Delaware Court Raises the Bar in Controlling Shareholder Transactions

POMERANTZ MONITOR, MAY/JUNE 2014

It is long-established law that where a transaction involving self-dealing by a controlling shareholder is challenged, the transaction will be reviewed under a standard referred to as “entire fairness.” That standard places the burden on the defendant to prove that the transaction with the controlling shareholder was entirely fair to the minority stockholders, including not only a fair price but a fair process for negotiating the transaction. 

Twenty years ago, the Delaware Supreme Court was presented with the question of whether the business judgment rule might apply to transactions with a controlling shareholder if the transaction was approved either by a special committee of independent directors, or by an informed vote of the majority of the minority shareholders. The Court said no, but that in such cases the burden of proof on the issue of the entire fairness of the transaction would be shifted to the plaintiff shareholders. While this may sound like splitting hairs, in fact the question of which standard — entire fairness or business judgment — will be applied usually determines the outcome of the case.

Now, in Kahn v. M&F Worldwide Corp., the Delaware Supreme Court was presented with a case where the controlling shareholder had used both protective devices: the transaction had to be approved both by an independent special committee and by the minority shareholders. The question was: What is the appropriate standard of review now? 

The Court concluded that those provisions, taken together, neutralized the influence of the controlling shareholder and the highly deferential business judgment standard of review should apply. This creates a much higher barrier for plaintiffs to overcome. They will now have the burden of proving that the challenged transaction was so egregious that it could not have been a result of sound business judgment. 

To demonstrate that the business judgment rule should apply, the controlling shareholder will have to agree at the outset that the completion of the merger will be contingent on the approval of a special committee and approval of the majority of the minority shareholders. Then, defendant must show that: 

• The special committee was composed of independent directors;

• The special committee was empowered to reject the controlling shareholder’s proposal, and is free to engage its own legal and financial advisors to evaluate the proposal;

• The special committee met its duty of care in negotiating a fair price; •    The majority of the minority shareholders was informed; and

• There was no coercion of the minority. 

The Court reasoned that the dual protections of the special committee and the majority of the minority “optimally protects the minority stockholders in controller buyouts.” It concluded that the controlling shareholder knows from the inception of the deal that s/he will not be able to circumvent the special committee’s ability to say no, and that s/he will not be able to dangle a majority of the minority provision in front of the special committee in order to close the deal late in the process, but will have to make a price move instead. 

While this ruling may serve as a setback to plaintiffs in certain cases, the business judgment standard of review will only apply when all of the above criteria are met. Defendants may be unwilling to condition the completion of the transaction at the outset on the approval of a special committee and a majority of the minority shareholders, as this might create too much uncertainty and risk around the proposed transaction.

Court Strikes Down “Cross-Listed Shares” Theory

ATTORNEY: C. DOV BERGER
POMERANTZ MONITOR, MAY/JUNE 2014

In 2010, the United States Supreme Court handed down its landmark decision in Morrison v. National Australia Bank, which held that United States federal securities laws only apply to transactions in securities listed on U.S. exchanges, or to securities transactions that take place in the U.S. The ruling has been interpreted to bar recovery under the U.S. federal securities laws by investors who bought shares on foreign exchanges. As previously reported in the Monitor (Volume 10, Issue 6, November/December 2013), Pomerantz has led the effort to seek alternative paths to recovery in the U.S. courts, including via pursuit of common law claims against issuers like British Petroleum and corporate executives charged with securities fraud. 

But what about instances where a security is listed both in the U.S. and on a foreign exchange, and the investor bought his shares overseas? A case in point is City of Pontiac Policemen's & Firemen's Ret. Sys. v. UBS AG, No. 12-4355-cv (2d. Cir.), a securities class action against Swiss Investment Bank UBS AG by foreign and domestic institutional investors that bought shares of UBS stock on the SIX Swiss Exchange. 

The complaint alleged that UBS failed to disclose that its balance sheet had inflated the value of billions of dollars in residential mortgage-backed securities and collateralized debt obligations. It alleged that when the market for those securities dried up, UBS eventually had to recognize a loss of $48 billion. The complaint also alleged that the bank made misleading statements claiming that it was in compliance with U.S. tax laws, only to be forced to settle tax fraud claims with federal authorities for a penalty of $780 million.

Although the plaintiffs had bought UBS shares on a foreign exchange, they invoked the so-called “Listing Theory,” which posits that since shares of UBS are traded on both the Swiss Exchange and in the U.S. on the New York Stock Exchange, all purchasers of UBS shares should be protected by the U.S. federal securities laws, regardless of which exchange they used to purchase their shares. The plaintiffs also invoked the “Foreign-Squared Claims Theory,” which posits that the place where the buy order was placed should control, rather than the location of the exchange where the trade was ultimately executed. The buy orders for some of the purchases of UBS shares at issue had been placed in the U.S. Under this theory’s rationale, such transactions should satisfy the second prong in Morrison, which applies the U.S. federal securities laws to “transactions” that take place in the U.S.

However, the District Court rejected both theories, holding that (1) reading Morrison as a whole, the limitation precluding U.S. securities laws from applying on foreign transactions should apply even when the foreign issuer also lists shares on a U.S. Exchange, and (2) the mere placement of a buy order in the U.S. is too tenuous a connection for the U.S. securities laws to apply to claims for losses related to a securities trade. The Second Circuit affirmed that ruling on appeal on May 6, 2014, in an opinion that aligns with the dominant interpretations of Morrison, whereby investors that had purchased UBS securities on the NYSE could have sought remedies under the U.S. federal securities laws, while those who had purchased UBS securities on the Swiss Exchange could not do so. The decision, a victory for dual-listed issuers, further curtails investor rights and remedies under the U.S. federal securities laws barring an appeal to the U.S. Supreme Court. 

As their rights to seek recovery under U.S. law for foreign-listed securities evaporate in the wake of Morrison, investors can only try to convince Congress to revise the federal securities laws so as to restore, in whole or in part, the protections they once offered. Otherwise, under certain circumstances, they may seek to pursue common law claims such as those pursued by Pomerantz against BP. Until then, investors will have to further weigh the benefits of buying shares of dual-listed companies on foreign exchanges, which may include better prices or lower transaction costs, against the possibility of losing the protection of U.S. federal securities laws in the U.S. courts. The UBS ruling could have added significance if it is followed in other U.S. federal Circuits.

Rise in “Dissenting Shareholder” Merger Conditions

ATTORNEY: ANNA KARIN F. MANALAYSAY
POMERANTZ MONITOR, MARCH/APRIL 2014 

The increasing frequency of appraisal proceedings has led directly to a significant change in Delaware law and practice, most notably to the increasing use of dissenting-shareholder conditions in merger agreements. These provisions allow an acquirer to back away from the merger if holders of more than a specified percentage of outstanding shares exercise their appraisal rights. Without this condition, the acquirer would have to go through with the merger even if there are a large number of dissenting shares, thereby running the risk of having to pay a lot more than what it had bargained for. In Delaware, valuation of the target company’s stock in an appraisal proceeding requires a court to “determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger” but taking into account “all relevant factors.” 

Historically, the appraisal remedy has been pursued infrequently because the appraisal process is complex and potentially risky for the dissenting shareholder. Shareholders seeking appraisal must be prepared to invest considerable time and expense in pursuing their rights. Even when the process goes quickly, dissenters face the risk that the court will undervalue the company and their shares. Dissenters must initially bear all their litigation expenses and do not receive payment until finally ordered by the court, and then only receive reimbursement depending on the number of other dissenters, each of whom must pay his or her share of the costs. Absent a group of dissenters who can share costs and (most importantly) legal and expert witness fees, the cost of an appraisal is prohibitively expensive except for holders with large stakes. 

Despite these obstacles, the appraisal remedy is becoming more and more popular, at least in Delaware. One reason is that appraisal valuations have exceeded the merger price in approximately 85% of cases litigated to decision. Another is that even if the court’s valuation is lower than the merger price, dissenters can still come out ahead because these awards include interest at a rate of 5% above the Federal Reserve discount rate. According to recent academic studies, last year the value of appraisal claims was $1.5 billion, a ten-fold increase in the past ten years; and more than 15 percent of takeovers in 2003 led to appraisal actions by dissenters. Recent changes to Delaware law encourage the appraisal remedy by allowing shareholders to exercise their appraisal rights even prior to the consummation of the merger, at the conclusion of the first step in the transaction. Mergers often are completed in two steps. In step one, the acquirer launches a tender or exchange offer for any and all outstanding shares. Upon the close of that transaction, the acquirer then scoops up any shares not tendered in the offer by way of a second-step merger. 

