McDowell v. Lopez: Arizona Court KOs Securities Fraud Claim

In McDowell v. Lopez, 2 CA-CV 2011-0073, 2012 WL 376690 (Ariz. Ct. App. Feb. 7, 2012), the Arizona court affirmed the finding that the the challenged transaction was not a security under the state statute. 

Joe Lopez (“Lopez”) promoted Mixed Martial Arts (“MMA”) or cage fighting events. In 2007, through his company Ringside Sports and Entertainment LLC, he organized an MMA event to be held in Sonora, Mexico.  Diana McDowell (“McDowell”) invested $20,000 in return for a percentage of the profits. The parties never signed a written agreement and McDowell received very little profit on her $20,000 investment or the $16,737 she paid to the fighters.

In her complaint, McDowell asserted claims of breach of contract, securities fraud, and common law fraud. In addition, she requested a partnership accounting.  An arbitrator ruled that the arrangement between McDowell and Lopez was an investment contract and that Lopez had committed securities fraud.  Lopez appealed to the superior court and the jury found in his favor on all counts. McDowell’s motions for a judgment as a matter of law and for a new trial were denied.

On appeal, McDowell argued that the trial court erred in “up[holding] a jury verdict in the face of a clearly defined investment contract” and that “Lopez violated Arizona securities law by failing to disclose certain material facts when he solicited the investment from her. The court recognized that before ruling  on the alleged fraud, it first had to determine whether the parties’ agreement constituted an investment contract. To do so, the court employed the three-part test developed by the United States Supreme Court in Securities and Exchange Commission v. W. J. Howey Co. According to the test, an investment contract exists when there is “(1) an investment of money, (2) in a common enterprise, (3) with the expectation that profits will be earned solely from the efforts of others.”  Given that there was no dispute as to the first two elements, the court focused its analysis on whether McDowell earned profits from the sole efforts of Lopez. S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298 (1946).

 Since McDowell and Lopez did not have a signed contract detailing their arrangement, the court “look[ed] to the nature of the parties’ relationship after the investment was made to determine their intent.”  Lopez testified that he and McDowell worked together to plan the event. When questioned as to the nature of the deal, McDowell described her relationship with Lopez as a partnership. McDowell also admitted that she knew she was taking a risk when she invested with Lopez and that profits were never guaranteed. The court determined that McDowell was involved in the “essential managerial efforts” of the venture and that she was aware of her risks.

The court held that the jury reasonably could have found that the parties’ agreement was not a security, or that Lopez did not commit fraud under Arizona Revised Statute § 44-1991(A), or both. Therefore, the court affirmed the trial court’s denial of McDowell’s motion for judgment as a matter of law. The court also affirmed denial of McDowell’s motion for a new trial on her claim for securities fraud.

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



City of Farmington Hills Employees Retirement System v. Wells Fargo Bank, N.A.: Court Grants Plaintiff’s Motion for Class Certification in Securities Lending Case

 In City of Farmington Hills Employees Ret. Sys. v. Wells Fargo Bank, N.A., 2012 U.S. Dist. LEXIS 41752 (D. Minn., Mar. 27, 2012), the court granted the City of Farmington Hills Employees Retirement System’s (“Plaintiff”) motion for class certification, allowing more than one hundred similarly situated institutional investors to bring a class action against Wells Fargo Bank, N.A. (“Wells Fargo”) for losses suffered from January 1, 2006 to the present as a result of their participation in Wells Fargo’s securities lending program (“SLP”).

According to the complaint, participants in the SLP allowed Wells Fargo to loan their securities to third-party borrowers in exchange for cash collateral; Wells Fargo would then invest and share a percentage of the revenues with the original participants.  Each putative class member, including Plaintiff, participated in the SLP and entered into one or more securities lending agreements with Wells Fargo.  Each lending agreement, as well as the investment guidelines for all accounts within the SLP, contained the phrase “[t]he prime consideration for the investment portfolio shall be safety of principal and liquidity requirements.”

