearing. And that's a balance that you have to really take.  Transcript, at 46.

Second, there was the expectation that management could learn the identities of shareholders who were unsupportive in a contest:

  • Well, if you're a shareholder and you're being told by the company that "this is won, we've got this one, it's a land slide," why would you -- when their solicitor will ultimately be able to root out how you voted and inform them of that, why will you then vote against them?  They see that, and you now risk owning a piece of this company but being shut off from any access to information, or really being at a disadvantage versus the general marketplace as to the value of the company.  Transcript, at 46.

Indeed, some of the testimony was supported by agents for Digirad.  Uncovering the identity of institutional investors and their voting behavior was part of the job of the solicitor.  The solicitor for Digirad kept a log of shareholders and altered the log when a determination was made about the likely position in the contest:

  • Q. In fact, you shaded the particular shareholders for which you were saying had voted one way or the other, right? A. I shaded the shareholders that I believe had voted one way or the other as of that time.  Transcript, at 197.

The court recognized this.  See Id. ("Armed with the preliminary Broadridge reports, [proxy solicitors for both sides], working independently, were generally able to figure out how Digirad's larger, institutional stockholders were voting."). 

The testimony appears to be uncontroverted. Thus, to the extent management made erroneous statements that it was going to win the contest, investors had every incentive to support management rather than risk access in a losing cause.

Moreover, much of the testimony was factual and common sense.  Small companies do not have as wide a following among analysts.  See The MicroCap Effect ("While information on large, well followed companies is rather easy to come by, micro cap companies enjoy the inefficiency that comes from a lack of industry analyst coverage.").  As a result, investors must do more of their own leg work.  Id. ("This lack of industry coverage is not synonymous with lack of investment merit, only that a certain management skill set is needed to unearth these opportunities.").  Access to management would presumably be a recognized part of this process. 

The effect was "speculative" only in the sense that there were no shareholders who came forward and said they altered their vote as a result of the statements.  But even under Delaware law, this is not required.  Disclosure violations can occur without evidence of reliance and without evidence that shareholders actually changed their vote. 

Nonetheless it is clear that this is in fact the standard the court imposed on shareholders.  Given the likely impossibility of uncovering this sort of data, the case stands for the proposition that misstatements by management about the outcome of the proxy contest are not actionable. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 4A)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

Red Oak raised a number of potential disclosure violations.  Two of them essentially amounted to arguments that Digirad overstated the preliminary results of the election in order to sway shareholders in their direction. 

The alleged misstatements arose out of conversations between officials connected to Digirad and two market participants who had some apparent ability to sway shareholders in the contest.  The individuals included a sell-side analyst and a portfolio manager. 

The analyst testified that he spoke with the proxy solicitor for Digirad.  Notes from the conversation suggested that the solicitor provided breakdowns showing Digirad ahead by significant margins.  Id.  (“[A] series of percentage breakdowns showing management first ahead 34% to 12%, then 45% to 10%, and finally management at just under 50% with 63% of shares included.”).  The percentages were based upon the “expected vote” and were not an “official tally.” 

The analyst testified that the purpose of the disclosure was to “share” the information with shareholders.  The proxy solicitor indicated, however, that he did not have that intent.  The court described this as the disclosure of “voting expectations” and not “actual votes.”     

The second instance was a disputed statement made by the chairman of the board of Digirad to the portfolio manager.  The portfolio manager said he was told, based upon preliminary election results, that Digirad would win in a “landslide.”  The chairman denied making the reference to a "landslide."  Without resolving whether the statement had been made, the court noted that the portfolio manager did not receive “specific numbers, aside from a disputed reference to a few index funds, or the specific source of his information on preliminary voting tallies.”  

Red Oak argued that "suggestions” about a “strong preliminary result” could “pressure certain shareholders not to want to vote against what's clearly the winning side.”   The court, however, found both statements to be immaterial. 

