The Ascendancy Of “Event-Driven” Securities Cases

ATTORNEY: MATTHEW C. MOEHLMAN
POMERANTZ MONITOR MAY/JUNE 2018

Corporate fraud comes to light by different routes. The Securities Exchange Act’s reporting requirements are designed to compel disclosure and transparency by public companies. Even so, investors cannot always count on bad corporate actors to blow the whistle on themselves.

When a third party reports an event that calls in to question the truth of a company’s statements to the market, some commentators refer to the resulting litigation as “event-driven.” These types of cases have become more common in recent years, as companies have found ways to avoid obvious admissions that their previ­ous statements were wrong. In some quarters, particularly the defense bar, event-driven cases are criticized as applying 20/20 hind­sight to an unprecedented bad event. But in our view, this ignores the many cases in which a company knows but conceals a risk that just such an event will occur. When the event then does occur and investors suffer losses due to the market’s reaction to the materialization of the concealed risk, we believe that the company should be held accountable.

RESTATEMENT CASES – A DWINDLING CATEGORY OF SECURITIES SUIT

Fifteen years ago, securities fraud often came to light when a company restated its past financial results. For example, if a company had engaged in several large, pre-arranged, round-trip transactions with no economic purpose, in order to inflate its reported revenue and cash flow, it might announce that it was restating its financial results to correct them. If the stock then plunged, share­holders suing to recoup their losses could invoke the restatement as an admission that the company’s earlier financials were materially misstated. Since materiality and falsity are two elements of a securities claim, therestatement would significantly strengthen the share­holders’ case.

Times have changed. Litigation analysts report that in the ten years since the Enron securities litigation wrapped up, the number of reissuance restatements filed by pub­lic companies has steadily declined—from nearly one thousand in 2006 to just over a hundred in 2016. Reg­ulatory reforms aimed at deterring accounting fraud may account for the downturn, or corporations may simply have learned that restatements increase litigation risk and learned not to lead with their chins.

In any event, astute shareholders should stay attuned to multiple non-company sources for revelations that dam­age their investment portfolio. Let’s look then at several examples of recent cases in which news reported by third parties prompted shareholder litigation.

EVENT-DRIVEN CORRUPTION CASE— IN RE PETROBRAS SECURITIES LITIGATION

A case prosecuted by this firm, the securities litigation re­lating to the Brazilian state-owned energy giant Petróleo Brasileiro S.A.-Petrobras, shows how investors may first learn of a fraud from external sources and events rather than a company announcement.

Reports of corruption had dogged Petrobras for years. The endgame began in early 2014, when newspapers reported that the Brazilian federal police had arrested a retired Petrobras executive as part of a crackdown on black-market money-laundering.

Petrobras did not mention the incident explicitly in its an­nual report filed the following month, saying only that it was conducting routine internal investigations into certain issues.

Petrobras had still not disclosed the findings of those investigations when, months later, the police released sworn affidavits in which the executive testified to orches­trating a decades-long kickback and bid-rigging scheme along with other top Petrobras executives, over a dozen large construction companies, and many of Brazil’s lead­ing political figures.

In addition to not divulging the scheme, Petrobras never restated its financials, despite having overvalued its fixed assets by, according to its own estimates, $30 billion.

Petro­bras wrote off $2.5 billion as kickback-related overpay­ments, and took a $16 billion asset impairment. Petro­bras argued in its motion to dismiss that $2.5 billion was immaterial to its financial results under SEC guid­ance regarding materiality from a legal and accounting standpoint. In denying Petrobras’ motion, the district court observed that materiality is not limited to a purely quantitative assessment but can also include qualitative factors, such as concealment of an unlawful transaction. In that regard, the court noted that Petrobras’ misstat­ed financials concealed an illegal kickback scheme that, when revealed, called into question the integrity of the company as a whole. The court also found that Petro­bras’ assertions of integrity and high ethical standards were actionable because they were alleged to have been made to reassure the market, and the market may have relied on their truth.

EVENT-DRIVEN PRODUCT CASE— MATRIXX INITIATIVES, INC. V. SIRACUSANO

Some events that lead to actionable claims implicate a company’s representations about its products. Matrixx Initiatives, Inc. v. Siracusano involved a drug manufac­turer that failed to disclose that its popular cold remedy had caused a small number of users to lose their sense of smell. When a morning television show revealed this potential side effect, the stock plummeted. On appeal to the Supreme Court of the United States, Matrixx argued that the possibility of loss of smell was so minute as to be immaterial. The Court disagreed. It found that misstate­ments need not be statistically significant to be material, and held that Matrixx’s press releases touting the safety and efficacy of the cold drug were actionable.

EVENT-DRIVEN OPERATIONS CASE— IN RE VALE S.A. SECURITIES LITIGATION

An event may also reveal a company’s statements about its operations to have been materially false and mislead­ing. In November 2015, it was reported that the Fundão dam in Minas Gerais, Brazil had collapsed, releasing tons of toxic sludge on the village below and leading to the worst environmental disaster in Brazil’s history. The dam was jointly owned by Vale S.A., a multi-national mining concern whose securities trade on NASDAQ.

The dam collapse shattered Vale’s carefully-crafted im­age as a good corporate citizen. While some economists say that the only social responsibility of business is to in­crease profits, socially responsible investing has become a major force across global markets, with over $23 trillion in responsibly invested assets reported to be under man­agement. Vale, like a number of large industrial compa­nies, published a detailed annual “Sustainability Report” in order to win inclusion in the Dow Jones Sustainability Index. Vale stated in one sustainability report that it would “prevent, control or compensate for [environmental] im­pacts,” and that it had “policies, systematic requirements and procedures designed to prevent and minimize risks and protect lives.” The district court found that these statements were actionable. The court, moreover, found that Vale’s executives had been privy to studies showing that the dam was structurally unsound for years before the foreseeable risk of its collapse became a reality.

Pomerantz Secures Milestone Settlement In Yahoo

ATTORNEY: HUI CHANG
POMERANTZ MONITOR MAY/JUNE 2018

Pomerantz is co-lead counsel in a securities fraud class action suit brought by investors in the Northern District of California on behalf of shareholders of Yahoo! Inc. (“Yahoo”). The case arises from the two biggest data breaches in U.S. history, in which Russian hackers stole the records of all of Yahoo’s three billion users in 2013 and compromised the accounts of 500 million users in 2014. In early March 2018, Yahoo agreed to pay $80 million to settle the action filed by the plaintiff shareholders in the action. Plaintiffs alleged that Yahoo and some its officers failed to disclose that these breaches had oc­curred and also failed to disclose two additional massive data breaches in 2015 and 2016, which affected approxi­mately 32 million Yahoo users and caused financial harm to its investors. The suit further alleged that defendants knowingly concealed its deficient security practices and the 2014 data breach from the market. Plaintiff share­holders alleged that the company’s share price fell over 31 percent during the class period in reaction to its data-breach disclosures. These data breach disclosures also had a substantial and quantifiable financial impact on Yahoo when Verizon Communications, Inc. reduced its bid to acquire Yahoo by $350 million, to $4.4 billion.

The proposed Yahoo settlement, which is still subject to final court approval, will be the first substantial shareholder recovery in a securities fraud class action related to a cybersecurity breach. Historically, data-breach disclosures by publicly traded companies have not been generally followed by significant stock price declines, making it hard to show that investors suffered material harm. With stock prices largely unaffected, cyber-related disclosures have instead mainly driven shareholder derivative orconsumer protection actions. For years, data breach classactions have been typically dismissed early on by courts, and were generally unsuccessful.

Recently, however, investors are far more focused on cybersecurity issues and more highly-publicized data breaches have been accompanied by stock price declines. While in the past, investors seemed to be indifferent to news of data breaches, investors now appear more aware of the increased risks of security breaches. This past year alone saw the filing of a handful of securities fraud class actions related to cybersecurity breaches, with the publicly traded companies Equifax Inc., PayPal Holdings, Inc. and Intel Corporation among those sued following cybersecurity breach announcements.

The Yahoo action is significant for another reason as well: on April 24, 2018, the U.S. Securities and Exchange Commission (“SEC”) imposed a $35 million fine on Yahoo in connection with the 2014 data breach, marking the first time a publicly traded company has been fined for a cybersecurity hack. The SEC recounted in its order that Yahoo found out in December 2014 about Russian hack­ers breaching the company’s systems to obtain user-names, phone numbers, encrypted passwords and other sensitive information, yet did not disclose the hack until 2016, when it was closing a deal with Verizon. While the SEC acknowledges that large companies are at risk of persistent cyber-related breaches by hackers, it did not excuse companies from reasonably dealing with these risks and of responding to known cyber-breaches. The SEC said that Yahoo continued to mislead investors with generic public disclosures about the risks of cyber-related breaches when it knew a significant breach had occurred.

The SEC has also recently toughened its reporting guidelines by updating its guidance on cybersecuritydisclosures. The guidance stresses the importance ofcybersecurity policies and procedures and advisescompanies that they need “disclosure controls andprocedures that provide an appropriate method ofdiscerning the impact that such matters may have on the company and its business, financial condition andresults of operations.” It also calls for public companies to be more open when disclosing cybersecurity risks, with companies expected “to disclose cybersecurity risks and incidents that are material to investors, including the con­comitant financial, legal or reputational consequence.”

This milestone settlement in Yahoo, in combination with updated SEC guidelines, may provide the foundation that allows plaintiff shareholders to bring securities fraud actions to pursue these claims with greater success.As exemplified by the Yahoo action, Pomerantz has been at the forefront of cyber-related securities fraud actions.

Are Cryptocurrency Offerings Subject To Federal Securities Regulation?

ATTORNEY: MICHELE S. CARINO
POMERANTZ MONITOR MAY/JUNE 2018

The ability to raise capital through an Initial Coin Offering, or “ICO,” has been hailed as a boon to innovation and economic growth, allowing small businesses and start-ups to bypass traditional (and more expensive) financing sources, such as venture capitalists and investment banks. In fact, in the first four months of 2018, ICOs have raised over $4 billion in funding, already exceeding the $3.3 billion raised in ICOs in 2017, and well ahead of the amounts raised through traditional venture capital.

But what exactly is an ICO, and what are investors buying? And what happens if they don’t get what they expected? Until recently, this emerging, decentralized capital mar­ket has been largely unregulated, exposing investors to price volatility, pump-and-dump schemes, and outright theft by fraudsters and hackers – oftentimes, with no legal recourse. Regulators have now started to take action, making it clear that while cryptocurrencies may be novel, they are not outside the bounds of existing laws.

Cryptocurrency, also known as virtual currency, coins, or “tokens,” is a representation of value that can be digitally traded and exchanged, and that may entitle the owner to certain other rights, such as access to a technology or platform. But it is more than just digital money. Accord­ing to the Securities and Exchange Commission (“SEC”), coins and tokens may also qualify as “securities” under U.S. laws, and thus be subject to regulation, including registration and disclosure requirements. The seminal Supreme Court case SEC v. Howey Co., decided in 1946, sets forth the test for determining if a financial instrument – actual or virtual – is an “investment contract” that meets the definition of a security. Specifically, a transaction is an investment contract if: (1) money is invested in a common enterprise, (2) the investor expects profits from the investment, and (3) the profit comes from the efforts of someone other than the investor. An instrument must meet all three criteria to be considered a security. Coins and tokens, like any other financial instrument, can take many forms, but to the extent a company utilizes coins or tokens to raise capital with the promise of increased value based on the company’s plans or growth prospects (e.g., launch of a new technology or product), coins and tokens seem to satisfy the “common enterprise” and “efforts of others” elements of the Howey test, in the same way as shares of stock. Indeed, just as with stock, the value of a  coin or token on an exchange will fluctuate depending on the perceived performance of the issuing company.

