Pomerantz Achieves Additional Victories for BP Investors

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, NOVEMBER/DECEMBER 2014

BP p.l.c. is a U.K. corporation with substantial U.S. operations. Its common stock trades on the London Stock Exchange (LSE), while its American Depository Shares (ADS) trade on the New York Stock Exchange (NYSE). In April 2010, the Deepwater Horizon offshore drilling rig chartered to BP exploded and sank, killing 11 people and spilling roughly five million barrels of crude oil into the Gulf of Mexico before the blown well was capped. 

Since 2012, Pomerantz has been pursuing ground-breaking claims on behalf of nearly three dozen institutional investors to recover losses in both BP securities stemming from allegedly fraudulent pre-spill statements about BP’s safety reforms and post-spill statements about the scope of the spill. 

The challenge has been to craft a legal strategy that would permit our clients to pursue claims for their LSE-traded BP shares in U.S. courts, notwithstanding the U.S. Supreme Court’s 2010 decision in Morrison v. Nat’l Australia Bank Ltd., which foreclosed use of the U.S. federal securities laws to pursue claims over foreign-traded securities. Throughout the litigation, BP has sought to get the cases dismissed, for litigation in foreign courts with disadvantageous rules, relying on Morrison and a litany of factual and legal arguments. As the Monitor reported last year, Pomerantz already defeated BP’s motion to dismiss claims brought by our first tranche of clients, three U.S. public pension funds. 

This time, in a series of landmark rulings by U.S. District Judge Keith P. Ellison of the Southern District of Texas in October 2014, Pomerantz defeated BP’s motion to dismiss claims brought by our second tranche of clients. Specifically, the court rejected BP’s attempts to: (i) dismiss foreign investors’ lawsuits so as to require them to be litigated abroad; (ii) extend the reach of a U.S. federal law so as to require dismissal of both foreign and domestic investors’ English common law claims, and (iii) shorten the time periods within which a U.S. federal securities claim (for our clients’ ADS losses) could be filed. Each of these cutting-edge victories preserved claims for our clients. 

Pomerantz Secures Rights of Foreign Investors to Sue in U.S. Courts

In the most significant October 2014 ruling, Pomerantz has now established the right of foreign investors who  purchased foreign-traded shares of a foreign corporation to pursue foreign-law claims for securities fraud losses in a U.S. court. This hard-fought outcome represents the first time after the Supreme Court’s Morrison decision that such claims have been permitted to proceed in a U.S. court. 

A year ago, Pomerantz defeated BP’s motion to dismiss similar claims by U.S.-based pension funds, when Judge Ellison held that their claims had sufficient ties to the U.S. to warrant adjudication here – rather than in England – even after he decided to apply English common law. At that time, facing only U.S. plaintiffs, he also did not credit BP’s arguments that Morrison or the U.S. Constitution prohibited such an outcome as impermissible regulation of foreign commerce. 

This time, BP, once again invoking the Morrison holding, sought to dismiss the cases of Pomerantz’s foreign clients under the same forum non conveniens doctrine, so that they would have to litigate their cases in English courts. Given the English system’s restrictions on contingent fee litigation and its imposition of a “loser pays” approach on legal fees, this argument posed a serious threat to the viability of our clients’ cases. BP’s argument, boiled down, was that because these clients were “foreign,” their cases necessarily had a stronger nexus to England – even though many of our “foreign” clients hailed from nations outside the U.K. (and indeed outside of Europe). 

After extensive briefing, Pomerantz Partner Matthew Tuccillo argued against dismissal in a multi-hour hearing in July 2014. He successfully argued that Pomerantz’s foreign clients deserved the same deference on their choice of forum as our U.S. clients. Drawing upon extensive advance due diligence that he and Pomerantz Associate Jessica Dell had conducted with the outside investment management firms that serviced our clients, Mr. Tuccillo then persuaded Judge Ellison that our foreign plaintiffs’ cases had considerable ties to the U.S., such that BP had not met its burden to disrupt their forum choice.

Pomerantz Defeats BP’s Attempt To Extend SLUSA Dismissal to Foreign Law Claims 

BP also argued that the Securities Litigation Uniform Standards Act (or “SLUSA”), which in certain instances requires dismissal of securities claims brought under U.S. state law, should be extended to apply to foreign-law claims. Under BP’s interpretation, SLUSA would have mandated dismissal of the English common law claims of all of Pomerantz’s foreign clients and U.S. non-public clients. 

Here, Pomerantz forcefully argued that the Exchange Act of 1934 expressly defined the “State” law claims to which SLUSA applies as those brought under the laws of “any State of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, or any other possession of the United States.” As Mr. Tuccillo argued to Judge Ellison in July, “Defendants ask this Court to do nothing less than to rewrite, selectively, an unambiguous statute that was duly elected by Congress to suit their purposes, and the Court should decline to do so.” Judge Ellison agreed. 

