Pomerantz Hosts International Conference in New York

ATTORNEY: ROXANNA TALAIE
POMERANTZ MONITOR NOVEMBER/DECEMBER 2018

On October 23, Pomerantz hosted its 2018 Corporate Governance and Securities Litigation Roundtable Event in the Four Seasons Hotel in New York City. The Round­table Event provides institutional investors from around the globe with the opportunity to discuss topics that affect the value of the funds they represent, and to net­work with their peers in an informal and educational setting. Presenters are international experts in the fields of corporate governance, securities litigation and asset management. This year, presenters and attendees trav­eled to the Roundtable from across the United States, the United Kingdom, France, Italy, Belgium, and Israel.

The theme of this year’s Roundtable Event focused on women and minorities who have risen through the ranks and have pioneered the path for change and unity in our communities. Pomerantz Partner Jennifer Pafiti, the event’s organizer, says, “We were excited to present is­sues of importance to institutional investors through the lens of diversity. Judging by the robust exchange of ideas during the day’s sessions and the feedback we have re­ceived, these are matters that resonate globally today.” As a first-year associate with Pomerantz, and as a wom­an with an ethnically diverse background, creating and participating in this event was a great point of pride and honor in my career. While our community is at the cusp of change, Pomerantz believes it is pivotal to be at the fore­front to encourage these discussions to further educate and bring awareness to ourselves and members of our community with the hope of encouraging and fostering a change that will benefit us all.

Counsel to a $400-billion European asset management company presented, “Corporate Governance: What Can the World Learn from the European Model?” This session explored the emerging European corporate governance model, and how it compares to its Anglo-American coun­terpart. The European Union’s 2017 Shareholder Rights Directive (“SRD”) mandates that institutional investors and asset managers develop and publicly disclose an engagement policy that describes, among other matters, how they integrate shareholder engagement in their in­vestment strategy, and how they monitor investee com­panies on relevant matters, including ESG: environmen­tal, social, and corporate governance. Of interest to many in the room was the news that the United States receives a relatively low ESG country rating in the EU for the rea­sons that it pulled out of the Paris Agreement on climate change and maintains the death penalty.

“Gunning for Profit” was another session that focused on ethical investing. Following a number of mass shootings in the United States, CalSTRS made the decision to stop investing in companies that sold assault-style weapons or devices that allow guns to fire more rapidly. The ses­sion inspired a lively discussion on whether ethical in­vesting makes financial sense, and provided insight into why CalSTRS, the second-largest pension fund in the U.S., decided to take a stand against the big guns.

The Roundtable Event also discussed the allegations against Harvey Weinstein and how they created a Hol­lywood movement that has since gained momentum around the globe, turning the focus to workplace culture and corporate governance. Beyond Weinstein’s liability, the conversation has since turned to the institutions that allowed those crimes to become a part of the corporate culture. The panel session, “Corporate Governance in a Post-Weinstein Era” addressed such issues. Among other information shared by panelists, Partner Gustavo Bruckner, who heads Pomerantz’s Corporate Gover­nance litigation team, described the firm’s involvement in current litigation relating to sexual and other harass­ment in the workplace (see his article in this issue of the Monitor).

Research indicates that companies with board members representing diversity of thought and culture deliver high­er returns on equity and better growth overall. In the past five years, many countries have passed legislation man­dating diverse board representation or set non-mandato­ry targets. However, some argue diversity cannot be truly measured and performance cannot be attributed to the makeup of those occupying boardroom seats. The panel “Diversity in the Boardroom: Fashion or Fact?” opened up vibrant debate among panelists and Roundtable at­tendees as it explored those conflicting ideals, how sub­conscious bias can affect selection processes, and why diversity in the boardroom should foster an environment in which every shareholder is represented.

In “Unleash the Lawyers: Securities Litigation Policy and Practice,” a panel of lawyers shared their thoughts on the hallmarks of a robust securities litigation policy and what to do to mitigate a fund’s liability in the absence of one.

Jeremy Hill, Group General Counsel for Universities Su­perannuation Scheme (“USS”), gave an enlightening pre­sentation on USS’s role as lead plaintiff in the Petrobras litigation, in which USS and Pomerantz recently achieved a historic settlement of $3 billion on behalf of defrauded investors with Brazilian oil giant, Petrobras, and its audi­tors. Armed with candor, facts, and figures, he explained how a conservative British pension fund that had never before served as lead plaintiff found itself leading the highest-profile class action in the United States.

Pomerantz Co-Managing Partner Jeremy Lieberman spoke on, “Will Trump’s SEC Negate Investors’ Ability to Fight Securities Fraud?” With serious indications that the new SEC Chair, Jay Clayton, is considering allowing corporations to use forced arbitration clauses to curtail investors’ rights to bring securities class actions, Jeremy used several examples from Pomerantz’s roster of ac­tive and recently settled cases to demonstrate the very real and deleterious effect that forced arbitration would have on investors. He also addressed what institutional investors can do to protect their right to hold companies accountable for securities fraud. Notably, the day after the Roundtable, Jeremy Lieberman and Jennifer Pafiti traveled to Washington D.C. to meet with Chairman Clay­ton and other key Senate staffers to strenuously argue against forced arbitration clauses and for the crucial func­tion of securities class action litigation as a fundamen­tal principal to hold corporate wrongdoers accountable. [Eds.’ note: See cover story for the update.]

The Pomerantz Monitor will keep our readers posted on the next Corporate Governance and Securities Litigation Roundtable Event, scheduled for 2020 in California.

California Champions Women for Board Seats

ATTORNEY: GUSTAVO BRUCKNER
POMERANTZ MONITOR NOVEMBER/DECEMBER 2018

In late September, California became the first state to re­quire its publicly held corporations to include women on their boards. Pursuant to this new law, SB-826, publicly traded corporations headquartered in California must have at least one woman on their boards of directors by the end of 2019. By the end of July 2021, a minimum of two women must sit on boards with five members, and there must be at least three women on boards with six or more members. Companies that fail to comply face fines of $100,000 for a first violation and $300,000 for a second or subsequent violation.

It is widely accepted that companies with gender-diverse boards of directors outperform their peers. Although it is not uniformly settled as to why this is so, companies with gender-diverse boards tend to have higher returns on eq­uity and net profit margins than their peers. Studies have shown that the greatest benefit to a company’s bottom line occurs when there are three or more women on a board. According to one famous study, “One female board mem­ber is often dismissed as a token. Two females are not enough to be taken seriously. But three give the board a critical mass and the benefit of the women’s talents.”

In the United States, women comprise about half of the total workforce; hold half of all management positions; are responsible for almost 80% of all consumer spending; and account for 10 million majority-owned, privately-held firms, employing over 13 million people and generating over $1.9 trillion in sales.

It is generally believed that gender diversity on boards translates to less “group think,” greater expression of non-conforming views, more leadership positions for tal­ented but often overlooked female employees, and less tolerance for underperforming CEOs.

Every company but one on the Standard & Poor’s 500 has at least one woman on its board and 11 of the Standard & Poor’s 500 companies, including Best Buy, Macy’s, Viacom and General Motors, have half or more of their board seats held by women. However, women still only hold 19.9% of board seats at Standard & Poor’s 500 companies.

Sixty-four countries have made some sort of national effort to promote boardroom gender diversity. In 2003, Norway passed a law mandating 40 percent representation of each gender on the board of publicly limited liability companies. Since then, approximately 20 countries have adopted some sort of legislation/quota to increase the number of women on boards, including Colombia, Kenya, Belgium, Denmark, Finland, France, Germany, Iceland, Italy, and Israel. Not surprisingly, a study of global companies found that Norway (46.7%) and France (34.0%) had the highest percentages of women on their boards.

