The SEC and Civil Prosecutions: The Cop on the Beat

The WSJ published an article based on an interview with an official from the FBI who explained the reasons for the lack of criminal prosecutions arising out of the fnancial crisis.  The article contained this paragraph:

• While at the FBI, Mr. Cardona oversaw dozens of criminal probes of large financial firms. The FBI's probes haven't led to any successful prosecutions of high-profile executives in relation to the financial crisis, despite demands from some lawmakers and angry Americans. In contrast, the SEC has filed crisis-related civil-fraud cases against 81 firms and individuals, and it has negotiated almost $2 billion in penalties in cases that have been settled.

In short, the SEC is the one organization that has been bringing actions as a result of the financial crisis, with considerable success.

In re Optimal U.S. Litigation: S.D.N.Y. Applies Janus

In In re Optimal U.S. Litigation, 10 Civ. 4095, (S.D.N.Y., Oct. 14, 2011), the court granted in part and denied in part the defendants’ motion to dismiss federal securities fraud claims brought by Plaintiffs in a class action. 

The plaintiffs are investors in Optimal Strategic U.S. Equity Fund (“Fund”), which invested all of its assets with Bernard Madoff.  The defendants include the Fund’s investment manager, Optimal Investment Management Services, S.A. (“OIS”), and OIS’s parent company, Banco Santander.  The plaintiffs allege defendants ignored red flags concerning Madoff, failed to conduct reasonable due diligence, and made material misstatements and omissions regarding the Fund.  The plaintiffs further allege that because of defendant’s actions, plaintiffs lost their investment and that the defendants improperly collected management fees. 

Rule 10(b)-5 permits actions for fraudulent disclosure in connection with the purchase or sale of a security.   17 CFR 240.10b-5.  Under the provision, however, an action can only be brought by a person who “make[s]’ the untrue statement.   In Janus Capital Group v. First Derivative Traders, the Supreme Court held that the maker of a statement is the person with “ultimate authority” over its contents. 

The defendants brought the motion to dismiss based on Janus Capital Group v. First Derivative Traders.  Defendants asserted that allegedly fraudulent statements made in Explanatory Memoranda (documents described in the opinion as “Bahamian equivalents of prospectuses”) that issued by Optimal Multiadvisors (OM), not the defendants.    

The plaintiffs argued that OIS exercised control and had “ultimate authority” over OM.  According to the complaint, OIS owned 100% of OM’s voting shares,  had authority to remove and add directors of OM, and its  CEO was one of OM’s directors.  Plaintiffs asserted that OIS exercised control over OM and that the “relevant statements are attributable to OIS.”    

The court held OM made the misstatements for purposes of Rule 10b-5.  The court concluded that OM’s Board of Directors had the ultimate authority over issuance of the prospectuses and made the statements.  The court further noted that under Janus, a statement is made by the entity that delivers it rather than the entity that drafts it.  The court also noted that under Janus, the affiliation of one OM director with OIS was not enough to impose liability on OIS under Rule 10(b)-5. 

Plaintiffs also argued that OIS was liable under a theory of “corporate veil-piercing”.   The court applied the law of the Bahamas, OM’s place of incorporation.  Under Bahamian law, a defendant “incurs liability to [P]laintiffs before creating a fraudulent shell entity.”  The court held that Plaintiff’s corporate veil-piercing claim failed under Bahamian law.  Because OM was founded in 1995 and the misstatements occurred between 2001 and 2008, the defendants could not have created OM to avoid liability. 

Lastly, the defendants argued that claims under §20(a) of the Exchange Act must be dismissed because the plaintiffs did not adequately show scienter.  Section 20(a) provides that any person who directly or indirectly controls any person is jointly and severally liable.  The court relied on a previous ruling from May 10, 2011 to hold that the plaintiffs adequately pled scienter with respect to OIS and OM and sustained the §20(a) claims against these two defendants.  The court dismissed the §20(a) claims against Banco Santander based on its control of OIS since OIS did not make the misstatements. 

Although the court dismissed the 20(a) claims against Banco Santander, the court sustained other claims of federal securities fraud against OIS and Banco Santander.  The court did not address the remaining claims of common law fraud, gross negligence, negligent misrepresentation, and aiding and abetting fraud in this action. 

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

The SEC and the Courts: Challenging the Citigroup Decision

The Commission has not had a pleasant time in the courts recently.  The difficult decisions fall into two broad camps.  There are those that adopt legal interpretations that make the SEC's ability to enforce the securities laws more difficult. 

Janus is an example of that.  By limiting liability to those with "ultimate authority," the Court restricted the category of persons subject to the antifraud provisions.  While the meaning of this phrase is yet to be played out, the SEC has already had to deal with attempts to dismiss actions against corporate officers on the grounds that they did not have "ultimate authority" over the allegedly misleading disclosure.  See SEC v. Carter, 2011 U.S. Dist. LEXIS 136599 (ND Ill. Nov. 28, 2011).

The other category of decisions are those where the courts excessively intrude into the duties and responsibilities of the SEC.  The decision to strike down the shareholder access rule was one example.  The court in Business Roundtable v. SEC found that the cost-benefit analysis was deficient.  Had the decision been narrowly drawn, it might have been defensible.  It was not.  The decision was extraordinarily broad.  Moreover, whatever one thinks of the merits, the decision effectively imposed substantial additional costs on the rulemaking process (discouraging the SEC from engaging in this process) and provided plenty of support for future legal challenges (adding uncertainty to any regulatory steps taken by the agency).  

Similarly, in Gupta v. SEC, the court allowed a decision to go forward involving a challenge to the forum selected by the SEC.  The case was not narrowly written and provided a basis for future law suits by defendants who sought to contest the forum selected by the staff.  The case has the potential to influence enforcement decisions within the SEC.  There may now be instances where the staff chooses to bring an injunctive rather than an administrative proceeding solely to avoid the possibility of a legal challenge.  

The SEC did not appeal the Business Roundtable decision.  In Gupta, the SEC agreed to dismiss the administrative proceeding.  An injunctive proceeding has since been filed. 

Citigroup is another case that has the potential to interfere with the SEC's internal process.  The order is here.  Courts have a role in the settlement process.  They must ensure that the terms are reasonable.  Sometimes they are not.  The same judge rejected a settlement against Bank of America with the result that the parties returned with a better settlement.

The decision in Citigroup, however, did not reject the settlement on the merits.  Instead, the settlement was rejected because the judge disagreed with the decision to allow Citigroup to neither admit nor deny the allegations in the complaint.  This was not a narrowly written opinion.  Indeed, the court suggested that his reasoning had universal application.  As the opinion stated:  "It is not reasonable, because how can it ever be reasonable to impose substantial relief on the basis of mere allegations?" 

In both Business Roundtable and Gupta, the Commission did not appeal the decisions, leaving the law as articulated by the respective courts unchallenged.  There are plenty of strategic reasons why appeals ought not to be taken.  They can make matters worse.  Challenging Business Roundtable would almost certainly have resulted in a loss given the current makeup of the DC Circuit. 

But to some degree, the Citigroup decision is the natural consequence of this approach.  The decision is an attempt to rewrite the process used by the SEC in reaching settlements.  To the extent that the reasoning stands, the SEC will either have to litigate more cases (perhaps substantially more cases) or bring settlements as administrative proceedings, thereby avoiding the need for judicial approval.  In the latter circumstance, that will mean more settlements not subject to enforcement through contempt.