A “short-form” merger does not require stockholder approval of the second-step merger, but can be used only if the acquirer buys at least 90 percent of the target’s stock after the step one. If the acquirer gets less than 90 percent, it has to use a “long-form” merger, which requires it to mail a proxy statement to all remaining shareholders and hold a stockholder meeting to approve the merger. Delaware recently enacted a new law that permits parties entering merger agreements after August 1, 2013, to agree to eliminate the need for a stockholder vote for a second-step merger if certain conditions are met, including receiving tenders of at least 50% of the shares. At the same time, Delaware amended its appraisal statute to provide that in connection with a merger under the new law a corporation can send the required notice of the availability of appraisal rights to its stockholders prior to the closing of the offer, and can require them to decide immediately whether to exercise their appraisal rights. In response to these changes, Delaware corporations have begun notifying their stockholders that all demands for appraisal must be made no later than when the first-step offer is consummated. 

The significance of these changes is that acquirers will now know, before they buy a single share of the target, how many shareholders are going to exercise their appraisal rights. This development, in turn, makes it possible for an acquirer to include a dissenting-shareholders condition to its obligation to consummate even step one of the deal, which, is, effectively, a condition to doing the entire deal. 

With the rising popularity of appraisal litigation and recent changes to the DGCL, a dissenting-shareholders condition will likely become a common feature in merger agreements.

Appraisal is the New Black

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, MARCH/APRIL 2014 

For decades, appraisal has been viewed as an antiquated, seldom-used procedure that “dissenting” shareholders can use if they believe that their company is being sold for an inadequate price. Instead of accepting the merger price, dissenters can ask a court to determine the “fair value” of their shares. But they rarely do. 

Until now. As highlighted in a recent New York Times Dealbook article, the “new, new thing on Wall Street is appraisal rights,” particularly in the hands of hedge fund investors who can easily afford the costs. 

The Dell management buyout may have been the start of this trend. There were months of wrangling between the buyout group and a “special committee” of disinterested directors, who were unable to scare up any legitimate competing offers from any third parties, despite intensive efforts to shop the company and lots of noise from Carl Icahn. Then, the deal finally went through, at a total cost of $24.9 billion. About 2.7 percent of shareholders exercised appraisal rights, including institutional investor T. Rowe Price. A much bigger percentage of dissenters appeared in the wake of the Dole Food management buyout of last fall. According to Dealbook, most investors were underwhelmed by the merger price, and in the end, only 50.9 percent of the shares voted to approve the merger. Four hedge funds reportedly bought about 14 million shares when the buyout proposal was first announced, and they have now exercised their appraisal rights. In all, about 25 percent of Dole’s public shareholders have sought appraisal -- an astonishing number. These four dissenting hedge funds have engaged in this same tactic several times in the past, and a nascent cottage industry in appraisal rights is developing. As discussed in the following article, this has led to significant changes in Delaware law and practice, to help acquirers back away from a merger agreement if too many shareholders choose to dissent. Acquirers are going to think twice if they can’t predict how much they are actually going to have to pay to buy a company. 

The threat of appraisal actions is probably a good thing, especially in the context of management buyouts, where the odds are heavily stacked against the public shareholders. It is useful for these insiders to know that, if they try to cut too good a deal for themselves, savvy financial institutions can take them to the cleaners in appraisal proceedings.

When Corporate Internal Investigations Become Part of the Problem

ATTORNEY: JOSHUA B. SILVERMAN
POMERANTZ MONITOR, MARCH/APRIL 2014 

When a company uncovers evidence of accounting improprieties or executive misconduct, or when the government does it for them, a common step is for the company to conduct an “independent” internal investigation. The American Institute of Certified Public Accountants has gone so far as to say that an audit committee must initiate an internal investigation when fraud is detected. A proper investigation, followed by a candid report of findings to investors, can play a critical role in rebuilding investor confidence. However, all too frequently internal investigations are used to hide the truth and protect those responsible. For example, the Office of the Comptroller of Currency (OCC) recently charged that a JP Morgan internal investigation into the bank’s handling of Madoff funds was designed to conceal the knowledge of key witnesses. After spending time with JP Morgan’s lawyers, the government said that the witnesses demonstrated “a pattern of forgetfulness.” 

Even worse, because the investigation had been conducted by lawyers, JP Morgan claimed that the details of the investigation were protected by attorney-client privilege. On that basis, JP Morgan refused to produce the notes from interviews of 90 bank employees following Madoff’s arrest. OCC lawyers argued that the privilege did not apply because it was being used to perpetuate a fraud. However, the argument failed because the OCC could not establish what the newly-forgetful witnesses told their lawyers, or what the lawyers told them to say to investigators. 

In December, 2013, the OCC dropped its attempt to discover details regarding JP Morgan’s internal investigation. A month later, JP Morgan agreed to pay a civil penalty of $350 million to the OCC. The deal represented the largest fine ever paid to the OCC, but it also ensured that the facts surrounding the internal investigation would forever remain private. Where the investigators’ report cannot be manipulated from the outset, companies sometimes contrive to conceal the results. In the AgFeed Industries, Inc. securities litigation, for example, Pomerantz uncovered evidence of an attempt to bury the findings of an internal investigation. In that case, the chairman of the committee investigating rampant fraud at the company testified that investigative committee lawyers and other committee members refused to produce a report to investors because the lawyers – who also represented management at the time – believed that the findings would expose management to litigation. As a result, the full breadth of the fraud was concealed for years. 

In a recent editorial in the Financial Times, short seller Carson Block questioned why these independent investigations so routinely failed to identify even blatant cases of fraud: “Time and again, investigators report that they have found no evidence to support claims of wrongdoing. The question that investors need to ask themselves is: how hard did these investigators look for clues that might have revealed something was amiss?” On his website, Block named names. Concentrating on U.S.-listed Chinese firms, Block identified seven independent investigations that purported to clear management despite obvious signs of fraud that caused investors to lose most of their investment: China Agritech, ChinaCast Education, China Integrated Energy, China Medical Technologies, Duoyuan Global Water, Sino Clean Energy, and Silvercorp. 

The OCC’s charges in the JP Morgan case and the list of improper independent investigations published by Carson Block both confirm a disturbing trend. One possible reason for the trend: outside law firms, which often turn internal investigations into a lucrative practice area. Shielding management is the safe play for the investigating law firms. If they candidly exposed wrongdoing to investors, what company is going to hire them the next time around?

Supreme Court Upholds Claims Arising From Stanford Ponzi Scheme

ATTORNEY: EMMA GILMORE
POMERANTZ MONITOR, MARCH/APRIL 2014 

In a 7-2 decision issued on February 26, 2014, the United States Supreme Court resolved a circuit split over the application of the Federal Securities Uniform Standards Act of 1998 (“SLUSA”). This act bars class actions alleging state law claims of common law fraud “in connection with” the sale of a SLUSA-defined ”covered security”. The decision clears the way for investors to seek recovery under state law from the law firms of Proskauer Rose and Chadbourne and Parke, and other secondary actors, of just under $5 billion they paid for certificates of deposit administered by Stanford International Bank Ltd. The decision marked a win for the plaintiffs’ bar. The plaintiffs alleged that convicted swindler Allen Stanford ran a multibillion dollar Ponzi scheme, selling investors bogus certificates of deposit issued by the bank. These certificates are not “covered securities” as defined by SLUSA. However, the proceeds of the offer were supposed to be invested in “covered securities” that were conservative investments. Stanford never bought the covered securities. Instead he used the investors’ money to repay old investors, maintain a lavish lifestyle, and to finance highly-speculative real estate ventures. 

The Court defined the crux of the claim as “whether SLUSA applies to a class action in which the plaintiffs allege (1) that they ‘purchase[d]’ uncovered securities (certificates of deposit that are not traded on any national exchange), but (2) that the defendants falsely told the victims that the uncovered securities were backed by covered securities.” The key phrase in SLUSA, according to the majority opinion, was its prohibition of state law class actions arising “in connection with” the purchase of a covered security. The majority interpreted that phrase narrowly, holding that an actual sale of a covered security has to occur for SLUSA to apply, and not just a promised sale. The majority observed that a broader interpretation would directly conflict with matters primarily of state concern the fact that the certificates were allegedly backed by covered securities was an insufficient connection to covered securities to bring the case within SLUSA’s reach. 

