This past year was an eventful one in the corporate and securities litigation arena, with the U.S. Supreme Court’s decision in the Omnicare case, important rulings in the lower courts applying the Supreme Court’s Halliburton II decision, and a host of other important decision on critical securities law issues. In the following memorandum from the Haynes and Boone law firm, attorneys from the firm’s Securities and Shareholder Litigation group take a look at the important securities litigation developments during 2015. I would like to thank the firm and the group for their willingness to publish their memorandum on this site. I welcome guest post submissions from responsible authors on topics of interest to readers of this site. Please contact me directly if you are interested in submitting a guest post. Here is the Haynes and Boone firm’s memorandum.
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Each year our Year in Review comments on significant securities-related decisions by the Supreme Court, federal appellate courts and district courts, notes key developments in SEC enforcement, and summarizes significant rulings in state law fiduciary litigation against directors and officers of public companies.
We begin with a discussion of the Supreme Court’s 2015 decision in Omnicare, which clarified when statements of opinion are considered false or misleading for purposes of public offering claims under Section 11 of the Securities Act.
Beyond the Supreme Court, there was notable activity at the Circuit Courts of Appeals and district courts, including early applications of Halliburton II, application of Comcast in a securities class action, and significant decisions on scienter, loss causation and other securities issues. Last year also saw Delaware decisions that are likely to change the landscape of M&A litigation and interesting developments in the area of SEC enforcement.
Supreme Court Summary: Omnicare Standard for Statements of Opinion or Belief
In 2015, the Supreme Court continued its recent trend of issuing landmark decisions that will shape securities litigation for years to come. This past March, the Court decided Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S.Ct. 1318 (2015). The decision identifies two avenues by which a company’s statements of opinion or belief in registration statements for initial public offerings can lead to liability under Section 11 of the Securities Act of 1933. First, an issuer can be liable for statements of opinion that are not genuinely believed or that contain embedded statements of untrue facts. Second, an issuer can be liable if a registration statement omits specific material facts that render the opinion misleading, as determined by the statement’s context and the foundation a reasonable investor would expect the issuer to have when expressing that opinion. Going forward, we expect the Omnicare analysis to spread beyond Section 11 cases and guide courts tasked with evaluating statements of opinion or belief under other provisions of the federal securities laws.
BACKGROUND AND PROCEDURAL HISTORY
Plaintiffs in Omnicare challenged a registration statement by a pharmaceutical company that included management’s opinions that company contracts were in compliance with federal and state law. Plaintiffs brought claims under Section 11 of the Securities Act, which provides liability for material misstatements or omissions in registration statements for public offerings. Section 11 is a strict liability statute: plaintiffs do not have to show that they relied on the alleged misrepresentation, or that a defendant acted with intent to deceive. Plaintiffs cited subsequent whistleblower litigation and other legal proceedings against the company and claimed that the company’s opinions about its legal compliance had been materially misleading.
The district court granted the company’s motion to dismiss. The court held that opinions are only actionable under the federal securities laws if the speaker did not believe the opinions when offering them. In other words, speakers cannot be held liable for genuinely-held beliefs. Applying this standard (the “subjective falsity” standard), the court found that the plaintiffs had not adequately alleged that the company did not believe that it was in compliance with the law when it offered the challenged opinions.
The Sixth Circuit reversed on appeal. Because Section 11 is a strict liability statute, the court noted, plaintiffs do not have to show scienter. For that reason, the Sixth Circuit found that plaintiffs did not have to make any allegations about management’s state of mind when the company and its management offered the challenged opinions. Under the Sixth Circuit’s analysis, statements of opinion – even if genuinely held – can be materially misleading under an “objective falsity” standard, and defendants that express misleading opinions in registration statements can be liable under Section 11. This holding created a split with other Circuits that had adopted subjective falsity standards for statements of opinion or belief. The company petitioned the Supreme Court to resolve the split.
WHEN IS AN OPINION MISLEADING UNDER SECTION 11?
In an opinion by Justice Kagan, the Court articulated two methods for alleging and assessing liability for opinions under Section 11: (1) where an opinion qualifies as a misstatement of fact; and (2) where an opinion is misleading due to the omission of material facts. Justices Scalia and Thomas filed concurring opinions.
With respect to the first basis for liability, the Supreme Court agreed with the company that a statement of opinion or belief does not qualify as a misstatement simply because it is or later proves to be erroneous. For an opinion to qualify as a material misstatement of fact, a plaintiff must show that the speaker did not actually believe the opinion at the time it was offered. The court also noted that an opinion or belief that embeds an untrue statement of material fact may also qualify as a material misstatement of fact.
With respect to omissions as a basis for liability, the Supreme Court held that opinions may lead to Section 11 liability if the registration statement “omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from the statement itself.” To determine whether an omission related to a statement of opinion or belief is materially misleading, the Omnicare decision instructs courts to consider “the foundation [a reasonable investor] would expect an issuer to have before making the statement,” considering the statement’s context, other facts provided by the issuer, and “any other hedges, disclaimers, or qualifications.” As Justice Scalia observed in his concurrence, the holding flips the analysis from what the speaker believed when offering the opinion to what the listener perceived from that opinion. If a statement of opinion omits a material fact that goes to the reasonable basis forming that opinion, the speaker may be liable under Section 11. The Court also cautioned that an opinion is not misleading simply because an issuer fails to disclose some fact that cuts the other way.
TAKEAWAYS FROM OMNICARE
While Omnicare affirms that honestly-held opinions cannot be actionable misstatements of fact, the Omnicare decision creates room for future disagreement as to what constitutes a reasonable basis for offering an opinion in light of the factual disclosures in a registration statement. Issuers should pay close attention to any statements that may qualify as opinions and carefully review the “hedges, disclaimers or qualifications” tied to those opinions. As the Supreme Court noted, such “context” is critical to determining whether an omission related to opinions or beliefs is material and misleading.
