Fifth Circuit Revives Our Houston American Case

ATTORNEY: MURIELLE STEVEN WALSH
POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014 

Pomerantz recently prevailed in an appeal before the Fifth Circuit In re Houston American Sec. Lit. The court reversed and remanded district Judge Harmon’s order dismissing the complaint.

The case involves misrepresentations by Houston American, a Texan oil drilling company, about the amount of its recoverable oil reserves, as well as the success of the company’s oil drilling efforts in a particular region, the so-called “CPO4 Block.” In November 2009, the company made the extraordinary claim that the CPO4 Block contained 1-4 billion barrels of recoverable oil reserves. Later, after it began drilling in the block, Houston American represented to investors that the drilling was producing significant “hydrocarbon shows,” which generally indicate the presence of oil.

The case alleges that, in fact, the company had never conducted any of the necessary tests to substantiate its estimate of recoverable oil, and that company executives were aware of significant problems concerning the drilling operations which conflicted with positive statements they made about the drilling. Houston American eventually admitted that it had abandoned drilling efforts in CPO4, and that the SEC was investigating what had happened.

The district court dismissed the complaint, holding that it failed to substantiate either of the required elements of scienter or loss causation. With respect to scienter, it accepted allegations by our confidential witnesses that the individual defendants were aware of serious problems with their drilling operations when they made positive statements about them to investors; and it also accepted the allegation that the defendants had no reasonable basis for their assertion that the CPO4 block had billions of barrels in recoverable oil reserves.

The court nonetheless found that defendants’ decision to invest additional money into the drilling ($5 million of corporate funds, not their own), somehow negated any inference of scienter as a matter of law. The district court reasoned that it would make no sense for the defendants to invest additional money in a venture if they didn’t believe it would ultimately be successful. In reversing, the Fifth Circuit emphasized that defendants’ personal beliefs about the ultimate success of their operations are irrelevant because they were aware of, but concealed, negative information that was inconsistent with those professed beliefs.

The district court had also held that plaintiffs had not sufficiently pleaded that their losses were directly caused by the misrepresentations, as opposed to “other economic factors.” The Fifth Circuit found that this too, was an error, because it imposed a heightened pleading requirement for loss causation that is not required under the Supreme Court’s decision in Dura.

A few weeks after the Fifth Circuit decision came down, the SEC filed a formal complaint against Houston American and its executives, alleging securities fraud.

Pomerantz Defeats Motion to Dismiss Delcath

ATTORNEY: TAMAR A. WEINRIB
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2014

On June 27, 2014 Judge Schofield of the U.S. District Court for the Southern District of New York denied defendants' motion to dismiss our case against Delcath Systems, Inc., in whichPomerantz is sole lead counsel.

Delcath is a specialty pharmaceutical and medical device company focused on oncology. The case concerns the company’s development of the "Melblez Kit," a device designed to deliver targeted high doses of melphalan (a chemotherapeutic agent) to treat certain types of liver cancer. A key part of the kit is a filter, the purpose of which is to remove the toxic byproducts of the melphalan before they reenter the bloodstream from the liver, thus preventing exposure to toxic levels of melphalan which can lead to severe and often fatal side effects. 

The FDA ultimately refused to approve the Melblez Kit, causing the market price of Delcath’s stock to plummet. Our complaint alleges that the company knowingly failed to disclose to investors that the filter it had used during the clinical trial had not sufficiently removed the toxicities from the blood, resulting in far more deaths and other serious adverse events than those caused by other available treatment methods.

Specifically, during of the clinical trial the company used a filter (the “Clark” filter) that had only been tested “in vitro,” and not on live subjects, prior to its inclusion in Phase III oftesting on humans. Those in vitro tests, however, failed to detect flaws in the Clark filter. After receiving a Refusal to File letter from the FDA in response to its first New Drug Application (“NDA”) for the Melblez Kit, which cited major deficiencies in the NDA including incomplete information regarding serious adverse reactions, as well as manufacturing and quality control issues, Delcath filed a second NDA purporting to correct these major flaws.

The second NDA, however, sought approval of the Melblez Kit with yet another new filter, the Generation 2 filter, which the Company had, once again, tested in vitro, even though it knew those same in vitro tests had failed to detect critical deficiencies in the Clark filter. The company never tested the Generation 2 filter on humans. Defendants did not disclose to investors that they developed the Generation 2 filter, and included it in the second NDA, because of the unprecedented toxicities caused by the Clark filter.  

