Securities Law Prof Blog

9th Circuit Decides Misappropriation Case in Favor of SEC

In an important case on the scope of the misappropriation theory of inside trading under Rule 10b-5, the 9th Circuit held that a director of a corporation could be held liable when he purchased shares in another corporation because of information that he learned about that corporation in his capacity as director of the first corporation, even though the SEC did not establish that the director's corporation had promised the other corporation to keep the information confidential.  Talbot sat on the board of Fidelity, which owned a 10% interest in Lending Tree.  At a Fidelity board meeting Talbot learned that Lending Tree was going to be acquired (or might be acquired) by a third party at a very attractive price.  Two days later, Talbot began purchasing Lending Tree shares, which he subsequently resold at a profit when a Lending Tree acquisition was announced.

The lower court granted summary judgement for defendant, because it interpreted the misappropriation theory as requiring a duty of confidentiality between Lending Tree and Fidelity as well as between Fidelity and Talbot.  In contrast, the SEC agreed with the SEC that the misappropriation theory focused on the duty that Talbot owed to Fidelity to keep the information confidential and his secret violation of that duty.  As a member of Fidelity's board of directors, Talbot was in a relationship of trust and confidence with Fidelity and could not use the information for his own personal benefit.  The 9th Circuit's opinion relies heavily on Professor Barbara Aldave's influential Hofstra Law Review article that the Supreme Court also cited in the O'Hagan case.

However, the 9th Circuit did not agree with the SEC that the information about Lending Tree's acquisition was material as a matter of law and instead agreed with the district court that its materiality presented a genuine issue of material fact, since there was evidence that the acquisition talk was just a rumor.  SEC v. Talbot (9th Cir. June 19, 2008).

Seventh Circuit Affirms Conviction of Conrad Black

The U.S. Court of Appeals for the Seventh Circuit affirmed the convictions of Conrad Black and other senior executives of Hollinger International for mail and wire fraud.  In an opinion authored by Judge Posner, the court rejected all of the defendants' arguments, finding that there was sufficient evidence for the jury to find that the defendants committed a conventional fraud, a theft of money from Hollinger by misrepresentations.  The opinion focused, in particular, on defendants' arguments that they could not be convicted for scheming to deprive Hollinger of its right to the "honest services" of its corporate officers, for the purpose of "private gain," because their objective was to achieve a gain at the expense of the Canadian government (favorable tax treatment), not at the expense of Hollinger.  The court rejected this as a "no harm-no foul" argument that "usually fare badly" in criminal cases.  There was "no doubt that the defendants received money ... and very little doubt that they deprived Hollinger of their honest services."  U.S. v. Black (7th Cir. June 25, 2008).

New York's Highest Court Dismisses 4 Claims against Grasso

The battle between the New York State Attorney General and Richard A. Grasso, the former CEO of the NYSE, over his outsize compensation continues, and Grasso achieved a significant victory today, as the New York Court of Appeals threw out four claims in the AG's complaint that were based on the common law and not the New York not-for-profit statute.  The trial court had held that the AG could bring these claims under the parens patriae doctrine to vindicate the interests of the investing public.  A majority of the Appellate Division reversed because it saw the non-statutory claims as an attempt to circumvent the fault-based claims of the statute.  New York's highest court unanimously agreed with the Appellate Division and dismissed the four nonstatutory claims.  In a opinion written by Chief Judge Kaye, that largely walked through the relevant statutory provisions and compared them with the AG's nonstatutory claims, the court emphasized that the statutory provisions provided the directors and officers with the protections of the business judgment rule and were essentially fault-based.  In contrast, the AG's nonstatutory claims attempted to impose liability based on the size of Grasso's compensation.  To allow the AG to do so would override the fault-based system created by the legislature and would permit the AG to reach beyond the bounds of his authority.  The court also noted that as a matter of separation of powers policy this extension would be especially troublesome: "Although the Executive must have flexibility in enforcing statutes, it must do so while maintaining the integrity of calculated legislative policy judgments."  The People &c. v. Grasso (N.Y. June 25, 2008).

What happens next?  The defendant has not contested the AG's authority to bring two of the statutory claims; the AG's authority to maintain the other two statutory claims is the subject of another appeal pending in the Appellate Division.  Will the current AG, Andrew Cuomo, fold and view this case as an unfortunate legacy of his predecessor Eliot Spitzer?  Let's wait and see.

Second Circuit Finds that LLC Interest is a Security

The Second Circuit addressed the definitional question of a "security" in a recent criminal case, U.S. v. Leonard (June 11, 2008), and held that an interest in a limited liability company organized to produce a movie was an "investment contract," despite the promoters' efforts to structure the LLCs so that they were not passive investments.  The court acknowledged that if it were to confine itself to a review of the organizational documents, it would likely conclude that the interests could not be securities because, according to the documents, every member was expected to play an active role in the management of the company.  The court, however, reaffirmed that in applying the Howey "investment contract" test the courts should look beyond the formal terms of the relationship to evaluate whether "the reasonable expectation was one of significant investor control."  Here the court found this was not the expectation since in reality the members played an extremely passive role in the management and operation of the companies: they did negotiate the LLC agreements, they had no experience or expertise in the move business, and they did not, in fact, exercise meaningful managerial control.  The court vacated the sentences and remanded for resentencing, however, since the district court had erred in its loss calculation by assuming that the securities were worthless.  While recognizing that illiquid securities in private investments are extremely difficult to value, the district court was required to exercise its sound discretion in determining their valuation.

