Tag Archives: PSLRA

4th Circuit Finds Section 10(b) Scienter Allegations Sufficient with No Motive in Zak v. Chelsea Therapeutics

In Zak v. Chelsea Therapeutics Int’l, No. 13-2370, a split Fourth Circuit panel found allegations of securities fraud sufficient in a putative section 10(b) class action.  The district court dismissed the complaint for failing to make allegations sufficient to support a strong inference of scienter under the Private Securities Litigation Reform Act (PSLRA) standard.  The majority of the panel reversed, despite an apparent lack of facts showing any real objective for the alleged fraud.  The opinion is available here: Zak v. Chelsea Therapeutics Intl.

The case involved a now-common fact situation in securities class actions against pharmaceutical companies.  Chelsea was trying to gain approval for a drug treatment for “symptomatic neurogenic orthostatic hypotension,” which is “a condition in which a dramatic drop in blood pressure occurs when a person stands.”  During the course of testing for the efficacy of the drug, Chelsea executives expressed optimism about how the tests were going, and for the prospect of getting the drug approved by the FDA.  At the same time, the actual testing showed mixed results.  One trial was successful and others were inconclusive.  All of the trial results were disclosed, however.  A meeting with FDA officials was also inconclusive — they indicated that the application for the drug could move forward on the basis of the one study, which was short-term, but that it was an obstacle to approval that other studies had not shown the drug’s efficacy over a longer period.  Management optimistically described this conversation as the officials agreeing that the application could move forward on the basis of the one successful trial.

There were other instances of management expressing overly-optimistic views on the approval of the drug, without also acknowledging that there were serious obstacles.  One of these included the contents of an FDA staff report.  Management received this report, in which a staffer recommended that the drug not be approved, 8 days before it was publicly disclosed.  The company’s published description of the report said it raised questions about the sufficiency of the support for approval of the drug, but failed to state that the staffer recommended against approval.  The stock price nevertheless declined 38%.  The press release also provided the web address to obtain to actual report when it was released by the FDA, which occurred 8 days later.  At that time, the stock price declined an additional 21%.

Three days later, an FDA advisory committee recommended approval of the drug in a non-binding recommendation.  The FDA itself, however, ultimately declined to approve the drug a little over a month later.

One interesting aspect of the case is the district court’s use of Chelsea’s public SEC filings in its consideration of whether these facts adequately pled scienter under the PSLRA.  The defendants submitted SEC proxy and Form 4 filings to show that there was no evidence that management or directors tried to take advantage of any arguably misleading statements by cashing out their stock.  Although the complaint did not plead insider stock sales as a motive for the fraud, the court took judicial notice of the SEC filings and based its decision in part on the lack of evidence of efforts to profit on any of the alleged misrepresentations or omissions in the complaint.

The entire 4th Circuit panel agreed that this was improper.  The opinion acknowledges the commonly accepted rule that on a motion to dismiss, the court can consider materials outside of the complaint if they are incorporated by reference or implicated by the allegations in the complaint.  But, since insider stock trading was never alleged in the complaint, it found judicial notice of materials addressed to that issue was improper.

The majority of the panel went on the conclude that the allegations of repeatedly optimistic statements about the drug approval process which left out key developments suggesting approval was in doubt were enough to support the required strong inference of scienter.  Two things are important about this.  First, it comes from the 4th Circuit, which rarely sees a class action complaint it thinks is sufficient.  Second, it allows a complaint to proceed on the basis of a fraud which, at least from the descriptions in the opinion, shows absolutely to motivation for committing the alleged fraud.  Usually, fraudulent misrepresentations or omissions are part of an effort to obtain some advantage from the misleading disclosures.  Here, there is no such apparent motive.  That may be why the district court went beyond the complaint to the trading data.  Surely a fraud must have an objective — but none is apparent here.  This is especially so as to the most troublesome of the alleged misleading disclosures: the misleading description of the staff report about possible approval of the drug.  Since the report itself was going to be published about a week after the company’s press release about it, and the press release provided the web address for someone to read the actual report one week later, what is the purported object of a fraudulent description of that document, which would last only a week.  There appears to be none, since no action during that period suggests an effort to take advantage of the misleading disclosure.

Perhaps this goes more to the issue of materiality than scienter, which, as we have seen before, can be interrelated (see 1st Circuit: Scienter Not Alleged Where Materiality Is Questionable and Regulatory Violations Remain in Doubt).  But it would seem to encompass both; how do you find a strong inference of intent to defraud in the absence of any apparent motive?