APPLYING OMNICARE IN THE LOWER COURTS
Although Omnicare is a Section 11 decision, many lower courts have found its analysis instructive as to what makes a statement of opinion or belief misleading for purposes of Rule 10b-5 claims. See, e.g., Nakkhumpun v. Taylor, 782 F.3d 1142 (10th Cir. 2015); In re Merck & Co., Inc. Sec., Deriv. & “ERISA” Litig., 2015 WL 2250472 (D.N.J. May 13, 2015); City of Westland Police & Fire Ret. Sys. v. MetLife, Inc., 2015 WL 5311196 (S.D.N.Y. Sept. 11, 2015); Starr Int’l U.S.A. Invs., LC v. Ernst & Young, LLP (In re Lehman Bros. Sec. & ERISA Litig.), 2015 U.S. Dist. LEXIS 125202 (S.D.N.Y. Sept. 18, 2015); In re Velti PLC Sec. Litig., 2015 WL 5736589 (N.D. Cal. Oct. 1, 2015). In Rule 10b-5 suits, some courts have read Omnicare’s first line of inquiry as consistent with existing “subjective belief” precedent but also cite Omnicare for the proposition that “in some circumstances, an omission may render a statement of opinion misleading.” See In re Fairway Grp. Holding Corp. Sec. Litig., 2015 WL 4931357 (S.D.N.Y. Aug. 19, 2015), report and recommendation adopted by 2015 WL 5255469 (S.D.N.Y. Sept. 9, 2015); see also FHFA v. Nomura Holding Am., Inc., 104 F. Supp. 3d 441 (S.D.N.Y. 2015). Other courts have analyzed challenged opinions separately under both Omnicare’s omissions framework and their Circuit’s “subjective belief” precedent for Rule 10b-5 claims. See, e.g., In re BioScrip, Inc. Sec. Litig., 95 F. Supp. 3d 711 (S.D.N.Y. 2015); In re Genworth Fin. Inc. Sec. Litig., 103 F. Supp. 3d 759 (E.D. Va. 2015). In the coming year, circuit courts will likely refine and incorporate the Omnicare analysis into their Rule 10b-5 precedent for challenged statements of opinion or belief.
District courts have also begun to apply Omnicare’s omissions inquiry by evaluating whether challenged opinions or beliefs were “misleading to a reasonable person reading the statement fairly and in context.” In re Fairway, 2015 WL 4931357, at *20 (quoting Omnicare); City of Westland, 2015 WL 5311196, at *13. Some courts have focused on whether the alleged omissions indicate that the challenged statement of opinion or belief did not “rest on some meaningful inquiry.” City of Westland, 2015 WL 5311196, at *13; Starr, 2015 U.S. Dist. LEXIS 125202, at *26-27. Other courts have analyzed whether the defendant was in possession of facts that did not “fairly align” with the expressed opinion. In re Merck, 2015 WL 2250472, at *20 (involving opinion that a favorable hypothesis was the “likeliest” explanation for certain test results); see also Nomura, 104 F. Supp. 3d at 565-66 (noting that “defendants were aware of information contradicting the representations”).
At the pleading stage, lower courts recognize that Omnicare requires plaintiffs to offer more than “conclusory allegations” or recitations of the “statutory language” to challenge a statement of opinion or belief under an omissions theory. To survive a motion to dismiss, plaintiffs must identify “particular (and material) facts going to the basis for the issuer’s opinion” that were omitted. City of Westland, 2015 WL 5311196, at *12 (“That is no small task for an investor.”) (quoting Omnicare). Courts have dismissed omissions claims where plaintiffs failed to meet this requirement. See, e.g., In re Fairway, 2015 WL 4931357, at *20 (“In context, the ‘excluded facts’ do not show that defendants ‘lacked the basis for making the[ir] statements that a reasonable investor would expect.’”); In re Velti, 2015 WL 5736589, at *19-26; City of Westland, 2015 WL 5311196, at *20 (finding that plaintiff had not adequately alleged that defendant “omitted to state a fact (or facts) necessary to prevent its view . . . from misleading reasonable investors reading the Company’s financial statements fairly and in context”). Omnicare’s pleading standard for omissions claims has not proved insurmountable for plaintiffs, however. See, e.g., In re BioScrip, 95 F. Supp. 3d at 730-31 (denying motion to dismiss where company expressed opinions about legal compliance without disclosing that it had received an information request from the government); In re Genworth, 2015 WL 2061989, at *15 (“Plaintiffs have adequately pled that these excluded facts illustrate that Defendants lacked the basis for making their alleged misrepresentations.”).
Courts also had an opportunity in 2015 to apply Omnicare at the summary judgment stage. Because the omissions analysis depends heavily on context, some plaintiffs have been able to point to genuine disputes of fact to survive summary judgment. See In re Merck, 2015 WL 2250472, at *21 (“The record contains evidence upon which a reasonable jury could conclude that Defendants not only lacked support for this assertion of belief but, additionally, knew that it did not ‘fairly align’ with other information in their possession.”); Starr, 2015 U.S. Dist. LEXIS 125202, at *38 (evidence would permit a jury to infer that defendant “had information in hand” that was not consistent with the challenged opinion.). For securities fraud defendants, these cases highlight the importance of challenging alleged omissions at the pleading stage.
One overarching trend from these cases is clear: Omnicare is joining the pantheon of landmark securities litigation decisions issued by the Roberts Court. As plaintiffs challenge more statements of opinion or belief in securities suits, courts will have more opportunities in the coming years to apply and develop Omnicare’s framework outside Section 11.
Class Certification Issues: Applying Halliburton II and Beyond
Our 2014 Year in Review began with a discussion of the Supreme Court’s decision in Halliburton II. In 2015, federal district court judge Barbara Lynn considered the next chapter of the “long and winding history” of the Halliburton case. See Erica P. John Fund, Inc. v. Halliburton Co., 309 F.R.D. 251, 255 (N.D. Tex. 2015). Other federal courts in 2015 also began to flesh out the contours of Halliburton II and continued to apply the Supreme Court’s Comcast decision from two years ago.
