Tag Archives: Ninth Circuit

In U.S. v. Salman, Judge Rakoff Distinguishes Newman in 9th Circuit Opinion Affirming Insider Trading Conviction

In an opinion issued July 6, 2015, a Ninth Circuit panel affirmed the insider trading conviction of Bessam Salman in the case captioned United States v. Salman, No. 14-10204 (9th Cir.).  The opinion is relatively straightforward, but is noteworthy for two reasons.  First, it is written by Southern District of New York Judge Jed Rakoff, who seems to attracting insider trading cases of late, and has written several opinions interpreting and applying the Second Circuit U.S. v. Newman decision.  Second, the defendant-appellant argued that the Newman opinion supported reversal of the conviction, which gave Judge Rakoff another chance to state his views on Newman.  The opinion can be read here: U.S. v. Salman.

The opinion does little to advance the interpretive analysis of the Newman decision because it is governed directly by the Supreme Court holding in Dirks v. SEC, 463 U.S. 646 (1983).  In fact, Judge Rakoff says so in no uncertain terms: “Dirks governs this case.”  Slip op. at 10.  The only real comment Judge Rakoff makes on Newman is that if Newman held that a personal gift of material inside information from a tipper breaching a fiduciary duty of confidentiality to a tippee with whom he has a close relationship, for the specific purpose of enriching the tippee, was insufficient to support a conviction, then “we decline to follow it.”  Slip op. at 13.  Since Newman never suggested such a result – which would be plainly contrary to the Dirks opinion – there is no distance between the Salman and Newman opinions.

As Judge Rakoff notes, the facts in Salman and Newman are very different.  In particular, in Newman, the evidence showed no intention by the original sources of the inside information to confer a benefit on a close friend or relative by improperly communicating the inside information.  In Salman, however, the evidence in the record was exactly the opposite.  The tipping brother testified “that he gave [his brother] the inside information in order to ‘benefit him’ and to ‘fulfill[] whatever needs he had.’”  Slip op. at 5.

The Dirks opinion plainly included this in its description of unlawful tipping, as quoted by Judge Rakoff: “[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.”  Slip op. at 10, quoting Dirks, 463 U.S. at 664.

Some may contend that Salman rejects the concept of a “personal benefit” to the source in the nature of a “quid pro quo” as a prerequisite for tippee liability, referred to in Newman.  See, for example, Ninth Circuit Disagrees with Second Circuit on Personal-Benefit Requirement for Insider Trading.  That is not how I read either Salman or NewmanNewman never questioned that the required benefit to the tipper could be a non-monetary one — like the benefit of directing wealth to a close friend or relative you want to benefit from being more wealthy — it just found the evidence of such a benefit insufficient in that case because the mere fact of providing information, with no evidence that it was to fulfill the tipper’s desire to transfer wealth, was “too thin” to support finding a benefit to the tipper.  And Salman plainly finds, and emphasizes, the strong evidence in the case of a benefit to the tipper in the form of intentionally directing wealth to a beloved relative.

There can be no doubt that the Newman court never rejected that holding in Dirks.  Instead, it tried to apply the Dirks holding to the evidence presented in Newman, which the court found insufficient to show any personal benefit derived by the sources from their “tips” because “the mere fact of a friendship, particularly of a casual or social nature” was not enough to prove a intent to benefit the tippee.  Slip op. at 12-13, quoting Newman, 773 F.3d at 452.  The Newman court found the “circumstantial evidence” in that case “too thin to warrant the inference that the corporate insiders received any personal; benefit in exchange for their tips.”  Slip op. at 13, quoting Newman, 773 F.3d at 451-52.  That obviously does not describe the evidence of benefit presented in Salman, which was neither circumstantial nor thin because the source himself described the pleasure he took in giving the gift of information to his brother.  See slip op. at 11 (testimony from the source and his tippee, who were brothers, showed that the tipping brother “intended to ‘benefit’ his [tippee] brother and to ‘fulfill[] whatever needs he had’”).

If Salman stands for anything meaningful, it is that it shows that Newman was not a meaningful departure from existing insider trading law, but rather a ruling that there are limits to how far the Government can stretch mere casual friendships or acquaintances to prove a transfer of information was intended as the “gift of confidential information” described in Dirks.  In short, the sky did not start falling when the Newman opinion was adopted.  See DOJ Petition for En Banc Review in Newman Case Comes Up Short.

