Eighth Circuit Makes it Too Easy to Rebut Presumption of Reliance

ATTORNEY: MURIELLE J. STEVEN WALSH
POMERANTZ MONITOR MAY/JUNE 2016

In a case called Halliburton II, the Supreme Court reaffirmed the validity of the presumption of reliance under the  fraud on the market theory,” which is critical to securities plaintiffs’ ability to show class-wide reliance on a company’s misstatements. But it also held that a defendant may rebut the presumption of reliance by showing that the alleged misstatements had no “price impact,” i.e. did not affect the price of the stock in question. Under Fed. R. Evid. 301, “the party against whom a presumption is directed has the burden of producing evidence to rebut the presumption,” but the rule does not specify how much evidence must be produced, and Halliburton II did not shed any light on this issue, either. This raises the question: how much evidence is enough to rebut the presumption? Is any showing enough?

In Best Buy, the Eighth Circuit recently handed down the first federal appellate decision to attempt to answer those questions. It is widely accepted that price impact may be proven by evidence showing that either the price increased after an alleged misstatement or that the price decreased after the truth was revealed. In Best Buy, plaintiffs met one but not both of these elements. Specifically, plaintiffs challenged three statements the company made on September 14, 2010. First, it issued an early morning earnings release saying that it was increasing its EPS guidance by ten cents. In response, the stock price opened for trading at a price higher than the previous day’s close. The next two statements were made later that morning in a conference call with analysts, when the CEO and CFO stated that the company’s earnings were “essentially in line with our original expectations for the year” and that it was “on track to deliver and exceed our annual EPS guidance.” The stock price did not increase after the conference call statements. The allegedly corrective disclosure occurred on December 14, 2010, when Best Buy announced a decline in its fiscal third quarter sales and a reduction in its 2011 fiscal year EPS guidance, causing a 15% stock price drop.

In an earlier decision, the district court held that the first misstatement, the early morning earnings release, was not actionable because it was a “forward-looking statement” with appropriate “cautionary language,” and was therefore covered by an Exchange Act “safe harbor” provision. The other two misstatements survived that motion and were the focus of the class certification motion, where defendants claimed that the misstatements did not move the market and that the presumption of class-wide reliance had therefore been rebutted.

In support of its class certification motion, plaintiffs submitted an expert report saying that Best Buy’s stock price had increased in reaction to all three September 14th statements, but did not parse how much of the increase was attributable to each individual statement. Defendants’ expert report said that there was no price impact from the conference call statements because the stock price increased only after the earlier morning press release, and not after the conference call occurred several hours later. In reply, plaintiff’s expert conceded that the conference call statements did not cause an immediate stock price increase, because it essentially just confirmed the representations in the previous early morning release. However, he said that the false statements that came afterwards maintained the artificially inflated price caused by that release.

The district court certified the class, recognizing that price impact (and therefore reliance) can be shown by a price decline in response to a corrective disclosure, and that defendants had failed to make any showing that Best Buy’s stock price did not in fact decrease after the negative news released on December 14th. The district court also found that the alleged misrepresentations could have prolonged the inflation of the price, or slowed the rate of fall, satisfying the “price maintenance” theory of “price impact.”

The Eighth Circuit reversed, pouncing on plaintiffs’ expert’s concession that the conference call statements did not move the stock price, and found that this was “strong evidence” sufficient to negate price impact and therefore class- wide reliance. The majority flatly rejected plaintiffs’ additional contention that the conference call statements caused a gradual increase in the stock price between September and December as “contrary to the efficient market hypothesis.” And the court largely ignored plaintiffs’ additional evidence of price impact, shown by the stock price decline after the corrective disclosure.

This decision is troublesome for several reasons.  Courts have generally found a presumption of reliance exists when shareholders show stock prices fell in response to a corrective disclosure. The Eighth Circuit did not follow that principle, focusing instead only on the front end of the supposed fraud, when misstatements had no obvious impact on the share price. The Eighth Circuit also explicitly rejected the price maintenance theory, which has been heavily relied upon by plaintiffs seeking to prove price impact where misstatements did not move the price of a company’s stock.

A decidedly pro-defendant decision, Best Buy shows that defendants facing securities fraud class actions can significantly narrow or eliminate liability during the class certification phase based on price impact arguments. If followed by other circuits, the decision could have significant negative consequences for securities actions, because false positive statements by a company often have little or no immediate impact on the company’s stock price.

Court Denies Motion to Dismiss Our Staar Surgical Complaint

ATTORNEY: MICHAEL J. WERNKE
POMERANTZ MONITOR MAY/JUNE 2016

Judge Fitzgerald of the Central District of California recently denied defendants’ motion to dismiss our action involving STAAR Surgical Company. The action alleges that the company, its CEO and its vice president of regulatory affairs violated section 10(b) of the Securities Exchange Act as well as section 20(a), the “control person” provision.

STAAR is an FDA regulated company that designs, manufactures and sells implantable lenses to correct vision problems. In March of 2014, the company told investors that it believed that it was in compliance with all applicable FDA regulations despite the fact that an FDA inspection of STAAR’s plant was ongoing at the time and the inspector had repeatedly told management that numerous and significant FDA violations had been found. These violations are particularly important to STAAR and its investors because STAAR had a major new lens that was going before the FDA Advisory Panel in mid-March, and these violations would likely delay its approval. The company did not disclose these reports of violations, and investors did not hear about them until the FDA posted them on its website months later. At that point, STAAR’s stock price plunged 17.5%

 Defendants’ main argument for dismissal was that at the time they made their representations of compliance the violation reports were only preliminary and had not been formalized in written notices. The court rejected that argument, holding that because the FDA inspector had repeatedly identified the violations orally to management, defendants would have known that their statements of compliance would mislead investors. The court also held that the company had a duty to disclose the subsequent Warning Letter from the FDA, which stated that the new lens would not be approved by the FDA until the violations were remedied. The court held that, even though the company did not make any further “compliance” representations when it received the Warning Letter, it nevertheless had a duty to correct its prior statement on that subject.

This opinion is significant because it shows that a statement of compliance can be misleading as a result of the FDA inspector orally identifying violations. Prior cases had dealt with the company having receipt of a written notice of violation or Warning Letter.

Supremes: Statistical Averages Can Provide a Basis for Class-Wide Liability

ATTORNEY: AATIF IQBAL
POMERANTZ MONITOR MAY/JUNE 2016

In Tyson Foods v. Bouaphakeo, the Supreme Court upheld the use of statistical sampling evidence in class actions, at least where such evidence would have been admissible in an individual action. Defendants had argued that such statistical methods improperly treated each individual as if he or she matched a statistical average, thus manufacturing predominance by assuming away the very individualized differences that made class-wide litigation inappropriate in the first place. The Court rejected this premise and focused instead on the relevance of the statistical evidence to the substantive claim at issue. It held that, if a given class member could have used the statistical evidence to obtain a favorable jury verdict in an individual action, then the class could use it the same way. It was up to the jury to decide, in light of all of the evidence presented, whether the statistical average was probative of the situation of each class member.

Particularly under the specific facts of the case, this ruling was a straightforward application of evidentiary common sense. Nevertheless, it was generally seen as a significant victory for the plaintiffs’ bar.

The case involved workers at a pork processing plant who claimed they were not paid overtime for time spent putting on and taking off protective gear, in violation of federal law requiring compensation for such “donning and doffing”  time if it is “integral and indispensable” to their regular work. After the district court certified two classes of employees, the case went to trial and the jury awarded the classes $29 million in damages. On appeal, the defendant argued that the verdict should be thrown out because the classes never should have been certified.

To be certified as a class, the worker-plaintiffs had to prove that they could establish key elements of their claims through generalized, class-wide proof. This was easy for some elements: they all worked in the same plant, had similar job responsibilities, and were subject to essentially the same compensation policies. But the defendant insisted that individualized inquiries into each employee’s total donning and doffing time were necessary because different employees wore different gear and took varying amounts of time to don and doff the gear. It also argued that no class could be certified without proof that every member was injured, which required individualized inquiries into each employee’s time.

Federal law, to some degree anticipating this evidentiary problem, has long required employers to keep accurate records of employee work hours. But despite a 1998 federal court injunction against the very same slaughterhouse requiring it to record employee time donning and doffing protective gear, Tyson Foods had never done so. Instead, it had been compensating workers based on its own approximations of how long those activities should take.

Because there was no good individualized evidence, the worker-plaintiffs used what they called “representative evidence” to show how long workers in each department generally took to don and doff protective gear. Most significantly, they presented a study by an industrial relations expert who drew on a representative sample of 774 videotaped observations of workers and calculated the average time for workers in each department to don and doff their gear.

