Securities Litigation 2007 Developments


1.Supreme Court clarifies Reform Act pleading standards, requiring all inferences to be drawn from complaint and judicial notice (Tellabs).


  1. A.In Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. ___, No. 06-484, slip op. (June 21, 2007), the Court held that to allege scienter, a plaintiff must plead facts that “a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” 


  1. B.The Tellabs lawsuit was filed after the company, a fiber optics equipment manufacturer, announced that demand for its products had declined, and lowered its revenue forecasts.  Plaintiffs claimed that the company’s CEO had misled investors by issuing earlier, optimistic forecasts which he knew could not be achieved.  The amended complaint attempted to support this claim by allegations from 27 anonymous sources.


  1. C.The district court found that the complaint failed to plead a strong inference of scienter.  The Seventh Circuit reversed, holding that the complaint sufficed because, assuming the truth of plaintiffs’ factual allegations, a reasonable person could infer from those facts that the CEO acted with scienter.  The court rejected an alternative standard used by the Sixth Circuit, which holds that a strong inference is pleaded only if scienter is the most plausible of competing inferences from the allegations of a complaint.


  1. D.The Supreme Court reversed and remanded.  It held that courts must apply a three part test:


  1. 1.Accept all factual allegations in the complaint as true.  The defendants did not disagree with this proposition—although, as a concurring opinion from Justice Alito noted, the Reform Act also requires that a complaint plead particularized facts giving rise to scienter, and hence there may be grounds to exclude from the analysis all non-particularized allegations, such as general, speculative or conclusory allegations of wrongdoing.

  2. 2.Consider the entirety of the complaint, plus matters of common or undisputed knowledge of which courts may judicial notice, in determining whether a strong inference of a defendant’s scienter has been pleaded.  There is no single factor that determines whether scienter is pleaded, but rather courts must look at a complaint as a whole.  For example, the Court rejected defendants’ contention that the lack of any stock sales by the CEO during the period of the alleged fraud was dispositive of his lack of scienter; rather, the significance to be ascribed to this fact “depends on the entirety of the complaint.”

  3. 3.Take into account all inferences that plausibly may be drawn from a complaint’s allegations and matters of judicial notice, and allow a complaint to survive dismissal only if an inference of scienter is cogent and at least as compelling as any opposing inference one could draw.  The Court thus rejected the position that only inferences which favor the plaintiff may be drawn.  Instead, the Court adopted a position consistent with that of the Sixth Circuit and other Circuits, which requires consideration of all inferences.  Indeed, the Court arguably went further:  it agreed that the lack of key allegations one would expect if a defendant possessed scienter, or ambiguities in a complaint’s allegations, are factors that may be held against plaintiffs; and it made explicit that matters of judicial notice also are included in the assessment of scienter.


  1. E.The Court left undisturbed the Seventh Circuit’s holding that scienter had to be pleaded on an individualized basis, rejecting a (distorted and incorrect) version of the so-called group pleading doctrine.

  2. F.One of the many issues arising from this decision is whether motive and opportunity pleading may survive.  The Court held that Congress did not mean to adopt the Second Circuit’s case law interpreting how a strong inference must be pleaded, i.e., motive and opportunity.  It also held that a plaintiff need not plead more than she must prove.  Consider Judge Scheindlin in the IPO cases, where she allowed §10(b) claims against the issuers based solely on motive (stock sale) allegations, and then said that at trial, plaintiffs would have to prove more than this in order to prevail.


2.Next up before the Court:  standards for primary liability of secondary actors \ counterparties to questionable transactions (Stoneridge \ Charter Communications)


  1. A.In In re Charter Communications, Inc. Sec. Litig., 443 F.3d 987 (8th Cir. 2006), the Eighth Circuit affirmed the dismissal of claims against the vendors of a cable television company.  Plaintiffs alleged that the company engaged in sham transactions (an additional $20 per set-top box fee in exchange for $20 in advertising revenues) with no economic substance, and that the vendors knew that the company was doing this in order to inflate its financials.  The court held that these were aiding and abetting allegations foreclosed by Central Bank, as the vendors themselves did not play any role in preparing or disseminating the company’s financial statements.  The court rejected plaintiffs’ contention that Central Bank did not extend to the scheme or course of business prongs of 10b-5(a) and (c).  The vendors did not engage in any deceptive act, and they were not under a duty to disclose information useful in evaluating the company’s true financial condition.  As the court concluded, “[t]o impose liability for securities fraud on one party to an arm’s length transaction in goods or services other than securities because that party knew or should have known that the other party would use the transaction to mislead investors in its stock would introduce potentially far-reaching duties and uncertainties for those engaged in day-to-day business dealings.  Decisions of this magnitude should be made by Congress.”

  2. B.Other federal courts have agreed, to some degree. 


  1. 1.In Simpson v. AOL Time Warner Inc., 452 F.3d 1040 (9th Cir. 2006), the Ninth Circuit affirmed dismissal, but remanded to reconsider leave to amend, in a lawsuit against counterparties to complex swap and round-trip transactions with an Internet site (homestore.com).  The court held that deceptive conduct in furtherance of a scheme to defraud (as distinguished from false or misleading statements) can give rise to liability.  This requires more than just participation in an improper transaction, as the SEC had urged.  Rather, to plead a primary violation (as is required by Central Bank), it must be alleged that the defendant’s own conduct had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme.  This “principal purpose” prong is related to but different than scienter; it asks whether the deception was the principal purpose rather than an accidental effect of the challenged conduct.  A possible example of this is the creation of sham corporate entities to misrepresent the flow on income, as in Enron.  In contrast, participation in a legitimate transaction does not give rise to liability even if the defendant knew or intended that another party would manipulate the transaction to effect a fraud.  Moreover, there must be more than assertions that the defendant helped or assisted another’s deception; the defendant must have actually engaged in a deceptive act.  As so limited, liability is consistent with Central Bank and the policy of flexible construction of §10(b).  It also must be the case that the fraudulent information is introduced into the securities market; this is required to satisfy the in connection with element, as well as reliance.  The present complaint did not meet these standards, although it was fair to allow plaintiffs leave to amend to try to do so because the district court had used a more restrictive liability standard.  A main problem for the plaintiffs was that the deals were legitimate, at least at first, and did not involve sham entities as in Enron.  For example, defendant AOL may have sold advertisements to Homestore as part of one challenged transaction, but actual advertisements were sold.  It also was the case that any deceptive nature of some AOL transactions did not arise until they were misreported by Homestore, and AOL could not be liable for participating in legitimate transactions that became “deceptive” only when distorted by the fraud of the counterparty.  For another company (Cendant), its press release announcing the transaction, which involved the creation of a new entity to buy from Homestore, said that Cendant planned to make purchases from Homestore; i.e., the triangular, swap nature of the deal was disclosed.  As to a third company (L90), the CFO refused to sign a 10-Q that included the revenue from the challenged transaction.

