Derivative Litigation 2004 Developments

 

1.New Scrutiny of Director Independence Based On Personal or Financial Ties Between Directors …

A.Starting early in 2003, Biondi v. Scrushy, No. Civ. A. 19896-NC, 2003 WL 203069 (Del .Ch. Jan. 16, 2003) (Strine, V.C.) [attached as Tab 1]:  the court denied a motion to stay a derivative lawsuit based on insider trading allegations brought by a Special Litigation Committee, because it was evident even before the SLC issued its report that it never would be able to satisfy the independence standard of Zapata Corp. v. Maldonado, due to some very close ties between board members and egregious public statements by the company.

i.The SLC was to be comprised of two directors  who served with the CEO [Scrushy] on the board of the National Football Foundation and College Hall of Fame, of which one director had been the Chairman since 1994.  “One of that organization’s key awards is named for HealthSouth, suggesting that the company, under [the CEO’s] managerial leadership, has been quite generous with a cause very important to [the director].”

ii.There also were “long-standing personal ties” between Striplin, the other director, and the CEO, who are both large contributors to college sports programs in Alabama.  “Indeed, a stadium at a college in Alabama is named Scrushy-Striplin Field.”

iii.The company “further undercut the SLC’s credibility” by making and announcing a “strange decision” to hire Fulbright & Jaworski “to investigate the securities trading issues that were at the heart of the pending lawsuits - i.e., the same issue supposedly entrusted to the SLC,” under the purview of the full Board. 

iv.Six days later, the company issued a press release in which the company’s new CEO exonerated Scrushy.

v.The final straw was that the company issued a press release quoting the new head of the SLC to the effect that Fulbright & Jaworski had issued a report exonerating Scrushy, just as the SLC’s own investigation was getting underway. 

B.In re Oracle Corp. Derivative Litig., 824 A.2d 917 (Del. Ch. June 17, 2003) [attached as Tab 2]:  two Stanford University professors (one of whom was Joe Grundfest) were not independent because two of the officers and directors whose alleged insider trading they were investigating (Larry Ellison and Donald Lucas) were major or potentially major benefactors of Stanford.

i.[Note that at the PLI in San Francisco, Bill Lerach opined that the decision came out this way because the Chancellor had heard of Judge Jenkins’ decision dismissing the parallel securities class action case against Oracle and the insiders, a decision Lerach thought was wrong and shocking.]

C.In what I think is an extreme case, in In re eBay, Inc. Shareholder Litig., No. Civ. A. 19988‑NC, 2004 WL 120234 (Del. Ch. Jan. 23, 2004) [attached as Tab 3], a director was interested because he held unvested stock options worth millions of dollars that would be lost if he was kicked off the board, which three director defendants had the voting power as shareholders to do.  Id. at *3.

i.To be certain, the circumstances are somewhat distinct:  three directors are not only defendants, but are alleged to have received funds (profits from IPO accounts) that belong to the corporation, hence presenting a more direct challenge to those directors than in most derivative cases; and the three directors plus a former colleague also named as a defendant collectively controlled 40% of the shares, thus putting them in a relatively unique position to exercise control.

ii.It’s still an extreme holding because this form of director compensation is common.  Also, ownership of stock options does not signify a lack of independence under the NYSE and Nasdaq rules; this is an important topic because under Sarbanes-Oxley, you need at least three independent directors on an Audit Committee.

D.This type of argument does not always prevail.

i.Beam v. Stewart, Civ.A. 19844‑NC, 2003 WL 22271421 (Del. Ch. Oct. 2, 2003) (Chandler, C.) [attached as Tab 4], found that demand futility had not been pleaded in a derivative lawsuit challenging the failure of the Board of Martha Stewart Organization to police and prevent Ms. Stewart’s alleged improper trading in ImClone stock.

This was despite the fact that Ms. Stewart controlled 94% of the stock of the company and hence was in a position to remove the outside directors, and there were allegations of long-standing friendship between Ms. Stewart and several of the directors.

The complaint did not plead that these directors were “incapable of considering demand without this extraneous consideration having an inappropriate effect on their decisionmaking process,” and the alleged personal ties did not rise to the levels pleaded in Oracle.