In the United States, there has been a deep reluctance to mandate gender quotas. The Securities Exchange Com­mission (SEC) requires that companies disclose whether they have a diversity policy, and how it applies to board recruitment practices (Regulation S-K, Item 407(c)). While the SEC recommends that this include “race, gender, and ethnicity of each member/nominee as self-identified by the individual,” ultimately, the definition of diversity is left to each issuer. Many states have passed resolutions encour­aging public companies to gender diversify their boards. Some, like Rhode Island, made pension fund investments conditional on increased board diversity. In March, the New York State Common Retirement Fund said it would vote against all corporate boards of directors standing for re-election at companies with no women board members. The California State Teachers’ Retirement System recent­ly sent letters to 125 California corporations with all-male boards warning them that they risk shareholder action if they do not self-diversify. Thirty-five of those companies subsequently appointed female directors.

The political forces in California felt that change was not being effected fast enough. A quarter of California’s public­ly traded companies do not have a woman on their boards and there are 377 California-based companies in the Rus­sell 3000 stock index of large firms with all-male boards that could be affected by the new law. 684 women will be needed to fill board seats for Russell 3000 companies by 2021.

Hare-Brained Tweet Gets Musk in Trouble

ATTORNEY: MARC C. GORRIE
POMERANTZ MONITOR NOVEMBER/DECEMBER 2018

On September 27, 2018, the SEC sued Elon Musk, CEO and Chairman of Tesla Inc., charging him with securities fraud. It alleged that on August 2, 2018, after the close of the market, Musk had sent an email with the subject, “Offer to Take Tesla Private at $420,” to Tesla’s Board of Directors, Chief Financial Officer, and General Counsel. Musk stated he wanted to take Tesla private because being a publicly-traded company “[s]ubjects Tesla to con­stant defamatory attacks by the short-selling community, resulting in great harm to our valuable brand.” Apparently Musk had not lined up financing or done any other prepa­ratory work before making this offer.

Before anyone at the company could respond, on August 7, 2018 Musk sent out a series of false tweets about the potential transaction to take Tesla private, confusingly saying that:

“My hope is *all* current investors remain with Tesla even if we’re private. Would create special purpose fund enabling anyone to stay with Tesla.”

“Shareholders could either to [sic] sell at 420 or hold shares & go private.”

“Investor support is confirmed. Only reason why this is not certain is that it’s contingent on a share­holder vote.”

Rule 10-b5 prohibits a company’s officers and directors from “knowingly or recklessly mak[ing] material misstate­ments about that company.” Musk’s tweets contain both clearly factual statements that are ambiguous or incom­plete at best and concern information that Tesla share­holders would find very important.

The SEC’s complaint alleged that Musk had not even discussed the deal terms he tweeted, which offered a substantial premium to investors that was greater than Tesla’s share price at the time. After the tweet, Tesla’s stock price rose on increased trading volume, closing up 10.98% from the previous day.

A press release issued by the SEC on September 27, 2018 made it clear that Musk’s “celebrity status,” includ­ing his 22 million Twitter followers, did not affect his “most critical obligations” as a CEO not to mislead investors, even when making statements through non-traditional media. This status and Musk’s large audience drove the tenor of the SEC’s complaint and the relief sought: a permanent injunction against future false and misleading statements, disgorgement of any profits resulting from the tweets, civil penalties, and a bar prohibiting Musk from serving as an officer or director of a public company.

The SEC had previously issued a report that companies can use social media to announce key information in compliance with Regulation Fair Disclosure, so long as investors have been alerted about which media avenues will be used and such statements otherwise comply with regulations. This clarification arose out of the 2013 in­quiry into a post by Netflix CEO Reed Hastings’ person­al Facebook page, stating that Netflix’s monthly online viewing had exceeded one billion hours for the first time. Due to the uncertainty about the rule, an enforcement action was not initiated regarding Hastings or Netflix.

Regarding the disclosure of material, company-specific information via Twitter, the SEC averred that Tesla had stated in 2013 that the company may use social me­dia to release information to investors, but never made any greater specification. Here, Musk announced a re­cord-breaking private buyout offer at a price he alone determined without any board approval or arms-length negotiation.

Musk initially rejected settlement negotiations outright, but lawyers for the company purportedly convinced him, and the SEC, to come back to the table. Before Musk or Tesla responded to the SEC’s complaint, settlement was quickly reached on September 29, 2018 and a joint motion for the court to approve the settlement was filed. The deal allows Musk to remain CEO and a board mem­ber but imposed a two-year ban as Chairman and a $20 million fine, as well as a $20 million fine on Tesla. The settlement further requires Tesla to add two independent directors as well as a permanent committee of indepen­dent directors tasked with monitoring disclosures and potential conflicts of interest. Such monitoring includes a required preapproval of any communications regard­ing Tesla in any format that contains, “or reasonably could contain, information material to the Company or its shareholders.”

On October 4, District Judge Alison J. Nathan ordered the parties to file a joint letter explaining why the proposed settlement was fair and reasonable, which was filed Oc­tober 11. As to the reasons behind the tweets, Musk has cryptically commented, “[i]f the odds are probably in your favor, you should make as many decisions as possible within the bounds of what is executable. This is like be­ing the house in Vegas. Probability is the most powerful force in the universe, which is why the house always wins. Be the house.”

Before the Court ruled on the proposed settlement, Musk released another confusing tweet:

“Just want to [sic] that the Shortseller Enrichment

Commission is doing incredible work. And the name change is so on point!”

The court nevertheless overlooked this outburst, ap­proved the settlement and entered final judgment on October 16. After taking a short Twitter break, Musk then tweeted that the whole debacle was “[w]orth it.”

The settlement comes without an admission or denial of wrongdoing by Musk, but stands as a clear reminder of the obligations that the officers and directors of public companies have to shareholders. Tesla is a company whose value is in no small part its future potential – a value driven by a belief that Musk is central to the com­pany’s ongoing success. It appears as though this was tacitly recognized through the settlement negotiations, as the second round resulted in the SEC backing away from their initial position that Musk be barred from being a corporate officer or director permanently. Such a pun­ishment could have easily proved ruinous for Tesla.

In a time where even presidential communiqués can issue via Twitter, officer and director statements con­cerning material information related to publicly traded companies must adhere to the well-established rules of disclosure, even when they are limited to 140 characters or less.

Protecting Shareholder Rights: Forcing Away Forced Arbitration Clauses

ATTORNEY: JENNIFER PAFITI
POMERANTZ MONITOR NOVEMBER/DECEMBER 2018

Pomerantz is the oldest law firm in the world dedicated to representing defrauded shareholders. When it came to our attention that the United States Securities and Exchange Commission (the “SEC”) hinted that it might consider allowing companies to include mandatory arbitration clauses in their bylaws, Pomerantz acted quickly to express its concern that such clauses could eviscerate a sharehold­er’s ability to hold to account a corporate wrongdoer.

Background:

Banks, credit card issuers and other companies, preferring to settle disputes with shareholders without going to court over class action lawsuits, often insert mandatory arbitra­tion/class action waiver provisions in the fine print of their service agreements. But for investors, a bar on securities class actions would eliminate the ability of all but the largest shareholders to seek compensation from compa­nies who have violated U.S. securities laws.

For decades, it has been the policy of the SEC not to ac­celerate any new securities registrations for companies that contained a class action waiver provision, as such waivers run counter to the SEC’s mission to enforce the federal securities laws. In 2012, the Carlyle Group’s Initial Public Offering registration was delayed because it con­tained such a waiver bylaw. Ultimately, under pressure to complete its offering, the Carlyle Group scrapped the offensive waiver. Since then, no public company has at­tempted to include such a waiver bylaw in its registration statement, preserving the right of defrauded investors to participate in securities class actions.

