Can Shareholders Propose Bylaws Requiring Mandatory Arbitration of Securities Fraud Claims?

ATTORNEY: MARC I. GROSS AND MICHAEL GRUNFELD
POMERANTZ MONITOR: MAY/JUNE 2019

Last year it was revealed that Johnson & Johnson (“J&J”) had knowingly marketed talcum powder containing asbestos, which may have caused ovarian cancer in consumers. This revelation caused J&J’s stock price to plummet and triggered a securities fraud class action on behalf of investors. In an effort to thwart that class action and others, Professor Hal S. Scott, the Director of the Program on International Financial Systems at Harvard Law School, representing a small J&J shareholder, submitted a proxy proposal to the Company for a shareholder vote to approve a corporate bylaw that would require all securities fraud claims against the company be pursued through mandatory arbitration, and would waive class action rights.

Such a proposal, if adopted, would sound the death knell for all securities claims against the company. In particular, prohibiting class actions would make it economically unfeasible, in almost all cases, for anyone but the largest shareholders to bring such an action.

J&J decided to reject this proposal because it would violate state law, and obtained a No Action Letter from the SEC, indicating that the agency would not object to exclusion of the proposal. Undeterred, Professor Scott filed an action in Federal District Court in New Jersey contesting the rejection, in an action called The Doris Behr 2012 Irrevocable Trust v. Johnson & Johnson. The court denied Professor Scott’s motion for an order compelling J&J to include the Proxy Proposal for the shareholder meeting that recently took place, on grounds that the motion was too late for this year. Nonetheless, the case will continue on the merits and there is little doubt that Professor Scott will pursue the proposal next year. While to date J&J has excluded the proposal from its proxy materials, there is no certainty that it will do so in the future. Pomerantz has been retained by the Colorado Public Employees’ Retirement Association (“Colorado PERA”) to intervene in the Proxy Litigation to ensure that investors’ rights are protected. We believe that Colorado PERA, a large J&J investor that is also a putative class member in the pending class action arising from underlying securities fraud claims, is ideally suited to represent shareholders’ interests—including their appellate rights—in the Proxy Litigation.

Historically, the Securities and Exchange Commission (“SEC”) has opposed proposals to mandate arbitration of claims brought by IPO and open market purchasers. More recently, in response to questions posed at Congressional hearings in early 2018, SEC Chairman Jay Clayton committed to hold public hearings if the Commission rethought its position. Pomerantz and institutional investors such as Colorado PERA have been at the forefront of explaining to the SEC why such proposals are contrary to law and public policy supporting shareholder rights.

Our objection is based on the proposition that corporate bylaw provisions, such as the proposal here, violate the “internal affairs” doctrine that is a fundamental principle of state corporate law. As then-Chancellor Leo Strine (who is now Chief Justice of the Delaware Supreme Court) set out in Boilermakers Local 154 Ret. Fund v. Chevron Corp., under Delaware law, the “internal affairs” doctrine limits corporate bylaws to regulation of intra corporate disputes between management and shareholders, such as breaches of fiduciary duty and waste. Bylaws cannot govern “external relationships” between third-party contractors and investors whose claims arise from deception when they purchased their shares. Consistent with that rule, on December 11, 2018, in Sciabacucchi v. Salzberg, the Delaware Court of Chancery rejected Blue Apron’s adoption of a bylaw mandating that Securities Act claims be filed only in federal court. The court based this decision on the “internal affairs” doctrine, explaining that “there is no reason to believe that corporate governance documents, regulated by the law of the state of incorporation, can dictate mechanisms for bringing claims that do not concern corporate internal affairs, such as claims alleging fraud in connection with a securities sale.” For these reasons, the New Jersey Attorney General issued an opinion on January 29, 2019 stating unequivocally that “the Proposal, if adopted, would cause Johnson & Johnson to violate New Jersey state law [where Johnson & Johnson is incorporated], [and] in the opinion of my office, the Proposal should be excluded” from the Company’s proxy materials. The Attorney General based this determination on the text of the New Jersey Business Corporations Act (including recent amendments to the statute), New Jersey case law, and the Delaware cases described above.

While efforts to date have thwarted imposition of mandatory arbitration on federal securities law claims, continued vigilance is necessary. Professor Scott no doubt hopes to ultimately bring this matter to the U.S. Supreme Court for a ruling on whether the Federal Arbitration Act pre-empts state law restrictions on mandatory arbitration agreements. Starting with AT&T Mobility v. Concepcion, 563 U.S. 333 (2011), the Supreme Court has held that brokerage clients, consumers, employees and others can be compelled by “contract” to arbitrate any disputes. Investors will argue, though, that aside from the Supreme Court’s prior deference to state law for corporate governance matters, there is no “contract” between investors and companies when securities are purchased in the open market. The “contract” is only with the direct seller, and there is certainly no “consent” to the arbitration.

Pomerantz expects challenges will nonetheless arise in this area over the next few years and intends to continue its efforts to protect investor rights.

Supremes: Distributing False Statement Can Be Securities Fraud

ATTORNEY: OMAR JAFRI
POMERANTZ MONITOR: MAY/JUNE 2019

In a case called Stoneridge brought by Pomerantz a decade ago, the Supreme Court approved the doctrine of “scheme liability,” holding that a defendant can be liable for securities fraud even if he never made a misleading statement to investors, so long as he participated in an “act, practice, or course of business which operates or would operate as a fraud or deceit.” Later, in Janus, the Court held that a defendant cannot be liable for a misleading statement made to investors unless he made the misstatement itself or had ultimate authority over the contents of that statement. Any lesser involvement, such as drafting the contents of the statement, could at most be considered “aiding and abetting,” which, under yet another Supreme Court decision, is not a violation.

These doctrines have now intersected in a recent Supreme Court decision in Lorenzo v. SEC. In this case, a false statement was made to investors, but the defendant was not the “maker” of the statement. The Supreme Court held that the defendant, who merely forwarded his boss’s false statement to his clients, was liable for securities fraud under the theory of scheme liability.

Scheme liability is based on the language of SEC Rule 10b-5, which makes it unlawful to (a) “employ any device, scheme, or artifice to defraud,” … or (c) “engage in any act, practice, or course of business which operates or would operate as a fraud or deceit … in connection with the purchase or sale of any security.” The question before the Court in Lorenzo was whether those who do not “make” the misleading statements, but who disseminate them to investors with the intent to defraud, can be found to have violated subsections (a) and (c) and other related provisions of the securities laws. Defendant Lorenzo argued that scheme liability applies only when there are no false statements; otherwise, someone could be held liable for a false statement even if he did not make the statement himself. The Supreme Court rejected that argument.