Seeking to avoid the complications and costs of compli­ance with U.S. securities laws, many entities have re-packaged and re-labeled coins as “utility tokens” and have downplayed the expectation of profit and/or prom­ised some future use, such as participation in a digital community. But the SEC recently clarified that labels do not matter: “Whether a par­ticular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.” SEC Chairman Jay Clayton further stated: “By and large, the [ICOs] that I have seen … directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”

While some have decried the regulatory intrusion into this new digital frontier, and others simply have gone the route of blocking U.S. investors from participating in offerings, the benefits of increased investigation and enforcement more than outweigh the potential downside. Industry insiders, including Joseph Lubin, the co-founder of the cryptocurrency Ethereum, and Brad Garlinghouse, CEO of Ripple, agree that curbing fraud will strengthen and legitimize cryptocurrencies and the distributed ledger platforms (“blockchains”) on which they trade. Moreover, to the extent ICOs mirror initial public offerings or other smaller offerings or private placements, there is already a well-established legal framework to ensure both access to capital and protection for investors, including that the coins or tokens be registered and that the issuer make adequate disclosures. These requirements would provide investors with recourse under the Securities Act for initial sales, as well as potential recovery in the instance of market manip­ulation and insider trading, which have been rampant in secondary markets for coins and tokens.

The SEC’s involvement in this area is likely to increase, as evidenced by the creation of a new cyber task force charged with policing ICOs. That task force already has been busy – the SEC filed a fraud suit against the organizers of the PlexCoin ICO in December, with the founder sentenced to jail by Canadian authorities. In recent weeks, the SEC has launched an investigation into Overstock.com’s token sale through its subsidiary tZero, which was supposed to be the first fully-compliant ICO by a publicly-traded company, but which has now been postponed. The SEC also halted trading in Longfin Corp., a cryptocurrency business, alleging that executives com­mitted securities fraud by running up the stock price and then illegally selling large blocks of restricted stock to the public while the price was elevated. The SEC obtained a court order freezing more than $27 million in trading proceeds before the illicit gains could be transferred to offshore entities.

Cryptocurrencies may still disrupt the financial industry and change the way we do business in the future. How­ever, in terms of regulation, the old adage that “the more things change, the more they stay the same,” may still hold true, especially in terms of investor protection.

Ninth Circuit Resolves Loss Causation Issue Under Section 10(B)

ATTORNEY: AUSTIN P. VAN
POMERANTZ MONITOR MARCH/APRIL 2018

In Mineworkers’ Pension Scheme v. First Solar, Inc., the Ninth Circuit recently resolved an internal conflict in its case law regarding the loss causation requirement of Sec­tion 10(b) of the Exchange Act. The court held that a plain­tiff may prove loss causation by showing that revelation of the very facts misrepresented or omitted by the defendant caused the plaintiff’s economic loss, even if the fraud itself was not revealed to the market. That is, to satisfy the loss causation requirement, a plaintiff need not point to a revelation that the defendants committed fraud, but rather only to a revelation of the facts concealed by the fraud. This commonsense ruling greatly improves the ability of investors in California and elsewhere in the Ninth Circuit to recover losses that were sustained as a result of fraud before the fraud itself was revealed to the public.

Defendant First Solar, Inc. is a large producer of solar panel modules. Plaintiffs, a putative class of purchasers of First Solar’s stock, alleged that the company discov­ered manufacturing defects in its solar panel modules that caused them to lose power within the first several months of use, as well as design defects in the modules that caused them to lose power faster in hot climates. Plaintiffs alleged that First Solar hid these defects and their cost and scope from the market and misrepresented key data in their financial statements.

First Solar’s stock price declined steeply after these defects and their cost and scope were revealed to the market. First Solar initially disclosed the manufacturing defect and significant additional costs related to curing the defect and, over the next year, the company disclosed consistently disappointing earnings and financial results, additional expenses related to curing the product defects, and the departure of the company’s CEO. However, at no point did the company or any other party reveal that First Solar had known about, and misrepresented or fraudulently concealed, any of these problems in the past.

On their motion for summary judgment, defendants ar­gued that plaintiffs had not satisfied the loss causation requirement of Section 10(b) because plaintiffs’ losses were not caused by the revelation that First Solar had committed fraud. Plaintiffs replied that revelation of the facts allegedly misrepresented and concealed by defendants, namely, the company’s product defects and related financial burdens, was sufficient to satisfy the loss causation requirement.

The district court identified two irreconcilable lines of Ninth Circuit case law on this issue. The first line of cases began with In re Daou Sys., where the Ninth Circuit reversed a district court’s decision dismissing a Section 10(b) action on the ground that the plaintiffs had not alleged any disclosures that defendants were engaging in improper accounting practices. The Ninth Circuit held that where disclosure of “the company’s true financial condition” caused the stock to drop, loss causation was satisfied, even though the company’s fraudulent accounting practices were not revealed to the market. The Ninth Circuit took a similar approach in Berson v. Applied Signal Technology, Inc., and ultimately fashioned a standard for loss causation in Nuveen v. City of Alameda when it held that a plaintiff can establish loss causation “by showing that the defendant misrepresented or omitted the very facts that were a substantial factor in causing the plaintiff’s economic loss.”

However, the district court in First Solar recognized that a second line of Ninth Circuit cases had applied a dif­ferent standard. In Metzler v. Corinthian Colleges, Inc., the plaintiff alleged that the defendant, an operator of vocational colleges, had manipulated student enrollment data, and that plaintiff suffered losses when the company issued a press release showing lower earnings than the false data had suggested. The Ninth Circuit affirmed dismissal of the complaint on the ground that plaintiff had failed to allege that the market “learned of and reacted to [the] fraud,” as opposed to merely reacting to reports of the defendant’s newly disclosed poor financial health. In In re Oracle Corp., the Ninth Circuit similarly held that plaintiffs cannot prove loss causation “by showing that the market reacted to the purported ‘impact’ of the alleged fraud . . . rather than to the fraudulent acts themselves.” The Ninth Circuit followed the holdings of Metzler and In re Oracle in Loos v. Immersion Corp. and Oregon Public Employees Retirement Fund v. Apollo Group, Inc., both of which held that loss causation requires a showing that the market reacted to the revelation of fraud, rather than the revelation of the facts concealed by the fraud or the impact of the fraud.

The district court in First Solar ultimately applied the stan­dard from the Daou line of cases and held that plaintiffs did not need to show that the market reacted to the fact that First Solar had committed fraud in order to satisfy the loss causation requirement. However, faced with two irreconcilable lines of cases, the district court requested that the Ninth Circuit resolve the conflict on interlocutory appeal.

In a brief yet unequivocal per curiam opinion, the Ninth Circuit affirmed the district court’s holding, and so upheld its prior rulings in Daou, Berson and Nuveen. The Court announced that “[t]o prove loss causation, plaintiffs need only show a causal connection between the fraud and the loss by tracing the loss back to the very facts about which the defendant lied.” Accordingly, plaintiffs may satisfy the loss causation requirement “even where the alleged fraud is not necessarily revealed prior to the economic loss.”

The Ninth Circuit’s holding in First Solar marks its first definitive resolution of the internal conflict in its case law on loss causation. While the Court did not expressly overrule the Metzler line of cases, it limited those cas­es to their facts. Moreover, the Court made clear that, contrary to Metzler and its progeny, a plaintiff may prove loss causation by showing that defendant’s stock price fell upon revelation of an earnings miss, even if the market was unaware at the time that fraud had concealed the miss.

In recent years, defendants in Section 10(b) actions in the Ninth Circuit have routinely cited to the Metzler line of cases to support an argument that loss causation is absent in any case where losses were sustained prior to the market learning the fact that defendants had committed fraud. This standard from Metzler permitted defendants to escape liability under Section 10(b) if the negative impact of their fraud was revealed to the market prior to revelation of the fraud itself. With First Solar, the Ninth Circuit has closed the door to that argument and, in the process, granted a significant victory for investors seeking to recover for losses due to fraud that occured prior to revelation of the fraud itself.

Dept. Of Treasury Promotes Forced Arbitration For IPO Claims

ATTORNEY: LEIGH HANDELMAN SMOLLAR
POMERANTZ MONITOR MARCH/APRIL 2018

When a company goes public, it seeks to raise money from investors by selling securities through an initial pub­lic offering (“IPO”). To effectuate an IPO, the company must file several documents with the SEC, including a registration statement and a prospectus. In these docu­ments, the company relays its financial statements and other important information about its business, opera­tions and strategy. Investors rely on these documents in determining whether to purchase the company’s securi­ties in the IPO.

Under the securities laws, investors can much more eas­ily recover for misrepresentations in IPO offering docu­ments than misrepresentations in non-IPO public disclo­sures. Section 11 of the Securities Act makes companies automatically liable for any material misstatements or omissions in their registration statements; and all officers and directors who sign the registration statement are also presumptively liable. In order to escape liability, these of­ficers and directors carry the burden of establishing that they did not know, and could not reasonably have known, about the misrepresentations. Investor reliance on these misrepresentations or omissions is also presumed, un­less the company can disprove it.

Of course, most investors cannot practically avail them­ selves of these rights unless they can pursue them in a class action. Except for large institutional investors, which may have large-scale individual damages, most investors’ losses are not great enough to justify bringing an individual securities action. The very threat of class action securities suits helps to keep companies honest, especially in their public filings. Investors are able to seek the full amount of damages from the fraud, whereas a government action typically only seeks disgorgement. Class action securities suits based on false or mislead­ing IPO documents have allowed investors to recover billions of dollars over the years. These investors range from an average citizen holding the security in his/her retirement account, to large pension funds. Private class action securities suits on behalf of investors have been a driving force in holding bad actors accountable. It is well-known that SEC resources are limited and that private enforcement has been more effective in not only holding bad actors accountable, but in deterring wrong­doing as well.

The very effectiveness of these Section 11 remedies has made them a prime target of pro-business groups; and the Trump administration is showing signs that it may well be listening to them, in the guise of promoting more IPOs. The U.S. Dept. of Treasury recently issued a report on ways to reduce the cost of securities litigation, including forced arbitration. Bloomberg News has report­ed that the SEC, under its new chair, Jay Clayton, might be looking for ways to effectively ban securities class actions based on misstatements in IPO documents, in favor of forcing arbitration. Often, class actions are impossible to arbitrate; therefore, requiring arbitration could effectively present an insurmountable barrier to any recovery for all but the minority of investors whose losses are large enough to make an individual action practicable.

While this move may promote more IPOs in the United States, taking away real investor rights has serious implications in the United States securities markets. In general, the SEC has been less successful in recover­ing monies for defrauded investors than private lawsuits. Further, as the Wall Street Journal recently reported, foreign investors purchased over $66 billion in U.S. stocks in 2017, which number is predicted to grow. One of the main reasons foreign investors like to invest in U.S. stocks is that the protections of the U.S. securities laws are stronger than those of other countries. The Petrobras case is a great example. There, investors in a class action who purchased pursuant to U.S. trans-actions were able to recover $3 billion (despite Petrobras bylaws requiring arbitration). However, investors who purchased securities through the Brazilian stock ex­change were required to arbitrate their claims rather than bring a private enforcement action. Those investors recovered nothing.

Aside from individual investors not being able to recover in an arbitration, there is another negative side effect: arbitrations are not matters of public record and, therefore, the deterrent effect is negated. Newly-appointed SEC Commissioner Robert J. Jackson, Jr. has recently stated similar concerns, displaying his skepti­cism for mandatory arbitration of these claims.

While SEC Commissioner Michael S. Piwowar indicat­ed he would be willing to consider such a drastic policy change, SEC Chairman Jay Clayton has told a Senate panel that he is “not anxious” to allow investors to be barred from filing securities class action claims after an IPO. Senator Elizabeth Warren has been vocal about refusing to dilute investor rights in this regard. She told Clayton, “The SEC’s mission is to protect investors, not throw them under the bus.” Further, former SEC Chair­man Harvey Pitt urged Clayton to put this issue on the “back burners,” citing the very limited resources that the SEC is already encountering. Jackson, Jr. also voiced concerns with respect to the limited budget of the SEC. Another critic of the proposed policy change, Rick Flem­ing, Investor Advocate at the SEC, has stated his opinion about mandatory arbitration of shareholder claims this way: “stripping away the right of a shareholder to bring a class action lawsuit seems to me to be draconian, and, with respect to promoting capital formation, counterpro­ductive.”