D.C. District Court Finds Courts Cannot Impose Penalties for Aiding & Abetting Advisers Act Violations

In what the court describes as a "case of first impression," the federal district court for the District of Columbia held that the SEC does not have the authority to seek, and the court lacks jurisdiction to impose, monetary penalties for aiding and abetting violations of the Investment Advisers Act of 1940.  The court relied on the plain meaning of Section 209(e) of the Advisers Act, which provides that civil penalties can be imposed on "the person who committed" a violation of the Act.  The court deemed the statute's failure to authorize explicitly monetary penalties for aiding and abetting violations of the Advisers Act dispositive.  It rejected the SEC's argument that this interpretation made no sense because it would mean that the SEC could only obtain monetary penalties against aiders and abettors under the Advisers Act in administrative proceedings and would require the agency to bring both an administrative and judicial proceeding where it sought both a monetary penalty and injunctive relief.  It also rejected the SEC's proffer of judicial decisions where the district courts imposed civil penalties for aiding and abetting Advisers Act violations, finding that none of them had actually analyzed the issue of the availability of the remedy.  SEC v. Bolla, 2008 WL 1959502 (D.D.C. May 6, 2008).

SEC v. Berry

As attorneys are well aware, the SEC has been bringing enforcement actions against inhouse counsel, particularly with respect to backdating stock options.  Since there are, to date, few opinions, every one is of interest.  Recently, the federal district court for the Northern District of California granted in part a motion to dismiss by Lisa Berry, a former General Counsel at two public corporations who, the SEC alleges, backdated options at both corporations.  The court found that the five-year statute of respose was applicable to the SEC's request for civil penalties (but not to its requests for other kinds of relief), but that the SEC could amend its complaint to allege equitable tolling because of the attorney's fraudulent concealment.  The court also held that the SEC's conclusory pleading that the attorney reviewed, discussed and finalized corporate filings was insufficient to plead scienter.  The court also rejected  the defendant's argument that the SEC could not bring aiding and abetting charges against her, since it did not charge any primary violators.  "While the argument may have some equitable appeal, it has no legal basis."  SEC v. Berry, 2008 WL 2002537 (N.D.Cal. May 7, 2008).

Ninth Circuit Upholds Earlier Statute of Limitations Decision

In the latest opinion in Betz v. Trainer, Wortham & Co. (Feb. 26, 2008), the Ninth Circuit confirmed its earlier interpretation of an "inquiry notice plus reasonable diligence" standard to determine when the statute of limitations for Rule 10b-5 actions begins to run and refused the defendant's petition for rehearing.  The appeals court had previously reinstated plaintiff's claim and held there were material issues of fact preventing a summary dismissal.  Judge Kozinski (joined by two other judges) was very unhappy about this outcome and complained, in a sharply worded dissent, that the Ninth Circuit's "unique interpretation" of the statute of limitations puts it "at odds" with ten other Circuits.  Plaintiff, a retired art dealer, invested over $2 million with defendant based on an oral promise to achieve high returns with no risk.  Judge Kozinksi already has trouble with this, since the oral promise was contradicted by the written contract.  He goes on to describe how plaintiff received a statement showing a loss in February 2000 and continued to receive 29 more statements, and waited three and a half years, before filing suit.  Judge Kozinski's dissent goes on for some length, but this lament sums it up:

If a securities defendant in a simple case like this cannot use the statute of limitations as a shield against the costs and hazards of trial, then no defendant can, and the statute of limitations Congress passed for 10b-5 cases is pretty much a dead letter in this circuit.

Second Circuit Orders Panel to Clarify Award in Worldcom Arbitration

In Rich v. Spartis (2d Cir. Feb. 8, 2008), the Second Circuit affirmed the district court's vacatur of a securities arbitration award in favor of customers, but instructed the the district court to order the NASD panel that issued the award to clarify it.  In its opinion the Second Circuit directs some critical words to the panel, two of whom (including the Chair), it notes, were lawyers and presumably should have known better.  The problem was that the customers, a married couple, suffered losses because of their brokers' "exercise and hold plan" for Worldcom stock options that the wife had received through her employment.  The customers, however, had not opted out of the Worldcom Securities class action, which barred them from arbitrating the Worldcom claims.  Although this was called to the attention of the panel before the conclusion of the hearing, the Chair determined to go ahead with the arbitration and leave it to the respondents to go to court to void the arbitration award.  The Chair also said that it would break out any damages awarded into Worldcom and non-Worldcom securities.  The award, however, entered a lump sum damages award.  At the hearing, the customers conceded that they could not enforce any portion of the award related to their Worldcom securities.  Accordingly, the district court issued an injunction that nevertheless permitted the panel to clarify whether any portion of the award relates to non-Worldcom claims.  However, the panel, without explanation, denied the motion to clarify the award.  The Second Circuit found that some, indeed all, of the damages could relate to non-Worldcom securities and that the customers were entitled to the benefit of the burden of proof that the FAA imposes on the challengers of the award to establish that the panel exceeded its authority.  Accordingly, the Second Circuit instructed the district court to order the panel to clarify the award and specify the amount of the award, if any, attributable to the Worldcom losses.

Supreme Court Denies Cert in Enron Case

For those who had some hope that the Supreme Court's Stoneridge opinion would allow an opportunity to distinguish Enron because the defendants in the latter case are investment bankers and the transactions thus were not the "ordinary" commercial transactions involved in Stoneridge, read it and weep:  the Court denied cert this morning in Regents of University of California v. Merrill Lynch (Docket No. 06-1341).  This was the Fifth Circuit opinion that held that the investment bankers who advised Enron on various transactions could not be held liable based on "scheme liability."

Seventh Circuit Adheres to Prior Decision in Tellabs

The Seventh Circuit (opinion by Judge Posner) issued its opinion on remand of Makor Issues & Rights, Ltd. v. Tellabs Inc. in which it considers whether the plaintiffs' allegations of securities fraud create the "strong inference" of scienter, as defined by the Supreme Court, required by PSLRA.  On remand, the Seventh Circuit adhered to its previous decision to reverse the judgment of the district court dismissing the suit. 