Then last year, a Consumer Financial Protection Bureau rule banning mandatory arbitration was overturned by the Republican-controlled Congress, under the Congres­sional Review Act. President Donald Trump signed the legislation, H.J. Res. 111 (115).

Adding concern is a recent push by the U.S. Chamber of Commerce and other affiliated groups to allow forced arbitration clauses. At a Heritage Foundation conference in July 2017, then Republican SEC Commissioner Michael Piwowar openly encouraged corporations to file registration statements containing class action waiver bylaws. In October 2017, the U.S. Treasury Department issued a position paper whereby it encouraged the SEC to change its policy regarding class action waivers. A few months ago, Republican Commissioner Hester Peirce answered “absolutely” to the question as to whether she believed such bylaws should be allowed.

The position today is that unless the cur­rent Chairman of the SEC, Jay Clayton, is convinced to maintain the status quo, the SEC can and will easily change its policy to allow class action waiver bylaws, which would doom investors’ rights to hold corporate wrongdoers accountable via securities class actions in the U.S.

Hear Us Roar:

To express concerns over a potential shift in policy, Pomerantz organized a coalition of large institutional investors from around the globe to meet with SEC Chairman Jay Clayton in D.C. on October 24, 2018. The key focus of this meeting was to attempt to persuade Chairman Clayton against the recent push by the U.S. Treasury Depart­ment and the Republican Commissioner of the SEC to allow for forced arbitration/class action waiv­er bylaws which could seriously undermine the future of defrauded investors.

Wanting to make sure all bases were covered, and after meeting with Chairman Clayton, Pomerantz and the team of institutional investors then met with a number of both Republican and Democratic Senate staffers. The purpose of the meetings was to encourage them, in particular Republican Senators, to write to Chairman Clayton cautioning against a shift in policy that would impose forced arbitration bylaws on investors.

Our Voices Were Heard:

On November 13, 2018 – two weeks after the SEC meetings – ten Republican State Treasurers, in a letter co-authored by the State Financial Officers Foundation, urged the SEC to maintain their existing stance against forced arbitration. In the letter, the State Financial Officers Foundation, which represents mostly conservative-lean­ing state treasurers, auditors and controllers, expressed “concerns about recent news reports that the SEC may change its long-standing position and allow public companies to include forced arbitration clauses in their corporate governance documents.” The letter went on to say that: “Allowing public companies to impose a private system of arbitration on investors “will eliminate the ability of all but the largest shareholders to seek recompense from criminals.” Republican Treasurers signing the November 13 letter represent Arizona, Arkansas, Idaho, Indiana, Kentucky, Louisiana, Maine, Nevada, South Carolina and Washington State. It is a significant and unusual step to have ten Republican Treasurers publicly take a position contrary to two Republican SEC Commissioners and the Treasury Department.

Pomerantz has been credited by the American Association for Justice for our dedication to this effort.

Jeremy Lieberman, Pomerantz’s Co-Managing Partner, said of the firm’s efforts on this matter: “Bringing a coalition of large institutional investors from around the globe to ex­press our concern to Chairman Clayton is an important step to ensuring the continued viability of shareholder litigation for institutional and retail investors. While we be­lieve that Chairman Clayton was receptive to our position, it is critical to continue a full court press to ensure that both Congress and policy makers understand the significance of this issue to the investor community.”

Looking Ahead:

Democrats remain concerned about mandatory arbitration and the issue is likely to get renewed attention when the party takes control of the House in January.

Rep. Carolyn Maloney of New York, currently the Dem­ocratic head of the House panel that oversees the SEC, said in April that “allowing companies to use forced arbi­tration clauses would devastate investor confidence in our markets.”

While the Republican letter to the SEC is a strong step for­ward, the institutional investor community should remain concerned about any SEC shift in policy. Pomerantz will continue to work proactively with the institutional investor community to prevent a policy change that would harm institutional investors.

Ninth Circuit Slams Overuse of "Judicial Note" and "Incorporation by Reference" on Motions to Dismiss

ATTORNEY: JENNIFER BANNER SOBERS
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2018

Therapeutics, a securities case, put the spotlight on a tactic defendants have long overused in support of their motions to dismiss. On such motions, district courts, in deciding whether the complaint states a legal claim for relief, are required to accept plaintiffs’ well-pled allegations as true. Increasingly, defendants have sought an end-run around that requirement, routinely requesting that the court accept, as true, documents outside of the complaint which, they claim, disprove plaintiffs’ allegations. They invoke the doctrines of judicial notice and incorporation by reference to place this extrinsic evidence before the court for the purpose of disputing plaintiffs’ allegations and providing the court with their own version of the facts.

This practice may change, thanks to the detailed 59-page ruling by the Ninth Circuit in Orexigen, which condemned the “unscrupulous use of extrinsic documents to resolve competing theories against the complaint.” Such tactics “can undermine lawsuits and result in premature dismissals of plausible claims that may turn out to be valid after discovery.” The Ninth Circuit observed that this risk is especially significant in securities fraud cases, where there is a heightened pleading standard and the defendants possess materials to which the plaintiffs do not yet have access.

The court reversed the district court’s order dismissing the complaint, holding that the lower court had abused its discretion by judicially noticing two of the documents and incorporating by reference seven documents, and by considering statements in those documents as being true. The main takeaway for investors is the Ninth Circuit’s recognition of the improper use of judicial notice and incorporation by reference, which the panel admonished.

Courts may take judicial notice of undisputed matters of public record to the extent permitted by Rule 201 of the Federal Rules of Evidence. Judicial Notice is appropriate for the limited purpose of noting that the statements were actually made at the time and in the manner described in the complaint. But judicial notice is not appropriate for the purpose of determining the truth of any of those statements.

Here, the Ninth Circuit found that the district court abused its discretion by judicially noticing two exhibits attached to Orexigen’s motion to dismiss and, more importantly, by accepting as true various assertions in those documents. Those documents were an investor conference call transcript submitted with one of Orexigen’s Security and Exchange Commission (SEC) filings, and a report issued by the European Medicines Agency (EMA). Generally, documents filed with the SEC and documents issued by a governmental agency may be judicially noticed because they are from sources whose accuracy cannot reasonably be questioned. But, the Ninth Circuit importantly noted that accuracy is only one part of the inquiry under Rule 201(b) – a court must also consider and identify which facts it is accepting as true from such a transcript. Just because the document itself is susceptible to judicial notice does not mean that every assertion of fact within that document must be accepted, as is true on a motion to dismiss. The Ninth Circuit held that reasonable people could debate what the conference call and EMA report disclosed or established. Therefore, the Ninth Circuit found that to the extent the district court judicially noticed the identified facts on the basis of the investor call transcript and report, it had abused its discretion.

The doctrine of incorporation by reference permits a district court to consider, as part of the complaint itself, documents whose contents are alleged in the complaint and whose authenticity no party questions. The doctrine prevents plaintiffs from, for example, selectively quoting parts of documents in their complaint, or deliberately omitting references to documents upon which their claims are based. Defendants are allowed to correct such allegations by demonstrating what the operative documents actually say.

However, there are limits to the application of the incorporation by reference doctrine. First, the complaint must refer “extensively” to the document in question; a passing reference will not justify bringing the whole document into the record on the motion. Second, as an alternative, defendants may establish that a particular document, whether referenced in the complaint or not, may be incorporated if it actually forms the basis of the plaintiff’s claim.

But, what this doctrine clearly cannot permit, according to the Ninth Circuit, is defendants introducing a document that is not mentioned in the complaint or that does not necessarily form the basis of the complaint to merely create a defense to the well-pled allegations in the complaint. If this is permitted, then defendants would, in effect, be disputing the factual allegations in the complaint and thereby circumventing the rule requiring alleged facts in complaints to be accepted as true at the pleading stage. And, if the district court does not convert the motion to dismiss into a motion for summary judgment, which would provide both sides an opportunity to introduce evidence regarding the factual allegations, then plaintiffs would be left without an opportunity to respond to the new version of the facts, making dismissal of otherwise cognizable claims very likely.