The FDA convened an advisory panel to review the new NDA, and that panel unanimously recommended that the agency not approve the Melblez Kit, because the risk of harm outweighed the Kit's potential benefit. The FDA relied on this recommendation and ultimately rejected the second NDA.

The court found that defendants should have informed investors that the severity and frequency of the serious adverse events far surpassed those resulting from other available treatments and that no patients in the control group died during the Phase III trial. The court held that the omitted facts about the relative toxicity of defendants’ product caused the FDA to reject the Melblez Kit. The court also found that the Complaint sufficiently pled scienter by alleging that defendants "knew facts or had access to information suggesting that their public statements were not accurate." 

Specifically, the court held that the following factors created a compelling inference of scienter: 1) Delcath is a small company focused on one product; 2) FDA approval of the Melblez Kit hinged on the Phase III trial results; 3) confidential witnesses all corroborated that Delcath's CEO, defendant Hobbs, made all the company's decisions, including those relevant to the Melblez Kit; 4) Hobbs' public statements indicated that he was familiar with the trial data; 5) the company proposed a new and relatively untested filter, the Generation 2 filter, in its revised NDA, rather than the Clark filter used in the Phase III trials, suggesting that defendants knew that the results of its Phase III trials were not as strong as they represented in public statements; and 6) the FDA, and the Advisory Panel it convened, both made scathing comments about the Phase III trial results, and ultimately rejected the Melblez Kit NDA as a result.

With regard to loss causation, the court found that defendants' argument that the drop in stock price was caused by the FDA's rejection of the NDA rather than the revelation of a fraud "is a factual argument for a later day and does not diminish the sufficiency of the Complaint."

The decision is notable as it requires pharmaceutical companies going through the FDA approval process for clinically tested drugs or devices to give investors a complete picture of specific known risks that may impact approvability, and not hide behind generalized risk warnings, particularly where the company opts to speak about the trial results.

The discovery process has begun and Lead Plaintiff will file its motion for class certification in October.

The Dust Starts to Settle After Halliburton

ATTORNEY:  MICHAEL J. WERNKE 
THE POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014

It has been a little over two months since the Supreme Court issued its decision in Halliburton Co. v. Erica P. John Fund, Inc., reaffirming the “fraud-on-the-market” presump­tion of class-wide reliance that makes most securities fraud class actions possible. Even in such a short period, we have seen significant developments in this area of the law.

In Halliburton, the Supreme Court declined to create a new requirement that the plaintiff, in order to invoke the fraud on the market presumption, had to demonstrate “price impact” at the class certification stage—i.e., that the misrepresentation actually affected the price of the stock. However, the Court did authorize defendants to try to defeat class certification by submitting “evidence showing that the alleged misrepresentation did not actually affect the stock’s market price.”

Since then, lower federal courts have begun interpreting Halliburton’s impact on current class certification stan­dards. In several cases the courts have concluded that it represents no fundamental change at all, particularly because even before Halliburton, many circuits had already permitted defendants to show the absence of price impact at the class certification stage.

More important are decisions of two courts that have addressed the question of whether Halliburton forecloses the so-called “price maintenance theory.” One textbook example of a fraud-on-the-market claim is that the defen­dant made misrepresentations that caused the market price of the company’s stock to move up, and that the price came back down only when the truth finally came out. In these cases the “price impact” occurred when the misleading financial information was first released.

The price maintenance theory, on the other hand, comes into play if the alleged fraud did not cause the price of the company’s stock to move up but, instead, prevented it from moving down. This can occur if the company falsely reports that its results are about the same as before, in line with market expectations, when in fact something bad has happened and the true results were really far worse.

Under this theory, the “price impact” of the fraud does not occur at the time of the misrepresentations, but only when the truth finally comes out and the price of the stock drops dramatically. If “price impact” is equated with price movement, and has to occur at the time of the misrepresentations, price maintenance cases – which are legion – will not qualify for the fraud on the market presumption.

The two courts that have ruled on this issue post-Halliburton have both concluded that price maintenance cases can qualify for the fraud on the market presumption. In a case involving Vivendi Universal, Judge Shira Scheindlin of the Southern District of New York denied the defendant’s request to make a renewed motion for judgment as a matter of law in light of Halliburton, reaffirming the continued viability of the price maintenance theory. The court emphasized that Halliburton made mention of how a plaintiff can prove price impact, but only discussed when a defendant can establish a lack of price impact.

