Securities Litigation 2003-2004 Developments

Safe Harbor applied by new Circuits

Sixth Circuit:  Miller v. Champion Enters., Inc., 346 F.3d 660 (6th Cir. Oct. 8, 2003).  Some challenged statements were “classically” forward-looking notwithstanding plaintiffs’ claim that they were present tense, and accompanied by risk factors sufficient to invoke the first prong of the Safe Harbor.  Indeed, the company “disclosed the exact risk that occurred in this situation: excess retailer inventory that could lead to negative economic effects … [It] is not required to detail every facet or extent of that risk to have adequately disclosed the nature of the risk.”

Ninth Circuit:   Employers Teamsters Local Nos. 175 & 505 Pension Trust Fund v. Clorox Co., No. 02-17474, ___ F.3d ___,  2004 WL 32963 (9th Cir. Jan. 7, 2004):  CFO’s statement that clearing out the inventory left over from an acquired company’s past aggressive trade promotions would involve a “slow bleed” and would be a “year-long process approximately.”  The CFO had “identified the important problems with First Brands that could cause her estimate of the approximate timetable to be off.  The safe harbor requires that the cautionary language mention ‘important factors that could cause actual results to differ materially from those in the forward- looking statement.’ . . . This her statements did.”  Here, the Court also considered statements in the 10-K incorporated by reference, rejecting plaintiffs’ argument that “only cautionary statements actually accompanying the false statements can be considered as a defense.”  

Gommper extended and followed by other Circuits

Gommper states that the anti-scienter allegations of a complaint must be considered in determining whether plaintiffs meet their burden to plead a strong inference of scienter.  This is not as unusual as one may think:

Sixth Circuit:  Miller v. Champion Enters., Inc., 346 F.3d 660 (6th Cir. Oct. 8, 2003).  Dismissal without leave to amend in affirmed in lawsuit alleging that prefab home manufacturer knew but concealed that its largest retailer had excess inventory, but “forced” retailer to buy more, and then misrepresented effects of retailer’s bankruptcy filing.  As to the bankruptcy claims, plaintiffs failed to plead scienter because “many of the plaintiff's allegations also show that [the company] was under the impression that it had reached a deal that would keep [its largest retailer] out of bankruptcy.”  Moreover, “[i]t also appears implausible that defendants would have continued to advance unsecured loans of $2.25 million and $350,000 to [the retailer] if they had known that [it] was going to file a Chapter 11 petition.”  An accounting fraud claim under FASB 5 failed because while the probability of a bankruptcy requiring a FASB 5 write off may have been plausible, it was equally plausible that the company thought it could keep the retailer out of bankruptcy, and the company did take the proper steps under GAAP when bankruptcy was declared; given this balance of plausibilities, plaintiffs could not plead a strong inference of scienter.

Ninth Circuit:  Employers Teamsters Local Nos. 175 & 505 Pension Trust Fund v. Clorox Co., No. 02-17474, ___ F.3d ___,  2004 WL 32963 (9th Cir. Jan. 7, 2004).  Claim that company knew from the start of an acquisition that due to problems with acquired company’s sales channel that deal would not be accretive not pleaded.  Indeed, contrary to an inference of perfect knowledge of the impact of the problems, one of the witnesses for the plaintiffs stated that after the closing, “[s]enior management was constantly requesting updated information on the trade promotions because Clorox still had not gotten a grip on the extent of the trade promotions, the spend levels and the amount of deferred spending that had not been adequately accrued for by First Brands.”  

Tenth Circuit:  Pirraglia v. Novell, Inc., 339 F.3d 1182 (10th Cir. Aug. 11, 2003).  The court largely approved Gommper as to Rule 12(b)(6) inferences as to scienter:  “In evaluating the strength of a plaintiff's inference of scienter, we may recognize the possibility of negative inferences that may be drawn against the plaintiff.  We do so, not in a preclusive manner, but in an evaluative manner.  That is to say, we consider the inference suggested by the plaintiff while acknowledging other possible inferences, and determine whether plaintiff’s suggested inference is ‘strong’ in light of its overall context.”  As to falsity, “while we will draw no inferences unfavorable to plaintiffs, we will likewise refuse to draw inferences in the plaintiffs’ favor when doing so would allow them to make allegations “on information and belief” without satisfying the particularity requirements of the Reform Act.”  Some of the accounting fraud allegations in the complaint survived dismissal.

Other interesting scienter decisions

Fourth Circuit speaks out.  Ottmann v. Hanger Orthopedic Group, Inc., No. 02-2283, ___ F.3d ___, 2003 WL 22992292 (4th Cir. Dec. 22, 2003):  dismissal affirmed in lawsuit alleging .  This is the Fourth Circuit’s first shot at the Reform Act, which it construed to apply a middle ground standard as in FTP v. Greebel.