Perhaps the most important limitation on the incorporation by reference doctrine is that while this doctrine, unlike judicial notice, permits courts to assume an incorporated document’s contents are true for purposes of a motion to dismiss under Rule 12(b)(6), it is improper to assume the truth of an incorporated document if such assumptions only serve to dispute facts stated in a wellpled complaint. This is consistent with the prohibition against resolving factual disputes at the pleading stage.

As the Ninth Circuit correctly noted, judicial notice and incorporation by reference do have roles to play at the pleading stage. It is the overuse and improper application of the doctrines that can lead to unintended and harmful results. During oral argument in the Orexigen appeal, Judge Berzon asked defense counsel, “[T]here are all of these judicially noticed and incorporated documents, do any of them matter…we are turning these things into summary judgment proceedings – why don’t we just stick to the complaint?” These are apt and fundamental questions. Hopefully, this decision will help tip the scale back in the direction of identifying the documents outside the complaint that actually matter and ensuring that they are applied correctly so that potentially meritorious claims have a fighting chance of surviving motions to dismiss.

Supreme Court Rules on SEC Administrative Law Judges

ATTORNEY: TAMAR A. WEINRIB
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2018

Like many federal agencies, the SEC uses administrative law judges (“ALJs”) to hear and render initial decisions on administrative cases brought by the agency. Up until now the SEC has considered these ALJs to be “employees” who could be hired and fired by agency staff.

On June 21, 2018, in Lucia v. SEC, the United States Supreme Court upended that practice, holding that the SEC’s ALJs are not mere employees but are actually “inferior officers” of the United States, subject to the Appointments Clause of the United States Constitution. The Supreme Court’s ruling means that going forward, ALJs must be appointed by the President, “Courts of Law,” or “Heads of Departments.”

The case reached the Supreme Court after an SEC ALJ rendered an unfavorable decision against Raymond Lucia, a financial radio host and investment adviser known for his “buckets of money” investment strategy. The unfavorable decision, under the Investment Advisers Act, banned Lucia from the industry and charged him a $300,000 fine. Lucia appealed within the SEC (and later to the D.C. Circuit) arguing that the administrative proceeding was invalid because the presiding ALJ had not been constitutionally appointed and thus lacked the constitutional authority to do his job. The Trump Administration sided with Lucia, reversing the position previously taken by the Obama administration that ALJs are not inferior officers.

Justice Kagan, writing for the majority and relying on three Supreme Court cases, explained that the ALJ’s are “inferior officers” because they hold a “continuing office established by law,” and “exercise significant authority pursuant to the laws of the United States” in carrying out “important functions,” which include adjudicating administrative decisions. The Court found its previous decision in Freytag v. Commissioner particularly compelling. There, the Supreme Court held that Special Trial Judges (“STJ”) in the United States Tax Court were “officers” for purposes of the Appointments Clause. The Supreme Court found that the SEC’s ALJs are nearly carbon copies of the STJs, except that the STJs must have their decisions adopted by a regular judge. An ALJ’s decision, on the other hand, only becomes final when the SEC declines review. “That last-word capacity makes this an a fortiori case: If the Tax Court’s STJs are officers, as Freytag held, then the Commission’s ALJs must be too.”

Notably, the SEC had already abandoned its position that ALJs were “employees” back in November 2017 (though after Lucia’s enforcement action) and ratified the prior hiring of its ALJs in a manner it deemed consistent with the Appointments Clause. The Supreme Court ruled on the issue anyway, concluding not only that Lucia is entitled to a new hearing before a properly appointed official, but also that this official cannot be the ALJ who previously heard the enforcement action, even if that particular ALJ “has by now received a constitutional appointment.” The Court did not rule on whether the SEC’s ratification of the prior hires was sufficient to satisfy the Appointments Clause.

On August 22, 2018, the SEC issued an order (the “Order”) lifting a stay it had imposed on June 21, 2018, in reaction to the ruling in Lucia on “any pending administrative proceeding initiated by an order instituting proceedings that commenced the proceeding and set it for hearing before an [ALJ], including any such proceeding currently pending before the Commission.” The Order also reaffirms the SEC’s November 30, 2017 order ratifying the constitutional appointment of certain ALJs; grants all respondents in the newly un-stayed proceedings the “opportunity for a new hearing before an ALJ who did not previously participate in the matter”; and remands all cases pending before the SEC to the Office of the ALJs “for this purpose.” Moreover, the Order vacates “any prior opinion” the SEC has issued in nearly 130 pending matters. The day after issuing the Order, Chief ALJ Brenda P. Murray confirmed that another nearly 70 cases pending before ALJs prior to the Order would be reheard, pursuant to the Order. As a result, parties who received a negative initial decision from an ALJ prior to the SEC’s ratification order but have not yet exhausted their appeal, now have the chance for a completely new hearing before a different ALJ. Parties who do not wish to have a new hearing in front of a fresh ALJ were required to notify the Chief ALJ by September 7.

This decision leaves open several questions, including the constitutionality of the SEC’s ratification order; the extent to which this ruling will apply to other agencies like the CFPB and the FDIC; and the degree to which political influence can and will be exerted in the ALJ appointment process.

Toshiba: Ninth Circuit Applies Morrison Two Prong Test

ATTORNEY: JESSICA N. DELL
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2018

In July the Ninth Circuit issued an important decision that reversed the dismissal of U.S. investors’ securities fraud claims against Toshiba, in Stoyas v. Toshiba Corp.

The case arose from revelations that Toshiba had overstated profits by $2.6 billion. Toshiba was fined a record $60 million by Japanese securities regulators, and Toshiba’s CEO resigned amidst the scandal. When the market discovered the fraud, the value of both Toshiba’s own stock, and the ADRs, plummeted. The U.S. investors’ dilemma was that while it was Toshiba that had committed the fraud, it was the banks, and not Toshiba, that had sold the Toshiba ADRs in the U.S.

Toshiba is a Japanese corporation whose common shares are listed and traded on the Tokyo Stock Exchange; they are not registered with the SEC or listed on any U.S. exchange. In this case, U.S. investors purchased “unsponsored” American Depositary Receipts (“ADRs”) for Toshiba shares over-the-counter in the U.S.

ADRs are a way for U.S. investors to purchase stock in foreign companies. ADRs are securities, denominated in U.S. dollars; the underlying security is bought on the foreign exchange by a bank and is held by that bank overseas. ADRs are said to be “sponsored” if the issuer takes a formal role with the bank creating the ADRs; unsponsored ADRs are created without much, if any, involvement by the issuer. Toshiba did not even have to register its securities with the SEC to allow the creation of the ADRs. The banks then arranged for these ADRs to trade over-the-counter in the U.S.

The principles to be applied here were established in 2010 by the Supreme Court in Morrison v. National Australia Bank. There the Court held that, while there is a presumption that the U.S. securities laws do not apply to overseas conduct of foreign companies, U.S. securities laws could be applied to transactions in a foreign company’s securities if that company’s shares are listed on U.S. domestic exchanges, or are “otherwise traded” in the U.S.

In dismissing the Toshiba case in 2016, the district court had held that 1) the over-the-counter market, where Toshiba ADRs are traded, is not a “domestic exchange”; and 2) that the ADRs are not “otherwise traded in the U.S.,” under Morrison, because even if the shares were actually bought in the U.S. Toshiba had no direct connection to those transactions. The district court concluded that “nowhere in Morrison did the Court state that U.S. securities laws could be applied to a foreign company that only listed its shares on foreign securities exchanges but whose stocks are purchased by an American depositary bank on a foreign exchange and then resold as a different kind of security (an ADR) in the United States.”