Moreover, it is not at all clear that private parties will benefit from abandonment of the "neither admit nor deny" language.  The absence of the language does not guarantee a trial.  Instead, the defendants will have an incentive to make some factual admissions.  But in general they will be less willing to do so in actions that can also be brought by private parties, such as fraud actions under Rule 10b-5.  Instead, defendants will put pressure on the SEC to bring actions for negligence or aiding and abetting.  As a result, there is no guarantee that the "overriding public interest in knowing the truth" will be advanced.  Quite the contrary.  The approach taken by the court in Citigroup may result in the truth becoming even more obscure.  

The reasoning of this decision cannot be left unchallenged.  Unlike Gupta and Business Roundtable, the SEC needs to take steps to clarify the law in this area.  So what might the SEC do?  It could seek voluntary dismissal and refile (and settle) the case as an administrative proceeding.  That, however, would leave the legal analysis in Citigroup unchallenged. 

The Commission could seek reconsideration of the decision and, in the alternative, an interlocutory appeal.  The trial court will not reverse his decision but with a spirited challenge he may at least narrow the holding. The same is true with respect to an appeal.  Moreover, it would seem likely that the Justice Department and other federal agencies that rely on a similar approach (and similar language) would support the challenge.  Certainly, such a united approach would, at a minimum, send a message to other judges that the SEC does not intend to accept this sort of reasoning. 

Citigroup Settlement Rejected (Part 4)

Where might the Commission go with this case?  The court has ordered that it go to trial.  That is one possible outcome.

The Commission could seek an interlocutory appeal.  This would require approval by Judge Rakoff.  See Section 1292(b).  The SEC could dismiss the case.  See FRCP 41(a) (allowing for voluntary dismissal upon "a stipulation of dismissal signed by all parties who have appeared.").  If that were to occur, the case could be refiled and settled as an administrative proceeding.  That, however, would merely postpone the issue for another day.  The judges in the Southern District are repeat players in the securities litigation area and the SEC will be presenting other "substantial" settlements to Judge Rakoff.

Finally, Citigroup and the SEC could agree to some facts, meeting the narrow terms of the court's order.  To the extent that the facts merely established negligence, they would not provide significant collateral benefit in any private litigation.

The Antifraud Provisions, the Supreme Court, and the "Hostility Towards Private Rights"

We have on this Blog taken issue with activist courts that rely on policy analysis in place of legal reasoning.  Nowhere has this been more clear than with respect to the view of the conservative majority on the Supreme Court concerning private actions under the antifraud provisions, particularly Rule 10b-5. 

In Stoneridge, for example, the majority decreed that henceforth, Rule 10b-5 would not be allowed to be "extended beyond its present boundaries."  The approach was not based upon principles of common law fraud, congressional intent, or the language of the statute.  Instead, it was a policy decision.  Unhappy that a private right of action existed at all, the Court all but announced that henceforth the guiding principle would be to restrict and narrow the reach of the action. 

As if the point was missed, the conservative majority repeated the point in Janus.  As the Court stated:

• Our holding also accords with the narrow scope that we must give the implied private right of action. Id., at 167. Although the existence of the private right is now settled, we will not expand liability beyond the person or entity that ultimately has authority over a false statement.

In justifying the policy decision, the Court reasoned that the restrictions on antifraud actions would have little impact because of the looming presence of government regulators.  As the Court noted in Stoneridge:

• Secondary actors are subject to criminal penalties, and civil enforcement by the SEC. The enforcement power is not toothless. Since September 30, 2002, SEC enforcement actions have collected over $ 10 billion in disgorgement and penalties, much of it for distribution to injured investors.

Commissioner Walter at the SEC recently gave a talk that called this analysis into question.  In a speech before the FINRA Institute at Wharton, she examined the Court's "hostility towards private rights" and the importance of these actions in protecting the securities markets.  The speech is here. 

Commissioner Walter traced the development of the private right of action under the antifraud provisions, noting early efforts by the Supreme Court in cases like Blue Chip Stamps to cut back on the right.  Congress, however, sought to correct many of the abuses associated with private actions through the adoption of the Private Securities Litigation Reform Act.  Nonetheless, these congressional limitations did not constrain the Court.  As she noted:  "Despite the broad sweep of the Litigation Reform Act, to this day the Supreme Court continues to demonstrate what I would characterize as hostility towards private rights."

To support the view, she gave three recent examples:  Stoneridge, Morrison and Janus.  While the first two had little impact on Commission actions (Stoneridge requires evidence of reliance, an element not present in Commission actions and Morrison was overturned by Congress in Dodd-Frank), Commissioner Walter expressed concern over the impact of Janus.  The reasoning regarding the relationship between the advisor and the fund was, in her opinion, "shockingly out of line with the realities of the marketplace."  More important was the potential impact on Commission actions.  

• In its recent Janus decision, the Supreme Court focused simply on the language of Section 10(b) and Rule 10b-5, which of course apply to Commission actions as well as private actions. This change may have the unfortunate and ironic result of throwing the proverbial baby out with the bathwater. What I mean is that by limiting implied private rights through strict statutory interpretation, the Court has also potentially limited the express public rights of action contained in the statute.

The approach taken by the Court effectively limits private enforcement.  Without adequate enforcement, a statute is "merely a suggestion, rather than a mandate".  Moreover, in making the statute meaningful, both "public and private aspects of securities enforcement are critical".

So what is the consequence of these limitations on private enforcement actions?  For one thing it increases the burden placed on regulators, particularly the Commission.

• I believe that the trend away from private rights of action under the securities laws has placed more and more pressure on the Commission and other regulators to be the sole guardians of the statutes. It is a vast understatement to say that the Commission has a big job to do. If private rights are cut back further, or further constrained, that puts an increasing burden on already scarce governmental resources.

Leaving matters to the Commission means that enforcement of the securities laws becomes subject to the vagaries of budgetary constraints. 

• The ebbs and flows of our appropriations process mean that the Commission has been faced repeatedly with budgetary constraints. The Commission is quite adept at using the resources it is given, and has and will rise to the occasion. But, it is far from clear that we will be able to reach an optimal level of enforcement where both private rights of action are contracting and public rights are limited unduly, and quite artificially, by resource deficiencies—both technological and in terms of number of staff.

Nor does the Commission precisely stand in the shoes of injured investors.  While the agency can seek penalties, it is not empowered to recover damages.  "Thus, while the agency can require wrongdoers to give up the benefits they have received from violations, it cannot necessarily make the victims whole."  Moreover, the agency's priorities and the priorities of private parties vary.   The result, "that there is both a long-term contraction in private rights and an inherent limited ability to maximize public enforcement should be a cause for significant concern."

The Commission, as the speech points out, routinely files amicus briefs in important securities cases filed at the US Supreme Court.  Perhaps the next one should flesh out the views in this speech and emphasize that judicially imposed limitations on private actions under the antifraud rules are not, at the Court apparently thinks, inconsequential to the securities markets. 

Fosbre v. Las Vegas Sands Corp.: United States District Court Denies Liability Under PSLRA “Safe Harbor”

In Fosbre v. Las Vegas Sands Corp., No. 2:10-CV-00765-KJD-GWF (D. Nev. Aug. 24, 2011), the court denied in part and granted in part the defendant’s motion to dismiss the plaintiffs’ class action lawsuit alleging that the defendant misrepresented or omitted key information about development plans and financing issues. 