Plaintiff and class members alleged that Wells Fargo failed to abide by this prime consideration and instead improperly invested proceeds in “high risk, long-term securities” and “systematically obscured the effects of its mismanagement by concealing investment performance . . . in order to prevent [putative class members] from exiting the SLP.”

 Plaintiff sought class certification under Federal Rule of Civil Procedure 23 (“FRCP 23”) on its breach of fiduciary duty, breach of contract, and consumer fraud claims.  FRCP 23(a) requires the following for class certification: “(1) the putative class must be so numerous that joinder of all members is impracticable; (2) questions of law or fact common to the class; (3) the claims or defenses of the class representatives must be typical of the claims or defenses of the class; and (4) the representative parties will fairly and adequately protect the class’ interests.”

Wells Fargo contested only the typicality and adequacy of the representation requirements.  It contended that putative class members entered into different agreements, participated in different pools within the SLP, and withdrew from the SLP at different times.  The court stated that “a common mandate to ensure liquidity and safety of principal existed across all of the funds” and the withdrawal date of class members was only relevant to the question of damages.  Because the putative class members pursued the same legal theories, the court held the typicality requirement was met.

The court next determined whether Plaintiff was “able and willing to prosecute the action competently and vigorously” and whether Plaintiff’s “interests [we]re sufficiently similar to those of the class that it is unlikely that their goals and viewpoints will diverge.”  Wells Fargo argued that there would be inevitable tension between the investors who withdrew from the SLP early and those who remained in the SLP until later.  The court disagreed, stating that Plaintiff and the other class members shared “the common goal of recovering damages from Wells Fargo as a result of the SLP’s losses.”

The court also determined that “questions of law or fact common to the members of the class” predominated over individual class members’ questions, thereby satisfying the predominance requirement in FRCP 23(b)(3).  The court’s finding of predominance will allow class members to use generalized, rather than individualized, evidence to prove the class’ claims against Wells Fargo.

Finally, the court determined that a class action was a superior form of action for this case, due to the efficiency and economy of combining all of the putative class members’ claims and the relative ease of managing this particular class action, given the similarity amongst the putative class members’ claims.

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



Fulton v. MGIC: Limiting Duties that a Corporation Owes to its Shareholders

In Fulton Cnty. Emp. Ret. Sys. v. MGIC Inv. Corp., No. 11-1080, 2012 WL 1216314 (7th Cir. Apr. 12, 2012), the Seventh Circuit of the U.S. Court of Appeals affirmed the district court’s dismissal of the appellant’s derivative action for failure to meet the heightened pleading standard under the Private Securities Litigation Reform Act (“PSLRA”). 

According to the complaint, MGIC, a private mortgage insurance company, owned a 46% equity stake in Credit Based Asset Servicing and Securitization, LLC (“C BASS”).  C BASS securitized single-family residential mortgage loans.  C BASS bought mortgages on the secondary market that were mostly subprime, consolidated them into packages, and sold security interests in the packaged loans to investors.  This type of business structure required C BASS to keep the collateral of its loan packages at contractually specified levels.  If the collateralized level dropped too low, lenders demanded margin calls, which required C BASS to contribute large portions of its cash reserves into the loan packages to meet the margin call requirements.  On July 19, 2007, C BASS’s cash reserves were $150 million; however, between July 19 and August 2, C BASS received another $470 million in margin calls.  On July 30, 2007, MGIC decided to stop investing in C BASS, which was at one time worth $516 million, and MGIC declared that its investment in C BASS would be written off as a loss. 

Plaintiff, on behalf of a class, alleged that the defendants committed securities fraud in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5. On appeal, Fulton County Employees Retirement System (“Fulton”) reduced its complaint to a sole claim that MGIC Investment Corporation (“MGIC”) committed fraud during, and in connection with, its quarterly earnings call on July 19, 2007.  Plaintiff also contended that MGIC was vicariously liable for statements made by the CEO and COO of C BASS at the press release under § 20(a) of the 1934 Act because MGIC was the “controlling person” over C BASS management.  In upholding the dismissal of the case, the court held that the proposition that MGIC should have seen the cash reserve problem looming may have been sufficient for negligence, but did not reflect the state of mind required to prove fraud.  The court reasoned that the $150 million in cash reserves that C BASS had on July 19 was “substantial liquidity,” demonstrating that C BASS did not have bad intent.  Additionally, the press release disclosed multiple problems that MGIC encountered, including the liquidity risk at C BASS.  MGIC managers did not have any private information that they failed to reveal at the press conference.  The problem that MGIC and C BASS faced was market-wide, apparent to anyone who studied the markets, and “MGIC had no duty to foresee the future.”