The Ninth Circuit held that plaintiffs could well be able to plead a viable claim under U.S. securities laws, and granted them leave to amend their complaint in the action in order to do so. Applying Morrison’s two prong test, it agreed with the District Court that the over-the-counter market was not an “exchange,” and that therefore the first prong of Morrison was not satisfied. But it disagreed with the lower court on whether the Toshiba ADRs were “traded in the U.S.” It held that, for U.S. securities laws to apply under Morrison’s second prong, plaintiffs needed to establish only that they purchased the Toshiba ADRs in U.S. domestic transactions. It held that it was the location of the sales, and not the identity of the participants in those sales, that was important. It recognized that, to prevail in the case, plaintiffs would ultimately have to plead, and prove, facts showing that Toshiba had committed fraud “in connection with” the U.S. sales of the ADRs. But it determined that the fact that Toshiba was not a participant in the U.S. sales is not controlling on whether the securities laws applied in the first place:

Specifically, Toshiba argues that because the [investors] did not allege any connection between Toshiba and the Toshiba ADR transactions, Morrison precludes the Funds’ Exchange Act claims. But this turns Morrison and Section 10(b) on their heads: because we are to examine the location of the transaction, it does not matter that a foreign entity was not engaged in the transaction. For the Exchange Act to apply, there must be a domestic transaction; that Toshiba may ultimately be found not liable for causing the loss in value to the ADRs does not mean that the Act is inapplicable to the transactions.

The court held that under the standard “irrevocable liability” test, the transaction occurs wherever the parties incur irrevocable liability” to buy or sell the shares. Noting that the plaintiffs’ transactions in the Toshiba ADRs have many connections to the United States, the court determined that “an amended complaint could almost certainly allege sufficient facts to establish that [the plaintiffs] purchased [their] Toshiba ADRs in a domestic transaction” in light of the “irrevocable liability” standard. Among the numerous connections to the United States they identified: the plaintiffs are U.S. entities located in the U.S., the ADRs were purchased in the U.S. and traded over-the-counter on a platform located in the States, and the depository banks that host ADR trading are located in the U.S.

In reaching this conclusion, the Ninth Circuit rejected Toshiba’s (and the district court’s) reliance on the Second Circuit’s Parkcentral Global Hub ruling, in which that court said that domestic transactions are not sufficient to establish the applicability of the U.S. securities laws under Morrison, and that some participation or involvement by the issuer in those transactions is required. The appellate court said Parkcentral is distinguishable and that Parkcentral’s test for whether a claim is “so predominately foreign as to be impermissibly extraterritorial” is an “open ended, under-defined, multi-factor test, akin to the vague and unpredictable tests that Morrison criticized and endeavored to replace.” The court likewise rejected the argument that allowing the securities laws to apply to ADRs would undermine principles of comity, holding that “it may very well be that the Morrison test in some cases will result in the Exchange Act’s application to claims of manipulation of share value from afar.”

By rejecting the holding of Parkcentral, the Ninth Circuit in Toshiba created a circuit split that could lead to a Supreme Court cert petition.

While there is no guarantee that the purchasers of the Toshiba ADRs will prevail in their next round of pleadings, the new decision showed that even a foreign company without any obvious participation in U.S. Securities transactions may still be subject to U.S. law if the pleadings show the misconduct was “in connection” with the purchase or sale in the U.S. It has, at least for now, defanged the arguments that any and all attempts at recovery by holder of unsponsored ADRs would per se be blocked by Morrison.

Judge Kavanaugh and the Impending Lorenzo Case Before the Supreme Court

ATTORNEY: J. ALEXANDER HOOD II
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2018

Several years ago, in Stoneridge Partners, Pomerantz persuaded the Supreme Court to rule that people who engage in schemes to defraud can be liable for securities fraud, even if they themselves made no misstatements to investors, under a theory known as “scheme liability.”  

On June 18, the Supreme Court granted certiorari in SEC v. Lorenzo, which presents the question of where the boundaries are between scheme liability (which is actionable) and aiding and abetting (which is not). The D.C. Circuit had affirmed the SEC’s imposition of sanctions against Lorenzo under scheme liability. Dissenting in that case was Circuit Judge Brett Kavanaugh, President Trump’s pending nominee for the Supreme Court.  

Unlike Justice Gorsuch, whose hostility towards securities law enforcement has been well documented, Judge Kavanaugh has had relatively few opportunities to rule on securities fraud cases, which are typically litigated in the judicial district in which the defendant company is headquartered. Accordingly, his judicial paper trail is less than illuminating with respect to some of the legal questions most frequently at issue in those cases. However, a review of his 2017 dissent in Lorenzo v. SEC suggests that a Justice Kavanaugh would try to define scheme liability out of existence.  

Lorenzo concerns communications by Francis Lorenzo, the director of investment banking at Charles Vista, LLC, a registered broker-dealer, to potential investors, concerning the company Waste2Energy Holdings, Inc. (W2E). In September 2009, W2E, in dire need of financing, commenced a $15 million convertible debenture offering, for which Charles Vista would serve as the exclusive placement agent. While W2E’s most recent SEC filings at that time contained no indication of any possible devaluation of the company’s assets, on October 1, 2009, following an audit, W2E filed an amended Form 8-K, in which it disclosed a significant impairment of its intangible assets. On that same day, W2E filed a quarterly report valuing its total assets for the second quarter of 2009 as only $660,408. Lorenzo was aware of W2E’s filings of October 1, and in fact received an email from W2E’s Chief Financial Officer several days later that explained the reasons for the significant devaluation of the company’s intangible assets. Nevertheless, on October 14, Lorenzo sent emails to two potential investors conveying “several key points” about W2E’s debenture offering. His emails failed to disclose the devaluation, and instead assured both investors that the offering came with “3 layers of protection.”  

In February 2013, the SEC commenced cease-and-desist proceedings against Lorenzo, charging him with violations of three securities law provisions: Section 17(1)(1) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder. An administrative law judge concluded that Lorenzo had “willfully violated the antifraud provisions” of the statutes at issue “by his material misrepresentations and omissions concerning W2E in the emails” to the two potential investors. She found that Lorenzo had sent the emails without thinking about their contents, but that doing so amounted to recklessness, satisfying the scienter requirement. Upon review, the SEC sustained the ALJ’s decision, including her “imposition of an industry-wide bar, a cease-and-desist order, and a $15,000 civil penalty.” Specifically, the SEC found that Lorenzo had violated Rule 10b-5(b), which prohibits the making of materially false and misleading statements in connection with the purchase or sale of securities, because he knew that each of the key statements in his emails “was false and/or misleading when he sent them.” Lorenzo petitioned for review by the D.C. Circuit.  

Contrary to the SEC’s conclusions, the D.C. Circuit ruled that Lorenzo did not “make” the statements at issue within the meaning of Rule 10b-5(b), finding that he had simply transmitted statements devised at the direction of his superiors. It nonetheless “conclude[d] that his status as a non-“maker” of the statements at issue does not vitiate the [SEC]’s conclusion that his actions violated the other subsections of Rule 10b-5 as well as Section 17(a)(1).” While Rule 10b-5(b) states that it is unlawful to “make any untrue statement of a material fact … in connection with the purchase or sale of any security,” the other securities law provisions at issue do not contain such more general terms of “employ[ing],” “us[ing],” or “engag[ing]” in deceptive conduct in connection with securities transactions. Accordingly, a majority of the court concluded that “Lorenzo, having taken stock of the emails’ content and having formed the requisite intent to deceive, conveyed materially false information to prospective investors about a pending securities offering.” As such, they found that Lorenzo had engaged in deceptive conduct and had acted with scienter. Accordingly the court upheld the previous findings with respect to his liability.  