There are procedural mechanisms to ensure the reliability of this kind of evidence, but the defendant largely ignored them. It did not challenge the expert’s qualifications or statistical methodology. It rejected the workers’ proposal to bifurcate the trial into separate proceedings for liability and damages. While it argued at trial that the expert’s calculations were too high, it did not present a rebuttal expert with different calculations. Instead, in opposing class certification and also at trial, it insisted that it was fundamentally improper to assume that each employee donned and doffed for the same time as the average in the sample. It decried being subjected to a “trial by formula” and barred from raising unspecified “defenses to individualized claims.” And on appeal, it called for a categorical rule barring the use of representative sampling evidence in class actions.

The Supreme Court rebuffed this effort and categorically rejected the idea that class actions required their own special set of evidentiary rules. It emphasized that statistical sampling evidence is routinely used in all kinds of litigation and is often the only practicable means, for plaintiffs and defendants in individual as well as class actions, to collect and present relevant data. Thus, it held that class certification was proper as long as a reasonable jury could have believed that the employees spent roughly equal time donning and doffing. If so, it was for a trial jury to weigh the expert’s average-time calculations against the other evidence presented and to decide whether the statistical average was probative of the time actually worked by each employee.

While the utility of statistical averages in other class actions will vary, the main takeaway is that the issue must be considered in practical terms of how a reasonable jury resolving the underlying substantive claim would view the evidence. In many cases, statistical averages will be the most compelling evidence available and will say a great deal about each member of the class. This was particularly true in Tyson Foods because the defendant had never bothered to keep individualized records (despite being legally mandated to do so), and instead simply paid workers based on its own approximations of how long donning and doffing should take. But in other cases with stronger evidence of meaningful individualized variations, a jury might find statistical averages less useful.

New York Adopts Delaware Standards for Going Private Mergers

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR MAY/JUNE 2016

In a case called the Kenneth Cole Shareholder Litigation, the New York Court of Appeals adopted, as the rule in New York, the MFW decision of the Delaware Supreme Court. There, the Delaware court held that, for claims seeking damages, the business judgement rule can protect the decision of a board of directors to accept a going private merger if certain conditions are met. Ordinarily, such decisions are reviewed under the “entire fairness” test, a very pro-plaintiff standard. The MFW court held that the business judgment rule can apply instead, provided that a series of shareholder protections exist: the merger was approved by both a special committee of independent directors and a majority of the minority shareholders; the special committee was independent and was free to reject the offer and to hire its own advisers; and the vote of the minority was informed and uncoerced. To survive a motion to dismiss, the complaint must allege facts showing that the transaction lacked one or more of these shareholder protections.

Meanwhile, the Delaware Supreme Court has itself recently extended the MFW decision to apply also to director decisions to approve mergers with unrelated entities. In such cases, where the complaint seeks damages, the entire fairness rule is inapplicable, but the courts have typically applied an intermediate standard of review, called enhanced scrutiny.” In a case called KKR, the court has now held that if the MFW conditions are met, the business judgment rule protects such decisions in post-closing actions as well. It added that under those circumstances, a showing of “gross negligence” by the directors is not sufficient to rebut the protection of the rule; “waste” has to be shown, which is an almost insurmountable burden.

Our Control Person Claims Upheld In Magnachip

ATTORNEY: MICHAEL J. WERNKE
POMERANTZ MONITOR MARCH/APRIL 2016

In this case, defendant Magnachip had been forced to restate its earnings drastically after its revenue recognition policies had been found wanting. We settled our claims against all the other defendants in the litigation, except for Avenue Capital Management, which was, at one point, Magnachip’s majority shareholder. We had sued ACM under the “controlling person” provisions of the securities laws.

The district court has now substantially denied ACM’s motion to dismiss our claims against it.

The Court rejected ACM’s argument that it did not control MagnaChip because it was a minority shareholder for much of the Class Period. The Court held as adequate to allege control that ACM was a majority shareholder when the alleged fraud began; its appointees continued to serve on the Board of Directors even after its holdings declined; it continued to have significant influence over MagnaChip’s affairs; and ACM used its control to cash out its investment in MagnaChip at enormous profits.

Loss Causation and Disclosures of Investigations

ATTORNEY: J. ALEXANDER HOOD II
POMERANTZ MONITOR MARCH/APRIL 2016

In many instances, the first indication of securities fraud is an announcement that a company is under investigation by some government authority—for example, the SEC, the Department of Justice, a U.S. Attorney’s office, or a state attorney general, to name a few. Frequently these announcements are immediately followed by significant stock drops, as the market reacts to the fact of the investigation, even before the investigation’s findings are disclosed. Because the market has already reacted to the bad news, it sometimes fails to react to subsequent news of the investigation’s findings or to disclosure of false statements by the company that the government was investigating. This non-reaction often reflects the fact that investors assumed the worst when the investigation was first announced, and thus do not react a second time to what is, in some sense, the same news, when the fraud at issue is subsequently confirmed.

For plaintiffs in securities fraud lawsuits, however, the market’s failure to react to news confirming the fraud can be a problem. To survive a defendant’s motion to dismiss, the complaint must show that the investor’s economic loss was caused by the revelation of the defendant’s fraud. Thus, when a company’s stock price plummets in reaction to news of an investigation and then barely moves when the fraud is subsequently confirmed, the company may argue that the only loss was caused by the announcement of an investigation, which the company would characterize as an intervening event, and that no losses were directly traceable to disclosure of news of the fraud itself.

Addressing these issues in Jacksonville Pension Fund v. CVB Financial Corporation, the Ninth Circuit Court of Appeals presented a sensible, context-specific view ofloss causation, holding that the announcement of an SEC investigation related to an alleged misrepresentation, coupled with a subsequent revelation of the inaccuracy of that representation, can serve as a corrective disclosure for the purposes of loss causation—in other words, that under such circumstances, the losses caused by the announcement of the investigation are recoverable, even if the stock fails to react to the subsequent confirmation of the fraud.

In 2008, CVB Financial Corporation was informed by the Garrett Group, a commercial real estate company that was CVB’s largest borrower, that Garrett would be unable to make payments on its loans from CVB. After the loans were restructured, Garrett again informed CVB in 2010 that it could not make the required payments and was contemplating bankruptcy. Nonetheless, in 2009 and 2010 SEC filings, CVB represented that  there was no basis for “serious doubt” about Garrett’s ability to repay its borrowings.

In 2010, the SEC served a subpoena on CVB, seeking information about the company’s loan underwriting methodology and allowance for credit losses. The day after CVB announced receipt of the SEC subpoena, the company’s stock dropped 22%, from $10.30 to $8.0 0per share, a loss of $245 million in market capitalization.

Analysts noted the probable relationship between the subpoena and CVB’s loans to Garrett. A month later, CVB announced that Garrett was unable to pay its loans as scheduled, wrote down $34 million in loans to Garrett, and placed the remaining $48 million in its non-performing category. On this news, however, the market barely reacted, and CVB’s stock price did not significantly fall.

As lead plaintiff in a consolidated action on behalf of CVB investors, Jacksonville Police & Fire Pension Fund filed a complaint in U.S. District Court for the Central District of California, alleging securities fraud by CVB and certain of its officers. However, the district court granted CVB’s motion to dismiss, holding that Jacksonville had failed to plausibly allege that the statements caused a loss to shareholders, given the market’s failure to react to CVB’s announcement that Garrett would be unable to pay its loans as scheduled.

On appeal, the Ninth Circuit reversed the district court’s decision on the loss causation issue. It agreed with the district court that the only significant fall in CVB’s share price occurred after the announcement of the SEC subpoena, and not after the disclosure that Garrett had failed to repay its loan. It noted that “the announcement of an investigation, standing alone and without any subsequent disclosure of actual wrongdoing, does not reveal to the market the pertinent truth of anything, and therefore does not qualify as a corrective disclosure.” However, the court held that in the case against CVB, the announcement of the SEC investigation did not stand alone; rather, the announcement was followed a month later by the company’s announcement that it was charging off millions in its Garrett loans. The market did not react to the subsequent news about the Garrett loans because the announcement of the SEC investigation foreshadowed the ultimate result. Commenting on the practical effects of its ruling, the Ninth Circuit observed that “any other rule would allow a defendant to escape liability by first announcing a government investigation and then waiting until the market reacted before revealing that prior representations under investigation were false.”

In short, the CVB Financial Corporation decision is a welcome and sensible development that removes a significant potential pleading obstacle to securities class actions in the Ninth Circuit.