  2. 2.In Regents of the Univ. of California v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. Mar. 19, 2007), class certification as to claims against investment banks was reversed in a Rule 23(f) interlocutory appeal.  The appealing defendants allegedly were the counterparties to transactions used by Enron to create false revenue.  District Court Judge Harmon had held that there can be Rule 10b-5(a) scheme joint and several liability for defendants who commit individual acts of deception in furtherance of a scheme to give the false appearance of revenues.  As a result, each defendant could be held liable for the loss caused by the entire scheme, including conduct of other scheme participants about which it knew nothing.  Moreover, no preliminary finding of an efficient market need be made for 10b-5(a) or 10b5-(c) claims.  The majority of the Fifth Circuit panel found that Judge Harmon had arrived “at an erroneous understanding of securities law that gives rise to its application of classwide presumptions of reliance.”  The court could not have found that the entire class was entitled to rely on the fraud on the market theory, “because the market may not be presumed to rely on an omission or misrepresentation in a disclosure to which it was not legally entitled.”   (The court added in a footnote that the same principle applies in the manipulation as well as the deception context.)  The Affiliated Ute presumption of reliance on omissions did not apply because plaintiffs did not satisfy the second requirement of that presumption:  they did not demonstrate that the defendant owed a duty of disclosure.  The logic of Affiliated Ute is that if a plaintiff is owed a duty of disclosure, he need not prove how he would have acted had a disclosure to which he was entitled been made.  Here, as Judge Harmon acknowledged, the banks were not fiduciaries and were not otherwise obligated to the plaintiff, and owed no duty to disclose the nature of the alleged transactions.  “Accordingly, it is only sensible to put plaintiffs to their proof that they individually relied on the banks’ omissions.”  As to the other classwide presumption of reliance— Basic v. Levinson—more than an efficient market is required for it to apply:  “If the banks’s actions were non-public, immaterial, or not misrepresentative because the market had no right to rely on them (in other words, the banks owed no duty), the banks should be able to defeat the presumption.”  The Basic presumption could not be based on the alternative rationale cited by Judge Harmon, which was a supposed duty not to engage in a fraudulent scheme.  “Deception” within the meaning of §10(b) requires that a defendant fail to satisfy to disclose material information to a plaintiff, and Basic requires that a defendant have made public and material misrepresentations.  Here, the district court’s definition of “deceptive act,” which allowed liability to banks that did not make statements and did not owe disclosure duties, was inconsistent with Central Bank’s decision that there is no private aiding and abetting liability.  In this discussion, the Court considered the primary liability for secondary actors debate (in which the Ninth Circuit is most liberal, see Software Toolworks and Simpson).  It rejected the standard used by the district court, which was taken from the SEC’s amicus brief in Software Toolworks:  namely, that primary liability “attaches to anyone who engages in a ‘transaction whose principal purpose and effect is to create a false appearance of revenues.’”  It instead adopted the Eighth Circuit’s criticism of that standard in Charter Communications, an “extraordinarily similar” case, under which “deception” requires “either a misstatement or a failure to disclose by one who has a duty to disclose.”  Thus, “Enron had a duty to its shareholders, but the banks did not.  The transactions in which the banks engaged at most aided and abetted Enron’s deceit by making its misrepresentations more plausible.”  The Court also reasoned that the banks’ alleged acts did not constitute “manipulation” within the meaning of §10(b), which “requires that a defendant act directly in the market for the relevant security.”  This definition was consistent with the policy rationale of the statute—an analysis it undertook because “Defendants do, after all, escape liability for conduct alleged that was hardly praiseworthy.”  The Court concluded that the plaintiffs’ view had some adherents, and that the district court, “with the best of intentions,” had mistakenly applied it.


  1. C.Plaintiff \ petitioner argued that Rule 10b-5(a) or (c) scheme liability is broad, and extends to the alleged conduct.  Petition For Writ Of Certiorari, sub nom Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. and Motorola, Inc.;  The Solicitor General was asked by the SEC to file an amicus brief on behalf of the plaintiffs (the SEC had supported the plaintiffs in Simpson), but did not.  Oral argument has not yet been held.


3.Courts continue to define loss causation following Dura Pharmaceuticals


  1. A.Cases defining Dura broadly and imposing high loss causation standards:


  1. 1.Estee Lauder Cos. Sec. Litig., No. 06 Civ. 2505 (LAK), 2007 WL 152260 (S.D.N.Y. May 21, 2007) (Kaplan, J.):  motion to dismiss granted in lawsuit alleging channel stuffing by cosmetics company.  The court took judicial notice of the pattern of the company’s stock price:  it closed at $37 at the start of the class period, dropped a bit later, and was back up over $38 for good some 14 months later.  Plaintiff did not allege when during this class period he had purchased stock, or that he sold it or suffered a loss.  The complaint failed to provide notice of its loss causation theory for that reason alone.  The court rejected plaintiffs’ contention that an economic loss is sustained simply as a result of the fact that the price of the stock dropped following disclosure.  Lesson:  no loss = no claim.


  1. 2.Ray v. Citigroup Global Markets, Inc., 482 F.3d 991 (7th Cir. Apr. 12, 2007):  summary judgment for lack of loss causation affirmed in lawsuit against investment advisor, his employer and its parent.  The advisor allegedly did not disclose that a company he had recommended had problems with its contracts.  When the truth emerged about these problems, the stock dropped to $1.  Of course, the company’s competitors also saw precipitous declines in value.  The court found that the loss causation argument here had been considered and rejected in Bastian, which prefigured and was cited by Dura Pharmaceuticals.  There was no materialization of an undisclosed risk in this situation, nor disclosure of the truth that deflated the stock price (as in Dura).  Nor was this the exceptional situation in which a defendant denies that there is any investment risk, a theory for which Bastian requires very explicit language that there is no risk.  Plaintiff had not produced any evidence—including no expert testimony—to the effect that the lack of the promised contracts caused the company’s collapse and stock price decline.  Rather, the record showed that the stock price had collapsed before the plaintiffs learned the truth of the broker’s supposed lies.  That the broker said to hang onto the stock because it would be a winner had to be considered in the backdrop of the public information, which suggested that the company “was, to put it charitably, a volatile stock” (it had gone from $1 to $170 in a year, then down to $80, then to $1 two years later).  Lessons:  a volatile or adverse history of stock prices during the class period undermines the Dura pattern of loss causation, which is a stock price that goes up with positive news, and then down with negative news.  This is useful even at the dismissal stage because stock prices are justicially noticeable.