Halliburton II Background
A plaintiff’s reliance on a defendant’s misrepresentation is an essential element in private federal securities fraud claims. However, requiring direct proof of reliance in class actions alleging securities fraud would make individual issues of reliance overwhelm the common ones, thereby making it impossible to satisfy the predominance requirement for class certification. In 1988, the Supreme Court in Basic Inc. v. Levinson considered this dilemma and held that investors could prove reliance in a federal securities fraud class action by invoking a presumption that the price of stock, traded in an efficient market, reflects all public, material information – including material misstatements. See 485 U.S. 224, 246-47. In such a case, investors who buy or sell the stock at the market price may be presumed to have relied on the misstatements. See id. at 247. This is known as the fraud-on-the-market presumption of reliance. The Court in Basic also held that a defendant could rebut this presumption in a number of ways, including by showing that the misstatements did not actually affect the stock’s price. See id. at 248.
Halliburton has twice been before the Supreme Court on issues related to the Basic presumption of reliance in the context of class certification. In Halliburton I, the Supreme Court held that the element of loss causation need not be proved at the class certification stage. See Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804, 131 S. Ct. 2179, 2183-86 (2011). The Court observed that it had “never before mentioned loss causation as a precondition for invoking Basic’s rebuttable presumption of reliance” and that “[l]oss causation addresses a matter different from whether an investor relied on a misrepresentation, presumptively or otherwise, when buying or selling a stock.” Id. at 2186. The Supreme Court similarly held in Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds, that proof of materiality is not required at the class certification stage, given that “the question of materiality is common to the class.” 133 S. Ct. 1184, 1197 (2013). The Court found that Amgen’s attempt to disprove materiality “[was] properly addressed at trial or in a ruling on a summary judgment motion.” Id.
In Halliburton II, the Supreme Court declined a request to abandon the fraud-on-the-market presumption but held that defendants may rebut the presumption at the class certification stage by showing that the alleged misrepresentations did not impact the stock price. See Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2407-17 (2014). The Court vacated the judgment of the Fifth Circuit and remanded the case for further proceedings. See id. at 2417.
Judge Lynn’s Decision on Remand from Halliburton II
On remand at the district court in Halliburton, “the parties . . . submitted event studies, i.e., regression analyses, to show that Halliburton’s stock price was, or was not, affected on days when an alleged misrepresentation or corrective disclosure reached the market.” Halliburton, 309 F.R.D. at 257. Judge Lynn considered “the competing methodologies of the parties’ experts” and found that Halliburton had shown a lack of price impact for five of the six corrective disclosures alleged by the plaintiff. See Halliburton, 309 F.R.D. at 262-80. Accordingly, the court denied the plaintiff’s motion for class certification except as to the single corrective disclosure regarding asbestos liabilities for which Halliburton had failed to rebut the fraud-on-the-market presumption. Id. at 254, 276-280.
Several of Judge Lynn’s comments shed light on the contours of Halliburton II. First, the court placed both the burdens of production and persuasion to show lack of price impact on Halliburton rather than on the plaintiff. See Halliburton, 309 F.R.D. at 258-60. Halliburton had the burden to “ultimately persuade the Court that its expert’s event studies [were] more probative of price impact than the [plaintiff’s] expert’s event studies.” Id. at 260.
Second, the court held that Halliburton could not rebut the fraud-on-the-market presumption at class certification by showing that the alleged corrective disclosure was not, in fact, corrective. Judge Lynn found that “Halliburton’s arguments regarding whether the disclosures were corrective [were], in effect, a veiled attempt to assert the ‘truth on the market’ defense, which pertains to materiality and is not properly before the Court at this stage of the proceedings.” Id. at 260-61 (citations omitted). Based on Halliburton I, Amgen and Halliburton II, the court found that “class certification is not the proper procedural stage . . . to determine, as a matter of law, whether the relevant disclosures were corrective.” Id. at 260 (citations omitted).
Judge Lynn’s decision on remand from Halliburton II illustrates that class certification will remain a major battleground in securities fraud cases and will typically involve competing expert reports and event studies on the question of price impact.
Pending Federal Appeals Regarding the Application of Halliburton II
The Fifth Circuit recently granted Halliburton’s motion for leave to appeal Judge Lynn’s rulings on the burden of persuasion and whether a court may consider whether the alleged corrective disclosure was actually corrective. See Erica P. John Fund, Inc. v. Halliburton Co., No. 15-90038, 2015 BL 369058, at *1 (5th Cir. Nov. 04, 2015). Judge James Dennis of the Fifth Circuit “reluctantly concur[red]” in granting Halliburton leave to appeal but expressed skepticism regarding Halliburton’s argument. See id. at *1-4. In addition, in October 2015, the Eighth Circuit in IBEW Local 98 Pension Fund v. Best Buy Co. heard oral arguments in the appeal of a federal district court’s class certification rulings on price impact and whether the alleged corrective disclosures were actually corrective. See No. 14-3178 (8th Cir. Oct. 22, 2015). The Fifth and Eighth Circuits’ determination of these pending appeals will shed additional light on the utility of defendants’ ability under Halliburton II to rebut the fraud-on-the-market presumption at the class certification stage.
Federal District Court Cases Applying Halliburton II
Several federal district courts also issued decisions in 2015 that reveal several key principles regarding the application of Halliburton II. For example, in In re Bridgepoint Education, Inc. Securities Litigation, the district court rejected a “truth-on-the-market” defense at the class certification stage. See No. 12-cv-1737 JM (JLB), 2015 WL 224631, at *7 (S.D. Cal. Jan. 15, 2015) (Miller, J.). The defendants had argued that the second of two alleged corrective disclosures was unrelated to the purported fraud, and therefore the class period should end on the date of the first corrective disclosure. See id. The court considered this to be a “truth-on-the-market” defense and noted that “Halliburton did not change” the rule that “a truth-on-the-market defense cannot be used to rebut the presumption of reliance at the class-certification stage.” Id. The court left open that it could shorten the class period at a later stage of the case if it were later shown that the presumption of reliance did not apply after the first corrective disclosure. See id.