In Tellabs, the Supreme Court directed the appellate court to dismiss the complaint unless "a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."  The Seventh Circuit found that it was "exceedingly unlikely" that the allegedly false statements were the "result of merely careless mistakes at the management level based on false information fed it from below, rather than of an intent to deceive or a reckless indifference to whether the statements were misleading."  The court noted that the alleged misstatements involved the company's most important products, and it was "very hard to credit" that no member of senior management knew that they were false.  The court also noted that "it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud."  Finally, it also distinguished the use of annonymous sources in Higginbotham v. Baxter Int'l -- where it said that such allegations must be steeply discounted -- from  the Tellabs complaint's dependence on 26 "confidential sources."  Here the confidential sources are numerous, consist of persons who, from their job descriptions, are in a position to know the facts to which they are prepared to testify, and the information is set forth in convincing detail.  The absence of the names does not invalidate the drawing of a strong inference from the informants' assertions.

D.C. Circuit Affirms SEC Findings of Scienter Involving Underwriter of Municipal Bonds

The D.C. Circuit recently affirmed, in SEC v. Bradbury, 2008 WL 108728 (D.C. Cir. Jan. 11, 2008) an SEC order that held a broker-dealer that acted as an underwriter for a municipal bond offering was liable for securities fraud.  The only issue on appeal was whether the SEC established that defendants acted with scienter, which, in this case, was extreme recklessness.  The D.C. Circuit also discussed the role of the underwriter and noted, pithily, that the underwriter is supposed to be a "trail guide, not a mere hiking companion."

The Dauphin County General Authority issued the bonds to finance the purchase of an office building in Harrisburg, PA.  At the time of the offering, the Pennsylvania Dept. of Transportation (PennDOT) was the substantial tenant in the building; however, the lease was scheduled to expire well before the maturity date of the bonds, and, as the underwriter knew, PennDOT planned to vacate the premises when repairs to its own building were completed.  Although a state official had mentioned that the state would use the space for other purposes, it made no commitments to do so.

The disclosure document contained cautionary language (in boldface caps): The leases are scheduled to expire prior to the maturity of the bonds; there is no commitment, requirement or guarantee that the [state] will renew or extend any of the office leases."  The Court said this disclosure was deficient and materially misleading because the underwriter had actual knowledge that PennDOT planned to leave the premises.  In addition, the projections assumed that the PennDOT leases would continue on the same terms.

The Court notes that Congress directs it to apply a "substantial evidence" standard in reviewing SEC orders, which the court describes as an "extremely deferential" standard.  Otherwise, this would be a cery close case, since the scienter standard is very high.

Fifth Circuit Holds that Customer of Non-NASD Brokerage Firm Did Not Have to Arbitrate Claim

The Fifth Circuit, in Galey v. World Marketing Alliance, 2007 WL 4323610 (Dec. 12, 2007), agreed with a securities customer that he did not have to arbitrate his dispute before NASD pursuant to an arbitration clause in his customer agreement, since the brokerage firm had allowed its membership in NASD to lapse.  NASD Rule 10301 provides that a claim involving a member whose membership has been terminated is ineligible for arbitration.  The Fifth Circuit found that the Rule meant what it says and it was incorporated by reference into the customer's arbitration agreement.  Moreover, since the Rule was to protect the customer, it was not severable from the rest of the agreement.  As a result, the customer was free to bring his claim in court.

Recent 9th Circuit Opinion Deals with Misrepresentation, Materiality Issues

The Ninth Circuit recently discussed the requirement of a misstatement of material fact under 33 Act Section 12(a)(2) in the context of a merger between a public corporation and a private corporation, Miller v. Thane Int'l, 2007 WL 4147327, 9th Cir. 11/26/07.  The proxy statement sent to shareholders of the acquired corporation represented that the acquiring corporation expects to have its shares approved for listing on Nasdaq and that it had already received Nasdaq approval (subject to meeting $5 bid requirement).  Both statements were literally true.  Because the company's investment bankers advised the company to wait to list the shares until completion of an anticipated secondary offering (which never took place), the shares in fact were never listed on Nasdaq.  First, the 9th Circuit said the district court committed "clear error" when it found that the acquiring corporation did not make a misrepresentation, since statements literally true on their face may be misleading when considered in context.  Second, the appeals court held that the district court committed error when it found that, even if there was a misrepresentation, it was not material, since the market price did not drop even after it was clear that the shares were not trading on Nasdaq.  The appeals court said it was error to consider the movement of stock prices that did not trade in an efficient market. 

However, plaintiffs have a remaining obstacle -- loss causation.  The defendants argued that since the district court found that the market did not react to the fact that the shares were not listed, plaintiffs could not establish loss causation.  The Ninth Circuit remanded to the district court for consideration of this issue.

Back Dating Class Action Against Openwave Allowed to Proceed

Judge Denise Cote of the Southern District of New York recently denied a motion to dismiss Rule 10b-5 claims against Openwave Systems and a number of its former executives involving an alleged seven-year stock option backdating scheme.  The court found that the plaintiffs adequately alleged scienter and loss causation.  In re Openwave Systems Sec. Litig., 2007 WL 3224584 (S.D.N.Y. Oct. 31, 2007).

Eleventh Circuit's Application of Blue Chip and Reves Tests

In a recent opinion, the Eleventh Circuit offers some observations on both the Blue Chip standing test and the definition of a security under the Reves test.  In Financial Security Assurance , Inc. v. Stephens, Inc., (11th Cir. Sept. 18, 2007), 2007 WL 2700280,  an insurer of municipal bonds that became the owner upon default by the issuer brought Rule 10b-5 claims against the underwriter of the bonds and a civil engineering firm.  The district court had dismissed the claims, but the appeals court initially affirmed in part and reversed in part and remanded the case.  On rehearing, however, in a per curiam opinion, the appeals court affirmed the district court completely and dismissed the case.  It found that the insurer had no standing to bring the Rule 10b-5 claims.  It rejected the plaintiff's arguments that, as guarantor of the bonds, it was the real party in interest and interpreted the Blue Chip standing test as rejecting any functional test.  In addition, the court rejected the plaintiff's argument that after default it had purchased the bonds under the terms of the insurance policy because, it said, that under the Reves test, the bonds were not securities because when the plaintiff purchased them they did not have the potential to generate any profit.  So apparently the bonds could be securities when owned by the initial purchasers, but became non-securities when held by the insurer.