With respect to the claim under § 20(a), the court held that MGIC’s 46% equity share did not allow MGIC to exercise unilateral control over C BASS and that the members of C BASS’s management acted as independent agents, speaking for themselves. 

Finally, the court declined to find MGIC liable for statements issued by managers of CBASS.  Plaintiff asserted that because these managers had been “invited” to speak, MGIC “effectively ‘made’ their statements.”  The court concluded that the argument could not be “squared” with the analysis in Janus.  As the court reasoned:  “We have explained why Williams and Draghi, not MGIC or its officers, had ultimate authority over their own statements. Janus Capital prevents treating MGIC as the statements' maker.”   Nor was there any obligation on the part of MGIC to correct any errors made by Williams and Draghi. 

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



In re Merrill Lynch Auction Rate Securities: Investor’s Claims Against Merrill Lynch and Money Market 1 Dismissed

In re Merrill Lynch Auction Rate Securities Litigation arose out of an action by an investor, Louisiana Pacific Corporation (“plaintiff”) filed suit against underwriters Merrill Lynch & Co. and Merrill Lynch, Pierce, Fenner and Smith Inc. (collectively “Merrill Lynch”); and broker-dealer Money Market 1 Institutional Investment Dealer (“MM1”) in connection with  the sale of auction rate securities (“ARS”).  2012 WL 523553, No. 09 MD 2030(LAP) (Feb. 15, 2012).  The court dismissed, with prejudice, claims against Merrill Lynch for market manipulation and securities fraud, under Section 10(b) of the Securities Exchange Act of 1934 (“1934 Act”) and Rule 10b-5.  The court dismissed, with prejudice, market manipulation and securities fraud claims against MM1 under Section 10(b) of the 1934 Act.  The court granted a motion to strike by MM1 while it denied MM1’s motion to dismiss the claims against it for breach of fiduciary duty.

ARS are “variable-rate debt instruments with interest rates set by way of periodic auctions in which potential buyers submit bids at various interest rates.”  According to the complaint, the plaintiff, between February 5 and July 30, 2007,  made approximately $55,575,000 worth of purchases of collateralized debt obligations (“CDOs”) involving Merrill Lynch and MM1.  Merrill Lynch was the sole broker-dealer for these issuances, and it remarketed the CDOs to other broker-dealers.  By placing “support bids,” Merrill Lynch participated as both a buyer and a seller in the auctions. 

In May 2006, the Securities and Exchange Commission (“SEC”) issued a cease and desist order stating this practice was a violation of securities laws unless it was fully disclosed.  After the order, Merrill Lynch disclosed its ARS practices online in response to the SEC’s requirement. The plaintiff also alleged that MM1 misrepresented that the CDOs purchased were “safe and liquid money market equivalents” and that the investments had no subprime market exposure.  MM1 recommended the CDOs at issue here to the plaintiff, despite specific direction to MM1 not to invest in structured finance investments like CDOs.  Additionally, MM1 stated that there was “virtually no risk of auction failure.” 

The plaintiff’s securities fraud claims under Section 10(b) alleged the failure by Merrill Lynch to disclose its ARS activities in the market.  To survive a motion to dismiss, the plaintiff’s claims each require allegations of a material misstatement or omission.  While security law violation claims require a heightened pleading standard under the Federal Rules of Civil Procedure 9(b) and the Private Securities Litigation Reform Act of 1995 (“PSLRA”), the court found that Merrill Lynch’s website disclosures constituted adequate notice of its ARS activities, especially because of the highly publicized SEC order and the sophistication of the investor.  The court also stated that the plaintiff did not adequately plead scienter.  The pleading required a showing that “the defendants had both the motive and opportunity to commit the fraud,” and here the claims against Merrill Lynch amounted to nothing more than “allegations of general business motive to make profit.” 