Potentially even more important is a recent decision by the Eleventh Circuit in a case against Regions Financial, where the court also affirmed the continued validity of the price maintenance theory. The court rejected the defendant’s argument that a finding of fraud on the mar­ket always requires proof that the alleged misrepresenta­tions had an “immediate effect” on the stock price. In such situations, the court held, a plaintiff can satisfy the critical “cause and effect” requirement of market efficiency merely by identifying a negative price impact resulting from a corrective disclosure that later revealed the truth of the fraud to the market. The court explained that Halliburton “by no means holds that in every case in which such evidence is presented, the presumption will always be defeated.”

In upholding the price maintenance theory, the court in Regions reaffirmed that, under Halliburton, there is no sin­gle mandatory analytical framework for analyzing market efficiency, and district courts have flexibility to make the fact-intensive reliance inquiry on a case-by-case basis. This flexible approach to reliance is a boon to investors because plaintiffs may be able to use various tools to show an efficient market existed—even where there are a few number of traded shares, or where a company is not followed widely by analysts, or where the market is generally accepted to be inefficient.

Beyond its holding, the Eleventh Circuit’s decision can also be viewed optimistically by investors as potentially a first step in courts permitting plaintiffs to establish Basic’s presumption merely through evidence of a corrective disclosure’s price impact on a stock, rather than general market efficiency for the stock. In Halliburton, the Court rejected the “robust” view of market efficiency proposed by Halliburton. The Court emphasized that Basic’s presumption is based on the “fairly modest premise that market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices” and that the question of a market’s efficiency is not a yes/no “binary” question, but rather a spectrum analysis:

The markets for some securities are more efficient than the markets for others, and even a single market can pro­cess different kinds of information more or less efficiently, depending on how widely the information is disseminated and how easily it is understood. . . Basic recognized that market efficiency is a matter of degree. . .

In permitting defendants to present evidence of no price impact, the Court noted that market efficiency is merely indirect evidence of price impact, and defendants should be able to provide direct evidence of what plaintiffs seek to establish indirectly. Arguably, the door has now been opened for plaintiffs themselves to eschew the indirect method of market efficiency when there is clear evidence of price impact.

Supremes to Police: Keep Your Hand off that Cell Phone

ATTORNEY: JAYNE A. GOLDSTEIN
POMERANTZ MONITOR, JULY/AUGUST 2014

In an unanimous decision issued on June 25, the Supreme Court held that in most cases the police must obtain a search warrant prior to searching an arrestee’s cell phone. This opinion will affect many of our police organization clients, by hampering the ability of their members to obtain evidence when making an arrest. 

The “search incident to arrest” doctrine allows police to search, without a warrant, the area within the arrested person’s immediate control, to protect officer safety or to prevent escape or the destruction of evidence. The question here was whether an officer is also routinely allowed to rummage through all the files on the arrested person’s cell phone without a search warrant. The Court said no, recognizing that “modern cell phones, as a category, implicate privacy concerns far beyond those implicated by the search of a cigarette pack, a wallet or a purse.” 

The Court recognized that cell phones are repositories of huge amounts of personal information, such as personal messages, bank statements, photographs, notes, mail, lists of contacts and/or prescriptions. “The sum of an individual’s private life can be reconstructed through a thousand photographs labeled with dates, locations, and descriptions; the same cannot be said of a photograph or two of loved ones tucked into a wallet.” In short, “more or two of loved ones tucked into a wallet.” In short, “more than 90% of American adults who own a cell phone keep on their person a digital record of nearly every aspect of their lives…” In order to address safety concerns of the police during an arrest, the police remain free to examine “the physical aspects of a phone to ensure that it will not be used as a weapon,” but once secured, “data on the phone can endanger no one.” To prevent the suspect from destroying evidence on the phone, the Court said that police could remove the phone’s battery or could place the phone in an enclosure that would prevent it from receiving radio waves. The Court also left open the possibility that in exigent circumstances the police could search the phone immediately. 

However, our police officer clients tell us that, at times, immediate access to information contained on a cell phone could be crucial, leading, e.g., to the rapid capture of an accomplice through the reading of text messages, and waiting for a search warrant could permit the accomplice to get away. This ruling will surely lead to more cell phones being seized, to preserve them for possible future searches after a warrant is obtained.

Data Breach: A 21st Century Consumer Problem

ATTORNEY: MARK B. GOLDSTEIN
POMERANTZ MONITOR, JULY/AUGUST 2014

Pomerantz is representing a class of Target customers who were victimized by a widely-publicized hacking incident late last year. Thieves were able to sneak into customer data files maintained by the company and steal 40 million credit and debit cards numbers and 70 million customer records. Target announced the breach last December and said that consumers who shopped at Target between November 27 and December 15, 2013 were victimized. 