Supremes: Rejected Offer Of Judgment Does Not Moot Claims Of Class Representative

ATTORNEY: LOUIS C. LUDWIG
POMERANTZ MONITOR MARCH/APRIL 2016

As we noted briefly in the last issue of the Monitor, in Campbell-Ewald Company v. Gomez, the Supreme Court ruled that a plaintiff’s claim cannot be mooted solely by an unaccepted settlement offer, including an offer of judgment pursuant to Federal Rule of Civil Procedure 68. Defendants had hoped that by offering the class representative – but not the class members – all the relief he or she had requested in the complaint, they could get rid of that representative and the class action as well.

The court’s ruling was widely seen on both sides of the bar as a victory for plaintiffs and their counsel. That reaction, however, was likely premature. Gomez leaves open the possibility that defendants could still “pick off” plaintiffs by actually paying or tendering them the amounts allegedly owed. Simply put, the “pick off” risk that bedeviled class action plaintiffs before Gomez remains at least theoretically intact in its wake.

Generally, Rule 68 allows a defendant to make an offer of judgment for a specified amount, including costs accrued   to date. If the plaintiff rejects the offer and the result obtained in the action is less than the amount of the rejected offer, the plaintiff must reimburse all of defendants’ costs incurred after the offer was made.

Turning down such an offer of judgment necessarily engenders risk, particularly for plaintiffs who choose to lead class actions, which, for various reasons, tend to incur higher costs on the path to trial. Even worse, defense lawyers have sharpened Rule 68 into a unique weapon known as the “pick-off” strategy,” which aims to quickly end potential class actions without ever getting to the merits of the claims.

The pick-off strategy typically plays out as follows: the named plaintiff in a class action is served with an offer of judgment for all the relief he or she personally seeks, separate from the class. Not wanting to sell out the class he or she represents, the named plaintiff rejects the Rule 68 offer in order to continue litigating for a favorable classwide outcome. Next, the defendant seeks the dismissal of the case on the basis that the offer provided the plaintiff with everything asked for in the complaint, leaving no “case or controversy” remaining to litigate. If that happens, the case cannot proceed on a class basis unless a new named plaintiff is willing to step forward. Even assuming that a new named plaintiff can readily be found, the successor is just as susceptible to the pick-off strategy as his or her predecessor.

Prior to Gomez, several federal appellate courts limited the pick-off strategy by making the effectiveness of a Rule 68 offer contingent on, variously, whether plaintiffs had been provided an opportunity to first file a motion for class certification or whether the offer actually preceded the filing of and/or ruling on a motion for class certification.

Gomez involved allegations of an unsolicited text message that violated the Telephone Consumer Protection Act (the “TCPA”). As a general matter, the TCPA places a $1,500 ceiling on statutory damages for a single violation. While Gomez was styled as a class action, the plaintiff, Gomez, had not filed a motion for class certification at the time defendant Campbell-Ewald (the advertising agency that sent the text message) served him with an offer of judgment for just over $1,500, plus reasonable costs. Gomez declined the offer by failing to accept it within the time provided. Subsequently, Campbell-Ewald prevailed on a motion for summary judgment on the ground that the offer of judgment mooted plaintiff’s individual claim.

The Court of Appeals for the Ninth Circuit reversed, holding, in part, that an unaccepted Rule 68 offer does not moot a plaintiff’s individual or class claims. As circuit precedent differed widely on these issues, certiorari was granted. The Supreme Court affirmed the Ninth Circuit, with the majority adopting Justice Elena Kagan’s dissent in Genesis HealthCare Corp. v. Symczyk, which reasoned that an “unaccepted settlement offer — like any unaccepted contract offer — is a legal nullity, with no operative effect.” The court concluded that the rejection could only mean that the settlement offer was no longer operative, and the parties “retained the same stake in the litigation they had at the outset.”

Nonetheless, the Gomez court’s focus on the offer-and acceptance dance of Contracts 101 led it to reserve, “for a case in which it is not hypothetical[,]” the question of whether defendants can continue to moot claims by making an actual payment of full relief. Justice Ruth Bader Ginsberg, writing for the majority, explained that a claim might be mooted under Rule 68 when a defendant “deposits the full amount of the plaintiff’s individual claim in an account payable to the plaintiff, and the court then enters judgment for the plaintiff in that amount.” Perhaps even more ominously, Chief Justice John Roberts described the majority’s “offers only”- circumscribed decision as “good news.”

With the recent passing of Justice Antonin Scalia and resultant 4-4 split on the Court, the possibility remains that defendants will try the tactic of full tenders of relief to named plaintiffs in class actions, and that the issue will likely find its way back to the High Court.

The securities plaintiff’s bar has not borne many such pickoff attempts, probably as an unintended consequence of the Private Securities Litigation Act of 1995 (“PSLRA”).

The PSLRA expressly creates an open competition for “lead plaintiff.” Although the investor with the largest losses usually wins that competition, it is only after a profusion of qualified plaintiffs has come forward following a nationwide notification process. Indeed, an entire informational infrastructure has arisen to provide investors with PSLRA-mandated notice of securities class actions. Moreover, unlike consumer class actions, where damages to individual class members may be relatively small, lead plaintiffs chosen in securities class actions typically hold hundreds of thousands or even millions of shares of company common stock, and have millions of dollars in individual damages. Thus, the act of picking off such plaintiffs would not only be extremely costly but would actually be futile owing to no shortage of potential replacements, and if it did work, it would result in thousands of individual shareholder claims being filed, swamping the courts. This would essentially amount to litigating thousands of shareholder claims on an individual basis. At least in the securities context, Gomez, a case about short-circuiting class actions, ironically ends up highlighting their economy, particularly from the vantage of the defendants’ bar. 

Executives Seeking To Avoid Securities Fraud Liability Must Plan Ahead

ATTORNEY: MATTHEW L. TUCCILLO
POMERANTZ MONITOR MARCH/APRIL 2016

A key element of any securities fraud claim is evidence of defendant’s scienter, or intent to defraud. One way to establish scienter is to show that a given defendant engaged in transactions (typically sales) in company securities during the alleged period of fraud. Indeed, a complaint that does not allege such transactions faces heightened scrutiny by the court on a motion to dismiss.

Executives trying to explain such transactions frequently point to the existence of a so-called Rule 10b5-1 stock trading plan, which, for example, could schedule automatic stock transactions at pre-determined intervals or at specific future times. Rule 10b5-1, enacted by the SEC in 2000, expressly states that a person’s transaction in a security is “not ‘on the basis of’ material nonpublic information” if it is demonstrated that “before becoming aware of the information, the person had…[a]dopted a written plan for trading securities.” See 17 C.F.R. 240.10b5 -1(c)(1)(i)(A)(3). Since then, the case law has strongly weighed in favor of executives who had sold company stock, even at the height of an alleged fraud, where the sales were made pursuant to such a trading plan, often ruling that stock trades made pursuant to the plan could not evidence scienter. 

However, one dogfight in which we frequently engage revolves around the circumstances and timing of a Rule 10b5-1 plan’s creation. In our experience, too often, executives chose either to adopt a new Rule 10b5-1 plan or to amend a pre-existing Rule 10b5-1 plan during the period of alleged fraud, frequently causing an increase in sales of company stock at inflated prices before the fraud gets revealed and the stock price corrected by such revelation. The executives later seek to hide behind the existence of such a plan as exonerating evidence of their lack of intent to profit from an alleged fraud, while we typically argue that the timing of its adoption or amendment negates that argument.

An important battleground on this issue has been the Second Circuit, which encompasses the U.S. federal district courts in Connecticut, Vermont, and most significantly, New York. For context, according to a recent report prepared by Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse, the Second Circuit alone accounted for 50 of the 189 (26.5%) securities class action lawsuits filed in 2015. Historically, we have relied upon a collection of lower court decisions from within the Second Circuit that discounted reliance by company insiders on Rule 10b5-1 plans adopted or amended during an alleged period of fraud. Included among them is George v. China Auto Sys., Inc., No. 11 Civ. 7533 (KBF), 2012 WL 3205062, at *9 (S.D.N.Y. Aug. 8, 2012), in which Pomerantz secured a ruling that Rule 10b5-1 trading plans entered into during the alleged period of fraud did not dispel the inference of the defendant executive’s scienter. Defendants, not surprisingly, have instead relied upon district court cases supporting the more generalized legal proposition that the existence of a Rule 10b5-1 plan undercuts the scienter inference, attempting to side-step the more nuanced factual issues surrounding the timing and circumstances of a plan’s adoption or amendment.