Chairman Clayton recognizes that the issue is complex, with investor rights pitted against public company rights, each with their own strong advocates. He confirmed that any policy change in this regard would be subject to great debate, reiterating his desire to delay decision on this is­sue: “[This] is not an area that is on my list for where we can do better[.]” In other words, Chairman Clayton does not appear to want to decide this issue anytime soon.

Regulation A+ Earns A D

ATTORNEY: JOSHUA B. SILVERMAN
POMERANTZ MONITOR MARCH/APRIL 2018

For more than eight decades, the Securities Act of 1933 has protected investors by requiring full disclosure in initial public offerings. As President Roosevelt explained at the time of its enactment, the statute was intended to restore confidence in public markets by ensuring that important information regarding new issues was not “concealed from the buying public.”

In 2012, the Jumpstart Our Business Startups (JOBS) Act created a new type of offering that largely bypassed these investor protections. Commonly known as a mini- IPO or Regulation A+ offering, the provision allowed small companies to raise $50 million or less with limited regula­tions. Advocates claimed that by bypassing “burdensome” regulations the act would facilitate capital formation, create jobs, and reinvigorate capital markets.

Regulation A+ companies go through only a minimal “qualification” process, avoiding most pre-offering scrutiny from the SEC’s Division of Corporate Finance. Such com­panies are not bound by the “quiet period” rules that restrict advertising of traditional IPOs. As a result, many are promoted by online ads and social media campaigns making aggressive promises. Even worse, Regulation A+ offerings are not subject to the strong private remedy under Section 11 of the Securities Act of 1933.

More than five years after the JOBS Act, none of the promised benefits has materialized. There is no evidence that Regulation A+ has created jobs (except for stock pro­moters) or boosted small business. Peeling back safe-guards, however, definitely hurt investors. Regulation A+ has become a “backdoor” mechanism to facilitate public listings by companies that would not be able to do so by traditional means, and most have resulted in heavy losses. Because most shares in these offerings are foisted on retail investors, they have borne the majority of these losses. But institutions are now getting involved. FAT Brands, for example, claims that institutional inves­tors accounted for 30% of its mini-IPO.

The first company to take advantage of the light-touch regulations, Elio Motors, listed on the OTCQX at $12 after running a heavily-advertised campaign on a crowd­funding site. Shares now languish below $3, less than 25% of their price at the time of listing. Instead of creating jobs, the undercapitalized manufacturer of three-wheeled vehicles has furloughed workers.

More than a dozen other companies have since used Regulation A+ to go public, with many even listing on the NASDAQ or NYSE. A recent study by Barrons magazine confirms that investors lost money in nearly all of these offerings. The fourteen offerings reviewed by Barrons dropped by an average of 40% on a price-weighted basis during their first six months of trading, at a time when the Russell 2000 and S&P SmallCap 600 indexes both registered strong gains.

Predictably, the reduced scrutiny of Regulation A+ has attracted promoters with shady pedigrees. For example, the CEO of Level Brands, Martin Sumichrast, was previously known for bringing low-quality companies public through Stratton Oakmont, the infamous penny-stock brokerage featured in Wolf of Wall Street. Rami El-Batrawi, the CEO and founder of YayYo, a ride-sharing company that filed to go public in 2017, was until recently banned from serving as an officer or director of a public company under a consent judgment settling claims that he manipulated trading of his prior company, Genesis Intermedia.

Although Regulation A+ has been a disaster by any objective measure, lawmakers seem intent to double down. A bill currently pending in the House of Representatives would raise the limit of Regulation A+ offerings to $75 million. Until Congress begins to consider the needs of investors, it truly is “buyer beware.”

Supremes Hold That State Courts Still Have Jurisdiction Over Securities Act Class Actions

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR MARCH/APRIL 2018

Since the Securities Act of 1933 (the “Securities Act”) was first enacted, it has provided that state and federal courts have “concurrent” jurisdiction over cases brought under that Act. So Congress passed SLUSA, the Securities Litigation Uniform  Standards Act of 1998, which prevents investors from bringing so-called “covered class actions” under state law which parallel misrepresentation claims under federal securities laws. Generally speaking, section 77p of SLUSA defines “covered class actions” as cases, brought on behalf of fifty or more investors in securities listed on a national exchange, that allege that defendants made misstatements or omissions in connection with initial public offerings, in violation of state law. The intent was to prevent investor plaintiffs from bringing state law cases alleging misrepresentations in securities transactions.

As we reported in the September/October 2017 edition of the Monitor, the Supreme Court had granted certiorari in a case called Cyan. That case poses the question of whether SLUSA deprives state courts of jurisdiction over class actions under the Securities Act.

The Cyan case concerns one of SLUSA’s “conforming” amendments, which added the following phrase to the Securities Act’s provision allowing state court concurrent jurisdiction over Securities Act claims: “except as provided in section 77p of this title with respect to covered class actions.” Since “covered class actions” are defined as actions raising state law claims, not securities laws claims, this “exception clause” seems to be a non sequitur.

So what does SLUSA’s “exception” clause mean? De­fendants said that it means that class actions under the Securities Act can no longer be prosecuted in state courts. Plaintiffs said that section 77p does not actually say that and applies only when a complaint contains claims under both the Securities Act and state law. The government had a third position, which is that such cases could still be brought in state courts, but that defendants could then have them “removed” (transferred) to federal courts.

The Supreme Court has now spoken. In a unanimous opinion, it agreed with the plaintiffs, holding that Securities Act cases can still be brought in state courts, and can­not be removed to federal courts. According to the Court, section 77p “says nothing, and so does nothing, to deprive state courts of jurisdiction over class actions based on federal law. That means the background rule of §77v(a)— under which a state court may hear the Investors’ 1933 Act suit – continues to govern.”

What, then, does the “exception clause” actually remove from state court jurisdiction? In our article last fall, we noted that “the exemption is codified in the jurisdictional provision of the Securities Act, so it must mean that concurrent jurisdiction does not exist for some claims under the Act. What those claims are is a puzzlement that only the Supreme Court can resolve.” As it turns out, the Court could not figure that out either.

The opinion states that the investors might be right that the “exception” clause applies only when the case involves both state law and Securities Act claims. Or it might be there for some other reason. It concluded that “[i]n the end, the uncertainty surround­ing Congress’s reasons for drafting that clause does not matter. Nor does the pos­sibility that the risk Congress addressed (whether specific or inchoate) did not exist. Because irrespective of those points, we have no sound basis for giving the “except” clause a broader reading than its language can bear.”

In cases involving statutory interpretation the Supreme Court has, in recent years, been relying heavily on the “plain meaning” of statutory language, a doctrine that presupposes that Congress, in passing statutes, means exactly what it says and says exactly what it means. Sometimes, though, Congress uses language that makes no sense. That seems to be what happened here.

Defendants in securities cases often believe that state courts will be more favorably disposed towards investor plaintiffs than the federal courts will be. If that is true, the Supreme Court’s decision in Cyan will preserve this tactical advantage for investors.

Recent Derivative Actions Highlight Directors' Obligation To Monitor And Prevent Employee Misconduct

ATTORNEY: VERONICA V. MONTENEGRO
POMERANTZ MONITOR JANUARY/FEBRUARY 2018

A pair of recent noteworthy derivative actions highlight directors’ potential liability for failure to prevent miscon­duct by employees. In In re Wells Fargo & Company Shareholder Derivative Litigation, plaintiffs brought a derivative action alleging that the company’s officers and directors “[f]rom at least January 1, 2011 … knew or consciously disregarded that Wells Fargo employees were illicitly creating millions of deposit accounts and credit card accounts for their customers, without those customers’ knowledge of consent.” In a 189-page com­plaint, filed in the Northern District of California, plaintiffs allege that cross-selling, the sale of new products and services to existing customers, was paramount to Wells Fargo’s financial success. Various Wells Fargo annual reports during the time period explained that the com­pany’s strategy was to increase the cross-sell business model and touted Wells Fargo as the “king of cross sell.” In order to fulfill its cross-selling plan, Wells Fargo implemented what was known as the “Gr-Eight Initiative,” which set a strict quota of eight products per household that bankers had to sell. Plaintiffs allege that the setting of these types of quotas translated into pressure on bankers to open numerous accounts per customer.

Like many companies, Wells Fargo’s articles of association include a so-called “raincoat” provision that protects directors from personal financial liability for breach­es of fiduciary duty that do not involve self-dealing or conscious misconduct amounting to bad faith.Such pro­visions have, in the past, made it extremely difficult to prosecute misconduct claims against directors for failing to prevent misconduct by employees. Yet here the court held that the alleged misconduct, as pleaded in the action, could be sufficient to meet the bad faith threshold.

Specifically, here Wells Fargo’s directors and senior management received numerous “red flag” warnings that the quota system was leading to widespread misconduct. For example, in September 2007, Wells Fargo directors received letters from employees discussing how the Gr-Eight Initiative created high-pressure sales conduct that resulted in unethical and illegal activity. Also, in 2008, Wells Fargo began tracking employee complaints regarding unethical sales practices, and between 2008 and 2013, several lawsuits against the company involved allegations of unauthorized account creation. In 2011, two branch managers emailed Wells Fargo CEO John Stumpf warning him that employees were creating fake accounts to meet the company’s sales quotas, and they were fired in retaliation. A December 2013 Los Angeles Times article reported that, based on a review of internal bank documents and courts records and interviews with almost 30 former and current Wells Fargo employees, they had determined that Wells Fargo employees had engaged in fraudulent account opening tactics fomented by the relentless pressure to sell. In September 2016, Stumpf testified before the Senate Banking Committee that he had discussed the article with the board. On April 3, 2015, a former Wells Fargo banker both mailed and emailed a letter to Stumpf and the board advising them of unethical practices in sales due to continuous management pressure, and during the next several months continued to email Wells Fargo representatives, copying the board and asking for updates. Additionally, in May 2015, a consumer class action challenging the illicit account creation scheme was filed against Wells Fargo. In 2014, the Office of the Comptroller specifically identified the need to assess cross-selling and sales practices as part of its upcoming examination of the company’s governance process, and in 2015 it issued several Supervisory Letters highlighting the lack of an appropriate control or oversight structure given corporate emphasis on product sales and cross-selling. In September 2016, Stumpf testified before the Senate Banking Committee that he learned of the fraud in 2013 and that the board learned of it later in 2013 and 2014. In response to written questions, he confirmed that at least from 2011 forward, the board’s Audit and Examinations Committee received periodic reports of Wells Fargo’s Internal Investigations Group, which investi-gates issues involving team members, as well as information on suspicious activity reporting.

In a decision last year, the court refused to dismiss the complaint, explaining that under the standard for director oversight liability and the standard for breach of the duty of care when the company has adopted an exculpa­tory provision protecting directors from financial liability, plaintiffs “must allege particularized fact that show that a director consciously disregarded an obligation to be reasonably informed about the business and its risks or consciously disregarded the duty to monitor and oversee the business.” In denying defendants’ motion to dismiss, the court held that “the extensive and detailed allegations in the complaint plausibly suggest that a majority of the Director Defendants did precisely that.” The court pointed to the numerous “red flag” allegations in the complaint and ruled that when viewed together, these allegations bolstered the conclusion that the director defendants consciously disregarded their fiduciary duties to the company. Additionally, the court rejected defendants’ ar­guments that the termination of 5,300 employees over a period of five years demonstrated that the company’s oversight systems and controls were working, hold­ing that the allegations, taken as a whole, support an inference that director defendants knew that the unauthorized creation practices were not isolated, but rather a systemic issue that was rampant and that the company’s oversight systems and controls for sales integrity issues were inadequate.