Another interesting point was that the court held that the directors did not have a duty to police Ms. Stewart’s stock transactions in other companies.  Given her significance to the company, if it leaked out that the Board was concerned enough about her to investigate, the disclosure itself could hurt the company and its shareholders.  The Board did not have a duty to do something that could injure the shareholders.

ii.Kindt v. Lundt, No. Civ.A. 17751‑NC, 2003 WL 21453879 (Del. Ch. May 30, 2003) (Chandler, C.) [attached as Tab 5] granted a motion by a Special Litigation Committee to terminate a derivative lawsuit challenging three transactions.

Chancellor Chandler sua sponte reviewed the independence of the Special Litigation Committee members.  One of them, former Utah Senator Jake Garn, was independent even though he had approved the challenged transactions while a director and was a defendant in the underlying action, as he had no financial interest in any of the transactions.

2.… Coupled With [Continued] Skepticism Of Other Bases For Demand Futility …

A.Rattner v. Bidzos, Civ.A. 19700, 2003 WL 22284323 (Del. Ch. Oct. 6, 2003) (Noble, V.C.) [attached as Tab 6]:  the court granted a motion to dismiss for failure to make demand in a lawsuit alleging that Verisign issued false financial statements by improperly recording round trip revenue and barter transactions and failing to write down investments, and made other misstatements, and allowed insiders to engage in insider selling. 

i.The typical demand futility allegations (participating in the challenged Board decisions or failure to act) were too conclusory to suffice, e.g., plaintiff “merely posits, without any particularized facts, that the Director Defendants knew of inside information, and that they knew of (or directly participated in) the allegedly material misstatements.”

ii.An interesting point in this regard is that the court acknowledged trading windows when it discussed the insider trading allegations.  The complaint “contains no particularized facts regarding the timing of the Director Defendants’ trades in relation to permitted trading periods; while the pattern observed does reflect trading activity on behalf of the Director Defendants after the release of allegedly misleading statements, no particularized allegation of the Amended Complaint answers whether this temporal proximity was in fact part of the Company’s practice to prevent Company insiders from improperly benefiting from informational asymmetries.” 

B.In re Citigroup, Inc. Sec. Litig., No. 19827, 2003 WL 21384599 (Del. Ch. June 5, 2003) (Lamb, V.C.) [not attached]:  the court granted another demand futility dismissal motion in a lawsuit challenging Citigroup’s involvement in Enron off balance sheet transactions, where the initial complaints “allege, in wholly conclusory terms, that all of the 19 directors breached his or her fiduciary duties by failing to exercise reasonable control and supervision over the “officers, employees, and agents of Citigroup and its subsidiaries.’”

C.Guttman v. Huang, 823 A.2d 492 (Del. Ch. May 5, 2003) (Strine, V.C.) [not attached], rejected indiscriminate insider trading allegations as a basis for demand futility in lawsuit alleging false financials (cookie jar reserves) at nVidia, a Silicon Valley graphics accelerator chip maker.

i.The court reasoned that where the case most cries out for the pleading of real facts‑‑e.g., about the board’s knowledge of the accounting problems at the company or the company's audit committee process‑‑the complaint is at its most cursory, substituting conclusory allegations for concrete assertions of fact.” 

ii.The court then rejected the claim that insider sales made the directors interested, on a valuable doctrinal basis:  “Although insider sales are (rightly) policed by powerful forces‑‑including the criminal laws‑‑to prevent insiders from unfairly defrauding outsiders by trading on non‑public information, it is unwise to formulate a common law rule that makes a director ‘interested’ whenever a derivative plaintiff cursorily alleges that he made sales of company stock in the market at a time when he possessed material, non‑public information.  [¶]  This would create the same hair‑trigger demand excusal that Aronson and Rales eschewed.” 

D.Litt v. Wycoff, No. Civ.A. 19083‑NC, 2003 WL 1794724 (Del. Ch. Mar. 28, 2003) (Noble, V.C.) [not attached]:  demand futility was not pleaded in lawsuit alleging that bank directors conducted lending activities, inappropriate for a thrift entity through the TechBanc division; approved an Incentive Compensation Plan that paid improper bonuses to officers in the form of warrants received from lending customers for securing business (loans) for the division, and paid certain other fees and commissions to officers and directors.  The complaint did not “allege any particularized facts regarding the process by which the Board initiated or approved the challenged actions, notably approval of the Incentive Compensation Plan.  Similarly, the Complaint does not allege that the Board failed to obtain appropriate legal advice or other professional guidance before implementing either the TechBanc program or the Incentive Compensation Plan.”