The Second Circuit Court of Appeals recently weighed in on this important issue, resolving it in favor of our  plaintiff side arguments in Employees’ Ret. Sys. of Gov’t of the Virgin Islands v. Blanford, 794 F.3d 297 (2d Cir. 2015).

Blanford concerned an alleged fraud regarding Green Mountain Coffee Roasters, Inc. and its Keurig brewing system, where investors were told that Green Mountain’s business was booming, with its inventory at “optimum levels” as it strained to meet high demand. In reality, it had been accumulating significant overstock of expiring and unsold product. During the alleged fraud, company insiders, including defendants Blanford (Green Mountain’s President/CEO/Director) and Rathke (its CFO/Secretary/Treasurer), sold company stock for millions of dollars in proceeds. Both Blanford and Rathke entered into new 10b5-1 trading plans just after one alleged misstatement (an earnings call), which permitted them to engage in significant sales shortly thereafter. The fraud was later revealed, causing Green Mountain’s stock price to plummet.

On these facts, the Second Circuit, citing Pomerantz’s decision in George v. China Auto Sys., among other precedent, rejected defendants’ argument that the 10b5-1 plan insulated them from an inference of scienter. Noting that Blanford and Rathke had entered into their 10b5-1 plans after an alleged misstatement (the earnings call) and after the fraudulent scheme began, the Second Circuit held: “When executives enter into a trading plan during the Class Period and the Complaint sufficiently alleges that the purpose of the plan was to take advantage of an inflated stock price, the plan provides no defense to scienter allegations.” Viewing the alleged facts holistically, the court held that defendants’ stock sales – including those made within the 10b5-1 plans – coupled with other alleged conduct (e.g., steps taken to conceal the true facts from investors), supported a strong inference of their scienter. Going forward, Blanford will be an important precedent, both in the Second Circuit and beyond, and we have already cited it to courts overseeing briefing on motions to dismiss our clients’ complaints.

Pomerantz Wins Class Certification In Two Major Cases: Barclays Investors Win Class Certification

ATTORNEY: TAMAR A. WEINRIB
POMERANTZ MONITOR MARCH/APRIL 2016

The same day as the class cert ruling in Petrobras, February 2, 2016, Judge Scheindlin of the federal district court in the Southern District of New York, after a full evidentiary hearing, granted plaintiffs’ motion to certify a class of allegedly defrauded Barclays investors in the Strougo v. Barclays PLC securities litigation, and appointed Pomerantz as counsel for the class.

The case, which involves claims pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, concerns defendants’ concealment of information and misleading statements over a three-year period regarding its management of its “LX” dark pool, a private trading platform where the size and price of the orders are not revealed to other participants. Even though the dark pool was just a tiny part of Barclays’ overall operations, Judge Scheindlin found that defendants’ fraud was highly material to investors because it reflected directly on the integrity of management. The court also found that reliance by class members on defendants’ omissions and misstatements could be presumed on a class-wide basis.

The court held that, under the Supreme Court’s Affiliated Ute doctrine, it was appropriate to presume that investors relied on the alleged material omissions, which involved defendants’ failure to disclose that they were operating their LX dark pool in a manner that did not protect Barclays’ clients’ best interests. Specifically, defendants failed to disclose that Barclays was not adequately protecting LX investors from “toxic” high frequency trading and were disproportionately routing trading orders back to LX. The court held that because LX constitutes a tiny fraction of Barclays’ business, a reasonable investor likely would have found the omitted misconduct far more material than the affirmative misstatements – because it reflected on management’s overall integrity. Indeed, it is for this reason that the court considered the omissions “the heart of this case.”

With respect to defendants’ affirmative misrepresentations, the court held that under the Supreme Court’s Basic “fraud on the market” doctrine, reliance by investors could also be presumed because Barclays’ stock trades in an efficient market. Its stock price would therefore have reflected defendants’ misrepresentations and omissions during the Class Period.

Of particular interest to Section 10(b) class action plaintiffs is the court’s rejection of defendants’ argument that to show market efficiency, plaintiffs must provide so-called “event studies” showing that the market price of the company’s stock price reacted quickly to the disclosure of new material information about the company. As in the Petrobras decision discussed in the previous article, though plaintiffs did in fact proffer an event study, the court held – consistent with a vast body of case law – that no one measure of market efficiency was determinative and that plaintiffs could demonstrate market efficiency through a series of other measures, which plaintiffs also provided here.

In so holding, the court observed that event studies are usually conducted across “a large swath of firms,” but “when the event study is used in a litigation to examine a single firm, the chances of finding statistically significant results decrease dramatically,” thus not providing an accurate assessment of market efficiency. The district court then found, following its extensive analysis, that plaintiffs sufficiently established market efficiency indirectly and thus direct evidence from event studies was unnecessary. Thus, the court went even further than the court in Barclays in downplaying the importance of event studies on class certification motions.

The district court also rejected defendants’ contention that certification should be denied because plaintiffs had supposedly failed to proffer a proper class wide damages model pursuant to the Supreme Court’s decision in Comcast. In rejecting that contention, the court recognized that the “Second Circuit has rejected a broad reading of Comcast” in its Roach v. T.L. Cannon Corp. decision. Indeed, the district court noted the Second Circuit’s finding in Roach that Comcast “did not hold that proponents of class certification must rely upon a classwide damages model to demonstrate predominance...[T]he fact that damages may have to be ascertained on an individual basis is not sufficient to defeat class certification.” The district court held that our expert’s proposal of using an event study and the constant dollar method to calculate damages is consistent with the theory of the case, and one that is typically used in securities class actions. The district court rejected defendants’ contention that plaintiffs should have proffered a model to identify and disaggregate confounding information as irrelevant, given that confounding information would affect all class members the same.

Pomerantz Wins Class Certification In Two Major Cases: Class Certification Granted In Our Petrobras Case

ATTORNEYS: H.ADAM PRUSSIN AND MATTHEW C. MOEHLMAN
POMERANTZ MONITOR MARCH/APRIL 2016

On February 2, 2016, Pomerantz achieved an important victory for investors when Judge Rakoff of the Southern District of New York certified two classes in our litigation against Petróleo Brasileiro S.A. – Petrobras, Brazil’s state run oil giant, concerning its involvement in one of the largest corruption and bribery scandals of the 21st century. One class consists of investors who purchased equity securities of Petrobras in the U.S. between 2010 and 2015. This class asserts fraud claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The other class consists of purchasers of debt securities Petrobras issued in public offerings in May 2013 and March 2014, who are alleging violations of Sections 11 and 12(a)(2) of the Securities Act of 1933. The lead plaintiff in the case is our client, Universities Superannuation Scheme.

The case concerns one of the most notorious securities frauds ever committed – a multi-year, multi-billion-dollar kickback and bid-rigging scheme. The scheme was allegedly orchestrated by former top Petrobras executives from at least 2004 onward, who systematically conspired to steer construction contracts to a cartel composed of 20-30 of Brazil’s largest contracting companies. The executives ensured that the contracts, padded by billions of dollars, were awarded to designated members of the cartel without any authentic competitive process. In return, the cartel kicked back hundreds of millions of dollars to the executives, who pocketed a cut of the bribe money, then gave the rest to their patrons in Brazil’s three ruling political parties. Revelations of this scheme decimated Petrobras’ stock price, devastating a class of investors. So far, five Petrobras executives have been convicted on criminal conspiracy and money-laundering charges, as well as a number of their confederates at the construction companies, and facilitating intermediaries.

As in many securities fraud cases, a central issue in the class certification motion was whether plaintiffs could establish that defendants committed “fraud on the market,” which allows investors to establish the element of reliance on a classwide basis. Failing this test would mean that reliance would have to be shown separately for each class member and that common questions would therefore not “predominate” over individual ones. To establish fraud on the market, plaintiff has to show that the securities in question trade on an efficient market, and that therefore defendants’ frauds affected the market price that each class member paid for purchasing Petrobras securities.

Courts have established a series of criteria for determining market efficiency, referred to as the “Cammer factors,” originally put together in a seminal case of that name. Most of these factors are indirect measures of market efficiency, including such things as the company’s market capitalization, the volume of trading in its securities, the typical bid-asked spread, the number of market makers in its shares and the number of analysts covering the company. The market for Petrobras securities easily passed all of these tests.