Since then there have been many similar breaches at other companies, including Sally Beauty, Michaels Crafts, and the popular Chinese restaurant chain P.F. Chang’s. Typically, thieves steal card data by hacking into cash registers at retail locations and installing malware that covertly records data when consumers swipe credit and debit cards through the machines. Often, the perpetrators re-encode the data onto new counterfeit cards and use them to buy expensive goods that can be resold for cash. Since last year, the cost of data breaches have risen on average 15%, to $3.5 billion. 

In response, consumers have filed class actions against the companies whose data bases were breached. Consumers and banks have filed more than 90 cases against Target, most of which allege that Target negligent¬ly failed to implement and maintain reasonable security procedures to protect customer data and that it knew, or should have known, about the security vulnerabilities when dealing with sensitive personal information. The cases also allege that Target did not alert customers quickly enough after learning of the security issue. Target did not disclose the data breach until weeks after it was announced by a security blogger. Then, Target revealed weeks later that even more customers were affected than originally announced. 

More recently, consumers sued P.F. Chang’s, alleging that it “failed to comply with security standards and allowed their customers’ financial information to be compromised, all in an effort to save money by cutting corners on security measures that could have prevented or mitigated the security breach that occurred.” The complaint claims that P.F. Chang’s failed to disclose the extent of the security breach and notify its affected customers in a timely manner. 

Data breach lawsuits are a relatively new phenomenon, so there is new law to be made here. There are practices that can cut down on these breaches. Most notably, since the Target breach, there has been much discussion of adopting the European-style “chip and pin” credit cards, whose information is more difficult to hack. These cards use a computer chip embedded in the smartcard, and a personal identification number that must be supplied by the customer. The benefit of the chip and pin system is that cloning of the chip (i.e. reproducing it on a counterfeit card) is not feasible. Only the magnetic stripe can be copied, and a copied card cannot be used on a PIN terminal. The switch to chip and pin credit cards in Europe has cut down theft dramatically. France has cut card fraud by more than 80% since its introduction in 1992. Chip and pin cards are yet to be adopted universally by American vendors. 

In the meantime, consumers should be vigilant with their credit card use, and frequently check their credit card statements. Additionally, consumers subject to data breach should act immediately and cancel their credit cards to limit their vulnerability.

BNP Paribas Joins the Bank Perp Walk

ATTORNEY: MICHELE S. CARINO
POMERANTZ MONITOR, JULY/AUGUST 2014

On June 30, BNP Paribas, France’s biggest bank and one of the five largest banks in the world, pled guilty to charges that it conspired to violate the International Economic Powers Act and the Trading with the Enemy Act. It agreed to forfeit approximately $8.9 billion traceable to its misconduct. This is the largest amount paid by any bank to settle allegations brought by the U.S. government and bank regulators. 

According to the Statement of Facts the Justice Department filed in the U.S . District Court in the Southern District of New York, from at least 2004 through 2012, BNP processed thousands of transactions through the U.S. financial system on behalf of banks and entities located in countries subject to U.S. sanctions, including Sudan, Iran, and Cuba. BNP structured the transactions to help clients move money through U.S. financial institutions while avoiding detection by U.S. authorities and evading sanctions. The practices were deliberate and pervasive, involving, for example, intentionally deleting references to sanctioned countries in order to prevent the transactions from being blocked, and using non-embargoed, non-U.S. “satellite banks” and complicated, multistep transfers to disguise the origin of the transactions. 

To make matters worse, U.S. authorities uncovered substantial evidence that senior executives knew what was happening and did nothing about it. In fact, in 2006, BNP issued a policy for all its subsidiaries and branches that “if a transaction is denominated in USD, financial institutions outside the United States must take American sanctions into account when processing their transac¬tions.” Then, in 2009 and 2010, when the U.S. DOJ and New York County District Attorney’s Office contacted BNP to express concern, the bank was less than cooperative in responding to requests for documents from BNP’s offices in Geneva. Overall, BNP allegedly processed 2,663 wire transfers totaling approximately $8.3 billion involving Sudan; 318 wire transfers totaling approximately $1.2 billion involving Iran; 909 wire transfers totaling approximately $700 million involving Cuba; and 7 wire transfers totaling approximately $1.5 million involving Burma. The New York Department of Financial Services places the estimates much higher, contending that a total of $190 billion of dollar-based transactions were concealed between 2002 and 2012. 