Judge Rakoff’s Salman opinion concludes: “If Salman’s theory were accepted and this evidence found to be insufficient, then a corporate insider or other person in possession of confidential and proprietary information would be free to disclose that information to her relatives, and they would be free to trade on it, provided only that she asked for no tangible compensation in return.  Proof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend is sufficient to establish the breach of fiduciary duty element of insider trading.”  Slip op. at 14.  Newman never suggests any different result.

Straight Arrow

July 6. 2015

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Stratte-McClure: 2d Circuit Creates Circuit Split on 10(b) Actions Founded on Alleged Item 303 Violations

The Second Circuit’s recent decision in Stratte-McClure v. Morgan Stanley, No. 13-0627-cv (Jan. 12, 2015) (2015 WL 13631) (slip opinion available hereStratte-McClure v. Morgan Stanley) (also referred to as Fjarde AP‐Fonden v. Morgan Stanley), stirs the pot on the important issue of private section 10(b) claims based on alleged violations of Item 303 of SEC Regulation S-K, 17 CFR § 229.303.  Claims founded on a purported failure to comply with Item 303 are problematic because Item 303 is the SEC’s effort to enhance disclosures of “soft information,” not historical facts, about a public company.  It requires that a company evaluate and discuss the future prospect that some developments or uncertainties could be important in future company performance.  Because such decisions (i) inevitably involve the exercise of management judgment the need for disclosure, and the nature and scope any such discussion, and (ii) are almost always subject to second-guessing in retrospect, when the future is revealed and the uncertainties become less uncertain, they present serious risks of converting private section 10(b) claims into a form of hindsight insurance against stock price declines.

The SEC at one time excluded forward-looking information from SEC filings, but about 40 years ago started to encourage companies to provide forward-looking information in SEC filings.  This eventually led to the development of mandatory disclosure requirements of “MD&A,” the short term for the Management Discussion and Analysis of Financial Condition and Results of Operations required by Item 303.

 Item 303 arose out of SEC concerns that investors were missing out on key elements of company information if they obtained only purely historical information.  Informed investment decision-making could be greatly improved if investors were able to get management insights into areas of company risk and uncertainty that had not yet been realized.  This type of non-historical, future-looking evaluation is often referred to as “soft information.”  The area of soft information disclosure is problematic because the SEC wants to encourage management to share such evaluative analysis, but to do so in a way that does not expand company and management exposure for not reading the future correctly.  Accordingly, along with developing rules encouraging such disclosure, the SEC, Congress, and the courts have taken steps to limit private securities claims based solely on allegedly inadequate forward-looking disclosures.

The SEC adopted so-called “safe harbor” rules (Rule 175 under the Securities Act of 1933 and Rule 3b-6 under the Securities Exchange Act of 1934), under which a forward-looking statement in a company’s MD&A disclosures could not be found fraudulent absent proof that it “was made or reaffirmed without a reasonable basis or was disclosed other than in good faith.”  In the Private Securities Litigation Reform Act of 1995 (PSLRA), Congress enacted a more general safe harbor precluding liability in private actions for a forward-looking statement if: (i) it is identified as such and accompanied by “meaningful cautionary statements identifying important factors that could cause actual results to differ materially,” or (ii) immaterial, or (iii) the plaintiff fails to prove that the forward-looking statement was made “with actual knowledge . . . that the statement was false or misleading.”  15 U.S.C. § 78u-5(c). The first portion of this statutory safe harbor was effectively a legislative adoption of the judicially-created “bespeaks caution” doctrine under which a forward-looking statement accompanied by meaningful cautionary language was deemed immaterial as a matter of law.

Nevertheless, forward-looking statements that turn out to be inaccurate, or the failure to provide advance warning of a likely future impact of a current problem, has been a theory underlying private securities actions for decades.  Because this allows a backward-looking theory of fraud to be pursued after events occurring after the alleged misleading statements or omissions are accompanied by significant stock price impact, it is a powerful lure for the plaintiffs’ class action bar.

This theory can be especially powerful in the context of so-called “material omissions.”  In those cases, the plaintiff can seek damages supposedly arising out of a company’s failure to provide a prediction about the future – the failure to disclose the potential impact of facts or circumstances that later turn out to harm the company.  The most difficult hurdle in these cases is finding a “duty to disclose.”  The securities laws do not require the disclosure of all company information to investors, nor even all material company information.  Instead, public companies are required to disclose only the specified information mandated in SEC regulations, and to ensure that when they do disclose information, they do not at the same time withhold information without which the disclosed information becomes misleading.  In general, companies have no obligation to provide evaluations or predictions about possible future developments, so this “duty to disclose” requirement can be a major obstacle to a private securities action based on a failure to do so.