Similar issues were presented in a case involving Twenty- First Century Fox (“Fox News”). It started as a request for inspection of corporate books and records under Section 220 of the Delaware Corporations Code, made when a stockholder of record, the City of Monroe Employ­ees’ Retirement System, submitted a production request. The request came soon after the July 2016 complaint filed by former Fox News reporter, Gretchen Carlson, against the company for sexual harassment and wrong­ful termination. Carlson alleged that Fox News CEO Roger Ailes had harassed and retaliated against her. The company opened a full-fledged investigation which led to Ailes’ ouster as well as allegations against Bill O’Reilly and others. In the summer of 2017, Fox News and the City of Monroe Employees’ Retirement System entered into a mediation agreement and the Stipulation of Settlement of the books and records case, filed concur­rently with a verified derivative complaint in the Delaware Court of Chancery, on November 20, 2017. The complaint, filed against CEO Rupert Murdoch, his two sons, the com­pany’s other directors and the Roger Ailes estate, alleges that Fox News had a systemic, decades-long culture of sexual harassment, racial discrimination and retaliation that led to a hostile work environment. It further alleges that the company did not take steps to address work-place issues such as sexual harassment and racial discrimination and that it failed to implement controls sufficient to prevent the creation and maintenance of a hostile work environment. The revelations not only led to numerous sexual harassment settlements and racial discrimination lawsuits, but to departures of talent and damage to the company’s good will and reputation, as well as significant financial harm.

The complaint pointed to numerous past sexual harass­ment allegations against Roger Ailes and Bill O’Reilly, as well as an EEOC settled charge against a mid-level Fox News Executive, as red flags showing that the company was aware of employee misconduct and was still not prompted to open a formal inquiry. Not only was no inquiry conducted until after Carlson’s lawsuit, but the company and the board failed to implement sufficient oversight over the workplace to prevent massive damage to the company. The complaint also detailed that the company has had to pay over $55 million in settlements over the unaddressed misconduct. The settlement provided for $90 million, as well as the implementation of governance and compliance enhance-ments at the company. In their brief filed in support of their motion for court approval of the settlement, plaintiffs’ counsel stated that a corporate board can­not pretend that such repeated conduct is isolated nor that it does not and will not pose a grave risk to companies and their shareholders.

While the Wells Fargo and Fox News cases have various differences, their shared similarity is worth highlighting: turning a blind eye to employee misconduct by failing to investigate red flags and establish strong monitoring controls runs the risk of companies’ executives being held accountable regardless of their lack of participation. Neither of the cases alleged that the company’s directors or executives engaged in the wrongdoing, but rather, that they breached their fiduciary duties because they knew of or consciously disregarded the alleged misconduct and failed to stop or prevent it.

Cryptocurrency: A New Frontier For Securities Fraud

ATTORNEY: ADAM GIFFORDS KURTZ
POMERANTZ MONITOR JANUARY/FEBRUARY 2018

Lately, Bitcoin and other digital currencies have been mak­ing headlines almost every day. For good reason: more and more people use them, while their value fluctuates wildly on an almost daily basis. Some proclaim it as the next giant leap forward in commerce, while others fear that it portends a financial apocalypse.

One conclusion, however, seems indisputable: cryptocur­rency is opening the door to a whole new breed of spec­ulators and their inevitable byproduct, securities fraud. The United States Securities and Exchange Commission (“SEC”) has wakened to this new threat by creating a new fraud unit, while Pomerantz recently became the first law firm to file an action alleging securities fraud involving a cryptocurrency company.

But first, a short primer for those who are not yet fluent in the language of bitcoin, blockchain and initial coin offerings.

EVERYTHING YOU WANTED TO KNOW ABOUT CRYPTOCURRENCY BUT WERE AFRAID TO ASK

What is cryptocurrency?
Cryptocurrency is a digital form of money—a type of digital token that relies on cryptography for chaining to­gether digital signatures of token transfers, peer-to-peer networking and decentralization. Cryptography is the science of coding and decoding messages so as to keep these messages secure. Coding takes place using a key that ideally is known only by the sender and intended recipient of the message.

What is Bitcoin?
Bitcoin, the most well-known form of cryptocurrency, was created in 2008 by an unknown person or group of people under the alias Satoshi Nakamoto, and released in 2009 as open-source software—in other words, soft­ware with source code that anyone with programming knowledge can inspect, modify, and enhance. Transac­tions are made with no middle men, and therefore no banks.

Why Bitcoin?
In February 2009, Nakamoto wrote, “The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a frac­tion in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.”

So what is a bitcoin, if it does not exist in the three-dimensional sphere of paper money, coins, and gold blocks?
Each bitcoin is created in a process called mining, by which transactions are verified and added to the public ledger, known as the blockchain. Anyone with a suffi­ciently robust computer and impressive tech chops can mine for bitcoin, but it is not a task for the casual surfer. One must compile recent transactions into blocks and try to solve a computationally complex puzzle by a very long process of trial and error. The person who first solves the puzzle gets to place the next block on the blockchain and claim the rewards: the transaction fees associated with the transactions compiled in the block, as well as newly released bitcoin. Nakamoto predetermined a hard limit of 21 million bitcoins to be generated by 2140. As of January 2018, 80% of the 21 million has been mined.

How can I get and use Bitcoins?
If you don’t want to earn your bitcoins through mining, you can also purchase them through exchanges set up for that purpose. You register your details via the exchange, deposit your local currency, and then purchase the bitcoin at the current rate of exchange. Once you’ve pur­chased your bitcoin, it is best, for security reasons, not to leave it on the exchange for too long, but instead to move it into a software wallet, such as the Bitcoin QT client, where it will be stored on your own computer until you are ready to make a purchase or sell your bitcoin. Today, any individual investor can open a bitcoin wallet online and buy a bitcoin with U.S. dollars or other currency, and then buy and sell on any number of online cryptocurrency or ICO trading platforms.

According to a December 2, 2017 article in Business Insider, one of the first tangible items ever purchased with the cryptocurrency was a pizza. Today, the amount of bitcoin used to purchase those pizzas is valued at $100 million. Obviously, you can buy pizzas with bitcoin only if the restaurant accepts it.

In 2017, the value of Bitcoin was up over 1,300%, while other cryptocurrencies, such as Ripple, Litecoin and Ethereum, were up over 36,000%, 5,000% and 9,000%, respectively. There have also been massive declines in value, but so far these have not been permanent. These wild fluctuations provide fertile grounds for speculation, not to mention fraud.

How do crypto tech startups raise money?
In 2017, tech startups, mostly in crypto tech, raised over $4 billion in startup capital through a new crypto tech funding method called Initial Coin Offerings (“ICO”), which is also based on blockchain technology. ICOs are like a cross between a traditional Initial Public Stock Offering and crowdfunding. Instead of buying shares of stock, investors typically acquire “crypto coins,” which the company produces or hopes to produce, and which investors hope will increase in value once the venture is launched. Thus, ICOs differ from traditional IPOs in that purchasers are not getting an ownership stake in a private company and its proprietary software. They are, in effect, buying the venture firm’s currency, which may or may not prove to have value. That is one reason ICOs have become notorious for pump-and-dump scams.

The blockchain.
The blockchain is the technology that makes Bitcoin, cryptocurrencies and ICOs work. In short, the blockchain technology is open-source software that creates a ledger maintained and visible by all users, and that cannot be altered or erased. The blockchain is like an immutable, comprehensive, real-time Google Docs Excel spread­sheet maintained and visible by every user that correctly records every transaction.

In a NYT article dated January 16, 2018, Steven Johnson wrote:

The only blockchain project that has crossed over into mainstream recognition so far is Bitcoin, which is in the middle of a speculative bubble that makes the 1990sinternet I.P.O. frenzy look like a neighborhood garage sale. And herein lies the cognitive dissonance thatconfronts anyone trying to make sense of the blockchain: the potential power of this would-be revolution is being actively undercut by the crowd it is attracting, a veritable goon squad of charlatans, false prophets and mercenaries. … the Bitcoin bubble may ultimately turn out to be a distraction from the true significance of the blockchain.

Nefarious ways bitcoins have been used.
One of the key features of cryptocurrency is the anonymi­ty of transactions. When the Silk Road, an online market­place for illegal drugs, launched in 2011, it used bitcoin as its chief form of currency. According to the same De­cember 2, 2017 article in Business Insider quoted above:

Bitcoin is inherently traceless, a quality that made it the ideal currency for facilitating drug trade on the burgeon­ing internet black market. It was the equivalent of digital cash, a self-governing system of commerce that pre­served the anonymity of its owner.

With Bitcoin, anyone could take to the Silk Road and purchase cannabis seeds, LSD, and cocaine without re­vealing their [sic] identities. And the benefit wasn’t entirely one-sided, either: in some ways, the drug trafficking site legitimized Bitcoin as a means of commerce, even if it was only being used to facilitate illicit trade.

The energy used to mine for bitcoins.
The creation of each virtual bitcoin consumes real en­ergy—an exorbitant amount. According to a December 2017 article in Ars Technica, the bitcoin network is con­suming power at an annual rate of 32TWh—about as much as the country Denmark. Each Bitcoin transaction consumes 250kWh, enough to power a home for nine days. Some crunching the numbers predict that the Bitcoin network will use as much electricity as the entire world does today by early 2020, a sober­ing thought.

EFFORTS BY POMERANTZAND THE SEC TO TAME CRYPTOCURRENCY ABUSES

Pomerantz and the SEC are actively in­volved in anti-fraud §10(b)(5) efforts and enforcement activity, respectively, as they pertain to the cryptocurrency and ICOmarketplace.

Last year, the SEC made it clear that most ICOs and the sale of their tokens will constitute the sale of securities within the meaning of the U.S. securities laws and, therefore, most ICOs will be subject to SEC registration, enforcement and the securities’ antifraud laws. Since this first enforcement action, SEC Chairman Clayton specifically warned that the SEC will investigate and prose­cute ICOs for securities law violations, and that he had yet to see an ICO that was not a sale of securities required to comply with all securities laws.

The SEC also announced the formation of a new, ro­bust internal cyber-crime unit that will police the crypto marketplace targeting distributed ledger technology and ICOs for securities law violations. In December 2017, the SEC obtained a cease and desist order against a tech company that was in the process of a $15 million ICO, for selling unlicensed securities. Currently, China and South Korea have banned Bitcoin trading, and recently

The only blockchain project that has crossed over into mainstream recognition so far is Bitcoin, which is in the middle of a speculative bubble that makes the 1990s internet I.P.O. frenzy look like a neighborhood garage sale. And herein lies the cognitive dissonance that confronts anyone trying to make sense of the blockchain: the potential power of this would-be revolution is being actively undercut by the crowd it is attracting, a veritable goon squad of charlatans, false prophets and mercenaries. … the Bitcoin bubble may ultimately turn out to be a distraction from the true significance of the blockchain.

Merrill Lynch, the brokerage arm of Bank of America, has banned its financial advisors from trading Bitcoin for their clients because it is “too much of a risk” for investors, according to an internal memo circulated to 17,000 of its of its own traders.

On December 21, 2017, Pomerantz was the first law firm to file a securities fraud class action complaint against the Crypto Company (“CRCW”), a crypto currency company. We allege that CRCW engaged in stock manipulation after its shares surged more than 17,000% in less than 3 months and to have made false and misleading statements relating to the compensation of paid promoters and the insider sale of stock. CRCW traded over-the-counter at $575 per share when trading was suspended by the SEC on December 19, 2017.

Pomerantz, at the leading edge of the litigation area relating to cryptocurrency, is working to protect investors in this cryptic and to date under-regulated field.

Pomerantz Achieves “Stunning” Class Action Settlement In Petrobras

ATTORNEY: EMMA GILMORE
POMERANTZ MONITOR JANUARY/FEBRUARY 2018

In a significant victory for investors, Pomerantz, as sole lead counsel for the class, along with lead plaintiff Universities Superannuation Scheme Limited, has achieved a historic $2.95 billion partial settlement with Petróleo Brasileiro S.A.–Petrobras–and its related entity, Petrobras International Finance Company, as well as certain of Petrobras’ former executives and directors, as well as a $50 million settlement with Petrobras’ auditor, Pricewaterhouse Coopers Auditores Independentes. This is not only the largest securities class action settlement in a decade, but is the largest settlement ever in a class action involving a foreign issuer, the fifth-largest class action settlement ever achieved in the United States, and the largest settlement achieved by a foreign lead plaintiff.

