Pomerantz LLP

Study Shows Drastically Increased Concentration Of Corporate Economic Power

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR May/June 2017

A recent academic study of public corporations in America has produced a picture of dramatically increased business concentration over the past 40 years. The study, done by professors Kahle and Stulz of Arizona State and Ohio State universities, respectively, which was published earlier this year, reveals the following startling facts about corporate

America in 2015 vs. 1975:

• In 1975, there were 4,819 publicly listed U.S. corporations. In 1997 there were 7,507. In 2015 there were only 3,766.

• Despite this decline, the aggregate market capitalization of U.S. public companies is seven times larger, in constant dollars, than it was in 1975. The 2015 mean and median market values of the equity of public companies (in

constant 2015 dollars) is almost 10 times the market values in 1975. In short, although there are far fewer public companies, they are far larger than ever before.

• An ever smaller proportion of public companies are responsible for most of the profits and assets. In 1975, 94 companies accounted for half of the assets of all public companies and 109 companies accounted for half of the net income. In 2015, 35 corporations accounted for half of the assets and 30 accounted for half of the net income.

• Capital expenditures as a percentage of assets fell by half between 1975 and 2015, while R&D expenditure increased fivefold. Capital expenditures are depreciated over time while R&D costs are expensed in the year incurred.

• In 1980, the first year for which the data are complete, the authors found that institutional owners represented 17.7% of ownership of U.S public companies. By 2015, the figure was 50.4%.

• The highest percent of net income paid out to shareholders during the 40-year period between 1975 and 2015 was in 2015. These payouts were not mostly in the form of dividends, but instead, of share repurchases.

It seems as if the “winner take all” phenomenon of outsized financial rewards for the top one percent of the population seems to apply at the corporate level as well.

As wealth becomes more and more concentrated, so too is the influence of the wealthy, not only in the business world but in the political world as well. Particularly after the Citizens United case, super-wealthy individuals and corporations are free to throw their financial weight around.

Other Shoes Keep Dropping At Wells Fargo -- But Is It Enought?

Attorney: Tamar A. Weinrib
POMERANTZ MONITOR May/June 2017

Though every attempt was made at first to “blame the little guy,” Wells Fargo executives have finally been called to task for an egregious scandal over fraudulent accounts, with the CEO fired and over $182 million in executive compensation rescinded.

As the Los Angeles Times first revealed back in 2013, and as the Monitor has recently reported, a pervasive culture of aggressive sales goals at Wells Fargo pushed thousands of workers to open as many as 2 million accounts that bank customers never wanted. This happened because low-level, low-wage employees had to meet strict quotas for opening new customer accounts, or risk their positions. To meet these quotas, the employees opened unneeded accounts for customers and forged clients’ signatures on documents authorizing these accounts. Wells Fargo employees called the bank’s practice “sandbagging” and a “sell or die” quota system. More recent reports have surfaced based on sworn statements signed by former Wells Fargo employees that indicate their former bank superiors instructed them to target Native Americans, illegal immigrants and college students as they sought to open sham accounts to meet the bank’s onerous sales goals.

Once the scandal hit the media, rather than placing accountability on those at the helm responsible for the corporate culture that fostered the scheme, Wells Fargo fired 5,300 low-level employees for creating the unauthorized accounts. However, that all changed after Wells Fargo agreed to a $185-million settlement in September 2016 with Los Angeles City Attorney Mike Feuer, the Consumer Financial Protection Bureau and the Office of the Comptroller of the Currency, to end investigations into the unauthorized accounts. Feuer had conducted his own investigation and then sued Wells Fargo, saying the bank’s impossible sales quotas had encouraged “unfair, unlawful, and fraudulent conduct” by employees forced to meet them. Notably, the bank did not admit any wrongdoing as part of the settlement, but apologized to customers and announced steps to change its sales practices. The $185 million settlement consisted of $100 million to the Consumer Financial Protection Bureau—the largest fine the federal agency has ever imposed—as well as $50 million to the city and county of Los Angeles and $35 million to the Office of the Comptroller of the Currency.

Also in September 2016, Wells Fargo CEO John Stumpf appeared before the Senate Banking Committee, where he was grilled by Senator Elizabeth Warren of Massachusetts. Berating Stumpf and noting the shocking lack of accountability, Senator Warren stated: “So, you haven’t resigned, you haven’t returned a single nickel of your personal earnings, you haven’t fired a single senior executive. Instead, evidently, your definition of accountable is to push the blame to your low-level employees who don’t have the money for a fancy PR firm to defend themselves. It’s gutless leadership.” In March 2017, Wells Fargo reached a $110 million preliminary settlement to compensate all customers who claim the scandal-ridden bank opened fake accounts and other products in their name.

Moreover, the independent directors on Wells Fargo’s board created an Oversight Committee to investigate the improper sales practices and to make recommendations to the independent directors. The investigation, assisted by outside counsel Sherman & Sterling, resulted in a detailed 110-page report that the bank released on April 10, 2017. The report laid the blame squarely on the shoulders of former CEO Stumpf and former head of the bank’s community banking business, Carrier Tolstedt— both of whom resigned in the fall of 2016 shortly after the Senate Banking Committee session. As a result of the report, the Wells Fargo Board was determined to clawback approximately $75 million in compensation from the two executives, which is in addition to the $60 million in unvested equity awards Stumpf and Tolstedt agreed to forfeit at the time of their ouster. The claw backs are reportedly the largest in banking history and one of the biggest ever in corporate America. They’re also unprecedented in that they are not called for by either Sarbanes -Oxley or the Dodd-Frank Act, both of which provide for claw backs only in the event of a restatement of financial results. The board also required the forfeiture or clawback of an additional $47.5 million in compensation from other former bank executives, bringing the total amount of compensation that the board has reclaimed to $182.8 million. This is apparently the second-largest clawback of executive compensation in history; and its massive size underscores how high executive compensation was at this bank. The bank also assured the public it has ended its sales quota program.

However, even though repercussions have appropriately made their way to the executive suite, many say it’s not enough. Specifically, angry shareholders claim that the board itself needs to be held responsible for what happened here. Indeed, in April 2017, Institutional Shareholder Services, which advises big investment firms about corporate governance issues, recommended that Wells Fargo’s shareholders oppose the re-election of 12 of the bank’s 15 board members at the bank’s annual meeting. Ultimately, all the board members were re-elected, but some by very small margins, even though they were running unopposed. Shareholders also asked why KPMG, Wells Fargo’s auditor, didn’t discover the phony accounts. Senator Warren and Senator Edward Markey agreed, and called upon the Public Company Accounting Oversight Board, which sets standards for audits of public companies, to review KPMG’s work for Wells Fargo.

Ninth Circuit Extends Whistleblower Protections To Employees Who Report Fraud to Management

ATTORNEY: AATIF IQBAL
POMERANTZ MONITOR MAY/JUNE 2017

Corporate employee-informants play an essential role in the enforcement of the federal securities laws. By reporting wrongdoing that might otherwise be very difficult for outside investors to detect, informants can make it easier to investigate and correct ongoing frauds, limiting the harm inflicted on investors as well as the broader public. In fact, according to a 2008 study by the Association of Certified Fraud Examiners, frauds are more likely to come to light through whistleblower tips than through internal controls, internal or external audits, or any other means.

Because confidential informants play such a vital role in disclosing and deterring securities fraud, the law recognizes the importance of protecting them from retaliation. The Sarbanes-Oxley Act of 2002 (“SOX”) requires companies to create robust internal compliance systems through which employees can anonymously report misconduct, and it protects such employees from any adverse employment consequences that might result. Significantly, SOX requires that certain employees first report violations internally, to allow the company to take corrective action before the SEC gets involved. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 further expands informants’ incentives by directing the SEC to pay a bounty to any “whistleblowers” who provide the SEC with information leading to a successful enforcement action.

Dodd-Frank includes an anti-retaliation provision that prohibits employers from retaliating against a “whistleblower” for acting lawfully within three categories of protected activity: (1) providing information to the SEC, (2) assisting in any SEC investigation or action related to such information, or (3) “making disclosures that are required or protected  under” SOX or any securities law, rule, or regulation.

In recent years, some corporate defendants have argued that Dodd-Frank’s anti-retaliation provision does not protect employees who complain internally about wrongdoing if they do not report to the SEC before they suffer retaliation. They argue that the provision’s text only protects a “whistleblower,” which Dodd-Frank elsewhere defines as an individual “who provides information relating to a violation of the securities laws to the Commission.” So, if an employee reports a suspected violation to a supervisor or internal compliance officer and is then fired before he can report to the SEC, he is not a “whistleblower” as defined under Dodd-Frank’s anti-retaliation provision.

In March 2017, the Ninth Circuit rejected this argument in Somers v. Digital Realty Trust. The plaintiff had complained to senior management about “serious misconduct” by his supervisor, but was fired before he could report to the SEC. The district court denied the company’s motion to dismiss, holding that, because the plaintiff was fired for internally reporting a suspected violation—in other words, for “making disclosures that are required or protected under” SOX—he was protected under Dodd-Frank’s anti-retaliation provision.

The Ninth Circuit affirmed, holding that Dodd-Frank’s anti-retaliation provision “necessarily bars retaliation against an employee of a public company who reports violations to the boss.” In reaching its conclusion, the Ninth Circuit emphasized “the background of twenty-first century statutes to curb securities abuses,” noting that SOX did not just strongly encourage internal reporting; it prohibited certain employees, such as lawyers, from reporting to the SEC until they’d first reported internally. Dodd-Frank’s antiretaliation provision “would be narrowed to the point of absurdity” unless it protected employees who reported internally; otherwise, the law would require lawyers to report internally and then “do nothing to protect these employees from immediate retaliation in response to their initial internal report.” The Ninth Circuit thus agreed with the Second Circuit, which had reached the same conclusion in 2015 in Berman v. Neo@Ogilvy LLC.