BNP potentially faced criminal, civil, and regulatory actions by various U.S. authorities involving potential penalties of about $19 billion. The $8.9 agreed-upon fine resolves all these related actions and ensures that BNP will not be subject to further prosecution for violations of U.S economic sanctions laws and regulations. While BNP may temporarily suspend payment of dividends to shareholders and may have to take steps to shore-up its capital ratio, the fine is not expected to have any long-term financial repercussions. Notably, BNP’s stock rose 3.6% the day the settlement was announced. 

But the plea agreement contains significant non-financial provisions. Specifically, BNP faces a five-year probationary period and is required to enhance it compliance policies and procedures. An independent monitor will be installed to review BNP’s compliance with the Bank Secrecy Act, Anti-Money Laundering Statute, and economic sanctions laws. In addition, BNP is banned from U.S. dollar-clearing operations through its New York Branch and other U.S. affiliates for one year for certain lines of business for certain BNP offices implicated in the conspiracy. BNP is not permitted to shuffle clients to other BNP branches or affiliates to circumvent this ban. This means that client relationships may be damaged, as clients take their business elsewhere. Furthermore, although there have not been any individual criminal prosecutions to date, 13 individuals were terminated and 32 others were disciplined as a result of the investigations and Plea Agreement. 

These measures are more likely to prompt reform, because they are implemented over a longer time period, require replacement of personnel, and change the way the business operates. They also signal to the industry what is required in this new regulatory environment. The fact that Deutsche Bank, itself a target of investigators, recently announced that it would be hiring 500 new employees in the U.S. in compliance, risk, and technology is not a coincidence. Other banks likely will follow suit. If that occurs, it may be the most positive result to come out of the BNP settlement for all investors.

Lawsuits Against GM are Mounting

POMERANTZ MONITOR, JULY/AUGUST 2014

Last February, General Motors decided to recall certain models due to defects in the ignition switches that can cause the engine and electrical system to shut down while the vehicle is in motion. If that happens, essential safety features such as airbags, power brakes, and pow¬er steering are all cut off. Since then, GM has recalled approximately 6 million cars due to the faulty ignition switch and nearly 29 million worldwide for a range of defects. 

Similar to the cases filed in the wake of the Toyota recalls, at least 85 lawsuits have been filed against GM seeking recovery of the declines in resale value on the recalled vehicles caused by revelation of the ignition-switch defect. With such lawsuits pending all over the country, in May a court in Chicago sent all of them to New York for consolidated pretrial proceedings. 

But many of these cases may not go forward at all. GM has claimed that economic loss cases are barred by a “discharge” order entered in its bankruptcy case in 2009 that, it argues, insulates the company from depreciation-related liability claims for automobiles sold before 2009. Plaintiffs’ lawyers claim this violates constitutional due-process rights, since GM allegedly knew about the ignition-switch problems at the time of the bankruptcy but kept them secret for years. A ruling on this issue is expected by the end of the summer. 

 GM also has to contend with its own shareholders, some of whom have sued the company and its top executives and board members. On March 21, 2014, Pomerantz filed the first and (so far) only securities class action in the Eastern District of Michigan on behalf of shareholders who purchased GM stock between November 17, 2010—the date of GM’s $20.1 billion initial public offering—and March 10, 2014. According to the complaint, GM’s misstatements and omissions about the ignition-switch defect resulted in “significant reputational and legal exposure” and caused the share price to tank “wiping out billions in shareholder value” when the true extent of the defect was disclosed. Four movants filed motions seeking appointment as lead plaintiff in the securities class action, including clients represented by Pomerantz. 

Oral argument is scheduled in August 2014.

Supremes Finally Weigh in on Crucial Securities Law Issues

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, JULY/AUGUST 2014

At the end of its term in June, the Supreme Court issued two significant rulings relating to securities laws issues. 

The main event was the decision in Halliburton, which addressed the continued viability of the “fraud on the market” presumption in securities fraud cases. Without the benefit of that presumption, most securities cases could not be certified as class actions. 

After the oral argument in Halliburton in March, we pre­dicted that the Court would not throw out the fraud on the market presumption, but would probably allow defendants to try to rebut that presumption at the class certification stage, if they could show that the fraud did not actually distort the market price of the company’s stock. Our pre­diction was right. In June, the Court issued its ruling, and now “price impact” will be a potential issue on class certification motions. If the company made significant misrepre­sentations about its business or financial results, it will be strange indeed if that had no effect on the price of its stock. 