However, using an argument being pressed by defendants in most securities actions, the Petrobras defendants claimed that the most important Cammer factor is the “direct evidence” test, measured by how the market price of the company’s securities actually reacted to disclosure of unexpected news. This test, typically measured by socalled “event studies,” can be more difficult for investors to satisfy, because price movements in the real world can be affected by a host of market-moving information that can obscure the effects of the actual disclosure of the fraud. Defendants argued that this single factor trumps all the other Cammer factors and that it was not satisfied here because the market did not always react perfectly and instantaneously to unexpected disclosures. The district court held that plaintiff’s event studies were sufficient, and, more importantly, that perfect efficiency was not required:           

In assessing market efficiency, courts should not let the perfect become the enemy of the good. In this case, where the indirect Cammer factors lay a strong foundation for a finding of efficiency, a statistically significant showing that statistically significant price returns are more likely to occur on event dates is sufficient as direct evidence of market efficiency and thereby to invoke Basic’s presumption of reliance at the class certification stage. 

The court also rejected defendants’ argument that, because several large institutional investors had already “opted out” of the class, electing to pursue their own actions, investors were motivated to pursue their own actions and a class action was therefore unnecessary. To the contrary, the court determined that to deny class certification would plunge the courts into a morass of individual lawsuits and would do more harm than good.

Pomerantz News, At Home and Abroad

POMERANTZ MONITOR, JANUARY/FEBRUARY 2016

As part of its commitment to education, Pomerantz presented a moot court in January 2016 for advanced law students of Bar Ilan University in Israel. Daniel J. Kramer, Partner at Paul, Weiss, acted as counsel for the defense; Jeremy Lieberman as counsel for plaintiffs; and Marc Gross as judge. They argued Polycom, an actual securities fraud class action in which Pomerantz is lead counsel for the plaintiff class. The case alleges that the company was making positive statements about its operation and prospects, while it did not disclose that its CEO had submitted numerous false expense reports, claiming personal expenses as business expenses, and thereby misappropriating hundreds of thousands of dollars from the company.

 Meanwhile, on the home front, Pomerantz is proud to announce that Brenda Szydlo has joined the firm as Of Counsel in our New York office. Brenda has more than twenty-five years of experience in complex civil litigation in federal and state court on behalf of plaintiffs and defendants, with a particular focus on securities and financial fraud litigation, litigation against pharmaceutical corporations, accountants’ liability, and commercial litigation.

 Brenda is a 1988 graduate of St. John’s University School of Law, where she was a St. Thomas More Scholar and member of the Law Review. She received a B.A. in economics from Binghamton University in 1985.

SCOTUS Shorts

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR JANUARY/FEBRUARY 2016

The Supreme Court has just issued two very significant rulings. In the first one, it granted certiorari to review U.S. v. Salman, a criminal insider trading prosecution. The case turns on the question of what sort of personal benefit, if any, a “tippee” has to give to his “tipper” in exchange for the inside information before the tippee can be liable for trading on it. This issue received national attention a few months ago when the Second Circuit gave its answer to this question in U.S. v. Newman; but the Supremes denied cert in that case.

In Salman, defendant Salman received the inside information from a close friend who, in turn, had heard it from his brother. The question is whether the personal relationship between the two brothers in itself satisfies the “personal benefit” requirement for insider trading, or whether the government also has to show that the tippee brother gave an additional, tangible benefit to his brother in exchange for the information. In its decision, the 9th Circuit held that no additional tangible benefit, beyond the personal relationship, was required. In Newman, the Second Circuit previously held otherwise. Curiously, the 9th Circuit’s opinion was written by Judge Rakoff, a District Court judge sitting by designation. Judge Rakoff sits in the Southern District of New York, which is part of the Second Circuit. Through this quirk of fate, Judge Rakoff got another circuit court to disagree, publicly, with the Second Circuit’s Newman decision, which is binding on him when he sits as a district judge in New York.

In the Supreme Court’s second ruling, Campbell Ewold, it struck a blow against a tactic increasingly used by defendants in class actions: trying to “moot” the claims of the class representative by offering to pay all of his claimed damages. If the representative’s claim is mooted (i.e., satisfied), his individual claim would be dismissed, and the class would have no representative. If the class could not find another representative, the whole class action would be dismissed. If this could work, the class action device could be eviscerated.

Fortunately, the Supremes said no, finding that a rejected offer of settlement does not wipe out the representative’s claim; but, unfortunately, they left open the question of whether this tactic could work if, instead of just offering to pay the claimed damages, the defendant actually pays the money into an account for the benefit of the plaintiff, such as an escrow account or the clerk’s office. To resolve that question, we may need “Campbell Ewold 2.”

Pomerantz, the oldest securities law firm in the United States, proudly celebrates its 80th birthday

Pomerantz was founded in 1936 by Abraham L. Pomerantz, who, during his legendary career, relentlessly fought to protect investor rights. In doing so, he secured numerous victories now enshrined in the laws applied to securities class actions and derivative lawsuits.

Abe’s trailblazing spirit lives on at Pomerantz – from our historic Supreme Court victory recognizing the right to a jury trial in derivative actions in 1970, to being appointed sole lead counsel in 2015 in the action against Brazilian oil giant, Petróleo Brasileiro SA – Petrobras, surrounding its conduct in one of the largest corruption and bribery scandals of the 21st century. Although our client did not suffer the largest financial loss, the court found that Pomerantz’s outstanding reputation and the client’s conduct in overseeing counsel represented the “gold standard” for institutional investors seeking to move for appointment as lead plaintiff.

We are celebrating our 80 years with a bang. Pomerantz acts as lead counsel in a closely-watched securities class action lawsuit against ChinaCast Education Corp., stemming from its CEO’s alleged misappropriation of $120 million in company funds. The Ninth Circuit recently revived the case – after its dismissal by a lower court – ruling that the CEO’s fraud could be imputed to ChinaCast, even though his alleged embezzlement and misleading of investors went against the company’s interests. The litigation will now return to the lower court for trial.

Pomerantz is co-lead counsel in a securities class action against S.A.C. Capital Advisors LLC, in which the court recently certified two classes of plaintiffs. The case arises from the most profitable insider-trading scheme ever uncovered, in which the defendants illegally gained profits and avoided losses of at least $555 million from trades in Elan Corporation plc and Wyeth Pharmaceuticals, Inc. securities and related options while in possession of material, non-public information.

In 2015, Pomerantz defeated defendants’ motion to dismiss the class action against Barclays plc for misstatements about its “dark pool.” The court found that, although revenues from Barclays’ dark pool were under 5% of company revenues – a statistical benchmark often used to assess materiality – the misrepresentations went to the heart of its reputation and were therefore actionable. The decision is a victory for investors for its recognition that corporate integrity and ethics are material factors upon which investors rely when purchasing securities, even where the mounts of money involved fall below a presumptive numerical threshold.

Pomerantz acts as lead counsel for investors in a securities class action against Groupon for alleged misconduct related to its 2011 initial public offering, a case in which we have won every substantive motion to date. One of the most important milestones was our defeat of a defense motion to disqualify the plaintiffs’ class certification expert in March 2015. The defense argued that he was unreliable as he failed to conduct put-call parity and short lending fee analyses. We disagreed, citing the landmark U.S. Supreme Court ruling in Halliburton. After an extensive evidentiary hearing, the court sided with Pomerantz, holding that such tests were unnecessary because they addressed an extreme variation of market efficiency that “was squarely rejected by the Halliburton court.”

We are lead counsel in a securities class action against Walter Investment Management Corporation, in which the court dismissed our original complaint, while granting leave to file an amended complaint. Pomerantz then prevailed, overcoming the difficult burden to prove, in the motion to dismiss phase, that disclosure of a government investigation of and proposed enforcement action against the company satisfied the requirement for loss causation. Given the Myers/Loos standard prevailing in the Ninth and Tenth Circuits, which strictly limits the circumstances under which the announcement of a government investigation can be said to cause a loss, this victory is significant.

Auditing the Auditors

ATTORNEY: JOSHUA B. SILVERMAN
POMERANTZ MONITOR JANUARY/FEBRUARY 2016

Investors rely on auditors to insure the integrity of corporate financial statements, but have little insight into the individual auditors themselves. That is about to change. A new rule adopted by the Public Company Accounting Oversight Board (PCAOB) will soon provide investors with much more transparency into the audit partners conducting the audit, and whether the audit firm outsourced substantial audit work.

Currently, auditors hide behind a mask of anonymity. They sign the opinion letters that go into SEC filings under the firm name only. But as recent PCAOB inspection reports confirm, even “big four” auditors produce shoddy audits with alarmingly high frequency. In its most recent inspection, the PCAOB found that KPMG was deficient in 54% of inspected audits. The remaining “big four” were only modestly better: EY 36%, PwC 29%, Deloitte 21%.