3.… And With A [Continued] Unwillingness to Second-Guess Analyses of Independent Special Committees

A.Special Litigation Committee:  Kindt v. Lundt, No. Civ.A. 17751‑NC, 2003 WL 21453879 (Del. Ch. May 30, 2003) (Chandler, C.), which I’ve already noted, granted a motion by a Special Litigation Committee to terminate a derivative lawsuit challenging three transactions.

i.Plaintiffs objected to the Report by asserting that the SLC lacked reasonable bases for its conclusions because it did not undertake one analysis and consider another point.

ii.The Court easily rejected these claims.  Indeed, because the SLC’s “actions were not egregious, irrational, or unwarranted,” the Court declined to exercise its discretion to “conduct an independent business judgment evaluation on the merits of plaintiff’s case,” the discretionary second step in the standard Zapata analysis.

B.For a Transactional Special Committee:  In re JCC Holding Co., Inc. Shareholders Litig., No. Civ.A. 19796, 2003 WL 22246591 (Del. Ch. Sept. 30, 2003) (Strine, V.C.) [attached as Tab 7], granted a motion for judgment on pleadings in a case challenging a cash-out merger between a corporation that owns a casino and its controlling (63%) stockholder.

i.The casino operator’s Special Committee, advised by Houlihan Lokey [an investment advisor firm that we work with from time to time], gave a fairness opinion. 

ii.Plaintiffs challenged this by claiming nondisclosures in the proxy statement.  Their first theory was that “information that did not exist (e.g., certain analyses that the plaintiffs believe Houlihan should have undertaken) should have been created in order to provide the JCC electorate with a full information base.”  But as a matter of law, there is no duty for a Board to disclose information that does not exist. 

iii.Plaintiffs’ second theory was that certain of Houlihan Lokey’s analyses were “wrong”.  Chancellor Strine reasoned here that “[t]he plaintiffs’ only beef is that Houlihan made mistakes in subjective judgment, even though those judgments were disclosed to the JCC stockholders . . .  This kind of quibble with the substance of a banker’s opinion does not constitute a disclosure claim.”  Indeed, it suggested the opposite:  the disclosures of what Houlihan Lokey had done were good enough to allow the plaintiffs to analyze the issue and make their own assessment!  Thus, “[a]ccepting the plaintiffs’ arguments . . . would be injurious to stockholders,” as it would discourage full disclosure.

C.Contrast Krasner v. Moffett, 826 A.2d 277 (Del. June 18, 2003) (Veasey, C.J.) [attached as Tab 8], which held that at the pleading stage, a derivative lawsuit may go forward if the Special Committee that considered a transaction did not have plenary power, but rather merely recommended the deal for approval to a majority-tainted Board that made the final decision.

i.The Supreme Court reversed the dismissal of a class action challenge to a merger that reunited two previously split portions of Freeport-McMoRan Company.  All but two of the directors allegedly were interested in the transaction.  The other two sat on a Special Committee that considered the deal.

ii.The Court held that “the directors, not the plaintiffs, bear the burden of proving that the merger was approved by a committee of disinterested directors, acting independently, with real bargaining power to negotiate terms.” 

iii.That burden was not met here where the Special Committee merely recommended the merger to the full board, which voted unanimously to approve the merger as none of the five allegedly conflicted directors abstained from the decision-making process. 

iv.The Court endorsed a Chancery Court opinion in Tremont, which stated that where a majority of directors allegedly are conflicted, “plaintiff plainly should have the right to discover into the answering facts, relating to the alleged effectiveness of action of any independent committee of directors who are relied upon to protect the proponents of that transaction from justifying the fairness of its terms.” 

4.Corporate Recovery of Personal Profit

A.Several recent cases have adjudicated derivative demands that corporate officers or directors pay to the corporation profits or benefits that belong to the corporation.