The litigation against Brazil’s energy giant, Petrobras, involved accusations that the company concealed a sprawling, decades-long kickback scheme from investors. The scandal ensnared not only Petrobras’ former ex­ecutives but also Brazilian politicians, including former presidents and at least one third of the Brazilian Congress. According to plaintiffs, defendants’ fraudulent scheme involved billions of dollars in kickbacks, and tens of billions of dollars in overstated assets, resulting in significant loss­es to Petrobras investors. Plaintiffs asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Sections 11, 12(a)(2) and 15 of the Securities Act of 1933.

A January 8, 2018 article in Corporate Counsel reported on the historic settlement: “If any general counsel out there are still letting their companies sleepwalk through compli­ance programs, Wednesday’s $2.95 billion class action settlement with the Brazilian oil company Petrobras should smack them wide awake.”

Law360, reporting on the settlement in a January 5, 2018 article, remarked that the “stunning sum combined with a key legal ruling in the case will add gas to the booming market for securities class actions, lawyers say. … At a period when new securities suit filings are nearing all-time highs, such a blockbuster payday will likely encourage other would-be filers.”

The settlement was achieved after nearly three years of hard-fought litigation, including U.S. and foreign discovery and complex motion practice in the Southern District of New York and an appeal at the United States Court of Appeals for the Second Circuit, and during the pendency of a petition by defendants for a writ of certiorari to the United States Supreme Court.

Pomerantz’ achievement is significant not only for the outstanding multi-billion dollar recovery to investors, but also for the precedent-setting decisions achieved during the litigation. Jeremy Lieberman, Co-Managing Partner of Pomerantz, who led the firm’s Petrobras litigation, commented:

We are very pleased with this historic settlement. Throughout the course of this litigation, plaintiffs achieved important precedents at the Second Circuit Court of Appeals regarding the ascertainability requirement during class certification, as well as the utility of event studies for es­tablishing predominance in securities class actions. These precedents will form the bedrock of class action jurisprudence in the Second Circuit for decades to come. Simply put, this litigation and its ultimate resolution have yielded an excellent result for the Class.

Defendants had appealed the district court’s opinion certifying classes of both purchasers of Petrobras equity and debt on multiple grounds, including for failure to satisfy the re­quirement of ascertainability and for failure to satisfy the burden of showing that the Petrobras securities traded on an efficient market. The Second Circuit accepted the appeal and, in an issue of first impression, squarely rejected defendants’ invitation to adopt the heightened ascertainability requirement promulgated by the U.S. Court of Appeals for the Third Circuit, which would have required plaintiffs to demonstrate that determining membership in a class is “administratively feasible.” The Second Circuit also refused to adopt a requirement, urged by defendants, that all securities class action plaintiffs seeking class certification prove through direct evidence (i.e., via an event study) that the prices of the relevant securities moved in a particular direction in response to new information. The Second Circuit rejected the notion that complicated event studies need to be submitted by plaintiffs at the class certification stage, agreeing with plaintiffs that “event studies offer the seductive promise of hard numbers and dispassionate truth, but methodologi­cal constraints limit their utility in the context of single-firm analyses.”

The impact of precedent set by Petrobras was demonstrat­ed when the Second Circuit handed another significant win to plaintiffs in Strougo v. Barclays PLC–another case where Pomerantz serves as sole lead counsel–where, building on its decision in Petrobras, it held that “direct evidence of price impact . . . is not always necessary to establish market efficiency and invoke the Basic pre­sumption” of reliance. Importantly, the Second Circuit also held that defendants seeking to rebut the presumption of reliance must do so by a preponderance of the evidence rather than merely meeting a burden of production.

Pomerantz Partner, Jennifer Pafiti, commented on the rolof the lead plaintiff in Petrobras:

Universities Superannuation Scheme, the largest private pension fund in the United Kingdom, diligently prosecut­ed this case as lead plaintiff to assist in securing a fantas­tic recovery for defrauded investors as well as achieving some key legal rulings along the way. The settlement serves as a reminder to companies, both foreign and domestic, that raise money by issuing stock on a U.S. exchange that, when it comes to corporate misconduct, their investors will be afforded the protection provided by the United States’ robust securities fraud laws.

Jeremy A. Lieberman led the litigation. Key members of the team were Partners, Jennifer Pafiti, Emma Gilmore, and Marc I. Gross; Of Counsel, John A. Kehoe and Brenda Szydlo; and Associate, Justin Solomon Nematzadeh.

Misrepresentations About Company Ethics Policies Should Be Actionable

ATTORNEY: LOUIS C. LUDWIG
POMERANTZ MONITOR NOVEMBER/DECEMBER 2017

At the recent Annual Institute for Investor Protection Conference held in Chicago, Professor Ann Olazabal of the University of Miami proposed a heightened emphasis on the enforcement of corporate codes of ethics. While this seems like basic common sense, courts in securities class actions have often seen things quite differently, and have repeatedly characterized statements about company codes of conduct as little more than inactionable PR fluff. Fortunately for investors, a countervailing judicial (and regulatory) trend of accountability has emerged, and may yet imbue corporate codes of ethics with the robust prophylactic function envisioned by Professor Olazabal.

To plead a claim under Section 10(b)(5) of the Securities Exchange Act of 1934, a plaintiff must allege that defendants made a material misrepresentation or omission in connection with the purchase or sale of a security, either intentionally or recklessly. Because so many well-known corporate scandals have been the product of serious ethical lapses, it should be actionable that a company chooses to speak falsely about its adherence to internal ethical standards in investor-targeted communications. Yet courts have proven reluctant to permit cases alleging precisely such facts to move forward.

The Ninth Circuit’s decision in Retail Wholesale & Department Store Union Local 338 Retirement Fund v. Hewlett-Packard Co. and Mark A. Hurd provides a prime example. In that case, following a 2006 ethics scandal in which it was revealed that HP had hired detectives to spy on directors, employees and journalists, the company had revised and strengthened its ethics code, or “Standards of Business Conduct” (“SBC”). In 2010, this purported strengthening was put to the test when it was revealed that Mark Hurd, HP’s then- CEO and Chairman, had sexually harassed an HP contractor and falsified expense reports to hide the relationship. In the press release disclosing Hurd’s resignation, HP admitted that Hurd knowingly violated the SBC and acted unethically. HP’s stock plummeted in response to the announcement of Hurd’s resignation, resulting in a $10 billion loss in market capitalization.

Investors filed suit, alleging misrepresentations in the form of HP’s statements about its ethics, which were inconsistent with Hurd’s conduct, or, alternately, material omissions regarding Hurd’s unethical behavior, which plaintiffs claimed HP had a duty to disclose. The district court dismissed, and the Ninth Circuit affirmed, holding, as an issue of first impression, that HP’s ethics-related representations were neither false nor material, and that the plaintiffs had failed to make out a prima facie claim under the Exchange Act.

First, the Ninth Circuit held that HP and Hurd had made no “objectively verifiable” statements regarding HP’s compliance with the SBC. Instead, the HP court described the SBC statements about it as “inherently aspirational” and therefore not “capable of being objectively false.” The court also concluded that “the aspirational nature of these statements is evident. They emphasize a desire to commit to certain “shared values” outlined in the SBC and provide a “vague statement[ ] of optimism,” not capable of objective verification.” Second, the panel found that HP’s ethical representations were not material because companies are required by the SEC to publish their codes of conduct, and that “it simply cannot be that a reasonable investor’s decision could conceivably have been affected by HP’s compliance with SEC regulations requiring publication of ethics standards.” Third, the court rejected allegations that HP and Hurd misled by omission, reiterating the view that these were “transparently aspirational” statements lacking any ironclad guarantee that nobody at HP would ever violate the SBC. In sum, HP outlines a vision of corporate ethics that is strikingly cynical. Indeed, it might even be asked why the SEC requires that codes of conduct be published if corporations do not believe them, while investors cannot believe them.

While HP drastically limits the circumstances under which a corporate defendant’s noncompliance with its code of ethics gives rise to actionable misrepresentations and omissions under the Exchange Act, there are some silver linings. Around the same time that the HP decision issued, the SEC imposed a $2.4 million fine against United Airlines’ parent company for violating the Exchange Act’s accounting provisions when its CEO failed to follow anti-corruption and anti-bribery procedure. Specifically, the airline had secured approval from the Port Authority of New York and New Jersey to build a maintenance hangar at the Newark Airport in exchange for reopening and operating a previously-closed route for the sole purpose of ferrying the Port Authority chairman to and from his home in South Carolina. The route was referred to internally as the “Chairman’s Flight” in an express nod to the bribery underlying its existence.

The SEC’s action against the company relied in large part on code-of-conduct provisions prohibiting bribery and requiring that any waivers from compliance with the code be both brought before the board of directors and publicly disclosed. There was no record that the relevant permission was obtained or the relevant disclosures made. Based on this misconduct, the United States Department of Justice entered into a nonprosecution agreement with United that mandated the airline’s development of a rigorous anti-bribery and anti-corruption compliance program. And because, as the HP experience proves, rules do not enforce themselves, U nited was also compelled to review the new policies at least annually and update the Justice Department as necessary to address developments in the field, as well as evolving international and industry standards. Perhaps most critically, United was required to designate an executive to be responsible for the oversight and implementation of these codes, policies, and procedures, and to report on them to the board of directors.

While private litigants unquestionably lack the enforcement muscle of the SEC, the United episode underscores that institutional change can emanate from a renewed focus on code-of-ethics compliance. The ironic challenge for securities fraud plaintiffs is how to spur that focus while the answer – deterrence through increased litigation – is in plain sight. To this end, some district courts have allowed claims premised on codes of ethics to move forward. They have done so by treating the content of ethical codes not as “aspirational” but as a representation of the state-of-affairs on the ground.

For example, in In re Petrobras Sec. Litig., in which Pomerantz is lead counsel, the court upheld a complaint alleging misrepresentations based on the defendant company’s claims that it had “established a commission ‘aimed at assuring the highest ethical standards,’ … that it ‘adopts the best corporate governance practices,’ … that it undertook to ‘conduct its business with transparency and integrity’ and .… that it was ‘fully committed to implementing a fair and transparent operation.’” More recently, the court in In re Eletrobras Sec. Litig. held that the company’s “repeated assertions about its strong ethical standards stand in stark contrast” with subsequently- disclosed criminal activities, and that therefore actionable misrepresentations had been alleged. It remains to be seen whether these cases or the more skeptical view on display in HP will dominate the landscape going forward, but it stands to reason that where a company’s public, ethical face is little more than a mask, investors will continue to be deceived about what  lies beneath.

Congress Shreds Another Pro-Consumer Regulation

ATTORNEY: SUSAN J. WEISWASSER
POMERANTZ MONITOR NOVEMBER/DECEMBER 2017

As noted in earlier editions of the Monitor, class action “reform” is most often anything but. Witness the Senate’s October 25 passage of a resolution ending the Consumer Financial Protection Bureau’s (CFPB)’s regulation that banned the use of mandatory arbitration clauses in consumer financial agreements. Those clauses not only mandated arbitration but also prevented aggrieved consumers from suing as a class. The House had already voted down the regulation in July, only two weeks after it had been released. On November 2, the President signed the joint resolution, thus killing the regulation for the foreseeable future.  

The CFPB was one of several new agencies established in 2010 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The overarching purpose of Dodd-Frank was to address weaknesses in the regulation of financial institutions that led to the financial crisis and recession of the late 2000’s. As the Washington Post noted at the time of Dodd-Frank’s passage, the CFPB was established “to protect borrowers against abuses in mortgage, credit card and some other types of lending[,] … give[] the government new power to seize and shut down large, troubled financial companies[,] … and set[] up a council of federal regulators to watch for threats to the financial system.”