Dodd-Frank’s promise of robust anti-retaliation protection is critical to deterring and correcting corporate fraud. By protecting whistleblowers whether they speak up internally or to law enforcement, the Ninth Circuit has helped ensure that both the external securities regulation system and the internal compliance system within each company can make use of these whistleblowers’ knowledge and insights in combating corporate fraud—and that wrongdoers cannot avoid the whistleblower protections entirely by firing any employee who reports misconduct internally, before he or she has the chance to inform the SEC.

Gorsuch Appointment Takes Partisanship To A New Level

ATTORNEYS: H. Adam Prussin and Jessica N. Dell
POMERANTZ MONITOR May/June 2017

Quick quiz: who wrote this?

the politicization of the judiciary undermines the only real asset it has — its independence. Judges come to be seen as politicians and their confirmations become just another avenue of political warfare. Respect for the role of judges and the legitimacy of the judiciary branch as a whole diminishes. The judiciary’s diminishing claim to neutrality and independence is exemplified by a recent, historic shift in the Senate’s confirmation process. Where trial-court and appeals-court nominees were once routinely confirmed on voice vote, they are now routinely subjected to ideological litmus tests, filibusters, and vicious interest-group attacks.

Our readers may be surprised to learn that the answer is none other than Neil Gorsuch, President Trump’s appointee to the Supreme Court. After this article appeared in 2005, he was appointed to the Tenth Circuit Court of Appeals and, a few weeks ago, was confirmed to fill the Supreme Court vacancy created by Justice Scalia’s passing in February 2016.

What better example of confirmation through “political warfare” could there possibly have been? Republicans had scuttled President Obama’s nomination of MerrickGarland, refusing to grant Judge Garland evena hearing in the Senate, in the hope that a Republican would win the presidency a year later and appoint a more conservative justice. Once Trump was elected, his new administration immediately began the push for Judge Gorsuch’s confirmation, to restore a 5-4 majority on the court for Republican appointees. When Senate Republican leaders couldn’t rally the requisite 60votes to confirm him, they changed the rules to allow Gorsuch (and all future nominees) confirmation by a simple majority. And a simple majority was all that he got, as both parties voted almost strictly along party lines to deliver the most politicallypolarized judicial confirmation in history.

Ironically, Gorsuch’s 2005 article put all the blame on liberals for the politicization of the Supreme Court. It was they, he said, who supposedly relied too heavily on unelected judges to advance their policy objectives. The passing of time, however, hasshown that Republicans can play that game at least as well as Democrats. Garland’s totally partisan rebuff, followed by Gorsuch’s totally partisan confirmation, come on the heels of a series of conservative crusades in the courts including, most notably, their efforts to allow corporate cash to flow unfettered into elections, and multiple attempts to strike down or cripple the Affordable Care Act, and to create a whole new free-fire zone of unlimited gun rights.

Although Gorsuch’s appointment raises a host of concerns, those of us who represent investor rights are especially troubled. In 2005, when he was a member of the Bush Justice Department, he wrote another article, which appeared in Andrews Securities Litigation, where he made plain his hostility to shareholder class actions. The first section of his article is entitled “The Incentive To Bring and the Pressure To Settle Meritless Suits”; the second is headed “The Incentive To Reward Class Counsel but Not Necessarily Class Members”; followed by a series of suggestions for choking off these “meritless” securities cases, most of which come from (or found their way into) the standard defense bar playbook. Prominent among them are his proposals for tightening “loss causation” pleading requirements and for slashing fees awarded to counsel for shareholders. Justice Gorsuch is not going to be a friend to investors. Sadly, the first case he heard after joining the Court was a securities case brought by CALPers.

There are other grounds for concern about Justice Gorsuch’s legal views. Some of them include his belief that corporations are people entitled to constitutional protections, including the rights to buy elections, avoid government regulation and oversight, and to impose management’s religious convictions on their employees. His views prompted Emily Bazelon of the New York Times to write that “Gorsuch embraces a judicial philosophy that would do nothing less than undermine the structure of modern government — including the rules that keep our water clean, regulate the financial markets andprotect workers and consumers.”

As a judge, Gorsuch’s most notable decision might have been his joinder in most of the Tenth Circuit’s en banc ruling in Hobby Lobby Stores, Inc. v. Sebelius, which famously held that the religious beliefs of the owners of a closely held corporation could be imputed to the company and justify its refusal to comply with the law. At issue were the religious beliefs of David Green, the evangelical Christian CEO of the chain. Green claimed that Hobby Lobby was exempt from providing coverage for the full range of contraceptives for his employees under the Affordable Care Act because of his own religious convictions. Gorsuch agreed that those religious beliefs could be considered to be the beliefs of his corporation, and that the Religious Freedom Restoration Act, which protects the religious freedom of all “persons,” therefore applied. Confronted on the topic of Hobby Lobby after his nomination, and asked how he could read the Religious Freedom Restoration Act to include corporations, Gorsuch said he relied on existing case law that support the idea that corporations could be considered as having the same rights as individuals. “Congress could change that if it thinks otherwise,” Gorsuch said. “… and it was affirmed by the Supreme Court.” The Hobby Lobby decision was indeed upheld by the Supreme Court.

If you are a fan of the rights of corporations to impose their will on individuals, while being immune from the claims of their own shareholders, then you will love Justice Gorsuch.

The Supreme Court To Review Duty To Disclose

Attorney: Brenda Szydlo
Pomerantz Monitor May/June 2017

The Supreme Court recently granted certiorari in Leidos, Inc. v. Indiana Public Retirement System, taking up the question whether the Second Circuit erred in holding that Item 303 of SEC Regulation S-K, which imposes specific disclosure requirements on public companies, creates a duty to disclose that is actionable under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The high court’s decision will resolve a split between the Second and Ninth Circuits, and could expand the playing field to other circuits by giving investors a powerful tool – the ability to use an SEC disclosure regulation as the basis for a securities fraud claim.

The Second Circuit’s decision in Leidos revived a Section 10(b) suit by investors against a government contractor that failed to disclose in its March 2011 Form 10-K a kickback scheme’s impact as a known trend or uncertainty reasonably expected to have a material impact on the corporation’s financial condition in violation of Item 303. The court stated that in Stratte-McClure v. Morgan Stanley, “we held that Item 303 imposes an ‘affirmative duty to disclose . . . [that] can serve as the basis for a securities fraud claim under Section 10(b)[,]’” and now “hold that Item 303  requires the registrant to disclose only those trends, events, or uncertainties that it actually knows of when it files the relevant report with the SEC.” The court concluded that the proposed amended complaint supported a strong inference that Leidos actually knew about the fraud before filing the 10-K, and that it could be implicated and required to repay the revenue it generated to the City of New York.

The Second Circuit’s holding in Leidos is in direct conflict with the Ninth Circuit’s decision in In re NVIDIA Corp. Sec. Litig. In finding that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b- 5[,]” the Ninth Circuit relied on the Third Circuit’s opinion in Oran v. Stafford, written by then-Judge Samuel Alito. In Oran, Justice Alito wrote that “a violation of SK-303’s reporting requirements does not automatically give rise to a material omission under Rule 10b-5” and further held that the duty did not arise under the specific facts of the case. (Emphasis added).

The Supreme Court’s decision in Leidos could be potentially explosive. In Matrixx Initiatives, Inc. v. Siracusano, the Supreme Court held that Section 10(b) and Rule 10b-5 do not create an affirmative duty for public companies to disclose material information, except in cases where an omission renders an affirmative statement misleading. As the Supreme Court stated in Basic v. Levinson, “[s]ilence, absent a duty to disclose, is not misleading under Rule 10b-5.” But the Supreme Court’s decision in Leidos could significantly alter the securities fraud landscape, in that public companies could be subjected to securities fraud liability for failing to comply with Item 303’s duty to disclose information about a subject it had been completely silent about.

Regulation S-K, and Item 303 in particular, set forth comprehensive reporting requirements for various SEC filings. If failure to disclose information required by Item 303 can serve as the basis for fraud, and the same is true for other regulations requiring disclosure of specific information, we could be on the verge of a new era in securities fraud litigation.

Private litigants should have the right to assert securities fraud claims against public companies that hide material information in violation of SEC disclosure regulations. There is no question that the failure to disclose immaterial information cannot support liability, even if Item 303 requires that it be disclosed. However, others will contend that the litigation floodgates will be opened if the high court sides with the Second Circuit and expands silence as a basis for securities fraud claims. Given the importance of the outcome, Leidos warrants careful observation.

Judge Rakoff Challenges The Securities Bar

ATTORNEY: MATTHEW C. MOEHLMAN
POMERANTZ MONITOR MARCH/APRIL 2017

On July 3, 2016, the European Union implemented Market Abuse Regulation (“MAR”), a rulebook that governs, in part, enforcement of insider trading violations. MAR differs sharply from the American approach to insider trading law in that it does not require the government to link the trade to a known breach of fiduciary duty.

In a speech earlier this month to the New York City Bar Association, U.S. District Judge Jed S. Rakoff challenged the securities bar to draft a statute that would provide needed clarity to U.S. courts trying to make sense of the confusing tangle of judge-made insider trading law and
pointed to MAR as a potential model.