In a dissention opinion, Justices Anthony Kennedy and Samuel Alito warned that the majority’s ruling could hamper SEC’s enforcement efforts, because Section 10(b) of the Securities Exchange Act, under which the SEC brings enforcement actions, also uses the phrase “in connection with the purchase or sale of any security.” The majority found that concern unfounded, however, saying the SEC failed to identify any enforcement action filed in the past 80 years that would be foreclosed by the ruling. Indeed, the SEC had already successfully sued Stanford and his accomplices over the certificates of deposit. “The only difference between our approach and that of the dissent,” Justice Breyer added, “is that we also preserve the ability for investors to obtain relief under state laws when the fraud bears so remote a connection to the national securities market that no person actually believed he was taking an ownership position in that market.” 

Securities law experts are backing the majority’s limited ruling. “The opinion is imminently correct as a matter of common sense and legal policy,” said Donald Langevoort, a professor of law at Georgetown University. Langevoort said he was “very surprised” the SEC tried to argue that a ruling for the plaintiffs may curtail the government’s enforcement powers.

Supreme Court Has a Full Plate of Securities Cases

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, MARCH/APRIL 2014 

Halliburton.
In our last issue, we devoted much space to discussion of Halliburton, which presents the issue of whether the “fraud on the market” theory, which underpins much of securities class action practice, is still the law of the land. As we said, since the Court’s decision in Basic v. Levinson about 25 years ago, securities class action plaintiffs have relied on this theory to obtain class certification. The theory helps investors establish the essential element of reliance on a class wide basis. It presumes that all investors rely on the market price of a security as reflecting all available material information about the security, including defendants’ alleged misrepresentations. By agreeing to reconsider this question, the Court threw the securities bar, on both sides, into a frenzy. 

On March 5, the Supremes held oral argument in Halliburton, and most observers thought that the Justices seemed unwilling to throw out Basic altogether. Instead, it seems likely that they intend to tweak it a bit, by allowing defendants to rebut the fraud on the market presumption at the class certification stage, with evidence that the false or misleading statements issued by the company did not actually distort the market price of its stock. If this prediction is accurate, investors will be able to live with the new Halliburton rule, and corporations will have to. 
Indymac.
Another venerable Supreme Court precedent in the class certification arena is American Pipe, a 1974 decision concerning the statute of limitations. In that case, plaintiffs filed a class action, but after the statute of limitations had expired the court refused to certify the class, and various would-be class members then tried to file individual claims. The Court held that for those people the statute of limitations was “tolled” – stopped running– while the class certification motion was still pending. That ruling made it unnecessary for potential plaintiffs to start filing individual lawsuits to protect themselves while the class certification motion was still undecided. Under American Pipe, only if class certification is denied would individual actions be necessary in order to protect a plaintiff’s rights from expiring. 

American Pipe talks about limitations periods which start to run when plaintiffs knew, or should have discovered, facts establishing their claim. The new case, Indymac, involves a so-called statute of repose, which in this case says that, under §11 of the Securities Act, the action must be brought within three years after the initial public offering that is the subject of the action, regardless of when investors knew or should have known of their claim. 

Class certification motions are usually not decided within three years, so the same problem that caused the Court to create the American Pipe tolling rule would arise with statutes of repose: as the three year limitation approaches, if the class certification motion is still not decided, individual investors would have no choice but to file individual actions in order to protect themselves from expiration of the “repose” period. A multitude of separate, duplicative lawsuits is not something investors or the courts want to see. 

All appeals courts that have considered the question until last summer had concluded that the three year statute of repose for §11 is tolled by the pendency of a class action motion; but then, in Indymac, the Second Circuit disagreed, setting up this Supreme Court appeal. 

Fifth Third Bancorp.
This case, to be argued in April, concerns the duties of fiduciaries of employee benefit plans governed by ERISA. Many of those plans invest participants’ contributions in stock of the employer corporation, or provide employer stock as an investment option. If the corporation then makes a “corrective” disclosure of negative information, plan participants who invested in company stock can suffer big losses. Sometimes they bring class actions against plan fiduciaries for ignoring warning signs that something was amiss. 

The issue the Court will consider in Fifth Third Bancorp is what plaintiffs in these cases must plead in order to survive a motion to dismiss. ERISA imposes on plan fiduciaries the obligation to act prudently and reasonably. Under one line of cases, plaintiffs must plead facts sufficient to rebut a presumption that the fiduciaries acted reasonably. In cases involving allegedly imprudent investments in company stock, the facts alleged have to show that the company was in dire straits for that presumption to be rebutted. In Fifth Third Bancorp, however, the Sixth Circuit held that this presumption of prudence does not apply at the motion to dismiss stage, but only later, when there is a fully developed evidentiary record. According to the Sixth Circuit, a plaintiff need only allege that “a prudent fiduciary acting under similar circumstances would have made a different decision”. Class actions against plan fiduciaries are a regular accompaniment to securities fraud litigations. Whatever the Court holds will have a major impact in the industry.

JPMorgan Chase Admits that it Covered Up the Madoff Ponzi Scheme

POMERANTZ MONITOR, JANUARY/FEBRUARY 2014 

This January, Federal District Judge Jed Rakoff published an essay in The New York Review of Books that reverberated in the financial community. He noted that, five years after the market crash of 2008 that caused millions of people to lose their jobs, “there are still millions of Americans leading lives of quiet desperation: without jobs, without resources, without hope.” Yet the Wall Street malefactors who caused this catastrophe have never been called to account. “Why,” he asked, “have no high-level executives been prosecuted?” Many of us have asked the same question. After all, after previous periods of financial scandal, several big time honchos spent years staring at the inside of a jail cell. Just ask Dennis Koslowski and Jeffrey Skilling, to name only two. The JPMorgan Chase case shows how much things have changed. The bank has confessed to a litany of misconduct, including fraud in connection with its sale of mortgage-backed securities, and allowing its “London Whale” trader to run amok, causing the company to lose billions of dollars, and then covering it up. Now, on almost the same day as Judge Rakoff’s essay was published, JPMorgan Chase has fessed up again, admitting that it committed two criminal violations when it covered up its knowledge of Bernard Madoff’s $65 billion Ponzi scheme, which was run through Madoff’s bank accounts at the bank. According to prosecutors, JPMorgan’s actions amount to “programmatic violation” of the Bank Secrecy Act, which requires banks to maintain internal controls against money laundering and to report suspicious transactions to the authorities. According to Preet Bharara, the U.S. Attorney for the Southern District of New York, JPMorgan’s “miserable” institutional failures enabled Madoff “to launder billions of dollars in Ponzi proceeds.” To resolve these Madoff cases, JPMorgan agreed to pay more than $2.6 billion in various settlements with federal authorities. At the same time, it also filed two settlements in private actions totaling more than $500 million – one for $325 million with the trustee liquidating the Madoff estate, and the other for $218 million to settle a class action. 

Interestingly, the federal prosecutors credited the trustee’s team with discovering many of the unsavory facts of the bank’s involvement. 

These payouts bring to nearly $32 billion the total that JPMorgan has reportedly paid in penalties to federal and state authorities since 2009 to settle a litany of charges of misconduct. Most notably it came to a record $13 billion settlement just months ago with federal and state law enforcement officials and financial regulators, over its underwriting of questionable mortgage securities before the financial crisis. 

And yet, no one at the bank has been criminally prosecuted for any of this. The deal reached by JPMorgan with prosecutors in the Madoff case stopped short of a guilty plea, and no individual prosecutions were announced. Instead, the bank entered into a deferred prosecution agreement, which suspends a criminal indictment for two years on condition that the “too big to fail” and “too big to jail” bank overhauls its money laundering controls. Even so, this is reportedly the first time that a big Wall Street bank has ever been forced to consent to a non-prosecution agreement. 