The opinion, however, struggled with a basis for the conclusion.  Although stating the traditional test (importance to a reasonable shareholder), the court's analysis focused on other matters.  See Id. (“The preponderance of the evidence shows that the conversations were not intended to be shared with stockholders and were not made with any knowledge that [the analyst] would share the information with stockholders. They were made with just the opposite intent—[the proxy solicitor] thought [the analyst] was working for Digirad.”); see also id. (“The testimony conflicts over whether any ‘landslide’ comment was made, and although [chairman] may have mentioned certain funds by name, the preponderance of the evidence does not show that [chairman] told [the manager] about the actual proxies submitted by any particular stockholder.”). 

The determination that the statements were not made with the "knowledge that they would be shared" or that they did not include tallies of the “actual proxies submitted” sidestepped whether the statements could have influenced a reasonable shareholder--the standard for determining materiality.   

Moreover, the court more or less acknowledged the importance of the information.  Particularly in smaller companies, shareholders had an incentive to not appear as opposing management.  As the court described:      

  • After an election, management at a small public company like Digirad can typically discern which stockholders voted for and against it. The apparent fear is that “if you don't support [management], they have no reason or obligation to want to spend their time speaking with you,” which can lock a stockholder out of access to information important to its investment decision, especially where there may not be Wall Street coverage of the company. 

Despite characterizing this as a “potentially difficult management-stockholder dynamic”, the court characterized the argument as an attempt to impose a special fiduciary obligation on microcap companies and declined to do so.  See Id.  (“This potentially difficult management-stockholder dynamic does not warrant subjecting microcap companies to additional fiduciary duties or requiring additional protections against an unfair election process.”).

We will discuss this analysis in the next post. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 3)

We are discussing Red Oak v. Digirad, a recent Delaware case where preliminary voting data played a significant role. 

In that case, Red Oak, the 5th largest shareholder with over 5% of the shares, ran a competing slate of five directors.  Red Oak's slate ultimately lost, with management receiving 40% and Red Oak receiving 34%.  In the aftermath of the case, Red Oak filed suit under DGCL §225 challenging the election. Red Oak essentially alleged that the election was "unfair."  

Red Oak made two claims with respect to interim voting data.  The complaint alleged that the company made "improper and illegal disclosures about non-public interimproxy voting tabulations." In addition, Red Oak asserted that the election was unfair because the company knew that the preliminary voting data from Broadridge was inaccurate but did not disclose the inaccuracy to Red Oak or the other shareholders.  

Section 225 permits a challenge to the "validity of any election."  Where the court determines that an election was not valid, it has broad remedial authority and can order a rerun of the contest. See Portnoy v. Cryo-Cell Int’l, 940 A.2d 43, 82-83 (Del. Ch. 2008) (ordering a new election and apportioning the costs to the incumbent directors).

Section 225 does not define an "invalid" election.  Sometimes it involves disputed elections that turn on things like the validity of a meeting.  See Adlerstein v. Wertheimer, 2002 WL 205684 (Del.Ch.,2002) ("Here, the question is whether the meeting held on July 9 was a meeting of the board of directors or not."). Or the issue may be the validity of shares issued by the company.  See In re Bigmar, Inc., 2002 WL 550469 (Del.Ch.,2002).  

On other occasions, however, challeges involve something that amounts to allegations of the use of "unfair" tactics.  See Portnoy, 940 A.2d 43 at 82-83 ("[T]he election was tainted by misbehavior by insiders who could not win an election simply using the traditionally powerful advantages afforded incumbents. Our law has no tolerance for unfair election tactics of this kind.").  In general, these are expressed as a breach of fiduciary obligations. See Red Oak, C.A. No. 8559-VCN (Del. Ch. Oct. 23, 2013) ("Shareholders can challenge the election by alleging a breach of fiduciary duty by the board.").  Often they are phrased as disclosure violations.  See id. (companies have an obligation “to provide a balanced, truthful account of all matters disclosed in the communications with shareholders.”).  