Judge Rakoff suggested that most of the headaches created by U.S. insider trading law arise from judgemade requirements, such as that trading on inside information can be a crime only if the tippee knew that the tipper breached a fiduciary duty. Not only that, but that breach must involve betraying confidences of an employer, and also receiving some kind of personal benefit in exchange.

Judge Rakoff knows these difficulties well. He gave his speech three months after the Supreme Court ruled in the insider trading case Salman v. United States. As we reported in the last issue of the Monitor, Salman held that someone who trades on inside information can be found guilty even if the source of the information was a friend or family member of the tippee, and did not receive a financial quid pro quo. Salman affirmed a 2015 ruling that Judge Rakoff had authored while sitting by designation on the Ninth Circuit Court of Appeals. In a further twist, Rakoff’s Ninth Circuit opinion in Salman relied on his reasoning in a 2013 insider trading decision, which the Second Circuit had reversed on appeal in 2014 in U.S. v. Newman. In effect, Judge Rakoff single-handedly created the circuit split that led the Supreme Court to validate his overturned district court ruling.

But Salman resolved just one of a myriad of issues surrounding insider trading: whether a tip to a friend or relative, without a financial quid pro quo, supports a claim of insider trading. As Rakoff noted in his speech, U.S. insider trading law is a judicial creation based on generalized
antifraud provisions of the federal securities laws. There is no statutory definition of what constitutes inside information, or when a tippee violates the law by trading on it. The result has been that decades of often inconsistent judicial decisions have congealed into a common law morass that erodes investor confidence in the U.S. capital markets.

Some of the difficulties of insider trading law are illustrated by the prosecutions brought by Preet Bharara, the former U.S. Attorney for the Southern District of New York. Notably, he secured a conviction in 2011 of Raj Rajaratnam, the founder of hedge fund Galleon
Group. But when Bharara decided to take on Steven A. Cohen, the hedge fund billionaire who founded S.A.C. Capital Advisors (“SAC”), he ran into a wall created by the requirement that a tippee, to be liable, has to be aware that the source of the inside information violated a fiduciary duty by disclosing it. Bharara decided not to go after Cohen.

As recounted in a recent New Yorker article, Bharara’s decision rested in part on the difficulty
in making the necessary evidentiary showing. The government’s best evidence against Cohen
was an email from one of his traders that conveyed inside information. To win, the government
had to convince a jury that Cohen not only read the email—one of a thousand or so he received
every day—but also that he read to the end of the email chain and realized that the trader’s source had breached a fiduciary duty. Even Bharara, not known for timidity, blinked when faced with an opponent with billions to spend on his defense and a burden of proof that becomes more difficult to carry the more remote the tipper is from the tippee. Instead, Bharara settled for convictions of two of Cohen’s top traders and a $1.8 billion penalty paid by Cohen’s company, SAC. Cohen skated. After shuttering SAC, he set up shop under a new company, and went on trading as if nothing had happened.

Just as telling, even the narrow ruling in Salman, which criminalizes trading on uncompensated tips from friends and relatives, is subject to nitpicking. One of the former SAC traders that Bharaha managed to convict, Mathew Martoma, has appealed his conviction to the Second Circuit on the grounds that the friendship by which the information was passed to him was not a “meaningfully close” friendship.

By contrast, under MAR, the EU treats insider trading as a threat to the proper functioning of the capital markets, in that it impedes transparency. Article 7 of MAR defines “inside information” as non-public information which, if revealed, would significantly affect the price of a security. Regarding tippee liability, Article 8 says that it is “insider dealing” where a tippee uses the tip and “knows or ought to know” that the tip is “based upon inside information.” This approach eliminates the fiduciary duty element of U.S. law, which Judge Rakoff has characterized as a “pretty complicated formulation.” Moreover, in cases against top executives like Steven Cohen, who are often several degrees of separation distant from the source of the tip, it increases the prosecutor’s ability to discern whether the law has been violated. While MAR is a new and relatively untested template, it has the potential to create a clear set of guidelines for traders, regulators, prosecutors and courts to follow, and a regime that the
market can trust.

Pomerantz is familiar with the proof issues in SAC, having recently settled a civil suit for insider trading against Cohen and SAC for $135 million, on claims not pursued by the government.

A Bad Choice For Auditor Reviews

ATTORNEY: JOSHUA B. SILVERMAN
POMERANTZ MONITOR MARCH/APRIL 2017

Tucked away in the latest Dodd-Frank reform bill is a provision that threatens to roll back crucial
investor protections for nearly a third of public companies. House Financial Services Committee
Chair Jeb Hensarling’s proposal, called CHOICE 2.0, would exempt all companies with market capitalization below $500 million, and all depository institutions with assets below $1 billion, from auditor review of internal controls. Currently, only the smallest companies – those with market capitalization below $75 million – are exempt from the requirement.

The auditor attestation requirement of Section 404(b) of the Sarbanes-Oxley Act of 2002
serves an important purpose. It helps to identify deficiencies in internal controls over financial
reporting, so that companies can fix those deficiencies at an early stage. Expanding the Section 404(b) exemption to $500 million would increase the number of exempt companies approximately eight-fold. The proposed expansion would also exempt some constituents of common market indices like the Russell 2000 and Russell 3000 from auditor review of financial controls.

While all companies that have been public for more than one year are required to have management attest to the sufficiency of internal controls, repeated academic studies show that the auditor review under Section 404(b) is far more effective. The studies demonstrate
that companies exempt from auditor attestation have a higher rate of accounting irregularities and restatements than those subject to the Section 404(b) requirement. Moreover, a review by the Government Accounting Office, required under Dodd-Frank, determined that compliance with Section 404(b) has a positive impact on investor confidence in the quality of financial reports. A recent analysis from MarketWatch’s Francine McKenna shows that the concern is more than academic. It found that approximately 11.4% of the non-bank companies that received an auditor internal control over financial reporting opinion in 2015 but would be exempted by Hensarling’s bill reported ineffective internal controls. 8.6% of the banks that would be exempted had control deficiencies. If CHOICE 2.0 is implemented, 
investors would not learn of these problems until it was too late.

The measure’s proponents incorrectly claim that removing the requirement will increase initial public offerings of small and mid-market companies. This is a red herring. Newly-public companies are not subject to the requirements of Section 404(b). Regardless of market
capitalization, no company needs to provide a Section 404(b) auditor attestation at the time it goes public, or even with its first annual report as a public company on SEC Form 10-K. The auditor attestation is only required after a company has already filed a full years’ worth of
periodic reports as a public company. Moreover, as an SEC study has determined, the cost to comply with Section 404(b) has declined significantly.

Nor does the broader regulatory environment justify stripping this important investor protection. Scores of recent measures such as the JOBS Act and Regulation A+ have already slashed red tape for small and middle market companies seeking to tap public markets. 
Companies choosing to remain private do so largely because they can easily raise money from private equity firms and lenders, not because current regulatory burdens are excessive.

When a proposal was introduced in 2014 to expand the Section 404(b) exemption to only $250 million, the Center for Audit Quality and the Council for Institutional Investors warned in a joint letter to the House Financial Services Committee that the assurance provided under
that statute was “an important driver of confidence in the integrity of financial reporting and in the fairness of our capital markets.” The expansion proposed today is twice as large, and would cause an even greater threat to investor confidence and accounting integrity.

 

Class Action “Reform” In The Age Of Trump

ATTORNEY: J. ALEXANDER HOOD II
POMERANTZ MONITOR MARCH/APRIL 2017

In February 2017, Rep. Goodlatte (R-Va.), Chairman of the House Judiciary Committee, introduced the Fairness in Class Action Litigation Act (H.R. 985), a bill that, if passed as written, would make it more difficult for plaintiffs to pursue class action litigation. Rep. Goodlatte was an author of the Class Action Fairness Act of 2005, which limited the ability to bring class actions in state courts. With Republicans now controlling both chambers of Congress and the White House, H.R. 985 stands a very real chance of becoming law. While the ultimate impact on securities class actions is unclear, as written the bill presents a near existential threat to the class action in its current form.

In a press release announcing the bill, Rep. Goodlatte made clear his disdain for class action litigation. “The current state of class action litigation has become an expensive business, and one easily gamed by trial lawyers to their own advantages.” He went on to describe the bill’s goal as “to maximize recoveries by deserving victims, and weed out unmeritorious claims that would otherwise siphon resources away from innocent parties.” According to Rep. Goodlatte, H.R. 985 “will keep baseless class action suits away from innocent parties, while still keeping the doors to justice open for parties with real and legitimate claims, and maximizing their recoveries.” Touting his experience authoring the Class Action Fairness Act of 2005, Rep. Goodlatte highlighted several provisions of the bill purportedly designed to close attorney-exploited loopholes and advance “fairness” for both “deserving victims” and “innocent parties”: preventing class actions filed by attorneys who are relatives of parties in the litigation; requiring that plaintiffs’ attorneys may only be paid after class members have been paid; and requiring disclosure to the court of any third-party litigation funding agreements.

Yet key features of H.R. 985 have nothing to do with weeding out frivolous claims or protecting “innocent parties.” Rather, the bill, as designed, would make it more difficult to prosecute any claims in class actions. For example, the bill prohibits federal judges from certifying a class unless “each proposed class member suffered the same type and scope of injury as the named class representative or representatives.” Limiting the range of injuries to be adjudicated in a single action naturally educes the number of claims that can be aggregated.