In Carpenters Pension Trust Fund of St. Louis v. Barclays PLC, the court found that defendants “ignore[d] the Supreme Court’s invitation [in Halliburton II] to offer their own evidence to prove lack of price impact” and instead challenged price impact based on the event studies and testimony of the plaintiffs’ expert. See 310 F.R.D. 69, 94 (S.D.N.Y. 2015) (Scheindlin, J.). The plaintiffs’ theory was that the allegedly false statements “artificially maintained the stock price, not that they artificially inflated the price of the stock.” Id. at 95. Thus, the purported failure of the plaintiffs’ event study “to show statistically significant price movements on the days” in which the alleged false statements were made “[did] not necessarily sever the link between” the alleged misrepresentations and “‘the price received (or paid) by the plaintiff[s.]’” Id. In sum, the defendants’ failure to “present[] compelling evidence of lack of price impact” relieved the plaintiffs of the burden “to present evidence of price impact.” Id. at 97. The court found that the plaintiffs were “entitled to rely on the Basic presumption of reliance” and granted their motion for class certification. Id. at 97, 100.
In In re Goldman Sachs Group, Inc. Securities Litigation, “there [was] no real dispute concerning the market efficiency for Goldman’s stock,” and the court found that “[d]efendants . . . failed to demonstrate a complete lack of price impact.” No. 10-cv-3461 (PAC), 2015 WL 5613150, at *6 (S.D.N.Y. Sep. 24, 2015) (Crotty, J.), appeal filed (2nd Cir. Oct. 8, 2015). The district court therefore granted the plaintiffs’ motion for class certification. Id. at 8. The plaintiffs alleged that Goldman’s purported misstatements and omissions “were revealed as untrue” through a series of corrective disclosures announcing SEC and DOJ “investigations and enforcement actions against Goldman,” which triggered a “decline in Goldman’s stock price.” Id. at *1. The defendants failed to show “the total decline in the stock price on the corrective disclosure dates [was] attributable simply to the market reaction to the announcement of enforcement actions and not to the revelation to the market that Goldman had made material misstatements about its conflicts of interest policies and business practices.” Id. at *6 (emphasis added). In other words, “whether or not the market was focused to some degree on the impact the enforcement actions would have on the stock price does not mean that no decline in stock price is attributable to the revelation of misstatements.” Id. at *7.
In In re Vivendi Universal, S.A. Securities Litigation, the defendant succeeded in making an “individualized rebuttal” of the fraud-on-the-market presumption. See __ F. Supp. 3d __, No. 02-cv-5571 (SAS), 2015 WL 4758869, at *8-11 (S.D.N.Y. Aug. 11, 2015) (Scheindlin, J.). After a jury verdict in favor of the class, the district court permitted the defendant, Vivendi, to conduct discovery to attempt to rebut the presumption of reliance as to individual class members. Id. at *1. This discovery revealed that an institutional asset manager, which had exercised full investment discretion on behalf of a group of class members, was itself indifferent to the fraud. Id. at *1, 3, 8-11.
The court in Vivendi noted that “Halliburton II did not disturb a central holding of Basic: that ‘[a]ny showing that severs the link between the alleged misrepresentation and . . . [the plaintiff’s] decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.’” 2015 WL 4758869, at *10. The court granted summary judgment for Vivendi on the claims submitted by the asset manager and its clients, finding that the link had been severed with respect to these class members. Id. at *1, 10-11. The court observed that a plaintiff’s “successful[] navigat[ion]” of “the choppy waters of class certification on a sturdy ship named Basic does not guarantee safe passage for the rest of the journey.” Id. at *9
Applying Comcast to Federal Securities Cases
In Comcast Corp. v. Behrend, the Supreme Court held that the predominance requirement was not met in a proposed antitrust class action in which the plaintiffs’ damages model did not attempt to identify the damages attributable to the plaintiffs’ only viable theory of liability. See 133 S. Ct. 1426, 1433-35 (2013). Following Comcast, federal courts agree that a class plaintiff’s measure of damages must match its theory of liability to satisfy the predominance requirement. Federal courts have differed, however, as to whether Comcast requires a class-wide damages methodology.
The Fifth Circuit in 2015 applied Comcast in the context of a federal securities class action. See Ludlow v. BP, P.L.C., 800 F.3d 674 (5th Cir. 2015). The case arose from the 2010 Deepwater Horizon oil spill. See id. at 678. The plaintiffs, shareholders of BP, alleged the company made two series of misrepresentations: “one series regarding [BP’s] pre-spill safety procedures, and one regarding the flow rate of the oil after the spill occurred.” Id. at 677. The district court certified the post-spill class, concluding the plaintiffs had shown “a model of damages consistent with their liability case and capable of measurement across the class.” Id. However, the district court refused to certify the pre-spill class, concluding “the plaintiffs had not satisfied Comcast’s common damages burden.” Id. The Fifth Circuit affirmed. Id.
Certification of Post-Spill Class
Regarding plaintiffs’ post-spill class, their damages expert had used an “out-of-pocket losses” measure based on a “corrective disclosure methodology to proxy the inflated stock price.” Ludlow, 800 F.3d at 683-685. Plaintiffs relied on a theory that the artificial inflation in BP’s stock price was exposed when “six corrective events” brought the “true” information to the market’s attention. Id. at 680, 687. BP challenged the adequacy of the nexus between these corrective events and the underlying misstatements. See id. at 686-87. The Fifth Circuit cited Amgen in affirming the district court’s refusal to resolve BP’s challenge at the class certification stage, noting that “the question of whether certain corrective disclosures are linked to the alleged misrepresentations . . . is undeniably common to the class, and is ‘susceptible of a class-wide answer.’” Id. at 688 (citing Amgen, 133 S. Ct. at 1196).
The Fifth Circuit similarly held the district court did not abuse its discretion in not requiring the plaintiffs to prove at the class certification stage “that all of the corrective events measured the effect of the misrepresentation, rather than the spill itself.” Ludlow, 800 F.3d at 688. The Fifth Circuit noted “[t]he core dispute” was about “the ‘fit’ between the corrective events and the misstatements,” which “is a question common to the class” that does “not require proof at the certification stage.” Id. To conclude otherwise would “require bringing forward the plaintiff’s proof of loss causation,” in violation of “Halliburton I’s requirement that loss causation need not be proved at this stage.” Id. The Fifth Circuit also noted that the plaintiffs’ damages methodology allowed for the removal of any corrective events later found to not “correct” the misrepresentations, which is “what Comcast requires at this stage.” Ludlow, 800 F.3d at 689.