According to PCAOB chair James Doty, many of those bad audits were produced by particular engagement partners. In a recent statement, he explained that “PCAOB inspections have revealed that, even within a single firm, and notwithstanding firm-wide or network-wide quality control systems, the quality of individual audit engagements varies. There are numerous factors required to achieve a high quality audit, but the role of the engagement partner in promoting quality, or allowing it to be compromised, is of singular importance to the ultimate reliability of the audit.”

SEC enforcement actions confirm that some engagement partners are repeat offenders. For example, a recent action against Grant Thornton shows that the same partner, Melissa Koeppel, overlooked at least three major accounting frauds in public companies: headphone-manufacturer Koss, Assisted Living Concepts (ALC), and Broadwind. In its 2008 inspection of Grant Thornton, the SEC highlighted deficiencies in one of Ms. Koeppel’s audits. By the third quarter of 2010, Ms. Koeppel’s public company audit clients had restated financials four times, and Ms. Koeppel was on an internal monitoring list at Grant Thornton for partners with negative quality indicators. Her track record was so bad that Grant Thornton switched most of her audits to other engagement partners, but it kept her on the 2010 audit of ALC. Those financial statements had to be restated due to accounting irregularities that were brought to Ms. Koeppel’s attention by subordinates, but were ignored.

Investors will soon get a new tool to help identify bad auditors like Ms. Koeppel. A recently-adopted PCAOB rule will require audit firms to file forms indicating the name of the engagement partner. The rule also requires identification of other firms that assisted in the audit, and the extent of their participation.

While the rule is an improvement, it was watered down under heavy pressure from accounting industry lobbyists. The original proposal called for the engagement partner to be identified directly in SEC filings, either in the audit opinion itself or by the issuer. The current rule places the information in a separate form, so investors will have to look in multiple places to find information about the audit. But this additional hurdle is minor. Over time, it may not pose any problem at all, as financial information providers like Bloomberg and Reuters begin to link audit engagement partner  track record information into their profiles of corporate issuers.

Your Right to Know If Your Personal Information Has Been Hacked

ATTORNEY: PERRY GATTEGNO
POMERANTZ MONITOR JANUARY/FEBRUARY 2016

In today’s digitized world, every day, nearly every consumer willingly or unwittingly shares sensitive personal information online. Almost as often, hackers successfully access corporate information databases, taking whatever data they can find.

Fortunately, nearly every state has data breach notification laws that apply to any entity that collects personally identifiable information. Those laws generally require the collecting entity to notify individuals when their personal information has been accessed by an unauthorized user. The first such law, enacted in California in 2003, set the model for data breach notification mechanisms by creating obligations for “any agency that owns or licenses computerized data that includes personal information.” In the case of a breach of security systems, the hacked company must disclose the breach to any California resident whose unencrypted personal information was, or is reasonably believed to have been, acquired by an unauthorized person.

The definition of personal information varies from state to state, but it generally includes names, telephone and Social Security numbers, home and e-mail addresses, and any information that falls under the umbrella of “personally identifiable information.” As defined by the California law, this extra information includes credit and financial data that creates access to private accounts, and driver’s license numbers. In California, only unencrypted information that has been transmitted to unauthorized persons must be reported, so California entities can obviate their reporting duties by encrypting all data.

Generally, the statutes include language requiring disclosure of the breach “without unreasonable delay,” (Connecticut, among others), “in the most expedient time possible” (Delaware, among many others) or “as soon as possible” (Indiana, among others). Most states allow the hacked company to wait until “delay is no longer necessary to restore the integrity of the computer system or to discover the scope of the breach,” or also to comply with a criminal or civil investigation by law enforcement. Some states, such as Louisiana, allow the breached entity not to notify consumers of a breach “if after a reasonable investigation the person or business determines that there is no reasonable likelihood of harm to customers.”

In the 13 years since the California law took effect, 47 states, as well as the District of Columbia, Guam, the U.S Virgin Islands and Puerto Rico, have enacted some form of data breach notification law. While they all authorize the local attorney general to enjoin violations and create civil and sometimes criminal penalties against violators, fewer than half the states also grant a private right of action to individuals whose data has been stolen. Civil penalties collectible by the state generally range from $100 to $2,500 per violation, while private rights of action generally permit aggrieved parties to recover actual damages, and often reasonable attorneys’ fees, from the hacked entity. These rights create a strong incentive to disclose these breaches to victims of a data breach. Illinois and California are among the states where a private right of action exists, while New York and Florida are among the states where there is no private right of action.

Nevertheless, holders of confidential data must also weigh the public relations nightmare that often accompanies data breaches, which are becoming high profile – and thus high-stakes – messes requiring immediate clean-up. Failing to comply with the relevant statute not only creates liability, it also causes embarrassment and discourages individuals from entrusting their data to the guilty party.

 Even those states that do not have a private right of action may have unfair trade practices statutes that may provide an alternative route to recovery. For instance, the Florida Deceptive and Unfair Trade Practices Act (FDUTPA) allows recovery of damages and attorneys’ fees for “unfair methods of competition, unconscionable acts or practices, and   unfair or deceptive acts or practices in the conduct of any trade or commerce.” Because FIPA, Florida’s data breach notification statute, defines a violation as an unfair or deceptive trade practice, the state statutory scheme essentially creates a single private right of action rather than FIPA creating a second one on top of the existing statute. FIPA merely creates a new category that falls under FDUTPA’s umbrella. The interplay around the country between analogous statutes varies by state.

Permitted methods of notification vary by state, but generally written notice, e-mail notice, or telephone/ fax notice are options if the breached entity has such consumer information in its possession. Some states permit alternatives in the vent that none of the previous methods are available, such as “Conspicuous posting of the notice on the Internet Web site page of the [breached] person or business, if the person or business maintains one” and “notification to major statewide media.”

Data breach notification laws confirm and crystallize the duties and obligations of entities that undertake to collect personally identifiable information of individuals. Even the best-intentioned holders of data may occasionally suffer unintentional breaches of information, but these laws incentivize stringent security and prompt action to mitigate harm wherever and whenever it might occur.

Court Upholds our Claims Against Lumber Liquidators

ATTORNEY: MICHAEL J. WERNKE
POMERANTZ MONITOR JANUARY/FEBRUARY 2016

Judge Allen of the Eastern District of Virginia recently denied defendants’ motion to dismiss our class action complaint against Lumber Liquidators Holdings, Inc. During the class period, the company, which sells hardwood and laminate flooring, reported record gross margins that were substantially higher than its major competitors’. Defendants represented that the major driver of these high margins was legitimate “sourcing initiatives” in China that supposedly reduced the cost of goods and cut out middlemen. In truth, however, the company’s high margins were due to importing cheap flooring made from illegally harvested wood and laminate that was contaminated with high levels of formaldehyde. When the truth emerged in a series of disclosures and events – including news of federal criminal charges for violations of the Lacey Act and the well-substantiated, televised broadcast by 60 Minutes of extensive wrongdoing -- the stock price plunged by 68%. In the aftermath, the board suspended the sale of Chinese laminate products, the CEO, CFO and the company’s “Head of Sourcing” abruptly resigned, and the company replaced its compliance officer.

The court held that the complaint adequately alleged that defendants’ statements were false: its increased margins were not due to legitimate “sourcing initiatives,” or to the company’s efforts to work with mills to produce flooring that meets their “high quality standard,” or to policies to ensure regulatory compliance, as the company had said. In fact, the company later admitted that its Chinese suppliers failed to adhere to regulations and that it did not build a compliance team in China until December 2014.

The court also held that the complaint raised a strong inference of scienter, because defendants had access to non-public information suggesting that their statements were false; third parties easily discovered the regulatory violations; defendants repeatedly discussed analyst calls regarding their personal involvement in the sourcing initiatives in China that were driving their margins higher; and defendants sold a majority of their stock during the class period. The court found that, given the importance and focus of the sourcing initiatives in China, it was part of the “core operations” of the business, another factor that supported the conclusion that management must have known the truth. Finally, the court imputed to management, and to the company, the knowledge of its head of sourcing.

Finally, the court found that the complaint adequately pleaded loss causation because the partial disclosures, when “taken together.... revealed the widespread scope of defendants’ allegedly fraudulent scheme.”

How Bad Does the Behavior Have to Be Before Shareholders Can Investigate It?

ATTORNEY: ANNA KARIN F. MANALAYSAY
POMERANTZ MONITOR JANUARY/FEBRUARY 2016

As the Monitor has previously reported, shareholders of Delaware corporations have a right to demand access to books and records of their company, provided that they have a “proper purpose” for doing so. One proper purpose is to investigate whether corporate officers and directors have violated their fiduciary duties. But merely expressing a desire to investigate such a possibility is not enough; the shareholder has to show that there are reasonable grounds to suspect that such a breach may have occurred. Many cases have explored the question of how much smoke there has to be to create a reasonable suspicion that there may well be a fire worth investigating.