Perhaps of the greatest significance for securities class actions, however, is a subsection titled “Prohibition of Conflicts,” which precludes federal judges from certifying a class for which the lead plaintiff is “a present or former client of . . . or has any contractual relationship with” class counsel. This provision would make it significantly more difficult to bring claims, either as a plaintiff or class counsel. In particular, this provision would prevent institutional plaintiffs from selecting the same firm as lead counsel in multiple litigations. The broad language of the bill, which precludes a lead plaintiff from retaining a firm it has “any contractual relationship with” whatsoever, would even prevent an investor from selecting as lead counsel a firm that
had previously merely provided portfolio monitoring services to the investor. 

As Professor John Coffee, an eminent commentator on securities law, stated in his recent article critiquing this bill, “the standard pattern in securities class actions” is for a “public pension fund [to] act as a lead plaintiff and retains a major plaintiff’s law firm that it has used before (presumably because it was satisfied with its prior efforts) …. Because the client may not use a firm that it has ever previously retained (apparently for any purpose), the result is to impose a legal regime of “one night stands” on clients and their counsel. Who benefits from this? The only plausible answer is: defendants!” Professor Coffee also notes that the provision may be unconstitutional because “several Circuits have repeatedly held that the Due Process Clause guarantees not simply the client’s right to retain counsel in a civil case, but “the right to choose the lawyer who will provide that representation.” Similarly, legal blogger Alison Frankel observed that “[s]ophisticated plaintiffs in complex securities and antitrust litigation need specialized lawyers, just like defendants in the same cases. … Why should a corporation be allowed to have an ongoing relationship with outside counsel but not a pension fund acting as a lead plaintiff?”

Interfering with an institution’s choice of counsel has nothing to do with weeding out frivolous claims or protecting the innocent. It is simply intended to discourage any financial institution from acting as a class representative. Notably, existing law (The Private Securities Litigation Reform Act of 1995 (the “PSLRA”)) already prohibits any institution from serving as a lead plaintiff in more than five securities class actions over a three year period.

The effect of this provision stands in marked contrast to the stated goal of the PSLRA, which was to encourage institutional investors to assume a greater role in securities class actions. In part, the rationale underlying this goal was that institutional investors, compared to “retail” investors, are sufficiently sophisticated to take an informed and active role in the litigation process, thus ensuring that the interests of the plaintiff remain front and center, while minimizing concerns about attorney-driven litigation. This new bill, for its part, purports to protect plaintiffs from unscrupulous attorneys who would take advantage of them, but actively
denies institutional investors the option of working with attorneys with whom they have an existing relationship, practically ensuring that the most sophisticated plaintiffs assume a diminished role in class actions.

H.R. 985 would also provide a host of other procedural obstacles to the prosecutions of class actions, whether or not those actions are meritorious. As Professor Coffee notes, the bill “would also slow the pace of class actions to a crawl. [because it] permits appeals of orders granting or denying class certification as a matter of right. Today, such interlocutory appeals are discretionary with the appellate court (and are infrequently granted). … Second, discovery
is halted if defendant makes any of a variety of motions ….Predictably, such motions will be made one after another, in seriation fashion, to delay discovery.” 

At present, the full scope and application of H.R. 985 remains unclear. A recent Wall Street Journal article reported that Lisa Rickard, president of the Institute for Legal Reform of the U.S. Chamber of Commerce, a major backer of the bill, has indicated that the bill is not intended “to restrict securities class actions . . . and will likely be clarified as it moves forward through the House and Senate.” Nonetheless, as drafted, nothing in H.R. 985 limits the scope
of its provisions to exclude securities class actions, and Ms. Rickard has previously characterized securities class actions as “betraying the individual investors [they are] designed to assist.” Several amendments proposed by Democrats that would have provided carve-outs for certain types of class actions were voted down in committee.

All of this, of course, presupposes that the legislation ultimately passes both the House and Senate and is signed into law—and even with Republican majorities in both chambers, this is not a foregone conclusion. At the time of this writing, H.R. 985 had narrowly passed through the House by a margin of 220-201, with all Democrats and 15 Republicans voting against it. Legitimate doubts exist as to whether the Senate Judiciary Committee, despite being controlled by Republicans, would let the bill out of committee without some measure of bipartisan support.

 

Recovery Of Reputational Damages In Securities Fraud Cases

ATTORNEY: MARC I. GROSS
POMERANTZ MONITOR MARCH/APRIL 2017

To paraphrase Tolstoy, while all good companies may be alike, all frauds are not. Corporate frauds usually involve lies about financial information, such as historic results or future prospects. The financial impact of these frauds on the company’s stock price is foreseeable and easily measured. However, the effects of lies that reflect the lack of management integrity or ineffectiveness of corporate governance controls are arguably less readily measured. These lies often have only a small direct impact on the bottom line; but when the truth is revealed, the effect on the company’s stock price can be substantial. Such stock price effects, sometimes referred to as “reputational losses” or “collateral damage,” are attributable to the market’s  reassessment of investor risks, including possible management turnover, or the possibility that problems lieahead. Nonetheless, the ability to recover the damages in these instances is disputed by some corporations and academics.

A textbook example of reputational losses is what happened at Wells Fargo. At the beginning of September 2016, the bank had surpassed its rivals to become the largest financial institution measured by stock market capitalization, with assets exceeding $100 billion. It had distinguished itself from peers through its “cross-selling” policy, i.e., marketing a menu of products (such as savings accounts and insurances policies) to checking account customers. Wells Fargo touted its cross-selling successes in shareholder reports, which were closely followed by analysts.

However, on September 8, 2016, investors were shocked to learn that the bank had agreed to pay $190 million to regulators to settle claims arising out of abusive cross-selling practices. Senior management’s pressure to meet astronomical cross selling “goals” – which was actually a euphemism for quotas – had pushed branch bank officers to engage in abusive and illegal practices in order to meet those quotas. Without informing their customers, much less obtaining their consent, bank officers withdrew funds from customers’ checking accounts near the end of the quarter, placed the funds in a new savings account for the customers, and then reversed the transactions at the beginning of the next quarter. Such schemes allowed bank officers to meet their quotas, while customers often found themselves paying overdraft fees when their checks unexpectedly bounced.

Senior Wells Fargo officials were aware of the illegal practices, having fired over 5,000 bank employees over several years for doing this. However, management continued to pressure bankers to meet cross-selling quotas, and awarded multi-million dollar bonuses to the Executive Vice President responsible for implementing the practices, making further illegal acts by many employees inevitable.  

These illegal practices had virtually no effect at all on Wells Fargo’s bottom line. They resulted in only $2 million of additional revenues for the bank over a multi-year period, and even the $190 million regulatory settlement was like a drop in the bucket to such a giant company. Most telling, none of the financial data or cross-selling metrics were materially false. Nonetheless, concern about the adverse publicity, potential investigations and management shake-up caused Wells Fargo’s share price to tumble 6% within days of the September 8, 2016 disclosure. Declines continued as pressure mounted for the resignation of the bank’s CEO, John Stumpf. By the time Stumpf appeared to testify before a Congressional panel, Wells Fargo shares had fallen 16% -- although Wells Fargo’s financial condition and prospects had not significantly changed.

Another example of pure reputational losses arose last year with Lending Club, a leader of the newly minted “online” lending services. LendingClub focuses on sub-prime customers whose credit ratings are too low to qualify for loans from regular banks. Once the loans were made, Lending Club bundled them and sold them to funders.

On May 9, 2016, Lending Club’s CEO, Renaud Laplanche, was forced to resign following findings by an internal investigation that $22 million in loans had been improperly sold to the Jeffries Group (one of its funders), in contravention to Jeffries’ express instruction. There were also indications that Laplanche had undisclosed interests in one of the company’s potential funders. The size of the improperly sold loans paled in comparison to the billions that Lending Club lent over the last several years.

Again, nothing indicated that Lending Club’s historic performance had been inflated, nor that its operating model was flawed. However, once these infractions were disclosed, investors immediately drove the stock price down 30%.

Reputational Losses Are the Rule, Not the Exception.

They occur whenever financial missteps are disclosed, whether the effects on the bottom line are material or not. Studies have shown that when a company restates prior performance or future prospects, only a portion of the declines in stock price can be explained by the resulting recalibration of likely future cash flows, a primary factor in stock valuation. Significant, if not larger, portions of those declines arise from the market’s reassessment of management’s reliability or integrity. One study actually concluded that “[f]or each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $2.71, due to reputation loss.”

Market perceptions of managerial competence and integrity are a distinct and critical factor in determining the stock price. Disclosure of fraud, as it reflects a lack of corporate integrity, augments any stock price reaction triggered by revising reported results. When the reliability and credibility of statements issued by management is called into question, it increases the perceived information asymmetry between management and stockholders.

The SEC has embraced the view that management integrity is critical to shareholder valuation: “[t]he tone set by top management––the corporate environment or culture within which financial reporting occurs––is the most significant factor contributing to the integrity of the financial reporting process.” So too has the Public Company Accounting Oversight Board. Courts have also recognized the impact of management integrity on stock valuations, deciding that investors may base their investment decisions, at least in part, on factors such as management ethics and accountability.

Perhaps because these effects are undeniable and substantial, defendants in securities fraud actions increasingly argue that stock declines caused by revelations of integrity issues are not recoverable. The case for denying such recovery was made forcefully in a law review article by Cornell and Rutten in 2009, entitled Collateral Damage and Securities Litigation (“Cornell/Rutten”). The authors defined collateral damage as “the valuation impact of a corrective disclosure that does not correspond to the original inflation.” They explained that, if the original misconduct did not materially affect the company’s bottom line, it could not have inflated the company’s market price at the time of purchase; therefore, “because the original misstatement could not have inflated the stock price in an efficient market, the decline following the corrective disclosure must be due to collateral damage.” They concluded that “while collateral damage can have a material impact on securities prices, declines associated with collateral damage are not, and should not be, recoverable under section 10(b) of the Securities Exchange Act of 1934.”