Las Vegas Sands Corporation (“LVS”) operates resorts and gaming properties in Las Vegas, Macao, and Singapore, and was raising equity by issuing common stock between August 2, 2007 and November 6, 2008 to develop additional properties.  The plaintiffs alleged that LVS violated §10(b) and §20(a) of the Securities and Exchange Act of 1934 when LVS “knowingly or recklessly made misrepresentations and omissions about LVS, its development and its financial condition” while raising equity. 

Under §10(b) of the Securities Exchange Act of 1934 it is unlawful “‘to use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe.’”  To allege security fraud in accordance with the Private Securities Litigation Reform Act (“PSLRA”), the plaintiffs’ complaint must “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”   When pleading §10(b) actions, a plaintiff must show that the defendant acted knowingly or recklessly.  To avoid dismissal of a §10(b) claim, the plaintiff “must allege (1) a material misrepresentation or omission, (2) scienter or intent to defraud, (3) in connection with the purchase or sale of a security, (4) reliance, (5) economic loss, and (6) loss causation.” 

A plaintiff’s allegations must be supported by facts that show either a false statement of material fact or “an omission of material fact that renders other statements misleading.”  The plaintiffs alleged three different areas where the defendants made material misrepresentations or omissions.  The first area dealt with the cost for LVS’s planned development in Macao.  The plaintiffs alleged that LVS stated that the project would cost $12 billion, despite internal company documents showing projected costs of $16 billion. 

The plaintiffs also alleged that LVS made false representations about their cash flow and need for equity to complete the development in Macao. LVS asserted it had the financial flexibility to fund the development despite internal documents indicating the LVS could not complete the development without additional equity.

The final area of misrepresentations and omissions involved the operating conditions in Macao.  The plaintiffs alleged that LVS stated the company was experiencing high returns and strong visitation.  These statements were, according to plaintiffs, inconsistent with the company’s internal reports.  The internal reports noted poor performance and declining visitation. The court found that the plaintiffs adequately pled facts to show that the LVS’s statements were both misleading and material. 

The court held that the facts alleged in the plaintiffs’ complaint, if assumed true, “present a sufficiently cogent and compelling inference that Defendant’s recklessly or fraudulently made misstatements or omissions in violation of §10(b) . . . [were] sufficient to create a strong inference of scienter.”  

LVS argued the plaintiffs’ complaint should be dismissed because the contested statements were forward-looking.  The “safe harbor” protects from liability forward-looking statements “‘accompanied by meaningful cautionary statements.’”    The plaintiffs argued that the statements were not supplemented by cautionary language. 

The court held that LVS had provided cautionary statements that adequately described potential misfortunes that it might encounter.  As a result, the forward looking statements were protected by the safe harbor.  The court, therefore, granted the defendant’s motion to dismiss with respect to the statements about time and cost of the projects, availability of future funding, the sale of condominiums, and the company’s hopes for performance in Macao.  The court did not dismiss other allegations not considered forward-looking.    

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

The Securities Litigation Uniform Standards Act’s Bar Against Claims

In Richek v. Bank of America, 2011 WL 3421512, N.D. Ill (August 4, 2011), the United States District Court granted Bank of America and LaSalle Bank’s (“Defendants”) motion to dismiss a class action lawsuit.  The claim alleged that Defendants misrepresented and omitted material facts related to the transfer of trust assets into mutual funds.  The court dismissed the claim because the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”), 15 U.S.C. § 77p(b) and § 78bb(f)(1) precluded the plaintiffs’ claim.

Stephen Richek filed the lawsuit as the trustee of the Seymour Richek Revocable Trust (“Trust”), on behalf of the Trust and all other entities who had similar accounts with LaSalle Bank or Bank of America (“Plaintiffs”).  In July 1985, Richek entered into a written agreement with LaSalle Bank (“LaSalle”) on behalf of the Trust.  Under the agreement, LaSalle managed and maintained an investment account for the Trust, subject to Richek’s instructions.  The Trust account had a “sweep” feature, which automatically reinvested the account’s cash balances into another investment vehicle at the end of every day.  Plaintiffs selected which investment vehicles to use, however, LaSalle never disclosed the existence of the sweep feature to Plaintiffs.  In turn, these investment vehicle companies paid cash reinvestment fees (or “sweep fees”) to LaSalle.  Plaintiffs never agreed to the sweep fees.  In August 2009, LaSalle merged with Bank of America, which notified Plaintiffs that sweep fees were eliminated.  This was the first time Plaintiffs realized that sweep fees on the trust account existed.  Plaintiffs filed suit in the Circuit Court of Cook County and Defendants removed the claim to District Court.

In 1995, Congress enacted the Private Securities Litigation Reform Act (“PSLRA”) to reduce frivolous lawsuits and other perceived abuses of securities class actions.  As a result, state court litigation of class actions involving nationally traded securities began to increase.  To remedy this “unintended consequence,” Congress enacted SLUSA.  SLUSA precludes a claim when plaintiffs allege that a defendant misrepresented or employed a deceptive device in connection with the purchase or sale of a covered security, the lawsuit is a covered class action based on a violation of state law, and plaintiffs are a private party. A “covered class action” is a lawsuit in which damages are sought on behalf of more than 50 people.  A “covered security” is one traded nationally and listed on a regulated national exchange. 

Plaintiffs did not dispute that the claim involved a “covered class action,” that it was based on state law, or that the securities in question were “covered securities.”  Instead, Plaintiffs argued that the sweep fees were incidental to Defendants’ alleged misconduct and not “in connection with” the purchase of covered securities.  Plaintiffs further argued that the court should construe SLUSA’s “in connection with” requirement narrowly.  However, the court disagreed and “construe[d] SLUSA’s ‘expansive language broadly’ to prevent frustration of the PSLRA’s objectives.” 

In an attempt to distinguish the case from controlling authorities, Plaintiffs highlighted that none of the precedent cases cited by Defendants involved a “written contract” or situations in which the defendant made “discretionary” investments on the plaintiff’s behalf.  However, the court rejected these arguments because the precedent did not turn on whether Plaintiff was dissatisfied with Defendants’ “discretionary” investments.  Rather, SLUSA applied because Defendants’ representations applied to the purchase or sale of a covered security.

The court concluded that, at a minimum, LaSalle’s alleged fraudulent conduct “coincided” with a securities transaction and Plaintiffs’ claim was barred by SLUSA. 

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

Scienter Specificity Required to Plead Securities Fraud: Curry v. Hansen Medical, Inc.

In Curry v. Hansen Med., Inc., No. 5:09-cv-05094-JF, 2011 U.S. Dist. LEXIS 96697 (N.D. Cal. Aug. 25, 2011) (unpublished), the United States District Court, Northern District of California, dismissed a class action securities fraud complaint against Hansen Medical Inc. (“Hansen”) for failing to meet the heightened pleading standards required by Fed. R. Civ. P. 9(b) and the Private Securities Litigation Reform Act of 1995 (“PSLRA”).

According to the allegations made by the Plaintiffs, Hansen obtained the majority of its revenue from the sale and installation of Sensei Robotic Catheter Systems (“Sensei”). In August 2009 a whistleblower alerted Hansen of an irregularity in the installation of Sensei which resulted in improper revenue recognition. Hansen conducted an internal investigation with independent outside counsel. The investigation revealed that data on certain Sensei transactions had been withheld from the accounting department and independent auditors and that related documents had been falsified.

Hansen filed a Form 8-K with the Securities and Exchange Commission (“SEC”) on October 19, 2009, and restated its financial reports for several quarters. The plaintiffs alleged that Hansen and three Hansen directors (“Defendants”) knew of these revenue recognition errors and induced sales of stock at artificially inflated prices by making knowing and intentional misstatements in violation of SEC Rule 10b-5 and section 20(a) of the Securities Exchange Act of 1934.