Given what JPMorgan Chase admits happened here, it is amazing that there were no prosecutions of individuals. According to documents released by the U.S. Attorney’s office, the megabank’s relationship with Madoff stretched back more than two decades, long before Madoff was arrested in 2008. One document released by prosecutors outlining the megabank’s wrongdoing observed that “The Madoff Ponzi scheme was conducted almost exclusively through” various accounts “held at JPMorgan.” 

By the mid-nineties, according to an agreed statement of facts released by prosecutors, bank employees raised concerns about how Madoff was able to claim remarkably consistent market-beating returns. Indeed, one arm of the bank considered entering into a deal with Madoff’s firm in 1998 but balked after an employee remarked that Madoff’s returns were “possibly too good to be true” and raised “too many red flags” to proceed. Then, in the fall of 2008, the bank withdrew its own $200 million investment from Madoff’s firm, without notifying either its clients or the authorities. 

Twice, in January 2007 and July 2008, transfers from Madoff's accounts triggered alerts on JPMorgan's anti-money-laundering software, but the bank failed to file suspicious activity reports. In October 2008, a U.K.-based unit of JPMorgan filed a report with the U.K. Serious Organised Crime Agency, saying that "the investment performance achieved by [the Madoff Securities] funds ... is so consistently and significantly ahead of its peers year-on-year, even in the prevailing market conditions, as to appear too good to be true — meaning that it probably is." But that information was not relayed to U.S. officials, as required by the Bank Secrecy Act. On the day of Mr. Madoff’s arrest in December 2008, a JPMorgan employee wrote to a colleague: “Can’t say I’m surprised, can you?” The colleague replied: “No.” 

In commenting on this latest settlement by the bank, Dennis M. Kelleher, the head of Better Markets, an advocacy group, observed that “banks do not commit crimes; bankers do.” Jailing people is the best way to deter future misconduct. If anyone thinks that huge fines are enough to deter misconduct by huge financial institutions, they should think again. Despite its huge penalties, JPMorgan just reported another multi-billion dollar quarterly profit, and announced that Chairman Jamie Dimon will receive a hefty raise. Obviously, it can afford to keep treating penalties as just another cost of doing business.

"Go-Shop" Provisions – Too Little, Too Late

ATTORNEY: OFER GANOT
POMERANTZ MONITOR, JANUARY/FEBRUARY 2014 

In a previous issue of the Monitor, we discussed potential problems the combination of certain “deal protection devices” may cause for shareholders wanting to receive the most they can get for their stock when their corporation receives an acquisition offer. 

In most merger transactions, the party making the offer wants to lock up the transaction as tightly as possible. The offeror, after all, has just finished negotiating the deal, usually after a long and expensive process of due diligence, and does not want its offer to be just the opening of an all-out bidding war with competing bidders. Offerors therefore typically condition their offer on the target agreeing to limit its ability to consider other offers. 

On the other side of the table sits the target company’s board of directors, which has fiduciary duties to the target company and its public shareholders. Among those is the duty to maximize shareholder value if the company is sold, and, to that end, to keep itself as free as possible to consider (or even to seek out) superior offers, should they be made (through what are known as “fiduciary out” provisions). 

This conflict is usually resolved through the adoption of multiple deal protection devices which are incorporated into the merger agreement between the target company and buyer. These devices can include, among other things, “no solicitation” provisions which restrict the target’s board of directors from soliciting and negotiating potentially superior offers; “matching rights” which essentially give the buyer a leg-up over any potential bidder, allowing it to match any superior offer made for the target company; and termination fees which require the target company to pay a significant amount (usually ranging between 3% and 4% of the total value of the transaction) to the buyer in the event the target’s board decides to pursue a superior offer. 

Sometimes the target’s board will negotiate what is known as a “go-shop period,” which is a period of time, usually between 30-45 days, during which the target’s board of directors is allowed to actively solicit superior offers from potential bidders without breaching the “no solicitation” mechanism. 

But there is an inherent flaw in this mechanism, which in most cases does not turn up any superior bids. More often than not, go-shop provisions are negotiated in lieu of a pre-signing market check. This usually happens when the buyer pressures the target’s board to accept its bid in a short period of time. The board, afraid that any delay may thwart this opportunity, may choose to skip a market check – a process that takes time – and instead enter into a merger agreement with the buyer, leaving itself the theoretical possibility of potentially securing a better offer after the deal with the buyer is already agreed upon and publicly announced. 

However, at that point, the target’s board has already approved the deal with the buyer, including the consideration to be paid for the target’s common stock. This acceptance by the target’s board sometimes leads to a number of insiders (including board members) entering into voting and support agreements pursuant to which they agree to vote their shares in favor of the deal with the buyer, and against any other deal. 

Moreover, the go-shop mechanism doesn’t necessarily neutralize the other deal protection devices in place including, without limitation, the termination fees and matching rights. This means that any potential bidder who is now interested in making an offer for the target company must assume significant time and expense just to be able to make a superior offer, knowing that the buyer can always simply match the bidder’s offer. Such potential bidder will also have to work harder to secure a majority supporting its offer, in light of any voting or support agreements entered into by target insiders. Even if the buyer chooses not to match, the new bidder must, directly or indirectly, incur the termination fees, thereby increasing even further the cost of such a transaction. 

It is no surprise, then, that the go-shop process usually produces zero competitive bids for the company. The hoops potential bidders must jump through are usually just too many, and they usually go on to search other opportunities, potentially leaving money on the table instead of in the target’s shareholders’ pockets. As a result, go-shop provisions are often dismissed as “too little, too late.” 

It should therefore be shareholders’ preference that a company undergo a significant and meaningful pre-signing market check, or outright auction, rather than negotiate a post-signing go-shop. Bidders are far more likely to materialize if the target hasn’t already signed a deal with someone else. Target boards have to weigh the risk that the offeror will walk away, with the risk that they will be foregoing possibly better offers. In other words, directors have to decide whether a bird in the hand is really better than two in the bush.

Threat to Shareholder Protections in Transactions with Controlling Parties

ATTORNEY: GUSTAVO F. BRUCKNER
POMERANTZ MONITOR, JANUARY/FEBRUARY 2014 

A recent Delaware Chancery Court decision, now on appeal before the Delaware Supreme Court, may dramatically lessen the customary safeguards for minority shareholders in controlling party transactions, such as going private mergers. 

In M&F Worldwide(“MFW”), Chairman Ronald Perelman offered to acquire the remaining 57% of MFW common stock he did not already own. As part of his proposal, Perelman indicated that he expected that the “board of Directors will appoint a special committee of independent directors to consider [the] proposal and make a recommendation to the Board of Directors,” and also noted that the “transaction will be subject to a non-waivable condition requiring the approval of a majority of the shares of the Company not owned by M&F or its affiliates.” 

Controlling shareholder transactions normally trigger the enhanced “entire fairness” standard of judicial review. This enhanced standard places a burden on the corporate board, and the controlling shareholder, to demonstrate that the transaction is inherently fair to the shareholders, by both demonstrating fair dealing and fair price. This is a very difficult standard for the company to meet. 

However, Delaware courts have held that the burden of proof on the issue of “entire fairness” can be shifted to the plaintiff challenger if the transaction has been approved either by an independent special committee of directors or by a positive vote of a majority of the minority shareholders. Independent committee and “majority of the minority” provisions are an attempt to assure that the company and its shareholders can exercise independent judgment in deciding to accept or reject the transaction. Although shifting of the burden of proof creates a higher hurdle for minority shareholders to surmount, it is not an impossible one, because the ultimate inquiry remains the same: the “entire fairness” of the transaction. 

Critically, even if these devices are used, Delaware courts have consistently held, up to now, that the business judgment rule does not protect the transaction. That rule, which protects most ordinary business decisions from shareholder challenge, is almost impossible for shareholders to overcome, because it provides that in making a business decision the directors of a corporation are presumed to have “acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” 

In his decision, Chancellor Strine (who was just nominated to become the next Chief Justice of the Delaware Supreme Court), ruled that where a transaction with a controlling person is conditioned on both negotiation and approval by an independent, special committee and a fully-informed, un-coerced vote of the majority of the minority, the proper standard of review is that of business judgment. According to Chancellor Strine, because Perelman conditioned the deal on implementation of procedural protections that essentially neutralized his controlling influence, the transaction is no different from routine corporate transactions in which the deferential business judgment standard is applicable. 