Typically, when allegedly false statements are released by the company, they do not have any immediate effect on the stock price, because they do not deviate much from previously disclosed information. It is the bad information, which is covered up or falsified, that has the impact, and that impact can be measured when the truth finally does come out, in the so-called “corrective disclosure.” We be­lieve that defendants, in order to rebut the fraud on the market presumption, are going to have a heavy burden to prove that the corrective disclosures had no significant effect on the market price of the company’s stock, and that any price movements that did occur at that time were caused completely by market-wide fluctuations in share prices, by general market conditions, or by some other “bad news” unrelated to the fraud. 

The Court’s other decision came in Fifth Third Bancorp, which concerns the requirements for pleading a breach of fiduciary duty claim under ERISA against retirement plan trustees who continued to invest assets into stock of the employer company despite warning signs of impending catastrophe. 

Under ERISA, trustees of retirement plans have an obligation to act with prudence in investing plan assets or in making investment recommendation to plan participants. In one sense, such claims are easier to win than run of the mill securities fraud claims because there is no scienter requirement. 

But what level of knowledge actually is needed to trigger culpability for trustees? In the past, the courts gave the trustees of an employee stock ownership plan (“ESOP”) a “presumption of prudence” when they decided to invest, or continue to invest, in company stock. To overcome that presumption, they previously required that plaintiff plead, with particularity, that the trustees ignored facts showing that the company was on the brink of financial collapse. The only open question, we thought, was whether the presumption of prudence applied at the motion to dismiss stage, or only later, at trial. 

We thought wrong. To everyone’s surprise, the Court has now thrown the presumption of prudence out the window not only at the pleading stage of the case, but at every stage of the case. 

Instead, the Court set forth a new set of considerations. It held that ERISA claims cannot be based on the theory that the trustees ignored publicly available information about the company or its line of business. But where, as in most cases, the trustees (who are typically company executives) had adverse non-public information about the company, courts must balance the requirements of prudence with the laws against trading on inside information, and with the possible adverse consequences to the company if its ESOP suddenly stops buying company shares. 

In other words, it is going to take years to figure this out.

Fannie Mae and Freddie Mac Secure $9.3 Billion Settlement With B of A

ATTORNEY: JESSICA N. DELL
POMERANTZ MONITOR, MAY/JUNE 2014

In March, Bank of America (“BofA”) agreed to pay $9.3 billion to settle four settle lawsuits filed by the Federal Housing Finance Agency (“FHFA”). The lawsuits alleged that the bank misrepresented risks inherent in billions of dollars in mortgage-backed securities that it sold to Fannie Mae and Freddie Mac. Under the terms of the settlement, BofA subsidiaries Countrywide Financial Corp and Merrill Lynch will pay $5.83 billion and repurchase another $3.2 billion in mortgage-backed securities, FHFA said. 

As many will recall, FHFA filed these lawsuits among seventeen similar cases in its capacity as conservator for Fannie Mae and Freddie Mac, after it was reported that Fannie and Freddie lost up to $30 billion in the subprime mortgage market. Cases were brought against all the big banks: JPMorgan, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, and UBS. To date, the lawsuits have recovered more than $20 billion. Seven of those cases are still pending. The recovery is impressive, but brings renewed scrutiny to the whole fiasco, including the unclean hands of some Fannie and Freddie executives, who had long insisted that Fannie and Freddie’s involvement with subprime loans was minimal. We now know that Daniel Mudd and Richard Syron, chief executives of Fannie and Freddie, were aware of the exposure and the risks. Internal documents released at Congressional hearings showed that both ignored repeated warnings from internal risk officers. In March 2006, Enrico Dallavecchia, Fannie Mae’s chief risk officer, wrote to CEO Daniel Mudd to say, “Dan, I have a serious problem with the control process around subprime limits.” 

Fannie’s role goes back to the beginning of the subprime phenomenon. The New York Times journalist Gretchen Morgenson reported that Fannie had actually recruited Countrywide to make the loans to help fulfill Fannie’s own “affordable housing” goals. In return, Countrywide was given a discount on fees. By 2004, Countrywide was Fannie’s top mortgage supplier, accounting for 26 percent of the loans purchased by Fannie. Fannie executives were also among the dozens of employees who enjoyed steeply discounted mortgage rates from Countrywide. The House Oversight and Government Reform Committee found that 153 “VIP loans” had been issued to 27 employees. 