To state a claim under SEC Rule 10b-5, “a plaintiff must plead (1) a material misrepresentation by the defendant; (2) scienter; (3) a connection [with] the purchase or sale of a security; (4) reliance; (5) economic loss; and (6) loss causation.” The plaintiff must specify each misleading statement and the reasons it was misleading. Scienter, the intent to deceive, manipulate, or defraud, requires the court to determine whether any allegation standing alone, would be sufficient. If no allegation meets the first inquiry, the court examines whether all of the allegations, taken together, create a strong inference of scienter.

Defendants asserted that the allegedly false statements were protected by the PSLRA safe harbor provision for certain forward-looking statements. The court noted that not all of the comments made by Defendants involved forward-looking statements but instead were “references to concrete rates of Sensei sales and user activity [and] would not be immune.”

Nonetheless, the court did not resolve the applicability of the safe harbor. Instead, the court found that the plaintiffs had not sufficiently alleged scienter. The plaintiffs mostly relied on confidential witnesses, the use of accounting treatment that violated Generally Accepted Accounting Principles (“GAAP”), and the relationship between the restatements and public equity offerings. The court found the allegations to be insufficient. Of the plaintiffs’ twelve confidential witnesses, only one was employed throughout the subject time period. Moreover, that witness’s statements relied on circumstantial evidence and did not address Defendants being fed doctored information. The court also determined that the GAAP violations were not so egregious as to establish Defendants’ awareness of a problem. Finally, the plaintiffs’ allegations that an inference of scienter was supported by the timing of two public equity offerings was also rejected. Despite the arguments that this provided a motive (the desire to raise capital), the court concluded that, in the Ninth Circuit, general allegations of “motive and opportunity,” were insufficient to support an inference of scienter.        

Because the plaintiffs’ section 20(a) claim relied on liability of Defendants for an SEC Rule 10b-5 violation, the court dismissed this claim. The court granted Defendants’ motion to dismiss with leave to amend.

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

Earning Less than Expected does not Constitute Securities Fraud: Material Yard Workers Local 1175 Benefit Funds v. Men’s Wearhouse Inc.

In Material Yard Workers Local 1175 Benefit Funds v. Men’s Wearhouse Inc., No. H-09-3265, 2011 WL 3059229 (S.D. Tex. July 22, 2011), the court dismissed an action alleging that a men’s suit retailer and the company’s officers were guilty of securities fraud.  Material Yard Workers Local 1175 Benefit Funds accused Men’s Wearhouse, CEO George Zimmer, and CFO Neill Davis of inflating the company’s 2007 earnings expectations.

Zimmer’s estimates of first and second quarter earnings were slightly below actual earnings.  The company’s estimated third quarter earnings were slightly above actual earnings.  Men’s Wearhouse predicted in November of 2007 that its fourth-quarter earnings would total between $0.43 and $0.48 and earnings for the year would be between $2.87 and $2.92.  During a call later in the quarter with analysts, Davis “admitted that the fourth-quarter would be challenging and require modest changes to promotions.”  As a result, Men’s Wearhouse stock decreased by 16%.

At the beginning of 2008, the company lowered its mid-fourth quarter earnings to between $0.16 and $0.18 and its 2007 earnings prediction to between $2.60 and $2.62.  Following the announcement, shares fell another 30%.  The actual fourth quarter earnings were $0.28 and the actual 2007 fiscal-year earnings were $2.73.

The fund alleged that Men’s Wearhouse and its officers made statements in 2007 that were materially misleading.  The fund relied upon the allegations of four “confidential witnesses,” each of whom was employed by Men’s Wearhouse or one of its subsidiaries.  The witnesses asserted that the company was aware of facts suggesting that the forecasts would not be met.  The opinion described one witness as alleging that the company

• knew that (a) its largely urban customers were susceptible to economic downturns and (b) the slowing economy that began in 2006 would be quickly reflected in 2007 sales.  He opines that it became apparent in the second quarter of 2007 that K&G would suffer a 20% decrease in revenue for that quarter and the remaining year.  This signaled a need to revise the earnings guidance.

The court stated that “[f]or a company to be responsible for an investor’s losses, the investor must show that (a) the company omitted or misstated a material fact knowingly, (b) the investor relied on that fact, and (c) his reliance directly caused his loss.”  15 U.S.C. § 78j(b).  A company or its officers has not issued misleading predictions if they are “(a) presented as predictions and (b) uttered without actual knowledge of their falsity.”  15 U.S.C. § 78u-5.

The court held that plaintiffs had not sufficiently alleged that Men’s Wearhouse had deliberately made false projections.  The various conference calls to analysts contained disclaimers that uncertainties could alter the predictions and warned that “its results were dependent on the slowing economy’s effect on the demand for tailored clothing.” The mere fact that a projection proved to be wrong was not enough to establish fraud.

The court severely criticized the plaintiffs’ use of confidential witnesses.  The trial judge described one of the witnesses as a “person without the courage of his convictions."  Under a section titled “office gossip,” he also noted that “[a] party who presents the stories of unnamed people is neither giving the court nor the defendant a plain statement of the facts” and described the practice as “dissembling.”  Likewise, “[a] secret witness is not far above a false witness.”

As for the suit itself, the court had this to say:

• The fund has lawyer friends. They talk. The fund decides to let them initiate a securities case. If the fund is wrong, it walks away with no responsibility for having wasted the company's owners' wealth. This lack of reciprocity creates what economists call a perverse incentive.

Since “[t]he fund simply equate[d] a dropped stock price to fraud,” the court dismissed the securities fraud litigation brought against Men’s Wearhouse.

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

VanCook v. SEC: Violating Rule 10b-5 through Inaccurate Time Stamps

In VanCook v. Securities & Exchange Commission, 2011 U.S. App. LEXIS 16355 (2d Cir. August 8, 2011), the Second Circuit Court of Appeals affirmed the Security and Exchange Commission’s (SEC) finding that New York stockbroker John Joseph VanCook willfully violated Section 10(b), Rule 10b-5, Section 17(a)(1), and Rule 17a-3(a)(6) of the Securities Exchange Act of 1934 (“Exchange Act”).

According to the SEC’s allegations, VanCook joined Pritchard Capital Partners (“Pritchard”) in 2001, and he persuaded the firm to use clearing broker Banc of America Securities (“BOA”). Through BOA, VanCook submitted clients’ trades after the 4:00 p.m. deadline, allowing the clients to receive the same day’s net asset value. Additionally, he purportedly disguised these late trades through a false time-stamping procedure and lied to Pritchard’s principal about his actions. Despite several warnings from attorneys and clients, Vancook continued to engage in these practices from 2001 to 2003, resulting in almost five thousand late trades. The SEC sanctioned VanCook by permanently barring him from securities work, issuing a cease-and-desist order, disgorging unjust enrichment of $533,234.01, and imposing a civil penalty of $100,000.

The Exchange Act’s antifraud provisions for securities trading include Section 10(b) and Rule 10b-5. Under these rules, the SEC must “[P]rove that in connection with the purchase or sale of a security the defendant, acting with scienter, made a material misrepresentation (or a material omission if the defendant had a duty to speak) or used a fraudulent device.” SEC v. First Jersey Sec., Inc., 101 F.3d 1450, 1467 (2d Cir. 1996). Scienter includes knowingly or willfully engaging in fraudulent or manipulative conduct.