  1. 3.Teachers’ Retirement Sys. v. Hunter, 477 F.3d 162 (4th Cir. Feb. 20, 2007):  dismissal affirmed in lawsuit against microelectronics company (Cree) filed after its co-founder, a former officer who also was a brother to the CEO, sued the company claiming accounting shenanigans.  The court found that plaintiffs were complaining about investment risk, not particularized securities fraud.  They sued after a temporary decline in the stock price after Eric Hunter, a co-founder who remained an advisor to the company, had sued Neal Hunter, his CEO \ co-founder brother, for securities fraud and under §806 of the Sarbanes Oxley Act (the whistleblower protection provision).  Based on the allegations of the complaint, plaintiffs alleged round trip transactions (sales to companies in which the defendant company had invested, investments in which it paid too much money in order to fund the purchases from the company); and channel stuffing sales.  The court carefully considered each allegedly fraudulent transaction.  As in the earlier decision, a key point was that the transactions and contracts at issue had all been disclosed; all that the Hunter lawsuit provided was new spin on them.  (The implications for the stock option backdating cases are substantial.)  The court’s innovation was to look at the underlying economic realities behind the transaction structure—realities which showed that the deals were real.  For example, one alleged contract looked exactly like a standard supply contract, which was disclosed and which is not fraudulent.  The Hunter complaint did not challenge this, and he had left the company anyway by the time he filed it.  The court found that an anonymous source’s allegations about shipping crystals that were rejected simply were wrong, for (as the company disclosed) it did not recognize any revenue on crystal shipments during the time period.  The alleged round trip transactions did not state a claim because the complaint did not allege that either side of the transaction lacked economic substance.  The court applied Matsushita to the pleading stage and held that to be a plausible allegation of round tripping, a complaint must allege that both sides are shams, lest the arrangement make no economic sense.  Plaintiffs claimed that the company had paid too much per share for one investment, ignoring the fact that the price was set earlier, and then the target’s price declined; and ignoring the fact that someone else (GE, no less) had paid the same price.  A supposed source for the allegation that the company didn’t perform any R&D work as required by one of the contracts actually said that he did not know whether the company did or did not perform such work.  The court also noted that it is well known that risks are great in high technology industries; this affirms Ninth Circuit law.  That employees may have regretted one transaction after the fact did not plead that it was fraudulent to being with.  The court also found a failure to plead scienter.  Most of the CEO’s stock sales were made far below the high stock price, and plaintiffs had inflated stock sale percentages by failing to take vested options into account.  Moreover, the lengthy class period (as in Vantive) strengthened a competing inference that plaintiffs were on a fishing expedition.  The court also considered loss causation.  It reasoned that a strong case could be made that loss causation was one of the circumstances constituting fraud for which Rule 9(b) applies.  On the merits, as the Hunter lawsuit did not reveal the “true facts” of any transaction, it could not have caused plaintiffs’ economic loss.  The court said that the district court had gotten it right in writing that the lawsuit disclosed nothing new, but merely attributed an improper purpose to previously disclosed facts.  The court added “as an epilogue” that the market agreed.  Lessons:  Rule 9(b) may apply to loss causation; Dura did not decide this, it assumed Rule 8 applied for appellate purposes only.  Regardless of the standard, if the supposed adverse disclosure is really not new news, one can argue that there is no loss causation.  The court also considered the stock bounceback in assessing loss causation from a common sense standpoint.  These latter two points are important to the backdating cases.  All that the academic or Wall Street Journal articles did was put a new spin on public information (option grant dates and prices).  They didn’t disclose anything that was new.  Usually, the stock price rebounds after the initial disclosure.  Under the logic of this case, there’s no loss causation.


  1. 4.Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147 (2d Cir. Jan. 31, 2007):  dismissal of auditors of bankrupt clothing company affirmed in decision with guest panelist Sandra Day O’Connor.   The court held that there is no duty (for auditors) to correct statements that were true when made.   Nor could the auditors be liable for quarterly financial statements which they reviewed but did not audit (not attest).  Liability on that basis would violate Central Bank and the Second Circuit’s spin on Central Bank, Wright v. Ernst & Young.  The requirement that auditors conduct quarterly reviews is not for the purpose of attesting financial statements, but rather to reduce the work needed in year-end audits.  The court also held that there was no loss causation for statements in a subsequent 10-K, where the company went bankrupt but the 10-K had included a going concern statement warning of the same.  It also could not have escaped investors’ attention that the company’s reported equity had declined precipitously.  Lesson:  adverse disclosures during the class period undermine loss causation.


  1. 5.Tricontinental Indus., Ltd. v. PricewaterhouseCoopers, LLP, 475 F.3d 824 (7th Cir. Jan. 17, 2007):  dismissal of auditors affirmed lawsuit by companies that sold assets to Anicom in exchange for stock allegedly inflated by such tactics as “pre-billing” customers and phony invoices.  Much of the opinion concerned Illinois common law claims.  On the federal securities side, the court confirmed that the complaint did not plead loss causation, that is, that the value of the stock was inflated by the misrepresentation and that the value declined once the truth was known.  Rather, it alleged that the disclosure of a later fraud (1998-1999) than the one pertaining to the fiscal year audited by the defendant (1997) caused the stock price decline.  Lesson:  examine precisely which alleged disclosures caused the stock price decline, and show there is no linkage to the alleged misrepresentations.


  1. 6.Berckeley Inv. Group, Ltd. v. Colkitt, No. 04-3844, ___ F.3d ___, 2006 WL 2052228 (3d Cir. July 25, 2006):  partial summary judgment affirmed in part and reversed in part in long-running lawsuit between seller and buyer of convertible debenture.  The seller was the CEO of the company that issued the securities, and the agreement acknowledged that it was subject to Regulation S and New York law.  The seller breached the agreement by failing to convert the debentures, and the long standing issue is whether the buyer’s breach of the securities laws allowed him to rescind under ’34 Act §29(b).  On the merits, the seller had lost an earlier appeal with another party to which it had entered this type of deal (GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189 (3d Cir. 2001)), and hence could not cite §29(b) as a means to seek rescission under §5 of the ’33 Act.  However, the district court did err in dismissing the §29(b) claim based on the buyer’s alleged violation of §10(b).  This, in turn, was based on the theory that the buyer represented that the shares it acquired would be re-sold only in accordance with the ’33 Act registration requirements, when in fact the buyer intended to re-sell shares in the United States without registration and already had done so.  (The seller abandoned a theory, which he had lost in the other case, that the buyer violated §10(b) by engaging in short selling.)  Sufficient evidence existed in support of this claim, including the lack of any viable offshore market (which would allow for unregistered sales under exemptions to Regulation S.)  Evidence also existed to support the claim that the buyer was reckless to the fact that it would not be entitled to an exemption as an underwriter (under ’33 Act §4(l) and Rule 144), including the fact that the buyer admitted that it was its intention to re-sell within two years through a broker (and hence not necessarily only to accredited investors).  The court found useful an expert opinion from a former SEC attorney, but the opinion did not go far enough as it did not say that the buyer had complied with its securities law duties, and as the statement that what was done was industry practice did not suffice (the whole industry could be wrong).  The seller lost on the key part of a stand-alone §10(b) claim for failure to prove loss causation, as there was no connection between the buyer’s representations that it would comply with the registration requirements and the decline in the company’s stock price.  (The seller really was complaining that the short selling drove the price down.)  Lessons:  examine precisely which alleged disclosures caused the stock price decline, and show there is no linkage to the alleged misrepresentations.