B.One important case is In re HealthSouth Corp. Shareholders Litig., No. Civ. A. 19896, 2003 WL 22769045 (Del. Ch. Nov. 24, 2003) (Strine, V.C.) [attached as Tab 9], which comes close to setting forth a strict liability standard, at least when an officer transacts with the company.

i.This case, like Biondi v. Scrushy (cited above), arises from a major scandal, namely HealthSouth.  It addresses a particular transaction between the CEO and the company, namely one in which the company extinguished a $25 million loan balance owed by the CEO in exchange for an equal value of stock.  “Equal value”, though, was at the current market price – which in turn was premised on the company’s reported financials, which later were restated.  (As the opinion notes, every person who served as CFO during the time the CEO was there has pleaded guilty to criminal securities fraud.)

ii.As the court began — ominously for the CEO – “Because Scrushy represented to HealthSouth that the market price was a reliable way to price his shares fairly, he was necessarily also representing that the company's financial releases were materially accurate.  That representation was false, regardless of whether Scrushy knew it was.  As a result of that inaccurate representation, HealthSouth received shares worth less than the value of the loan Scrushy was retiring.”

iii.The court thus granted summary judgment for the derivative plaintiffs, even assuming for purposes of the motion that the CEO was not aware of the inaccuracy of the financials, on their claims of unjust enrichment and equitable fraud.  (The plaintiffs didn’t pursue an intentional falsehood standard because they did not want to implicate the CEO’s Fifth Amendment rights.)

iv.As the court summarized, “The HealthSouth board was entitled to and did rely upon Scrushy’s assurance of the fairness of the market price as a transactional pricing mechanism.  After all, as the company’s CEO, he was in a better position than the rest of the board to assess the reliability of the company’s financial statements and press releases, given that it was his job to assure that management prepared those documents with care and accuracy.  To its detriment and Scrushy’s unjust benefit, HealthSouth took back shares worth far less than Scrushy represented they were worth.  To remedy the injury to HealthSouth, rescission is a fitting and practicable remedy, coupled with pre‑ judgment interest.”  This was enough to show unjust enrichment – it was the CEO’s job to ensure the filing of accurate financial statements, and the reports he signed did not contain accurate financial statements.

v.The CEO, with an eye to the pending criminal investigations, did not really contest the facts – he rather asserted, without support, that the financial statements at the time of the deal were in fact materially accurate because the auditors are still working on the restatement.  The CEO didn’t even argue that he believed the statements were accurate at the time he entered into the transaction.  His major argument was the company was in pari delicto with the false statements:  “If Scrushy’s subordinates were the cause of the falsity, says Scrushy, then HealthSouth as an entity is equally to blame with him for failing to catch this subordinate‑level fraud.”  The court replied, “[t]his is transparently silly.  If Scrushy’s subordinates blew one ‑ or several seasons' full of pitches ‑ past him, that still does not absolve him or render him on equal status with HealthSouth as an entity.”

vi.The direct impact of this case will be minimized because it involves a transaction between an insider and the company; the opinion repeatedly refers to this in assessing which party (the CEO or the company) should bear the risk of the false financial statements.  Moreover, officer or director loans are no longer allowed, per Sarbanes-Oxley.  Still, the opinion enunciates a standard for liability to the corporation that is hard to reconcile with Delaware law (e.g., with director liability-limiting provisions) – which the court did not really attempt to do.

vii.By the way, the representation of reliance on market price that undermined the CEO in this case contrasts to a recent decision in the WorldCom litigation, In re WorldCom, Inc. Sec. Litig., Nos. 02 Civ.3288 (DLC), 03 Civ.1052, 2004 WL 27721 (S.D.N.Y. Jan. 6, 2004).

There, the court granted a motion to dismiss in a lawsuit by purchasers of securities issued by an investment bank (UBS) whose payout depended on the price of another stock, namely (and unfortunately) WorldCom.   The securities (“GOALs”) were notes that paid an annual interest rate of 12% over two years, payable semi-annually; the amount of the principal to be repaid at maturity depended on the performance of WorldCom common stock.

viii.The court held that the accurate description of historical prices for a company’s stock cannot support a Section 11 claim when those prices were artificially inflated through another party’s fraud.  It helped the defendant that it explicit disclaimed the historical prices; that is, it said that did not know whether WorldCom had made accurate disclosures, that it had not done due diligence, etc.  Thus, there was no false or misleading statement:  the prices were accurately set forth, and “there was no statement (or omission) by UBS that related to the reliability of the stock prices as an indicator of WorldCom’s financial health in either the past or the future.”