When the government took over and ousted the executives, Fannie and Freddie appeared to be winding down and out. But wait. Mel Watt, head of FHFA, just signaled that Fannie and Freddie may not be exiting the mortgage industry, but instead might be enjoying something of a renaissance. As the Times reported, in a quote attributed to Jim Parrott of the Urban Institute, “(Watt’s) message was he will turn from focusing on the enterprises as institutions in intentional decline to institutions that should be better prepared to form the core of our system for years to come… this shift in focus ripples through the many decisions announced in the speech and signals a watershed moment in the brief history of the agency.” 

The BofA settlement plays a significant role in the appearance of renewal: of the $5.7 billion Fannie Mae reported as comprehensive income for the first quarter, $4.1 billion was revenue from legal settlements, nearly double the $2.2 billion that Fannie had garnered in 2013. Freddie Mac also reported $4.9 billion in benefits from legal settlements. 

This is only the latest in a seemingly endless cycle of banking industry misdeeds. In addition to misrepresentations about mortgage backed securities, we have money laundering, manipulations of LIBOR, aiding and abetting tax evasion, circumventing the sanctions on Iran, the London Whale fiasco, and a host of other high crimes and misdemeanors. That public outrage has somewhat waned on the matter might be attributed to sheer exhaustion. We have not seen the last of it. Not by a long shot.

The Struggle Over the Use of Confidential Witnesses

ATTORNEY: LEIGH H. SMOLLAR
POMERANTZ MONITOR, MAY/JUNE 2014

In 1995, Congress passed the PSLRA to eliminate what it considered to be abusive practices in federal securities litigation. Among other things, it raised plaintiffs' burden in pleading federal securities fraud actions. It heightened the standard to plead scienter, requiring that the complaint plead facts "giving rise to a strong inference that the defendants acted with the required state of mind." At the same time, it instituted an automatic discovery stay until resolution of the defendant's motion to dismiss. In combination, these requirements can pose a significant hurdle to securities plaintiffs in making sufficiently specific allegations of wrongdoing. 

Plaintiffs often attempt to meet this burden by relying on statements from former company insiders. Because they often are wary of the possibility of retaliation from their former employers, or because they are still employed, or hope to be employed, in the same line of business, they typically demand that their names be kept confidential, and complaints usually refer to them as “CWs,” or confidential witnesses. Ultimately, their names must be disclosed to defendants, which must be relayed to the CW at the time of the interview. In ruling on motions to dismiss, some federal judges have expressed discomfort in relying on statements of anonymous CWs, worrying that they may not be in a position to know what they are talking about, or that they may be disgruntled former employees looking for revenge while hiding behind a smokescreen of anonymity. Other federal judges believe that CWs are reliable where there is strength in the number of confidential witnesses, their corroborative aspects, and the specific descriptions of each of them. Many cases have required that allegations based on information from CWs must disclose enough about them to substantiate that they were in a position to know what they are talking about. This requirement, of course, makes it easier for the former employers to figure out their identity. Once that happens, defendants have often tried to discredit their allegations or even to contact them to pressure them to “recant.” Southern District of New York Judge Jed Rakoff, a leading jurist in securities litigation, has noted that heightened pleading standards in securities class actions have left confidential plaintiffs' witnesses in a tough spot—sometimes lured by plaintiffs lawyers to exaggerate wrongdoing, and/or unfairly pressured by defendants to recant truthful allegations. 

Defense attorneys have different theories on what can be done to alleviate these concerns; however, many of these “theories” are not practical, such as, for example, requiring plaintiffs’ lawyers to include a sworn declaration from a confidential witness verifying the allegations in the complaint. Such disclosures would reveal the name of the signatory, defeating the protection of confidentiality. As Judge Rakoff noted, once the identities of confidential witnesses are known, they can then be “pressured into denying outright the statements they had actually made.” In fact, fear of retaliation by the former employer accounts for most of witness recantation. Moreover, any requirement that former employees sign a formal legal document, especially under oath, would have a chilling effect on their willingness to reveal what they know. 

Defense attorneys have also suggested that plaintiffs’ lawyers themselves, and not just investigators, participate in the witness interviews. While this might help ensure that the complaint’s summary of CW allegations is accurate, it would be impractical. The involvement of a lawyer, rather than an investigator alone, would be a deterrent for some CWs. Investigators would have to coordinate meetings among counsel and the witnesses, making information collection much more burdensome and time-consuming. 