With respect to the securities fraud and manipulation claims against MM1, the court found that the plaintiff failed to plead the fraudulent conduct with the particularity required by the Federal Rules of Civil Procedure 9(b) and the PSLRA.  The plaintiff did not name speakers, listeners or dates of the misstatements, and failed to allege any connection between the misstatements and the ARS at issue.  The claims also failed for lack of justifiable reliance due to the sophistication of the investor.  The court granted MM1’s motion to strike the plaintiff’s punitive damages language from the complaint because the claim of breach of fiduciary duty has an extremely high bar for allowing punitive damages, and it was not met here.

The primary materials for this case are available on the DU Corporate Governance website.


Picard v. Katz: Madoff Trustee Wrestles Mets Owner to a Draw

In Picard v. Katz, No. 11cv03605JSR, 2012 WL 691551 (S.D.N.Y. March 5, 2012), the court granted partial summary judgment in favor of plaintiff-trustee Irving Picard and denied the motion for summary judgment submitted by defendants Saul Katz and Fred Wilpon. 

This litigation stemmed from Picard’s ongoing effort as court-appointed trustee of Bernard Madoff’s investment firm, Madoff Securities, to recover money for the victims of Madoff’s Ponzi scheme.  In March of 2011, Picard filed suit to recover fraudulent transfers dispersed to Wilpon, the majority owner of the New York Mets, and Katz, Wilpon’s business partner.  In a previous decision issued in September of 2011, the court ruled that Wilpon and Katz could block the recovery of the funds to the extent that they could prove the transfers were taken “for value” and “in good faith.”

In the decision at hand, the court granted Picard’s motion for partial summary judgment to recover approximately $83 million.   The court ruled that while the defendants gave value to Madoff Securities for the principle investment, they did not give value for any investment profit.  As a result, the court ruled that Picard could recover the investment profit.  The exact amount of profit to be recovered and how much each defendant must pay was left to be determined in a subsequent ruling.

The court also denied the defendants’ motion for summary judgment to block recovery of the principal investment, because even though the defendants gave value for the principal investment, the question of whether they invested in Madoff Securities in good faith still remained.  The court expressed doubt as to whether Picard could establish willful blindness to the scheme and thereby overcome the defendants’ previous  showing of good faith; nevertheless, there remained a “residue of disputed factual assertions” to be resolved at trial.  The court set the trial for March 19, 2012.

On March 16, 2012, Picard and the defendants reached a final settlement agreement.  Under the terms of the agreement, the defendants agreed to pay the trustee $162 million over five years.  However, for the first three years of the agreement, the defendants need not pay anything to the trust.  Instead, the defendants agreed to sign over any money they might recover from the trust as a result of their consumer claims.  In the last two years of the agreement, the defendants must pay any remaining balance in equal annual installments to the trust.

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


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 TradersDefendants 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


SEC v. Scammell: Trader Accused of Breaking Duty of Trust with Girlfriend

In SEC v. Scammell, No. 2:11CV06597, 2011 WL 3506153 (C.A.C.D. Aug. 11, 2011), the Securities and Exchange Commission (“SEC”) brought charges against Toby G. Scammell for insider trading under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)-5. 

According to the SEC’s allegations, Scammell purchased 659 Marvel Entertainment, Inc. (“Marvel”) call options for $5,465 between August 13, 2009 and August 28, 2009.  The Walt Disney Company (“Disney”) announced the planned acquisition of Marvel on August 31, 2009.  In the nine days following the announced acquisition, Scammell sold all of the Marvel call options for a total profit of $192,496.61.