It is in this context that recent cases have considered the impact on private securities actions of Item 303 of Regulation S-K.  Two recent appellate cases adopt very different approaches to this issue: the Second Circuit’s decision in Stratte-McClure and the Ninth Circuit’s decision in In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014).  It is no exaggeration to say that billions of dollars of future litigation costs and liabilities may turn on which of these approaches ultimately prevails.

Item 303(a)(3)(ii) requires that as part of its annual (Form 10-K) and quarterly (Form 10-Q) MD&A disclosures, a company must:

Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.

The SEC discussed this requirement further in an interpretive release:

Where a trend, demand, commitment, event or uncertainty is known, management must make two assessments:

(1) Is the known trend, demand, commitment, event or uncertainty likely to come to fruition? If management determines that it is not reasonably likely to occur, no disclosure is required.

(2) If management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event or uncertainty, on the assumption that it will come to fruition. Disclosure is then required unless management determines that a material effect on the registrant’s financial condition or results of operations is not reasonably likely to occur.

Exchange Act Release No. 34–26831 (May 24, 1989).

NVIDIA and Stratte-McClure examine whether the failure to comply with this SEC disclosure requirement can form the basis for a private securities fraud action under section 10(b) and Rule 10b-5.  NVIDIA says “no”; Stratte-McClure says “yes.”

NVIDIA involved the company’s alleged failure to include in its Item 303 MD&A disclosures the potential financial impact of a defect in a chip incorporated into various manufacturers’ computers and other devices.  Although the existence of the defect was disclosed, the amounts to be paid under warranty obligations were allegedly known uncertainties, and the MD&A allegedly failed to include a required discussion of that prospect.  Stratte-McClure involved the alleged failure by Morgan Stanley to include in its MD&A a discussion of the potential future financial impact of long positions it held on collateralized debt obligations or credit default swaps at the time of the housing mortgage meltdown.

Let’s start with a key point on which both courts agree.  They both emphasize that information required to be disclosed under Item 303 may not satisfy one of the key elements of a section 10(b) claim: materiality.  That is because the SEC instructions make it clear that disclosures may be required “unless management determines that a material effect . . . is not reasonably likely to occur” (emphasis added).  As a result, disclosures of immaterial information are required if management cannot “determine” they are unlikely to have a future material impact.  Accordingly, plaintiffs will still have the burden of pleading facts showing a required disclosure was, in fact, material. See NVIDIA, 768 F.3d at 1055; Stratte-McClure, slip op. at 18-19.

Add to this another point of agreement: a section 10(b) claim requires proof that the defendants acted with scienter, which means that a claim can proceed only if the plaintiff pleads particular facts – under the PSLRA pleading standard, as further interpreted in Tellabs Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322-23 (2007) – plausibly supporting that the defendants’ omission was intended to defraud shareholders.  That could be even more difficult than normal for these cases to the extent the safe harbor provisions mentioned above may apply.  Both NVIDIA and Stratte-McClure found the allegations of scienter in failing to make required Item 303 disclosures were deficient and supported dismissal of the claims.  See NVIDIA, 768 F.3d at 1056-65; Stratte-McClure, slip op. at 26-29.  In Stratte-McClure, the Second Circuit found the failure to plead scienter adequately was grounds to affirm the district court’s dismissal of claims, even while reversing the lower court’s ruling that Item 303 did not create a disclosure duty.  (Technically, that makes the panel decision on the “duty to disclose” issue dicta, which theoretically has diminished precedential value, but don’t count on it.)

The difference between the courts – a critical one – is that the NVIDIA court concluded that Item 303’s requirement that certain immaterial information must be disclosed prevents it from creating the “duty to disclose” necessary to support a fraud claim under section 10(b), while the Stratte-McClure court concluded that the “duty to disclose” and materiality elements should be disaggregated for this purpose.