Presumably this analysis could apply even when the underlying misconduct did have a material effect on the company’s bottom line, but the post-disclosure price drop is viewed as “disproportionate” to the specific financial impact of the fraud. Experts would then be called upon to parse out how much of the post-disclosure price drop was “proportional” and how much represents “collateral damage” caused by the realization that management was incompetent or corrupt.

It is true that, in assessing “loss causation,” a fundamental element of any securities fraud claim, courts have started with the precept that the underlying fraud must have inflated the purchase price of the stock, and that revelation of the fraud removed that inflation, injuring investors. Cornell/ Rutten’s fundamental assumption is that stock price inflation can be caused only by misstatements of financial information, such as revenue or cash flows. They fail to attribute any possible inflation to investors’ mistaken assumption of management integrity, and thus the reliability of statements regarding performance and outlook. But perceptions of competence and integrity are as critical as profits and losses in determining and maintaining the market price of a company’s stock. That is why, when such perceptions are shaken, the market price drops dramatically.

Public policy objectives also support recovery of such reputational losses. As noted by the Second Circuit in Gould v. Winstar Communs, Inc.:

 The argument is one of culpability and foreseeability. When a defendant violates section 10(b) by making a false statement to investors with scienter, the defendant in many cases should be able to foresee that when the falsity is revealed, collateral damage may result. As between the culpable defendant—who could foresee that investors would suffer the collateral damage—and the innocent investors, it would seem entirely appropriate to require the defendant to be the one to bear that loss.

 Thus, when a company makes affirmative misrepresentations concerning its managerial competence and integrity, there can be no doubt that those statements help inflate the market price of its stock. But it is just as true that, in the absence of any representations on this subject, investors should be entitled to assume that management has the basic integrity necessary to guiding a modern public corporation. Just as it is reasonable to recognize that investors are entitled to presume the “integrity of the market” (untainted by fraud), so too should investors be entitled to presume the “integrity of management” (untainted by a propensity to commit fraud). Recovery of such additional “reputational” damages is consistent with policies intended to curb securities fraud.

“Scheme Liability”: When Can Investors Sue Bad But Silent Actors For Securities Fraud?

Attorney: Michele S. Carino
Pomerantz Monitor January/February 2017

In Pomerantz’s precedent-setting Stoneridge case, the Supreme Court recognized that securities fraud can be committed by people who themselves make no public statements, but who nonetheless deploy a “device, scheme, or artifice to defraud” or engage in “any act, practice, or course of conduct” that defrauds a person in connection with the purchase or sale of a security – socalled “scheme liability.” Because deceptive conduct often accompanies or facilitates false statements, it has been difficult to discern what type of conduct, by itself, can satisfy this “scheme liability” standard. In other words, what is actionable fraudulent or deceptive conduct?

On December 28, 2016, in a case called Medtronic, the Eighth Circuit addressed that question. Medtronic involved claims that the company, its officers and senior managers and certain doctors had engaged in a scheme to defraud investors by concealing information related to Medtronic’s product, INFUSE, which was developed as an alternative to bone grafting procedures in spinal surgery. In particular, plaintiffs alleged that Medtronic violated the securities laws, because not only did it fail to disclose financial ties between the company and doctors who conducted the clinical trials for INFUSE, but it also paid doctors to conceal adverse events, employ weaker safety rules for clinical trials, and publish favorable articles promoting the product. Medtronic sought dismissal of the scheme liability claims, arguing that it could not be held liable for the false or misleading statements made by doctors concerning INFUSE, because it was not the “maker” of those statements. The district court agreed, and dismissed the case.

The Eighth Circuit reversed. In the first instance, it distinguished between scheme liability claims, which may be brought by private investors, and “aiding and abetting” claims, which cannot. The court explained that aiding  and abetting refers to situations where “entities … contribute ‘substantial assistance’ to the making of a [false] statement but do not actually make it.” For instance, if a supplier engaged in sham transactions with a company so that the company could boost its revenues and misstate its financials, the supplier cannot be held directly liable for the false statements made by the company. In contrast, scheme liability imposes primary liability “based on conduct beyond misrepresentations or omissions.” Thus, the actor has to actually do something besides knowing that a statement is false. As a result, the Eighth Circuit cautioned that “a plaintiff cannot support a scheme liability claim by simply repackaging a fraudulent misrepresentation as a scheme to defraud.

In Medtronic, the court found that “the act of paying physicians to induce their complicity is the allegation at the heart of the scheme liability claim.” This deceptive con duct was separate and apart from the misrepresentations themselves, and thus, not merely a “repackaging” of allegations to create a scheme.

The Eighth Circuit also reaffirmed that to state a claim based on a deceptive scheme, a plaintiff must allege that the market relied on the fraudulent conduct. Following the Supreme Court’s decision in Stoneridge, the court explained that this “causal connection” between the defendant’s deception and the plaintiffs’ injury was necessary to limit liability to conduct that affected the price of the company’s stock and therefore caused the plaintiff’s loss. Otherwise, scheme liability could be extended to all aiders and abettors whose conduct may have facilitated the fraud, but which did not reach the public. In Stoneridge, the Supreme Court held that the scheme liability claim failed, because investors could not demonstrate that they relied on defendants’ conduct, and thus, the necessary “causal link” was missing. But in Medtronic, the court found that Medtronic’s manipulation of clinical trials and concealment of adverse results directly caused the production of false information on which the market relied. Indeed, the company utilized the fraudulent scheme as a mechanism to convince investors of the company’s competitiveness and sustainability. Because reliance was established, the court upheld the scheme liability claim.

Although potential defendants may characterize the Eighth Circuit’s decision as a “back-door” to circumvent the restrictions on bringing claims against aiders and abettors, it is no such thing. Rather, the Eighth Circuit carefully defined the requirements for bringing a scheme liability claim consistent with the language of the securities laws, as well as the recognition by numerous courts that “conduct itself can be deceptive.” The Eighth Circuit’s decision highlights an important mechanism for investor recovery, because actors can and should be held accountable for their actions, as well as their words, particularly when markets are affected.

It’s Not OK To Leak Inside Information To Your “Trading Relative Or Friend”

Attorney: Jennifer Banner Sobers
Pomerantz Monitor January/February 2017

The past two years have seen a series of significant decisions on insider trading criminal liability, which all came to a head last month when the Supreme Court handed down its decision in Salman v. United States. The Court affirmed the conviction of a person who traded on inside information that he had received from a friend who was also a relative-by-marriage. It held that the recipient of inside information (the “tippee”) could be convicted even if the person who disclosed it (the “tipper”) did not receive any tangible financial benefit in exchange for tipping the information – a tipper is liable if s/he personally benefits by gifting confidential information to a trading relative or friend.

The issue started to percolate two years ago when, as we reported at the time, the Second Circuit issued a controversial decision in U.S. v. Newman. There, the court overturned the insider trading convictions of tippees who were several layers removed from the original tipper. The Second Circuit held, among other things, that in order to convict, the government had to provide evidence of a tangible quid pro quo between tipper and tippee. The court’s reasoning seemed to run afoul of the Supreme Court’s insider trading decision decided decades earlier, Dirks v. SEC, which held that tippee liability hinges on whether the tipper’s disclosure breaches a fiduciary duty, which occurs when the tipper discloses the information for a personal benefit. Further, the personal benefit may be inferred not only where the tipper receives something of value in exchange for the tip, but also if s/he makes a gift of confidential information to a trading relative or friend. The Second Circuit, by contrast, held that the government could not prove the receipt of a personal benefit by the mere fact of such intangible things as a friendship, or that individuals were alumni of the same school or attended the same church. The Supreme Court declined to review the Newman decision.

Less than a year later, the Ninth Circuit weighed in with its decision in U.S. v. Salman, in which it held that the “personal benefit” requirement did not always require that the tipper receive a financial quid pro quo. The court reasoned that the case was governed by Dirks’s holding that a tipper benefits personally by making a gift of confidential information to a trading relative or friend. With the split among the Circuits in place, this time the Supreme Court took up an appeal to settle the Circuit split on the “narrow issue” of whether the government must prove that a tipper received a monetary or financial benefit or whether gifting inside information to a trading relative or friend is enough to establish liability.

The Supreme Court upheld the Ninth Circuit’s analysis. Last month, SCOTUS found that Dirks “easily resolves” the narrow issue presented. It reasoned that under Dirks, when an insider makes a gift of confidential information to a trading relative or friend, the tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient. In these situations, the tipper personally benefits because giving a gift of trading information to a trading relative is the same thing as trading by the tipper followed by a gift of the proceeds – the tipper benefits either way. The Court consequently reasoned that by disclosing information as a gift to his brother with the expectation that he would trade on it, the former Citibank investment banker breached his duty of trust and confidence to Citigroup and its clients – a duty acquired and breached by Salman when he traded on the information with full knowledge that it had been improperly disclosed. Thus, SCOTUS decided that the Ninth Circuit properly applied Dirks to affirm Salman’s conviction.

This decision is in line with the direction most Justices seemed to be heading during oral argument, about which we most recently reported. At that time, SCOTUS seemed reluctant to side with Salman to find that a tipper does not personally benefit unless the tipper’s goal in disclosing information is to obtain money, property, or something of tangible value, which SCOTUS signaled during the argument would conflict with Dirks. Ultimately, the Court made clear in its decision that traders can be liable even if the insider does not receive a financial benefit for passing the tip as long as the insider makes a gift to a trading friend or relative.