Tenth Circuit uses “logical” standard.  Adams v. Kinder-Morgan, Inc., 340 F.3d 1083 (10th Cir. Aug. 11, 2003):  dismissal reversed in pertinent part in lawsuit alleging that natural gas company misrepresented profitability of three key transactions or plants and published false financial statements.  The complaint appears to be detailed.  The scienter standard applied by the court, though, is puzzling:   “We therefore understand a ‘strong inference’ of scienter to be a conclusion logically based upon particular facts that would convince a reasonable person that the defendant knew a statement was false or misleading.”  

Knowledge not attributed from employee to supervisor.  Kushner v. Beverly Enterprises, Inc., 317 F.3d 820 (8th Cir. Jan. 23, 2003):  dismissal affirmed, where “the assertion that someone who may have been involved in the scheme ‘reported’ to [one of the defendants] is not specific enough to support a strong inference that he knew of or participated in the fraudulent practice while it was occurring.”  

Does Rule 9(b) apply to Section 11 claims?

Two avenues to apply Rule 9(b) in Ninth Circuit.  Vess v. Ciba-Geigy Corp., 317 F.3d 1097 (9th Cir. Jan. 31, 2003):  the Ninth Circuit rule that if a Section 11 sounds in fraud (Stac) is affirmed.  If a claim does not sound in fraud, consider the allegations (averments) in the claim that sound in fraud; strip away those allegations that do not meet Rule 9(b); and then determine if the averments that remain states a claim.

May not always result in its application.  In re Calpine Corp. Sec. Litig., ___ F. Supp. 2d ___, 2003 WL 22351414 (N.D. Cal. Aug. 28, 2003) (Armstrong, J.):  The court declined to apply Rule 9(b) to the ’33 Act claims, citing Vess, although it (vehemently) dismissed all fraud claims.

Or Rule 9(b) may apply and be satisfied.  In re Iasia Works, Inc., Sec. Litig., Nos. C 01-3224 SI etc., 2002 WL 1034041 (N.D. Cal. May 15, 2003) (Illston, J.):  motion to dismiss granted with prejudice in ’33 Act lawsuit alleging that an Internet provider’s prospectus misrepresented the costs of Internet Data Centers it was building.  The court applied Rule 9(b) under Stac because the claim sounded in fraud:  “The complaint alleges that, at the time of its IPO, iAsia works intended, pursuant to an undisclosed business plan, to establish IDCs averaging 120,000 square feet and costing over $50 million to build, and had in fact begun establishing these large IDCs … Plaintiffs allege that, instead of revealing their true plans, defendants distributed a prospectus representing the size and cost of the IDCs to be much smaller than they actually were … Given these factual allegations, the gravamen of plaintiffs’ complaint is that defendants deliberately concealed facts known to them, … [and that] … contrary to statements contained in the prospectus, iAsia was proceeding with its ‘true business plan’ which it kept hidden from investors.”  The complaint satisfied Rule 9(b), under a pretty cursory review.  What it did not plead was a materially false and misleading statement, given the risk disclosures about the size and costs of the IDCs

Divergent standards on pleading loss causation

Second Circuit requires more than just an inflated price.  Emergent Capital Investment Mgt., LLC v. Stonepath Group, Inc., 343 F.3d 189 (2d Cir. Sept. 4, 2003):  claim that the defendant company did not reveal the close connections and numerous complicated pump and dump schemes between its CEO and “a man who has been barred from the securities industry for life” pleaded loss causation, although this was a close question.  Plaintiffs alleged that its investment was akin to the pump and dump schemes previously peddled by the CEO-barred person’s team.  Here, the Court “clarified” its previous holding on loss causation, Suez Equity, and in so doing rejected the district court’s alternative finding that the omissions pleaded loss causation because they undermined the “investment quality” of plaintiff’s investment at the time it was made.  Rather, the “allegation of a purchase time value disparity, standing alone, cannot satisfy the loss causation pleading requirement,” but rather merely restated transaction causation.  The Suez Equity complaint went further by specifically asserting a causal connection between the concealed information  i.e., the executive’s poor history   and the ultimate failure of the business.