Ninth Circuit Finds Securities Registered under Form S-8 Were Invalidly Sold to Raise Capital

In SEC v. Phan, 2007 WL 2429365 (9th Cir. Aug. 29, 2007), the Ninth Circuit affirmed the district court's grant of summary judgment for the SEC, finding a violation of section 5 of the Securities Act (sales of unregistered securities),  where the CEO of a financially troubled corporation directed a consultant to resale shares registered on Form S-8 (available for employee compensation shares) to an investor to raise capital for the corporation.  Even if the shares were originally validly issued to the consultant on Form S-8 (an issue on which there were disputed issues of fact), the consultant's resale was not covered by the Form S-8 registration.  The Ninth Circuit, however, reversed the district court's summary judgment in favor of the SEC on the fraud claim, holding that the one undisputed misstatement -- that the consultant would be required to pay $1.25 million in cash upon exercise of the option -- was not material as a matter of law, since there were disputed factual assertions that the consultant promised to give a promissory note in lieu of cash.  The court said it could not hold as a matter of law that reasonable investors would consider the difference between cash and a promissory note material.

Reviewing the Amicus Briefs in Stoneridge

I have been reading some of the amicus briefs filed in Stoneridge Investment Partners v. Scientific-Atlantic, which will be argued before the U.S. Supreme Court this fall.  The complaint alleges that defendants, equipment vendors, knowingly participated in a scheme by Charter Communications to inflate its operating cash flow through sham transactions.  Plaintiff argues that defendants were primary violators, and not simply aiders and abetters, because they participated in a scheme under Rule 10b-5(b) -- rather than the typical case involving misstatements under subparagraphs (a) and (c) of the Rule.  The Eighth Circuit rejected plaintiff's argument.

The Government's brief in support of affirmance (where President Bush broke the "tie" between Treasury Secretary Paulson, who supported the defendants, and the SEC, who supported the plaintiff) carefully makes its argument to maintain the SEC's authority to bring aiding and abetting actions.  Thus, it begins by criticizing the 8th Circuit's conclusion that section 10(b) reaches only misstatements, omissions made when under a duty to disclose, or manipulative trading practices.  To the contrary, the Government argues, the plain meaning of the statute makes it clear that it reaches all conduct that is manipulative or deceptive, including non-verbal decptive conduct.  Thus, while the alleged conduct of the defendants may have constituted a violation, plaintiff could not recover because it could not establish reliance, since it does not even allege that it was aware of the transactions that defendants entered into with Charter.  In addition, plaintiff cannot show loss causation. Accordingly, allowing plaintiff to recover would be a sweeping expansion of the Rule 10b-5 implied remedy.

An interesting amicus brief was filed by a group of former SEC Commissioners and Officials and Law and Finance Professors, also in favor of affirmance.  In essence, the brief argues that plaintiff's "scheme liability" theory is simply a "semantic ploy" to recast secondary conduct as a primary violation and that the alleged conduct in this case is indistinguishable from that in Central Bank.  The brief also addresses policy considerations made by plaintiff and concludes that they do not warrant deviation from the statute.  To the contrary, they assert, considerations of legal and economic policy cast "considerable doubt" on the wisdom of allowing private suits like plaintiff's.  As would be expected in a brief signed by law professors, lots of law review articles are cited.

Recent Third Circuit Opinion in Inquiry Notice

A recent Third Circuit decision provides another illustration of the obstacles federal courts impose on investors who allege securities fraud.  In DeBenedictis v. Merrill Lynch & Co., 2007 WL 1732254 (3d Cir. June 18, 2007), the court held that the lead plaintiff's class action against his brokerage firm for recommending the purchase of Class B mutual fund shares was time-barred because he was on "inquiry notice" of his claims more than two years before.  A significant portion of the opinion is a verbatim recital, from both the mutual fund prospectus and the SAI, of the descriptions of the different classes of mutual fund shares and the compensation structure for sales personnel.  (The court does not acknowledge, if indeed it is aware, that most mutual fund investors do not receive the SAI.)  In addition, the court took judicial notice of two articles (one from USA Today, one from Time magazine) and a Wall St. Journal article that warned investors about the high costs of Class B shares, as well as several NASD press releases disciplining other brokerage firms for unsuitable recommendations of Class B shares.  According to the Third Circuit, these communcations put the plaintiff on inquiry notice because a "reasonable investor of ordinary intelligence would have discovered the information and recognized it as a storm warning."  It did not matter, as the plaintiff argued, that the media coverage and the NASD actions did not specifically identify Merrill Lynch as an offender; in fact, the Wall St. Journal referred approvingly to Merrill Lynch's efforts to train its brokers on the different classes of mutual funds.  Instead, the court concludes: "even if a mutual fund investor failed to read the Registration Statements when they were initially received and failed to run any independent calculations of the fees that would be incurred on Class B shares [!], the news articles questioning the profitability of such shares and highlighting the possible conflict of interest would urge the reasonable investor to return to the profitability of his or her own investments and investigate their broker's conflict of interest."   Thus, apparently, a reasonable investor is expected to follow media coverage of his investments in order to second-guess the recommendation of his trusted "financial consultant."   

Tellabs v. Makor Issues & Rights

The Court's task, as framed by Justice Ginsburg in her majority opinion, was to resolve the disagreement among the Circuits on whether, and to what extent, a court must consider competing inferences in determining whether a securities fraud complaint gives rise to a "strong inference" of scienter, the PSLRA requirement.  The "strong inference" requirement "unequivocally raise[d] the bar for pleading scienter" and signalled Congress' purpose to promote greater uniformity among the Circuits, according to Justice Ginsburg.  Thus, the Court must set forth a "workable construction of the strong inference standard ... geared to the PSLRA's twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors' ability to recover on meritorious claims."