Lorenzo was a director of investment banking at Charles Vista, LLC (“Charles Vista”). Lorenzo’s client, Waste2Energy, publicly touted that its assets were worth about $14 million, but Lorenzo knew that this figure included intellectual property claimed to be valued at $10 million that, as he later testified, was a “dead asset” that “didn’t really work.” In 2009, Waste2Energy hired Charles Vista to sell debentures to investors. In the fall of 2009, Waste2Energy told Lorenzo that the company had written off all its intellectual property as “worthless,” which left the company with a net worth of $370,552. Still, Lorenzo sent two emails to potential investors that described the debentures as having “multiple layers of protection,” including “$10 million in confirmed assets.” Lorenzo testified that he had not composed the emails himself but had merely forwarded them to clients at the direction of his boss. But he did know they were false.

The Supreme Court held that Lorenzo’s dissemination of false or misleading statements fell within the scope of subsections (a) and (c) and subjected him to scheme liability. The Court held that because Lorenzo sent emails that he knew contained material untruths, he had “employed” a “device,” “scheme,” and “artifice” to “defraud” and had violated subsection (c) because he “engage[d] in a[n] act, practice, or course of business” that “operate[d] … as a fraud or deceit.” The Court, repeatedly noting that Lorenzo’s conduct easily fell within the ambit of both subsections (a) and (c), relied on dictionary definitions of the words contained in those subsections to emphasize that they apply to a wide range of misconduct.

The Court also repeatedly emphasized that its conclusion is consistent with the purpose of the securities laws. For example, the Court noted that the application of subsections (a) and (c) to a broad range of misconduct is consistent with the principle established in the Court’s decision in SEC v W.J. Howey & Company over seventy years ago: “to substitute a philosophy of full disclosure for the philosophy of caveat emptor in the securities industry.” Similarly, the Court noted that its broad interpretation of subsections (a) and (c) was consistent with the principle highlighted in an earlier decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.: that even a “bit participant in the securities market … may be liable as a primary violator under Rule 10b-5,” so long as all of the other requirements are met.

It rejected Lorenzo’s argument that subsections (a) and (c) apply only to conduct that did not involve misstatements, and since he was not the “maker” of an untrue statement under subsection (b), none of the provisions of Rule 10(b)-5 applied to him. The Court held that this argument was irreconcilable with the plain and expansive language of subsections (a) and (c), and further held that sustaining Lorenzo’s argument would allow those who disseminate, but do not make, statements to escape liability altogether. The Court also rejected Lorenzo’s and the dissent’s claim that an application of subsections (a) and (c) to his conduct would render the Court’s decision in Janus a “dead letter.” It noted that Janus remains relevant where an individual neither makes nor disseminates false or misleading statements. Because Lorenzo clearly disseminated false statements and, in fact, did not contest that he did so intentionally, the Court held that he violated subsections (a) and (c) of Rule 10b-5 even if he was not the “maker” of the statements under subsection (b).

The distinction between aiding and abetting, which is not actionable, and engaging in a scheme to defraud, which is, will doubtless continue to pose perplexing issues for courts well into the future. It is hard to understand why drafting a misstatement is OK, while sending that misstatement to someone else is not.

Pomerantz Achieves $110 Million Class Action Settlement in Fiat Chrysler Litigation

ATTORNEY: MICHAEL J. WERNKE
POMERANTZ MONITOR: MAY/JUNE 2019

In a significant victory for investors, Pomerantz, as lead counsel for the class, has achieved a $110 million settlement with Fiat Chrysler Automobiles N.V. as well as certain of Fiat Chrysler’s former executives. Judge Jesse Furman in the district court of the Southern District of New York granted preliminary approval of the settlement on April 10, 2019 and set the final approval hearing for September 5, 2019.

The litigation against one of the world’s largest car manufacturers involved accusations that the defendants misled investors when they asserted that the company was complying with its obligations to conduct safety recalls under regulations promulgated by the National Highway Traffic Safety Administration (“NHTSA”) as well as with emissions regulations, promulgated by the Environmental Protection Agency (“EPA”) and the European Union, designed to control emissions of Nitrogen Oxide (“NOx”). In truth, Fiat Chrysler had a widespread pattern of violations dating back to 2013, in which the company would purposefully delay notifying vehicle owners of defects and failing to repair the defects for months or years. The company also improperly outfitted its diesel vehicles in the U.S. and Europe (including Jeep Grand Cherokee and Ram 1500) with “defeat device” software designed to cheat NOx emissions regulations. The defeat device software, which was similar to that employed by Volkswagen in the highly publicized “Dieselgate” scandal, was able to detect when the vehicle was being tested by a regulator (such as the EPA). When testing conditions were detected, the vehicle would perform in a compliant manner, limiting emissions of NOx. When testing conditions were not detected, such as during real-world driving conditions, the emissions controls were disabled, and the vehicles would spew illegal and dangerous levels of NOx.

The truth concerning Fiat Chrysler’s violations was revealed in a series of disclosures that caused the company’s stock price to plummet. On July 26, 2015, NHTSA announced a Consent Order against Fiat Chrysler, fining the company a record-high $105 million and requiring a substantial number of recalls and repairs. On October 28, 2015, the company announced a $900 million charge to earnings for an increase in estimated future recalls. The company’s stock price also declined in 2016 and 2017, when the EPA and other US and European regulators publicly accused Fiat Chrysler of using defeat devices to cheat NOx emissions regulations.

The settlement was achieved after three and a half years of hard-fought litigation. Discovery was wide-ranging. It involved analyzing millions of pages of documents concerning highly complex issues of emissions software programming and resulted in the exchange of reports by eleven experts on issues implicating U.S. as well as European regulations. The claims ultimately survived multiple rounds of motions to dismiss. Initially the emissions allegations were dismissed because the court determined that the complaint did not plead facts sufficient to demonstrate that the defendants knew that their statements of compliance were misleading. We were given leave to replead, and Pomerantz then filed Freedom of Information Act requests with the EPA. Its response included emails from Fiat Chrysler executives showing that they knew that the EPA had discovered certain defeat devices on the company’s vehicles. The defendants nevertheless continued to falsely assure investors that the company’s vehicles were compliant and did not contain any such defeat devices. When we filed an amended complaint that included those facts, these additional allegations revived the emissions claims.

Ultimately Pomerantz secured class certification on behalf of investors, which was followed by summary judgment proceedings. As the prospect of trial loomed, defendants finally agreed to the settlement.