As part of its mandate, the CFPB was tasked with studying the effect of mandatory arbitration provisions in consumer financial contracts. (Dodd-Frank expressly proscribes the use of arbitration clauses in mortgage contracts.) The results, released in early 2015 after a multi-year study, confirmed what many consumers and creditors already knew: customers hardly ever pursue individual legal actions or arbitration against financial service providers. Ultimately, therefore, clauses barring participation in class actions choke off all avenues of relief that wronged consumers might have otherwise received.

The main reason for this failure to litigate or arbitrate on an individual basis is that, unless their losses are large, the investment of time and money required to pursue an individual action is simply not worth it. Moreover, arbitration clauses commonly require the losing party to pay the legal fees of the winning party. This risk is even greater where creditors employ lawyers with high rates who can staff a case with several attorneys.

Since attorneys’ fees in class actions are awarded only if there is a recovery, and are spread out among the entire class, this is the only economically feasible way to pursue all but the largest consumer claims.

Another important advantage to class actions is that the relief granted may include changes to the offender’s business practices, known as equitable relief. Some examples of these changes are writing protections against self-interested transactions-in-lending into a bank’s policies, and incorporating heightened disclosure requirements by credit card companies into consumer contracts. In the long run, these changes can be of greater value than cash payments as they protect consumers into the future and serve as deterrents for potential bad conduct.

So it was particularly troubling when Congress, claiming concern for consumers and economic growth, used an obscure rule to abolish the CFPB regulation. Under the Congressional Review Act (“CWA”), legislators can disapprove regulatory rules of federal agencies before they take effect if done within sixty “legislative” days after the regulation’s release. And this is what Congress did, in an action that typifies its tactics since January. Unable to pass their own laws, legislators have taken to canceling existing regulations even when members have previously supported deference to an agency’s decisions. Since the 2017 inauguration, Congress has effectively invoked the CWA at least 14 times. Previously, the Act had been used successfully only once since its passage in 1996.

According to a recent Washington Post article, members of Congress  who voted for the CFPB rule’s abolition maintained that keeping  it “would trigger a flood of frivolous lawsuits and drive up credit card rates. Arbitration, they argued, was a faster, cheaper way to settle disputes.” That argument presupposes that all or most consumer class actions are “frivolous.” That is a self-serving assumption promulgated by the potential targets of such litigation, such as big banks. Those lawsuits  that are truly frivolous usually do not get very far, and the possibility that some class actions might not have much merit hardly justifies eliminating them altogether – which is the practical effect of these mandatory arbitration clauses.

Moreover, class actions provide significantly greater monetary relief than individual court cases or arbitrations. The CFPB’s study noted that “between 2010 and 2012, across six different consumer finance markets, 1,847 arbitration disputes were filed. More than 20 percent of these cases may have been filed by companies, rather than consumers.

In the 1,060 cases that were filed in 2010 and 2011, arbitrators awarded consumers a combined total of less than $175,000 in damages and less than $190,000 in debt forbearance. Arbitrators also ordered consumers to pay $2.8 million to companies, predominantly for debts that were disputed.”

At the same time, “[a]cross substantially all consumer finance markets, at least 160 million class members were eligible for relief over [a] five-year period studied. The settlements totaled $2.7 billion in cash, in-kind relief, and attorney’s fees and expenses – with roughly 18 percent of that going to expenses and attorneys’ fees. Further, these figures do not include the potential value to consumers of class action settlements requiring companies to change their behavior. Based on available data, the Bureau estimates that the cash payments to class members alone were at least $1.1 billion and cover at least 34 million consumers.”

As the director of the CFPB said in an August 22, 2017, NY Times op-ed piece, “In truth, by blocking group lawsuits, mandatory arbitration clauses eliminate a powerful means to get justice when a little harm happens to a lot of people.” In the current climate of deregulation, there will be more and more little harms that will go unremedied.

Second Circuit Upholds $806 Million Judgment After Trial Under The Securities Act

ATTORNEY: MICHAEL GRUNFELD
POMERANTZ MONITOR NOVEMBER/DECEMBER 2017

In Federal Housing Finance Agency v. Nomura Holding America, Inc., the Second Circuit recently upheld the $806 million judgment handed down by the district court after a bench trial in 2015. This is one of the few cases arising out of the recent financial crisis to have gone all the way to trial.

The judgment was entered in favor of the Federal Housing Finance Agency (“FHFA”) against Nomura and Royal Bank of Scotland. This case related to residential mortgage -backed securities (“RMBS”) that defendants sold to Fannie Mae and Freddie Mac (which FHFA is the conservator for) between 2005 and 2007, shortly before the housing market collapsed. The district court held that defendants made material misrepresentations in RMBS offering documents in violation of the Securities Act and analogous state securities laws (also known as “Blue Sky laws”), by stating that the mortgages underlying the RMBS had been issued in conformity with underwriting guidelines when, in fact, they had not. Defendants appealed several legal rulings that the district court made prior to and at trial. The Second Circuit ruled in FHFA’s favor on all issues, concluding that the “district court’s decisions here bespeak of exceptional effort in analyzing a huge and complex record and close attention to detailed legal theories ably assisted by counsel for all parties.”

This massive case involved many legal issues and resulted in a district court opinion of more than 300 pages, and a Second Circuit opinion of over 100 pages. The most interesting issues revolved around the question of “negative loss causation.” One of defendants’ main arguments was that their misrepresentations did not “cause” the disastrous decline in value of the securities they sold, and that the broader market collapse was entirely to blame.

Section 12 of the Securities Act provides an affirmative defense to defendants who can establish that some or all of the investor’s losses were not caused by the defendant’s misrepresentations. Here, defendants argued that they were not liable for the decrease in value of FHFA’s RMBS because the entirety of their losses “were attributable to macroeconomic factors related to the 2008 financial crisis and not attributable to [defendants’] misrepresentations.” The Second Circuit rejected this argument because it determined that this was a case where a “marketwide economic collapse is itself caused by the conduct alleged to have caused a plaintiff’s loss.” As the district court determined, the “shoddy mortgage loan origination practices” that defendants misrepresented “contributed to the housing bubble” that created the financial crisis that, in turn, contributed to defendants’ losses.

The Second Circuit also rejected defendants’ argument that their misstatements could not have caused FHFA’s losses because the securities sold here played only a “tiny” role in causing the financial crisis. As the Second Circuit explained, “[f]inancial crises result when whole industries take unsustainable systemic risks. … Defendants may not hide behind a market downturn that is in part their own making simply because their conduct was a relatively small part of the problem.”

This loss causation ruling was based in part on the “heavy” burden that defendants have under the Securities Act to prove that their actions did not cause the plaintiff’s losses. Courts should therefore “presume[e] absent proof to the contrary that any decline in value is caused by the misstatement or omission in the Securities Act context.” Under this “negative causation” standard, “any difficulty separating loss attributable to a specific misstatement from loss attributable to macroeconomic forces benefits the plaintiff.” The court’s decision here thus helpfully explains how difficult it is for defendants to avail themselves of the negative causation defense under the Securities Act.

The Second Circuit also rejected defendants’ attempt to raise the reasonable care defense that is available under the Securities Act. The court held that “no reasonable jury could find that Defendants exercised reasonable care.” This decision was based in part on the deficiencies in the particular due diligence practices that defendants used to review the loans underlying the RMBS at issue in this case. Defendants argued that their due diligence efforts were no worse than procedures being applied at the time across the entire mortgage securitization industry. The court rejected that argument, explaining that “[t]he RMBS industry in the lead up to the financial crisis was a textbook example of a small set of market participants racing to the bottom to set the lowest possible standards for themselves.” Because of this danger, an industry is not allowed to set its own standards of care. Rather, “[c]ourts must in the end say what is required.” The Second Circuit’s analysis here was therefore “only informed by industry standards, not governed by them.” Because of the rampant irresponsible behavior of the mortgage industry that led to the financial crisis, the court concluded that “even if Defendants’ actions on the whole complied with that industry’s customs, they yielded an unreasonable result in this case.”

The issues of causation in the context of a marketwide downturn and compliance with mortgage industry standards that the court addressed here have been raised in many cases arising out of the financial crisis. In agreeing with the district court’s ruling in favor of FHFA, the Second Circuit ruled authoritatively that defendants’ arguments on these issues cannot shield them from liability under the Securities Act.

Another Post-Halliburton II Second Circuit Victory For Pomerantz in Barclays plc

ATTORNEY: TAMAR A. WEINRIB
POMERANTZ MONITOR NOVEMBER/DECEMBER 2017

Several years ago, in a case known as Halliburton II, the Supreme Court reaffirmed the so-called “fraud on the market” theory, which allows investors in securities fraud class actions to establish reliance on a class-wide basis. If the company’s stock traded on an efficient market that reacted quickly to the release of material information by the company, investors are entitled to a “presumption” that they all relied on the defendants’ misstatements, because they would have affected the price at which they bought their stock.

However, Halliburton II also notably allowed defendants the right to try to rebut this presumption of reliance at the class certification stage, by showing that the market for the company’s shares was not, in fact, efficient. Since then, a mountain of ink has been spilled over the question of who has to prove what, and how, on class certification motions that turn on market efficiency.

In November, Pomerantz achieved another seminal post-Halliburton II victory in the Second Circuit for investors in Strougo v. Barclays PLC, where the Second Circuit affirmed the district court’s decision granting plaintiffs’ motion for class certification. The case concerns defendants’ misrepresentations and concealment of risks involving 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. Pomerantz is lead counsel for a class of investors who purchased Barclays’ American Depository Shares (“ADS”) and lost hundreds of millions of dollars when the truth about Barclays’ management of its dark pools came to light.

The district court rejected defendants’ argument that to show market efficiency, plaintiffs must provide 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. While 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 indirect evidence. 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 found, after extensive” analysis, that plaintiffs sufficiently established market efficiency indirectly, and thus direct evidence from event studies was unnecessary.

Leaving no ambiguity, the Second Circuit’s decision affirming that of the district court cited its own recent decision in Petrobras—another Pomerantz victory—and stated that, “We have repeatedly—and recently—declined to adopt a particular test for market efficiency.”

This decision is a significant win for plaintiffs as it conclusively holds that “direct evidence of price impact … is not always necessary to establish market efficiency.” The Court further made clear that the burden on plaintiffs is not “onerous” and that there would be little point to considering factors looking at indirect evidence of market efficiency if they only came into play after a finding of direct efficiency through an event study.

The Second Circuit also put an end to efforts by defendants to minimize their burden of rebuttal, making it abundantly clear that defendants seeking to rebut the presumption that investors rely on prices set on an efficient market must do so by a preponderance of the evidence. In so holding, the Second Circuit recognized that the presumption of reliance would be of little value if defendants could overcome it easily. Specifically, the Court —pointing to language in Halliburton II, the Supreme Court decision addressing the issue— stated that defendants could only rebut the presumption of reliance by making a showing that “sever[ed] the link” between the mis- representation and the price a plaintiff paid and that any such evidence must be “direct, more salient evidence” and held that it would be inconsistent with Halliburton II to “allow defendants to rebut the Basic presumption by simply producing some evidence of market inefficiency, but not demonstrating its inefficiency to the district court.” The Court made clear that to rebut the Basic presumption, the burden of persuasion properly shifts to defendants, by a preponderance of the evidence. The

Court placed the burden of showing there is no price impact squarely upon defendants and confirmed that plaintiffs have no burden to show price impact at the class certification stage.

Jeremy Lieberman, Co-Managing Partner of Pomerantz, commented: “We are very gratified by the Second Circuit’s decision. In reaching this and the Petrobras decision this past summer, the Second Circuit has unambiguously reaffirmed Halliburton II and Basic’s guidance that class certification for widely traded securities such as Barclays and Petrobras is a “common sense” proposition. For too long, defendants have tried to obscure this guidance by attempting to require arcane event studies at the class certification stage, which had little to do with the merits of the case, or the damages suffered by investors. This decision debunks that effort, providing a far easier and more predictable path for securities class actions plaintiffs going forward.

The Barclays and Petrobras decisions will likely form the bedrock of securities class certification jurisprudence for decades to come. In successfully litigating both appeals, Pomerantz is continuing its more than eighty years of trailblazing advocacy for securities fraud victims.”