Refusal to Certify Pre-Spill Class: Rejection of “Materialization of the Risk” Theory
Regarding the pre-spill class, the plaintiffs’ damage theory was “‘based on [a] materialization of the risk theory,’” in which the “‘investors are harmed by [ ] corrective events that represent materializations of the risk that was improperly disclosed.’” Ludlow, 800 F.3d at 689 (internal quotation marks omitted). The Fifth Circuit framed the question as “whether a damages model based on this theory is ‘susceptible of measurement across the entire class for purposes of Rule 23(b)(3),’ as required by Comcast.” Id. at 690. It held the district court did not abuse its discretion in concluding the pre-spill damages theory was incapable of class-wide determination. Id. “That theory hinges on a determination that each plaintiff would not have bought BP stock at all were it not for the alleged misrepresentations—a determination not derivable as a common question, but rather one requiring individualized inquiry.” Id. (emphasis in original).
The Fifth Circuit noted that some risk-averse investors may not have bought BP stock at all had they known of the true risk of a catastrophe, while others still may have purchased the stock, even had they known of the “true” risk, albeit for a “lower price that accounted for the increased risk.” Ludlow, 800 F.3d at 690. The plaintiffs’ damages model “[did] not provide any mechanism for separating these two classes of plaintiffs,” and therefore it “[could not] provide an adequate measure of class-wide damages under Comcast.” Id. It also “presume[d] substantial reliance on factors other than price, a theory not supported by Basic and the rationale for [the] fraud-on-the-market theory.” Id. at 691.
Loss Causation
Plaintiffs are required to show loss causation, the causal relationship between an alleged material misrepresentation and a shareholder’s economic loss when the truth is revealed to the market. The Supreme Court did not address this requirement in 2015, but several circuit and district courts in the Second, Seventh, Ninth, and Tenth Circuits did issue rulings on loss causation that tended to be favorable for plaintiffs.
In Financial Guaranty Insurance Co. v. The Putnam Advisory Co., 783 F.3d 395 (2d Cir. 2015), the Second Circuit reversed a district court’s dismissal of the Financial Guaranty Insurance Company’s (“FGIC”) suit against Putnam Advisory Company, LLC (“Putnam”) alleging fraud relating to Putnam’s management of a collateralized debt obligation (“CDO”) called Pyxis. FGIC alleged that Putnam gave control of significant aspects of the Pyxis CDO to a hedge fund, Magnetar Capital LLC (“Magnetar”), that held a substantial short position in Pyxis such that Magnetar stood to profit millions of dollars in the event that Pyxis failed. FGIC alleged that Putnam made misrepresentations regarding the delegation to Magnetar and that if Putnam had disclosed the extent of Magnetar’s involvement, FGIC would not have engaged in the transaction. Furthermore, FGIC alleged that Magnetar’s CDOs defaulted more frequently and much more quickly than comparable CDOs. The district court held that FGIC failed to plead loss causation because in light of the market-wide downturn, FGIC could not show that it would have been “spared all or an ascertainable portion of the loss absent the fraud.” But the Second Circuit disagreed, finding that by alleging that Magnetar’s assets defaulted more frequently and more quickly than other CDOs, FGIC raised a reasonable inference that Magnetar’s involvement caused an ascertainable portion of the loss.
Shortly after its decision in Putnam, the Second Circuit took another look at loss causation and reaffirmed its plaintiff-friendly stance in Loreley Fin. (Jersey) No. 3 Ltd. v. Wells Fargo Sec., LLC, 797 F.3d 160 (2d Cir. 2015). The factual bases of Loreley were very similar to Putnam: plaintiff investors in three CDOs alleged that defendants represented that independent managers would make important decisions for the CDOs while in fact defendants permitted entities with substantial short positions in the CDOs to make those decisions. Not surprisingly, the Second Circuit again ruled that plaintiffs had adequately alleged loss causation. Judge Calabresi went on to articulate a lower bar for survival of a 12(b)(6) motion to dismiss for failure to allege loss causation: “It is sufficient under Rule 12(b)(6) that the allegations themselves give Defendants ‘some indication’ of the risk concealed by the misrepresentations that plausibly materialized in Plaintiffs’ ultimately worthless multimillion-dollar investment in these CDO notes.” 797 F.3d at 188-89. Together, Putnam and Loreley suggest that, at least at the pleading stage, a market-wide financial crisis will not provide a basis for dismissal of plaintiffs’ securities fraud claims in the Second Circuit.
In Glickenhaus & Co. v. Household Int’l, Inc., 787 F.3d 408 (7th Cir. 2015), the Seventh Circuit generally approved of the plaintiff’s use of a leakage model to prove loss causation and damages. The leakage model at issue estimated the true value of the stock using historical data and data from the S&P 500 and the S&P Financials Index. Rather than measure the purported artificial price inflation based on the stock price declines that occurred following specific negative disclosures, as is typical in plaintiff’s damages models, the leakage model attributed all the difference between the predicted value and actual value of the stock during the disclosure period to the alleged fraud and calculated damages accordingly. This method purportedly has the ability to handle situations where disclosures are gradually made public over a period of time better than traditional models. The defendant argued that several corresponding weaknesses rendered the model legally insufficient. The Seventh Circuit rejected defendants’ fundamental challenge to the model: that it impermissibly attributed the full inflation amount to fraud despite evidence that the price only increased by a small percentage of the inflationary amount on the date of the misrepresentation. The court did remand, however, to correct for two inadequacies in the specific application of the leakage model: first, because both plaintiffs and defendants failed to develop a sufficient record regarding the expert’s treatment of firm-specific, non-fraud effects, which could undermine the results, and second, because the jury was instructed to use the inflation amount starting on the first date of a material misrepresentation, not on the first date when misrepresentations on all material subjects had been made. Despite the remand, Glickenhaus represents an important decision accepting a leakage disclosure model, even in light of their inherent limitations. Leakage models have not historically been accepted by courts in securities fraud cases, and if that changes, it could represent a major increase in the potential liability for defendants.