At oral argument, the Supreme Court seemed interested in the policy arguments both for accepting and rejecting the Chancellor’s reasoning. Chancellor Strine’s ruling, if adopted by the Supreme Court, could provide a roadmap for corporate boards to forestall litigation on even the most one-sided controlling shareholder transactions. Though too early to predict fully the repercussions of such a ruling, there is fear that institutional investors will use the power of the purse to reduce their holdings in controlled corporations over time, if their assets lose the valuable protections they are currently afforded.

Supremes About to Hear Historic Challenge to Fraud on the Market Theory

ATTORNEY: LOUIS C. LUDWIG
POMERANTZ MONITOR, JANUARY/FEBRUARY 2014

Twenty five years ago, in Basic Inc. v. Levinson, the Supreme Court adopted the so-called “fraud on the market” (“FOTM”) theory in securities fraud class actions. That theory holds that a security traded on an “efficient” market presumably reflects all public “material” information about that security, including any public misrepresentations by the defendants; and that in such cases investors rely on the market price as a fair reflection of the totality of information available. Because investors purchase their shares at the market price, assuming that that price reflects all available material information, it is fair to presume that all investors relied, indirectly, on defendants’ misrepresentations when they purchased their shares. 

Reliance is an essential element of securities fraud claims. The FOTM presumption allows investors to establish reliance on a class-wide basis, without having to show that each member of the class personally relied on defendants’ misrepresentations. If reliance had to be shown separately for each of the hundreds of thousands, or even millions, of investors, individual questions of reliance would overwhelm the case. In legalese, individual questions would “predominate” over common questions in the action, and it would be next to impossible to certify a class. The FOTM theory adopted in Basic is therefore a foundation of securities fraud class actions. The importance of class-wide reliance was apparent to the courts from the outset of the modern class action era in 1966. Just two years later, the Second Circuit rejected a defendant’s argument “that each person injured must show that he personally relied on the misrepresentations” because, the court concluded, “[c]arried to its logical end, it would negate any attempted class action under Rule 10b-5 ….” Because most investors do not suffer large enough losses from securities fraud to support prosecution of an individual action, class actions are often the only way for most investors to obtain redress for securities fraud. In recent years, some members of the Supreme Court have become more critical of securities fraud class actions, echoing Chamber of Commerce arguments that the mere act of certifying a class in a securities fraud action puts enormous financial pressure on defendants, forcing them to settle claims regardless of their merit. Before Halliburton, defendants had mounted a series of efforts to get the courts to make it harder to certify a class, arguing that plaintiffs should be forced to prove, at the class certification stage, that the misrepresentations were material (the Amgen case), or that they caused plaintiffs’ losses (an earlier Halliburton case). Both of those efforts failed. 

Those were merely the preliminary bouts; the main event is now here. For years, corporate interests have been mounting attacks on the FOTM theory, arguing that markets are not as efficient as economists previously thought. With the Supreme Court agreeing to revisit its decision in Basic, these well-funded efforts have finally paid off. On November 15, 2013, the Court granted certiorari in Halliburton Co. v. Erica P. John Fund. In Halliburton, the Supreme Court will decide two issues: 

 (1) Whether it should overrule or substantially modify the holding of Basic to the extent that it recognizes a presumption of class-wide reliance derived from the fraud-on-the market theory; and

(2) Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock. 

For everyone involved in litigating securities fraud class actions, the answers to these questions could be game-changers; and Pomerantz’s clients are among the potentially affected. If Basic is overruled and FOTM is jettisoned, securities fraud class actions as we have known them for a quarter century will be a thing of the past. 

Another possibility is that the Court will modify, rather than reject, Basic and FOTM. This possibility exists because FOTM theory actually consists of two distinct, but related, parts: first, “informational efficiency,” the idea that the market is capable of efficiently and speedily processing material information; and second, “price distortion,” whether fraudulent statements injected into the informationally-efficient market in a particular case actually distort a given security’s market price. After Basic was decided, courts weighing class certification in securities fraud cases focused primarily on informational efficiency, allowing the FOTM presumption of reliance to attach where that test was satisfied. By contrast, inquiries into price distortion were rare, if they occurred at all, on class certification motions. The Court could keep FOTM while requiring that plaintiffs establish both an informationally-efficient market, and some price distortion, perhaps using event studies of a type already much in use in securities fraud litigation. 

Defendants are arguing that the issue of price distortion is closely related to another element of a securities fraud claim, “loss causation,” proof that defendants’ misstatements, once corrected, caused the price of the stock to drop, causing plaintiff’s losses. A court that simply assumes price distortion also, to some extent, assumes loss causation. Second, the FOTM presumption is essentially predicated on another independent element of a securities fraud claim, “materiality.” By presuming reliance, courts presume the materiality of the alleged misstatement, and on the class certification motion defendants cannot offer rebuttal evidence negating materiality. Defendants argue that plaintiffs should not be entitled to such presumptions in their favor on a class certification motion. 

At the end of the day, at summary judgment or at trial, defendants will have their opportunity to rebut all these presumptions. But, the argument goes, that is too late, as a practical matter. Once a class is certified, defendants have a strong incentive to settle. Very few defendants have the chutzpah to take a “bet the company” securities fraud class action to trial. 

Even if the Court abrogates Basic and the FOTM theory completely, class actions will still be possible in cases involving failures to disclose (rather than misrepresentations), or involving violations of the Securities Act, which relates primarily to initial public offerings. In other cases, however, investors will be left to pursue individual actions, mostly on behalf of large institutional investors, and possibly in state court. Pomerantz’s current BP litigation, which alleges common law fraud and negligence claims stemming from over two dozen clients’ losses associated with BP common stock investments, provides a glimpse into what this post-Basic world might look like. In such cases, institutions with significant losses can pursue individual actions even without the FOTM presumption, if their advisors actually relied on defendants’ misrepresentations. 

Oral arguments in Halliburton are set for March 5, 2014. In the meantime, Pomerantz attorneys continue to work with economists, Supreme Court consultants, and the law firm that will argue the case, to craft an amicus brief that will support the continued viability of FOTM. Barring the outright affirmance of Basic, we will urge the Court to adopt an approach that leaves FOTM in place – as securities fraud class actions are untenable without some version of it – while adopting a limited inquiry into price distortion.

Whistleblower Program Picks Up Steam

POMERANTZ MONITOR, NOVEMBER/DECEMBER 2013 

The Whistleblower Bounty Program created by the Dodd-Frank Act mandates that the Securities and Exchange Commission (“SEC”) pay significant financial rewards to individuals who voluntarily provide the agency with original information about securities law violations. If the information provided leads to a successful enforcement action resulting in $1 million or more in sanctions, the whistleblower may receive between 10 and 30% of the sanctions collected. The SEC is required to maintain confidential treatment and anti-retaliation measures for tipsters. 

In a report issued by the SEC staff on November 15, the agency reported that it had received 3,238 tips in fiscal 2013, and had paid out $14.8 million in whistleblower awards that year, $14 million of which went to a single tipster in an award announced on October 1. In announcing the award, SEC Chair Mary Jo White stated that “Our whistleblower program already has had a big impact on our investigations by providing us with high quality, meaningful tips…. We hope an award like this encourages more individuals with information to come forward.” 

As more investigations are resolved, observers expect that more and greater awards will be granted. Currently, the SEC has over $400 million available for the program. 

While this program is new, it may ultimately supplement securities class actions in two important ways. The fundamental purpose of the Whistleblower program is to detect fraud. Unlike the basic purpose of securities class actions – to deter and hopefully monetarily punish fraud – the Whistleblower program incentivizes tipsters to come forward with information to the SEC – thus improving fraud detection. Generally, both corporate insiders (those with independent knowledge of misconduct from non-public sources) and corporate outsiders (those who detect misconduct through independent analysis and investigation of publicly available data) are incentivized to tip information to the SEC. 

Opponents of the program insist that, because the monetary incentives are so high, whistleblowers will turn first to the SEC before disclosing problems internally to obtain corrective action. However, SEC rules seek to preserve the attractiveness of internal reporting, and the SEC reports that most whistleblowers who have come forward since the program’s inception used internal channels of resolution before turning to the SEC. In addition, the SEC has indicated that its standard practice involves contacting the involved corporation directly upon receipt of a tip, describing the allegations, and giving the firm a chance to investigate the matter internally. On balance, the deterrent and detection benefits of the program, coupled with the SEC’s measures to encourage initial internal reporting, outweigh any incentive to simply run to the SEC first on the chance that a tip will result in a large reward.