In addition to creating precedent-setting case law in successfully defending the various motions to dismiss, Pomerantz also significantly advanced investors’ ability to obtain critically important discovery from regulators that are often at the center of securities actions. During the course of the litigation, Pomerantz sought the deposition of a former employee of NHTSA. The United States Department of Transportation (“USDOT”), like most federal agencies, has enacted a set of regulations — known as “Touhy regulations” — governing when its employees may be called by private parties to testify in court. On their face, USDOT’s regulations apply to both current and former employees. In response to Pomerantz’s request to depose a former NHTSA employee that interacted with Fiat Chrysler, NHTSA denied the request, citing the Touhy regulation. Despite the widespread application, and assumed appropriateness, of applying these regulations to former employees throughout the case law, Pomerantz filed an action against USDOT and NHTSA, arguing that the statute pursuant to which the Touhy regulations were enacted speaks only of “employees,” which should be interpreted to apply only to current employees. The court granted summary judgment in favor of Pomerantz’s clients, holding that “USDOT’s Touhy regulations are unlawful to the extent that they apply to former employees.” This victory will greatly shift the discovery tools available, so that investor plaintiffs in securities class actions against highly-regulated entities (for example, companies subject to FDA regulations) will now be able to depose former employees of the regulators that interacted with the defendants during the class period to get critical testimony concerning the company’s violations and misdeeds.

The firm’s perseverance resulted in a recovery that provides the class of investors with as much as 20% of recoverable damages—an excellent result when compared to historical statistics in class action settlements, where typical recoveries for cases of this size are between 1.6% and 3.3%.

The Institute For Legal Reform's Latest Attack on Shareholders

ATTORNEY: JOSHUA B. SILVERMAN
POMERANTZ MONITOR: MARCH/APRIL 2019

Each year around this time, corporate-backed lobbyists issue reports in order to reinvigorate their endless crusade against investor protections. Most recently, the U.S. Chamber of Commerce’s Institute for Legal Reform published a paper urging Congress to consider further limits on securities litigation, including an unprecedented damages cap that would severely curtail the ability of institutional investors to recover losses. Titled “Containing the Contagion,” the paper places ideology above fact, ignoring the actual statistics regarding securities litigation and its beneficial impact on holding perpetrators of fraud responsible to their victims.

Even a cursory review of the Institute’s arguments shows their fallacy. First, the Institute claims securities fraud cases have “exploded.” The data cited tells a different story. Last year, 221 non-M&A securities fraud class actions were filed, only slightly more than 214 in the prior year, and somewhat above an average of 182 cases over the past 20 years. Higher, yes, but well below the prior high of 242.

More importantly, the Institute does not address the rise in corporate fraud driving the uptick in securities fraud litigation. Each month brings new revelations of corporate misconduct, suggesting that Congress needs to increase, not cut, investor remedies. From LIBOR-rigging to Petrobras to the Billion Dollar Whale to Theranos, fraud has become more frequent and brazen in recent years. Startups and life sciences companies have hit investors especially hard. Embracing Silicon Valley’s “fake it until you make it” culture, many of these companies show little hesitation to tell investors whatever is necessary to raise capital, whether truthful or not.

While the Institute would prefer to blame lawyers rather than fraud perpetrators for the uptick in filings, facts do not support that conclusion. Dismissal rates for securities fraud cases have dropped substantially since 2015, reflecting the strong factual underpinning for recent cases. Further, securities fraud cases are filed in only a tiny minority of statistically significant stock drops, not indiscriminately. Once filed, courts apply one of the highest pleading standards under federal law, ensuring that only meritorious cases proceed. Courts also assess whether each pleading is frivolous, and must impose sanctions for those that are. The fact that courts have assessed thousands of complaints but only imposed a handful of sanctions demonstrates that current standards are working.

The Institute’s conclusions about M&A filings also defy logic. The paper cites an increase in federal M&A filings, the result of an ongoing shift in M&A lawsuits from Delaware state court to federal court. But, as Cornerstone Research confirmed in its most recent tally, the overall rate of M&A lawsuits has declined in recent years, slipping 11% below the average annual rate.

The Institute next takes aim at what it calls “eventdriven” litigation—a securities fraud lawsuit brought after an issuer has misrepresented a risk that comes to fruition. For example, if a medical device company misrepresented known safety defects, and patients later died, triggering investor losses, the Institute would call ensuing shareholder litigation “event-driven.” Any concerns about such litigation are overblown. Shareholders will only be able to sustain securities cases, however labeled, if they have a factual basis to properly allege scienter, falsity and loss causation. As a result, courts will quickly weed out any lawsuits based only on an unforeseen triggering event.

None of the Institute’s arguments supports the most drastic remedy it urges Congress to consider: a damages cap that would deprive institutional investors of compensation for injuries suffered as a result of securities fraud. Specifically, the Institute proposes that the damages payable by securities fraudsters be capped at an arbitrary, unspecified amount for all cases other than those arising from initial public offerings, and that small investors be prioritized in the allocation of those damages. To justify this proposal, the paper repeats the discredited claim that securities fraud litigation is just “pocket shifting” for large, diversified investors, supposing that the investors gain on securities litigation settlements but also lose when other companies in which they invest have to pay out settlements. No academic research has shown this to be the case. In fact, a recent study found a statistically significant rise in share prices when a corporate securities fraud defendant announces a settlement. As a result, institutional investors benefit both from receiving settlement proceeds, and from the boost in valuation when portfolio companies come clean with investors.

While unpopular among some special interests, private securities litigation has returned tens of billions of dollars to defrauded investors. Even after fees and expenses, private securities fraud litigation remains the most important source of recovery for defrauded investors, far outpacing the SEC. The Institute’s latest anti-investor positions may satisfy its backers, but they do not justify any rollback of investor protections.  

The Supreme Court's Unanimous Decision in Tims V. Indiana Represents A Decisive Victory for Criminal Justice Reform

ATTORNEY: VERONICA V. MONTENEGRO
POMERANTZ MONITOR: MARCH/APRIL 2019

In an era where many states and localities are trying to plug their budget deficits by imposing draconian “civil forfeitures” on alleged criminals, the Supreme Court’s unanimous decision in February in Tims v. Indiana is a decisive victory against some of the most egregious abuses stemming from this practice. In this case, defendant Tims argued that the state of Indiana imposed an excessive fine on him when it seized his sports utility vehicle, valued at $42,000, after he was arrested for selling heroin. The value of this SUV was more than four times the maximum $10,000 monetary fine assessable against Tims for his drug conviction. The Supreme Court, in an opinion authored by Justice Ruth Bader Ginsburg, overturned the forfeiture and, in the process, held that the Eighth Amendment’s Excessive Fines Clause applies to the states under the Fourteenth Amendment’s due process clause, because it is a safeguard “fundamental to our scheme of ordered liberty” with “deep roots in our history and tradition.”