The following facts are based on the allegations in the SEC’s complaint.  During the time period in question Scammell worked for an investment fund in San Francisco and Scammell’s girlfriend had an externship in Disney’s corporate strategy department in Burbank, California.  From mid-July until August 2, 2009, Scammell lived in his girlfriend’s apartment.  The two spoke and emailed each other about the ‘big project’ she was working on.  During this time, Scammell had access to his girlfriend’s Blackberry.  On August 2, Scammell moved away to work for the investment fund but continued to speak to his girlfriend several times a day.  The SEC alleged that, by August 10, Scammell knew the timing of the acquisition announcement because his girlfriend mentioned that the timing would allow them to attend her friend’s wedding.  The SEC also alleged that by August 13, Scammell found out the identity of the acquisition target, Marvel Comics, either by overhearing conversations or seeing electronic documents meant for his girlfriend.

Over two weeks Scammell purchased 659 call options for Marvel using an Ameritrade account.  Scammell’s purchases in some cases represented over 90% of the daily market volume of Marvel options.  At the time he purchased call options for $45 and $50, Scammell knew Marvel stock had never closed above $41.74.  

Scammell took some of the funds used for the options from his brother who had given him a power of attorney in financial matters and did not know about the trades.  Typically, Scammell only purchased long term investments in his brother’s account, with the Marvel purchases representing only the second time he had ever traded call options.  All of the options purchased with his brother’s funds were short term, risky, and “represented an amount that was more than fourteen times the normal monthly investment.”  He never told anyone of the profit he made and placed his profit under his brother’s name into a new account.  The SEC included in the complaint that on or about August 16, 2009, Scammell “searched the internet for the terms ‘insider trading,’ ‘tender offer,’ ‘Williams Act,’ ‘Rule 10b-5,’ and ‘material, non-public information.’”  

The SEC claimed Scammell violated Section 10(b) of the Exchange Act and Rule 10(b)-5.  The SEC stated that due to the nature of their relationship Scammell “owed his girlfriend a duty of trust and confidence” and breached this duty by “trading Marvel options while he was aware of material non-public information he misappropriated” from her; thus he knew, or was reckless in not knowing, the information was confidential and he could not use it to his benefit. The complaint also alleged that Scammell acted with scienter when he purchased Marvel options based on confidential, material and non-public information.

The SEC seeks permanent enjoinment of Scammell from violating Section 10(b) of the Exchange Act, 15 USC §78j(b) and Rule 10b-5.  It also seeks orders to disgorge all illegal trading profits plus prejudgment interest, as well as civil penalties under Section 21A of the Exchange Act.

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



Pipefitters Local 636 Insurance Fund: Superiority of a Class Action Does Not Rest on the Similarity of the Claims

On August 12, 2011, the Sixth Circuit reversed a class action certification in Pipefitters Local 636 Ins. Fund v. Blue Cross Blue Shield of Mich., 418 F.App’x. 430 (6th Cir. 2011). The plaintiffs, members of the Pipefitters Local 636 Insurance Fund (the “Fund”), filed a claim against Blue Cross Blue Shield of Michigan (“BCBSM”).  The Fund is a multi-employer trust fund that provides health and welfare benefits to members and is regulated under the Employee Retirement Income Security Act (“ERISA”) and the Labor Management Relations Act. 

In June 2002, the Fund entered into a contract with BCBSM for a variety of administrative services.  BCBSM began collecting a cost transfer subsidy fee, which the Fund did not believe it had to pay.  In September 2004, the Fund filed suit against BCBSM, alleging that BCBSM breached its fiduciary duty under ERISA by imposing and failing to disclose the subsidy fee from 2002 to 2004.  After the Sixth Circuit denied a Federal Rules of Civil Procedure (“FRCP”) 12(b)(6) motion to dismiss by BCBSM, the case was remanded back to the trial court.  The trial court referred the issue of class certification of the plaintiffs to a Magistrate Judge, who held a hearing and issued a report in February 2009.