C.A second case, Beam v. Stewart, Civ. A. 19844‑NC, 2003 WL 22271421 (Del. Ch. Oct. 2, 2003) (which I already discussed), dismissed a separate claim that Ms. Stewart and an outside director (John Doerr) had usurped a corporate opportunity by selling a large block of their personal shares of the corporation in a private transaction, rather than asking the company whether it wanted to sell its own shares to the buyer.

i.At the outset, the claim failed because selling stock was not in the company’s line of business:  “MSO [Martha Stewart Organization] is a consumer products company, not an investment company.  Simply stated, selling stock is not the same line of business as selling advice to homemakers.  Further, I would presume that a company’s ‘line of business’ is one that is intended to be profitable.  By definition, a company’s issuance of its stock does not generate income.” 

ii.Nor did the company have an interest or expectancy in the stock sales:  the complaint did not allege facts that would imply that the company was in need of additional capital, seeking additional capital, or even remotely interested in finding new investors. 

iii.As a consequence of these factors, the sales did not place the directors in a position inimical to their duties to the company.

D.The same jurist, Chancellor Chandler, applied the corporate opportunity doctrine in eBay (which I already discussed) when the conduct at issue was buying other companies’ stocks.

i.Here, Goldman Sachs allegedly allowed the founders of eBay to buy “hot” and scarce IPO stocks, and then sell them immediately at a large profit.  Goldman Sachs, which already was eBay’s investment banker, supposedly did this to show appreciation for their past business with the company and enhance their chances of obtaining additional business.

ii.The Court decided that the ability to buy hot IPO stock was a corporate opportunity of the company, which placed the recipients in conflict with their duties to the company.  Here, the court found significant that the complaint alleged that part of eBay’s investment strategy was to buy securities, hence it made sense that this is an opportunity in its line of business.  Part of the allegations here referenced the company’s SEC filings, which showed that it possessed marketable securities.  Editorializing, this is a questionable inference if taken too far:  most companies possess “marketable securities,” but that’s a far cry from buying shares in other companies – to the contrary, most Treasury policies prohibit investment of spare cash in all but the most conservative of securities.

iii.The court also opined that calling the right to buy IPO shares a corporate opportunity would not open the floodgates to all advantageous investment opportunities presented to officers and directors because this was a “unique, below-market price investment” opportunity offered by Goldman Sachs “to maintain and secure corporate business,” not merely a broker’s investment recommendation to a wealthy client. 

iv.The Court also ruled that even if the right to buy shares was not a corporate opportunity, “a cognizable claim is nevertheless stated on the common law ground that an agent is under a duty to account for profits obtained personally in connection with transactions related to his or her company.”  Here, the complaint “gives rise to a reasonable inference that the insider directors accepted a commission or gratuity that rightfully belonged to eBay but that was improperly diverted to them,” in breach of the duty of loyalty.

v.These holdings raise numerous questions that are left unanswered.  How can Goldman Sachs’ state of mind or intentions in allocating the IPO shares matter to the recipients of the shares?  What if the recipients were not made privy to those intentions?  What if they were told that there was a different purpose (e.g., the shares were offered to secure their personal banking business, which makes sense because they were wealthy individuals)?  Does it suffice that a reasonable person would conclude or suspect that the bank gave the shares in order to win business?  Does this opinion require a per se rule that officers and directors not bank at the same firm as the company’s investment bankers?  Would this protective measure suffice, given the potential allegation that the other bank at which the insiders conducted their personal business also was trying to curry favor with the insiders and gain investment banking work?

E.Note that I have not yet seen a case asking for the return of an officer’s stock sale profits or bonus payments under the Sarbanes-Oxley Act, which requires an officer or director to disgorge profits or bonus for periods covered by a financial restatement that is the result of wrongdoing.

5.Partial Recognition of Impact of Parallel Securities Class Action Case

A.In most of our derivative cases that track the allegations of a parallel securities class action, we contend at one point or another that it would not benefit the corporation to allow the derivative action to go forward, for all that discovery or success in the derivative action would achieve is to help prove the securities plaintiffs’ case – which would or could injure the corporation by exposing it to liability.  [This is my “piling on” argument from my PLI article in 1999.]