Tims pleaded guilty in Indiana Court to selling heroin to undercover officers. In addition to sentencing Tims to a year of house arrest, five years’ probation, and assessing reasonable fines and fees, Indiana sought civil forfeiture of a $42,000 SUV Tims had purchased with the proceeds of an insurance policy he received when his father died. The trial court denied Indiana’s request, noting that the vehicle had been recently purchased (and was therefore not likely part of the proceeds of his crime) and was valued at more than four times the maximum fine. Therefore, the trial court determined that the seizure of the SUV would be grossly disproportionate to Tims’ crime and unconstitutional under the Eighth Amendment’s Excessive Fines Clause. The Court of Appeals affirmed, but the Indiana Supreme Court reversed, holding that the Excessive Fines Clause did not apply to state action. Tims appealed.

As Justice Ginsburg remarked, the Supreme Court has held, with only a handful of exceptions, that the Fourteenth Amendment’s Due Process Clause “incorporates” many of the protections in the Bill of Rights, thus rendering them applicable to the states. A Bill of Rights protection is incorporated if it is “fundamental to our scheme of ordered liberty.” In holding that the Excessive Fines Clause is “fundamental to our scheme of ordered liberty,” Justice Ginsburg traced the adoption of the prohibition against excessive fines back to the Magna Carta, the Virginia Declaration of Rights, and similar colonial-era provisions. Justice Ginsburg also noted that by the time the Fourteenth Amendment was ratified, 35 of the 37 states expressly prohibited excessive fines in order to guard against such fines being used to subjugate the newly freed slaves “and maintain the prewar racial hierarchy.” Justice Ginsburg further noted that historically, excessive fines were used to undermine other constitutional liberties.

Indiana argued that the Clause, as applied to in rem forfeitures (i.e. seizure of specific property), is neither “fundamental” nor “deeply rooted.” In Austin v. United States, the Court held that civil in rem forfeitures fall within the Excessive Fines Clause protection when they are at least partially punitive. While Austin arose in the federal context, the Court noted that when a Bill of Rights protection is incorporated, the protection applies identically to the federal government and the states.

The Court held that the proper question in determining whether the Fourteenth Amendment incorporates a protection contained in the Bill of Rights is whether the right guaranteed – rather than each and every particular application of that right – is fundamental or deeply rooted. Thus, regardless of whether application of the Excessive Fines Clause to civil in rem forfeitures is itself fundamental or deeply rooted, the conclusion that the Clause is incorporated remains unchanged. The Court remanded the case to the Indiana Supreme Court for determination of whether the seizure of Tims’ SUV was excessive under this standard.

The Tims decision was cheered by advocates of criminal justice reform who have argued that civil asset forfeiture laws create an incentive for abuse. In many places, such laws facilitate the seizing of assets from individuals who have not been convicted of or even charged with a crime, and require only a tenuous connection between the crime and the seized asset. For example, in January 2019 an investigation conducted by The Greenville News and Anderson Independent Mail uncovered that the South Carolina police seized more than $17 million over a three year period through civil asset forfeiture. The investigation concluded that a review of the cases demonstrates that the “police are systematically seizing cash and property—many times from people who aren’t guilty of a crime— netting millions of dollars each year” and that “nearly a fifth of the 4,000 people who had their property seized by South Carolina police between 2014 and 2016 were never arrested nor even charged with a related crime.”

Additionally, critics of civil asset forfeiture laws contend that they are disproportionally harmful to lower-income communities and communities of color. For example, an investigation conducted by The Washington Post concluded that “of the 400 court cases examined where people challenged seizures and received money back, the majority were Black, Hispanic or another minority.” Another investigation found that Philadelphia cash forfeitures disproportionally target African-Americans who, while making up 44% of the population, are subject to an astounding 71% of forfeitures without conviction.

Critics of the Tims decision argue that the ruling will create financial challenges to police departments that have come to rely on civil forfeitures as a way to finance police operations. After Tims, they will have to look elsewhere for their funds.

Section 14(a) And Inadequate Risk Disclosures

ATTORNEY: MICHAEL GRUNFELD
POMERANTZ MONITOR: MARCH/APRIL 2019

In Jaroslawicz v. M&T Bank Corporation, the Third Circuit Court of Appeals recently held that allegations that defendants failed to disclose M&T Bank Corporation’s (“M&T”) compliance violations in a proxy statement issued in connection with M&T’s merger with Hudson City Bancorp (“Hudson”) could be a violation of Section 14(a) of the Exchange Act, which prohibits proxy fraud. The Court explained that the omission of information from a proxy statement violates Section 14(a) and the Securities and Exchange Commission (“SEC”) Rule 14a-9 if, among other reasons, “the SEC regulations specifically require disclosure of the omitted information.” The parties therefore agreed that Section 14(a) required the Joint Proxy to comply with Item 503(c) of SEC Regulation S-K. Item 503(c), in turn, requires issuers to “provide under the caption ‘Risk Factors’ a discussion of the most significant factors that make the offering speculative or risky.”

The parties disagreed, however, over whether M&T’s alleged past consumer violations posed a risk to regulatory approval of the merger and whether M&T had adequately disclosed the risk of M&T’s Bank Secrecy Act/Anti-Money Laundering (“BSA/AML”) deficiencies.  The Third Circuit concluded that the complaint plausibly alleged that M&T’s consumer violations “made the upcoming merger vulnerable to regulatory delay” and that the defendants did not adequately disclose the risk of M&T’s BSA/AML compliance violations. The Court’s decision thus emphasizes the breadth of factors that must be disclosed under Item 503(c) and the highly specific level at which defendants must disclose that information or be subject to liability under the federal securities laws.

According to the District Court, Item 503(c) did not require the defendants to disclose M&T’s consumer violations because the complaint did not adequately allege that those past violations posed a significant risk to the merger at the time the Joint Proxy was issued. In addition, the District Court held that M&T adequately disclosed the risk that its BSA/AML deficiencies posed to the merger by describing the general risk of regulatory oversight related to BSA/AML compliance issues. The Third Circuit disagreed with both of these conclusions.

First, the Third Circuit held that Item 503(c) required disclosure of M&T’s consumer rights violations because “[d]espite the fact that M&T had ceased [those violations], it is plausible that the allegedly high volume of past violations made the upcoming merger vulnerable to regulatory delay.” The Court then assessed whether the proxy materials adequately disclosed this risk factor as required by Item 503(c). As the Third Circuit explained, “generic disclosures which could apply across an industry are insufficient. Rather, adequate disclosures are companyspecific. They include facts particular to a company, such as its financial status, its products, any ongoing investigations, and its relationships with other entities.” The Court concluded that the plaintiffs plausibly alleged that the Joint Proxy’s disclosures concerning consumer violations, which “discussed the regulatory framework facing consumer banks” in general—but did not mention M&T’s fraudulent practices or the Consumer Financial Protection Bureau’s investigation into them—“were too generic to be adequate.”