Justice Ginsburg thus proceeds to set forth the roadmap.  First, as with any motion to dismiss, the court must accept all factual allegations in the complaint as true.  Second, the court must consider the complaint in its entirety, as well as other sources courts ordinarily consider when ruling on motions to dismiss -- documents incorporated by reference and other matters of which the court may take judicial notice.  The inquiry is whether all of the alleged facts, taken collectively, give rise to a strong inference of scienter.  Third, in determining whether the pleaded facts give rise to a "strong" inference of scienter, the court must take into account plausible opposing inferences.  The inference of scienter must be cogent and compelling, thus strong in light of other explanations.  In sum, the court must ask: when the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?

Justice Scalia and Justice Alito each wrote concurring opinions, expressing the view that "strong inference" required that the test should be whether the inference of scienter is more plausible than the inference of innocence because this is the natural reading of the statute. Justice Stevens was the lone dissenter, arguing that the standard should be analogous to the probable-cause standard from criminal law.

In my view, the majority opinion was quite predictable and, indeed, inflicted probably the least amount of damage on plaintiffs, given the statute and the pro-business tendencies of this Court.  Under the majority's test, the plaintiff "only" has to demonstrate that the inference of scienter was at least as likely as any plausible opposing inference.  In contrast, if Justices Scalia and Alito had their way, the "strong inference" test would have constructed an even higher obstacle to private securities fraud cases, requiring that the inference of scienter be more plausible than the contrary inference.  These days, the majority's rejection of that view can count as a victory.

Supreme Court Holds Securities Laws Prevent Antitrust Claims Against Underwriters

The Supreme Court (7-1 vote) held, in Credit Suisse First Boston v. Billing, that the federal securities laws prevent private antitrust claims against several underwriters of IPOs in connection with tie-in arrangements that required firms to purchase additional securities in the aftermarket.  The decision reversed the Second Circuit.   Justice Thomas dissented.

Second Circuit Interprets Sections 13(d) and 16(b)

The Second Circuit recently revisited the difficult issue of pleading a "group" for purposes of Section 13(d) in reversing a district court's dismissal of plaintiff's Section 16(b) claim seeking disgorgement of short-swing profits and also examined the final sentence of section 16(b) (which states that the section does not apply if the person is not a beneficial owner at both ends of the transaction).  In dismissing the complaint, the Second Circuit held, the court improperly gave too much weight to defendants' disclaimer of "group" status in their SEC filings and misconstrued the meaning of the final sentence of Section 16(b).  The Second Circuit did agree with the district court that a member of the alleged group could not be held liable under Section 16(b) where there were no allegations that it profited from any stock transactions during the relevant time period. Roth v. Jennings, 2007 WL 1629889, 2d. Cir. June 6, 2007.

EMR had purchased about 14.8% of shares in MMI; shortly thereafter, Jennings purchased about 8.3% of MMI stock with funds borrowed from EMR.  Jennings sold some of his shares in the open market within a six-month period, and, because he was not himself a statutory insider, 16(b) liability turned on whether he and EMR were a group under section 13(d).  SEC filings disclosed the loan agreement and also disclaimed group status. The district court, in granting defendants' motion to dismiss, gave two principal reasons:  (1) Plaintiff did not allege any facts that contradicted defendants' disclaimer, and (2)Defendants' uncontradicted evidence showed that EMR and Jennings were not a group at the time of the sales because Jennings had refused to sell his shares to EMR, instead selling them in the open-market, exactly the opposite, the court said, from what a group member would have done.

The Second Circuit essentially found that the district court overstepped its bounds on dismissing the complaint as to Jennings and improperly resolving issues of facts against the plaintiff at the pleading stage.  Contrary to the district court's reasoning, determination of "group" status depended on the application of the law to the defendants' activities, not on defendants' legal characterization of their activities.  A jury might find that the loan agreement between Jennings and EMR established a "group," notwithstanding the parties' disclaimer.  In addition, the final sentence of Section 16(b) did not require coordinated activity among the group members at both ends of the transactions; thus, the court's analysis of the parties' actions at the time of Jennings' sales was both legally irrelevant and also constituted additional impermissible fact-finding.   

The Second Circuit did agree with the district court that the complaint should be dismissed against EMR since there were no allegations that it sold any of its shares and profited in any way from Jennings' sales.  Under these circumstances, there were no profits for EMR to disgorge.

Seventh Circuit Tippee Liability Conviction

The Seventh Circuit recently decided, in U.S. v. Evans, that a tippee can be found guilty of insider trading even though the tipper was acquitted in an earlier trial.  The tipper was a financial analyst at Credit Suisse who apparently missed the orientation program about confidentiality and talked a lot about his work to his friends.  The tippee, a college buddy, traded profitably in stocks of four companies involved in deals that Credit Suisse was working on.  At the first trial, the jury acquitted the tipper on both substantive and conspiracy charges and acquitted the tippee on the conspiracy charge, but deadlocked on the substantive charges against the tippee.  The government retried the tippee and won a conviction.  On appeal the Seventh Circuit recognized the applicability of the Dirks two-part test for tippee liability, which requires, first and foremost, a breach of duty on the part of the insider and, secondly, the tippee's knowledge of the breach (or, at least, he should have known).  Since the jury had acquitted the tipper, that would seem to foreclose tippee liability.  The court, however, theorized that the tipper could have leaked the information negligently to his friend and thus would have lacked the requisite scienter in leaking the information to his friend.  According to the Seventh Circuit, it was not essential to the tippee's conviction that the tipper know that his leaking of confidential information was improper.  Indeed, the tippee could have induced the tippee's disclosure and then taken advantage of it, so he can be guilty of insider trading when the tipper is not.  Frankly, the court's logic sounds wrong to me.  While it is an attractive theory if, for example, the tippee plies the tipper with liquor so that he blurts out the company secrets and the tippee then trades on the information, I don't see how the first requirement of Dirks -- the breach of the duty -- is met.  How is this case different from Dirks itself -- where the tippee is off the hook because the tipper is found to have done nothing wrong? 