B.One of the remedies we’ve suggested [again, suggested by my article] is to stay the derivative case until it’s determined whether there is any viable securities claim.  No harm, no foul.

C.Brudno v. Wise, No. Civ.A. 19953, 2003 WL 1874750 (Del. Ch. April 1, 2003) (Strine, V.C.) [attached as Tab 10], issued such a stay.  The court granted a motion to stay derivative case demanding as relief that the directors of El Paso are liable for the damages in parallel securities lawsuits and FERC actions for the alleged “serious violations of the federal securities laws and of federal energy market regulation policies”. 

D.As the court reasoned, “[p]ut simply, if the Federal Securities Action were to lead in the exoneration of El Paso and the other defendants on the grounds that the company did not in fact engage in any type of securities violation, market manipulation, or improper conduct of any kind designed to artificially inflate the value of El Paso, it is not apparent what, if anything, would be left of this Action,” which sought indemnification for the company from the officers and directors for the injury the company was going to incur in those parallel cases.

6.Two Brief Highlights From Our Home State of California

A.In State Farm Mutual Automobile Ins. v. Superior Court, No. B168662, ___ Cal. Rptr. 3d ___, 2003 WL 22953657 (Cal. Ct. App. Dec. 16, 2003) [attached as Tab 11], a California court applied the law of the State of incorporation to a matter of a corporation’s internal affairs, namely whether it was required to pay dividends to its shareholders.

i.Believe it or not, in California, it’s not clear that in a derivative lawsuit involving a Delaware corporation, Delaware law applies to such fundamental issues in derivative lawsuits as the standards for demand futility and the (in-)ability to obtain discovery.

ii.This is because California has a unique choice of law test called “governmental interest” or “comparative impairment,” where the first question is whether the laws of another State differ from those of California.  A large part of Delaware and California law concurs – but not everything! – so courts often will say that “California” law applies, and then cite also to Delaware cases.  Oakland Raiders v. National Football League, 93 Cal. App. 4th 572, 586 n.5 (2001) (Delaware law “is identical to California corporate law for all practical purposes.”); Shields v. Singleton, 15 Cal. App. 4th 1611, 1620-21 (1993) (demand futility inquiry identical under California and Delaware law).

iii.State Farm followed the internal affairs doctrine, under which certain issues are subject to the a priori use of the law of the State of incorporation, without recourse to the governmental interest standard.

iv.The decision does not go all the way to getting the law correct, for the plaintiffs had alleged a breach of contract to pay dividends, and the court distinguished, in part, choice of law issues for tort cases.

v.In the long run, the right answer is that the articles of incorporation constitute a contract, and that the choice of law (of the State of incorporation) in that contract will be honored by California courts without recourse to the governmental interest standard.

B.In Desaigoudar v. Meyercord, 108 Cal. App. 4th 173 [not attached], immaterially modified, 108 Cal. App. 4th 916A (2003), an appellate court set forth a more deferential standard that Delaware law for judicial review of a Special Litigation Committee decision to terminate a derivative lawsuit.

i.Under Delaware law, where demand has been excused and a Special Litigation Committee has been formed in response, a court’s review of that response may include an examination of the merits of the Committee’s decision to terminate the derivative lawsuit.  Zapata, 430 A.2d at 787.  This is in addition to a review of the adequacy of the Committee’s procedures (its independence and investigative procedure).

ii.In Desaigoudar, the court adopted the New York rule, under which a court does not take the second step, but rather considers only the adequacy of the Committee’s procedures.

4.Scope of (Plain Old) Discovery in Securities Cases

A.In re Initial Public Offering Sec. Litig., 21 MC 92 (SAS), 2004 WL 60290 (S.D.N.Y. Jan. 12, 2004) [attached as Tab 6]:   “in what appears to be a matter of first impression,” Judge Scheindlin held that Wells submissions are discoverable.


i.The court reasoned that Wells submissions are not “intrinsically” settlement materials, and hence that they are not encompassed with Fed. R. Evid. 408 (which renders “offers of compromise” inadmissible), even if they contain an offer of settlement.


ii.She also held that even if they were inadmissible under Rule 408, they were discoverable; inadmissibility does not confer protection from discovery.