There are, however, some steps that plaintiffs’ counsel can take to make the CW process more reliable. Investigators should be required to state clearly that they work for a law firm adverse to the former employer, and that they do not represent the witness. They should also be required to ensure that the witness is not currently employed with the defendants and that there is no confidentiality agreement that precludes disclosure. Counsel should also make sure that the information from the CW is consistent with all of the other evidence gathered in the case. The court’s decision in Tellabs III provides that corroborating evidence is the key to CW allegations. Because the Reform Act requires plaintiffs to plead the details of the CW’s position and ability to know the facts alleged, the defendants often can figure out who the CWs are, and “reach out” to them. As Judge Rakoff has stated, the witness often feels pressure to recant or water down what s/he has said. If defendants succeed in this effort and the complaint is dismissed, defendants often file a Rule 11 motion seeking sanctions against plaintiff’s counsel. Such “recantation” should not be the basis for a Rule 11 motion. Plaintiffs’ attorneys should not be deterred by defendants’ latest attempt to dismiss valid securities fraud cases through Rule 11 motions. However, plaintiffs’ counsel should take care to ensure that the allegations in any complaint are accurate, and move for cross-sanctions where appropriate.

Lululemon Ordered to Produce Records of Its Stock Trading Plan

ATTORNEY: SAMUEL J. ADAMS
POMERANTZ MONITOR, MAY/JUNE 2014

In a dishearteningly familiar scenario, a couple of years ago the chairman of lululemon athletica dumped a large number of company shares he owned, a few hours before the company announced that its CEO was resigning. By trading ahead of the news, the Chairman saved about $10 million. In defending himself from the charge that he traded the shares on inside information, the company’s chairman had publicly claimed that he had sold a big block of his company stock pursuant to his 10b5-1 stock trading plan, and not because he had inside information about impending bad news. 

Pomerantz represents a shareholder of lululemon, and we and our client were interested in finding out whether the chairman’s assertions were true. So we brought a “books and records” action, asking to inspect the company’s records relating to the plan and to this particular transaction. 

Deciding an issue of first impression in Delaware, the Chancery Court recently granted our request, holding that the circumstances of this transaction raised enough suspicion to warrant inspection. The importance of the inside information was beyond dispute. The company, which is known for its yoga apparel, had recently announced a highly embarrassing recall of approximately 17 percent of its women’s workout pants. News of the recall caused the price of lululemon common stock to drop almost 7% within two days, which, in turn, led to the resignations of several key executives and the termination of the company’s Chief Product Officer.

Then came the big blow: soon afterwards, the company’s Chief Executive Officer announced his resignation. That news caused lululemon’s stock to drop almost 22% in the span of a few days. The same day that the lululemon Board of Directors learned of the CEO’s imminent departure, but prior to any public announcement of it, lululemon’s chairman sold over 600,000 shares of company stock for more than $49.50 million. Had he waited to sell until after the public announcement, he would have received a little more than $39 million—approximately $10 million less. This looks a lot like insider trading.

Delaware law allows stockholders of public companies to inspect certain corporate documents, if the stockholder can assert a proper purpose and satisfy other technical requirements. After lululemon refused our requests, Pomerantz filed a complaint, known as a Section 220 action, to compel lululemon to produce certain documents relating to the stock trading plan. Delaware courts have encouraged stockholders to file Section 220 actions as investigatory tools before commencing other forms of litigation, such as derivative actions. 

In response to the Section 220 action, lululemon argued that stockholders had no basis to question the chairman’s stock sales because the trades were executed by the chairman’s broker, who was granted sole discretion under a trading plan to sell shares on behalf of the chairman over a period of time. The plan, known as a 10b5-1 stock trading plan, is implemented by corporate insiders in an attempt to insulate themselves from allegations of insider trading.

Pomerantz, on the other hand, pointed to the fact that the stock sale at issue here was the single largest stock sale conducted on the chairman’s behalf since the establishment of his pre-arranged stock trading plan in late 2012, raising suspicions as to both the timing and the size of the sale.

The Court found that the 10b5-1 stock trading plan did not preclude potential liability for insider trading. The Court also found that there were “legitimate questions as to the propriety” of the sale and ordered the production of certain related documents. In addition to acknowledging that the chairman’s sale was the single largest he had made under the 10b5-1 stock trading plan, the Court also inferred that the number of shares sold was the maximum amount that the chairman could have sold in any one month under the terms of the 10b5-1 plan. These facts allowed the Court to infer a “credible basis” that wrongdoing may have taken place in connection with the June 7, 2013 stock sale. Accordingly, the Court ordered lululemon to produce the 10b5-1 trading plan, as well as certain other documents relating to the stock sale.

The Court’s holding that the mere existence of a 10b5-1 trading plan will not serve as an absolute defense for defendants and will not preclude a finding of a credible basis for an inference of wrongdoing, was an important victory for stockholders of public companies.

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.