  1. 7.In re Eastman Kodak Co. Sec. Litig., No. 6:05-CV-6326-MAT, 2006 WL 3149361 (W.D.N.Y. Nov. 1, 2006):  motion to dismiss granted with prejudice in lawsuit alleging that photography company failed to disclose the difficulties in its conversion to digital photography, but instead engaged in channel stuffing.  The court found that many of the alleged misrepresentations were puffery (such as, “the digital portfolio continues to gain traction”) or were protected by the bespeaks caution doctrine.  On the whole, the company’s disclosures didn’t just alert investors to potential problems:  they informed investors that the company actually was experiencing the problems.  Moreover, no reasonable investor would have relied on the statement that the company was strengthening its financial position by paying down debt.  As to scienter, plaintiffs essentially claimed that it was fraudulent for defendants not to disclose that the company’s future was in digital photography, when in fact that is exactly what the company did disclose (and what had been revealed in the media for almost a decade prior to the class period).  The complaint did not plead loss causation based on a stock price drop when the company announced it was cutting its dividend, as this statement itself was not fraudulent and the alleged underlying cause of it (the company was changing its focus to digital photography) had been disclosed years earlier.  Lesson:  adverse disclosures during the class period undermine loss causation.  Also, be skeptical of true adverse statements that lead to stock price declines.

  2. 8.In re Teco Energy, Inc. Sec. Litig., No. 8:04-CV-1948-T-27 EAJ , 2006 WL 2884960 (M.D. Fla. Oct. 10, 2006):  motion to dismiss granted in large part on loss causation grounds in lawsuit alleging that utility holding company failed to disclose the risks of aggressive moves into wholesale energy markets, its exposure to Enron, and other flaws.  The court emphasized the fact-specific nature of the loss causation inquiry, and explained (interestingly) that disclosure of the risk cases involve alleged omissions.  Loss causation narrowly was pleaded on one claim:  that the company represented it hard large merchant power contracts when it did not.  When an analyst disclosed this, the stock price declined, and the complaint provided defendants with fair notice of its causation theory.  For the many other allegations, the complaint did not allege a corrective disclosure, and hence did not allege that the stock price declined when the truth became known.  The court concluded that if a stock price decline from a mundane event such as a failure to meet forecasts sufficed by itself to state a claim, the securities laws would be transformed into investor insurance.  Lessons:  loss causation is not an all-or-nothing matter; it may be pleaded for some but not all falsity allegations of a complaint.  Also, characterize overbroad loss causation allegations as asking for investor insurance.


  1. 9.In re Glaxo Smithkline PLC Sec. Litig., No. 05 Civ. 3751 (LAP), 2006 WL 2871968 (S.D.N.Y. Oct. 6, 2006):  motion to dismiss amended complaint granted with prejudice in lawsuit alleging that pharmaceutical company failed to disclose problems with patients who attempted to discontinue use of a drug, misrepresented patent position during contest with generic substitutes.  The statute of limitations barred the patient problems claim because even the complaint alleged that the problems had been disclosed more than two years before the lawsuit, leading to a stock price decline.  The statute also barred the patent-based claims, as the company had disclosed its litigation positions and status.  The company’s statements that it was confident in its patent positions (including that the PTO had confirmed that the patents were rock solid) did not remove inquiry notice, as these were mere “expressions of hope” (i.e., puffery) and the company could not assure success in its patent litigation.  There was nothing in the complaint indicating that the company had misrepresented the status of the litigations as they occurred, and to penalize companies for taking positions that end up losing in court “would have a chilling effect on publicly traded companies seeking to defend their interests in litigation.”  Nor could plaintiffs state a claim based on alleged sponsorship by the company of false studies that the drug in question was good for children.  This was not material because the drug concededly was approved for adults, and use for children was an off-label application representing but a small proportion of total sales.  Furthermore, the complaint undermined this allegation by claiming that generic competitors were trying to break into this market at the defendant company’s expense, which the competitors would not have done had the use been clearly improper.  Scienter was not pleaded as to this claim because there were no allegations that the doctors presented the information knowing it was false, or indeed their motive for making false statements.  Plaintiffs also asserted a failure to disclose exposure to False Claims cases due to overbilling the government, but the only support was a settlement of such a case two and half one years earlier involving a different drug.  Scienter also failed because the CEO made only one sale during the class period, and that was after an adverse news disclosure and after he had held all his shares through eleven prior adverse disclosures.  Moreover, the court noted from the public record that the sale was through the exercise of an option that was about to expire; thus, this case is very important for an expanded scope of judicial notice.  The court found that loss causation was not pleaded by looking carefully at the timing of lead plaintiff’s purchases and profits.  Further amendment was denied because plaintiffs had been given the chance to do better, but had failed.  Lessons:  tie loss causation to the alleged losses (purchases and sales) of each named plaintiff.


  1. 10.Glover v. DeLuca, No. 2:03-CV-0288, 2006 WL 2850448 (W.D. Pa. Sept. 29, 2006):  motion to dismiss granted with prejudice in lawsuit alleging failure of company’s expansion program.  Among the favorable points, the court reasoned that if an officer knew of the company’s impending doom, logically he would have sold his shares at the high price or close to it, rather than held and sold later.  The court also rejected a Casmas v. Hassett-style “core operations” theory of scienter, which requires more specific allegations to suffice.  That the auditors characterized the company’s position on collecting receivables as aggressive did not mean that the strategy was fraudulent or that the receivables were improperly accounted for.  The complaint alleged that a new controller at the company questioned some practices, but it appeared to be the case that the Audit Review Committee of the company took these allegations seriously and commissioned an investigation, and this action was inconsistent with recklessness.  The court reasoned that the Reform Act requires both scienter and falsity to be pleaded with particularity, as both are elements of fraud.  It also held that the fact that the SEC proposed changing its accounting regulations two years later did not render false a company accounting estimate under the prior rules.  The claim that the company should have exhaustively examined its receivables when it acquired a company, rather than two years later, was a mismanagement claim at best. Moreover, the allegation that the acquired receivables were questionable was undercut by facts in the documents cited by plaintiffs, from which plaintiffs had misleadingly cherry-picked the 20 worst examples while ignoring what was favorable.  Some of the positive information was litigation settlements in which some of a receivable was collected; the decision to accept such a settlement (or to write off an account rather than continue to pursue collection) were matters of business judgment.  The court also faulted plaintiffs for “equating a culpable state of mind with knowledge and concern,” in impugning (rather than praising) defendants’ systematic review of accounts; indeed, has defendants done nothing and failed to try to collect, plaintiffs would have had a stronger argument. The court also rejected a challenge to the purchase accounting for acquisitions.  Here, plaintiffs did not help themselves by alleging that a particular method was “technically allowable when done,” nor by simply mis-stating the applicable provisions (of FAS 38 and FAS 141).  Plaintiffs also did not plead that the company’s cash position was misstated because it held off paying vendors while trying to pay down its credit line as quickly as possible.  After all, investors knew that the company had taken on the huge debt load to finance the expansion plan; and the payment practice, even if adequately alleged, simply did not constitute fraud or a GAAP violation.  This was not changed by the fact that the bankruptcy trustee alleged that the company was insolvent years before it declared bankruptcy; here, the court “decline[d] to accept as evidence of scienter an allegation made in a separate lawsuit in another forum.”  The complaint alleged that one project undertaken by an acquired company was a disaster and fiasco, but all that could be inferred was that it was a problem – not fraud.  Plaintiffs misstated a press release they challenged, made “other unfounded leaps” in reading others press releases, and mistakenly alleged that a Form 10-K failed to disclose something that it did disclose.  A subordinate’s alleged knowledge of an issue could be imputed to his boss, the CEO.  A bankruptcy report that by the end of the class period, the company could “no longer” invoice for certain work, supported the inference that it could do this during the class period.  The complaint also did not plead loss causation.  The stock price had declined significantly prior to any alleged corrective disclosure.  Moreover, plaintiffs could not (as they were required to do) point to any risk that was not disclosed and later materialized to cause a stock price decline.  This was because the liquidity problems that brought the company down had long been known to investors.  Other than requiring the company to disclose in every public statement that it might, someday, declare bankruptcy, it was difficult to see what more it could have done to inform investors of its risk.  The court dismissed with prejudice, consistent with the Reform Act’s purpose of providing a filter for lawsuits with no factual basis.  Lessons:  no loss causation if adverse information already known to investors.  Also, courts are skeptical of  loss causation when stock price already had declined.