So did a judge in the E.D. Mich.  D.E. & J Ltd. Partnership v. Conaway, No. 02-CV-70684-DT, ___ F. Supp. 2d ___, 2003 WL 22207640 (E.D.Mich. Sept. 19, 2003):  This “requires the plaintiff to point to some causal link between the alleged misrepresentations and a concrete decline in the value of the plaintiff’s stock,” and which can be negated by intervening causes for the stock price decline.  Plaintiffs did not attempt this, but instead relied on the insufficient “inflated at the time of the purchase” theory.  (This is the same theory rejected by the Second Circuit in the same month in Emergent Capital Investment Mgt.

Eighth Circuit does not.  Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824 (8th Cir. June 30, 2003):  dismissal reversed in lawsuit alleging that subsidiary of company engaged in accounting fraud.  “Our finding of materiality allows the plaintiffs to invoke the fraud-on-the-market theory and assume that the misrepresentations inflated the stock’s price.  Paying more for something than it is worth is damaging.”

Ninth Circuit, same as Eighth Circuit.  Broudo v. Dura Pharmaceuticals, Inc., 339 F.3d 933 (9th Cir. Aug. 5, 2003):  the district court had concluded that plaintiffs had not pleaded a connection between allegedly false statements regarding FDA approval of a drug in progress and the stock price drop at the end of the class period, which followed an earnings miss.  The Ninth Circuit held that it was enough that the complaint pleaded that the price at the time of purchase was overstated and sufficient identification of the identification of the cause; plaintiffs did not have to plead that the price dropped upon the revelation of the truth.  

“Real” plaintiffs are suing – including parties that look more like typical defendants

A brokerage firm.  Stevenson v. Deutsche Bank AG, Nos. Civ.024845(RJL/AJB), ___ F. Supp. 2d ___, 2003 WL 22136062 (D. Minn. Sept. 8, 2003):  sprawling lawsuits alleging complex scheme causing collapse of brokerage firm.  One of the plaintiffs is E*TRADE Securities.  Essentially, the defendants manipulated the prices of three thinly traded securities that were loaned to broker-dealers like the plaintiffs.  

An issuer, against its former investment banker.  Antigenics Inc. v. U.S. Bancorp Piper Jaffray, Inc., No. 03 Civ. 0971 (RCC), 2004 WL 51224  (S.D.N.Y. Jan. 9, 2004):  lawsuit by company against its former investment banker and employees regarding a secondary offering.  The company alleged that the firm threatened to drop analyst coverage and market maker status if it was not picked to lead the secondary (when it had been the lead underwriter of the IPO), a threat the firm said was necessary to “teach their clients a lesson.”  The court dismissed the claim, which was based on the analysts’ cessation of coverage “without disclosing their illicit intention.”  As all the firm said was that it had ceased coverage, it had not made a false or misleading statement; the company had not shown any duty to disclose the reasons for the cessation; and, in any event, an unexplained decision to drop coverage was not a forbidden manipulative or deceptive device sanctioned by 10b-5.

Affiliates of a leading insurance company?  In re Adelphia Communications Corp., 293 B.R. 337 (Bankr. S.D.N.Y. May 15, 2003) (stay of discovery in pending State court securities fraud action granted pursuant to Uniform Standards Act; the first plaintiff in the State court action is …. AIG DKR Soundshore Holdings, Ltd.); AIG Global Sec. Lending Corp. v. Banc of America Securities LLC, 2003 WL 1738484, No. 01 CIV. 11448 (JGK) (S.D.N.Y. Mar. 31, 2003) (motion to dismiss granted in lawsuit by purchasers of securities in two private offerings of receivable-backed securities (of home furnishing company that went bankrupt) against underwriters).

Banks and other lenders.  BHC Interim Funding, L.P. v. Finatra Cap., Inc., No. 02CIV. 6553 (WK) (DFE), ___ F. Supp. 2d ___, 2003 WL 22212973 (S.D.N.Y. Sept. 24, 2003) (motions to dismiss largely granted in lawsuit by lender of funds for acquisition against acquiring company and its officers, following loan defaults); 

The issuers themselves, against their officers, directors and advisors – more accurately, parties in bankruptcy who succeed to claims of the issuer.  In re Complete Management, Inc., No. 02 Civ.1736 NRB, 01-03459, 2003 WL 21750178 (S.D.N.Y. July 29, 2003) (motion to dismiss for lack of standing granted in malpractice lawsuit by creditors of bankrupt corrupt corporation against auditors.  Even though the suit purported to state claims for negligence and not fraud, it clearly alleged fraud on the part of the company’s managers, and added a fraud claim against all defendants (including the auditors) to boot.  The creditors stood in the shoes of the fraudulent company, and hence could not sue.)