In this decision, SCOTUS significantly noted that to the extent the Second Circuit in Newman held that the  tipper con must also receive something of a pecuniary or similarly valuable nature in exchange for a gift to a trading relative, that rule is inconsistent with Dirks. It is hard to believe that anyone could be more pleased about that pronouncement than Preet Bharara, United States Attorney for the Southern District of New York. Since the Newman decision, Bharara’s office has dropped at least a dozen cases against alleged inside traders, including ones who had already pled guilty, largely because of the Second Circuit’s analysis. The day SCOTUS handed down its decision, Bharara issued a press release in which he said “the Court stood up for common sense” and that the “decision is a victory for fair markets and those who believe that the system should not be rigged.”

However, the Supreme Court declined to take its decision to the other extreme that the government proffered – that a gift of confidential information to anyone, not just a trading relative or friend, is enough to prove securities fraud because a tipper personally benefits through any disclosure of confidential trading information for a personal purpose.

Indeed, SCOTUS did not venture any further than the contours of this case – the “gift of confidential information to a trading relative” – that Dirks envisioned. SCOTUS reaffirmed its statement in Dirks that “determining whether an insider personally benefits from a particular disclosure, a question of fact, will not always be easy for courts.” The Court seemed relieved that it did not have to “address those difficult cases” in deciding this case.

So what does this all mean? Well, in the wake of this decision, we will probably see a ramp up of insider trading prosecutions by Bharara’s office and other prosecutors in 2017 against people who passed insider tips to their relatives and friends.

However, the Salman decision did not address the other reasons the Second Circuit reversed the Newman defendants’ convictions, and in many instances, those additional obstacles could prove daunting. The Second Circuit held that the government had to prove not only that the tipper received a personal benefit, but also that defendants knew the information they traded on came from insiders and that the insiders received a personal benefit in exchange for the tips. These issues provide a significant bar for the government to overcome with respect to proving remote tippee liability, where the original tip is passed around from the original tippee to his or her colleagues, and those further down the information chain may know nothing about where the information came from, much less whether the tipper benefited from leaking the information. This is exactly what happened in Newman as Bharara’s office had become renowned for pursuing pre-Newman. Moreover, courts gained no learning from SCOTUS as to where to draw the line regarding how close a friend must be or how far removed a relative can be to trigger insider trading liability. Indeed, the court consistently referenced the precise wording in the Dirks decision, “trading relative,” presumably to avoid elaborating on what that actually means. Given the dearth of Supreme Court insider trading cases, courts may continue to struggle with these issues for years to come.

A Dark Cloud's Silver Lining: The First Circuit's Decision In Ariad Pharmaceuticals

Attorney: Louis C. Ludwig
Pomerantz Monitor: January/February 2017

On December 14, 2012, ARIAD Pharmaceuticals announced that the FDA had approved the marketing of ponatinib, a treatment for advanced-stage chronic myeloid leukemia (“CML”), a unique and especially deadly form of leukemia. Like many cancer-focused drug companies, ARIAD first secured approval for ponatinib to treat only the most gravely ill cancer patients. Ponatinib quickly became ARIAD’s most important drug, the linchpin of its entire business. The FDA’s action was not all good news, however, as it required ARIAD to include a “black box” warning on ponatinib’s label disclosing the risk of possibly deadly side effects, most notably adverse cardiovascular events. Meanwhile, ARIAD conducted further studies to see if the drug was safe and effective enough to use with expanded classes of patients, including those who were not as seriously ill.

Despite the black box warning, ARIAD nevertheless continued to publicly project confidence in ponatinib’s future. But before too long, more troubling news came out. First, on October 9, 2013, ARIAD informed investors that it was pausing enrollment in all clinical studies of ponatinib due to increased instances of medical complications. Days later, ARIAD disclosed that it had agreed to halt an international, open-label trial of ponatinib trial entirely. Finally, on October 31, ARIAD announced that it was “temporarily suspending the marketing and commercial distribution” of ponatinib at the direction of the FDA. The market reacted harshly, and ARIAD’s stock price fell all the way to $2.20 per share.

A shareholder class action lawsuit was not far behind. Even for the tiny group of patients who had been allowed to receive the drug, those who were the most desperately ill, ponatinib was something of a mixed blessing. Ponatinib is targeted at relatively few CML patients because the drug is not safe enough for a broader swath of CML patients. ARIAD has used these restrictions to push through price hikes on a regular basis. By early 2015, ponatinib’s monthly gross price was $11,280. As of October 2016, it had increased to $16,561 for a month’s supply, prompting a public rebuke from Senator Bernie Sanders.

As in all securities fraud class actions, ARIAD moved to dismiss the case. The district court granted the motion, but on November 28, the First Circuit held that one of plaintiffs’ alleged misrepresentations did raise a compelling inference that ARIAD’s executives acted with scienter, or intent to defraud. That statement occurred at a breakfast meeting with securities analysts, where ARIAD executives allegedly said that the company expected the drug to be approved by the FDA with a “favorable label.” That statement was then included in an investment bank’s report that was disseminated to the market the following day. The truth, however, was that the FDA had already informed the company that it was rejecting Ariad’s proposed label and requiring additional safety disclosures.

The misstatement that the appellate court held to be actionable is significant because it related to defendants’ representations to investors that failed to disclose critical communications with the FDA. That statement was deemed both material and strongly supported an inference of scienter. The court held that ARIAD’s upbeat comments at the meeting amounted to an “expression of . . . hope without disclosure of recent troubling developments [that] created an impermissible risk of misleading investors” and was therefore knowingly or recklessly misleading. This claim will move forward in the district court.

This is notable because the First Circuit has ratcheted up the already-stringent pleading standards in securities class actions for both materiality and scienter. Its 2015 decision in Fire and Police Pension Ass’n v. Abiomed, Inc. held that doubts about the materiality – or significance to investors – of a statement can prove fatal to a plaintiff’s scienter allegations.

In In re: ARIAD Pharmaceuticals Inc. Securities Litigation, an appellate panel that included retired Supreme Court Justice David H. Souter recognized that misleading statements that omit information about communications with the FDA can support a finding of scienter. Such communications are frequently at the heart of securities class actions involving pharmaceutical companies.

ARIAD Pharmaceuticals is in line with long-standing circuit precedent that statements published in light of a defendant’s knowledge of contrary facts provide classic evidence of scienter. What is new is that the Court of Appeals has joined lower courts within the First Circuit in explicitly extending this principle to the realm of FDA communications so often kept secret until the truth is revealed to investors. Therefore, despite largely affirming the lower court, ARIAD Pharmaceuticals will nonetheless help plaintiffs who allege misrepresentations of FDA communications meet the tough pleading standard set by the First Circuit in Abiomed.

Supremes Take Up Three Big Cases

Attorney: H. Adam Prussin
Pomerantz Monitor January/February 2017

The Supreme Court has recently granted certiorari in three cases of great interest to the business world.

Class action waivers in employment agreements. One case, Murphy Oil, concerns the question of whether employees can be forced, as a condition of their employment, to sign agreements that prevent them from joining together to bring class actions in court against their employers. In this case, employees claim that they were forced to sign agreements containing arbitration provisions that prohibit them from pursuing class or collective actions, in violation of the National Labor Relations Act (the “NLRA”). In the wake of the Supreme Court’s 2011 decision in AT&T Mobility, which upheld class action waivers in some consumer transactions, corporations have increasingly turned to this device to try to slam the courthouse door on people attempting to sue them. The availability of class actions is often the only economically feasible way for people with small claims, or small resources, to pursue their rights.

Wells Fargo is also trying to enforce agreements precluding class actions brought by its own customers who claim that Wells Fargo opened accounts in their names without permission.

The class action waiver debate turns on the fact that these provisions are included in arbitration agreements.

The Supreme Court likes to enforce arbitration agreements, which it considers to be an efficient, costeffective alternative to full blown judicial proceedings. Arbitrations are typically not considered suitable for conducting class action procedures because these procedures undermine the efficiency and costeffectiveness of arbitration. But wiping out the right to participate in class actions, just to promote the use of arbitration, would effectively deprive claimants of any effective remedy at all. That’s because the alternative to judicial class actions is not a host of individual arbitrations, which could never be cost-effective for the claimants, but no claims being filed at all.

The NLRA says that “[e]mployees shall have the right to “engage in other concerted activities for the purpose of collective bargaining or other mutual aid or protection.” The Supreme Court has described these provisions as including employees’ efforts “to improve terms and conditions of employment or otherwise improve their lot as employees through channels outside the immediate employee employer relationship,” including “through resort to administrative and judicial forums.” The National Labor Relations Board, which rules on these matters in the first instance, considers the “no class action” provisions to be illegal, in violation of the NLRA, because they interfere with efforts of employees to pursue their rights collectively. Because these provisions are illegal they are not enforceable under the Federal Arbitration Act, which governs the use of arbitration provisions.

In AT&T Mobility, the Supreme Court held that state laws providing that that class action waiver provisions are unenforceable because they are unconscionable (i.e. grossly unfair and one-sided) do not make the class action waiver provisions  illegal. In Murphy Oil, the Fifth Circuit held that the NLRA does not “override” the FAA and that the “use of class action procedures . . . is not a substantive right.”

The two places where waiver provisions are most common are employment and consumer transactions. The Court’s resolution of Murphy Oil, and its companion cases, will decide the fate of such provisions in one of its two most common applications.