VanCook argued that “timestamping [clients’] proposed trading sheets at the time of receipt, even if final orders came in after 4:00…satisfied any ‘4:00 p.m. rule.’” VanCook also asserted that he did not meet the requirements for liability under Rule 10b-5 because his actions were not deceitful or manipulative. The appellate court disagreed and held that VanCook’s late trading scheme resulted in “numerous deceptive acts” and “implied misrepresentation” which directly violated Section 10(b) and Rule 10b-5.

In addition, the court, in distinguishing other authority, found that VanCook’s behavior involved an “implied” misrepresentation.  As the court noted:

• We agree with the Commission that by submitting orders after that time for execution at the current day's NAV, VanCook made an implied representation that the orders had been received before 4:00 p.m., because such late trading "incorporates an implicit misrepresentation" by "falsely mak[ing] it appear that the orders were received by the intermediary before [4:00 p.m.] when in fact they were received after that time." Other courts have reached similar conclusions. We now join them, and conclude that late trading of the sort committed by VanCook constitutes an implied misrepresentation in violation of Rule 10b-5 and Section 10(b).

Finally, the court also found VanCook violated the reporting procedures in Section 17(a)(1) and Rule 17a-3(a)(6). In upholding VanCook’s personal liability on this claim, the court found that he had knowledge of, and “provided ‘substantial assistance’ to,” the violations committed by Pritchard.

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

The Unusual Administrative History of Rule 10b-5

The Supreme Court has in two recent decisions (Janus and Stoneridge) all but indicated that, were the issue to arise ab initio, there would be no private right of action under Rule 10b-5.  17 CFR 240.240.10b-5.  The rule, of course, is the primary vehicle for class actions against public companies based upon allegations of false disclosure and the legal source for the prohibition on insider trading.  The securities laws without a private right of action under Rule 10b-5 would project a very different landscape.  

But a private right of action aside, the creation of the rule itself was a result of bureaucratic serendipity that is often forgotten in the discussion over the provision.  The rule was written by Milton Freeman, one of the early greats in the securities area in 1942.   Other than the text of the rule itself, the adopting release had only this to say about the new provision:

• The Securities and Exchange Commission today announced the adoption of a rule prohibiting fraud by any person in connection with the purchase of securities. The previously existing rules against fraud in the purchase of securities applied only to brokers and dealers. The new rule closes a loophole in the protections against fraud administered by the Commission by prohibiting individuals or companies from buying securities if they engage in fraud in their purchase.

Exchange Act Release No. 3230 (May 21, 1942). 

The actual process of writing and adopting the rule was described by Mr. Freeman himself back in 1967.  Here is what he had to say about it:

• It was one day in the year 1943, I believe.  I was sitting in my office in the S.E.C.  building in Philadelphia and I received a call from Jim Treanor who was then the Director of the Trading and Exchange Division.  He said, "I have just  been on the telephone with Paul Rowen," who was then   the S.E.C. Regional Administrator in Boston, "and he has told me about the president of some company  in Boston who is going around buying up the stock of his company from his own shareholders at $4.00  a share, and he has been telling them that the company is doing very badly, whereas, in fact, the earnings are going to be quadrupled and will be $2.00 a share for this coming year.  Is there any thing  we can do about it?"  So he came upstairs and I called in my secretary and I looked at Section 10(b)   and I looked at Section 17, and I put them together,  and the only discussion we had there was where "in  connection with the purchase  or sale" should be, and we decided it should be at the end.

That was the administrative process.  It still had to be submitted to the Commission for approval.

• We called the Commission and we got on the calendar, and I don't remember whether we got there that  morning or after lunch.   We passed a piece of paper around to all the commissioners.  All the commissioners read the rule and they tossed it on the table, indicating  approval.  Nobody said anything  except Sumner Pike who said, "Well," he said, "we are against fraud, aren't we?" That is how it happened.  Louis [Loss] is absolutely right that I never thought that twenty-odd years later it would be  the biggest thing that had ever happened.   

Conference on Codification of the Federal Securities Laws, 22 BUS. LAW. 793, 921-23 (1967). 

This was truly another era, when rulemaking was not the impossible affair it is today.  See Business Roundtable v. SEC,  No. 10-1305, July 22, 2011.

Loss Causation and Class Certification: Erica P. John Fund, Inc. v. Halliburton Co.

In Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179 (2011), the Supreme Court agreed to resolve a discrepancy in the way circuit courts certified class actions in securities fraud cases. The issue was whether plaintiffs had to demonstrate “loss causation” in order to obtain certification as a class under the Fed. R. Civ. P. 23(b)(3).

EPJ Fund alleged that Halliburton violated SEC Rule10b-5 when it knowingly made false statements about its potential liability in asbestos litigation, its expected revenue from construction contracts, and its benefits of a merger with another company.  Under Rule 10b-5, a plaintiff must prove “‘(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.’”

EPJ Fund contended that Halliburton’s stock price declined once Halliburton announced corrective disclosures and that the connection between the defendant’s misrepresentation and the plaintiff’s injury was sufficient to be granted certification as a class under Basic’s fraud-on-the-market doctrine.  Basic Inc. v. Levinson, 485 U.S. 224 (1988).  The fraud-on-the market doctrine presumed that an investor relied on the defendant’s misrepresentation during the relevant transaction and that the misrepresentation was “reflected in the market price.” Defendant asserted and the appellate court agreed that EPJ Fund also had to establish loss causation at the certification stage to “trigger the fraud-on-the-market presumption.”   Because plaintiff had not sufficiently alleged the element, the class was not certified.   

On June 6, 2011, the Supreme Court unanimously decided that the Fifth Circuit erred in requiring the plaintiffs to prove loss causation to obtain class certification and remanded the case for further proceedings.  The Court held that at the class certification stage EPJ Fund only needed to meet the requirements of Fed. R. Civ. P. 23(b)(3), and not the loss causation element of SEC Rule 10b-5.  Fed. R. Civ. P. 23(b)(3) states that a court must  find “that the questions of law or fact common to class members predominate over any questions affecting only individual members, and that a class action is superior to other available methods for fairly and effectively adjudicating the controversy.” 

In securities fraud cases, reliance on the defendant’s alleged misrepresentation is the essential element and question of law that predominates the underlying action. Basic allowed plaintiffs to obtain class certification based on a fraud-on-the-market theory alone, and did not require additional evidence of loss causation.   As the Court observed:

The Court of Appeals’ requirement is not justified by Basic or its logic. To begin, we have never before mentioned loss causation as a precondition for invoking Basic’s rebuttable presumption of reliance. The term “loss causation” does not even appear in our Basic opinion. And for good reason: Loss causation addresses a matter different from whether an investor relied on a misrepresentation, presumptively or otherwise, when buying or selling a stock.

The Court spent a considerable portion of the opinion discussing the differences between loss causation and reliance and finally concluded that “[l]oss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.” 

The Court, therefore, concluded that loss causation, as an element of reliance, did not have to be established at the class certification stage.  However, according to the Corporate Law Daily, the only place that this decision has an impact is the Fifth Circuit, because it was the sole circuit that required loss causation for class certification.

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

Morrison, Jurisdiction and the Uncomfortable Results of the Supreme Court's Analysis (Part 4)

Morrison addressed jurisdiction over actions under Rule 10b-5.  The Court required that the relevant security be traded on a US stock exchange or that the transaction occur in the US.  The Court did not deal with other antifraud provisions, particularly Section 17(a) of the Securities Act of 1933.  That provision largely duplicates Rule 10b-5 except that it applies not just to sales but also to offers.  

