Saturday, January 25, 2020
One of the things I’ve talked about before is how courts adjudicating securities claims must perennially police the line between “fraud” and “mismanagement.” The issue goes back to the Supreme Court’s decision in Santa Fe Indus. v. Green, 430 U.S. 462 (1977), which held that “the language of § 10(b) gives no indication that Congress meant to prohibit any conduct not involving manipulation or deception.” Thus, Section 10(b) claims cannot be based on mismanagement or breach of fiduciary duty alone.
That said, as federal securities regulation increasingly enters into the governance space, the distinction between fraud and mismanagement is harder and harder to identify. In general, courts hold that if there’s been a false statement, then the claim is properly stated as securities fraud; if not, not. The problem is, as the SEC imposes more and more disclosure requirements, many of which concern core aspects of governance (ethics codes, risk taking, and whatnot), the “deception” test does not seem to emotionally do the work of distinguishing a claim based on poor governance from a claim based on fraud.
As I’ve repeatedly blogged about – and written articles about, most extensively in Reviving Reliance– given this problem, courts have deployed a number of doctrines to dismiss claims that feel more governance-y than fraud-y, the most prominent of which is puffery. Puffery, ostensibly, refers to statements that are so vague or hyperbolic that they are essentially without content, but it’s often used to toss claims that courts feel just don’t belong in the securities space.
Anyhoo, I lay out the theory in more detail in the links above, but for today, I want to highlight a recent example of the phenomenon, In re Liberty Tax Securities Litigation, 2020 WL 265016 (E.D.N.Y. Jan. 17, 2020).
In this case, the CEO, who was also the controlling shareholder, was accused of using the company to “advance his romantic and personal interests.” Which basically means he conducted romantic relationships in the office, including dating employees and bringing them along on business trips. The false statements that formed the basis of the claim included representations that the company’s internal controls were “effective,” and risk warnings that the CEO’s interests as a controlling stockholder might differ from those of the other stockholders.
This is, to be sure, weak sauce. And speaking as a former plaintiffs’ attorney, I read this and the first thing I think is, why was this case even brought? There wasn’t a stock price drop upon revelation of the misconduct, so whose bright idea was it to file a complaint?
Well, it turns out, after the CEO’s unprofessional conduct was revealed, he was actually fired (which itself is remarkable, given his voting control), the company’s auditor resigned, and there was some board turnover. That’s the kind of thing that catches the attention of a plaintiff’s attorney, and my guess is that we’re seeing the results of some of the perverse incentives created by the Private Securities Litigation Reform Act (PSLRA).
Once upon a time, the first plaintiff to file a complaint got to control a securities fraud class action – which incentivized attorneys to file poorly-researched complaints the moment there was any hint of fraud. In 1995, the PSLRA changed the system: Now, the court considers multiple applicants for the “lead plaintiff” slot, selects the one most appropriate – usually the one who has the largest loss – and that lead plaintiff selects lead counsel. The theory here is that because there’s no advantage to filing early, counsel will seriously research a case before filing a complaint. And the kind of large, institutional clients who have large losses, and thus are viable contenders for a lead plaintiff appointment, will expect such research, and refuse to sign on until they see the work.
I actually think the PSLRA’s lead plaintiff provisions are the best things about the PSLRA, but in this respect, they didn’t play out as expected. Specifically, there is little incentive for counsel to expend the resources to research a case – which can include hiring an investigator, hiring an accountant, and spending multiple attorney hours combing through news reports and SEC filings – before they’re sure they will be appointed lead. Instead, what tends to happen is that counsel identifies cases that look promising, pitches the idea to a potential institutional client who experienced a large loss, the client hires them, and then counsel and client seek a lead plaintiff appointment. After the court appoints lead plaintiff and counsel, the serious research begins. But at this point, counsel is committed. The last thing they want to do is discover there’s no fraud, and go back to the valuable client – who they hope will hire them for future cases – and admit error. So counsel will continue to pursue the case even if there’s no there there.
If I had to wager - and I am just drawing inferences based on the opinion - I’d say this is what happened in Liberty Tax. KPMG resigned and the controlling shareholder was fired by his own board: HUGE red flags! Plaintiffs’ counsel jumped, assuming accounting shenanigans would eventually turn up. But none did, either because there were none to be had, or because they were buried deep enough that without discovery (which the PSLRA blocks before resolution of the motion to dismiss), nothing could be established.
And rather than drop the case and confess error to the client, counsel made the best of a bad situation, arguing that the CEO’s boorishness and self-dealing amounted to fraud because the company claimed it had effective internal controls.
The court, clearly, sensed all of this: We’re looking at something like classic controller breach of duty, tunneling, misuse of corporate resources for personal gain, what-have-you. But none of that counts as fraud under Section 10(b) without a clear misrepresentation, and “internal control deficiencies” doesn’t capture what’s going on here. Internal controls concern appropriate recordkeeping, ensuring that material information is communicated to management, ensuring that unauthorized persons cannot alter records, and so forth. For all the CEO’s sins, there’s no allegation that expenses were misrecorded in the company books, or that – if they were – the errors were ever disclosed to the public or caused plaintiffs any losses.
Rather than say that, however, the court held that representations as to the effectiveness of internal controls are “puffery,” namely, that they were “too general to cause a reasonable investor to rely upon” them.
But that really misunderstands and distorts the concept of internal controls. Internal controls are a critical aspect of corporate governance, and they have a fairly defined meaning with respect to accounting and information flow within the firm. Saying they are effective is not, in other words, the equivalent of saying “world’s best coffee!”
Moreover, ever since Sarbanes Oxley, corporate officers are required to disclose whether internal controls are effective. It is perverse to suggest that these mandated disclosures – which the SEC, and Congress, clearly think are critically important to investors – are immaterial as a matter of law. (That’s also how I feel about codes of ethics, by the way, which have also been held to be puffery – most recently in the case concerning undisclosed sexual harassment at CBS, Construction Laborers Pension Trust for Southern California v. CBS Corporation, 2020 WL 248729 (S.D.N.Y. Jan. 15, 2020) – but that’s an argument for another post.) I mean, imagine we had an actual, for real case of accounting fraud, where the internal controls did not in fact prevent unauthorized entries and expenditures, and the CEO knew it and lied about it. Would we seriously say that was puffery? Well, after this opinion, that’s certainly what defendants are going to argue.
So I come back to where I started, which is, courts are grasping for some basis to distinguish poor governance from fraud. Given today’s disclosure requirements, not to mention new demands for investors to act as stewards, that may be a fruitless exercise, but in the meantime, courts seem to be treating just about any statement about internal governance and corporate procedure as “puffery.” Which means that the concept of “puffery” has drifted from its original meaning – vague and unfalsifiable self-praise – to become synonymous with, “I know fraud when I see it, and this isn’t really fraud, exactly.”