The Tenth Circuit found that a plaintiff had met its 12(b)(6) burden to allege loss causation in Nakkhumpun v. Taylor, 782 F.3d 1142 (10th Cir. 2015). The plaintiff alleged that the defendant misled investors about the true reason for termination of a potential transaction when the defendant announced the potential buyer was unable to arrange financing. The plaintiff claimed the true reason was that the potential buyer valued the company’s assets at far less than the $400 million that had previously been announced. Although defendants argued that plaintiff failed to show when the truth was revealed to the market, the Tenth Circuit disagreed and accepted plaintiffs’ theory that the allegedly concealed risk (that the company’s assets were not worth $400 million) materialized when the market learned that company was unable to find another buyer. The court’s acceptance of this disclosure as a materialization of the risk is significant because it has a looser nexus with the original misrepresentation than is typical in many securities fraud cases.
In Smilovits v. First Solar, Inc., 2015 U.S. Dist. LEXIS 105355 (D. Ariz. Aug. 10, 2015), a district court in Arizona analyzed two competing Ninth Circuit tests for establishing loss causation. The plaintiff alleged that the defendant company misrepresented and failed to disclose the extent of its exposure resulting from flaws in its manufacturing process. The district court analyzed the Nuveen test finding loss causation when “the loss was due to the very facts that were misrepresented” and the Metzler test under which “the complaint must allege that the practices that the plaintiff contends are fraudulent were revealed to the market and caused the resulting losses … that the market learned of and reacted to [the] fraud, as opposed to merely reacting to reports of the defendant’s poor financial health generally.” The court concluded that it should apply the less restrictive Nuveen test and found that the plaintiff adequately alleged loss causation, but also certified the issue for interlocutory appeal. This appeal is currently pending before the Ninth Circuit. If the Ninth Circuit upholds the district court’s decision, it will continue the general trend towards less restrictive standards for loss causation.
Together, these 2015 loss causation cases suggest a trend of courts focusing less on specific corrective disclosures, which would make it more difficult for defendants to achieve early dismissal on loss causation grounds.
Scienter
An essential element of a securities fraud claim under Section 10(b) and Rule 10b-5 is scienter — the mental state to deceive, manipulate, or defraud. To sufficiently plead scienter, a plaintiff is required to state with particularity facts giving rise to a “strong inference” of the requisite mental state – at least deliberate or severe recklessness. A strong inference arises when the inference of scienter is at least as compelling as any plausible, opposing inference that the court must take into account. In 2015 we saw decisions from seven circuits shedding light on how scienter is and should be analyzed in those jurisdictions.
First Circuit
In Fire & Police Pension Ass’n of Colo. v. Abiomed, Inc., 778 F.3d 228 (1st Cir. 2015), the First Circuit analyzed the materiality of alleged misleading statements as one indicator of scienter. The putative class alleged that a company failed to disclose that its top-selling product’s revenue grew as a result of unlawful, off-label marketing.
The court held that the plaintiffs did not adequately plead scienter. The marginal materiality of the company’s failure to attribute revenue growth to off-label marketing weighed against a strong inference of scienter, especially because the company cautioned investors that the FDA might disagree with the legality of its marketing practices which would, in turn, adversely affect sales. Furthermore, the company told investors that the FDA was investigating it and that it could not promise a positive resolution.
Moreover, the court did not credit the plaintiffs’ confidential witnesses. These witnesses did not describe particularized facts showing a strong inference of scienter. They also were not in management positions and had little interaction with senior executives. Thus, even if the witnesses did provide facts from which improper activity could be inferred, they did not suggest it was done with intent. The plaintiffs’ allegations of insider trading also did not support scienter because the plaintiffs showed neither an unusual nor suspicious pattern of trading, and the trading did not personally benefit the defendants.
In the end, the court held that the company’s marketing was risky and likely to prompt FDA investigation—as it did. But this was not enough to show intent to defraud because the plaintiffs premised their case on securities fraud, not FDA violations.
Second Circuit
In Employees’ Ret. Sys. v. Blanford, 794 F.3d 297 (2d Cir. 2015), the plaintiffs adequately pleaded scienter where strong circumstantial evidence showed the company’s intent to deceive or defraud investors. Defendants allegedly concealed excess inventory while assuring investors the company had positive business performance and growth prospects and appropriate inventory levels. Thereafter, the executives prospered from increasing stock prices by strategically selling their shares to realize significant personal gain. Even though the executives entered into pre-determined 10b5-1 trading plans, they did so during the relevant time period, not before it, allegedly knowing that the stock sales would correspond to the misleading statements. Thus, plaintiffs showed defendants’ motive and opportunity to commit fraud, as well as strong circumstantial evidence of such intent.
In Acticon AG v. China N. E. Petroleum Holdings Ltd., 615 F. App’x 44 (2d Cir. 2015), a former CEO had financial motive and opportunity to commit fraud because of the personal and concrete benefit he received from the alleged fraud. He signed all relevant SEC filings attesting to adequate internal controls while simultaneously stealing company money. The court imputed the CEO’s scienter to the company. On the other hand, the plaintiffs could not show scienter for the remaining defendants, corporate directors and officers, under the recklessness standard. The defendants’ alleged failure to identify defects in the company’s internal controls and errors in the company’s accounting statements did not demonstrate severe recklessness, especially without particularized facts showing fraudulent intent.
Fourth Circuit
The Fourth Circuit found a strong inference of scienter due to a company’s failure to disclose damaging information in Zak v. Chelsea Therapeutics Int’l, Ltd., 780 F.3d 597 (4th Cir. 2015). The plaintiffs alleged that the company made materially misleading statements and omissions regarding the likely regulatory approval of a new drug. The company chose to reveal to investors select, less damaging information about the FDA’s possible approval of the drug. At the same time, it did not disclose additional information about the FDA’s critical view of the drug. This selective disclosure made the statements incomplete and misleading, which supported a strong inference of scienter.
The Fourth Circuit clarified that the mere failure to disclose information does not create a strong inference of scienter on its own; rather, the court must assess scienter relating to omissions within the context of the statements that a defendant affirmatively makes.