The court in Red Oak addressed whether a breach of fiduciary duty was a precondition for a challenge to the fairness of the election.  The court declined to “fashion a bright-line rule that an election may be found invalid under Section 225 only if there is a breach of fiduciary duty.”  In the absence of a breach of fiduciary duty, however, a shareholder seeking to invalidate an election “should offer more than mere speculation about the possible consequences of the perceived unfair election.”  

In other words, the standard for showing unfairness would be higher in non-fiduciary duty cases.  The approach provided a road map for future challenges.  Given the difficulty in establishing a fiduciary duty violation, the court set out a basis for nonetheless overlooking instances of obvious unfairness.  And, in fact, that is what occurred in this case. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 2)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

Access to preliminary voting instructions has become increasingly important.  Moreover, the area entails considerable interaction between the state and federal law.   

State law gives voting rights to "record" owners.  Most "shareholders," however, hold stock indirectly through street name accounts.  In those cases, DTC appears as the record owner.  DTC, however, assigns voting rights to participants (the brokers and banks) through an omnibus proxy.  As a result, brokers and banks rather than street name owners have the legal right to vote the shares at the time of a meeting. 

The rules of the SEC and the stock exchanges impose a complicated system that requires issuers to provide proxy materials to brokers for forwarding to beneficial owners.  This system is discussed at length in:  The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility? 

These rules ensure that street name owners receive proxy materials.  With respect to voting, Rule 451 of the NYSE provides a choice.  Brokers can send to street name owners either a proxy card or voting instructions.  The method matters.  Proxy cards go back to the issuer.  If they are not returned, the shares are not voted, are not present at the meeting, and are not counted as part of the quorum. 

Voting instructions go back to the broker.  To the extent a street name owner does not return the instructions, brokers, as the record owners (as a result of a DTC omnibus proxy), retain voting rights.  Rule 452 of the NYSE, however, limits brokers voting rights to "routine" matters, something that does not include, for example, the election of directors. 

Brokers almost universally rely on Broadridge to distribute and collect voting instructions.  See Exchange Act Release No. 68936 n. 8 (Feb. 15, 2013) ("Other intermediaries competing with Broadridge are Proxy Trust (focuses on nominees that are trust companies), Mediant Communications and Inveshare, but their market share is relatively small. The Exchange is aware of one broker-dealer, FOLIOfn Investments, Inc., that provides proxy distribution to its accounts itself, without using the services of an intermediary."). Broadridge in turn executes a proxy that reflects the instructions from street name owners (and broker votes on routine matters) and gives it to the issuer. 

Broadridge is not directly regulated by the Commission.  Instead, the firm acts as an agent for brokers.  It is brokers that have an obligation to forward proxy materials to street name owners.  See Rule 14b-1, 17 CFR 240.14b-1.  Because the act of distributing proxies involves the brokers in the solicitation (and indeed constitutes a solicitation), brokers rely on an exemption from the proxy rules in Rule 14a-2(a).  The provision exempts them from all of the proxy rules (including Rule 14a-9), but imposes a number of requirements, including an obligation of impartiality.  Merely acting in a ministerial fashion by forwarding and collecting information does not favor one side or the other and does not require application of the proxy rules to the behavior.

Broadridge distributes and collects voting instructions.  The firm, therefore, has raw data that consists of voting instructions received from street name owners.  Preliminary voting information is routinely disclosed to anyone soliciting proxies.  Thus, the issuer receives the information.  So does any third party soliciting proxies.  As a result, both sides get the information in a contest. 

Some third parties, however, engage in "exempt" solicitations.  These are solicitations that involve efforts to influence shareholders but without actually soliciting a proxy.  Exempt solicitations essentially arise where third parties distribute solicitation materials in order to encourage shareholders to vote against a recommendation of management with respect to a proposal or candidate for the board.  A "just say no" campaign is an example. These solicitations are typically exempt from the proxy rules under Rule 14a-2(b) (although not the antifraud provisions). 