In a strongly worded dissent, Judge Kavanaugh vehemently disagreed, blasting the actions of the SEC. First, he concluded that the SEC, similarly to his colleagues in the majority, had failed to “heed the administrative law judge’s factual conclusions” concerning Lorenzo’s “not thinking about” the accuracy of the information his boss had sent him and which he forwarded to the investors. He bitterly criticized the SEC for having “simply manufactured a new assessment of Lorenzo’s credibility and rewrote the [administrative law] judge’s factual findings.” Yet, despite the ALJ’s conclusion that Lorenzo had “not thought about” the accuracy of the emails, she did specifically find that Lorenzo had acted with scienter – presumably because it is, in fact, extremely reckless to send information to investors without thinking about whether it was true or not. Judge Kavanaugh’s dissent makes no mention of that fact.  

Of wider import, however, is the dissent’s savaging of the SEC, while sympathizing with a broker’s actions in conveying to investors information that he knew was false and misleading. In his view, this case was just another example of the SEC’s efforts, over a period of decades, to evade the Supreme Court’s prohibition of liability under the securities laws for “aiders and abettors.” In his view, this case involves “nothing more” than the making of false statements, and since Lorenzo did not himself “make” the false statements he should not be held accountable for them under any theory of liability.

The majority opinion creates a circuit split by holding that mere misstatements, standing alone, may constitute the basis for … willful participation in a scheme to defraud--even if the defendant did not make the misstatements. …Other courts have instead concluded that scheme liability must be based on conduct that goes beyond a defendant’s role in preparing mere misstatements or omissions made by others.  

Judge Kavanaugh thinks that it was incongruous to conclude both that: (i) Lorenzo had not “made” any statements, but merely transmitted the emails at issue; and (ii) “Lorenzo nonetheless willfully engaged in a scheme to defraud solely because of the statements made by his boss.”  The granting of certiorari in this case indicates that the Supreme Court is interested in this issue, and that this is going to be an important case for establishing the contours of scheme liability.

In our view, Judge Kavanaugh got it wrong. He seems to have concluded that whenever a false or misleading statement is made, no one can be liable except the person who made it, and that any other rule would eviscerate the prohibition of aiding and abetting liability. In support of this conclusion he relied on several previous Circuit Court decisions which, he argues, held that a defendant cannot be held liable under a theory of scheme liability where the case involved “nothing more” than false statements. In one of those cases, KV Pharmaceuticals, the complaint alleged, in conclusory fashion, that a corporate securities filing was false and misleading and that two of the company officers knew about it. The court held that, to be liable in such a case, a complaint had to allege that the defendants did something more than merely know that their company had made a false filing. It concluded that “the investors do not allege with specificity (or otherwise) what conduct Van Vliet and Bleser engaged in beyond having knowledge of the misrepresentations and omissions.” The court did not mention aiding and abetting; it merely held that scheme liability must entail actions beyond mere awareness that someone else had made a misstatement.

In another case, Luxembourg Gamma Three, the scheme liability claim was simply another label plaintiffs had applied to a classic non-disclosure case against the same people who had themselves made the false and misleading statements. As the court said, “the fraudulent scheme allegedly involved the Defendant-Appellees planning together to not disclose the Founders’ sale of securities in the secondary offering, and then not disclosing those sales; fundamentally, this is an omission claim.”

In Lorenzo the claims against the defendant went beyond “making” a false or misleading statement. Lorenzo sent the false information, under his own name, to investors, and implicitly vouched for its accuracy. If that is not enough to establish scheme liability, what is?

Judge Kavanaugh’s dissent reflects his hostility towards the SEC itself, confirming the Trump administration’s statement nominating him to SCOTUS. There it specifically touted the fact that he has “overruled federal agency action 75 times.” He is, in fact, widely regarded by commentators on both the left and the right as hostile to the “administrative state.” His dissent in Lorenzo is a prime example of this. First he mocked the agency’s determination that Lorenzo acted with scienter, which he claimed contradicted the findings of the ALJ even though the ALJ held that Lorenzo had acted with scienter. Then he lashed out at the agency for what, in his view, amounted to trying to make an end run around Supreme Court case law that sharply distinguishes between primary and secondary liability. It is hard to avoid the conclusion that, in his view, the SEC is a rogue agency that simply has to be reined in.  

If he is confirmed, it will be another sad day for investors.

SEC Says Bitcoin, Ether are Not Securities

ATTORNEY: SAMUEL J. ADAMS
POMERANTZ MONITOR JULY/AUGUST 2018

A recent spike in interest surrounding cryptocurrencies has left investors wondering whether or not the federal securities laws apply to transactions involving digital currency such as Bitcoin and Ether. As noted in previous Monitor articles, broadly speaking, cryptocurrency is a form of payment that can be exchanged online, with digital “tokens,” for goods and services. Unlike traditional currency, cryptocurrency exists solely in the digital realm and is not backed by any government or central banking entity. Interest in cryptocurrency reached a fever pitch in 2017, as cryptocurrencies, such as Bitcoin, experienced dramatic increases in value. By way of example, one Bitcoin traded for approximately $1,000 in January 2017 and reached a high of $19,500 in December 2017. In July 2018, the currency dipped below $6,000 per Bitcoin, and the price continues to fluctuate. Given such volatility, speculators have started purchasing cryptocurrencies as investments. In determining whether the federal securities laws apply to these purchases and sales, the salient question is whether purchasers are investing in the currencies themselves or in the network or platform on which they run. The backbone of the cryptocurrency ecosystem is a decentralized technology known as blockchain, which is spread across many computers that manage and record transactions in cryptocurrency. Bitcoin, the original cryptocurrency, was developed as a “peer-to-peer electronic cash system” and allows online Bitcoin payments to be sent directly to a party without the involvement of any financial institution or other third party. Similar, but slightly different, is the Ethereum blockchain, for which Ether is the underlying token. Although Ether is traded on public markets, it was not intended to be a unit of currency on a peer-to-peer payment network; rather, it is a necessary input, often called the “native asset,” used to pay the Ethereum platform, a decentralized world computer upon which users can build and run applications, to perform certain tasks. For this reason, Ether is sometimes characterized as a cryptocommodity rather than a cryptocurrency, but it can and does function like a cryptocurrency in many respects. In terms of market value, Ether and Bitcoin are the two largest cryptocurrencies or tokens currently available to investors. In an effort to clear up confusion, William Hinman, director of the SEC’s division of corporation finance, recently stated that transactions in Bitcoin and Ether are not subject to federal securities laws, calming concerns that the SEC may seek to regulate these transactions. In prepared remarks delivered on June 14, 2018, Hinman noted that, in determining whether a cryptocurrency is a security, a central consideration is how the cryptocurrency is being sold and the “reasonable expectations of purchasers.” For example, where cryptocurrency is being sold chiefly as an investment in an enterprise or cryptocurrency platform, as is the case in some Initial Coin Offerings (“ICO”), the SEC takes the position that the transaction is a securities offering subject to the federal securities laws and should be registered. Conversely, once a sufficiently decentralized network for the exchange of a cryptocurrency has been established, such that it would be difficult to even identify an issuer or promoter to make the requisite disclosures to investors, sales of the cryptocurrencies will not be subject to the federal securities laws. Hinman noted that “the network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception.” Hinman added that “putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” Finally, Hinman left the door open to other digital currencies escaping SEC scrutiny, stating that “over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.” The price of Bitcoin and Ether both increased on this news. Hinman also laid out a roadmap of sorts for establishing a cryptocurrency exchange and insuring that investors have clear expectations regarding their cryptocurrency transactions. In order to get an exchange off the ground, Himan suggested raising initial funding through a registered or exempt equity or debt offering, rather than an ICO. After the network has already been established and is sufficiently decentralized, tokens or cryptocurrency can then be offered in a manner whereby it is evident that purchasers are not making an investment in the development of the cryptocurrency network, but rather are purchasing an asset used to purchase a good or service. While the current state of play for Bitcoin and Ether appears to be settled, at least from the perspective of the SEC, there is sure to be confusion going forward as additional forms of cryptocurrency proliferate and new exchanges lure additional investment.