Dissenting Judge Thacker certainly had problems with finding fraudulent conduct alleged here.  He reminded the court that even if recklessness can be sufficient to support scienter — and he reiterated that the Supreme Court still has not accepted that theory (slip op. at 33 n.2) — in the 4th Circuit i”we insist that the recklessness must be ‘severe’ — that is, ‘a slightly lesser species of intentional misconduct.'”  Slip op. at 35.  He argued that the company’s statements were not “literally” inaccurate, and there was enough support for management to express an optimistic view without committing fraud.  He concluded : “Today’s decision clears the way for more litigation, heightening the risk that shareholders will exploit the judicial process to extract settlements from corporations they chose to fund. This is exactly what Congress sought to prevent when it enacted the PSLRA.”  Slip op. at 43.

This case is a very close call.  Based on the fact descriptions in the opinion, it looks like management erred on the side of optimism, and may have elevated wish above reality, putting the best light on everything while hoping for approval of the drug.  It should give us pause on the fraud issue that the advisory committee actually did recommend approval of the drug, even with the alleged shortcomings of the trial studies.  In the end, it is the absence of any apparent planned gain or advantage from the alleged misleading disclosures that suggests to me that whatever happened here, intentional fraud was not what it was about, especially under the high scienter pleading standard of the PSLRA.

In any event, the class plaintiffs seem to have some serious uphill fighting on the materiality front.

Straight Arrow

March 17, 2015

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1st Circuit: Scienter Not Alleged Where Materiality Is Questionable and Regulatory Violations Remain in Doubt

The recent First Circuit decision in Fire and Police Pension Ass’n v. Abiomed, Inc., No. 14-1502, is noteworthy for its unusual mix of scienter and materiality analysis to affirm dismissal of a section 10(b) securities class action.  Ultimately, the court affirmed dismissal for the lack of sufficient scienter allegations under the heightened pleading standard of the Private Litigation Securities Reform Act (PSLRA), but it was the court’s mixing of scienter and materiality considerations that provokes interest.  The court also made it clear that a securities fraud claim cannot be based on an alleged failure to disclose misconduct while the resolution of the matters at issue with regulators remain uncertain.  A copy of the opinion is available here: Fire and Police Pension Ass’n v. Abiomed Inc.

The claims were founded on allegations that Abiomed, Inc., which sells medical devices, made misrepresentations about the Impella 2.5, a micro heart pump, which was Abiomed’s most important product. The alleged misrepresentations and omissions related to interactions between Abiomed and the FDA regarding marketing used to promote the Impella 2.5, and the possible promotion of off “off-label” uses of the device, that is, uses for purposes beyond those approved by the FDA.

The gist of the complaint was that Abiomed failed to disclose in its SEC filings several FDA communications warning about possible marketing and advertising improprieties, and failed to disclose that its revenues from the sales of that device were achieved in violation of FDA rules.  After ongoing communications between Abiomed and the FDA in 2010-2012, two things occurred.  In November 2012, Abiomed disclosed that federal prosecutors were investigating Abiomed’s promotional and marketing practices and published revised revenue projections, which was followed by a significant decline in stock price.  And in February 2013, the FDA gave Abiomed a “Close-Out Letter” stating its concerns had been adequately addressed by the company, and afterward, the stock price recovered its earlier losses.

The court noted that although it was “far from clear” that “plaintiffs plausibly alleged that “defendants made false or misleading statements which had a material effect on Abiomed’s stock price,” it was affirming the district court’s ruling that the plaintiffs did not sufficiently allege that defendants made those statements with a “conscious intent to defraud or ‘a high degree of recklessness.’”  Slip op. at 4 (quoting ACA Fin. Guar. Corp. v. Advest, Inc., 512 F.3d 46, 58 (1st Cir. 2008)).

 The court’s consideration of the materiality of the alleged misstatements played a significant role in its scienter analysis. The court wrote:

We do address the strength of the materiality of the statements because “[t]he question of whether a plaintiff has pled facts supporting a strong inference of scienter has an obvious connection to the question of the extent to which the omitted information is material.” . . .   “If it is questionable whether a fact is material or its materiality is marginal, that tends to undercut the argument that defendants acted with the requisite intent or extreme recklessness in not disclosing the fact.” . . . The materiality of the impugned omission here — Abiomed’s failure to state that some of the increased revenues were due to off-label marketing — is marginal at best. Plaintiffs’ contention that the omission would have mattered to a reasonable investor depends on a long chain of inferences, most of which are not sufficiently substantiated by the allegations in the complaint.