Relying on the Magistrate’s report, the trial court certified the class under two provisions of the FRCP.  It certified the class under FRCP 23(b)(1)(A), which states that a class action may be certified if the consideration of separate cases would result in “inconsistent or varying adjudications with respect to individual class members that would establish incompatible standards of conduct for the party opposing the class.”  The trial court then certified the class under FRCP 23(b)(3), which allows a court to certify a class when “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 efficiently adjudicating the controversy.”  Because all of the cases “turned on basically the same questions,” the court determined that the class action was superior.  BCBSM then filed an interlocutory appeal regarding the trial court’s decision to certify the class action suit.

The Sixth Circuit disagreed with the trial court’s findings and held that the proposed class action would not be superior to other available methods under FRCP 23(b)(3).  Despite the similar legal claims, ERISA would require the trial court to individually analyze “contract terms and funding arrangements of 550 to 875 class members.”  In addition, the class action would have serious impacts on BCBSM insurance holders not involved in the case.  Finally, there was a potential for large damage awards for individual plaintiffs.  The court also held that the class action did not qualify under FRCP 23(b)(1)(A).  As a result, the Sixth Circuit reversed the trial court’s certification of the class and remanded the case back for an order of final judgment in the Fund’s individual action.

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


SEC v. Gupta, Redux

Most of the recent attention with respect to Rajat Gupta has focused on the criminal indictment.  Less prominant was the action filed by the SEC.  Unlike the prior action, an administrative proceeding which the Commission voluntarily dismissed after an adverse ruling by Judge Rakoff, this one is an injunctive proceeding in federal district court. 

One has to suspect that Gupta will fight the charges (although perhaps not because of the views of an astrologer).  The newly filed action by the SEC once again raises the wisdom of Gupta's efforts to obtain dimissal of the administrative proceeding (we have criticized the court's reasoning on this Blog).  Had the administrative proceeding been taking place, Gupta through discovery might have obtained more insight into the government's theory of the case and the evidence that it intends to present.  Moreover, as we have noted, the settlement of an administrative proceeding is viewed generally as less serious than a settlement of an injunctive proceeding. 

Of course, if Gupta convinces a jury in the criminal case, it may prove to be an advantage to have a jury in the civil case.  Time will tell.


Gibbons v. Malone: Section 16(b) of the Securities Exchange Act Applies only where Stocks are Part of the Same Equity Security Class

In Gibbons v. Malone, No. 10 CV 8640(BSJ), 2011 WL 3516065 (S.D.N.Y. Aug. 8, 2011), the district court granted the defendant’s motion to dismiss the plaintiff’s action alleging a violation of Section 16(b) of the Securities Exchange Act of 1934. 

Discovery Communications (“Discovery”) has three classes of common stock, including Series A and C, both publicly traded on the NASDAQ.  Each class of stock possessed distinct characteristics.  Series A stock had voting rights, was not controvertible into other classes of stock, and could receive stock dividends.  Series C stock lacked voting rights, was not controvertible into other classes of stock, and could not receive stock dividends. At the time of the alleged insider trading, an options market existed only for Series A stock.

Defendant John Malone (“Malone”), a Discovery director and Chairman of Liberty Media Corp. and Liberty Global Inc., engaged in ten purchases of Series A stock and nine sales of Series C stock between December 5, 2008 and December 17, 2008.  At the time these transactions occurred, Malone was the owner of over ten percent of a class of the company’s stock.

Plaintiff Michael Gibbons (“Gibbons”) alleged that Malone realized an illegal profit of at least $313,573 under Section 16(b) of the Exchange Act because “for each share of Series A Stock purchased by Malone, a corresponding sale of Series C Stock was made at a higher price by Malone.”

Section 16(b) is intended to prevent directors from profiting from insider information.  The provision provides that “profit realized by [a director] from any purchase and sale, or any sale and purchase, of any equity security of such issuer…within any period of less than six months…shall inure to and be recoverable by the issuer…”  15 U.S.C. 78p(b).

Defendants argued that the transactions in Series A and C shares were not the same equity security.  The court agreed.  The court noted that Section 16(b) groups “purchase and sale” and “sale and purchase” together, indicating that they are each “directed at the same prepositional object—i.e. the same equity security.”  The phrase “any equity security” refers to the fact that the law applies to any of the different types of equity securities, not that the law applies when an individual buys one type of equity security and sells another type.