Tolling Statutes of “Repose.” Key provisions of the securities laws tend to have two different periods of limitations, within which actions must be brought or be time-barred. The first, and most familiar, is the statute of limitations, which typically expires a certain amount of time after the cause of action “accrues.” Because accrual typically depends on whether plaintiffs knew or should have known about the facts constituting their claim, statutes of limitation tend to be elastic, with no readily knowable expiration date. To mitigate this uncertainty, the statute of repose tends to expire a certain amount of time after the transaction occurs that is the subject of the lawsuit. This provides potential defendants with a definitive date when they are “in the clear.” For the antifraud provisions of the Securities Exchange Act, including Section 10(b), claims are barred two years after the plaintiff knew or should have known about the facts constituting the violation (statute of limitations) or five years after the violation itself (the statute of repose). Claims under Sections 11 or 12 of the Securities Act must be brought within the shorter of one year from the date of the violation (statute of limitations), or three years from the date the security was first offered to the public and in no event more than three years after the relevant sale (statute of repose).

What happens if, shortly after an alleged violation comes to light, an investor files a class action raising claims under the securities laws? Does every member of the class have to file his own case within the limitations/repose periods to prevent the statutory periods from running out on them? In American Pipe, the Supreme Court decided in 1974 that the filing of a class action “tolls” the statute of limitations for all class members; so that if, many years down the road, the court decides not to certify the class, or some class members are dissatisfied with a proposed settlement, members of that would-be class could still file their own actions.

But then, almost 40 years later, companies started wondering whether American Pipe tolling also stopped statutes of repose from running. And in 2013, in Indymac, the Second Circuit said that it didn’t. Although the Supreme Court granted cert in that case, the parties settled before the Court could decide it. The issue has now come up again in a case brought by CalPERS under the Securities Act against ANZ Securities and other underwriters of mortgage-related securities issued by Lehman Brothers.

Lehman Brothers issued over $31 billion of debt securities between July 2007 and January 2008. CalPERS purchased millions of dollars of these securities. On June 18, 2008, another investor filed a securities class action lawsuit in the Southern District of New York against Lehman Brothers and certain of its directors and officers, alleging that the defendants had made material misrepresentations and omissions with respect to the debt offerings. In February 2011, more than three years after the debt offerings, CalPERS filed its own, separate complaint under the Securities Act, also challenging alleged misrepresentations and omissions in the offering documents. Later in 2011, the securities class action lawsuit settled, and CalPERS opted out of the settlement in order to pursue its own claims. CalPERS argued that its own individual claim would not be barred by the three-year statute of repose for its Securities Act claims because that three-year period was tolled during the pendency of class actions involving those securities.

The pros and cons of this question are all quite technical, but boil down to the question of whether the equitable tolling doctrine derives from the class action procedural rules, or, rather, is based on judicially created doctrines intended to promote fairness. Appellate courts have come down on both sides of this issue. Although the issue is technical, the consequences of a ruling, either way, will be seismic.

As noted in the D&O Diary, a prominent securities industry publication, without the benefit of American Pipe tolling with regard to the statute of repose, many investors, including institutional investors, will have to monitor the many cases in which their interests are involved more closely, and intervene or file individual actions earlier in order to preserve their interests. It its cert petition, CalPERS argued that in the circuits’ holding that the prior filing of a securities class action lawsuit,

potential securities plaintiffs are forced to guess whether they must file their own protective lawsuits to safeguard against the possibility that class certification in a pending action will be denied (or granted, then overruled on appeal) after the limitations period has run. If they guess wrong, genuine injuries and blatant frauds may go unaddressed. If they act conservatively, they will burden the courts with duplicative pleadings and redundant briefing that serve no real-world purpose.

By the time a class action reaches the settlement stage, and class members have to decide whether to opt out or not, there is a very good chance that the statute of repose has already expired. Without tolling, opting out of the settlement at that time will be self-defeating: it will be too late, by then, for individual class members who opt out to start their own lawsuit.

Statutes of Limitations Period for “Disgorgement” Claims. “Disgorgement” is a technical legal term that brings to mind regurgitation; and that is appropriate, because the term means that a wrongdoer must cough up the profits wrung from his or her wrongdoing. It is a favorite remedy often sought by the SEC and other government agencies. Given the long delays that have often occurred before agencies have brought cases related to the 2008 financial crash and other similar cataclysmic events, it is important to know how long these agencies have to bring these cases. Courts are often skeptical of claims that the statute doesn’t start to run for years because government watchdog agencies did not know about the wrongdoing, or could not have discovered it earlier.

Notably, courts, including the Eleventh Circuit, have held that there is no statute of limitations for injunctive and other equitable relief. The law has, until now, been mixed as to whether disgorgement is a form of equitable relief immune from the five-year statute of limitations. In Gabelli v. Securities and Exchange Commission, the Supreme Court held, in 2013, that § 2462 and its five-year statute apply to enforcement actions seeking civil penalties, and they must be brought within five years from the date when the defendant’s allegedly fraudulent conduct occurs, rather than when the fraud is discovered. In January, the Supreme Court granted certiorari in a case addressing a question left open by Gabelli: whether claims for disgorgement are subject to the same rule.

Under 28 U.S.C. § 2462, any “action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued.” A case called SEC v. Kokesh has now raised the question of whether this five-year statute of limitations applies to claims for disgorgement or whether, instead, forfeiture is simply an equitable remedy to which no statute of limitations applies. The resolution of this issue will also have huge consequences for the SEC and other agencies seeking similar remedies in other cases.

Under 28 U.S.C. § 2462, the question is whether disgorgement is a form of penalty or forfeiture. The SEC had filed suit against Kokesh in 2009, accusing him of misappropriating money from four business development companies over a twelve-year period. The agency won a jury verdict against Kokesh in 2014, and the court ordered him to disgorge nearly $35 million, plus more than $18 million in prejudgment interest, and pay a $2.4 million penalty.

Kokesh appealed to the Tenth Circuit, arguing he shouldn’t have been ordered to cough up money he was paid before 2004 because of the five-year statute of limitations. The Tenth Circuit rejected Kokesh’s arguments in August 2016, holding that neither his disgorgement nor an injunction warning him not to violate securities laws were penalties, because neither remedy was a punishment. The Tenth Circuit sided with the D.C. Circuit and the First Circuit, which had also said the two types of recovery are different. But the decision conflicted with another from the Eleventh Circuit, which ruled in May that disgorgement is effectively the same as “forfeiture,” which is specifically limited to five years. Barring a lengthy fight over Senate confirmation, it seems likely that the ninth seat on the Supreme Court, left vacant by the death of Justice Scalia, will be filled by the time this case is briefed and argued.

SCOTUS Hears Oral Argument On Standards For Insider Trading

Attorney: Leigh Handleman Smollar
Pomerantz Monitor November/December 2016

We previously reported to you about the controversial decision by the Ninth Circuit, U.S. v. Salman, decided July 6, 2015, upholding an insider trading conviction. The court held that the “personal benefit” requirement did not require that the tipper receive a financial quid pro quo.  Instead, it held that it was enough that he “could readily have inferred [his brother-in-law’s] intent to benefit [his brother].” The court noted that if the standard required that the tipper received something more than the chance to benefit a close family member, a tipper could provide material non-public information to family members to trade on as long as the tipper “asked for no tangible compensation in return.”

The Salman decision was a departure from the holding in a 2014 Second Circuit Newman decision, which overturned the insider trading convictions of hedge fund managers, who received information down the line. The Newman decision interpreted the standard for “personal benefit” more strictly, finding that prosecutors must show that the tipper received a “tangible” benefit. The split amongst the circuits allowed the Ninth Circuit Salman decision to appeal to the Supreme Court of the United States. On October 5, 2016, SCOTUS heard oral argument on the issue of what constitutes “personal benefit” for purposes of insider trading. This is the first insider trading case to come before SCOTUS in 20 years. Specifically, SCOTUS considered whether insider trading includes tips on material, nonpublic information passed between relatives and friends, without any financial benefit to the tipper.

Prosecutors argued that a tipper who simply provides a “gift,” e.g., the tip, to family and friends, constitutes a benefit for purposes of insider trading. Opposing counsel argued that the benefit should be something that can be monetized. SCOTUS questioned both sides of the argument. While skeptical about giving prosecutors broad authority to determine whether the tip was a gift, SCOTUS seemed more skeptical in allowing insider trading only when the tipper gains a monetary benefit. Justice Anthony Kennedy said “you certainly benefit from giving to your family. . . It enables you and, in a sense it – it helps you financially because you make them more secure.” Justice Breyer stated, “to help a close family member is like helping yourself.” Justices Breyer and Kagan seemed to suggest that the defendants’ position would require SCOTUS to change the statute that has been used to prosecute insider trading for decades. The Justices seemed reluctant to do so, given the fact that such a holding would conflict with the SCOTUS 1983 decision in Dirks v. SEC, which held that insider trading violates the federal securities laws if an insider makes a gift of nonpublic information to a trading relative or friend.

The tougher question is whether the government’s position would apply to an unrelated friend, such as when a tipper tips nonpublic information to an acquaintance. The Justices seem to be struggling with where to draw the line. Justice Kagan seemed to suggest that they don’t need to draw the line on this more esoteric situation.

A ruling by the court should clarify what prosecutors must prove to secure insider trading convictions based on tipping, and how far the Justices draw the line.