The Purple Pill and “Pay for Delay”

ATTORNEY: JAYNE A. GOLDSTEIN
POMERANTZ MONITOR, NOVEMBER/DECEMBER 2013 

Pomerantz is serving as interim co-lead counsel in an antitrust lawsuit against various pharmaceutical companies. We allege that the brand company, AstraZeneca, paid generic drug manufacturers Ranbaxy Pharmaceuticals, Teva Pharmaceuticals and Dr. Reddy’s Laboratories (“Generic Defendants”) to keep generic versions of the blockbuster drug Nexium from coming to market for six years or more. Nexium, a prescription medication commonly advertised as “the purple pill,” is used to treat heartburn and gastric reflux disease. Pomerantz represents consumers, self-insured insurance plans and insurance companies who were forced to pay monopoly prices for Nexium because there was no generic competition. 

Generic versions of brand name drugs contain the same active ingredient, and are determined by the Food and Drug Administration (“FDA”) to be just as safe and effective as their brand name counterparts. The only significant difference between them is their price: when there is a single generic competitor, generics are usually at least 25% cheaper than their brand name counterparts; and when there are multiple generic competitors, this discount typically increases to 50% to 80% (or more). The launch of a generic drug usually brings huge cost savings for all drug purchasers. 

We allege that in order to protect the $3 billion in annual Nexium sales from the threat of generic competition, AstraZeneca agreed to pay the Generic Defendants substantial sums in exchange for their agreement to delay marketing their less expensive generic versions of Nexium for as many as six years or more, i.e., from 2008 until May 27, 2014. 

Under the Hatch Waxman Act, the law which governs how generic pharmaceuticals come to market, when a generic drug manufacturer wants to sell a generic equivalent of a patented drug, it must file an Abbreviated New Drug Application (“ANDA”) which must certify either that (1) no patent for the brand name drug has been filed with the FDA; (2) the patent for the brand name drug has expired; (3) the patent for the brand name drug will expire on a particular date and the generic company does not seek to market its generic product before that date; or (4) the patent for the brand name drug is invalid or will not be infringed by the generic manufacturer’s proposed product (a so-called “Paragraph IV certification”). 

In the case of Nexium, the generic manufacturers filed a Paragraph IV certification. This filing gave the brand manufacturer forty-five days in which to sue the generic companies for patent infringement. If the brand company initiates a patent infringement action against the generic filer, the FDA will not grant final approval of the new generic drug until the earlier of (a) the passage of thirty months, or (b) the issuance of a decision by a court that the patent is invalid or not infringed by the generic manufacturer’s ANDA. In this case, AstraZeneca sued all three of the Generic Defendants. 

As an incentive to spur generic companies to seek approval of generic alternatives to branded drugs, the Hatch Waxman law rewards the first generic manufacturer to file an ANDA containing a Paragraph IV certification by granting it a period of one hundred and eighty days in which there is no competition from other generic versions of the drug. This means that the first approved generic is the only available generic for at least six months, a large economic benefit to the generic company. Brand name manufacturers can “beat the system” by claiming a valid patent even if such patent is very weak, listing and suing any generic competitor that files an ANDA with a Paragraph IV certification (even if the competitor’s product does not actually infringe the listed patents) in order to delay final FDA approval of the generic for up to thirty months. 

In Nexium’s case, when the Generic Defendants filed their Paragraph IV certifications they alleged, among other reasons, that the Nexium patents were not valid because Nexium was not significantly different from AstraZeneca’s prior drug, Prilosec. The active ingredient in Prilosec is omeprazole, a substance consisting of equal parts of two different isomers of the same molecule. 

Nevertheless, after receiving the Paragraph IV certifications from the Generic Defendants, AstraZeneca filed patent infringement litigation. Just as the thirty months was about to expire and generic Nexium would have been able to come to market, the companies settled the patent litigation. AstraZeneca used the strength of its wallet as opposed to the strength of its patents to obtain the Generic Defendants’ agreement to postpone the launch of their generic Nexium products. In light of the substantial possibility that AstraZeneca’s Nexium patents would be invalidated, in which case AstraZeneca would have been unable to keep generic versions of Nexium from swiftly capturing the vast majority of Nexium sales, AstraZeneca agreed to share its monopoly profits with the Generic Defendants as the quid pro quo for the Generic Defendants’ agreement not to compete with AstraZeneca in the Nexium market until May 27, 2014. 

These cases are commonly called either “pay for delay” or “reverse payment” cases. Until recently, the various federal appellate courts were divided on whether these “settlements” violated the antitrust laws by improperly prolonging the monopoly granted by the patent laws. In June of 2013, the U.S. Supreme Court held that such settlements are subject to antitrust scrutiny. 

The trial of this case is scheduled to begin on March 3, 2014.

Health Insurers’ “Recoupment” Tactic Derailed

POMERANTZ MONITOR, NOVEMBER/DECEMBER 2013 

In Pennsylvania Chiropractic Ass’n v. Blue Cross Blue Shield Ass’n, Pomerantz’s Insurance Practice Group obtained summary judgment on behalf of our client health providers against Anthem and Independent Blue Cross in a recoupment case. Recoupment itself has been described as a “legal gray zone” that insurers exploited prior to Pomerantz’s challenges. Recoupment occurs when insurers such as Blue Cross Blue Shield (“BCBS”) pay claims initially and later decide that the claims should not have been paid, demanding repayment and claiming fraud. When the provider refuses to return the money, the insurer deducts the full amount from payment of future claims that are not challenged as improper. 

When these subsequent denials are made in the context of an employee health insurance plan, they are controlled by ERISA, which requires disclosure and appellate rights. In its decision, the court found that Blue Cross insurers violated ERISA by improperly denying beneficiary rights and making arbitrary and capricious benefit denials. The court also denied BCBS’s motion for summary judgment against several chiropractic associations, also represented by Pomerantz, for injunctive relief. This ruling paved the way for a December trial to modify the way Blue Cross obtains benefit recoupments from chiropractors across the country. 

This decision has national significance. As we stated to Law 360, an online legal publication: “The decision found for us on the merits of our claim that an insurer must comply with ERISA when seeking to recover previously paid health care benefits from providers. Given the hundreds of millions of dollars recouped by insurers every year, this decision will have widespread implications.” 

The decision follows Pomerantz’s successful trial verdict on behalf of other providers in another recoupment and fraud case in the District of Rhode Island, Blue Cross & Blue Shield of R.I. v. Korsen, and our win in yet another recoupment case in the Third Circuit in Tri3 Enterprises, LLC v. Aetna, Inc. We have other recoupment cases ongoing, the results of which we will report in future editions of the Monitor.

FIRREA: No, It’s Not a Disease, Unless You Are a Naughty Financial Institution

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, NOVEMBER/DECEMBER 2013 

As JPMorgan Chase struggled to put the finishing touches on its $13 billion settlement with the federal government over its misadventures in the mortgage-backed securities area, a major ingredient in the government’s success seems to have come from out of nowhere – or, more precisely, from the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"). This provision, enacted in the wake of the savings and loan meltdown of the 80’s, has been pulled out of the mothballs to punish some of the misbehaving financial institutions that brought about the financial crisis of 2008. 

Section 951 of FIRREA authorizes the Justice Department to seek civil money penalties against persons who violate one or more of 14 enumerated criminal statutes (predicate offenses) that involve or “affect” financial institutions or government agencies. On April 24, 2013, the U.S. District Court for the Southern District of New York issued the first judicial interpretation of the phrase "affecting a federally insured financial institution" as used in FIRREA. In United States v. The Bank of New York Mellon, the DOJ sued the bank and one of its employees under FIRREA. Defendants allegedly schemed to defraud the bank’s custodial clients by misrepresenting that the bank provided "best execution" when pricing foreign exchange trades. The DOJ contended that the defendants' fraudulent scheme "affected" a federally insured financial institution—namely the bank itself—as well as a number of other federally insured financial institutions. The bank, on the other hand, contended that a federally insured financial institution may be "affected" by a fraud only if it were the victim of or an innocent bystander, but not if it were the perpetrator. 