Judge Ellison also rejected BP’s argument that the original pleading of Texas law claims (later amended to be English law claims) and/or the use of Texas choice of law rules to identify English law as the governing substantive law served to trigger SLUSA’s dismissal provisions. In doing so, he validated our read of the existing split in the national case law on SLUSA’s application. 

These rulings were significant, as they preserved the lawsuits of dozens of BP plaintiffs, including both foreign and domestic institutions represented by Pomerantz and other firms. 

Pomerantz Establishes a Broader Time Period for Exchange Act Claims

The court also ruled in Pomerantz’s favor as regards the U.S. federal securities claims being pursued by some of our foreign and domestic clients who purchased BP’s ADS on the NYSE. Normally, the pendency of a class action will serve to toll the applicable statute of limitations for individual plaintiffs who may later pursue the same claim. Here, a parallel class action has sought to pursue, on a class-wide basis, a claim under Section 10(b) of the Exchange Act for losses in BP’s NYSE-traded ADS (although, notably, the court has more recently failed to certify most of the proposed class). 

BP had argued that Pomerantz’s clients waived this tolling by filing their individual lawsuits prior to the adverse decision on class certification in the class action. BP also argued that in any event, the statute of repose for our clients’ Exchange Act Claims, which is normally intended to be the “outside” date by which a claim must be filed, was never tolled. These arguments, if credited, would have served to bar as untimely our clients’ Exchange Act claims. 

Judge Ellison sided with us on both arguments, thereby preserving tolling of both the statute of limitations and the statute of repose. The repose ruling in particular was significant, because there is a deep divide in the case law nationally, and the Supreme Court had been poised to hear the issue this term (before the case raising it was settled). These rulings permit our clients to continue to file Exchange Act claims regarding their BP ADS losses, a very valuable right in the wake of Judge Ellison’s decisions denying class certification for most of the time period at issue in the parallel class action.

The Path Ahead

Together, these landmark rulings have highlighted a new path toward recovery in U.S. courts for foreign investors pursuing foreign law claims regarding their losses in foreign-traded securities. Ever since Morrison was decided in 2010, no other case like this has survived. 

Pomerantz serves on a court-appointed Steering Committee overseeing all individual actions against BP by institutional investors and serves as the sole liaison with the court and BP. Our third tranche of plaintiffs’ cases is already on file, and discovery is anticipated to commence in all cases in the near future. 

Pomerantz currently represents nearly three dozen institutional plaintiffs in the BP litigation, including U.S. public and private pension funds, U.S. limited partner-ships and ERISA trusts, and pension funds from Canada, the U.K., France, the Netherlands, and Australia. The BP litigation is overseen by Partners Marc Gross, Jeremy Lieberman, and Matthew Tuccillo. 

To Salt or Not to Salt, That Is the Question

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014

Starboard Value LP, a hedge fund, is trying to take over Darden Restaurants, the parent company of Olive Garden restaurants. Recently it made history, of a sort, when it sent out a 300 page proxy statement asking shareholders to vote for its 12 nominees to the Darden board. Its solicitation was a soup to nuts critique of everything it believes is wrong with Olive Garden and its recipe for fixing it all. What makes it noteworthy is its scathing attack on the restaurants themselves. Most notable: it expresses outrage that Olive Garden does not add salt to the water it uses for cooking its pasta, a practice it believes to be universal everywhere else. Starboard characterized this non-salting as an “appalling decision [that] shows just how little regard management has for delivering a quality experience to guests.” This generated a lot of buzz from casual observers who could care less about Starboard’s takeover efforts. Most people apparently agree that failing to salt the water is a serious faux pas.

Not content with pouring salt on this open wound, Starboard also criticized Olive Garden for oversupplying guests with unlimited breadsticks and salad. While not saying much about the salting issue, Darden did vigorous¬ly debate the issue of the endless breadsticks. Starboard had contended that Olive Garden was wasting millions of dollars by delivering more breadsticks to each table than customers normally eat, though it has said it doesn’t want to get rid of unlimited breadsticks. Darden’s rejoinder: its breadstick generosity “an icon of brand equity since 1982″ and claims that it “conveys Italian generosity.” 

Institutional Shareholder Services and Glass Lewis, the two leading proxy advisory firms, have both rec-ommended that their institutional clients vote in favor of all 12 Starboard nominees. The vote is next month. 

We’ve been to Olive Garden. Salt and breadsticks are the least of their problems.

Is Da Fix In?

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR: SEPTEMBER/OCTOBER 2014

About two years ago, the Commodities Futures Trading Commission started an investigation into whether the world’s largest banks had conspired to manipulate ISDA¬fix, a benchmark similar to LIBOR, which in this case is used to set rates for trillions of dollars of complex financial products, such as interest-rate swaps. Much of the evidence collected by the CFTC seems to have been provided as a byproduct of the LIBOR rate-fixing investigation. Pomerantz currently represents a number of banks and financial institutions in a class action on behalf of lenders arising out of the LIBOR rate-rigging scandal.