  1. 11.In re ConAgra Foods, Inc. Sec. Litig., Nos. 8:05 CV 292 etc., 2006 WL 324199 (D. Neb. Sept. 19, 2006): motion to dismiss granted in lawsuit against food company alleging false financials and optimism in corporate efficiency program.  The plaintiffs also claimed that forecasts were rendered false by the accounting errors, which had occurred several years earlier and led to a restatement.  The court rejected this view in its entirety.  It found that one scienter theory “defies logic” because it assumed that the executives would orchestrate an accounting fraud in 1997 in order to inflate profit-based bonuses paid 6 to 7 years later.  The complaint also did not allege loss causation.  Here, the court mentioned that the stock price declined only 70 cents upon the disclosure of the restatement, when (1) the price bounced back within four days; and (2) it had declined between 51 cents to $1.03 eight times in the three months prior to the disclosure, indicating that the decline was not unusual.  Lesson:  do the math.


  1. 12.In re Ramp Corp. Sec. Litig., No. 05 CIV. 6521 (DLC), 2006 WL 2037913 (S.D.N.Y. July 21, 2006):  motion to dismiss granted as to all but one defendant in lawsuit alleging that now-bankrupt seller to health care service providers made numerous misrepresentations about its management and control in the course of registration statements for stock sold in PIPES.  The complaint presented a litany of allegations about how an investor group secretly gained control via one management member, without disclosing their status in a Form 13D; illegal PIPE transactions; the authorization by the CEO to lie to pharmacy customers about the number of doctors that had signed up with the company’s service; and a bribe to the new CEO from the secret controlling investors.  The court dismissed a claim against the auditors, based on their statement that the financial statements were audited under GAAS and prepared under GAAP (which they withdrew when the discovered the bribe).  Plaintiffs claimed that the certification was false because management lacked integrity, but the court (sensibly) responded that an auditors’ “certification” is not a blanket statement vouching for the integrity of management; rather, plaintiffs must identify a material misrepresentation in the financial statements, which they did not try to do.  Nor was loss causation pleaded as to this alleged falsehood:  while it was true that the stock price dropped when the auditors resigned and said that it was due to the bribe issue, there were numerous other adverse disclosures in the same time period – the company’s statement that it could not issue financials, the resignation of the new CEO, the bankruptcy filing, a stock delisting – which caused the stock price to decline.  (Thus, the court implicitly weighed the effects of the adverse disclosures and decided that plaintiffs had not attributed a stock price decline to this one factor – not even a decline of $1 per share.)  The loss causation point also carried the day as to most of the individual defendants.  There were no allegations that any of the alleged omissions were disclosed other than the bribe, and it would sweep too broadly to allow the disclosure of the bribe to serve as a disclosure of the lack of management integrity as a whole, and hence all of the other alleged problems.  Rather, “[t]here must be a sufficient connection between the disclosed fact and the alleged loss to plead causation from the disclosure.”  Lessons:  require at least some specificity and logic to loss causation allegations, even if Rule 9(b) does not formally apply, and dismiss if the complaint itself points to other reasons for the stock price decline.


  1. B.Cases defining Dura narrowly and imposing low loss causation standards.


  1. 1.Steiner v. MedQuist, Inc., No. 04-5487 (JBS), 2006 WL 2827740 (D. N.J. Sept. 29, 2006):  company’s motion to dismiss denied, but auditors’ motion to dismiss granted, in lawsuit alleging that medical transcription service inflated bills in order to create pre-determined “profits.”  The allegations were specific—one source alleged that the CEO bragged about the ways the company used to inflate revenues at an all-employee meeting—and hence adequate.  There was a questionable holding in that the court found that liability could be based on the nondisclosure of the fraud because the company’s statements attributing its revenues to legitimate business reasons gave rise to a duty to disclose the fraudulent reasons.  The defendants relied on disclosures of company problems and a billing dispute to create inquiry notice for statute of limitations purposes, but too many factual issues remained.  The corrective disclosure giving rise to loss causation was not a single event, but rather a series of adverse news releases.  If that did not suffice, then companies could avoid liability by leaking out bad news a bit at a time.  The court noted that Dura opined in dictum that there could be economic loss even if a share’s higher price is lower than it otherwise would have been.  There were price declines following negative disclosures in this case, as well as losses that were masked by accompanying good news.  The auditors prevailed because the alleged scheme was concealed from them; the company allegedly used secret codes and left no paper trail, rendering its actions almost undiscoverable.  Lessons:  this court does not rule out a securities claim for a stock price that increases.


  1. 2.Ong v. Sears, Roebuck & Co., No. 03 C 4142, ___ F. Supp. 2d ___, 2006 WL 2990438 (N.D. Ill. Oct. 18, 2006):  motion to dismiss second amended complaint denied in bondholders’ ’33 Act and ’34 Act lawsuit alleging that retailer manipulated credit card operations to inflate price of debt securities issued by credit card subsidiary.  Most of the allegations were the usual suspects for this type of business and case, with a difference being that the company said that it did not have the problems that had surfaced with a subprime credit card company, Capital One, and in general appeared to deny that it was in the subprime lending business at all.  Most of the case had survived, and the only remaining question was loss causation.  The court assumed that had Dura intended that Rule 9(b), the Supreme Court would have said so.  Plaintiffs were not required to affirmatively allege that the price decline between the date of their purchases and sales were not caused by other factors.  Lesson:  this court believes that Dura, by its silence on the applicability of Rule 9(b) to loss causation, indicates that Rule 9(b) does not apply.