The applicability of Morrison came up in SEC v. Tourre, the surviving remnant of the case brought against Goldman Sachs.  Tourre sought dismissal of the action against him on the grounds that many of the claims were precluded by the analysis in Morrison.  The court agreed with respect to the claims brought under Rule 10b-5.  The SEC did not allege that the relevant investors had assumed "irrevocable liability" in the US.  Instead the Commission sought to establish jurisdiction by showing that "the entire selling process" had taken place in the US.  Such activity was not, however, enough under Morrison to establish the application of Rule 10b-5.

• The shortcoming of all of this U.S.-based conduct is precisely that—it is just conduct. Morrison was clear that domestic conduct is not the test for determining Section 10(b) liability.  130 S. Ct. at 2884 (explaining "the focus of the Exchange Act is not upon the place where the deception originated, but upon purchases and sales of securities in the United States" and that "Section 10(b) does not punish deceptive conduct, but only deceptive conduct 'in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered'").

The claims under Section 17(a), however, were treated differently.  Essentially, Tourre argued that the antifraud provisions in the 1933 Act should have no greater geographical reach than those in the Exchange Act.  The court disagreed.   

• Tourre argues that the SEC's allegation that Goldman offered ABACUS securities to IKB from the United States is irrelevant because IKB is based in Germany. In effect, Tourre's argument is that an "offer," even if made in the United States, is not domestic if it is made to a foreign party. Nothing in the definition of "offer," however, indicates that the focus of that term, for purposes of Section 17(a) liability, is on the recipient. To the contrary, the Securities Act defines an "offer" to "include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value." 15 U.S.C. 77b(a)(3).  This definition leaves no doubt that the focus of "offer," under the Securities Act, is on the person or entity "attempt[ing] or offer[ing] to dispose of" or "solicit[ing] . . . an offer to buy" securities or security-based swaps. Id.

To adequately establish jurisdiction, the SEC had to allege an "(1) 'attempt or offer[,]' in the United States, 'to dispose of' securities or security-based swaps or (2) 'solicit[,]' in the United States, 'an offer to buy' securities or security-based swaps."  The court found that the SEC met this pleading standard.

• Here, the SEC alleges Tourre, acting in and from New York City, offered ABACUS notes to IKB and solicited ABN's participation in an ABACUS CDS via direct and indirect communications. These communications included phone calls Tourre participated in from New York City and/or emails he sent from New York City to IKB and ABN regarding ABACUS and constituted domestic "offers" of securities or security-based swaps.  In these communications, the SEC alleges, Tourre knowingly, recklessly, or negligently failed to disclose Paulson's involvement in the portfolio selection process.  In view of these allegations, the SEC sufficiently alleges Tourre violated Section 17(a) with respect to IKB and ABN. 

Behavior short of an actual sale will not, therefore, be subject to Rule 10b-5 but can easily be subject to Section 17(a).  This increases the category of foreign companies with exposure in the US and increases the "probability of incompatibility with the applicable laws of other countries".

The consequence of the decision is to force the SEC to make greater use of Section 17(a) when bringing actions against foreign issuers.  One consequence is that the SEC will bring actions under a Section that requires a lower state of mind.  Unlike Rule 10b-5, Section 17(a)(2) and (a)(3) do not require scienter; negligence will suffice. 

Tourre has filed a motion for reconsideration.  For primary materials on this case, including the motion for reconsideration, go to the DU Corporate Governance web site.

Morrison, Jurisdiction and the Uncomfortable Results of the Supreme Court's Analysis (Part 3)

The 11th Circuit, however, reversed the trial court's decision and applied the analysis set out in Morrison.  The court noted that "regardless of whether the underlying fraudulent conduct occurs in or affects the United States, § 10(b) applies only where the security at issue is listed on a domestic stock exchange or, if not so listed, where 'its purchase or sale is made in the United States.'” 

Because the stock involved in the allegedly fraudulent transaction was not listed on a US stock exchange, the only issue was whether the sale occurred in the US.  Id.  (" In this case, there is no dispute that the Templeton stock was not listed on a domestic stock exchange, and so the only issue under Morrison is whether the 'purchase or sale' occurred in the United States."). 

Plaintiffs alleged that in fact the closing took place in this country.   Irrespective of the location of the fraud or the activities leading up to the sale, this was enough to establish the applicability of Rule 10b-5. 

• Thus, Quail alleged that the closing actually occurred in the United States, and it was here that “the transaction [wa]s consummated.”  Black’s Law Dictionary 291 (9th ed. 2009) (defining “closing”).  Indeed, the purchase and sale agreement confirms that it was not until this domestic closing that title to the shares was transferred to Quail.

Thus, a transaction otherwise taking place overseas becomes subject to US jurisdiction of the transfer happens to occur in the US.  Investors seeking the protections of the US antifraud provisions for their foreign transaction need only provide for consummation in the US, something that can be imposed in the sales documents.  Moreover, the approach allows for the applicability of the antifraud provisions in circumstances that would not have been allowed under the conduct and effects test.

Jurisdiction has become an arbitrary matter that turns on the location of the transactions. Its not a good result but it is what the Supreme Court commanded in Morrison.

The cited brief and the appellate opinion for this case can be found at the DU Corporate Governance web site.

Morrison, Jurisdiction and the Uncomfortable Results of the Supreme Court's Analysis (Part 2)

Some of the consequences of the Supreme Court's reasoning in Morrison can be seen from a recent decision in the 11th Circuit. 

In Quail Cruises Ship v. Agencia de Viagens CVC Tur Limitada, No. 10-14253, 11th Cir., July 8, 2011, the court addressed a securities fraud action brought by a foreign investor (Quail Cruises is a Bahamian corporation) against a foreign issuer (Templeton International, Inc. is also a Bahamian corporation).   Moreover, according to a brief for one of the defendants, most of the investment activity (and presumably the fraud) occurred outside the US.

• The district court correctly determined that the Amended Complaint failed to state a claim under §10(b) of the 1934 Act because Quail alleged fraud in connection with a “transaction” that did not take place in the U.S. As pleaded in the Amended Complaint, the transaction that triggered Quail’s fraud claims consisted of: I) a proposal for the sale of stock made in late May, 2008 in Brazil; ii) an agreement for the purchase and sale of that stock in late May or early June, 2008, that was entered into outside of the U.S. by two entities, neither of which was organized or based in the U.S.; iii) a “formal stock purchase agreement” that was entered into outside the U.S. in June, 2008, between two entities, neither of which is even a party to this action; and iv) a so-called “closing” in Florida that, as described in the Amended Complaint, consisted of nothing more than the transmission of previously executed and effective transaction documents to the Florida offices of Quail’s counsel.
  

In other words, the case involved a foreign security, a foreign plaintiff, and fraud that presumably took place outside the US. 

The district court dismissed the case relying on Morrison.  See 732 F.Supp. 1345 (SD Fla. 2010).  The court was concerned that jurisdiction in the US had been deliberately triggered by ensuring that the transaction took place in the US.  As the court noted:

• The Defendants also contend that Morrison's central holding would be undermined if parties could elect United States securities law merely by designating the law offices of one of the parties' counsel, located in the United States, as the place of closing the transaction when the transaction otherwise has no relationship with the United States. The Court agrees with the Defendants' analysis. Just as Title VII concerns domestic employment, the Securities and Exchange Act concerns domestic securities transactions. The principle takeaway from Morrison is that Congressional intent, not the intent of the parties, is dispositive of the application of federal securities law to foreign securities transactions. Adopting a rule that permits the intent of parties located abroad and contracting from their home countries in a wholly off-shore transaction to apply United States securities law is inconsistent with Morrison. 