Slip op. at 29 (citations omitted).  The court also took note that Abiomed’s disclosures explicitly warned about the FDA’s marketing concerns, including disclosures that concerns raised in FDA Warning Letters could have serious consequences.  Id. at 31-32.

Defense counsel should take particular note of the court’s response to the allegation that “Abiomed should have affirmatively admitted widespread wrongdoing rather than stating that the outcome of its regulatory back-and-forth with the FDA was uncertain.”  Slip op. at 32.  Class action complaints often allege fraud based on a failure to disclose that matters involving regulatory uncertainty (or other uncertainties) should have been disclosed as company shortcomings.  But the court here correctly noted that this approach would improperly mandate potentially misleading disclosures of uncertain future events:

That would be a perverse result; such an admission would have been misleading, since the off-label marketing issues had the potential to be resolved with no adverse action from the FDA.  We made a similar point in In re Boston Scientific Corp. Securities Litigation, 686 F.3d 21 (1st Cir. 2012), where we noted that “a company may behave ‘irresponsibly’ if it issues an ominous warning about an uncertain risk that ‘had not yet been adequately investigated.’” Id. at 31. … There must be some room for give and take between a regulated entity and its regulator.

 Id. at 32-33.

The opinion also addresses allegations of statements by so-called “confidential witnesses,” whose statements about the company’s operations did not support scienter because the alleged roles of these persons did not put them in a position to provide information about the knowledge and intent of company management. See id. at 35-36.  The court likewise found allegations of stock sales by insiders insufficient to support scienter because the facts alleged did not show unusual or suspicious trading. See id. at 36-38.

But the two key takeaways from this opinion are: (1) that even without showing alleged misrepresentations were immaterial as a matter of law – which is often tough on a motion to dismiss – defendants can use doubts about materiality to support arguments that scienter is not sufficiently supported under the PSLRA standard; and (2) that allegations of failure to disclose regulatory concerns fall short of fraud when the matters are being actively discussed with law enforcement authorities and it remains uncertain whether they can be resolved without any enforcement action.

Straight Arrow

January 12, 2005

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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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Hi-Crush Securities Class Action Settlement Benefits Lawyers and No One Else

In a companion post published earlier today, I discussed a Wall Street Journal op-ed piece decrying the cottage industry of abusive private state law actions following announced mergers or acquisitions.  See here.  In that discussion, I noted that the federal securities class action cottage industry suffered a decline after the passage of the Private Securities Litigation Reform Act in 1995, but there was still room for further reform of federal securities class actions.  Lo and behold, just yesterday Judge Colleen McMahon gave final approval to a settlement of the federal securities class action In re Hi-Crush Partners L.P. Securities Litigation, Civil Action No. 12-Civ-8557 (S.D.N.Y.), which shows we still have a long way to go in securities class action reform.  The order approving the settlement can be found here: Hi-Crush Securities Class Action Settlement Order.

The Hi-Crush class action arose out of an IPO of 11.35 million shares at $17 per share.  The company allegedly inaccurately described a key contractual relationship in its registration statement after the contractor had already said it wanted to terminate the contract.  When that information became known in the marketplace, the stock price dropped from $20 to $15 per share.  The complaint asserted claims under section11 of the Securities Act of 1933 and section 10(b) of the Securities Exchange Act of 1934.

On a motion to dismiss all claims, Judge McMahon dismissed the section 11 claim but allowed a section 10(b) claim to survive.  That was because the section 11 claim had to be founded on alleged misrepresentations or omissions in the July 2012 registration statement, but the section 10(b) claims covered securities transactions in the aftermarket through November 2012.  The judge found no misrepresentation about the contractual relationship as of July 2012, but that later events rendered statements to shareholders in September 2012 on that issue potentially misleading.  See the decision on the motion to dismiss here: Hi-Crush Decision on Motion To Dismiss.  The section 11 claim was by far the more powerful cause of action, with tens of millions of dollars in potential damages and no requirement to prove scienter, which is an element of the section 10(b) claim.  As a result, the guts of the claims asserted were dismissed, leaving a difficult, small value claim moving forward.

It is understandable, then, that the ultimate settlement of the action was for a mere $3.8 million.  It probably should have been less, but the judge did not need to second-guess at that low level.  It was in the attorneys’ fee award that Judge McMahon dropped the ball.  Class action settlements are not permitted to be made contingent on a specific attorneys’ fee award, but the parties typically agree on what the plaintiff’s firm can seek without any challenge from the defense.  That is a collusive aspect of the settlement process — no party is incented to try to minimize the legal fee award.  In the end, Judge McMahon handsomely rewarded the plaintiff’s law firm but left little else for anyone else, i.e., the shareholders.  The law firm, Kirby McInerney LLP, took home $1.27 million in fees, and another $106,451 in costs, out of a total settlement fund of $3.8 million, leaving about $2.4 million (less administrative costs) for the shareholders allegedly defrauded.  A review of the judge’s approval order leaves little doubt that she rubber-stamped what was presented to her — there is no real analysis or discussion of the fee issue, and by all appearances the judge merely signed the final approval order put in front of her by counsel.