A few weeks ago, the press reported that the CFTC reported to the Justice Department that it had found evidence of criminal collusion in manipulating ISDAfix rates. 

Here we go again. 

Until this year, the dollar-denominated version of the ISDAfix rate was set daily by ICAP, a brokerage firm, based on price quote data submitted by banks. Once the CFTC started investigating, ICAP lost that central role.

Bloomberg News reported last year that the CFTC had found evidence that traders at Wall Street banks had instructed brokers to buy or sell as many interest-rate swaps as necessary to rig ISDAfix, by moving it to a predetermined level. Doing so helped banks reap millions of dollars in trading profits, at the expense of companies and pension funds.

Since then, the Alaska Electrical Pension Fund has filed a civil action accusing 13 banks, including Barclays, Bank of America and Citigroup, of conspiring to fix ISDAfix. The Fund claimed the banks did this in order to manipulate payments to investors on the derivatives. The banks’ alleged actions affected trillions of dollars of financial instruments tied to ISDAfix, including so-called “swap¬tions,” which enable institutions to hedge against moves in interest rates. By fixing the rate, the banks apparent¬ly hoped to profit on transactions in these instruments.

The Alaska Fund further alleges that the banks coordi¬nated their scheme through electronic chat rooms and other private communications channels, and the result was that, as far back as 2009, they often submitted identical rate quotes to ICAP, down to the thousandth of a ratings point. The Fund alleges that “even if reporting banks always responded similarly to market conditions, the odds against contributors unilaterally submitting the exact same quotes down to the thousandth of a basis point are astronomical. Yet, this happened almost every single day between at least 2009 and December 2012.” 

The Feds want to throw some people in jail to show that they are tough on Wall Street after all. Maybe they have found some ripe targets.

Pomerantz Defeats Motion to Dismiss in Accounting Row

POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014

Pomerantz recently scored a significant win for investors in a securities class action involving Avid Technology, a software company. Our complaint alleges that Avid, certain of its officers and directors and its long-time outside auditors Ernst & Young committed accounting fraud. On June 27, 2014, U.S District Judge William Young of the District of Massachusetts denied motions to dismiss filed by all the defendants.

This case presents a rare victory for investors on a motion to dismiss where a company has announced that it will have to file restated financial results but, over a year later, had still failed to file them when the complaint in the action was filed (well after the filing of the complaint). In such cases it is often much harder to plead the fraud in sufficient detail, because it is not until the restatements are issued that the company spells out in detail what was wrong with those original results, and why. Even more importantly, the court refused to let Avid’s auditors off the hook for restatements that, when they come, will affect three years’ worth of software contract revenues.

In 2013, Avid announced that it would restate three years’ worth of financial results because it had improperly recognized revenue from post-contract customer support (“PCS”). Avid revealed that it improperly recognized PCS up front, rather than ratably over the life of the contracts, as accepted accounting standards require. Delayed recognition of PCS in this manner is a fundamental accounting rule for software companies such as Avid. Its announcement said that it would conduct a comprehensive review of the accounting treatment for five years’ worth of software contracts.

Avid had not restated its financial results as of the filing of the complaint. The company tried to take advantage of its own delays, claiming that the allegations were not specific enough because they did not identify specific PCS contracts that were mishandled. We were forced to rely on Avid’s disclosures when it originally announced the need to restate its financials, which were not very specific. However, Judge Young was persuaded that Avid’s repeat¬ed statements about proper revenue recognition practices with respect to PCS sufficiently alleged that material misstatements had been made.

With respect to scienter, the court highlighted statements found in conference call transcripts in which Avid’s CEO demonstrated his knowledge of PCS accounting requirements, as well as allegations from a confidential witness who claimed that the CEO himself decided to recognize PCS up front, rather than ratably. The Court also found persuasive our argument that a compelling inference of scienter was bolstered by the magnitude of the restatement—especially considering that, even though a year had passed since announcing the restatement, the restatements was not complete at the time of the motion to dismiss.

Finally, the Court did not let Ernst & Young, Avid’s long-time outside auditors, escape responsibility. The court was persuaded that the length and magnitude of the errors, the systematic lack of internal controls, and the long-standing relationship between the auditors and Avid sufficiently alleged recklessness as to the auditors. 

Avid recently filed the restated financial results, and the changes were massive. Before 2011, Avid’s net accumulated losses were $495.3 million; after the restatement, Avid’s pre-2011 net losses total $1.246 billion, reflecting a previously-reported understatement of net losses of 60%. Avid made public, only last week, the fact that the restatement dates back to 2005, restates almost $900 million of previously-reported revenues, and involves a whopping 5 million transactions—apparently all, or nearly all, of Avid’s software contracts since 2005. Because Avid’s restatement and on-going internal control failures are broader and deeper (and have come to light later in time) than we could have anticipated, we likely will amend the complaint to encompass the massive fraud revealed by the restatement. 

Pomerantz currently is engaged in discovery with the company and its auditors. Depositions are set to begin shortly.

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?