Fifth Circuit
In Owens v. Jastrow, 789 F.3d 529 (5th Cir. 2015), the Fifth Circuit held that the plaintiffs’ circumstantial evidence did not create a strong inference of scienter absent particularized facts of severe recklessness.
The court addressed several procedural issues at the outset. First, the inquiry is whether all allegations taken collectively show scienter, not whether individual allegations scrutinized in isolation do. Nevertheless, the Fifth Circuit affirmed the district court’s two-step method of analyzing scienter: analyzing each allegation individually to see whether it contributed to an inference of scienter, and then concluding whether the allegations as a whole raised the requisite inference.
Next, the court reiterated its rejection of the group pleading doctrine. Under the PSLRA, scienter allegations against defendants as a whole are impermissible; plaintiffs must specifically plead individualized allegations for each defendant. Yet, dismissal was not warranted because this was not a case where plaintiffs made no attempt to make specific allegations. Instead, the court held it could disregard group-pleaded allegations and determine whether the remaining, properly pleaded allegations created a strong inference of scienter for each defendant.
As to the substantive issues, the plaintiffs alleged that the defendants made materially false and misleading statements regarding the company’s assets. The plaintiffs claimed that the defendants had knowledge of the company’s undercapitalization; that the company continued to rely on an inaccurate valuation method despite internal warnings and a large misstatement; and that the defendants signed the SEC filings in question.
The court held that these inferences were not strong enough to prove scienter, especially given the competing ones. The defendants, for example, disclosed the various red flags alleged by the plaintiffs and also told investors that its valuations were uncertain. Furthermore, although the magnitude of the accounting errors was large, its inference of scienter was small because they involved subjective concepts under GAAP. Moreover, the defendants relied on AAA ratings and believed that its internal models were accurate, even if they did so negligently. In sum, the plaintiffs’ allegations did not give rise to a strong inference of scienter that was at least as likely as the alternative inferences of admittedly negligent conduct.
Ninth Circuit
The Ninth Circuit addressed what it described as an issue of first impression in Costa Brava P’ship III LP v. ChinaCast Educ. Corp., 2015 U.S. App. LEXIS 18462 (9th Cir. Oct. 23, 2015): whether the court can impute an executive’s scienter to a company even if the executive’s acts were adverse to the company’s interests. In the case, all parties agreed that a CEO committed securities fraud with scienter: he embezzled millions of dollars from the company and misled investors through false statements. Although the actions of a corporate agent are usually imputed to the company when acting within the scope of employment, the question was whether the adverse interest exception applied. This exception bars imputation when a rogue agent acts adversely to the principal’s interests.
The court held it could impute the CEO’s scienter to the company. The CEO acted with apparent authority on behalf of the corporation so his scienter was imputed to the company, his principal, under the law of agency. More importantly, the adverse interest exception did not apply even though the CEO’s conduct was adverse to the company’s interest. The court held that, similar to other circuits, the exception does not apply and scienter is imputed to the corporation when necessary to protect the rights of innocent third parties. Here, innocent shareholders relied on the CEO’s representations. The court importantly noted that the adverse interest exception will rarely apply in private securities fraud cases because the plaintiffs—shareholders—are usually innocent third parties. The court explained that its narrow view of the adverse interest exception supports the policy goals of deterring fraud and promoting confidence in the securities markets.
Tenth Circuit
In three decisions this year, the Tenth Circuit reiterated that plaintiffs must plead with particularity facts giving rise to a strong inference of scienter under the PSLRA’s heightened standards.
In Banker v. Gold Res. Corp., 776 F.3d 1103 (10th Cir. 2015), the court held that the defendants’ overbilling issues, misleading profit statements, and GAAP violations did not, on their own, raise a strong inference of scienter. There must be specific factual allegations of fraudulent intent. And other facts created plausible, opposing inferences. Regarding overbilling, the company’s employees delayed disclosing the overbilling issues to executives, the executives wanted to investigate the matter before publicly reporting it, and the buyer contracted to pay the amounts in question. Moreover, the plaintiffs’ allegation that the defendants concealed severe production problems did not create a strong inference of scienter. The defendants issued cautionary statements to investors explaining the volatile and unpredictable nature of mining operations. This opposing inference was as plausible as plaintiffs’ inferences of scienter.
Several months later, in Nakkhumpun v. Taylor, 782 F.3d 1142 (10th Cir. 2015), the court held that two defendants lacked scienter but that one possessed it.
The Chairman of the Board acted with scienter when misleading investors as to the true reason why a deal to sell some of its assets fell through. The Chairman said that the other party lacked adequate financing, while the real reason was that the other party believed the company’s assets were worth less than the asking price. The court held that scienter allegations may suffice without a motive to commit securities fraud. The Chairman argued he made the statements to entice prospective buyers and maximize shareholder value, not mislead shareholders. Even so, he recklessly disregarded the likelihood of misleading shareholders into thinking the assets were more valuable than they actually were. Furthermore, because the Chairman chose to affirmatively explain why the deal terminated, rather than simply saying that it had, he assumed a duty to fully disclose all material facts and not mislead investors.
As to the other two defendants, executives at the company, they lacked scienter in making an alleged misleading statement about the company’s liquidity. The executives spoke about indicia of liquidity in publicly filed earnings data. Although it was “overly rosy” and the executives should have known the company’s financial condition was poor, the executives made the statements with sincerity and without intent to deceive or recklessness.
In the final case, Swabb v. Zagg, Inc., 797 F.3d 1194 (10th Cir. 2015), the former CEO and Chairman did not act with scienter in failing to disclose that he had pledged half of his company shares as collateral in a margin account. His reporting violation and signature of certification was insufficient to show knowledge that he omitted a required disclosure—and his position did not, on its own, impute such knowledge. Moreover, the officer’s forced resignation and the company’s subsequent policy change prohibiting pledging shares in margin accounts did not show an earlier intent to defraud. Lastly, the plaintiffs could not show that the defendant had a motive to conceal the margin account; he disclosed it to the SEC after each margin call. Although the plaintiffs’ allegations were all relevant to an inference of scienter, the plaintiffs lacked particularized facts of intent required by the PSLRA. The opposing inference, that the defendant lacked knowledge of the requirement, was more compelling.