There is no way that this case should have resulted in handsome profits for plaintiff’s counsel.  The core of the case was rejected by the court on the motion to dismiss.  The dregs that remained afterward were hardly worth pursuing, but if they were pursued, it should have been for the purpose of generating real benefits to shareholders, not a payoff to the lawyers.  The approval order notes (at p. 9) that the plaintiff’s lawyers “devoted over 1,594.75 hours, with a lodestar value of $900,705.00, to achieve the Settlement,” but the bulk of that surely was in pursuit of claims that the court concluded had no merit.  (That included claims against underwriters in the IPO that undoubtedly increased costs for no purpose.)  Plaintiff’s counsel should have been held accountable for causing major expenses in the defense of a flawed section 11 claim when considering the overall fee award; instead they were rewarded for doing so.  In the end, they were paid more than $800 per hour, plus expenses, for bringing a near-worthless case.  Amazingly, the judge approved an award for 25% above the purported lodestar in what was essentially a failed case.  And the shareholders?  Who knows what they will get.  But there will be less than 20 cents available for each of the 11 million shares sold in the IPO.  To be sure, they may not be entitled to much because there really wasn’t much of a claim.  But why, under those circumstances, should the people responsible for causing this ruckus, the plaintiff’s lawyers, be getting much of anything at all?

The abuses in securities class action litigation continue even after the PSLRA.  Plaintiff’s firms are now focused are trying to pursue section 11 claims because the bar for proving them is lower and defending them is more difficult.  But unless plaintiff’s firms are held accountable for bringing flawed claims, and not rewarded for doing so, the abuses will continue.  Judge McMahon is a good judge, and she did a good job on the motion to dismiss.  But she mailed it in on the fee award instead of performing the key role in teaching the plaintiff’s lawyers to be more selective in their pursuit of profits.

Straight Arrow

January 6, 2015

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Commentary on Abusive State Law Actions Following M&A Deals

I devote this post to a commentary in the January 6, 2015 Wall Street Journal by Gerry Walpin, a highly-regarded New York litigator.  His op-ed piece entitled “How To Stop a Class-Action Scam” can be found here.

Gerald WalpinGerald Walpin

Gerry describes the abusive process now prevalent in filing suits objecting to corporate mergers or acquisitions.  Virtually every corporate m&a deal is met by a private action, normally filed in state court, challenging the transaction.  The calculation is simple: the plaintiff’s lawyer knows that completing the transaction is the company’s first priority and the cost of settling such a case is minor in comparison to the overall deal costs.  So, with virtually no work, the lawyers can bank a fee for entering into a “settlement” that really does not provide any significant benefit to the company or shareholders.  Usually, such settlements, being supported by all parties to the action, are rubber-stamped with the necessary court approval.  The deal is completed, making company management happy, and the settlement payment of legal fees makes the plaintiff’s lawyers happy.  It’s win-win, right?  Well, maybe so, if you don’t consider the interests of the shareholders, or, perhaps more importantly, the public interest in avoiding such abusive scams.

Here’s some of what Gerry had to say:

If you own any stock, you know the frustration of getting a notice announcing settlement of a lawsuit, commenced by a lawyer on behalf of a class composed of all shareholders—you included.  The notice informs you that, under this settlement, you get nothing.  What that really means is you get zilch but you must pay a pro rata share of your corporation’s legal expenses and of the legal fees for the lawyer who commenced the lawsuit—often millions of dollars. . . .

As soon as a corporation announces an asset acquisition or sale, the [plaintiff’s] lawyer finds one of his ready-plaintiffs and files a class action to stop the transaction. Such behavior is ubiquitous.  As an analysis of merger litigation in the February 2014 Texas Law Review showed, the likelihood of a shareholder suit exceeds 90%.

The defendant corporation, seeking to close the transaction and avoid costly litigation, accepts a quick settlement.  Both sides agree to wallpaper the settlement with meaningless “supplemental disclosures,” supposedly to demonstrate that the plaintiff lawyer contributed something of value, and thereby justify his claim to millions in legal fees.  Also, the corporation is forced to agree not to oppose the fee application. . . .