As for M&T’s BSA/AML deficiencies, the Court held that “it is plausible that the[] boilerplate disclosures were too generic to communicate anything meaningful about this specific risk to the merger.” For example, although the Joint Proxy mentioned AML compliance requirements at a general level, it did not describe M&T’s “Know Your Customer” program, the bank’s alleged deficiencies, or the Federal Reserve Board’s investigation into them. Fur - thermore, because M&T’s supplemental disclosure of the Federal Reserve Board’s identification of these deficien - cies, which M&T noted would likely delay the merger, was made, at most, six days before the shareholder vote on the merger, the adequacy of these supplemental disclosures “raise[d] a fact issue, which preclude[d] dismissal of the BSA/AML allegations.”

The Court therefore concluded that the complaint ad - equately alleged a violation of Item 503(c)—and, by extension, Section 14(a)—and vacated the District Court’s dismissal of the mandatory-disclosure claims relating to M&T’s consumer rights violations and its BSA/AML deficiencies.

The Court, however, rejected claims that the defendants had failed to disclose information that might have contradicted their expressed opinions of confidence that the merger would be approved expeditiously. Plaintiffs alleged that defendants violated their duty to disclose facts that allegedly would have shown that they had little or no basis for these opinions. In its decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, the Supreme Court held that defendants have a duty to disclose information that forms the basis for their opinions when the omission of that information makes the opinion statements at issue misleading to a reasonable person. The Court here determined that the complaint did not allege specific undisclosed facts about the defendants’ knowledge of, or investigation into, M&T’s compliance violations that would have belied their stated opinion that the merger should obtain regulatory approvals in a timely manner.

Although this case dealt specifically with a claim brought under Section 14(a) of the Exchange Act, the Court applied the same standard that other circuits have applied to determine what disclosures Item 503(c) requires under the Securities Act. While these separate statutory provi - sions might cover different securities filings or participants, the Court explained that those distinctions are immaterial for purposes of determining the content of the disclosures required by Item 503(c). The Third Circuit’s decision in M&T helpfully sets out the standard for the duty to dis - close risk factors under Item 503(c), the violation of which gives rise to liability in connection with covered securities filings, including under Section 14(a) of the Exchange Act and Sections 11 and 12 of the Securities Act. In particular, the Court made clear the SEC’s concern that “inadequate disclosure—particularly in the form of disclosing only generic risk factors—presents a persistent problem.” Defen - dants must therefore disclose all of the most significant risk factors in a company-specific way, rather than relying on the common—but insufficient—practice of providing generic warnings that could apply to any company or an industry as a whole.

Courts Tackle Merger Proxy Rules Supremes To Determine Fate of Merger Litigation

ATTORNEY: AUSTIN P. VAN
POMERANTZ MONITOR: MARCH/APRIL 2019

Section 14(e) of the Exchange Act prohibits fraudulent, deceptive, and manipulative acts in connection with a tender offer. Mergers are often implemented through tender offers, which are accompanied by offering statements and recommendations from the target corporation.

On January 4, 2019, the Supreme Court granted certiorari in Varjabedian v. Emulex Corp., to review the Ninth Circuit’s holding that to state a claim under Section 14(e), shareholders need allege only that a misrepresentation or omission in connection with a tender offer was negligent. This case is of critical importance to the future of securities litigation relating to mergers. The Court could significantly expand Section 14(e) claims by siding with the Ninth Circuit (and against five other circuit courts) by holding that Section 14(e) requires only allegations of negligence, rather than proof of scienter (i.e., the intent to defraud). Alternatively, the Court might decide that no private right of action exists under Section 14(e) at all, and so significantly curtail merger-related securities litigation.

In Emulex, a shareholder of Emulex Corp. brought a Section 14(e) class action against the company following the merger of Emulex and Avago Technologies Wireless Manufacturing, Inc., two companies that sold storage adapters, network interface cards, and related products. Pursuant to the terms of a merger agreement, the Avago merger sub had initiated a tender offer for Emulex’s outstanding stock to obtain control of Emulex. In connection with this tender offer, Emulex issued a statement to shareholders recommending that they accept the offer. This statement included a summary of a non-public analysis Emulex had commissioned from Goldman Sachs of the fairness of the proposed merger. Goldman Sachs’s original fairness analysis included a comparison of the premium shareholders would receive in the tender offer and the premium of previous offers for similarly situated companies, and concluded that the premium, while below average, was within the normal range. Emulex omitted this analysis of premiums from its summary of Goldman Sachs’s fairness analysis. The complaint alleged that this omission rendered Emulex’s tender offer statement misleading, in violation of Section 14(e). The district court dismissed the complaint on the ground that it failed adequately to allege scienter.

The Ninth Circuit reversed the district court’s decision and held that only negligence, rather than scienter, need be pleaded to state a claim under Section 14(e). The Court noted that Section 14(e) contains two clauses, each prohibiting different conduct: the first clause prohibits “mak[ing] any untrue statement of material fact” and misleading omissions, while the second clause prohibits “engag[ing] in any fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer. ...” Each clause proscribes different conduct, as otherwise one clause would be superfluous. The Court then noted that the Supreme Court, in Aaron v. SEC, in interpreting the wording of Section 17(a)(2) of the Securities Act— which is nearly identical to the wording in the first clause of Section 14(e) —had held that that language did not require a showing of scienter.

The Ninth Circuit also addressed the Supreme Court’s holding, in Ernst & Ernst v. Hochfelder, that claims under Section 10(b) of the Exchange Act and Rule 10b-5 must allege scienter. The Court in Ernst expressly held that language nearly identical to that in the first clause of Section 14(e) could be read as proscribing negligent conduct, not merely intentional conduct. Nevertheless, the Ernst Court concluded that SEC Rule 10b-5 requires a showing of scienter because the enabling statute, Section 10(b) of the Exchange Act, permits the SEC to regulate only “manipulative or deceptive device[s],” and manipulation and deception are intentional acts. 15 U.S.C. § 78j(b). As the SEC cannot proscribe a broader range of conduct than permitted by the enabling statute, the Court interpreted Rule 10b-5 to prohibit only intentional conduct.