  1. 3.Lapin v. Goldman Sachs Group, Inc., No. 04 CV 2236 (KMK), 2006 WL 2850226 (S.D.N.Y. Sept. 29, 2006):  motion to dismiss denied in lawsuit alleging undisclosed analyst conflicts by investment bank.  A key difference in this lawsuit is that it is brought by purchasers of the bank’s stock, not the purchasers of covered companies.  The court decided that it was too early to decide statute of limitations and truth on the market defenses, as the public reports of conflicted analysts had been denied by the company and were not particularized.  The court also held that pre-class period statements could be considered in determining whether there was a duty to update during the class period; apparently, it never occurred to defendants to note that the supposed “duty to update” is tenuous at best.  The statements (such as that integrity was “at the heart” of the company’ business) purportedly were not puffery.  Loss causation was pleaded by the drop in stock price following the disclosure of Spitzer’s investigation.  Lesson:  one may argue in the stock option cases and others that a decline in stock price due to the adverse publicity effects of the announcement of a government investigation is not the type of economic loss for which the securities laws are meant to compensate.  This court thinks otherwise.


4.Increased burdens to show suitability of class action treatment at class certification stage


  1. A.Case law imposing tougher standards:


  1. 1.Oscar Private Equity Investments v. Allegiance Telecom, Inc., No. 05-10791, ___ F.3d ___, 2007 WL 1430225 (5th Cir. May 16, 2007):  class certification vacated on Rule 23(f) appeal for failure to show that the market reacted to the corrective disclosure in lawsuit against telecommunications provider alleged to have issued false line installation counts, which were later restated upon the implementation of a new billing system.  The stock price, “like that of the rest of the telecom industry, was plunging during what is now the class period, losing nearly 90% of its value during 2001” (when the class period started April 24, 2001).  The court decided that “[g]iven the lethal force of certifying a class of purchasers of securities enabled by the fraud-on-the-market doctrine, we now in fairness insist that such a certification be supported by a showing of loss causation that targets the corrective disclosure appearing among other negative disclosures made at the same time.”  (Later, the court referred to “the in terrorem power of certification.”  Near the end of the opinion, the court added that the class certification decision “bears due-process concerns for both plaintiffs and defendants.”)  It is no longer the case that certification must be considered “as soon as practicable”; Rule 23 now requires that it be considered “at an early practicable time,” and as in the IPO decision (cited below) this may involve an inquiry that overlaps with merits issues.  The standard is preponderance of the evidence that the negative information caused a significant amount of decline, and should require little discovery.  The court explained that there are two cases in which a stock meets the general indicia of an efficient market, yet may fail to satisfy the fraud on the market presumption for reliance:  if the market is inefficient with respect to the particular information involved in the case (here, line counts), or if it is so strong-form efficient that it already took the corrective disclosure into account through absorbing the insider trading information (!).  Here, the district court had abused its discretion in finding that plaintiffs had made a sufficient showing at the certification stage.  The plaintiffs’ expert’s report did not establish loss causation, as it rested on speculation about the effect of the line count restatement from analyst reports, and did not isolate the effect of this particular piece of negative information.   A dissenting opinion claimed that the majority undercut the Basic presumption of reliance, and had conducted a de novo rather than abuse of discretion review of the district court.


  1. 2.In re Initial Public Offering Sec. Litig., 471 F.3d 24 (2d Cir. Dec. 5, 2006):  class certification was vacated on Rule 23(f) appeal test cases alleging underwriters’ manipulation of IPO aftermarkets.  Doctrinally, the Court approved a more probing, fact-intensive standard for certification than assumed in some opinions to the effect that there is no inquiry into the merits.  In so doing, it in effect apologized for earlier decisions that seemingly limited the inquiry at the pleading stage.  While it is true that class certification is not a substitute for litigation on the merits, this does not mean that no evidence may and indeed must be considered, or that plaintiffs get a free pass based on he allegations of their complaint.  Rather, some showing must be made, and where, as here, the issues were complex, this allowed defendants room to maneuver and make pointed challenges at the premises of the claims.  On the merits, the principal basis of its ruling is that there are no common issues of whether investors relied on the underwriters’ alleged manipulation of IPO markets, because, the Court found, IPO markets are not efficient.  The Court also ruled that plaintiffs’ allegations raised individualized questions as to whether each class member already knew of the alleged manipulation at the time of his or her stock purchase.  After all, the Court reasoned, plaintiffs allege that the manipulation scheme was far-reaching and widespread; hence, it must have been well-known.  The Court also found individualized issues as to whether the transactions in unrelated securities allegedly undertaken for the primary purpose of providing inflated commissions as kickbacks for obtaining cheap IPO stock were done for that purpose, as distinguished from other reasons for the transactions.


  1. 3.In re Polymedica Corp. Sec. Litig., No. 00-12426 WGY, ___ F. Supp. 2d ___, 2006 WL 2776669 (D. Mass. Sept. 28, 2006):  motion for class certification denied after remand.  Defendants’ expert, Dr. Frederick Dunbar of NERA, testified to the “quite technical” reasons for the lack of efficiency in the market for the stock; and a milestone in class certification law.  The court addressed the five Cammer factors for efficiency, this time (as directed by the First Circuit opinion from last year) considering all the evidence as to the fifth factor, a cause and effect relationship over time between unexpected (adverse) disclosures and the stock price.  Thus, even though the stock was traded on NASDAQ, with sufficient average trading volume, market makers, analyst coverage, and S-3 eligibility, there was no efficiency.  The keys were the difficulties in shorting the stock, which is a key mechanism of an efficient market; positive serial correlation in stock prices; insufficiently prompt response to disclosures.  Shorting was difficult because there were insufficient shares to short due to the already large short position, and because the costs of shorting (measured as the loan fee to the broker) for this stock was extraordinarily high.  These factor showed up in violations of put-call parity.  Positive serial correlation is the opposite of the random walk predicted of an efficient market, and indicates that the same news affected the stock price on more than one day.  The court, in a case of almost first impression, held that an information-efficient market requires that the stock price react to news on the same trading day — a standard defense lawyers should advocate in all cases.   Dunbar accurately criticized plaintiffs’ expert for looking first for the largest stock price drops and then trying to explain them; this does not follow the scientific method, in which a researcher would obtain a sample and then study price movements.  Plaintiffs’ expert also failed to account for other reasons for price movements.   The court praised Dunbar for his “helpful and impressive” responsiveness to questions.


  1. B.Implications:

  2. 1.Class certification is now supposed to be considered “at an early practicable time.”  Should defendants accelerate the issue?  Should plaintiffs accelerate the issue, so as to know at an early stage the parameters of their case?

  3. 2.As the Enron decision mentioned in the second section of this outline illustrates, Rule 23(f), which allows interlocutory appeal of class certification decisions, can be used to obtain early appellate review of the legal aspects of a case.


5.Implementing Merrill Lynch v. Dabit To Dismiss Claims Under The Securities Litigation Uniform Standards Act


  1. A.Early last year, the Merrill Lynch  v. Dabit decision interpreted the “in connection with” phrase of the Securities Litigation Uniform Standards Act of 1998 (aka SLUSA) broadly, such that the statute requires dismissal of claims that would not satisfy the “in connection with” element of a private §10(b) action.

  2. B.Two cases from the past year show the impact of Merrill Lynch, as claims that probably would have survived prior to that opinion were dismissed based upon it.