B.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) [attached as Tab 7]:  in a dispositive motion (here, an early summary judgment motion) predicated on the first prong of the Safe Harbor, it is appropriate to limit discovery to the contents of the words spoken (including the warnings), forestalling discovery as to the speaker’s state of mind.


i.At issue in part of the motion were the CFO’s statements in an analyst call 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.” 


ii.The company produced documents relating to what was said in the analyst call.


iii.The Ninth Circuit reasoned that the CFO had “identified the important problems with [the acquired company] 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.” 


iv.The district court also refused to allow additional discovery under Rule 56(f), rejecting plaintiffs’ claim for discovery “necessary regarding what [the] officers knew at the time the false statements were made.”  The Ninth Circuit agreed:  plaintiffs were not entitled to discovery bearing on scienter or other claims raised in the complaint because “the motion for summary judgment focused narrowly on whether [the COO] characterized the inventory problems as temporary or transitory and whether the statements that [the CFO] made on April 22 were protected as a matter of law.” 


C.In re Adelphia Communications Corp., 293 B.R. 337 (Bankr. S.D.N.Y. May 15, 2003) and In re DPL Inc. Sec. Litig., 247 F. Supp. 2d 946 (S.D. Ohio Feb. 25, 2003) [Tab 8]:  federal courts handling securities cases stay discovery in parallel State court lawsuits, pursuant to SLUSA.


i.Adelphia:  where debtor (Adelphia) sued its former officers in a bankruptcy court adversary proceeding for breach of duty and fraud, a stay was necessary in aid of the bankruptcy court’s jurisdiction in order to protect the court’s orders by maintaining a level playing field that it had established vis-a-vis discovery, and to avoid a scenario under which its jurisdiction to rule on motions to dismiss the pending federal securities claims might be circumvented by discovery in the State court action.  The court also found that one of the purposes of the stay provision was to protect defendants from plaintiffs’ use of discovery in a state court action to resuscitate claims that would not otherwise meet the heightened pleading standards of the Reform Act.


ii.DPL:  discovery stayed in State court derivative actions involving same events granted in federal securities case.  The court agreed that a stay of the discovery in the state derivative actions was necessary in aid of its jurisdiction:  “Simply stated, if this Court does not stay discovery . . ., its jurisdiction to rule upon a motion to dismiss the federal securities claims, before any discovery has been conducted, will have been circumvented by discovery in the state court actions and, therefore, compromised.”


D.In re Lantronix, Inc. Sec. Litig., No. CV 02-03899 PA, 2003 WL 22462393 (C.D. Cal. Sept. 26, 2003) [attached as Tab 9]:  motion to lift Reform Act discovery stay to allow discovery of documents produced by company to all governmental entities, including transcripts of witness interviews and depositions, and all documents produced in connection with State court lawsuits, denied. 


i.The twist here was that the company conceded that a portion of the complaint stated a claim, in not moving to dismiss the claim in its entirety.  However, the pendency of the motions to dismiss filed by the remaining defendants and the company’s motion to dismiss plaintiff’s other claims still triggered the discovery stay. 


ii.“Moreover, because Plaintiff only seeks documents which have already been produced and are in the custody of third parties, the risk that evidence will be lost is negligible.”


E.In re Initial Public Offering Sec. Litig., 21 MC 92 (SAS), 2003 WL 22462041 (S.D.N.Y. Oct. 30, 2003) [attached as Tab 10]:  Judge Scheindlin granted a motion to compel plaintiffs to provide names of all persons who entered into transactions challenged in the litigation (tie-in agreements or undisclosed compensation), even if those persons did not serve as sources for complaint.


i.The court rejected plaintiffs’ public policy argument that disclosure was prohibited by whistleblower protections, including the new protections from the Sarbanes-Oxley Act.  “Once a litigation is pending, the balance of interests change.  While it is important to protect whistle-blowers, it also is important, once the whistle is blown, to allow all parties the opportunity to engage in the robust discovery permitted by the Federal Rules.”


ii.However, disclosure was not required by the “plead all facts” requirement.

© David Priebe 2016