Discovery Series A stock and Series C stock were not convertible into each other, and they were not debentures or derivatives which fell into the same class; they were separate equity securities.  Because Series A and C had different characteristics, they belonged in separate classes of equity securities.  The Second Circuit noted that if Section 16(b) applied to a situation in which one class of stock was purchased and a different class was sold, this would be “beyond the realm of judicial fantasy.”  Smolowe v. Delendo, 136 F.2d 231, 237 n.13 (2d Cir. 1943)Because an application of Section 16(b) under the plaintiff’s argument would eliminate the statute’s bright-line rule, the court granted the defendants’ motion to dismiss. 

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.


SEC v. Daifotis: Applying the New Janus Standard to 10b-5 Claims

In August 2011, the United States District Court for the Northern District of California (the “court”) reconsidered its order in the case of SEC v. Daifotis, No. C 11-00137 WHA (N.D. Cal., August 1, 2011), in light of the Supreme Court’s recent decision in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011).  The SEC brought various claims against two men, Kimon Daifotis (“Daifotis”) and Randall Merk (“Merk”) for alleged acts committed during 2007 and 2008 regarding an ultra-short bond fund.

Defendants Daifotis and Merk were employees of Charles Schwab Corporation. The Securities and Exchange Commission (“SEC”) alleged that Daifotis attempted to portray YieldPlus, the ultra-short bond fund in question, as a safe “cash-alternative” investment without fully disclosing its differences from other cash-like investments. The SEC’s allegations against Merk include that he made misleading statements about YieldPlus, voted to approve a plan that allowed YieldPlus to violate its concentration planning, made further misleading statements about YieldPlus in order to dissuade investors from redeeming their investments, and allowed certain Charles Schwab mutual funds to redeem their YieldPlus investments after obtaining material insider information regarding the YieldPlus fund.

On June 6, 2011, the Northern District of California granted the defendants’ motions to dismiss claims of scheme liability and the receipt of money or property by Merk.  The court also dismissed two claims alleging that the defendants had aided and abetted in violations of provisions of the Investment Company Act of 1940.  However, the court denied the defendants’ motion to dismiss for claims alleging violations of Section 10(b) and 10b-5 of the Exchange Act, Section 206 of the Advisers Act and Section 34(b) of the Investment Company Act, among others.   

Less than a week later, on June 13, 2011, the Supreme Court clarified the definition of “mak[ing] a statement” under Rule 10b-5 in Janus Capital Group, Inc. v. First Derivative Traders.  Rule 10b-5 states that it is unlawful for any person “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”  17 C.F.R. § 240.10b–5.  In Janus, the Supreme Court held that a person who merely suggests what to say, or who prepares or publishes a statement on behalf of another, does not “make” a statement under Rule 10b-5.  Rather, “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.”

In light of this new precedent, the defendants moved for reconsideration of the June 6th order.  On August 1, 2011, the court granted the defendants’ motions for reconsideration and modification of the motions to dismiss and strike certain claims.  The court held that a “Manager’s Discussion” issued to the public and reviewed by Daifotis under his title as manager was a statement under the Janus standard.  In addition, misstatements made in an advertisement, which had a picture of Daifotis on it, were not to be statements under the new Janus standard.

The Court also considered the SEC’s claims of aiding and abetting under Rule 10b-5.  These claims require a primary violation of the relevant securities law, actual knowledge by the alleged aider and abettor of the primary violation and of his or her role in furthering it, and substantial assistance in commission of the primary violation.  The defendants argued that the SEC attributed misstatements to Schwab entities in general, rather than to specific people.  This fact did not justify dismissing the claims because Janus had not been decided when the SEC pleaded these claims.  The court allowed the SEC to file an amended complaint to attribute these misstatements clearly to a specific Charles Schwab entity as required by Janus.  

Finally, the court held that Janus does not apply to Section 17(a) of the Securities Act, which prohibits any person from obtaining money or property by making an untrue or misleading statement, nor to Section 34(b) of the Investment Company Act of 1940, which makes it unlawful for any person to make any untrue statement of a material fact in a variety of business documents. 