  1. 1.In In re Edward Jones Holder Litig, No. CV 06-1974 FMC (VBKX) , ___ F. Supp. 2d __, 2006 WL 2772638 (C.D. Cal. Sept. 25, 2006), a motion to remand was denied, and dismissal ordered, in a California law unfair competition lawsuit alleging that a brokerage firm placed mutual funds on customers’ preferred lists due to kickbacks.  The difference in this case was Merrill Lynch v. Dabit, which placed this holders’ claim under the scope of SLUSA, and hence in federal court.  Also, plaintiffs waited more than 30 days to file the remand motion, and hence waived all challenges to the procedural nature of the removal.  (The defendants had lost once, and then removed a second time after Merrill Lynch.)  Dismissal was the only appropriate remedy under the Uniform Standards Act.

  2. 2.In Felton v. Morgan Stanley Dean Witter & Co., No. 04 Civ. 7892 (CSH), ___ F. Supp. 2d ___, 2006 WL 1149184 (S.D.N.Y. May 2, 2006), a motion to dismiss under SLUSA was granted in a lawsuit alleging that a brokerage firm breached contracts with its clients through conflicted analyst recommendations.  Merrill Lynch v. Dabit, as newly issued, foreclosed the claim, even though plaintiffs alleged that they merely held securities (as distinguished from bought or sold them).  The fact that plaintiffs chose to frame the claim as common law breach of contract did not change this result; indeed, the court “conclude[d] without difficulty that Plaintiffs’ claim is a securities fraud wolf dressed up in a breach of contract sheep’s clothing.”  Plaintiffs alleged that they had retained the brokerage firm as a broker notwithstanding its breach of industry conduct rules prohibiting false or misleading statements; this required a “fraud analysis” by necessity, and alleged a fraudulent scheme.  Hence, while the brokerage firm’s alleged conduct was “dishonorable” and potentially addressable by individual actions, it could not state a class claim.


  1. C.This does not mean that all SLUSA dismissal motions succeed.  The issue sometimes becomes, how integrally connected is the alleged misrepresentation to any security or securities transaction.  Consider the following cases:


  1. 1.In Sofonia v. Principal Life Ins. Co., 465 F.3d 873 (8th Cir. Oct. 20, 2006), the Eighth Circuit affirmed the dismissal of a class action case alleging State law claims based on misrepresentations during insurance company’s demutualization process.  (It also affirmed the simultaneous denial of a motion to remand.)  The plaintiff policyholder’s grievance was that the company wrongfully induced the demutualization vote so as to shift the costs of an unfair business practices class action settlement to the class in that case (of which plaintiff was a member).  The issue was whether the alleged misrepresentations were in connection with the purchase or sale of securities.  Plaintiff said it was not because the vote sought the conversion of insurance policies, but the court replied that the putative class received securities in the demutualization.  This exchange could constitute a purchase or sale, as it transformed the class’ interests into something dramatically different, namely liquid securities.  The court rejected plaintiff’s contention that the misrepresentations were merely incidental to the exchange, as the crux of his complaint clearly was to the contrary.  The court also held that the McCarran-Ferguson Act did not preempt the Uniform Standards Act.

  2. 2.On the other hand, in Ring v. AXA Financial, Inc., 483 F.3d 95 (2d Cir. Apr. 6, 2007), the Second Circuit reversed a dismissal under SLUSA in a lawsuit challenging the collection of payments on “Children’s Term Rider” to a variable annuity.  The basic issue was whether the CTR was separable from the underlying annuity, which is a security and hence covered by SLUSA.  The court showed that components of multi-part investments or transactions have been considered separately for many purposes.  Here, the CTR was optional, could be attached to vehicles other than a variable annuity, entailed a separate premium and risk, and did not affect the investment function or return of the underlying policy.


  1. 3.Likewise, in Gavin v. AT&T Corp., No. 05-4398, ___ F.3d ___, 2006 WL 2548283 (7th Cir. Sept. 11, 2006), the Seventh Circuit (through Judge Posner) reversed a remand under SLUSA in a lawsuit by a person who exchanged shares of two acquired companies for acquiring companies’ shares pursuant to a post-merger cleanup administered by Georgeson.  Plaintiff alleged that the follow-up notices Georgeson sent to shareholders who had not yet tendered their shares gave the misleading impression that Georgeson had become the exclusive means for exchange, and failed to inform shareholders they could exchange their shares through the transfer exchange agent or a different broker, thereby avoiding the allegedly excessive processing fee charged by Georgeson, and (in a twist) avoiding the property escheating to the State.  This is the same claim dismissed in Starr v. Georgeson Shareholder, Inc., 412 F.3d 103 (2d Cir. 2005), when brought under federal law.  Here, the court held that the in connection with requirement was not satisfied.  By the time of the allegedly misleading communication, the merger already had been consummated and the former shareholders of the acquired company were now beneficial owners of the acquiring company.  The alleged misrepresentation didn’t affect anyone’s vote on the transaction, nor was Georgeson trying to acquire shares cheaply.  The alleged problem was what happened after the transaction, not in the transaction.  The but-for fact that the transaction was necessary in order for the fraud to take place did not satisfy the in connection with requirement.  All in all, this was a garden variety State law consumer fraud case, not an attempt to litigate a federal securities claim in disguise (as forbidden by the Reform Act.)


  1. D.SLUSA jurisprudence can make odd bedfellows.  Plaintiffs need to argue that a claim is not in connection a securities transaction in order to avoid the statute.  If they are correct, this may narrow the scope of private §10(b) actions.  Defendants have the same issue in the other direction.


6.The Duty To Correct (Considered In The Auditors’ Context)


  1. A.In Overton v. Todman & Co., CPAs, 478 F.3d 479 (2d Cir. Feb. 26, 2007), the Second Circuit reversed the dismissal of non-class action lawsuit against the auditors of a failed broker-dealer firm.  This case is the flip side of Lattanzio, decided by the same Circuit one month earlier (and reported below).  The auditors allegedly had made significant errors that concealed the company’s large payroll tax liability.  To put it bluntly, the liability disappeared; the company stopped paying taxes, and the workpapers showed no reason for it, nor investigation of it.  That the company was not paying payroll taxes as it continued to operate and pay workers was but one of five red flags ignored by the auditors.  (Later, the company discovered that the CFO had failed to record the obligation on the books.)  Unfortunately, the plaintiff invested $500,000 and lent $1.5 million more before the company collapses due to its outstanding tax liabilities. The court held that the auditors could be liable for failing to take reasonable steps to correct or withdrawal their prior audit opinion.  The court said that this was the first appellate decision holding that there was a duty to correct—which the court explicitly carefully limited to situations in which an accountant learns that its statements had been false when made, and extends only to its statements.  However, liability in this situation (in which a party stands in a fiduciary relationship) had been prefigured in prior opinions.  Liability did not conflict with Central Bank.