The court disagreed, concluding that a federally insured financial institution could be "affected" by a fraud committed by its own employees, even though it may actually have profited from that fraud in the short run. The court reasoned that the fraud exposed the bank to a new or increased risk of loss, as shown by the fact that BNY Mellon had been named as a defendant in numerous private lawsuits as a result of its alleged fraud, which required it to incur litigation costs, exposed it to billions of dollars in potential liability, and damaged its business by causing a loss of clients, forcing BNY Mellon to adopt a less-profitable business model, and harming its reputation. 

Every fraud committed by bank employees could lead to such consequences; and because mail and wire fraud are very broad statutes that apply to virtually all fraudulent schemes, FIRREA has wide scope and potentially devastating impact. 

Other features of FIRREA also cause bankers to lose sleep. Although the DOJ has to prove that certain criminal statutes have been violated, the burden of proof is not “beyond a reasonable doubt” but, rather, only a “preponderance of the evidence.” The statute of limitations is ten years, which is important given that the five-year limitations period applicable to securities fraud and other statutes is expiring on many cases involving the 2008 financial meltdown. 

Finally, and most spectacularly, the potential penalties under FIRREA are astronomical. The statute authorizes penalties of up to $1.1 million per violation; for continuing violations, the maximum increases up to $1.1 million per day or $5.5 million per violation, whichever is less. That’s not much; but FIRREA allows the court to increase the penalty up to the amount of the pecuniary gain that any person derives from the violation, or the amount of pecuniary loss suffered by any person as a result of the violation. 

The DOJ has invoked this special penalty rule to seek more than $5 billion in civil money penalties in a current litigation involving fraud allegedly committed by the credit ratings agency Standard & Poors. 

The U.S. Attorney in Manhattan has now filed civil fraud actions against Wells Fargo, BNY Mellon and Bank of America, among others, and in October a jury found Bank of America liable. Finally, potential FIRREA liability reportedly has played a major role in convincing JPMorgan Chase to pony up $13 billion to settle with the DOJ.

A New Way to Curtail Class Actions?

ATTORNEY: MARK B. GOLDSTEIN
THE POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2013 

A recent decision by the Third Circuit has the potential to further restrain consumer and other types of class actions. Last August, in Carrera v. Bayer Corp., the Third Circuit reversed and remanded the certification of a class of Florida consumers who purchased Bayer's One–A–Day WeightSmart diet supplements. 

This was a potential class action by consumers claiming that Bayer falsely and deceptively advertised its supplement. When the District Court certified the class, Bayer appealed, arguing that class certification was improper because the class members were not “ascertainable”. This requirement means that “the class definition must be sufficiently definite so that it is administratively feasible to determine whether a particular person is a class member.” This is important because all class members have to be notified if a class has been certified or if a settlement has been reached, and because, if there is a recovery for the class, the court can determine who is entitled to share in it, and who isn’t. 

Here the class was to consist of everyone who purchased the supplement in Florida. Figuring out who these people are is no easy matter. In securities cases, for example, there are brokerage and other records identifying everyone who bought or owned a particular security at a particular time. Similarly, records are kept of everyone who purchases prescription drugs. But no one keeps a comprehensive list of everyone who buys consumer products like over the counter diet supplements. If such a list must exist in order to certify a class action, it will be a major roadblock in many cases. 

Plaintiffs here proposed that class members could be identified through retailers’ records of online sales and of sales made through store loyalty or reward cards. They also suggested that when class members file their individual proofs of claim to share in any recovery, they could submit affidavits attesting that they purchased WeightSmart and stating the amount they paid and the quantity purchased. 

The Third Circuit rejected those arguments, concluding that it could not know for certain whether retailers’ records would identify all or most of the class members. It also held that affidavits from people who claimed, without documentary proof, that they bought the product could be unreliable. 

It is too soon to know whether other Circuits will follow suit and adopt this standard for ascertainability. If they do that would be a problem. There are many products sold for which there is no comprehensive and authoritative source identifying all purchasers. In such cases, purchasers may have no feasible method for seeking recourse if defendants engage in deceptive or illegal conduct.

SEC Wrests Admissions in Settlement of Falcone Case

ATTORNEY: MURIELLE STEVEN WALSH
POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2013 

The JPMorgan “London Whale” case is not the first time the SEC has insisted on admissions of wrongdoing as part of its settlement agreements. A few weeks earlier, for example, the SEC secured admissions as part of its settlement of charges against Hedge Fund manager Philip Falcone. 

The current push to insist on admissions of wrongdoing in these settlements can probably be traced to November of 2011, when Judge Rakoff of the Southern District New York famously rejected Citigroup’s $285 million settlement with the SEC, primarily because it did not contain any admission of wrongdoing by the bank. The judge found that the deal was "neither fair, nor reasonable, nor adequate, nor in the public interest." Judge Rakoff has been highly critical of settlements that allow defendants to neither “admit nor deny,” and has called them “a stew of confusion and hypocrisy unworthy of such a proud agency as the S.E.C.” 

Judge Rakoff was criticized as overstepping his bounds and challenging the authority of the SEC. Wall Street interests argued that admissions of wrongdoing in SEC settlements would encourage private investor litigation. Others pronounced that a requirement for admissions would make it difficult, if not impossible, for the SEC to settle cases. The Second Circuit is now reviewing whether, in fact, the court went too far. 

But regardless of the outcome of that appeal, Judge Rakoff’s opinion has had profound repercussions. When Mary Jo White was first appointed as the new SEC chair, she announced that henceforth the Commission would require admissions of wrongdoing as a condition to settlement in certain situations. 

Judge Rakoff’s colleague in the Southern District, Judge Marrero, recently approved a settlement between SAC Advisors and the SEC that also had no admissions of wrongdoing. However, he conditioned his approval on a finding by the Second Circuit in the Citigroup matter that district courts lack the authority to reject SEC settlements solely because of “admit or deny” policy. If the Second Circuit does not make such a finding, SAC will be back on the hook. 

The recent $18 million civil settlement between hedge-fund manager Philip Falcone and securities regulators is a case in point. Falcone and his hedge fund, Harbinger Capital Partners, had been accused of engaging in an illegal “short squeeze” to force short-sellers to sell distressed, high yield bonds at inflated prices, and favoring certain investors over others when granting redemption requests. An earlier agreement reached between Falcone and the SEC’s enforcement staff did not contain any admissions of wrongdoing. In a rare move, the SEC commissioners rejected the agreement and sent the parties back to the table. The new deal contains Falcon’s admissions of underlying facts of alleged improper behavior, specifically, that he had acted “recklessly” with regard to several market transactions. It does not, however, include admissions of specific securities law violations. Obviously, the facts can potentially be used as fodder in private litigation – in this case, an admission of reckless conduct has important ramifications for fraud claims. 

At the same time, Falcone won’t be limiting his legal options in other lawsuits that may follow on the heels of this settlement. As noted by James Cox, a law professor at Duke University School of Law, the admitted facts “may be helpful, but not perfectly helpful, to follow-on litigation."

Not So Fabulous After All

ATTORNEY: TAMAR A. WEINRIB
POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2013 

In August, the SEC scored a much-needed win when a nine-member jury, after deliberating for two days, found Fabrice Tourre, a former Goldman Sachs bond trader once known as “Fabulous Fab,” liable on six of seven civil fraud charges. 

The SEC brought the action in 2010 against both Mr. Tourre and Goldman Sachs, accusing both of misleading investors about a complex mortgage-based financial product known as “Abacus 2007-AC1.” Abacus was a “collateralized debt obligation,” a financial vehicle based on a collection of underlying mortgage-related securities. Tourre played a major role in putting Abacus together; but he (and Goldman) allegedly failed to disclose to potential investors that hedge fund titan John Paulson, a key Goldman Sachs client, had also played a major role in selecting the securities underlying Abacus. Paulson’s involvement was critical because he himself made a huge bet against Abacus, selling millions of shares short, and made a killing when Abacus failed. In other words, the SEC claimed that Abacus was secretly designed to fail so that Paulson could make a killing at the expense of Goldman’s other clients. 

Goldman settled the SEC’s claims some time ago, agreeing to pay a $550 million fine, without admitting or denying wrongdoing. Abacus, and the large fine it generated, heavily damaged Goldman’s reputation, helping to earn it the sobriquet “great vampire squid.” 