The primary materials for this case may be found on the DU Corporate Governance website.  A previous case summary of Janus may be found here.


Disclosure, Citizens United, and the Securities Laws

The NYT reported on a series of lower court cases that have, in the aftermath of Citizens United, upheld campaign finance requirements premised upon disclose.  The article is here.  The theme of the article was that the Court had opted for a more libertarian approach to campaign finance.  While substantive restrictions on contributions were struck down, disclosure was acceptable.  With disclosure, individuals could resolve the consequences for themselves.

In many respects, the federal securities laws has reflected this libertarian approach.  The primary function of the SEC is to ensure proper disclosure.  Of course, disclosure can influence substantive behavior.  The requirement that companies disclose whether they have a financial expert on the audit committee likely ensures that they have one.  See Item 407 of Regulation S-K.  The recent efforts by the SEC to require disclosure of board diversity is likely designed to prod companies into improving diversity (and making the disclosure less stark).  A post on the subject is here

But as the securities laws have shown, disclosure does not always work.  Efforts to publicize executive compensation through detailed disclosure requirements probably put upward rather than downward pressure on the amounts.

For disclosure to work with respect to campaign contributions, it must provide the necessary information.  In the corporate context, there also must be an opportunity of the owners of the company, the shareholders, to have some authority to act if they object to the payments.  Currently there is no such authority although the Sharholder Protection Act would change that.


SEC v. Cuban: Affirmative defense of “Unclean Hands” no longer available to Cuban

In SEC v. Cuban, a Texas district court held that Mark Cuban had not sufficiently pled the requirements of the affirmative defense of unclean hands.  Sec. Exch. Comm’n v. Cuban, 2011 U.S. Dist. LEXIS 77549 (N.D. Tex., July 28, 2011). 

The SEC claimed that Cuban violated §17(a) of the Securities Act of 1933, §10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.  The claims stemmed from allegations that Cuban dumped stock in Inc. after learning nonpublic information.  The SEC claimed that Cuban had a conversation with Guy Faure,’s CEO, in which Faure told Cuban of an impending stock offering by the company.  Cuban then avoided substantial losses by acting on the information.

An enforcement action is an equitable remedy.  The defense of unclean hands arises when a party seeking an equitable remedy acts inequitably by committing some wrongdoing or acting in bad faith.  Cuban asserted an affirmative defense of unclean hands contending that the SEC acted with egregious misconduct during their investigation of the enforcement action. 

In response, the SEC claimed that when the government was acting in the public interest, equitable defenses were not available.  The SEC, as a regulatory agency, had the right to seek injunctive relief because Congress “provided this statutory remedy for the public’s benefit as a mechanism for effective law enforcement.”  The court rejected this approach, holding that the defense of unclean hands was not strictly barred in actions against government regulatory agencies.  Nonetheless, the standard for invoking unclear hands was very exacting.

Describing the demanding requirements to plead unclean hands, the court said the:

“SEC’s misconduct must be egregious, the misconduct must occur before the SEC files the enforcement action, and the misconduct must result in prejudice to the defense of the enforcement action that rises to a constitutional level and is established through a direct nexus between the misconduct and the constitutional injury.”

The only allegation of unclean hands pled with enough facts to make an inquiry into whether it met the standard was Cuban’s allegation that the SEC engaged in acts of “outright investigative and litigation misconduct.”  Cuban alleged that an SEC agent deterred the counsel of a key witness from talking to Cuban’s attorneys.  He also alleged that the SEC threatened the same witness with perjury for not remembering statements from a phone call from almost a year earlier.  Additionally, he alleged that the SEC reopened its investigation of in an attempt to get a key witness to change his testimony.

The court found Cuban’s allegations to be insufficient to justify application of the unclean hands doctrine.  The court determined that plaintiff had not shown that the alleged misconduct "impaired his ability to defend” or that any prejudice “rose to a constitutional level.”  

Further posts on SEC v. Cuban can be found here.

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