Case in point: On Nov. 10, 2014, I received a class-settlement notice regarding my Verizon  stock.  It concerned a September 2013 lawsuit commenced by a plaintiff’s lawyer filed only three days after Verizon announced its $130 billion purchase of Vodafone’s 45% minority stake in Verizon Wireless. The claim was that Verizon paid an “excessive and dilutive price” and that the company failed to disclose material information regarding the fairness of the transaction.

Yet the proposed nonmonetary settlement was limited to supplemental disclosures that added immaterial minutiae about the transaction, and Verizon’s agreement to obtain a fairness opinion from a financial adviser for “any transaction regarding assets of Verizon Wireless having a book value . . . in excess of $14.4 billion.”  Oh, and the plaintiffs lawyer sought $2 million in legal fees. . . .

[I] filed a 15-page objection with the court. . . .  In my objection, I detailed my reasons for concluding that this settlement was not in the interests of the shareholders the plaintiff’s counsel supposedly was representing.  Shareholders received nothing, while the plaintiff’s attorneys were to be paid $2 million, coming directly from shareholders. . . .

Happily, the New York Supreme Court judge on this case, Gordon v. Verizon Communications Inc., is Melvin L. Schweitzer, with an excellent reputation as conscientious, careful and courageous, and thus one who would not take the easy way to quickly close out a case by accepting any settlement.  [H]e rejected the proposed settlement and wrote that it would be “a misuse of corporate assets were plaintiff’s legal fees to be awarded.”  As for the supplemental disclosures, he ruled that they “fail to enhance the shareholders’ knowledge about the merger” and provide “no legally cognizable benefit to the shareholder class.”

Judge Schweitzer went on to decry the “tsunami of litigation” that abuses a “body of law meant to protect shareholder interests . . . turned on its head to diminish shareholder value by,” among other means, “imposing additional gratuitous costs, i.e. attorneys’ legal fees on the corporation.”

You can read an article in the New York Law Journal about Judge Schweitzer’s rejection of the settlement here And you can read Judge Schweitzer’s opinion here: Decision and Order in Gordon v. Verizon Communications.

Of course, Gerry Walpin is an experienced securities litigator who knew what to discuss in his objection, and Judge Schweitzer is perhaps more likely than many other judges to direct a jaundiced eye at the collusive settlement placed before him.  There was also another objector represented by counsel (Szenberg & Okun), who was reported as saying: “Lawyers should not be compensated for these type of actions and obtaining these useless settlements.”  The plaintiff’s law firm involved was Faruqi & Faruqi, a common player in these cases.

The state court judge is where the rubber really meets the road in these cases.  Even without a well-conceived objection filed by a knowledgeable shareholder, the judges in these cases should be turning away collusive settlements that do little other than line the pockets of opportunistic plaintiff’s lawyers — with the knowing assent of corporate abettors whose minds are focused elsewhere.  In the Verizon case, as Judge Schweitzer noted, the defense lawyers (heavy hitters Wachtell, Lipton, Rosen & Katz) were more focused on getting an extremely broad release of claims for the officers and directors than negotiating down the $2 million lawyer fees.  Court approval of these settlements is mandatory before they can proceed, and more judicial diligence is needed to make abusive practices like these unprofitable for the lawyers.

In some respects, the state of the law in this area is akin to federal securities class actions before 1995, when the Private Securities Litigation Reform Act was enacted to try to curb abusive practices in federal securities class actions.  Before then, federal securities class actions were virtually assured whenever a company suffered a significant stock price decline.  The statute made filing those actions a little more difficult.  Today, there are fewer abusive federal securities class actions filed, although the frequency of such filings is still significant, and more judicial skepticism for such claims is needed.

If state court judges are not willing to put the kibosh on the approval of extortion payments to plaintiff’s lawyers in order to complete these deals, statutory reform may be the only answer.  That would be difficult, though, because it would require changes to state laws governing the filing of such claims.  Delaware, the leading jurisdiction governing such corporate m&a transactions, tends to move through judicial, not legislative, reforms.  The recent brouhaha in Delaware over apparent judicial willingness to accept corporate “loser pays” by-laws for derivative actions could be where these issues are thrashed out.  But “loser pays” provisions won’t really do the job here, because it will be only the rare case that generates a judicial winner or loser, with collusive settlement being the norm.  There may be no recourse other than increased judicial willingness to hold the settling parties’ feet to the fire before approving such agreements.  Let’s hope that the state law judges will start earning their keep, as did Judge Schweitzer in the Verizon case.

Straight Arrow

January 6, 2015

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