The implication of the lower court's opinion was, apparently, that those allegedly defrauded could not arrange to arbitrarily seek application of the antifraud provisions while those committing the fraud could arbitrarily seek to avoid application of the antifraud provisions.  See SEC v. Goldman Sachs, 2011 U.S. Dist. LEXIS 62487 (SD NY June 10, 2011) (“In response, at oral argument, the SEC argued that U.S. companies should not be allowed to skirt U.S. federal securities laws by using foreign affiliates to complete securities transactions. Justice Stevens voiced similar concerns in a concurring opinion in Morrison.”).

We will look at the 11th Circuit's approach in the next post.

The cited brief and the appellate opinion for this case can be found at the DU Corporate Governance web site.

Morrison, Jurisdiction and the Uncomfortable Results of the Supreme Court's Analysis (Part 1)

As we have noted on this Blog, the Supreme Court in Morrison v. NAB adopted an uncomfortable test for determining when courts have jurisdiction over securities fraud suits involving foreign issuers. The Court wanted to limit the impact of Rule 10b-5 on these issuers but did so with a test that produced anomalous results. 

In an effort to do away with the fact specific "conduct and effects" test, the Court shifted the focus away from the actual fraud and replaced it with an emphasis on the type of security involved or the the location of the transaction.  The Court held that Rule 10b-5 gave courts jurisdiction over securities traded on a US exchange and over transactions that occurred in the United States. 

With the location of the fraud rendered irrelevant, the test allowed for securities fraud to be conducted entirely within the borders of the US but to avoid applicability of Rule 10b-5 so long as the security was not traded on an exchange and the actual transaction took place elsewhere.  Imagine a ponzi scheme occuring in the US but where the final sales pitch and transaction takes place at a resort in Mexico.  The SEC has indicated concern with this type of manipulation of the antifraud provisions, but it is allowed under the Supreme Court's reasoning.  See SEC v. Goldman Sachs, 2011 U.S. Dist. LEXIS 62487 (SD NY June 10, 2011) (“In response, at oral argument, the SEC argued that U.S. companies should not be allowed to skirt U.S. federal securities laws by using foreign affiliates to complete securities transactions. Justice Stevens voiced similar concerns in a concurring opinion in Morrison.”). 

The holding also did not accomplish its central goal of excluding foreign issuers from the reach of Rule 10b-5.  With the analysis focused on the location of the transaction, the Court left open the possibility that jurisdiction would arise where the company and shareholders were foreign, the fraud took place entirely overseas, but the sale actually occurred in the US.  How might this occur?  An investor could insist that the transaction take place in the US solely to ensure attachment of the federal antifraud provisions. 

Perhaps because of the disconnection between the goal and the test, the federal courts in New York have struggled with the standard.  They have tended to exempt transactions in foreign companies even if the sale occured in the United States.  Thus, one court found a lack of jurisdiction for transactions in ADRs where the sales took place in the US. 

In fact, this very possibility has occurred.  We will discuss the case in the next post.

In this case, there is no dispute that the Templeton stock was not listed on a

domestic stock exchange, and so the only issue under Morrison is whether the

“purchase or sale” occurred in the United States.

US Competitiveness and Securities Class Actions: The Need for a New Explanation

Securities class actions fraud suits have been subject to a number of restrictions and limitations designed to reduce their frequency. 

Some seek to make the cases more difficult to bring, irrespective of whether fraud actually occurred.  The PSLRA and the need for a "strong inference of scienter" is the best example of reducing fraud suits not by reducing fraud but by imposing higher pleading standards.  Similarly, the Supreme Court's decision in Stoneridge and now Janus have gone a long way to eliminating fraud actions against tertiary players, even when they commit a deceptive act.

Another sent of changes has been designed to reduce the incidents of fraud.  Changes in Sarbanes-Oxley strengthened the role of the audit committee in the oversight of financial disclosure.  CEOs and CFOs had to certify the accuracy of the financial statements in periodic reports, something that no doubt caused greater focus on their contents.

All of this has impacted the number of securities class action fraud suits.  The most recent report from the Standford Clearinghouse on securities fraud actions shows that, for the first half of 2011, the numbers are down.  For the six month period, 94 actions were filed, a decline of 9.6% from the prior year.  Moreover, 2010 itself had a relatively low level of activity.  Of the 14 years of data on the Stanford site, it was the fourth lowest in total number of securities class action fraud suits (176 actions). 

The data also shows that size matters.  Of the 96 suits filed in the first half of 2011, twenty four arose out of Chinese reverse mergers.  These are on the whole smaller companies.  Only 8.5% of the cases brought were against companies in the S&P 500, down from 15.4% the year before.  So the data shows that there were fewer suits brought against smaller companies.

The reduction in fraud suits for 2011, while only a six month period, looks to be part of a broader trend.  With the exception of a spike in 2008, the number of securities class action lawsuits has remained significantly below levels seen from 1998 to 2004.  In other words, whether explained by SOX or the PSLRA, the actions have become less common. 

There was a time when securities litigation was routinely blamed for the perceived decline in US competitiveness in the global market place.  The Supreme Court used it as a justification for narrowing the reach of Rule 10b-5 in Stoneridge.  Yet as the number of fraud actions continues to decline, perhaps it is time to look for other sources that really may explain the perceived decline in competitiveness.   

SEC Vacates 21(d)(3) Penalties for Insider Trading

In SEC v. Rosenthal, 10-1204-cv (L) (2d Cir. June 9, 2011), the court held that section 21(d)(3) of the Securities Exchange Act of 1934 does not provide for civil monetary penalties for insider trading. 

According to the allegations in the case, Amir Rosenthal, one of the defendants, learned from a friend working at Ernst & Young in April 2005 about a proposed acquisition of a public company by an Ernst & Young client. After obtaining this information, Amir sold put options of the target company.  In addition, Amir passed the information on to his supervisor at his law firm; Amir’s supervisor subsequently purchased call options for the target company. Ultimately, the transaction did not take place and Amir’s put options did not generate profits or avoid any losses. 

While working as an accountant at PricewaterhouseCoopers in May 2005, Ayal Rosenthal, Amir’s brother and another defendant in the case, also learned of a proposed merger and shared this information with Amir.  Once again, Amir sold put options and his supervisor bought call options.  Upon learning from Ayal that the merger would not take place, Amir liquidated the position without generating profits or avoiding losses. 

The Court of Appeals began its analysis of whether the defendants faced penalties pursuant to section 21(d)(3).  As the provision provides:

Whenever it shall appear to the Commission that any person has violated any provision of this chapter, [or] the rules or regulations thereunder, . . . other than by committing a violation subject to a penalty pursuant to section 78u-l of this title, the Commission may bring an action in a United States district court to seek, and the court shall have jurisdiction to impose, upon a proper showing, a civil penalty to be paid by the person who committed such violation.

Section 21A provides that penalties may be imposed for "purchasing or selling a security . . . while in possession of material, nonpublic information in, or . . . communicating such information in connection with, a transaction . . . ." 15 U.S.C. § 78u-1(a)(1).   Penalties were computed based upon the profits gained or the losses avoided.  Id. 

The SEC asserted that Section 21A was inapplicable because, while both brothers engaged in insider trading, neither earned any profits (or avoided any losses).  As a result, they could not be subjected to a penalty under the Section.