In concluding that Section 14(e) requires only negligent conduct, the Ninth Circuit broke with the Second, Third, Fifth, Sixth, and Eleventh Circuits, all of which previously had held that Section 14(e) required scienter. The Ninth Circuit disagreed with the analysis of those other circuits and held that they had failed to apply the holdings in Aaron and Ernst. The other circuits each had interpreted the language of Section 14(e) with reference to Rule 10b-5 and had concluded that because language in the latter had been found to require scienter, the former should as well. Yet these cases, the Ninth Circuit found, failed to recognize that the language in Rule 10b-5 required scienter only because the enabling statute limited scope of the Rule to intentional conduct. Circuit cases decided after Aaron and Ernst failed to recognize that the Supreme Court twice had interpreted language nearly identical to that in Section 14(e) to encompass negligent conduct.

Following the Delaware Court of Chancery’s 2016 ruling in Trulia that required greater scrutiny of cases alleging insufficient disclosures relating to a merger, shareholders increasingly have chosen to bring their merger-related claims in federal rather than state court. If the Supreme Court adopts the Ninth Circuit’s reasoning in Emulex and permits Section 14(e) cases to proceed based merely on allegations of negligence, federal merger-related securities litigation likely will increase even more significantly. However, the Court, with its additional conservative members, may be loath to endorse such a result and may simply adopt the holdings of the five circuits that have found that Section 14(e) requires scienter. However, the Court may take this case as an opportunity to address whether there is an implied private cause of action under Section 14(e) at all. If the Court finds that no implied private cause of action exists under Section 14(e), the holding may result in a significant curtailment of merger-related securities litigation. Moreover, this holding may encourage companies to use the tender offer more often for business combinations (in place of traditional mergers with board approval) so as to avoid private litigation, and so may curtail merger-related litigation even further.

Pomerantz Achieves Settlement with Barclays plc

ATTORNEY: TAMAR A. WEINRIB
POMERANTZ MONITOR JANUARY/FEBRUARY 2019

As this issue of the Monitor was going to press, Pomerantz, as sole Lead Counsel, achieved a $27 million settlement on behalf of the Class in Strougo v. Barclays PLC, which is pending court approval. In this high-profile securities litigation, plaintiffs alleged that defendants Barclays PLC, Barclays Capital US, and former head of equities electron­ic trading William White, concealed information and misled investors regarding its management of its Liquidity Cross, or LX, dark pool -- a private off-exchange trading platform where the size and price of orders are not revealed to other participants.

Specifically, during the Class Period, Barclays touted its Liquidity Profiling tool, describing it as “a sophisticated surveillance framework that protects clients from predatory trading activity in LX,” while promoting LX as “built on transparency” and featuring “built-in safeguards to manage toxicity [of aggressive traders].” However, the suit alleges that rather than banning “predatory” traders, Barclays actively encouraged them to enter the pool, applied manual overrides to re-categorize “aggressive” clients as “passive” in the Liquidity Profiling system, failed to police LX to prevent and punish toxic trading, intentionally altered marketing materials to omit reference to the largest predatory high frequency trader in LX, and preferentially routed dark orders to LX where those orders rested for two seconds seeking a “fill” vulnerable to toxic traders. This preferential treatment to high-frequency traders allowed them to victimize other dark pool investors by trading ahead of anticipated purchase and sell orders, thereby rapidly capitalizing on proprietary information regarding trading patterns.

In certifying the Class in February 2016, Judge Shira S. Scheindlin of the federal district court in the Southern District of New York held that even though the dark pool was just a tiny part of Barclays’ overall operations, defendants’ fraud was qualitatively material to investors because it reflected directly on the integrity of management. Defendants appealed Judge Scheindlin’s ruling in the Second Circuit Court of Appeals.

Pomerantz, in successfully opposing the appeal, achieved a precedent-setting decision in November 2017, when the Second Circuit affirmed Judge Scheindlin’s class certifica­tion ruling. The Court held that direct evidence of market efficiency is not always necessary to invoke the Basic presumption of reliance, and was not required here. The Court further held that Defendants seeking to rebut the presumption must do so by a preponderance of the evidence. This ruling will form the bedrock of class action securities litigation for decades to come.

Pomerantz Managing Partner Jeremy Lieberman stated, “We are extremely pleased with this settlement, which represents more than 28 percent of plaintiffs’ alleged recoverable damages,” he said, “well above the norm in securities class actions.”

Pomerantz Partner Tamar A. Weinrib led the litigation with Managing Partner Jeremy Lieberman and Pomerantz Senior Partner Patrick V. Dahlstrom.

Delaware Chancery Court Threatens the Future of Mandatory Arbitration Provisions

ATTORNEY: ANDREA FARAH
POMERANTZ MONITOR JANUARY/FEBRUARY 2019

In March 2018, the United States Supreme Court in Cyan, Inc. et al. v. Beaver County Employees Retirement Fund (“Cyan”) held that state courts continue to have concurrent jurisdiction (along with federal courts) over claims alleging violations of the Securities Act of 1933 (the “1933 Act”). The 1933 Act most notably provides claims based on misrepresentations in initial public offering ma­terials. The holding in Cyan raised the prospect that such claims could be filed by different shareholders in different state and federal courts.

In response, many companies going public adopted provisions in their bylaws or charters designating federal courts as the exclusive forum for the resolution of claims against them under the 1933 Act. For example, twenty of the 241 companies that went public with offering sizes of at least $10 million that began trading between Jan. 1, 2017 and May 3, 2018, had provisions designating federal courts as the only forum for securities law complaints. By doing so, companies hoped to avoid state court litigation of 1933 Act claims, or to prevent concurrent litigation of identical cases in state and federal court. If all the claims were in federal courts, it would be possible to consolidate them in a single multi-district litigation.

In a recent, significant decision in Sciabacucchi v. Salzburg (“Blue Apron”), the Delaware Chancery Court refused to dismiss the action, and in the process refused to enforce three company charters mandating that federal district courts be the sole and exclusive forum for the resolution of complaints asserting violations of the 1933 Act.

Plaintiff, a shareholder of meal delivery service Blue Apron, Inc., streaming device maker Roku Inc., and online personal shopping service Stitch Fix. Inc., filed a complaint seeking declaratory judgment under the 1933 Act against twenty individuals who signed the allegedly misleading registra­tion statements for the companies and who have served as the companies’ directors since their respective public offerings.

The case came before the Chancery Court, a state court, on cross motions for summary judgment. The charters of the three companies, incorporated under the laws of Delaware, contained substantially the same federal forum provisions, which provided, in relevant part, that “the federal district courts of the United States of America shall be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act of 1933.”