Two-Tier Pricing for Brokerage Services After FPA v. SEC

I was very surprised at the SEC’s announcement yesterday that it would not seek rehearing of FPA v. SEC (D.C. Cir. Mar. 30, 2007), in which the court vacated, in its entirety, SEC Rule 202(a)(11)-1.  The brokerage industry had been lobbying the SEC hard for a rehearing petition, and indeed, just last week Commissioner Paul Atkins said he thought the SEC should do so.  Instead, the SEC is requested a four-month stay of the decision, to allow time for investors and brokers to respond to the decision.  Chairman Cox also stated that the SEC was committed to take the opportunity “to improve investors’ ability to make educated decisions about their investment accounts and their financial services providers.”

The controversy over the Rule, and the reason the Financial Planners Association brought the lawsuit, is its exemption of broker-dealers offering fee-based accounts from regulation as investment advisers.  The D.C. Circuit (2-1 decision) held that the SEC exceeded its authority in granting this exemption.  The court, in a startling example of narrow statutory interpretation, held that since the statute set forth one exemption for broker-dealers, the SEC could not use its statutory authority to promulgate rules  exempting “other persons” to create an additional exemption for broker-dealers.  (I have previously written that the SEC Rule was bad policy, but I never doubted the SEC's statutory authority to promulgate it.)

Chairman Cox also announced that the SEC was accelerating the timetable of a previously commissioned study by the RAND Corporation on how the different regulatory systems that apply to broker-dealers and investment advisers affect investors,  which is expected “to provide an important empirical foundation for considering improvements in regulatory and legislative rules that date back to the 1930s.”  This suggests that the SEC has given up on the D.C. Circuit and plans, instead, to propose legislative changes.

Another part of the vacated SEC Rule has received much less attention.  It allowed full-service brokerage firms to offer discount, execution-only services without being deemed investor advisers.  Under prior SEC interpretations going back to 1978, a two-tier pricing system for commissions (with or without advice) meant that the brokerage firm was receiving “special compensation” for its advice and fell within the definition of “investment adviser.”   Because the D.C. Circuit vacated the Rule in its entirety, the earlier interpretation presumably is still in effect.  Indeed, the D.C. Circuit made a point of setting forth the prior interpretation in a footnote and approvingly noted that it was based on the SEC’s  “contemporaneous” (i.e., 1940) views of the statute.

The exemption allowing two-tier pricing programs was not an issue in the FPA litigation, and, so far as I know, no one considered this aspect of the Rule controversial.  It may be that the SEC can simply rescind its 1978 interpretation as an erroneous and strained interpretation of the “special compensation” language in the statutory definition to allow two-tier pricing programs.  This would make good sense, but I have not seen any discussion about what the SEC intends to do about this. 

6th Circuit Dismisses 10b-5 "Class B Shares" Class Action Against Morgan Stanley

Broker-dealers have frequently sold Class B mutual fund shares to their customers instead of Class A shares because the higher Class B fees make it more profitable for the broker.  In recent years NASD has brought many enforcement actions against securities firms for this practice and issued warnings to investors.  The Sixth Circuit, however, recently dismissed a class action brought by customers purchasing at least $50,000 in mutual funds against Morgan Stanley for placing them in Class B shares, when, according to plaintiff (and accepted as true by the court for purposes of deciding the motion to dismiss) at this level of investment, Class A shares was always a better choice.  The Robert N. Clemens Trust v. Morgan Stanley DW, Inc., 2007 WL 1263964 (6th Cir. May 2, 2007). 

A bit of background: a customer's claim against his broker for an unsuitable recommendation is almost always brought in arbitration; generally, unsuitability claims are not amenable to class action because of the predominance of individual questions of fact such as the nature of the recommendation made by the broker to his customer and the individual investor's investment objectives (NASD rules exclude class actions from arbitration, one of the few exceptions to mandatory arbitration under the customers' agreement.) Plaintiffs occasionally attempt to bring class actions by alleging that their brokers engaged in common practices such as illegal business practices or widely disseminated misstatements that have the same impact on numerous customers.  Plaintiffs' attempt to do so here, however, failed, largely because of the stringent pleading requirements of PSLRA.  Specifically, plaintiffs (1) failed to state specific factual allegations that Morgan Stanley and its brokers knew or were reckless in not knowing that Class B shares were inferior to Class A shares; (2) failed to state sufficient facts to allow the court to draw an inference that MS knew that Class B shares were inferior to Class A shares; and (3) failed to state sufficient facts to establish that MS brokers knewe that Class B shares were unsuitable for plaintiffs.  After all, the court reasoned, MS could have legitimately offered only the more expensive Class B shares, so how could it be fraudulent to offer their customers a choice?  While recognizing hypothetically that MS could have engaged in a scheme to defraud its customers, the court did not believe that plaintiffs provided enough specific factual allegations facts that MS was steering its investors into Class B shares regardless of each investor's personal investment goals.  In addition, it finds that plaintiffs abandoned their claims under Rule 10b-5(a) and (c) because they did not specifically refer to these subsections of the Rule in their opening brief.

As an investors' advocate, I have frequently argued that whatever the failures of SRO arbitration, it offers one great advantage to investors -- the arbitrators don't have to apply federal securities laws that have become increasingly anti-investor over the years.  This case provides an excellent illustration for my argument.  In arbitration a customer can base his claim on the unsuitability of the recommendation without having to establish scienter. 

The 6th Circuit opinion is also noteworthy in that it is one of the few opinions (and perhaps the first from a federal appellate court) that cites an arbitration award to support its analysis.  This is not a trend to be encouraged -- arbitrators do not have to apply the law, they do not have to give reasons, and arbitration awards have no precedential value -- the arbitrators' task is to resolve the dispute before them.