The NVIDIA court relied heavily on reasoning in the Third Circuit decision Oran v. Stafford, 226 F.3d 275, 287–88 (3d Cir. 2000) (Alito, J.), which in turn relied heavily on the discussion of section 10(b) elements in the Supreme Court’s opinion in Basic, Inc. v. Levinson, 485 U.S. 224, 238 (1988).  The NVIDIA wrote as follows:

[I]n Basic, the Supreme Court stated that materiality of forward-looking information depends “upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.” . . . As the court in Oran also determined, these two standards differ considerably.  226 F.3d at 288.  Management’s duty to disclose under Item 303 is much broader than what is required under the standard pronounced in Basic.  The SEC intimated this point as well: “[Item 303] mandates disclosure of specified forward-looking information, and specifies its own standard for disclosure—i.e., reasonably likely to have a material effect….  The probability/magnitude test for materiality approved by the Supreme Court in [Basic] is inapposite to Item 303 disclosure.”  Exchange Act Release No. 34-26831, 54 Fed. Reg. at 22430 n. 27.  The SEC’s effort to distinguish Basic’s materiality test from Item 303’s disclosure requirement provides further support for the position that Item 303 requires more than Basic—what must be disclosed under Item 303 is not necessarily required under the standard in Basic. Therefore, “[b]ecause the materiality standards for Rule 10b5 and [Item 303] differ significantly, the ‘demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b–5. Such a duty to disclose must be separately shown.’”  Oran, 226 F.3d at 288.

The Stratte-McClure court, on the other hand, saw no reason why a “duty to disclose” sufficient to make an omission potentially actionable must satisfy the Basic materiality requirement. Instead, it concluded the materiality standard should be applied separately, only after the determination whether there was a duty to disclose the omitted information.  Immaterial information could still satisfy the “duty to disclose” requirement, even if a plaintiff could not show it was material:

The Supreme Court has instructed that “[s]ilence, absent a duty to disclose, is not misleading under Rule 10b–5.”  Basic, 485 U.S. at 239 n. 17….  Such a duty may arise when there is “a corporate insider trad[ing] on confidential information,” a “statute or regulation requiring disclosure,” or a corporate statement that would otherwise be “inaccurate, incomplete, or misleading.”…

As Plaintiffs correctly argue, Item 303 of Regulation S–K imposes disclosure requirements on companies filing SEC-mandated reports, including quarterly Form 10–Q reports…. Those requirements include the obligation to “[d]escribe any known trends or uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on … revenues or income from continuing operations.” …  The SEC has provided guidance on Item 303, clarifying that disclosure is necessary “where a trend, demand, commitment, event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial conditions or results of operations.” …

Item 303’s affirmative duty to disclose in Form 10–Qs can serve as the basis for a securities fraud claim under Section 10(b).  Rule 10b–5 requires disclosure of “material fact[s] necessary in order to make … statements made … not misleading.”  This Court and our sister circuits have long recognized that a duty to disclose under Section 10(b) can derive from statutes or regulations that obligate a party to speak….  And this conclusion stands to reason—for omitting an item required to be disclosed on a 10–Q can render that financial statement misleading….  Due to the obligatory nature of these regulations, a reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of “known trends or uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on ․ revenues or income from continuing operations.”…  It follows that Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).

The failure to make a required disclosure under Item 303, however, is not by itself sufficient to state a claim for securities fraud under Section 10(b)….  Since the Supreme Court’s interpretation of “material” in Rule 10b–5 dictates whether a private plaintiff has properly stated a claim, we conclude that a violation of Item 303’s disclosure requirements can only sustain a claim under Section 10(b) and Rule 10b–5 if the allegedly omitted information satisfies Basics test for materiality.  That is, a plaintiff must first allege that the defendant failed to comply with Item 303 in a 10–Q or other filing. Such a showing establishes that the defendant had a duty to disclose.  A plaintiff must then allege that the omitted information was material under Basic‘s probability/magnitude test….

Stratte-McClure, slip op. at 14-20 (citations and footnotes omitted).