Counterparties to suspicious transactions that help other companies cook their books challenged by SEC and private plaintiffs

Securities & Exchange Comm’n v. Steckler (N.D. Cal.):  SEC charges senior officer of a Legato customer who placed order that he knew was cancelable, and put the cancellation provision in a side letter that he knew Legato’s auditors would not see

Securities & Exchange Comm’n v. Brightpoint, Inc., No. Civ. 03 CV 7045 (HB) (S.D.N.Y.):  SEC sues and settles with AIG, where AIG sold an “insurance” product that really was designed to, and did, allow a company to smooth its revenue stream.  As a result, AIG has a §10(b) consent decree and cannot use the safe harbor for three years!

In re McCool, Securities Act of 1993 Release No. 8296 (Sept. 30, 2003):  director of sales for one of the largest vendors to Just For Feet, Inc. signed phony audit confirmation letter consents to §10(b) decree

Securities & Exchange Comm’n v. Sebastian., No. No. 03-6909 SVW (FMOx) (C.D.Cal.):  civil and criminal complaints filed against CFO of former Internet advertising firm, who entered into barter or sham transactions with other companies, including Homestore.  (Key:  Homestore got into trouble for its side of the barters, now the counter party is in trouble too)

Securities & Exchange Comm’n v. [Robert] Quattrone, No. 04-33 (SRC) (S.D.N.Y. Jan. 7, 2004):  SEC sues four entities that purported to buy or sell products to Supreme Specialities in round trip transactions

Not always successful.  In re Veritas Software Corp. Sec. Litig., No. C-03-0283 MMC (N.D. Cal. Dec. 10, 2003):  motion to dismiss granted in lawsuit alleging improper recognition of purported barter transaction (software licenses for Internet advertising from AOL).  

Divergent standards on allowing leave to amend

Fifth Circuit:  Schiller v. Physicians Resource Group, Inc., 342 F.3d 563 (5th Cir. Aug. 29, 2003).  The Court focused almost exclusively on the district court’s denial of further leave to amend, affirming the lower court’s discretion to disallow further amendment to add new allegations (which could have been brought earlier) when plaintiffs already had taken “four bites at the apple.”

Sixth Circuit:  Miller v. Champion Enters., Inc., 346 F.3d 660 (6th Cir. Oct. 8, 2003).  The Court affirmed a leasding district court opinion that had reasoned that the Reform Act strict pleading standards mitigate against allowing multiple amendment.

Ninth Circuit:  liberal standard, at least and perhaps only where progress in stating a claim under the difficult and technical standards of the Reform Act is being made.  Eminence Capital, LLC v. Aspeon, Inc., 316 F.3d 1048 (9th Cir. Jan. 21, 2003) (per curiam) (concurring opinion by Judge Reinhardt specifically rejecting handling this question by how many “bites at the apple” plaintiffs had); Broudo v. Dura Pharmaceuticals, Inc., 339 F.3d 933 (9th Cir. Aug. 5, 2003).

Strict standard in post-judgment attempts to add new allegations.  Goldstein v. MCI WorldCom, 340 F.3d 238 (5th Cir. July 28, 2003) (dismissal and denial of Rule 60(b) motion to add new facts affirmed in lawsuit alleging false financial statements by extremely unsympathetic telephone company, where plaintiffs had not met their burden to show diligence in bringing forward the evidence and its material and controlling nature); Rosenzweig v. Azurix Corp., 332 F.3d 854 (5th Cir. June 13, 2003) (motion for leave to amend under Rule 59(e) opening brief was only two pages, and didn’t say what would be added other than that “as a result of the Enron investigations being conducted by Congress and the press, additional facts have come to light on the Azurix fraud.”  Even though Rule 59(e) amendment standards are similar to those under Rule 15(a), the district court did not abuse its discretion because plaintiffs admitted that they had made a “strategic decision” to hold off on their new allegations and risk dismissal, with the expectation they would be granted leave to amend.); In re Stone & Webster, Inc. Sec. Litig., 217 F.R.D. 96 (D. Mass. Aug. 25, 2003) (motion to amend denied in lawsuit against construction project management company.  Plaintiffs alleged there was newly discovered evidence, but failed to identify what new information was made available after the dismissal.  Moreover, plaintiffs previously chose to oppose the motions to dismiss on grounds that complaint was sufficiently pleaded, rather than providing the additional information at that time).

Other Interesting Cases

No claim against plaintiffs who sell inflated stock in merger

McKesson HBOC, Inc. v. New York State Common Retirement Fund, Inc., 339 F.3d 1087 (9th Cir. Aug. 13, 2003):  motion to dismiss “novel securities fraud claim brought under state law” affirmed, where McKesson HBOC sued the former shareholders of HBOC, alleging that they were unjustly enriched when McKesson acquired the company, because the value of HBOC had been inflated by that company’s revenue recognition fraud.  The Court (properly) reasoned that this would infringe upon the limited liability premise of share ownership.