In 2011, Broadridge subjected persons involved in an exempt solicitation to a confidentiality requirement with respect to preliminary voting results.  Issuers were apparently not subject to the same restriction.  In 2013, during a contest at JP Morgan Chase, Broadridge announced that it would no longer share preliminary voting information with exempt solicitors.  As a result, where shareholders submit a proposal and seek support over management's objection, they will not be told by Broadridge how the voting is progressing.  Likewise, in a "just vote no" campaign, those shareholders distributing solicitation materials opposing the directors will not receive the preliminary voting information.  Issuers, however, will receive the information. 

So the current scheme at the federal level is that preliminary voting information is disclosed to both sides in a contest and only one side in an exempt solicitation.  The information is not disclosed publicly.  Broadridge has, apparently, indicated that it would provide the data to exempt solicitors if the issuer gave permission.  At least some efforts to obtain issuer permission have been unsuccessful. 

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 1)

In the corporate governance area, there is often tremendous overlap between state and federal law.  The proxy area is one example. State law mostly regulates substance while federal proxy rules mostly regulate disclosure.    Thus, for example, Rule 14a-4 regulates the content of the proxy card, including the format. 17 CFR 240.14a-4.  Contents of the card must, therefore, be in "bold face type," a phrase that has been around since 1942.  See Exchange Act Release No. 417 (Dec. 18, 1942) (discretionary voting authority permitted where "the form of proxy contains a statement in bold-face type indicating that if the ballot is not marked the shares represented by the proxy will nevertheless be voted in a specified manner.").

At the same time, state law governs the substance.  For example, state law imposes the "last in time" rule.  Only the last proxy submitted to the company can be voted.  See Standard Power & Light Corp. v. Investment Associates, Inc., 51 A.3d 572, 580 (Del. 1947) (“[W]hen two proxies are offered bearing the same name, then the proxy that appears . . . to have been last executed will be accepted and counted under the theory that the latter--that is, more recent--proxy constitutes a revocation of the former.”); see also Parshalle v. Roy, 567 A.2d 19 (Del. Ch. 1989) (“Faced with two identical proxies having differing dates, the Inspectors correctly gave effect to the later-dated proxy--a result mandated [] by Delaware case law . . . .”).

The discussion suggests a stark distinction.  In fact, the SEC also has substantive rulemaking authority in the proxy area under Section 14(a) of the Exchange Act.  15 USC 78n(a) (providing the Commission with the authority to adopt "such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors, to solicit or to permit the use of his name to solicit any proxy or consent or authorization in respect of any security"); see also Business Roundtable v. SEC, DC Cir. 1990 ("We do not mean to be taken as saying that disclosure is necessarily the sole subject of § 14.").  

Thus, in Rule 14a-4, the Commission has occasionally engaged in substantive rulemaking.  A proxy obtained under the federal system can only be used for a single annual meeting.  This preempted state law.  See DGCL § 212(b) (providing that "no such proxy shall be voted or acted upon after 3 years from its date, unless the proxy provides for a longer period.").   

The involvement of two regulators in the proxy process (not to mention the stock exchanges) provides serious complications.  It also, however, allows each regulator an opportunity to correct an obvious problem.  Yet as we will see in the next several posts, there is a serious problem concerning the disclosure, use, and accuracy of preliminary voting information.  This is the data that reflects the running tallies of voting instructions returned by street name owners in the period preceding the shareholder meeting.  

The Delaware Chancery Court recently addressed some of these issues.  See Red Oak v. Digirad, C.A. No. 8559-VCN (Del. Ch. Oct. 23, 2013).  Red Oak involved, among other things, the use of inaccurate voting tallies.  Although the inaccuracy originated at, and benefited, the company, the court declined to find that an unfair election had occurred.  The case raises serious concerns about the willingness of Delaware courts to ensure fair elections and the willingness to police the use of preliminary voting information.  The outcome suggests the need for federal intervention. 