Second Circuit's Clarifying Opinion in Denial of IPO Class Action Certification

The Second Circuit recently issued a "clarification" in denying a rehearing of the In re IPO Sec. Litig. case, where it reversed the district court's certificaton of the class because it found that individual issues of reliance and knowledge precluded a finding that common issues predominated.  In the petition for rehearing, plaintiffs argued that the purchasers in the aftermarket could establish reliance based on fraud on the market and would have no knowledge of the alleged fraud.  Yes, but, "whatever [this argument's] merit," said the Second Circuit in response, the broad class certified by the district court included both initial purchasers in the IPO as well as purchasers in the after market.  In addition, in a footnote, it clarified its reference to the section 11 claims to make clear that section 11 does not require the plaintiff to allege reliance.  (Thanks to Maggie Sachs for calling this to my attention.)

7th Circuit on Loss Causation

The Seventh Circuit provides further clarification on the distinction between transaction and loss causation and upholds summary judgement against plaintiff in this securities fraud class action because plaintiff introduced no evidence of loss causation.  Ray v. Citigroup Global Markets, Inc., 2007 WL 1080426 (4/12/07).  Plaintiffs represented a class of retail investors who purchased shares in a wireless data services company allegedly based on stockbrokers' misrepresentations and the stock price dropped along with the rest of the market in similar companies. The appellate court agreed with the district court that plaintiffs had no evidence that would show that any particular misrepresentation had a causal connection with the loss in value of the shares.  The Seventh Circuit identified three approaches to establishing loss causation:  the "materialization of risk" standard ("it was the very facts about which the defendant lied which caused its injuries"); the "fraud on the market" scenario (the Dura situation, where plaintiff has to show that the alleged misrepresentations inflated the value of the stock and that the value of the stock declined once the market learned of the deception), and a third situation where loss causation "might be shown" if a broker falsely assures the plaintiff that the investment is "risk-free."   The latter approach (if tenable at all after Dura) requires that the plaintiff to show that the broker used very explicit language to misrepresent that the investment was risk-free.

Merck Securities Fraud Action Dismissed as Time-Barred

The Federal District Court in New Jersey this week dismissed a securities fraud class action brought by purchasers of Merck stock charging that the company had lied about the safety of its drug VIOXX, finding that the claims were time-barred.  Because the first complaint was filed Nov. 6, 2003, the applicable date was Oct. 9, 2001 (Because the action was brought after SOX became law, the court applied the 2 year limitations period.)  Applying the Third Circuit's "inquiry notice" standard, the court found an "overwhelming" amount of information ("storm warnings") by that date that Merck may have been deceiving the public about the drug's safety, including a New York Times article where Merck admitted the drug may increase the risk of heart attacks, an FDA Warning Letter and product liability lawsuits.  In the face of this information, the burden shifted to the plaintiffs to show that they conducted an investigation.  The court rejected plaintiffs' arguments that they could rely on management's reassurances.  Following 3d Circuit precedent, the district court noted that the duty to investigate is greater where the plaintiffs are direct investors in the company, as opposed to mutual fund investors.  See In re Merck & Co. Sec. Litig., 2007 WL 1100820 (D.N.J. 4/12/07).

D.C. Circuit Throws Out SEC Rule on Fee-Based Accounts

Financial Planning Association v. SEC, 2007 WL 935733 (Mar. 30, 2007):

The D.C. Circuit (by a 2-1 decision) threw out the SEC's rule that exempted broker-dealers offering fee-based accounts to their customers from regulation as investment advisers.  Because broker-dealers have an exemption under section 202(a)(11)(C) of the Investment Advisers Act where their advice is "solely incidental" to their business as broker-dealers and they receive no "special consideration" for their advice [i.e., for commission-based accounts], the SEC has no authority to grant broker-dealers another exemption under section 202(a)(11)(F), which gives the SEC authority to exempt "other" persons not within the intent of the statute.  The court relied principally on the statutory language,  but it also looked to the legislative history of the IAA and the agency's longtime policy prior to adopting this rule, initially on a temporary basis to allow broker-dealers to offer fee-based accounts.  In recent years, brokerage firms have heavily marketed fee-based accounts as revenues from commissions have dropped.

Form U-5 Statements Have Absolute Privilege, New York Court Rules

The New York Court of Appeals held that brokerage firms have an absolute privilege against defamation suits with respect to statements made on the U-5 Forms filed upon termination of a broker's employment.  Previously, the law was unclear whether the privilege was absolute or qualified.  Answering a question certified to it by the 2d Circuit, New York's highest court (in a 4-2 decision) said that absolute privilege followed from the "Form U-5's compulsory nature and its role in the NASD's quasi-judicial process, together with the protection of public interests."  Rosenberg v. MetLife, 2007 WL 922920 (Mar. 29, 2007).

Tellabs Oral Argument

Tellabs, Inc. v. Makor Issues & Rights was argued today before the U.S. Supreme Court.  Here's the link to the transcript.

Supreme Court Accepts Cert in Aiding and Abetting Case

The U.S. Supreme Court accepted certiorari in an aiding and abetting securities fraud claim.  Specifically the question presented is:  Does the Central Bank decision foreclose claims for deceptive conduct under Rule 10b-5 (a) and (c) when respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public company's financial statements, but made no public statements concerning these transactions?  The lower court decision is Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc., 443 F.3d 987 (8th Cir.)  The Docket Number is 06-43.

6th Circuit Decides NSMIA Preemption Issue

Brown v. Earthboard Sports USA, 6th Circuit Mar. 16, 2007, 2007 WL 777491:

NSMIA preempts state registration of "covered securities" issued "pursuant to" a Reg D exemption.  Federal and state courts have split on the conditions for establishing the applicability of the NSMIA preemption to unregistered offerings purportedly exempt under Reg D.  Specifically, must the offering actually meet the conditions for an exemption under Reg D, or is it enough that the offering was purportedly made under Reg D?  Reversing the district court, the 6th Circuit held that the offering must actually qualify for the Reg D exemption for NSMIA preemption to apply.  The court relied on the statutory language to reach this conclusion.

The 6th Circuit also reversed the district court on its conclusion that, as a matter of law, a non-reliance clause in the subscription agreement precluded the purchaser from establishing reliance on the broker's misrepresentations, since determining reasonable reliance requires a contextual analysis.