Defendants argued that the Delaware General Corporation Law, which allows certain provisions for the “management of the business and for the conduct of the affairs of the corporation,” was intended to provide great flexibility in a corporation’s ordering of its affairs, including the adoption of forum selection provisions, so long as the provisions were not unreasonable or contrary to public policy. Ad­ditionally, defendants argued that the law’s provision precluding corporations from adopting provisions that prohibit bringing internal corporate claims in the State of Delaware did not apply, since claims arising under the 1933 Act were not based upon a violation of a duty by a current or former officer, director or stockholder in such capacity.

Relying, in part, on the 2013 Chancery Court’s landmark decision in Boilermakers Local 154 Ret. Fund v. Chevron Corp. (“Boilermakers”), plaintiff argued that exclusive forum provisions must be limited to internal corporate governance claims, which — by definition — excluded claims brought under the 1933 Act. Those, according to plaintiff, “ha[d] nothing to do with the corporation’s internal governance” and nearly always involve false statements made even before the plaintiff became a stockholder.

In a 56-page opinion, Vice Chancellor Laster sided with plaintiff, holding that the companies’ federal forum provi­sions were “ineffective and invalid,” on the grounds that “constitutive documents of a Delaware corporation cannot bind a plaintiff to a particular forum when the claim does not involve rights or relationships that were established by or under Delaware’s corporate law.” In so holding, Vice Chancellor Laster reasoned that although the state of incorporation has the power to regulate the corporation’s internal affairs — including the rights and privileges of shares of stock, the composition and structure of the board of directors, and what powers the board can exercise — the state cannot use corporate law to regulate the corpora­tion’s external relationships. Consequently, since a claim brought under the 1933 Act is external to the corporate contract, “corporate governance documents, regulated by the law of the state of incorporation, can[not] dictate mech­anisms for bringing … claims alleging fraud in connection with a securities sale.”

The Chancery Court’s decision in Blue Apron is one in a series of critical judicial pronouncements relating to the state courts’ jurisdiction over class actions alleging only 1933 Act violations by private plaintiffs.

If companies cannot force certain types of claims into federal court, can they force them into arbitration instead? A critical implication arising from the Chancery Court’s reasoning in Blue Apron is that provisions mandating arbitration of 1933 Act claims could also be deemed invalid. As partner Jennifer Pafiti wrote in the previous issue of The Pomerantz Monitor, “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.” Pomerantz organized a coalition of large institutional investors from around the globe to meet with SEC Chair­man Jay Clayton in D.C. in October 2018, and also met with a number of both Republican and Democratic Senate staffers. Two weeks after these 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. Pomerantz has been credited by the American Association for Justice for our dedication to this effort.

On the other hand, proponents of mandatory arbitration clauses argue that such provisions are consistent with other litigation management tools that Delaware’s courts have recognized in the past, particularly in the Boilermakers case where the Chancery Court characterized compa­ny bylaw as a “flexible contract.” If the courts side with the consumers — a hypothesis that undoubtedly will be tested in litigation — corporations would be deprived of another vehicle by which they control the forum for resolution of claims arising under the 1933 Act. Most critically, it usually follows that if certain claims must be arbitrated, they cannot proceed as class actions.

If the Delaware Supreme Court affirms the Blue Apron decision, it could become a landmark.

In the Beginning...

ATTORNEY: GUSTAVO F. BRUCKNER
POMERANTZ MONITOR JANUARY/FEBRUARY 2019

In its landmark 2014 decision, Kahn v. M&F Worldwide, known colloquially as MFW, the Delaware Supreme Court held that the deferential business judgment standard of re­view will apply to going private mergers with a controlling stockholder and its subsidiary if and only if the merger is conditioned “ab initio” —Latin for “from the beginning” — on two specific minority stockholder protective measures. Once a transaction has business judgment rule review, the Court will not inquire further as to sufficiency of price or terms absent egregious or reckless conduct by a Special Committee. Deals subject to the “entire fairness” standard of review have a significantly tougher time getting judicial approval than those subject to review under the business judgment rule.

These two conditions, which the controlling stockholder must agree to at the outset, are that the merger receive the approval of (1) an attentive Special Committee comprised of directors who are independent of the controlling stock­holder, fully empowered to decline the transaction and retain its own financial and legal advisors, and satisfies its duty of care in negotiating fair price, and (2) a major­ity of the unaffiliated stockholders, who are uncoerced in their vote and fully informed. Delaware courts require that these conditions be agreed to “at the outset” to ensure that controlling shareholders not use the MFW condi­tions as “bargaining chips” during economic negotiations, essentially trading price for protection. Controllers are thus motivated to maximize their initial offer if they want the immediate benefit of business judgment review.

Until the MFW decision, transactions that involved a con­trolling stockholder were always subject to the heightened, entire fairness level of review, which shifts to the controlling stockholder the burden to show that the transaction is fair to the minority stockholders and functionally precluded dismissal of a complaint at the pleadings stage.

An interesting question arose in Flood v. Synutra: what constitutes the beginning? In January 2016, Liang Zhang, who controlled 63.5% of Synutra’s stock, wrote a letter to the Synutra board proposing to take the company private, but failed to include the MFW procedural prerequisites of Special Committee and majority of the minority approvals in the initial bid. One week after Zhang’s first letter, the Synutra board formed a Special Committee to evaluate the proposal and, one week after that, Zhang submitted a revised bid letter that included the MFW protections. The Special Committee declined to engage in any price negotiations until it had retained and received financial projections from its own investment bank, and such ne­gotiations did not begin until seven months after Zhang’s second offer. Ultimately the board agreed to a deal.

Plaintiff Flood brought a lawsuit challenging the fairness of the price and asserting breach of fiduciary duties. Flood argued that because controller Zhang, who held 63.5% of the company’s stock, failed to propose inclusion of the MFW protections in his first offer (even though he did so shortly thereafter, before negotiations commenced), the transaction did not comply with MFW and still had to meet the “entire fairness” test.

The Delaware Supreme Court declined to adopt a “bright line” rule that the MFW procedures had to be a condition of the controller’s “first offer” or other initial communication with the target about a potential transaction. Rejecting this narrow reading of MFW, the Court clarified that the conditions need not be included in the initial overture but must be in place “at the beginning stage of the process of considering a going private proposal and before any negotiations commence between the Special Committee and the controller over the economic terms of the offer.” Thus, even if those protections were not included in the “first offer,” the key concern of MFW — “ensuring that controllers could not use the conditions as bargaining chips during economic negotiations”—would still be addressed if the protections were in place before any economic negotiations commenced. This more flexible approach in­centivizes controlling stockholders to pre-commit to these conditions, which in turn benefits minority stockholders.