Even after Goldman settled, Tourre fought on, and lost. Tellingly, his lawyers opted not to call any witnesses at trial, an interesting strategy which perhaps reflected the weakness of their case. The SEC called two witnesses, Laura Schwartz from the ACA Financial Guaranty Corporation, and Gail Kreitman, a former Goldman saleswoman, who testified that they were misled about who was investing in Abacus. Also key to Mr. Tourre’s downfall was a number of emails to his girlfriend, which he called “love letters,” in which he joked about selling toxic real estate bonds to “widows and orphans.” 

As of Monitor press time, Mr. Tourre was planning to ask the court at the end of September to either overturn his securities fraud verdict or grant a new jury trial. If the judge declines that request, the question will then become one of punishment. Mr. Tourre faces three potential remedies. First, the court can impose civil monetary penalties ranging from $5,000 to $130,000 for each violation. Second, the court can order that Mr. Tourre forfeit any profits he received from his violations, though it is unclear at this point what that would encompass. Third, Mr. Tourre could also face an administrative proceeding before the SEC, which could permanently bar him from any future association with the financial industry. One potential obstacle for the SEC in pursuing a bar, however, is that it obtained the power to do this when Congress passed the Dodd-Frank Act in 2010, three years after Mr. Tourre’s violations occurred. It is unclear whether the SEC’s authority to issue a bar applies retroactively. Given that Goldman continues to bankroll all of Mr. Tourre’s legal fees, it is likely he will appeal any bar order, challenging retroactivity, and continue to drag this case on further. 

Mr. Tourre is now enrolled in a doctoral economics program at the University of Chicago and seems to be gearing up for a future in academia. Other than damage to his reputation, which he has already incurred in spades, it is questionable whether a bar would make much of a difference. 

Meanwhile, the Tourre trial, though clearly a success for the SEC, has led many to question why the agency continues to pursue mid-level employees like Mr. Tourre while leaving the high-level executives unscathed. Mr. Tourre clearly did not commit these violations on his own.

Mergers Foreclose Derivative Litigation

ATTORNEY: SAMUEL J. ADAMS
POMERANTZ MONTITOR, SEPTEMBER/OCTOBER 2013 

In a case involving the notorious Countrywide Corporation, with implications for derivative actions filed across the country, the Delaware Supreme Court, has declined to expand the circumstances under which a derivative action, brought on behalf of the injured corporation, can survive a merger of that corporation into another. Because mergers often happen while derivative suits are pending, and in fact are sometimes motivated by the directors’ desire to eliminate derivative claims against them, this decision will make it harder in many cases to hold directors of Delaware corporations accountable for their reckless mismanagement. 

As is well known, Countrywide played a major role in the financial crash of 2008, because it was probably the most prolific perpetrator of toxic mortgage securities. When the mortgage market imploded, Countrywide nearly collapsed and was sold under the gun to Bank of America (“B of A”) – the unlucky purchaser of last resort not only of Countrywide but also of equally ill-fated Merrill Lynch. If ever there were directors who deserved to be sued for destroying their company, the directors of Countrywide fit the bill. Yet, when they were sued by Countrywide shareholders, they claimed that the sale to B of A wiped out the plaintiffs’ claims. 

The directors were invoking the so-called “continuous ownership” rule, which says that in order to assert a derivative claim a plaintiff shareholder must have owned stock in the injured corporation continuously from the time of the alleged wrong until the resolution of the litigation. Should the corporation be sold in a cash-out merger before the litigation is resolved, the shareholder plaintiff would be divested of his holdings, and therefore his chain of continuous ownership would be broken. 

Here, plaintiffs sued the former directors of Countrywide in California federal court, claiming that they were responsible for allowing Countrywide to engage in a host of reckless and fraudulent mortgage practices. The District Court dismissed the derivative claims under the “continuing ownership” rule, holding that under Delaware law plaintiffs lost standing to pursue the derivative claims upon consummation of Countrywide’s Merger with B of A. Plaintiffs had argued that there was an exception to this rule in cases where it was the alleged wrongdoing that forced the company to enter into the merger in the first place. On appeal, the United States Court of Appeals for the Ninth Circuit asked the Delaware Supreme Court to consider, as a “certified question,” whether this exception actually existed and, if so, whether it applied here. The certified question was prompted, in part, by the fact that state and federal courts had reached divergent results in previous cases applying Delaware law in this situation. 

In a famous decision decades ago in Lewis v. Anderson, the Delaware Supreme Court recognized a “fraud exception” to the continuous ownership rule, allowing plaintiffs to litigate post-merger derivative claims “where the merger itself is the subject of a claim of fraud,” meaning that the merger served “no alternative valid business purpose” other than eliminating derivative claims. Although there is a very low threshold for finding a “valid business purpose” for a merger, it is a short step from this doctrine to the proposition that the exception should apply if the very fraud that was the subject of the derivative action also drove the corporation to enter into the merger. 

Arguing before the Delaware Supreme Court, plaintiffs, in a twist, urged the court to consider resolving the certified question by creating a new cause of action, which they referred to as a “quasi-derivative” claim. Defendants argued that there is “no need and no basis” to recognize an exception to the continuous ownership rule even where the conduct in question forced the company to merge with another company. 

The Delaware Supreme Court found in favor of defendants, holding that shareholders cannot pursue derivative claims against a corporation after a merger divests them of their ownership interest, even if a board's fraud effectively forced the corporation into the merger. However, the court was careful to note that shareholders who lose derivative standing in a merger may nonetheless have post-merger standing to recover damages from a direct fraud claim, should one be properly pleaded.

The Oxford Decision: the Silver Lining?

ATTORNEY: JENNIFER BANNER SOBERS
POMERANTZ MONITOR, JULY/AUGUST 2013 

Ten days before the American Express decision, the Supreme Court, in a case involving the Oxford health insurance company, unanimously affirmed an arbitrator’s decision to authorize class arbitration. He held that because the arbitration agreement stated that “all disputes” must be submitted to arbitration -- without specifically saying whether “all disputes” includes class actions -- nonetheless the agreement means that class action disputes can be arbitrated. 

This case was filed in court by a pediatrician in the Oxford “network” who alleged that Oxford failed to fully and promptly pay him and other physicians with similar Oxford contracts. The court granted Oxford’s demand that the case be arbitrated. The parties then agreed that the arbitrator should decide whether the contract authorized class arbitration. In finding that the contract did permit class arbitrations, the arbitrator focused on the language of the arbitration clause, which stated that “all” civil actions must be submitted to arbitration. Oxford tried to vacate the arbitrator’s decision, claiming that he exceeded his powers under the Federal Arbitration Act. The District Court denied the motion, and the Third Circuit affirmed. 

In agreeing with the lower courts, the Supreme Court held that when an arbitrator interprets an arbitration agreement, that determination must be upheld so long as he was really construing the contract. Whether this interpretation is correct is beside the point, as far as the courts are concerned. Judicial review of arbitrators’ decisions is far more constrained than the review of lower court decisions. 

This case may turn out to be the silver lining to the Supreme Court’s series of rulings curtailing class actions in arbitration. This decision will specifically benefit plaintiffs, including those, like the plaintiff here, whose claims lie in the health care arena. 

Moreover, the decision seems to narrow the effect of the court’s previous decision in 2010, which held that “silence” in an arbitration agreement usually means that the parties did not agree to arbitrate on a class-wide basis. To the extent that arbitrators in future cases interpret an agreement to arbitrate “all disputes” as including class-wide disputes, plaintiffs will be more likely in the future to have a realistic chance to have their claims resolved. That is, unless there is an explicit class action waiver. 

Many consumers are subject to arbitration agreements, including physicians who often have no choice but to accept such agreements if they want to be in-network providers for insurers. As Pomerantz and co-counsel argued in an amicus brief on behalf of the American Medical Association and the Medical Society of New Jersey in support of the pediatrician, without being able to arbitrate on a class-wide basis, physicians will have no effective means by which to enforce their contracts with insurers and challenge underpayments. The typical claim by a doctor against an insurer is relatively small. Prosecuting such small claims in individual arbitration is impossible, given that the cost of bringing an arbitration will almost always exceed the amount an individual doctor could potentially recover through arbitration. Moreover, individual arbitrations could not adequately address certain pervasive wrongful practices by insurers such as underpayment or delayed payment of claims and do not provide injunctive relief to stop such practices – a critical remedy sought in many class actions.