Eleventh Circuit
In Brophy v. Jiangbo Pharms., Inc., 781 F.3d 1296 (11th Cir. 2015), the Eleventh Circuit held that a CFO’s opposing inferences were more compelling than the plaintiffs’ inferences of scienter in her misrepresentation of the company’s cash balances.
The plaintiffs alleged that the court should infer scienter based on the CFO’s position; her suspicious activity during the period in question, including her resignation and alleged obstruction of an internal investigation; the scope of the fraud; and certain red flags indicating fraud, such as an SEC investigation and weak internal controls.
The court held that these allegations did not create a strong inference of scienter. First, the plaintiffs relied wholly on circumstantial evidence and pleaded no particularized facts showing intent or recklessness. There were also several factual omissions that weakened any inference of scienter, such as an amount by which she overstated cash balances or how the alleged red flags should have alerted the CFO to the fraud. The court noted that any inference of scienter is diluted when drawn from predicate inferences lacking specific facts to back them up.
Lastly, the CFO alleged equally compelling competing inferences of no scienter. For example, she explained that she resigned for family reasons and that she continued to work part-time. And although she failed to turn over certain documents for the internal investigation, she also personally prepared many of the materials to aid in it. Moreover, she did not reside at the company’s principal location and could not observe day-to-day operations, and she did not make any stock sales to profit from the alleged fraud.
Thus, the court found that plaintiffs’ allegations did not create a strong inference of scienter and, at most, showed negligent behavior. The CFO propounded equally compelling competing inferences, and the plaintiffs failed to provide more particularized evidence of intent other than layers of circumstantial evidence.
Duty to Disclose and Materiality
This past year saw several notable decisions regarding whether a defendant’s alleged misstatements or omissions were material. Among those decisions, the Second Circuit in IBEW Local Union No. 58 Pension Trust Fund & Annuity Fund v. Royal Bank of Scotland Group, PLC, 783 F.3d 383 (2d Cir. 2015), affirmed the dismissal of a putative securities class action brought against the Royal Bank of Scotland Group (RBS) for alleged false and misleading statements RBS made leading up to the 2008 mortgage crisis. Among the allegations, the plaintiffs alleged that RBS misrepresented its subprime exposure in December 2007 and falsely stated its obligation to conduct a Rights Issue related to a capital raise in April 2008. In affirming the dismissal of plaintiffs’ claims with respect to the subprime exposure, the Second Circuit held the misstatement immaterial under factors identified in the SEC’s Staff Accounting Bulletin No. 99 (SAB 99). The particular quantitative factor in play specified that a misstatement is presumptively immaterial if it involves less than 5% of a registrant’s financial statement. Further, the court held that the plaintiffs failed to adequately plead sufficient facts to meet SAB 99’s qualitative factors that could overcome this presumption of immateriality. With respect to the alleged false Rights Issue statements, the court held, among other things, that the statement was immaterial because a reasonable investor would not deem the alleged falsity “as having significantly altered the total mix of information made available.” The decision is notable in that it confirms that defendants can seek dismissal of securities fraud claims on materiality grounds, which is often considered a highly factual inquiry more appropriate for summary judgment. Moreover, the decision demonstrates the applicability of the SEC’s qualitative and quantitative factors to assess materiality, providing an additional tool for defendants at the motion to dismiss stage.
In another Second Circuit decision—Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015)—the court held that an issuer’s alleged failure to comply with disclosure obligations under Item 303 of SEC Regulation S-K can give rise to Section 10(b) liability. Generally, Section 10(b) prohibits materially untrue statements and omissions of information that would be necessary to avoid misleading investors, but does not create an affirmative duty to disclose any and all material information. In this case, the court concluded that Morgan Stanley had a duty to disclose certain long positions it took in 2007 on collateralized debt obligations as a “known trend or uncertainty” under Item 303. Although the Item 303 violation in Stratte-McClure was sufficient to impose Section 10(b) liability, the court clarified that not all Item 303 violations can create such liability because Item 303’s materiality standard is not as onerous as the materiality standard under Section 10(b). Notably, this decision directly conflicts with the Ninth Circuit’s decision in In re Nvidia Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014), which concluded that Item 303 disclosure duties are not actionable in a Section 10(b) claim. Although Stratte-McClure was dismissed for failing to meet pleading standards, this decision potentially exposes issuers to increased Section 10(b) liability under the various general disclosure obligations outlined under Item 303.
In the Ninth Circuit—in In re Yahoo! Inc. Securities Litigation, No. 12-17080, 2015 U.S. App. LEXIS 8050 (9th Cir. May 15, 2015)—the court affirmed the dismissal of a securities class action regarding certain alleged misstatements Yahoo! made about its stake in Chinese e-commerce giant, Alibaba Holding Group Ltd. The plaintiffs alleged that Yahoo! made two misrepresentations when it did not disclose estimates about the value of Alibaba’s privately-held businesses and later when it did not disclose details about the value or fact of Alibaba’s restructuring. In affirming the dismissal, the court held that the alleged misstatements regarding Yahoo!’s stake in Alibaba “neither stated nor implied anything regarding” the value of the company and that the alleged misstatements about Alibaba’s restructuring—although less detailed—“was entirely consistent” with the actual facts. The court held that these statements did not “affirmatively create an impression of a state of affairs that differed in a material way from the one that actually existed.” Consequently, the court held that the statements were immaterial and not actionable.
Two recent decisions involving the SEC and the DOJ also significantly touched upon the issue of materiality. In Flannery v. S.E.C., No. 15-1080, 2015 WL 8121647 (1st Cir. Dec. 9, 2015), the First Circuit vacated a SEC order imposing sanctions against two former employees of State Street Bank and Trust Company for alleged misstatements made to investors. Among the reasons for vacating the sanctions, the First Circuit found that a misstatement in a slide deck presented to investors was immaterial. The misstatement consisted of a slide representing the fund’s typical allocation as 55% in a certain investment, when in fact the fund’s investment was nearly 100%. Although the slide was deemed misleading by the court, the materiality showing was “marginal” because investors had numerous other avenues to obtain accurate information about the fund’s actual allocation. For example, accura