The Stratte-McClure court noted the NVIDIA court’s disagreement, arguing that the NIVIDIA court conflated the “duty to disclose” and materiality requirements, and misapplied then-Judge (now Justice) Alito’s reasoning in Oran:

We note that our conclusion is at odds with the Ninth Circuit’s recent opinion in In re NVIDIA Corp. Securities Litigation….  That case held that Item 303’s disclosure duty is not actionable under Section 10(b) and Rule 10b–5, relying on a Third Circuit opinion by then-Judge Alito, Oran v. Stafford….  But Oran simply determined that, “[b]ecause the materiality standards for Rule 10b–5 and [Item 303] differ significantly,” a violation of Item 303 “does not automatically give rise to a material omission under Rule 10b–5” (emphasis added).…  Having already decided that the omissions in that case were not material under Basic, the Third Circuit concluded that Item 303 could not “provide a basis for liability.”… Contrary to the Ninth Circuit’s implication that Oran compels a conclusion that Item 303 violations are never actionable under 10b–5, Oran actually suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material 10b–5 omission. At a minimum, Oran is consistent with our decision that failure to comply with Item 303 in a Form 10–Q can give rise to liability under Rule 10b–5 so long as the omission is material under Basic, and the other elements of Rule 10b–5 have been established.

It is possible that the differences between these decisions reflect the proverbial “distinction without a difference.”  After all, the Stratte-McClure court requires that materiality be pleaded and proved in addition to a disclosure duty, which eventually may lead to the same result.  But “eventually” can be a big word.  The name of the game is these cases is surviving dismissal and getting into discovery.  Materiality is a notably hard element on which to get a claim dismissed.  Even scienter-based dismissals tend to be arduous litigated results with multiple amended complaints, and plaintiff’s counsel often manage to survive dismissal by presenting often dubious “confidential witness” allegations that prevent dismissal, even if they don’t stand up in discovery.  Dismissing these cases will be much easier if the “duty to disclose” is understood to mean “duty to disclose material information,” as the NVIDIA (and arguably Oran) court ruled.  That would require a disclosure duty in an omissions case to be founded in the substance of omitted material, and not just on a disclosure duty not founded in the importance to investors of the omitted information.  The practical effect of the two different rules could be enormous, since the issue is not which side will win at trial, or even summary judgment, but will the case survive to the point that a hefty settlement may be the preferred result for both sides.

It is important to remember, as the Supreme Court has done in past private actions under section 10(b), that the section 10(b) private right of action was judicially created, and for that reason is more amenable to judicial interpretation and refinement than statutory causes of action.  The Supreme Court has in the past, and likely will in the future, taken into account the policy implications of endorsing one approach or another in determining the precise parameters of the elements of private section 10(b) claims.  In doing this, the Court may also place some weight on obvious efforts by the SEC and Congress to limit exposure to private actions from the forward-looking disclosure requirements.  As a result, even if the Second Circuit’s disaggregation approach is arguably more sound from the standpoint of pure logic, the practical appeal of interpreting “duty to disclose” to include, at least implicitly, a materiality aspect could ultimately prevail.

Straight Arrow

January 19, 2015

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9th Circuit Adopts Demanding Loss Causation Pleading Standard in Weak Opinion

On December 16, 2016, the Court of Appeals for the Ninth Circuit affirmed the dismissal of class action securities fraud claims against Apollo Group in Oregon Public Employees Retirement Fund v. Apollo Group.  The complaint alleged that Apollo’s disclosures about its for-profit post-secondary education business (predominantly the University of Phoenix) were materially misleading in the way they described the for-profit education business model, business and recruiting practices, and treatment of financial defaults by students, among other things.  The appellate court affirmed dismissal on multiple independent grounds, finding the allegations failed to state elements of materiality, scienter, and loss causation.

Loss Causation Pleading

The most important aspect of the decision was the Ninth Circuit’s determination that the Fed. R. Civ. P. 9(b) particularity pleading requirements apply to allegations of loss causation in securities fraud claims.  The court wrote: “Although it is clear that Rule 9(b) and the PSLRA apply to almost all elements of a securities fraud action, the law is less clear about the pleading standard that applies to the loss causation element.”  Slip op. at 8.  Although the Ninth Circuit previously resisted addressing this issue when it was not dispositive to its decision, it took a different approach here.  Although it ultimately held that loss causation was insufficiently pleaded under either a Rule 9(b) or Rule 8(a) pleading standard, the court decided it was time to put the pleading standard issue to rest, at least in that circuit.