Recently corporations have ratcheted up the argument. Now, they say, not only must there be grounds for suspicion of a breach, but that breach must be of the type that is compensable in damages. Since a books and records complaint is filed before there is any claim on file for breach of fiduciary duty, this argument requires that the court forecast the type of claim that might be made in the future.

Delaware law provides broad protections for directors against damage claims based merely on violations of the duty of care; only much more serious violations, such as breaches of the duty of loyalty, are compensable in damages. To escalate a claim of carelessness into a duty of loyalty claim, the shareholder must be able to show extreme misconduct -- the type of conduct that is hard to plead without company records to provide the crucial details. Those, of course, are the very details that the inspection provisions of Delaware law were intended to provide. It is to obtain such information that the shareholders bring a books and records proceeding in the first place. This question is now being considered by the Delaware Supreme Court in a case involving the AbbVie corporation, in which oral argument was heard on November 4, 2015.

In the action, Southeastern Pennsylvania Transportation Authority (“SEPTA”), a shareholder of AbbVie, sought access to AbbVie’s books and records relating to AbbVie’s failed $55 billion merger with Shire. Plaintiff claimed that it had a proper purpose because it wanted to investigate whether the AbbVie directors breached their fiduciary duties in connection with the approval of that merger.

The goal of the merger was to allow AbbVie to take advantage of Jersey’s more favorable tax laws, since Shire is incorporated in Jersey, a tiny island principality off the coast of Normandy that is controlled by England. If the merger had been consummated, AbbVie’s tax rate for 2016 would have dropped from about 22 percent to roughly 13 percent. About two months after the announcement of the merger, the Treasury Department and Internal Revenue

Service, alarmed over the possible drop in tax revenues from such “inversion” transactions, vowed to take action to deter American companies from acquiring foreign competitors to avoid domestic taxes. The AbbVie board responded by withdrawing its recommendation that stockholders vote in favor of the deal. The AbbVie board ultimately terminated the deal and paid Shire a $1.6 billion contractual termination fee.

SEPTA argued that it had a right to investigate the question of whether AbbVie would not have had to pay $1.6 billion if the AbbVie board had properly evaluated the risks of the merger, as required by their fiduciary duty. SEPTA demanded that AbbVie produce board minutes, correspondence, and other documents to investigate potential corporate wrongdoing.

In denying the books and record demand, Vice Chancellor Glasscock inferred that they were seeking an investigation to aid in future derivative litigation against the directors.

The court then held that if a plaintiff’s sole purpose for seeking inspection was to decide whether to bring derivative litigation to recover for alleged corporate wrong- doing, a proper purpose exists only if the plaintiff has demonstrated that the possible wrongdoing would be compensable in damages, and was not barred by the “raincoat” protections of Delaware law. Because SEPTA did not show that the conduct it was investigating could possibly rise to the level of a duty of loyalty claim, the court dismissed the inspection demand.

On appeal, SEPTA argued that the lower court’s decision essentially puts stockholders in the impossible situation of having to show exactly how serious the potential breaches of fiduciary duty might be before they could gain access to the records they would need to make that decision. AbbVie countered that without such detailed information, SEPTA was engaged in a mere fishing expedition, which the books and records statute does not allow.

Even if the appeal is denied, however, the Vice Chancellor, on several occasions, specifically noted that SEPTA sought inspection solely to investigate whether to bring derivative litigation, and that in order to state a proper purpose the claims must be non-exculpated. An exculpatory provision, however, does not bar all derivative litigation, and, accordingly, even in the face of an exculpatory provision, under certain circumstances investigating potential derivative litigation may still be a proper purpose. For example, claims seeking injunctive relief, such as an order barring consummation of a merger, or requiring additional disclosures, are not exculpated and therefore could be explored in a document inspection. At the early stage where a books and records case is filed, the plaintiff shareholder has not yet made any specific claims of actual wrongdoing, and can posit that, depending on what the documents may show, all sorts of non-exculpated relief could be possible.

Where's The Accountability?

ATTORNEY: TAMAR A. WEINRIB
POMERANTZ MONITOR NOVEMBER/DECEMBER 2015

At a conference last year, SEC Chair Mary Jo White began by asserting that “strong enforcement of our securities laws is critical to protecting investors and maintaining their confidence and to safeguarding the stability of our markets.” She went on to suggest that one of the SEC’s primary roles is to “bring wrongdoers to account and to send the strongest possible message of deterrence to would-be fraudsters.”

However, often the message sent is hardly one of deterrence. Many an SEC settlement amounts to nothing more than a mere “cost of business” for the wrongdoer, which is ultimately borne by the shareholders, particularly where the settlement terms do not require any accountability. Indeed, it was for precisely this reason that Judge Rakoff initially rejected the SEC’s $285 million settlement with Citigroup in 2011 that stemmed from the bank’s sale of mortgage-backed securities that cost investors $700 million but yielded a $160 million profit for the bank. Judge Rakoff referred to the settlement, which required no admission of wrongdoing, as “pocket change.”

Although the SEC has obtained admissions of wrongdoing in some cases, the Citigroup settlement was not unique in its failure to require Citigroup to either admit or deny liability (indeed Judge Rakoff rejected a settlement between the SEC and Bank of America in 2009 for similar reasons) but it prompted Judge Rakoff to proclaim that it “is neither fair, nor reasonable, nor adequate, nor in the public interest.” Just last month, the SEC entered into yet another settlement with two units of Citigroup that holds no one at the bank accountable for selling municipal bonds to wealthy clients for six years as a safe money option despite the innate risk resulting from considerable leverage, which caused investors to lose an estimated $2 billion. This settlement, for $180 million, like the settlement in 2011, did not require Citigroup to either admit or deny wrongdoing. Once again, it is the innocent investors who will bear the settlement cost.

The SEC is not alone in its zeal to settle claims with no accountability. The New York State Attorney General announced a settlement with Bank of America and former CEO Ken Lewis in 2014 over statements made in connection with the 2008 BofA and Merrill Lynch merger. Specifically, the SEC accused BofA of failing to reveal the truth about $9 billion in losses at Merrill Lynch before voting to approve the merger. After the merger, BofA needed a federal bailout partly because of the increasing losses at Merrill Lynch, and investors suffered when shares took a nosedive. The $25 million settlement did not require any admission of wrongdoing by either BofA or Lewis. Moreover,

BofA ultimately paid the $10 million of the settlement amount that Lewis was supposed to pay. In other words,

Lewis walked away from the settlement unscathed and therefore undeterred. Settlements such as these are ineffectual at deterring future misconduct by either the settling party or other entities and executives.

The question, however, is what the consequences are of the alternative. There exists a particularly sharp double-edged sword when considering the nature of the “deterrent.” The obvious concern is that if regulators continue to enter settlements that require no admissions of wrongdoing, those settlements will unlikely deter future misconduct but rather create a cost of business that further victimizes, rather than protects, investors. However, on the flip side, if regulators were to require admissions of wrongdoing as a condition to any settlement, the risk is that far fewer such actions/investigations would result in a settlement. Companies hesitant to admit any wrongdoing lest an investor or other party use that admission against it in a private lawsuit will not as readily agree to settle, which will undoubtedly result in protracted and costly litigation with uncertain outcomes. The question is what is the true goal --- to deter future misconduct as regulators consistently proclaim or to settle as many actions as possible, thereby avoiding the costs of lengthy litigation and the withering of budgetary constraints?

 Perhaps the greatest deterrent to securities fraud would be criminal prosecutions of individual wrongdoers, which is the prerogative of the Justice Department. The track record there has, if anything, been even spottier. The recent spate of insider trading convictions has been drastically undermined by the Second Circuit’s landmark ruling in the Newman case, which raises the bar dramatically for insider trading convictions. Other types of securities fraud criminal convictions of individuals are almost completely nonexistent.

Shareholder Approval Of Merger Held To Eliminate Claims Against Conflicted Investment Bankers

ATTORNEY: MATTHEW C. MOEHLMAN
POMERANTZ MONITOR NOVEMBER/DECEMBER 2015

On October 29, 2015, Vice Chancellor Parsons of the Delaware Court of Chancery dismissed the sole remaining claim in In re Zale Corporation Stockholder Litigation, the shareholder suit arising from Zale’s 2014 merger with Signet Jewelers Ltd. The Zale opinion, in which Parsons reversed his own earlier ruling in light of binding new precedent from the Delaware Supreme Court, serves as a blunt reminder to investors that Delaware courts are highly reluctant to meddle with the decisions of corporate boards.