Pomerantz: Securities Practice Group of 2018

\Pomerantz earned a place on Law360’s coveted list of Securities Practice Groups of the Year for 2018. In its announcement, Law360 credited the firm’s stunning $3 billion win for investors in Petrobras securities as one of the reasons for this accolade. According to Law360, which interviewed Managing Partner Jeremy Lieberman pursuant to the award:

Pomerantz attorneys were able to achieve this re­sult, as well as an $80 million settlement resolving investor allegations involving Yahoo data breaches, by focusing much of their efforts on proving dam­ages, said managing partner Jeremy Lieberman. For the Petrobras case, investors ultimately alleged what they called an “unprecedented” 21 corrective disclosures revealing the fraud, and Lieberman said he personally spent about 500 hours with their damages expert.

“It was really understanding the damages and … putting defendants on the defensive and saying: Listen if you don’t pay us large settlements, you’re going to be in front of a jury and they’re not going to like to hear about some company involved in a mas­sive fraud and kickback scheme,” Lieberman said.

The Petrobras deal represented the biggest securities class action settlement in a decade and the big­gest-ever in a class action involving a foreign issuer, according to Pomerantz. … The class action settlement represented a 65 percent premium to the recoveries the individual plaintiffs secured, according to court documents.

“That’s really a unique, once-in-a-generation result where you’ll have the class do better than the opt-outs,” Lieberman said. “And it wasn’t by accident.”

Law360 further ascribed Pomerantz’s top standing to the precedent-setting rulings in Petrobras that the firm achieved in the Second Circuit Court of Appeals. The three-judge panel rejected Petrobras’ bid for a heightened standard when determining whether a class is ascertainable, or identifiable, and also rejected Petrobras’ argument that the investors should have been required to show that the stock increased in response to positive news and declined in response to negative news. As Jeremy Lieberman has stated, “These favorable decisions will form the bedrock of securities class action litigation for decades to come.”

Pomerantz Seeks Redress in Denmark for Danske Bank A/S Investors

ATTORNEY: JEREMY A. LIEBERMAN
POMERANTZ MONITOR JANUARY/FEBRUARY 2019

Pomerantz has formed a coalition to seek redress in Denmark on behalf of investors who lost billions of dollars in the fallout from a €200bn money laundering scandal at Danske Bank A/S (“Danske” or the “Bank”). The coalition consists of the International Securities Associations & Foundations Management Company for Damaged Dan­ske Investors, LLC and Danish law firm, Németh Sigetty Advockater (“Németh Sigetty”). Németh Sigetty has a well-deserved reputation for handling major, complex, and high-stakes disputes against both private party litigants and government authorities and has vast experience with investor group litigations in Denmark.

Danske, Denmark’s largest bank and a major retail bank in Scandinavia and Northern Europe, had until recently enjoyed a reputation as one of Europe’s most respected financial institutions. Last year, Danske’s star swiftly fell, as media reports placed it at the center of one of the world’s largest and most egregious money laundering schemes.

On February 27, 2018, several newspapers revealed that Danske’s upper management had known about an extensive money laundering scheme and falsification of records at Danske’s Estonia branch since December of 2013, but had first concealed the misconduct and then misrepresented the extent of its participation in the money laundering scheme—all while touting Danske’s purported commit­ment to anti-money laundering policies and practices. The revelations emerged after a whistleblower had informed Danske that relatives of Russian President Vladimir Putin and high-ranking members of Russia’s Federal Security Service (the FSB, formerly the KGB) were behind one of the companies that were laundering money through the Bank’s Estonia branch. An internal audit at Danske had confirmed the accuracy of the whistleblower’s allegations as early as February 2014, and that Danske’s Board of Directors and Executive Board had been made aware of the audit’s conclusions. The Estonia Financial Supervisory Authority (“EFSA”) immediately announced an investigation to determine the Bank’s culpability in knowingly withhold­ing this information during prior EFSA inspections at the Estonia branch in 2014.

On April 5, 2018, Danske announced that Lars Morch, Danske’s Head of Business Banking, would be released from his ordinary work duties “as soon as possible,” but would remain formally employed at the Bank until October 2019. In announcing Morch’s release, Danske’s Board Chairman, Ole Andersen, stated that “the bank should have undertaken more thorough investigations at an earlier point,” which would have “prompted swifter actions.” On May 3, 2018, the Danish Financial Super-isory Authority (“DFSA”) issued its investigative report, which provided additional detail of stonewalling by the Bank’s central management.

On July 3, 2018, it was reported that the alleged money laundering volume at issue was approximately $8.3 billion, much larger than the earlier estimate of $1.5 billion. Two weeks later, Danske announced that it had made an estimated profit as high as $234 million in connection with the suspicious transactions, and that it would forego the illicit profit.

On September 7, 2018, The Wall Street Journal reported that Danske was conducting a probe of transactions subject to money laundering concerns and that the value of the suspicious transactions under review might be as high as $150 billion. Then, on September 19, 2018, Danske issued a report documenting the results of its internal investigation, which con­firmed the knowledge and complicity of Danske’s senior management in covering up the money laundering scheme at the Bank’s Estonia branch. The report added key details to previous news reports, and also disclosed that the cash flows through the Estonia branch’s Non-Resident Portfolio were much higher than previous estimates, amounting to approx­imately $234 billion worth of transactions bearing the suspicious hallmarks of money laundering activity.

Since the initial disclosure of the money laundering scheme and Danske’s management’s role in concealing it, Danske’s stock price has fallen from 250.10 DKK 122.00 DKK at the time of this writing, representing a total loss of more than 86 billion DKK, or nearly $13 billion, in market capitalization. Criminal investigations are currently pro­ceeding against Danske and members of its management in France, Denmark, the United Kingdom, the United States, and Estonia. In November 2018, Danske was formally charged by the Danish Prosecutor for money laundering-related violations.

Generally speaking, Danish group actions proceed on an opt-in basis, in which a group representative is appointed by the court to represent the group’s interest. Under Denmark’s legal regime, the “loser” is typically required to pay the legal costs of the prevailing party. However, Pomerantz has organized to bring a group action in Denmark in which all legal fees and any adverse costs for which an investor could otherwise become liable be borne by litigation funders and/or other parties. This means that there is no downside financial risk for any inves­tor with respect to costs by participating. Pomerantz will work in conjunction with Danish counsel with respect to its clients, overseeing and operating in a supervisory role with respect to their claims.

The process to recover losses requires damaged investors to proactively join an organized litigation “group” which will aggregate each investor’s loss into a collective loss in a single claim and action before the Danish Court. Németh Sigetty will file this group litigation on behalf of eligible investors organized via Pomerantz’s coalition in the second quarter of 2019. Only those investors who are named as participants will be able to benefit from any settlement or judgment.

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.