The court identified the Fifth, Seventh, and Second Circuits as having previously adopted some form of heightened particularity pleading requirement for loss causation in section 10(b) cases, and noted the Fifth Circuit had gone the other way, applying Rule 8(a) to that aspect of pleading section 10(b) claims.  See id. at 9-10.  It then announced its choice to apply Rule 9(b) to that loss causation pleading: “We are persuaded by the approach adopted in the Fourth Circuit and hold today that Rule 9(b) applies to all elements of a securities fraud action, including loss causation.”  Id. at 10.  The court gave three reasons for this choice:

(1)        “[T]he law on securities fraud is derived from common law fraud.”  The case law developed by the Supreme Court regarding section 10(b) is based on doctrines of common-law fraud and deceit.  “The requirement of loss causation, in particular, is founded on the common law of fraud and deceit.”  Since Rule 9(b) applies “to all circumstances of common-law fraud, . . . and since securities fraud is derived from common law fraud, it makes sense to apply the same pleading standard to all circumstances of securities fraud.”  Slip op. at 10-11.

(2)        Rule 9(b) requires pleading with particularity of “the circumstances constituting fraud or mistake.”  Securities fraud encompasses six elements, including loss causation.  As a result, loss causation is part of the “circumstances” constituting fraud because, without it, a claim of securities fraud does not exist.  Id. at 11.

(3)        This approach “creates a consistent standard through which to assess pleadings in 10(b) actions, rather than the piecemeal standard adopted by some courts.”  Id.


In analyzing the complaint itself, the court first turned to materiality.  It found that plaintiffs’ allegations fell short on materiality “because the material misrepresentations the Plaintiffs allege are not objectively false statements.”  The court distinguished “puffing” from misrepresentation, noting that “’[p]uffing’ concerns expressions of opinion, as opposed to knowingly false statements of fact.”  Investors do not rely on “vague statements of optimism” or “feel good monikers.”  In contrast, statements “that are capable of objective verification are not “puffery” and can constitute material misrepresentations.”  Id.  at 12.

The alleged misrepresentations in this case were found to be “inherently subjective ‘puffing’ and would not induce the reliance of a reasonable investor.”  In particular, statements that start “we believe,” and vague descriptions of things as “significant events” are not objective facts.  “Unlike accounting calculations or ignorance of rule violations, the statements by Apollo were subjective and preceded by qualifiers, such as ‘We believe.’”  Id. at 13-14.


On the issue of pleading scienter, the court said that where plaintiffs “seek to hold individuals and a company liable on a securities fraud theory, we require that the Plaintiffs allege scienter with respect to each of the individual defendants.”  Employing a “holistic view,” the court concluded there were insufficient facts alleged to establish that the defendants knew or were “consciously reckless” of their deceptive practices.  At best, plaintiffs alleged examples of flawed practices “rather than widespread deception, which would be necessary to establish fraudulent intent or reckless ignorance based on a holistic analysis.”  Id. at 16.

Loss Causation

As to loss causation, the court found the allegations failed under either a Rule 8(a) or Rule 9(b) standard because plaintiffs “do not allege specific statements made by the Defendants that were made untrue or called into question by subsequent public disclosures.”  The complaint left it unclear which of the previous disclosures were later shown to be inaccurate.  Moreover, general “expressions of concern” in a government report about the nature of Apollo’s student recruitment do not “constitute a corrective disclosure and a public admission of Apollo’s alleged fraud.”  Likewise, a GAO report discussing the industry as a whole does not “specify which of the Defendants’ statements” were untrue.  “As a result, the Plaintiffs have not adequately alleged that there was a causal connection between the public information contained in the GAO Report and subsequent market activity.”  Slip op. at 17-18.


Because the Apollo decision stands as a new circuit court judgment on the pleading standard for loss causation in section 10(b) cases, it is significant.  But in other respects it seems unlikely to be influential on future appellate decisions.  The reasoning is brief, and the analysis limited.  The notion that stock price declines cannot be proximately caused by public disclosures that raise general issues about the truth of previous company disclosures, without specifically identifying any of them as wrong, seems overly narrow, and appears to deprive a fact-finder of an opportunity to consider evidence that could bear on the issue.  The scienter discussion, based on a nebulous “holistic” standard, does not advance the ball much, and certainly lacks the kind of serious consideration reflected in the recent Sixth Circuit decision in Ansfield v. Omnicare, Inc., No. 13-5597 (Oct. 10, 2014) (other aspects of which are discussed in this prior post).  That Sixth Circuit analysis, correct or not, is at least provocative, and has been the subject of much discussion.  And the notion that starting a disclosure sentence with the words “we believe” has a significant impact on materiality seems, at a minimum, overly simplistic.  That very approach was rejected by the Sixth Circuit in an earlier Omnicare decision now awaiting decision on appeal in the Supreme Court on when a “we believe” statement can be materially false (although the Sixth Circuit probably reached the wrong result there for other reasons, as discussed previously here).  In short, this is an unimpressive effort that supplies a data point on the pleading standard issue, but not much more.