Stock sales alone does not give rise to a claim

Friedman v. Rayovac Corp., No. 02-C-308-C, ___ F. Supp. 2d ___, 2003 WL 22705327 (W.D. Wisc. Oct. 17, 2003):  motion to dismiss amended complaint granted with prejudice in lawsuit alleging that battery company made false announcement of new relationship with major distributor and engaged in channel stuffing.  This is a remarkably sensible and sophisticated opinion, especially on the notion that stock sales alone can give rise to 10b-5(a) or (c) scheme or manipulation liability.  While plaintiffs cited three cases in which the manipulative act giving rise to liability was the buying and selling of stock, “in these cases, the defendants were engaging in sham transactions with the purpose of creating the appearance of heavy trading, which would suggest that the stock was worth more than it was.  In this case, however, defendants’ sales were not designed to communicate anything.  According to plaintiffs’ allegations, defendants sold their stock because they believed it was overvalued and wanted to dump it before the stock’s true worth became known.  Insider sales of large amounts of stock would not convey an impression that a stock is worth more than its market value.”  

Sophisticated purchaser means higher standards of reliance and lower standards of duty

R2 Investments v. Phillips, No. Civ. A. 302CV0323 N, 2003 WL 22862762 (N.D. Tex. Dec. 3, 2003):  motion to dismiss granted in lawsuit by purchaser of millions of dollars of senior notes of now-bankrupt company.  The court rejected a claim that the defendants violated §10(b) by announcing a repurchase tender offer when it lacked the resources to consummate it.  While the offer said that the company “will pay” $160 million in the deal, it also expressly anticipated that the company might default in the payment of the purchase price.  Dismissal also was appropriate because the company had no duty to disclose the omitted information and because the plaintiff neglected its duty of due diligence.  On factor was that “as a sophisticated offshore investment company accustomed to investing tens of millions of dollars at a time, [plaintiff] surely relied on a wide variety of sources, not just the defendants, in making investment decisions.”  Furthermore, even if there was a duty to speak, the defendants disclosed the failure of an acquisition and the consequent $120 million loss in anticipated cash only one week after the tender offer.  “There is no Rule 10b-5 omission just because the Individual Defendants took longer to disclose than the Plaintiff would have liked.”  “Nevertheless, even after the announcement, [plaintiff], a sophisticated offshore investment company, chose to continue to acquire more than $38 million of the Senior Notes.  Yet there is no suggestion that R2 made even a single phone call to find out from [the company] whether the failure of the . . . acquisition would impact its ability to complete the tender offer.  Had the defendants affirmatively denied any such impact, plaintiff might have had an actionable claim against them.  However, no such allegation was made, and thus because plaintiff “neglected to pursue its interests with the due diligence required by this Circuit, the omissions alleged in the complaint fail to state a claim on that ground as well.”  

First case to apply Rule 10b5-1(c) trading plans to private 10(b) claim

Wietschner v. Monterey Pasta Co., No. C 03-0632 MJJ, ___ F. Supp. 2d ___, 2003 WL 22889372 (N.D. Cal. Nov. 4, 2003) (Jenkins, J.):  motion to dismiss granted in lawsuit alleging channel stuffing by fresh pasta company.  For the first time, a court held that a Rule 10b5-1(c) trading plan (it had been alleged in the complaint) could negate an inference that stock sales were suspicious.  

Private right of action exists for violating “best price” provision of Williams Act

In re Luxottica Group S.p.A., Sec. Litig., No. 01 CV 3285 NG MDG, ___ F. Supp.2d ___, 2003 WL 22829401 (E.D.N.Y. Nov. 26, 2003):  motion to dismiss denied in lawsuit under “best price” provision of §14(d)(7) of the Williams Act alleging that the acquired company’s Chairman received a better price for his shares than was given to other shareholders for theirs, because he received a non-competition and consulting agreement.  The court held that at a private right of action existed under the provision, and that the Reform Act did not apply to it because fraud was not an element. 

Manipulation \ scheme claim by SEC stated arising from acceptance of bribes

Securities & Exchange Comm’n v. Santos, No. 02 C 8236, ___ F. Supp.2d ___, 2003 WL 22764456 (N.D. Ill. Nov. 10, 2003):  motion to dismiss denied in lawsuit alleging that city treasurer demanded illegal cash payments and campaign donations from the registered representatives of authorized broker-dealers in order to secure their receipt of city’s investment business.

© David Priebe 2017