We will discuss the regulatory regime with respect to preliminary voting data.  The posts will then move on to an analysis of Red Oak v. Digirad, illustrating weaknesses in the court's reasoning.  In the meantime, the opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


In re Tremont Securities Law, State Law, and Insurance Litigation (Elendow Fund, LLC v. Rye Select Broad Market XL Fund): The Heightened Pleading Standards for Securities Fraud Claims under the PSLRA

In In re Tremont Sec. Law., State Law, & Ins. Litig. (Elendow Fund, LLC v. Rye Select Broad Mkt. XL Fund), Master File No. 08 Civ. 1117, 10 Civ. 9061, 2013 BL 249529 (S.D.N.Y. Sept. 16, 2013), Plaintiff Elendow Fund, a small investment fund, filed suit against Rye Select Broad Market XL Fund (“XL Fund”), Rye Investment Management, Tremont Partners (“Tremont”), and other entities alleged to be directly and indirectly involved in the exchange of XL Fund investments (collectively, the “Defendants”) in an effort to recover assets lost as a result of the Bernard Madoff Ponzi scheme. Elendow Fund’s complaint made several allegations including securities fraud, control-person liability, and violations of various state-law provisions. The Defendants moved to dismiss and the United States District Court for the Southern District of New York granted the motion.

According to the allegations, XL Fund engaged in an investment strategy that entailed, among other things, investments in a fund managed by Bernard Madoff. Tremont allegedly “induced” Elendow Fund to invest in XL Fund through misrepresentations. Tremont’s alleged misrepresentations included statements about the investment strategy of the XL Fund.  Tremont also allegedly misrepresented the due diligence that it performed on fund managers.  Elendow Fund also brought claims for control-person liability.

Actions for securities fraud allegations are subject to the heightened pleading standards set out in the Private Securities Litigation Reform Act and Rule 9(b) of the Federal Rules of Civil Procedure. To meet these requirements, a complaint must identify “each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” § 78u-4(b)(1). Furthermore, plaintiffs must also allege a “strong inference” of scienter. This requires allegations: “(1) showing that the defendants had both motive and opportunity to commit the fraud or (2) constituting strong circumstantial evidence of conscious misbehavior or recklessness.”

Elendow Fund argued that its complaint met the heightened pleading standard for securities fraud. The court, however, disagreed. The complaint did not “specifically and plausibly allege that Tremont actually knew that Madoff’s operation was a fraud.” With respect to the allegation that Tremont recklessly disregarded red flags, the court found that the complaint failed to sufficiently allege facts to establish that “the dangers posed by Madoff were so unmistakable that Tremont must have known that its representations were false.” The court further noted that Tremont recognized the risks and benefits associated with investing with Madoff, but nonetheless chose to continue doing so.  

The court also found that Elendow Fund’s allegations about Tremont’s due diligence were insufficient to plead securities fraud. Specifically, the court highlighted the fact that the complaint failed to sufficiently allege that some of the statements (the promise to perform “careful” due diligence posted on the Internet) were false. More specific representations about the level of due diligence in Tremont’s Form ADV failed because of the vagueness of the allegations. As the court reasoned:

This allegation might have been sufficient if, in context, it clearly referred to any specific representations. But this allegation appears, not alongside any allegations of actual representations, but in the formulaic recitation of the elements of count I of the complaint. In that context it is not clear what “statements described above” the allegation refers to. When an allegation couched in such generic language is completely separated from the substantive, factual allegations of the complaint, it is simply too vague to support an action for securities fraud under the applicable heightened pleading standards.  Elendow Fund’s generic allegation that it relied upon such representations as those described in the complaint is simply not adequate to push its reliance allegation over the line from conceivable to plausible.

Accordingly, the court dismissed the securities fraud claim. In absence of a primary violation, the court also dismissed Elendow Fund’s claim for control-person liability. Additionally, the court dismissed all of Elendow Fund’s state-law claims.

Therefore, the United States District Court for the Southern District of New York granted Defendants’ motion dismissing Elendow Fund’s complaint in its entirety.

The primary materials for this case may be found on the DU Corporate Governance website.