 Straight Arrow

December 17, 2014

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Ninth Circuit Misconstrues Loss Causation Requirement in Loos v. Immersion Corp.

The U.S. Court of Appeals for the Ninth Circuit recently amended an opinion in Loos v. Immersion Corp., No. 12-15100 (9th Cir. Sept. 11, 2014) (available here: Loos v Immersion Corp), affirming dismissal of a securities class action for failure to allege facts supporting loss causation.  The change to the opinion was small, adding a footnote saying that the court did “not mean to suggest that the announcement of an investigation can never form the basis of a viable loss causation theory,” and noting that “[t]o the extent an announcement contains an express disclosure of actual wrongdoing, the announcement alone might suffice” to support loss causation for the wrongdoing acknowledged.  Because the opinion, even as amended, is founded on specious analysis of the content of these types of public disclosures, how the market functions, and the nature of loss causation, it is worthy of discussion here.

In substance, the Loos opinion, even as amended, continues to accept the questionable notion that a drop in stock market price can be “caused” by a revelation of prior false or misleading public statements only if the price reaction follows news explicitly showing that the earlier disclosures were inaccurate.  That approach adopts a simplistic view of the content of information – and of the reasons underlying the market price reaction – that bears little relation to reality.  It represents, in effect, an illegitimate fact-finding exercise by the courts on the issue of causation long before the evidence is collected and evaluated.  It prevents the judicial process, which includes fact-finding by a jury in most such cases, from running its course.

To see why this is true, let us look at the factual allegations in Loos as stated by the appellate court.

Immersion Corp. develops and licenses “haptic” technology, which is the means by which electronic devices vibrate to provide tactile feedback to users.  The complaint centers on Immersion’s quarterly disclosures of its business activity, and in particular its quarterly revenues and profits.  In successive quarters in 2007, Immersion reported its first profits, and, more importantly, increasing revenue growth.  The profitability trend stalled in Q1 2008, but the company reporting continuing revenue growth nonetheless, with increased revenues in Q1, Q2 and Q3 2008.  The reported revenue growth ended in Q4 2008, but continued revenue growth was reported in the company’s medical device segment.  In May 2009, the company reported that in Q1 2009, revenue was stagnant, and reported medical device revenue dropped significantly.

In July 2009, the company issued a press release revealing “an internal investigation into certain previous revenue transactions in its Medical line of business,” and that it had “not yet determined the impact, if any” to its historical financial statements.  The stock price dropped 23% following this news release.

In August 2009, Immersion said that its previous financial statements “should no longer be relied upon” because of irregularities with certain revenue transactions in its medical device business.

In February 2010, the company disclosed errors in its recording of revenue in the medical line of business and a restatement of earnings for 2006, 2007, 2008 and Q1 2009.

The critical issue addressed in the appellate opinion is one of loss causation: whether the stock price drop in July 2009 following the announcement of an internal investigation into previous revenue disclosures could have been caused by investor awareness of previously undisclosed overstatements of company revenue.  The court ruled it could not because the July 2009

announcement of an investigation does not “reveal” fraudulent practices to the market.  Indeed, at the moment an investigation is announced, the market cannot possibly know what the investigation will ultimately reveal.  While the disclosure of an investigation is certainly an ominous event, it simply puts investors on notice of a potential future disclosure of fraudulent conduct.  Consequently, any decline in a corporation’s share price following the announcement of an investigation can only be attributed to market speculation about whether fraud has occurred.

Slip. Op. at 19.  In reaching this result, the Loos court endorsed and followed the reasoning of the Eleventh Circuit in Meyer v. Greene, 710 F.3d 1189 (11th Cir. 2013).

In this view, inaccuracies in earlier disclosures are only “revealed” by a new disclosure that what was previously stated to be a “fact” is no longer a “fact.”  It reflects an assumption that investors can only have a binary view of disclosed information: either it is true or false, and until it is known (to some unstated degree of certainty) to be false, investors can only “speculate” over whether it is true or false.  That approach is wholly artificial because it ignores the reality that people, including investors, reason their way to conclusions about the truth or falsity of information based on less than certain evidence.  When investors reevaluate the price of a security based on new information that raises the prospect that previous information about a company may no longer be correct, that is not “speculation,” it is the human process of determining, as quickly as possible, the long-term implications of the new facts on the value of the company’s securities.