Pomerantz Secures Reversal In Ninth Circuit In Atossa Genetics Action

ATTORNEY: MICHAEL J. WERNKE
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2017

In a decision issued by the Ninth Circuit on August 18, 2017, Pomerantz scored a major victory for investors in the securities class action against Atossa Genetics, Inc. This is the latest in a series of cases concerning drug companies’ failure to disclose accurately the regulatory approval status of their products. In Atossa, the company represented that two of its cancer screening tests, which were its main source of revenue, had been approved by the FDA, but, in fact, neither had been approved. When the truth finally came out, Atossa’s share price plummeted by more than 46%.

The Ninth Circuit held that the complaint pleaded facts establishing that the company’s statements were materially misleading, in violation of Section 10(b) of the Securities Exchange Act, and reversed the district court’s dismissal of the claims Pomerantz brought on behalf of investors.

Atossa develops and markets products used to detect pre-cancerous conditions that foreshadow the development of breast cancer. At issue in the case are Atossa’s statements concerning FDA clearance of its MASCT System and ForeCYTE Test, which it marketed as being able to detect breast cancer. Our complaint alleges that Atossa’s CEO misled investors by repeatedly stating that the MASCT System and ForeCYTE Test had been approved by the FDA for cancer screening. In truth, the ForeCYTE Test had never been approved. While the MASCT System had been FDA-cleared as a collection device for tissue samples, Atossa was marketing it as part of the cancer screening test. Moreover, Atossa had materially altered the MASCT System but never sought the required updated FDA clearance. Defendants also misled investors by concealing an FDA Warning Letter that demanded that the company cease marketing the ForeCYTE Test as FDA-cleared. Investors were injured when, on October 4, 2013, Atossa publicly disclosed that the FDA demanded that it recall the MASCT System and ForeCYTE Test, admitting that the ForeCYTE Test has not been cleared or approved by the FDA for any purpose and that the MASCT System had never been approved for cancer screening.

Reversing the district court’s dismissal, the Ninth Circuit held that Pomerantz’s complaint adequately alleges that the CEO’s statements that the ForeCYTE Test was “FDAcleared” were materially misleading because they misrepresented the true status of the test. It had never been approved by the FDA, which was material to investors because the test was Atossa’s main source of revenue. Defendants asserted that the company had disclosed in prior SEC filings that the ForeCYTE Test was a type of diagnostic test that did not require FDA clearance, but likely would require such clearance in the near future. The court rejected the argument that this constituted adequate disclosure, because the prior statements did not contradict the CEO’s assertions of FDA approval but, rather, highlighted why his statements were misleading. “That the FDA did not require clearance at the time of the IPO, does not indicate that the ForeCYTE test was not cleared. … If the FDA was likely to start requiring clearance, then surely a reasonable investor would care whether Atossa’s test was FDA-cleared.”

The court also found materially misleading Atossa’s SEC filing that purported to provide notice of the FDA Warning Letter that the company received. While the notice stated that the company received a Warning Letter and identified the FDA’s concerns regarding the modifications to the MASCT System that required a new clearance application, it left out the FDA’s concerns about the ForeCYTE Test lacking FDA clearance. The court rejected defendants’ argument that the notice was not misleading because it stated that the Warning Letter identified “other matters” and that until they were resolved Atossa may be subject to additional regulatory action. For cautionary language to cure an otherwise misleading statement, it must be a forward-looking statement and must be specific enough such that “reasonable minds could not disagree that the challenged statements were not misleading.” The court found that the misleading part of the notice concerned past facts concerning FDA clearance and the FDA’s findings, and the cautionary language was insufficient because it was “vague enough to cover any concern the FDA might have related to Atossa.”

The Ninth Circuit remanded the case to the district court for further proceedings consistent with the court’s decision.

Attorneys Marc I. Gross and Michael J. Wernke were involved in the appeal.

Supreme Court To Decide Whether All Whistleblowers Are Protected By The Dodd-Frank Act

ATTORNEY: OMAR JAFRI
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2017

Next term, the Supreme Court has agreed to resolve a split of authority among the federal courts of appeals on whether an employee who blows the whistle on corporate misconduct internally, but has not yet registered a formal complaint with the SEC, is protected by the anti-retaliation provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”).

Section 21F of the Exchange Act, added by Dodd-Frank, directs the SEC to pay awards to individuals who provide information to the SEC that forms the basis of a successful enforcement action, and prohibits employers from retaliating against such whistleblowers for reporting violations of the securities laws. Section 21F defines a “whistleblower” as “any individual who provides . .  .information relating to a violation of the securities laws to the Commission . . . ” This definition limits whistleblowers to people who actually provide information to the SEC; but subdivision (iii) of the anti-retaliation provisions protects any employee who makes disclosures to the SEC or makes “disclosures that are required or protected under the Sarbanes-Oxley Act of 2002 [“SOX”], . . . the Securities Exchange Act of 1934 . . . and any other law, rule, or regulation subject to the jurisdiction of the Commission.” So, the question is whether the anti-retaliation provisions apply to people who may not fall within the definition of whistleblowers under the Act.

In 2013, the manager of G.E. Energy in Iraq filed a lawsuit against the company pursuant to the antiretaliation provisions of Dodd-Frank. He alleged that he was fired because he reported to senior corporate officers that the company had engaged in corruption to curry favor with a government official in an effort to negotiate a lucrative business deal. When he was fired he had not (yet) reported the violations to the SEC. The Fifth Circuit affirmed the dismissal of his complaint, holding that the plain and unambiguous meaning of the statutory term “whistleblower” did not include anyone who had not yet reported any corporate misconduct to the SEC. It rejected the argument that the anti-retaliation provision was broader than the statutory definition of a whistleblower because it was plausible that an employee could simultaneously report corporate misconduct to both the company and the SEC, thus qualifying for protection. Based on this far-fetched hypothetical scenario, the Fifth Circuit refused to defer to the SEC’s contrary interpretation, and held that the statute’s plain and unambiguous language precluded its application to those who had only reported corporate misconduct to management.

Most federal courts, including the Second and Ninth Circuits, have disagreed with the Fifth Circuit’s reasoning. These courts have concluded that the anti-retaliatory provisions of the statute protect people who are protected or required under SOX, even if they do not meet the statutory definition of a whistleblower. They have held that the anti-retaliation provisions are, at least, in tension with each other if not independently ambiguous, justifying deferring to the SEC’s judgment that internal whistleblowers are protected by Dodd-Frank.

The Fifth Circuit’s reasoning would have an especially dramatic effect on auditors and attorneys, who are prohibited by SOX and SEC rules from filing reports with the Commission unless they first report corporate misconduct to senior managers or to a committee of the board of directors of the company. If they can be picked off before they have a chance to report violations to the SEC, companies may be able to stifle them. Auditors and attorneys played a central role in the Enron and other scandals, and the purpose and intent of SOX is to also regulate the behavior of these professionals. The Fifth Circuit utterly failed to address the impact of its decision on the obligations imposed by SOX on auditors and attorneys.

Supremes To Decide Whether State Courts Still Have Jurisdiction Over Securities Act Class Actions

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2017

The Exchange Act provides that federal courts have “exclusive” federal jurisdiction over all claims brought under the act, meaning that those claims, including anti-fraud claims, cannot be brought in state courts. In contrast, the Securities Act provides for “concurrent jurisdiction” of claims brought under that act, meaning that such claims, including claims relating to initial public offerings, can be brought in either federal or state courts. At least, that’s what we thought until now.

At the end of its last term, in a case called Cyan, the Supreme Court granted cert in a case involving SLUSA, the “Securities Law Uniform Standards Act.” That law was primarily designed to limit investors’ ability to bring class action claims under state law concerning securities transactions (so-called “covered class actions”) in state courts, rather than under federal securities laws in federal courts. To accomplish this goal, SLUSA requires that “covered class actions,” including state law claims involving misstatements in securities transactions, must be litigated in federal court under federal law. The act was passed in response to complaints that securities plaintiffs were recasting federal securities laws claims as state law claims in order to avoid the enhanced pleading requirements for federal claims imposed by the Private Securities Litigation Reform Act (“PSLRA”). The practical effect is that it is no longer possible to bring “covered class actions” under state law in either state or federal court; the claims must be made under the federal securities laws, in federal court, subject to the strictures of the PSLRA – or not at all.

But defendants have also been trying, with mixed success, to use SLUSA as a weapon to keep federal Securities Act claims out of state court as well; some companies and other securities defendants view state courts (so-called “judicial hellholes”) as overly sympathetic to securities laws claims.

The hook defendants have been using to advance this argument is a provision in SLUSA that amends section 22 of the Securities Act to provide that federal jurisdiction over Securities Act claims shall be “concurrent with State and Territorial courts, except as provided in section 77p of this title with respect to covered class actions.”

Although there have been no federal appeals courts rulings on what this exception means, there have been dozens of conflicting rulings by federal district courts and state courts, most notably in the two states where most securities class action litigation is conducted: California and New York. Courts in New York tend to read the exception to mean that state courts no longer have jurisdiction over covered class actions alleging violations of the Securities Act. Others, such as a California state appellate court in Luther v. Countrywide Financial, read the exemption language not as creating a new exemption for all covered class actions, but simply as acknowledging the exceptions to state court jurisdiction that are actually established in section 77p of SLUSA. The Countrywide court explained that

Section 77p does not say that there is an exception to concurrent jurisdiction for all covered class actions. Nor does it create its exception by referring to the definition of covered class actions in section 77p(f)(2). Instead, it refers to section 77p without limitation, and creates an exception to concurrent jurisdiction only as provided in section 77p “with respect to covered class actions.

The Countrywide court held that there was nothing in section 77p that eliminated state court jurisdiction over claims brought solely under the Securities Act, and that therefore SLUSA’s exception to concurrent jurisdiction did not apply in such cases. Yet, the exemption is codified in the jurisdictional provision of the Securities Act, so it must mean that concurrent jurisdiction does not exist for some claims under the Act. What those claims are is a puzzlement that only the Supreme Court can resolve.

It goes without saying that the drafting of this confusing exemption to state court jurisdiction was not among Congress’s finest hours. But given that the overriding purpose of SLUSA was to keep misrepresentation claims under state law out of state court, it would be anomalous if this provision were construed as a backhanded way to restrict jurisdiction over federal claims as well.

Kokesh v. SEC: A Door Is Closed, But Windows Are Opened

ATTORNEY: JUSTIN SOLOMON NEMATZADEH
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2017

In Kokesh v. Securities and Exchange Commission, the Supreme Court recently applied the five-year statute of limitations to claims by the SEC for disgorgement of ill-gotten profits from violations of the federal securities laws. Dealing a blow to the SEC’s enforcement powers, the Court held that the disgorgement remedy is not primarily remedial but more closely resembles a “punishment” subject to the five-year limitation period. By forcing the SEC to move more quickly in these cases, the Kokesh opinion has actually helped plaintiffs in class actions and individual lawsuits. It should motivate the SEC to file actions at an earlier date, and thereby expose securities law violations sooner, better enabling private plaintiffs to file their own actions within the five-year statute of limitations that private plaintiffs face in bringing class actions and individual lawsuits.

In 2009, the SEC commenced an enforcement action against Charles Kokesh, who owned two investment advisory firms, seeking civil monetary penalties, disgorgement, and an injunction. The SEC alleged that between 1995 and 2009, Kokesh misappropriated $34.9 million from four business development companies and concealed this through false and misleading SEC filings and proxy statements. After a five-day trial, the jury found that Kokesh violated securities laws. The district court decided that $29.9 million of the disgorgement request resulting from Kokesh’s violations outside the limitations period was proper because disgorgement was not a “penalty” under §2462. The Tenth Circuit affirmed this decision, agreeing that disgorgement is neither a penalty nor forfeiture, so §2462 did not apply. The Court granted certiorari to resolve a circuit split on this issue, and in a unanimous decision authored by Justice Sotomayor, the Court reversed the Tenth Circuit.