In the suit, the Zale plaintiffs had alleged that they were cashed out of their investment at an unreasonably low price due to the involvement of a conflicted financial advisor, Bank of America Merrill Lynch. Zale’s Board of Directors retained Merrill Lynch to advise it as to the financial fairness of the merger. In accepting the engagement, Merrill Lynch failed to inform the Board that it had recently met with Signet to pitch an acquisition of Zale. Notably, the same Merrill Lynch investment banker who led the team advising Zale’s Board had also led the team that pitched to Signet. Further, in the pitch meeting, Merrill Lynch had suggested that Zale pay no more than $21 per share for Zale, and ultimately, the merger was approved by Zale’s Board for an acquisition price of $21 per share. Finally, while Merrill Lynch ultimately informed the Board of its meeting with Signet, it waited to do so until after the merger was announced.

On those allegations, the plaintiffs asserted a claim for breach of fiduciary duty against the Board for insufficiently vetting Merrill Lynch for potential conflicts of interest, and against Merrill Lynch for aiding and abetting the Board’s breach by concealing the conflict from it. Plaintiffs sued Merrill Lynch as aiders and abettors because the bankers owed no fiduciary duties to shareholders.

Initially, Vice Chancellor Parsons found that the plaintiffs had plausibly alleged that Zale’s Board had breached its duty of care to shareholders by not ferreting out Merrill Lynch’s conflict. Parsons noted that Zale had “rather quickly decided to use Merrill Lynch, the only candidate they considered,” and did not ask probing questions designed to detect conflicts of interest, such as whether the bank had made any presentations regarding Zale to prospective buyers within the last six months. Nevertheless, Parsons dismissed the Board from the suit due to an exculpatory charter provision—a protection permitted by Delaware statute that insulates directors from damage claims based on breach of their duty of care. But Parsons sustained the aiding and abetting claim against Merrill Lynch for failing to promptly disclose its meeting with Signet to the Board, which potentially allowed Signet to have the upper hand in negotiations.

However, the day after Parsons issued his opinion, the Delaware Supreme Court undercut it. Specifically, in Corwin v. KKR Financial Holdings LLC, the high court held that a fully-informed vote by an uncoerced majority of disinterested stockholders invoked the deferential “business judgment” standard of review. Practically speaking, business judgment review precludes second guessing of Board decisions, and its application is typically outcome-determinative against shareholder plaintiffs.

The Zales-Signet merger had been approved by 53% of Zale’s shareholders. Accordingly, under Corwin, Parsons should have evaluated the Board’s conduct in vetting Merrill Lynch under the business judgment standard. Parsons had instead applied the stricter “enhanced scrutiny” standard of review. Parsons held that enhanced scrutiny was appropriate under the Delaware Supreme Court’s 2009 decision in Gantler v. Stephens, which he found did not mandate business judgment review where a shareholder vote was statutorily required. Corwin clarified that Parsons had misread Gantler. Corwin said where the approving shareholders were disinterested, fully-informed and uncoerced, it did not matter whether their vote was required or purely voluntary—business judgment was the standard of review. Corwin thus made it exceptionally difficult to find that Zale’s Board had breached its duty of care to shareholders. And because Merrill Lynch’s liability as an aider and abettor was predicated on the Board’s duty breach, the Corwin holding benefitted it as well.

So, after politely holding off for three days —no doubt to give the Zale plaintiffs time to wind up their affairs and come to terms with the inevitable—Merrill Lynch moved for reargument in light of the holding in Corwin. Parsons saved Merrill Lynch the trouble, reconsidering his earlier ruling and dismissing the bank from the case. Perhaps showing his ambivalence at the result, he observed that, “The conduct of Merrill Lynch in this case is troubling, and it was disclosed only belatedly to the Zale Board.”

In a broad sense, the Zale opinions, and the holding in Corwin, illustrate the substantial protections that Delaware continues to afford the directors of companies incorporated there—estimated to be 50% of all U.S. public corporations. By clarifying that banker conflicts may be scrutinized less after a merger receives shareholder approval, it also marks an important qualification to the series of scathing banker conflict opinions that have boiled out of the Court of Chancery in recent years.

For example, in In re Del Monte Foods Co. Shareholders Litigation, Vice Chancellor J. Travis Laster found that Del Monte’s financial advisor Barclays PLC had “secretly and selfishly manipulated the sales process to engineer a transaction that would permit Barclays to obtain lucrative buy-side financing fees.” Likewise, in In re El Paso Corporation Shareholder Litigation, former Chancellor, now Chief Justice of the Delaware Supreme Court, Leo Strine skewered El Paso Board advisor Goldman Sachs for “troubling” conduct that led him to conclude that the transaction was “tainted by disloyalty.” And in In re Rural/Metro Corporation Stockholders Litigation, Vice Chancellor Laster took aim at RBC Capital for steering Rural/Metro’s Board to consummate a deal with an acquirer that RBC secretly hoped would hire it to provide financing for the transaction.

Such rulings are salutary because they recognize that bankers wield considerable influence in merger transactions, and that a self-interested sell-side banker can prevent shareholders from realizing maximum value when cashed out of their investments. As the outcome in Zale shows, Corwin makes it that much more difficult to show director liability after a merger has been consummated. The further rub for investors is that, after Corwin, bankers enjoy more flexibility to act selfishly and against shareholders’ interests —so long as they make the perfunctory disclosures, the deal gets done, and the merger is approved.

Petrobras Court: Opt-Outs Beware

ATTORNEY: MARK B. GOLDSTEIN
POMERANTZ MONITOR NOVEMBER/DECEMBER 2015
 

As reported in previous issues of the Monitor, Pomerantz is lead counsel in a class action lawsuit against the Brazilian oil giant Petrobras. Lead Plaintiff Universities Superannuation Scheme Limited and additional institutional plaintiffs allege securities fraud violations that stem from a large-scale undisclosed bribery and money-laundering scheme that caused tens of billions of dollars of damages to shareholders. On July 9, 2015, the court denied most of defendants’ motions to dismiss, upholding, most notably all of our Securities and Exchange Act claims. The class includes investors who purchased their Petrobras shares after January 22, 2010.

Some investors had decided to opt out of our class action, and to file individual suits. Defendants moved to dismiss their claims as well; and on October 19, 2015, Judge Jed S. Rakoff of the Southern District of New York dismissed their claims “to the extent such claims under Section 10(b) of the Exchange Act cover purchases prior to June 2, 2010, on the ground that such claims are barred by the statute of repose.”

In our class action, by contrast, the court upheld claims going back six months earlier, to January 22, 2010. Therefore, by opting out, these individual plaintiffs forfeited six months’ worth of claims.

 The statute of repose for the Exchange Act bars claims brought more than five years after the occurrence of the fraud. The fraud is deemed to have occurred on either the date the investor purchased the stock or the date of the act or transaction constituting the violation.

 Unlike a statute of limitations, the statute of repose is not concerned with when the investor discovers that he or she has a claim for securities fraud. It acts as a bar to all claims under the securities laws and begins to run from the date the investor purchased the security or from the date of the act or transaction constituting the violation. This five year period had not yet run on any of our claims when we brought our class action.

In opposing the motion to dismiss, the opt-out plaintiffs argued that the statute of repose should be tolled (stopped) for the period these plaintiffs were part of the class. In a case called American Pipe the Supreme Court held that such tolling applied to the statute of limitations: “the commencement of a class action suspends the applicable statute of limitations as to all asserted members of the class.” There currently exists a split among the circuits regarding whether the American Pipe doctrine applies to plaintiffs who elect to opt out of a pending class action prior to a decision on class certification, and a number of district courts, the Sixth Circuit, and the First Circuit have held that tolling of the statute of limitations is not available in such circumstance.

 However, in a case called IndyMac, the Second Circuit held two years ago that the statute of repose under the Exchange Act is not covered by American Pipe tolling. In particular, the Second Circuit ruled, “in contrast to statutes of limitations, statutes of repose create a substantive right in those protected to be free from liability after a legislatively- determined period of time.” The reasoning is that the statute of repose allows issuers and underwriters of securities to know, by a date certain, when all potential claims arising out of a particular securities issuance have been extinguished. This holding was followed by Judge Rakoff when he dismissed the opt-out plaintiffs’ claims covering Petrobras purchases prior to June 2, 2010.

While there may sometimes be good reasons for institutions with large claims to opt out of a class and bring their own actions, they do so at the risk that they will lose some of their claims because of the statute of repose.