Before the July 2009 disclosure of an internal investigation, investors had no reason to believe that Immersion’s historical revenue disclosures could be inaccurate, including its oft-noted increases in revenue generally and particularly in revenue from the medical segment of its business.  That changed on July 1, 2009.  Investors then were presented with a new state of the world for the company in which there was: (i) some probability that there were no errors, but that there could be significant drains on company performance arising out of the investigation, likely regulatory investigations and private litigation; and (ii) some probability that the prior revenue disclosures were false, which could change future projected performance of the company, in addition to the costs and dislocations from investigations and litigation.  The market needed to reach a judgment on these respective probabilities, and how they would impact future enterprise value.  That is a complex calculation which depends on how costly the investigation and litigation process will be (in dollars and lost focus on business activities); how likely it is that revenues would be restated; if so, by how much; and how that would translate into likely future earnings of the company.  (Keep in mind that, at least theoretically from the standpoint of an economist, a company’s stock market price should be based on the market’s estimate of present value of future earnings.)

The 23% drop in stock price was the result of that type of analysis on a marketwide basis.  While it is hard, and perhaps impossible, to determine what portion of that price decline is based on the expectation of restated revenues, undoubtedly some part of the decline is tied to that prospect.  I say “undoubtedly” because investors know from experience that company management and boards of directors are reluctant to commence an internal investigation, and all the negative side effects it can have, even if it shows no misconduct occurred.  The very fact that an investigation was commenced suggests the Board of Directors found something in the nature of “probably cause” that a problem existed.  As a result, even without total certainty that revenues were previously overstated, it is more than plausible that some portion of the decline in stock price is attributable to expected future disclosure of a revised revenue pattern going back some period of time.  If loss causation is to have any meaning at all, it has to include that portion of the price drop attributable to revised market estimates of likely company revenue in light of the newly disclosed prospect of false historical revenue disclosures.

Why is that so?  Why is it wrong to insist, as the Loos and Meyer courts do, that loss causation can only be proved after a disclosure reveals definitively, or at least to a high degree of probability, that a fraud occurred?  Because that is not how markets work, and taking that approach inevitably will prevent recovery of losses plainly resulting from market estimates that fraud occurred.  The Loos court adopts a market model that is backward-looking, when markets are always forward-looking.

At all times, investors are looking to see if prices need to be adjusted because of future events of varying likelihood.  That plainly is true for something like consumer tastes.  If new data shows that consumers are moving towards a preference for smartphones with larger screens, investors will bid up the price of stock for companies producing larger-screen phones, and punish those producing smaller screens, long before those preferences are actually reflected in smartphone sales.  Even though those stock price changes occur before the consumer purchases actually change, there can be no doubt that the lost value in stock of companies selling small-screen phones is, at least partially, “caused” by the expected changes in consumer product preference.  The market functions by “speculating” about the future (in the Loos court’s words), although that would more properly be described as “revising expectations” of future company earnings.  That same process applies to market expectations about future revelations of corporate misconduct.

If, as the Ninth and Eleventh Circuits seem to be saying, loss causation from a stock price decline can only be proved when the decline follows a definitive or near-definitive “revelation” that a fraud occurred, investors will be precluded from recovering identifiable losses incurred from stock price declines that can be proximately tied to the reasoned expectation of a future announcement of a fraud.  Stock price declines that might be shown by a preponderance of evidence to have occurred because they arose out of revised market expectations based on clues that a fraud could be revealed will not be compensated.  And when the definitive evidence of fraud is “revealed,” the market reaction may well by  negligible because the market already correctly predicted that it would occur and bid the stock price down before the announcement, thereby negating any compensation for the loss.  To be sure, the prospect of developing evidence showing that stock price declines are caused by expectations of future fraud revelations, rather than concerns about the impact of investigations and litigation apart from any fraud, may be slim.  But whether losses demonstratively associated with clues of future fraud disclosures are proximately caused by the fraud is a decision that the ultimate trier-of-fact should make.  It is not a decision properly made by the court as a matter of law to deprive investors of an opportunity to pursue relief in a private cause of action.

Straight Arrow

September 16, 2014

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