  1. B.In Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147 (2d Cir. Jan. 31, 2007), on the other hand, dismissal of claims against the auditors of a bankrupt clothing company was affirmed by a panel of the same Court, in a decision with guest panelist Sandra Day O’Connor.   The court held that there is no duty —at least for auditors—to correct statements that were true when made.   Nor could the auditors be liable for quarterly financial statements which they reviewed but did not audit (not attest).  Liability on that basis would violate Central Bank and the Second Circuit’s interpretation of Central Bank in Wright v. Ernst & Young.  The requirement that auditors conduct quarterly reviews is not for the purpose of attesting financial statements, but rather to reduce the work needed in year-end audits.  The court also held that there was no loss causation for statements in a subsequent 10-K, where the company went bankrupt but the 10-K had included a going concern statement warning of the same.  It also could not have escaped investors’ attention that the reported equity had declined precipitously.


7.Don’t Give Up The Ship!  No Securities Fraud Where Time Remains To Fix Problems


  1. A.My favorite proposition in securities laws is that it is not fraud for an issuer to not disclose or admit to internal problems or shortcomings when time remains to fix them.


  1. 1.This is important from a policy perspective because a rule to the contrary would encourage management to give up and admit defeat before it was necessary to do so.  That doesn’t help the shareholders.

  2. 2.This is particularly important for forecast and new product cases.  Once you disclose you are gong to miss the forecast, your salespersons will stop working to meet them.  Once you publicly allow product schedules to slip, your engineers will stop pulling all nighters to make the prior schedule.


  1. B.Until this year, there had been only a few cases to support this proposition.


  1. 1.The leading case is In re Syntex Corp. Sec. Litig., 95 F.3d 922, 930 (9th Cir. 1996), where, in a brief section in the opinion, the Ninth Circuit said that even if the defendant pharmaceutical company knew of the alleged problems in its drug testing procedure, it could conclude that it would fix problems and obtain FDA approval on schedule, such that it did not have to disclose the problems.

  2. 2.Two other cases are a decade old:  May v. Borick, No. CV 95‑8407 LGB (EX), 1997 WL 314166, *14 (C.D. Cal. Mar. 31, 1997) (“knowledge of problems does not make predicting an end to those problems fraud.”); Wallace v. Systems & Computer Tech. Corp., 1997 WL 602808, *15 (E.D. Pa. Sept. 23, 1997) (summary judgment) (company that knew of defects in its key product was entitled to assume business would pick up when it fixed defects).


  1. C.Courts have finally started to pick up on this, and four new opinions support this proposition.


  1. 1.In In re Ditech Communications Corp. Sec. Litig., No. C 05-02406 JSW, 2007 WL 902549 (N.D. Cal. Mar. 22, 2007), a motion to dismiss a second amended complaint was granted in a lawsuit alleging misrepresentation of the status of two orders from a new customer in China.  Plaintiff relied solely on an anonymous source for the allegations that the parts could not be shipped due to the failure of customs documentation.  The CEO allegedly was told about this, but did not take action for several weeks.  The court found this inadequate; notably, plaintiffs did not allege that the alleged deficiencies would be difficult or time consuming to fix.  Thus, this is another case in which problems are not insuperable if time remains to fix them.  The court also considered other allegations.

  2. 2.In In re PDI Sec. Litig., No. CIV. A 02-211 (GEB), 2006 WL 3350461 (D. N.J. Nov. 16, 2006), a motion to dismiss amended complaint was granted with prejudice in a lawsuit alleging that biotechnology marketing services company misrepresented lack of success of new business model (performance-based contracts) by engaging in channel stuffing.  This is an excellent decision for its common sense, logic and meticulousness in examining false forecast claims, and in explaining Safe Harbor standards (which, alas, the court already had determined did not apply).  The pertinent part concerns an alleged forecast.  Among other points, the court said that even assuming the truth of plaintiffs’ allegation that the market share for the drug was declining, this did not contradict a projection of increasing revenues.  After all, “[t]he amount of a good demanded is presumed to be steadily increasing (except for goods that become obsolete) since market economies like the United States are presumed to increase their ‘economic pie,” and hence more sales could be made as the total market for the product increased.  As the prescription drug market in America has been steadily increased—the court cited and hence must have taken judicial notice of an article to that effect—an alleged decline of 0.1% of market share could not possibly constitute a fact informing defendants that their earnings would decline.  Beyond this, “Defendants could legitimately factor such increase in Defendants’ projections (or sincerely believe that PDI could ‘turn the tide’ and increase Ceftin market share through a skillful marketing) ....”  Hence, this too is a very helpful addendum cases which hold that companies need not admit to failure when time remained to remedy a problem.

  3. 3.In In re Polaroid Corp. Sec. Litig., No. 03 Civ. 6480 (SHS), 2006 WL 3298388 (S.D.N.Y. Nov. 13, 2006), the court granted a motion to dismiss in a lawsuit alleging that this instant photography pioneer failed to disclose its dire financial position prior to filing for bankruptcy.  Plaintiffs’ allegations echoed in part a report of a bankruptcy examiner, which had found that the company had been deteriorating more rapidly than disclosed for some time.  Among other points, the court reasoned that as the company still had nine months before its short term debt matured at the time of one of challenged statements about its prospects (that it was working on some funding sources), hence management could have thought that the prospects were good.  Hence, this case also reasons that companies need not admit to failure when time remains to remedy a problem.

  4. 4.In In re Nokia Oyj Sec. Litig., No. 04-CV-2646 (KMK), 2006 WL 851155 (S.D.N.Y. Mar. 31, 2006), a quite remarkable opinion, the court granted a motion to dismiss with prejudice granted in a lawsuit alleging that this leading cell phone manufacturer’s results and forecasts failed to disclose that its success was due merely to the temporary effects of stumbles by competitors.  Plaintiffs alleged that in reality, the company knew that it product development pipeline was behind in the market segments that were going to be hot in the near future.  They alleged internal communications showing the company was taking remedial actions during the class period to catch up in these areas.  The court reasonably held that these allegations worked against scienter – “having tried to fix some of its problems, [the company] was well within reason to have an optimistic outlook about its new products,” even if in hindsight it was a bit too optimistic.  Indeed, it was perfectly reasonable for the CEO to feel positive about the viability of the company’s product portfolio for 2003 and 2004 even if he knew there was room for improvement in certain phone in mid-2003.  Thus, this case goes to the head of the line of cases holding that it is not fraud to predict that problems can be fixed if there is time to fix them.


8.    Securities Laws Preempt Antitrust Regulation Of IPO Underwriters’ Alleged Manipulation (Credit Suisse v. Billing)


  1. A.This isn’t central to securities fraud law, but it is a recent Supreme Court case concerning the scope of the securities laws, and it relates to the allegations of the IPO laddering cases.

  2. B.In Credit Suisse Sec. (USA) LLC v. Billing, ___ U.S. ___, No. 05-1157, 2007 WL 1730141 (June 18, 2007), the Court held that allegations that underwriters obtained excess compensation by laddering and tie-ins are outside the scope of antitrust law, but rather are regulated exclusively by the securities laws.  The SEC had enacted regulations to govern (and generally ban) the challenged practices, which raise technical issues.  It would conflict with that regulatory authority to allow the matters to also be governed by antitrust law.
© David Priebe 2016