 After finding the statutory language ambiguous, the court concluded that the applicability of Section 21A did not depend upon whether the insider trading transaction resulted in profits but only whether insider trading had occurred.  The court held that “a defendant is ‘subject to’ a penalty under 21A as soon as he engages in insider trading, regardless of whether this activity ultimately ripens into profits or permits the avoidance of losses.” 

Based on this reading of 21A, the court found the defendants satisfied the requirements because they “purchased or sold securities ‘while in possession of material, nonpublic information’ or ‘communicat[ed] such information in connection with’ such transaction.”  One who violates insider trading laws is subject to a penalty directly proportional to the “profit gained or the loss avoided.” 

Because the defendants neither made money nor avoided losses, the court determined that the defendants were ineligible for a monetary penalty under Section 21A.  The applicability of Section 21A, however, took them outside of the penalties contemplated by 21(d)(3). 

Similarly, the court found support in the legislative history of Section 21(d)(3).  The provision was enacted with the intention of filling a gap to cover securities law violations other than section 21A and insider trading.  As a result, the court concluded the 21(d)(3) civil penalties imposed on the defendants must be vacated. 

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

Holder Doctrine Not An Obstacle to Plaintiffs’ Claims Under Colorado Securities Laws

In a recent ruling, the U.S. District Court for the District of Colorado allowed a suit brought under the Colorado Securities Act where the plaintiffs neither purchased nor sold securities but instead relied on misrepresentations in deciding to retain their investment and lost $65 million as a result.  Agile Safety Variable Fund L.P. v. RBS Citizens, N.A., No. 09-cv-02786-WJM-BNB, D. Colo., May 31, 2011.  

The plaintiffs in the case are Agile Safety Variable Fund L.P. and Sky Bell Select L.P.  According to the allegations.  Agile invested in Lancelot Investors Fund L.P. and Lancelot Investors Fund II, L.P. in 2004.  By 2007, Agile was beginning to question its investments in Lancelot and decided to pursue additional due diligence.  As part of its due diligence, Agile talked to Charter One, one of the defendants and Lancelot’s financing bank.  Charter One assured Agile that it performed bi-annual, independent audits of Lancelot’s records, and also vouched for Lancelot’s manager, citing a long-standing relationship.  Swiss Financial, the other defendant and Lancelot’s fund manager, provided similar assurances to Agile, including personal assurances by the chief executive officer that Swiss Financial was comfortable with Lancelot following an investigation of the fund.

As a result of these assurances, Agile decided to retain its investment in Lancelot.  In September 2007, just one month after Charter One provided Agile with information regarding the field exam of Lancelot, Agile formed an additional entity, Sky Bell, solely to invest in Lancelot.  A year later, in September 2008, a federal grand jury indicted Lancelot’s principal, Thomas Petters, on allegations of fraud.  One month later, Lancelot filed for bankruptcy.

Agile and Sky Bell sued Swiss Financial and Charter One for negligent misrepresentation, negligence, and violation of Colorado’s securities laws.  Plaintiffs alleged that Swiss Financial never independently verified Lancelot’s assets and thus failed to uncover the fact that Lancelot had no assets.  The plaintiffs survived motions to dismiss on all three claims. 

With respect to the claim under the Colorado Securities Act, defendants sought dismissal asserting that plaintiffs had not, as a result of the alleged misrepresentations, purchased or sold securities.  Instead, the plaintiffs had acquired the securities before the alleged wrongdoing and, as a result, were precluded from recovery under the “holder doctrine.”  The doctrine precluded claims alleging material misrepresentations or omissions that merely caused investors to retain ownership of securities acquired prior to the alleged wrongdoing.  Such claims are not recognizable under the federal securities laws because of the inherently speculative nature of proving reliance and damages.  See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 739-40 (1975).

The court held that the plaintiffs’ decision to retain their ownership interest in the securities as a direct result of the defendants’ misrepresentations was sufficient to satisfy the Act’s requirements.  The court noted that the policy concerns underlying the holder doctrine were inapplicable because unlike owners of common stock, the plaintiffs could not buy or sell their interests in Lancelot on an open market at will, removing the speculative element from their actions.  Moreover, the presence of direct communications and representations between the shareholder and the persons making the alleged misrepresentations provided evidence of actual reliance on the alleged misrepresentations.  The court concluded that “the evidence was sufficient to persuade a reasonable jury that Agile had every intention to redeem its Lancelot investments in early 2007, and not only was dissuaded from doing so by the Defendants’ affirmative misrepresentations, it was also induced to increase exposure in Lancelot through the reinvestment of its monthly returns.”

The court rejected the defendants’ argument that the plaintiffs’ failure to purchase their Lancelot interest through the defendants defeated the plaintiffs’ cause of action, because the Colorado Securities Act does not require privity.

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

Janus Capital: What it means to ‘make’ a statement under Rule 10b-5

Janus Capital Grp. v. First Derivative Traders, 2011 WL 2297762 (U.S. June 13, 2011), created a shield to liability for investment fund advisors by narrowing the reach of Rule 10b-5, the antifraud provision in the Securities Exchange Act of 1934.  17 CFR 240.10b-5.  The decision allows advisors to circulate prospectuses for investment funds even when they know the document contains false statements.  The Court reached this result by concluding that the fund rather than the advisor had ultimate control over the statements in the prospectuses.

First Derivative Traders (“First Derivative”), a group owning stock in Janus Capital Group (“JCG”), brought a class action suit under Rule 10b-5 for securities fraud.  First Derivative alleged that a subsidiary of JCG known as Janus Capital Management LLC (“JCM”), distributed prospectuses for Janus Investment Fund while knowing that the prospectuses contained false statements.

Under SEC Rule 10b-5, a plaintiff must show that the defendant made a material misrepresentation or omission, with scienter, a connection between the misrepresentation or omission and purchase or sale of a security, reliance, economic loss, and loss causation.  Defendants, however, asserted that they were not responsible for the allegedly false information in the prospectuses because they had not “made” the statements.  Instead, the statements had been made by the Funds, the entities legally responsible for drafting, issuing and filing the prospectuses.

The Court agreed with the defendants.  The Court focused its analysis on the word “make” contained in Rule 10b-5 (providing liability for those who “make any untrue statement of a material fact”).   It stated, “[f]or purposes of Rule 10b-5, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”

This ruling narrowed the scope of private action under SEC Rule 10b-5 by only allowing private action against those who actually “make” the “untrue statement of material fact.”  To the Court, those were the persons with “ultimate authority” over the statements.  Id. (“For purposes of Rule 10b–5, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”).  As the Court elaborated:

• “Without control, a person or entity can merely suggest what to say, not ‘make’ a statement in its own right.  One who prepares or publishes a statement on behalf of another is not its maker.”

The majority went on to explain that contributing substantial assistance will not be seen as making a statement under SEC Rule 10b-5.  The Court decided that Janus Investment Fund had final say over what was published in its prospectuses.  This meant that the fund, not JCM, was “making” the statements contained in its prospectuses. In arriving at the conclusion, the Court emphasized that Janus Investment Fund and JCM were separate and that “the two entities maintain[ed] legal independence.”

Commentators see this as a blow to primary liability to non-speaking advisors of investment funds.  Some speculate this will lead to the SEC taking action to alter primary liability or result in more suits relying on theories of secondary liability.

Commentary regarding this case can be found here.

The dissenting Justices outlined the problems with this ruling, which we have previously discussed here.

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