Pomerantz Paves Way For Use of Confidential Informants' Allegations

ATTORNEY: JUSTIN NEMATZADEH
POMERANTZ MONITOR JULY/AUGUST 2018

In Cohen v. Kitov Pharmaceuticals Holdings, Ltd., Judge Lorna Schofield of the Southern District of New York sustained, in part, the class action claims of lead plaintiffs represented by Pomerantz and the Rosen Law Firm. We brought these claims under Sections 10(b) and 20(a) of the U.S. Securities Exchange Act of 1934 and Rule 10b- 5, against defendants Kitov Pharmaceuticals Holdings, Ltd. and its CEO Isaac Israel. This was a significant victory for plaintiffs, primarily because Judge Schofield adopted an ideal blend of crediting confidential informants’ allegations about a relatively small corporation, while protecting them from retaliation. Kitov is an Israeli biopharmaceutical company. Its American depository shares trade on the NASDAQ. Kitov’s leading drug candidate is KIT-302, a fixed-dosage combination product based on two generic drugs designed to treat pain and hypertension. To commercialize the drug, it was necessary for the company to obtain FDA approval of KIT-302’s New Drug Application (“NDA”). A milestone in this process would have been reached when pivotal clinical trials were completed, the data was analyzed, and the data analyses demonstrated promising results in reducing blood pressure. To facilitate FDA approval, Kitov agreed to a procedure requiring it to conduct a detailed Phase 3 study (the “Study”). Kitov’s board of directors appointed an independent committee to evaluate whether the Study results were good enough to support the NDA. After reviewing the results, the committee determined that the Study had, indeed, demonstrated the drug’s efficacy. Plaintiffs alleged that the Study results were falsified prior to submission to the committee and that the actual, undisclosed results failed to provide statistically significant evidence of efficacy. Although the company never admitted what had happened, the truth emerged. On February 6, 2017, Mr. Israel was reportedly arrested and questioned by the Israel Securities Authority on suspicion of fraud. The next day, Kitov issued a press release announcing the launching of the formal investigation, while maintaining that it “stands fully behind the validity of all of its clinical trial results” and that it “continues to move forward toward the filing of [its] New Drug Application for KIT-302 with the FDA.” The price of Kitov’s ADS dropped precipitously after these revelations.

IDENTIFYING THE INFORMANTS. Scienter, defined as acting deliberately or recklessly in misrepresenting the facts, is an essential element of any securities-fraud claim. To state a cause of action, plaintiffs must allege facts constituting strong circumstantial evidence of conscious misbehavior or recklessness. This can be shown where a defendant engaged in deliberate illegal behavior, knew facts or had access to information contradicting its public statements, or failed to review or check information that the defendant had a duty to monitor. Judge Schofield held that, to satisfy this requirement, “[a] complaint may rely on information from confidential witnesses if they are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.” In support of its claim, the complaint cites information provided by several former Kitov employees and consultants. Significantly, Judge Schofield found that plaintiffs had sufficiently alleged scienter against Kitov and Mr. Israel, based, in part, on relatively general allegations from confidential informants. These allegations were relatively broad because the company, at any given time, never engaged more than ten people as employees or consultants, whose anonymity would have been jeopardized had more specific allegations been provided. Critical to this finding was plaintiffs’ reliance on several former Kitov consultants for allegations that Mr. Israel falsified the Study data: “[A]ccording to several former consultants of Kitov with knowledge of the clinical trial results, Israel was the individual who directed that the . . . data be falsified to show efficacy[.]” Judge Schofield stated that while this description may not have sufficed in an organization with hundreds of employees, any more detailed description here likely would have revealed the identity of the sources. This evidence from multiple former consultants, combined with Mr. Israel’s position as head of a small organization and news of the ISA’s investigation, gave rise to a plausible inference that Mr. Israel was responsible for the falsification of data. Judge Schofield emphasized that “[r]equiring disclosure of confidential sources could deter them from providing information ‘or invite retaliation against them.’”

DUTY TO SPEAK THE FULL TRUTH. Another major issue in the case was whether defendants had a duty to disclose that the results of the Study had been falsified. Defendants argued that they had no duty to provide any details about the Study. The court disagreed, holding that “[O]nce a company speaks on an issue or topic, there is a duty to tell the whole truth, even where there is no existing independent duty to disclose information on the issue or topic.” When defendants made statements about the Study results, including, without limitation, that they “successfully met the primary efficacy endpoint of the trial protocol[,]” they made material omissions by failing to disclose that the results had been falsified. Defendants argued that the failure to disclose falsified data was not actionable because the results were not falsified: they quoted their own SEC filings to argue that the Study was conducted by independent research organizations and that defendants had no access to the data and therefore could not have tampered with the results. But Judge Schofield, crediting plaintiffs’ allegations, found this argument unpersuasive because it was premature on a motion to dismiss.

LOSS CAUSATION. Finally, defendants argued that the complaint did not properly allege “loss causation”—that the misrepresentations concerning the Study did not “cause” the price of Kitov stock to drop. Typically, loss causation is established by showing that a curative disclosure of the true facts occurred, followed directly by a drop in the price of the company’s stock. Here, defendants argued that because they never admitted that the results of the Study were falsified, there was no curative disclosure and, therefore, no loss causation. They also argued that the results of the Israeli investigation into the company had not been disclosed when the stock price fell and therefore could not have caused the losses, asserting that plaintiffs must have shown that a “misstatement or omission concealed something from the market that, when disclosed, negatively affected the value of the security.” Judge Schofield found that disclosure of the investigation and the subsequent drops in Kitov’s ADS prices sufficiently demonstrated loss causation, even though Kitov released a statement that it stood by its earlier disclosures about KIT-302 and was on track with its NDA approval.