Beginning in the 1970s, courts ordered disgorgement in SEC enforcement actions to deprive “‘defendants of their profits in order to remove any monetary reward for violating securities laws and to ‘protect the investing public by providing an effective deterrent to future violations.’” The Court had already applied the five-year statute of limitations for any “action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise,” when the SEC sought statutory monetary penalties. Disgorgement would also fall under this if deemed a “fine, penalty, or forfeiture.” A “penalty” is a “punishment, whether corporal or pecuniary, imposed and enforced by the State, for a crime or offen[s]e against its laws.” Whether disgorgement is a penalty hinged on two factors: first, whether the wrong to be redressed is one to the public or to an individual; and second, whether the sanction’s purpose is punishment and to deter others from offending in a like manner, as opposed to compensating a victim for her loss.

First, the Court decided that SEC disgorgement is imposed by courts as a consequence of public law violations. The remedy is sought for violations against the United States—rather than an aggrieved investor. This is why a securities-enforcement action may proceed even if victims do not support it nor are parties. Even the SEC conceded that when “the SEC seeks disgorgement, it acts in the public interest, to remedy harm to the public at large, rather than standing in the shoes of particular injured parties.”

Second, the Court decided that disgorgement is a punishment. Disgorgement aims to protect the investing public by deterring future violations: “[C]ourts have consistently held that ‘[t]he primary purpose of disgorgement orders is to deter violations of the securities laws by depriving violators of their ill-gotten gains.’” Sanctions imposed to deter public law infractions are inherently punitive because deterrence is not a legitimate nonpunitive governmental objective. Moreover, disgorgement is not compensatory. Disgorged profits are paid to the district court, and it is within the court’s discretion how and to whom to distribute the money. District courts have required disgorgement regardless of whether the funds will be paid to investors as restitution: some disgorged funds are paid to victims; other funds are dispersed to the U.S. Treasury.

The Court found unpersuasive the SEC’s primary response that disgorgement is not punitive but instead remedial in lessening a violation’s effect by restoring the status quo. According to the Court, it is unclear whether disgorgement simply returns a defendant to the place occupied before having broken the law, as it sometimes exceeds profits gained from violations. For example, disgorgement is sometimes ordered without considering a defendant’s expenses that reduced the illegal profit. SEC disgorgement is then punitive, not simply restoring the status quo, but leaving the defendant worse off. Although disgorgement can serve compensatory goals, it can also serve retributive or deterrent purposes and be a punishment.

This decision puts limits on the SEC’s use of a favored tool—in recent years, the SEC secured nearly $3 billion in disgorgements, more than double what it received in penalties. But the decision should open doors for civil plaintiffs in class actions and individual lawsuits for violations of the federal securities laws. Within the five-year statute of limitations imposed on private civil plaintiffs, the SEC would now have to reveal to investors securities-law violations by companies and individuals who would be defendants in private lawsuits. This will better equip private civil plaintiffs to sue those defendants in a timely fashion. In any case, disgorgement is not a common remedy for private civil plaintiffs in securities lawsuits. Further, defendants who pay relatively less disgorgement in SEC enforcement actions may have more funds to satisfy parallel private civil lawsuits. Through closing the door on an element of the SEC’s enforcement powers, the Court has opened several windows for private civil plaintiffs.

Second Circuit Reconsiders “Personal Benefit” Requirement

ATTORNEY: MARC C. GORRIE
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2017

As the Monitor has reported, in the past year there have been numerous developments concerning the requirements for criminal liability for insider trading. Most recently, in U.S. v. Martoma, the Second Circuit revisited its 2014 decision in U.S. v. Newman and decided that there was no requirement, after all, that the recipient of the leaked information (the “tippee”) be a close relative or friend of the insider who leaked the information (the “tipper”).

The seminal case in this area is the 1983 Supreme Court decision in Dirks v. Securities and Exchange Commission.

There, the Court held that culpability for insider trading can exist if the tipper received a personal benefit for leaking the information, such as when he “makes a gift of confidential information to a trading relative or friend.” The Court did not elaborate on how close the relationship had to be between the tipper and the “trading relative or friend.”

When the Second Circuit decided Newman in 2014, it effectively put the brakes on much of the government’s expansive insider trader enforcement efforts. The Newman court overturned the convictions of two “remote” tippees, who had received the information indirectly from the original tippee. The Newman court held that the government must prove that the tipper had a “meaningfully close personal relationship” with the tippee, and that he expected “at least a potential gain of a pecuniary or similarly valuable nature” to support a finding of criminal liability for insider trading. This heightened standard required a showing that the tipper received some “tangible” benefit other than the satisfaction of rewarding the friend or relative – an interpretation rejected by other circuits. Further, the Second Circuit required that the government must also demonstrate the tippee knew that the tipper breached a fiduciary duty. This can present a major problem if the defendant is a remote tippee, such as colleagues of the original tippee at a brokerage firm, who may have little information of how the information was obtained and under what circumstances.

In Salman v. United States, the Supreme Court affirmed the defendant’s conviction for insider trading, unanimously holding that a jury may infer a personal benefit when a tipper provides inside information to a relative or friend, and that this is sufficient for a finding of criminal liability for insider trading. The Supreme Court went on to address the Second Circuit’s Newman decision, finding that any requirement “that the tipper must also receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends” is inconsistent with Dirks.

On August 23, 2017, the Second Circuit affirmed the insider trading conviction of Mathew Martoma in a 2-1 opinion holding that the Supreme Court’s decision in Salman effectively overruled Newman’s requirement of a “meaningfully close personal relationship,” but did not disturb Newman’s other requirement that a tippee knew that the tipper breached a duty and received a benefit.

Martoma was a pharmaceutical and healthcare portfolio manager at S.A.C. Capital Advisors, LLC, (“S.A.C.”), a former group of hedge funds founded by Steven A. Cohen. During the course of his employment,  he acquired shares of Elan and Wyeth, two companies that were developing an experimental Alzheimer’s drug. Martoma executed these trades based on information he obtained from the chair of the safety monitoring committee for the drug’s clinical trial, Dr. Sidney Gilman. The two of them met in approximately 43 consultations where, for some, Martoma paid Gilman $1,000 per hour. Dr. Gilman disclosed trial results and other confidential information to Martoma during these consultations.

Martoma and Gilman met twice, just before a conference at which Gilman was to present the clinical trial results of the new drug. After these two meetings but before the conference, S.A.C. began to reduce its positions in Elan and Wyeth. Following Gilman’s July 29 presentation disclosing that the drug failed to improve cognitive function in a test of 234 Alzheimer’s patients after 18 months of treatment, the share prices of Elan and Wyeth plummeted. The trades that Martoma’s hedge fund had made in advance of the presentation resulted in approximately $80 million in gains and $195 million in averted losses.

Martoma was convicted of insider trading and during his appeal, the Supreme Court decided Salman, doing away with the personal benefit requirement. Martoma argued that the jury instructions improperly ignored that he did not have a close personal or family relationship with the tipper.

The Second Circuit held that the logic of Salman meant that “Newman’s meaningfully close personal relation- ship requirement can no longer be sustained.” The Court held that “the straightforward logic of the giftgiving analysis in Dirks, strongly reaffirmed in Salman, is that a corporate insider personally benefits whenever he discloses inside information as a gift with the expectation that the recipient would trade on the basis of such information or otherwise exploit it for his pecuniary gain” – whether the recipient has a close personal relationship with the tipper or not.

Acknowledging a vigorous dissent that argued that Salman did not overrule Newman’s “meaningfully close personal relationship” requirement where inferring a personal benefit from a gift, the majority concluded that though the government must still prove that the tipper received a personal benefit, a “meaningfully close personal relationship” need not exist between tipper and tippee.

Though the Second Circuit dispensed with Newman’s “meaningfully close personal relationship” requirement, the other controversial Newman requirement, that the tippee knew the tipper provided inside information in exchange for some benefit, apparently remains intact. Additionally, it appears that one fact-sensitive evidentiary foray was replaced with another, with the government now having to prove “the expectation that the recipient would trade” based on inside information. En banc review of Martoma may also be on the horizon, as the dissent contended the Martoma court could not overrule Newman without convening en banc.

Corporate Governance & Therapeutics

ATTORNEY: GABRIEL HENRIQUEZ
POMERANTZ MONITOR JULY/AUGUST 2017

On September 16, 2015, Lithia Motors, Inc. filed a Form 8-K with the SEC announcing that Sidney DeBoer, its founder, controlling shareholder, CEO, and Chairman, would step down as an executive officer of the company and would receive annual compensation—for life— in consideration for his past services. According to a “Transition Agreement” between Lithia and DeBoer, the company would pay him $1,060,000 and a $42,000 car allowance annually for the rest of his life, plus other benefits. The payments under the Transition Agreement were in addition to the $200,000 per year that DeBoer receives for continuing to serve as Chairman.

Although the company annually submitted its executive compensation packages to a (non-binding) shareholder vote, it did not do so this time, even though the agreement was tainted by obvious self-dealing by the controlling shareholder. Companies usually appoint a special committee of independent directors to negotiate contracts with a CEO or controlling shareholder; but here, Sidney DeBoer and his son, the current CEO, Bryan DeBoer, negotiated all the material terms. The company’s Compensation Committee, consisting of four directors who are purportedly “independent,” had minimal input into the terms of the Transition Agreement. Once it was handed to them, they rubber-stamped it with only minor changes, which had been mostly proposed by, and favorable to, Sidney DeBoer.

Our client, as well as another one of Lithia’s shareholders, filed derivative complaints on behalf of Lithia in Oregon state court, where Lithia is headquartered. We alleged that the board of directors breached its fiduciary duties by approving the Transition Agreement without any meaningful review, injuring the company and its shareholders. We also alleged that the board was not independent and was conflicted due to the existence of longstanding relationships between the purportedly independent directors and Sidney DeBoer, as well as significant compensation paid to the directors, which they would lose if Sidney DeBoer decided to remove them from the Board. At the time of the approval of the Transition Agreement, Lithia’s Audit and Compensation Committees (both of which reviewed the agreement before it was entered into) had the same four members; the only difference was which director served as chair of the respective committees. Each of the four members had close personal ties to Sidney DeBoer.

Documents obtained by plaintiffs during the discovery phase of the litigation revealed that Sidney DeBoer: routinely attended meetings of the Compensation Committee responsible for setting his compensation and the compensation of Bryan DeBoer; was directly involved in setting compensation for management and the Board; and single-handedly made determinations regarding the composition of the Board, and continues to dominate and hold tight command over Board decisions. If Sidney DeBoer did not agree with how the Compensation Committee would vote on a particular matter, he would instruct to hold off on the vote until each director had a discussion with him first. The consequences of this lack of checks and balances was clear. The directors approved an agreement that committed Lithia to paying lavish sums indefinitely, regardless of whether Sidney DeBoer provided services effectively for Lithia, or even if he provided no services at all.

This circumstance highlights the need to have an independent board of directors able to effectively monitor management and corporate success without undue influence by the CEO, Chairman, controlling shareholder— or all three, as was the case here.

Through extensive litigation efforts, Pomerantz, together with its co-counsel, was able to extract corporate governance therapeutics that provide substantial benefits to Lithia and its shareholders and redress the wrongdoing alleged by plaintiffs. For example, the Board will be required to have at least five independent directors as defined under the New York Stock Exchange rules by 2020; all future life-time compensation contracts for named executive officers exceeding $1 million per year must be submitted to shareholders for approval, and will be reviewed by disinterested members of the Audit Committee; the Audit and Compensation Committees shall each have at least one independent director who is not a member of both committees; a four-consecutive-year term limit shall be imposed for the chair of committees of the Board; a 15-year term for shall be imposed for service as an independent director on Lithia’s Board; Lithia will also publicly disclose, in information accompanying its annual proxy statement and accessible on Lithia’s website, the most recent five years’ compensation of the named executive officers. Finally, but perhaps most importantly with regards to the issue at hand, the settlement calls for the Transition Agreement to be reviewed by an independent auditor who will determine whether the annual payments of $1,060,000 for life toSidney DeBoer are reasonable. Lithia has agreed to accept whatever decision the Auditor makes.