Amici Briefs in Tellabs Case

Here is a list of the amicus briefs filed in Tellabs, Inc. v. Makor Issues & Rights, Ltd., which will be argued before the U.S. Supreme Court on March 28.  The issue is the appropriate standard for determining whether plaintiff met the PSLRA requirement of pleading facts giving rise to a "strong inference of scienter."

Briefs for Respondents (the plaintiff):

• Regents of the University of California, CALPERS and 7 law professors (Cox, Buxbaum, Frisch, Friedman, Partnoy, Steinberg, and Eisenberg)
• NASAA
• Amalgamated Bank as Trustee (oldest labor-owned bank)
• Center for Study of Responsive Law and Public Citizen
• German Association for the Protection of Shareholders, et al.
• Council of Institutional Investors
• Ohio and 23 other states, territories and commonwealths
• Arkansas and 7 other states and 2 public retirement funds
• New York State and other states' retirement funds
• American Association for Justice
• National Conference on Public Employee Retirement Systems and National Association of Shareholder and Consumer Attorneys
• Allan N. Littman and William I. Edlund

The following were filed on behalf of Petitioner (defendant):

• Washington Legal Foundation
• American Institute of Certified Public Accountants et al.
• New England Legal Foundation
• Technet, The Information Technology, et al.
• Joseph Grundfest et al
• Pixelplus Co. and Quest Software
• DOJ and SEC
• SIFMA and U.S. Chamber of Commerce

2d Circuit Opinion on Accountant's Liability

The Second Circuit held, in Overton v. Todman & Co., 2007 WL 574623 (2d Cir. 2/26/2007), that an accountant has a "duty to correct" and can be held primarily liable for securities fraud when it provides a certified opinion containing false and misleading statements, subsequently learns (or is reckless in not learning) that the statements were false and misleading, knows (or should know) that investors are relying on that opinion, and fails to take reasonable steps to correct or withdraw its opinion. 

Eleventh Circuit: Section 11 Really Does Have a Reliance Requirement

APA Excelsior III v. Premiere Technologies, 2007 WL 286258 (11th Cir.(2/2/07).   The 11th Circuit affirmed a district court's dismissal of a complaint filed under 33 Act section 11 brought by investors who were 30% shareholders in a corporation that merged with defendant corporation. The stock issued pursuant to the merger was registered under section 11, and the registration statement allegedly contained false and misleading statements.  Finding that plaintiffs were sophisticated investors who had not exercised their due diligence rights in any meaningful way, the court said could not show reasonable reliance on the registration statement.  Since section 11 does not require a showing of reliance (except in one narrow instance, not applicable here), the court looked at legislative history to interpret section 11 as setting forth a presumption of reliance (and not a strict liability statute) and further found the presumption was rebutted in this instance because of its "pre-registration commitment theory."

4th Cir. Opinion on PSLRA, Loss Causation

Teachers Retirement System v. Hunter, 2007 WL 509787 (4th Cir. 2/20/07).  Plaintiff alleged a channel-stuffing scheme involving 6 other companies that went on for almost four years, allegedly to inflate the stock price.  The majority trashed the plaintiff's 168-page complaint, finding it short on substance.  It upheld the district court's dismissal of the compaint both for failure to meet the standards of pleading scienter under the PSLRA and for failure to plead adequately loss causation.  In holding that loss causation must be pled with specificity, the 4th Circuit found that the drop in stock price was caused by fallout of an intra-family dispute and was not causally related to misrepresentations.

Further Due Process Restrictions on Punitive Damages

The Supreme Court, in a 5-4 decision, imposed further restrictions on punitive damages awards, holding that the award cannot penalize the defendant for harm done to non-parties.  While punitive damages are not allowed in federal securities claims, they may be awarded in some state securities claims and in arbitration cases against brokerage firms.  Recently, there have been some judicial opinions holding that due process limits on punitive damages awards are applicable in arbitration, even though there is no state action.  For discussion of the Phillips Morris v. Williams decision, see WSJ, High Court Throws Out Verdict Against Philip Morris.

Amicus Briefs in Tellabs

To date, amicus briefs in Tellabs Inc. v. Makor Issues & Rights, Ltd.  have been filed by the following, all in favor of the Defendant issuer's position, and contrary to plaintiff's position and the holding of the 7th Circuit:

The SEC

The Washington Legal Foundation

The American Institute of Certified Public Accountants

SIFMA and the Chamber of Commerce

Northeastern Legal Foundation

Technet, The Information Technology Association of America

Joseph A. Grundfest, et al.

District Court Opinion on SLUSA Delaware Carveout

A federal district court in S.D. Texas held that shareholders could sue the corporation for allegedly misleading statements in the company's preliminary proxy statement  prepared in connection with a proposed merger, because it fell within the "Delaware carveout" exception to SLUSA.  The court held that the preliminary proxy materials, which were available on the SEC website, constituted "communications ... made by the issuer to its equity security holders" for purposes of the Delaware carveout:  "In this day and age, the act of posting information on the internet, making the data available to the public, is tantamount to "communication.... Merely because a copy of the preliminary proxy statement is not physically mailed to shareholders does not exclude it from being a 'communication.' " Superior Partners v. Chang, 2007 WL 101848 (S.D. Yex. 01/08/07).

Margin Payments held by Broker Avoided in Ponzi Scheme Bankrupty

In the bankruptcy proceeding arising out of Michael Berger's Ponzi scheme, the bankruptcy trustee of the fund recovered  as fraudulent transfers margin payments deposited into the Fund's account at Bear Stearns.  Because Bear Stearns had the power to use the moneys to protect its financial interests, it was not simply a "conduit" of the funds but an "initial transferee from whom the trustee could recover the funds.  In addition, Bear Stearns was not successful in arguing that it took the money in good faith, because it was on inquiry notice of the fraud for over a year and took no steps in investigate.  Gredd v. Bear Stearns Corp., 2007 WL 60843 (Bankr. S.D.N.Y. 1/09/07).