The Supremes Rule on Tolling the Statute of Limitations

ATTORNEY: AATIF IQBAL
POMERANTZ MONITOR JULY/AUGUST 2018

Class actions are brought by individuals or institutions (the proposed (“named”) class representatives) who seek to represent a “class” composed of a large number of parties (the “absent class members”) who, they believe, have been similarly victimized by the same wrongdoing. Can absent class members rely on the class action to protect their rights, or should they bring their own lawsuits? It may take years for the court to decide whether the action should be dismissed or properly proceed as a class action. What happens if, before the court makes such a determination, the statute of limitations expires? If the court then refuses to certify the class, or dismisses the action altogether, is it too late for individual class members to act to protect themselves? Until recently, the answer was an unequivocal “no.” A recent decision by the Supreme Court in China Agritech, Inc. v. Resh now makes the answer unsure. Decades ago, in American Pipe & Construction Co. v. Utah, and then in Crown, Cork & Seal Co. Inc. v. Parker, the Supreme Court held that a timely-filed class action tolls the statute of limitations for all would-be class members—so that, if the class action is dismissed or class certification is denied after the limitations period has run out, they can still pursue their individual claims by filing a new lawsuit. The Court reasoned that one of the main purposes of the class action device is to make it unnecessary for similarly situated plaintiffs to rush to pursue their claims individually, resulting in courts being inundated with countless duplicative individual actions, all raising essentially the same issues. This benefit would be eroded if statutes of limitation forced class members “to file protective motions to intervene or to join in the event that a class was later found unsuitable.” American Pipe addressed this problem by protecting class members’ rights to pursue other options if the class action failed. This made it possible for class members to rely on a pending class action to protect their interests, while holding off on pursuing other options until after a court could decide if class treatment was appropriate. At that point, they could make a more informed decision about what to do. In fact, the Court emphasized that absent class members had no “duty to take note of the suit or to exercise any responsibility with respect to it” until after “the existence and limits of the class have been established and notice of membership has been sent.” In other words, the best way for class members to promote the “efficiency and economy of litigation” was to wait for a court to rule on class certification before pursuing other litigation options. But more recent court decisions have sharply limited the scope of American Pipe tolling, eliminating many of its efficiency benefits and forcing absent class members to make premature protective litigation decisions. Last year, in California Public Employees’ Retirement System v. ANZ Securities Inc., the Supreme Court held that although a timely class action tolls the statute of limitations, it does not toll statutes of repose. Statutes of repose begin as soon as a defendant’s violation takes place, whereas statutes of limitation don’t start to run until a plaintiff discovers or should have discovered the defendant’s violation. (For example, the Securities Act has a 1-year statute of limitations and a 3-year statute of repose; and the Exchange Act has a 2-year statute of limitations and a 5-year statute of repose.) So class members cannot wait until they receive a notice about class certification being granted or denied before deciding whether to opt out or pursue an individual claim, as the American Pipe Court instructed. If a class certification ruling takes more than 3 or 5 years— as is increasingly common—then class members have forfeited their right to opt out or file any individual action. This creates perverse incentives for defendants to delay class certification so as to cut off potential class members’ opt-out rights. Now, in China Agritech, Inc., the Supreme Court has limited the scope of American Pipe once again, holding that, even within the repose period, if class certification is denied after the limitations period has passed, former class members can file new individual actions, but they cannot file a new class action, even if class certification had been denied, solely because the previous class representative was inadequate. The Supreme Court unanimously held that the pendency of an existing class action does not toll the statute of limitations for claims brought on behalf of a class. As a result of the Supreme Court’s ruling, if the statute of limitations expires and the original class action is later dismissed, or class certification is later denied, it is too late for class members to file another class action. Now, those who fear that class certification may be denied after the statute of limitations expires can no longer afford to wait to see how the class action unfolds. They must file their own separate class action suit right away. It is therefore increasingly important to monitor class actions closely from the outset, in order to make informed decisions early on about whether to stay in the class, fight for class leadership, or file a separate class action. The Court reasoned that American Pipe tolling promoted efficiency for individual claims because there was no reason for plaintiffs to bring individual claims until after class certification had been litigated. But any competing class representative claims were most efficiently addressed early on and all at the same time, so that courts could hear all the parties’ relevant arguments, select the best class representative, and then either grant or deny class certification once and for all. The Court also reasoned that any would-be class representative who filed a lawsuit after the limitations period could “hardly qualify as diligent in asserting claims and pursuing relief,” as is ordinarily required both to benefit from equitable tolling and to show adequacy as a class representative. Finally, the Court reasoned that limiting American Pipe tolling in this way was necessary to prevent a “limitless” series of successive class actions, each rendered timely by the tolling effect of the previous ones. However, as Justice Sotomayor pointed out, this reasoning may have been viable with respect to securities class actions such as China Agritech itself, but far less so in in other kinds of class actions that may raise more difficult questions about how to structure a class or subclasses. Among other things, the Private Securities Litigation Reform Act already mandates an early process for resolving competing class representative claims following the dissemination of notice. But in employment or consumer class actions, it may be far more efficient to encourage absent class members to wait and see if a proposed nationwide class is viable before forcing them to file precautionary class action lawsuits with regional or other kinds of subclass structures. But under China Agritech, class members who take this “wait and see” approach would be deemed not “diligent” enough. Even worse, what if a case turns out to be perfectly suited for class treatment, but class certification is denied solely because the class representative is inadequate? Then the former class members would be able to pursue their claims through duplicative individual actions, all raising essentially the same issues, but not through a class action – even though they can satisfy every element of Rule 23. The result is that, in many class actions, the availability of effective avenues for relief will turn largely on accidents of timing, forcing absent class members to make premature decisions to protect themselves, and thus squandering many of the efficiency and consistency benefits of the class action device.      

Court Denies Motion To Dismiss Our Quorum Health Corporation Complaint

ATTORNEY: MICHAEL J. WERNKE
POMERANTZ MONITOR MAY/JUNE 2018

Chief Judge Waverly D. Crenshaw, Jr. of the Middle District of Tennessee recently denied defendants’ motion to dismiss Pomerantz’s securities fraud class action involving Quorum Health Corporation (“Quorum”) and Community Health Systems, Inc. (“CHS”). CHS is one of the nation’s largest operators of hospitals. Quorum, an operator and manager of hospitals, was spun off from CHS in April 2016. The action, brought on behalf of investors in Quorum who purchased Quorum shares after the spinoff, alleges that Quorum, CHS and certain of their officers violated section 10(b) of the Securities Exchange Act as well as section 20(a), the “control person” provision, by issuing financial statements for Quorum that misrepresented its financial condition.

Specifically, our complaint alleges that CHS hatched a scheme to unload its worst-performing hospitals at an inflated price. It set up the new subsidiary, Quorum, to buy these hospitals from CHS for $1.2 billion, which Quorum borrowed. That price was based on fraudulent calculations of “good will” attributable to those hospitals. Goodwill is an intangible asset that that results when one company purchases another for a premium value. The value of a company’s brand name, cus­tomer base, and good customer relations are examples of goodwill. That is, when a company like CHS purchases hospitals like those that came to make up Quorum, it must record as goodwill the amount it paid for those hospitals in excess of the fair value of the assets. A company must then periodically test the goodwill and record an “impairment” to the goodwill when it is more likely than not that the fair value of the as­set has declined below its carrying amount (or book value). This occurs when “triggering events” lead management to believe that the expected future cash flows of an asset have significantly declined.

The inflated value of Quorum’s goodwill was then reflected in Quorum’s financial statements, which were dissemi­nated to investors when Quorum’s stock started trading as a separate public company.

We allege that the defendants knowingly inflated Quorum’s goodwill and failed to take a necessary impairment. As a result of the defendants’ false statements about Quorum’s goodwill, investors that purchased Quorum stock in the market following the spin-off paid an inflated price. The truth was revealed when Quorum and CHS each announced only a few months after the spin-off was completed (and CHS received its $1.2 billion) that each company was severely impairing its goodwill. As a result, Quorum’s stock price plummeted $4.99, almost 50%, damaging investors.

Defendants’ main argument for dismissal was that their statements of goodwill, which are considered statements of opinion under the law, were not false and misleading when made, or made with the intent to mislead inves­tors. The court rejected these arguments, finding that the multiple “triggering events” or “red flags” indicating that the goodwill was impaired were known to the defendants prior to the spin-off. For example, in the months prior to the spin-off, CHS’s stock price decline 78%, correspond­ing to a decline in market capitalization of $5.6 billion. The court also noted the extremely poor performance of the hospitals that made up Quorum as an indicator that the goodwill was impaired. Thus, the court held that because the complaint alleged that the defendants’ state­ments of goodwill did not fairly align with the information they knew, Pomerantz adequately alleged that the defen­dants knew that their statements of goodwill were false.

This opinion is particularly significant because the court held that the CHS defendants, in addition to the Quorum defendants, were “makers” of the false statements of goodwill in Quorum’s initial financial statements even though the filings were made on behalf of Quorum, not CHS. Normally, only the company and officers whose stock the class purchased are liable for false statements under the federal securities laws. Here, that would be Quorum and its officers. However, the court accepted our argument that CHS and its officers should also be liable for the false statements because Quorum was part of CHS prior to the spin-off and all of Quorum’s financials in the spin-off documents were calculated by CHS.

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.