Really Lost In Translation

Attorney: H. Adam Prussin
Pomerantz Monitor November/December 2016

TransPerfect is – or was -- a very successful, privately held company primarily engaged in language translation services. It has 3,500 full-time employees, half a billion dollars in annual revenue and 92 offices in 86 cities around the world. It maintains a network of more than 10,000 translators, editors, and proofreaders working in approximately 170 different languages.

Yet the company is tearing itself apart because its two founders can no longer get along. . . Elizabeth Elting and Philip Shawe founded TransPerfect almost 25 years ago in the dorm room they shared while attending NYU Business School. They were co-owners, co-CEOs, and the only company directors. Initially they were romantically involved, but Elting broke off their engagement in 1996 and eventually married someone else. This apparently did not sit well with Shawe, and 15 years later, when it was Shawe’s turn to get married, that didn’t sit well with  Elting either.

But the company they founded was so successful that neither wanted to walk away from it. Trying to force each other out, they began all-out warfare while the rest of management, and most of the employees, looked on in horror. Their sophomoric tantrums, retaliations, “hostage-taking” and other embarrassments have now been spelled out, in gory detail for the world to see, in a 104-page decision issued by the Delaware Chancery Court. The court, entering an unusual judgment forcing the sale of an immensely profitable company, concluded that

the state of management of the corporation has devolved into one of complete dysfunction between Shawe and Elting, resulting in irretrievable deadlocks over significant matters that are causing the business to suffer and that are threatening the business with irreparable injury, notwithstanding its profitability to date.

Most of the infighting involved petty power struggles over what otherwise would have been routine business decisions. But eventually their disputes escalated way out of control. Among a list of embarrassing episodes the court found that Shawe repeatedly burglarized Elting’s locked office, when she was away, to “dismantle” her computer hard drive so that he could read her thousands of confidential communications with her own lawyers; and that Shawe once filed a “domestic incident report” with the police, claiming that Elting had pushed him and kicked him in the ankle. According to the court, “Shawe identified Elting as his ex-fiancée, even though their engagement ended seventeen years earlier, apparently to ensure that the matter would be treated as a domestic violence incident and require Elting’s arrest.”

Before these two could completely destroy TransPerfect, the court granted Elting’s request that a custodian take it over and put it up for sale. Selling a successful company obviously runs the risk of destroying whatever it was that made it so successful for so long. In the end, though, the court determined that leaving these two to fight it out to the end was an even riskier bet.

 

Court Upholds Our Claims In Fiat Chyrsler Case

Attorney: Michael J. Wernke
Pomerantz Monitor November/December 2016
 

The district court for the Southern District of New York has substantially denied defendants’ motion to dismiss our complaint in Koopman v. Fiat Chrysler Automobiles N.V. et al. The complaint alleges Section 10(b) and 20(a) violations against the Fiat-Chrysler (“FCA”), CEO Sergio Marchionne, and the executive in charge of vehicle safety regulatory compliance.

The complaint alleges that defendants misled investors when they asserted that FCA was “substantially in compliance” with the National Highway Traffic Safety Administration’s (“NHTSA”) regulations. In truth, FCA had a widespread pattern of systemic regulatory violations dating back to 2013, in which FCA would delay required owner notification of defects and vehicle repair. Prior to defendants’ statements regarding compliance, NHTSA had at least twice written directly to Marchionne and the executive in charge of regulatory compliance, expressing concern about FCA’s regulatory violations/non-compliance. The truth was revealed on July 26, 2015, when NHTSA announced a Consent Order against FCA, fining the company a record-high $105 million and requiring a substantial number of recalls and repairs. Then on October 28, 2015, the company announced a $900 million pre-tax charge for an increase in estimated future recalls. The stock declined about 5% following each disclosure.

The court denied defendants’ motion to dismiss. It found that the complaint adequately alleged that defendants’ statements that FCA was “substantially in compliance” with the “relevant global regulatory requirements” were false when made. The court rejected defendants’ argument that violations in one country as to one regulator did not render such a broad statement misleading, agreeing with our argument that given the context of the statement the reasonable investor would conclude that FCA was in substantial compliance as to each area of regulation, including vehicle safety. The court also found that defendants’ statements regarding the “robustness” of FCA’s compliance systems and that they were “industry best” and similar statements were not puffery. However, the court found that the complaint failed to allege that the company’s statements of loss reserves for recalls, which were opinions, were false.

The court also found that the complaint adequately alleged scienter because defendants had received a letter from NHTSA expressing concern about certain compliance issues. The court also found that defendants repeated public discussions of compliance, access to reports identifying violations and the abrupt resignation of the compliance executive supported an inference of scienter.

Delaware Supreme Court Determines That Investor "Holder" Claims Belong To Them, Not The Company

Attorney: H. Adam Prussin
Pomerantz Monitor November/December 2016

In 1998, Arthur and Angela Williams became investors in Citigroup. They planned to sell all their shares in 2007; but because the company’s financial disclosures looked good at that time, they sold only 1 million shares, at a price of $55 per share, holding onto their other 16.6 million shares. 22 months later, after the financial meltdown of 2008, they sold the rest of their shares, for $3.09 per share, $800 million less than they would have received had they sold those shares when they originally planned. They then sued Citigroup and several of its officers and directors in federal court for failing to disclose Citigroup’s true financial condition, and thereby inducing them not to sell their shares.

One of the many issues in the case was whether their claim belonged to them or, rather, was a “derivative” claim that belonged to Citigroup. Because Citigroup is a Delaware corporation, the federal courts turned, for the answer to this question, to the Delaware Supreme Court. Its answer, in a recent en banc decision called AHW investment Partnership, was that the Williams’ claim was a direct claim that they could assert themselves.

In hindsight, this decision looks like a no-brainer. How could Citigroup be the owner of a claim seeking recovery from Citigroup, for false public statements Citigroup itself issued, which allegedly injured investors directly?

But here is the problem: Citigroup also suffered from whatever wrongdoing its officers and directors committed that led to the meltdown of its share price, including the financial misrepresentations made to its investors. So, could the same wrongs produce separate injuries and separate claims belonging to entirely different people? There was case law that suggested that the answer was no: a claim either belonged to the company or its shareholders, but not both. AHW says that, at least where the claims do not involve breaches of fiduciary duty, separate claims based on the same wrongdoing can belong to both.

A Distinction With a Difference. One of the many esoteric distinctions made by Delaware corporate law is between “direct” and “derivative” investor claims. Direct claims are those that belong to the investors personally, involving injuries that they have suffered directly. Derivative claims are those that belong to the company in which they have invested, and affect its investors only as an indirect result of injury to the company. Of course, anything that injures the company also injures its shareholders – but only indirectly. For example, if officers mismanage the company, that injures the company directly. Investors suffer the consequences, but, usually, only indirectly.

From a litigation standpoint this distinction has major consequences. In a direct suit any damages recovered go to the investors; but in a derivative suit, damages go to the company, not the investors. Moreover, from a tactical standpoint, while investors may pursue their own “direct” claims without restriction, they can prosecute derivative claims only if they can surmount the “demand” hurdle. Normally, investors are allowed to pursue derivative claims only if they can show that the directors are so conflicted that they cannot independently decide whether to pursue those claims. In such cases, demanding that the board bring a lawsuit would be “futile.” This “demand” requirement is often an insurmountable obstacle.

Many investor suits involve claims that the company’s directors have breached their fiduciary duties. Some of those duties run to the company itself, such as the duties of loyalty and care; others run to the shareholders directly, such as the duty of “candor” in communications made to investors. Sometimes these same duties can run in both directions. So Delaware law devised a legal test to distinguish whether fiduciary duty claims in a particular case are direct or derivative. In a 2004 decision named Tooley the Delaware Supreme Court held that this test involves two questions:

((1) who suffered the alleged harm (the corporation or the suing stock-holders, individually): and (2) who would receive the benefit of any recovery or other remedy (the corporation or the suing stock-holders, individually)?

The question, then, is either or: either the corporation owns the claim, or the investors do, but not both.

In Tooley, the investors claimed that the directors breached their fiduciary duties by improperly agreeing to postpone the closing of a merger, which delayed the payout of the merger consideration to the shareholders. The Court held that this was not a derivative claim because “there is no derivative claim asserting injury to the corporate entity. There is no relief that would go to the corporation.”

Since Tooley, many Delaware cases have held, or implied, that if the alleged injury is caused by a drop in the company’s stock price, the investors’ losses flowed from an injury to the corporation, and that under Tooley the claims must be derivative.

In AHW, for example, Citigroup argued that plaintiffs’ losses flowed from injuries suffered by the corporation, which caused the price of its stock to collapse. Nonetheless, AHW held that these individual investors had their own direct claim, based on representations made to investors. The court held that the Tooley “either/or” analysis for claims involving fiduciary duties did not apply to other types of claims.

AHW involved claims of common law fraud and negligent misrepresentation. These are typically considered to be direct claims that investors can pursue on their own behalf. If the Williamses had purchased or sold their shares based on these misrepresentations, there would have been no confusion; but because they were asserting so-called “holder” claims, alleging that they were  misled into holding onto their shares, their losses were traceable to injuries suffered by the company. AHW held that the Tooley analysis did not apply to claims that do not involve alleged breaches of fiduciary duty. The Court rejected the assertion that Tooley

was ―intended to be a general statement requiring all claims, whether based on a tort, contract, or statutory cause of action . . . to be brought derivatively whenever the corporation of which the plaintiff is a stockholder suffered the alleged harm. . . . when a plaintiff asserts a claim based on the plaintiff‘s own right, such as a claim for breach of a commercial contract, Tooley does not apply.

In other words, the Court is saying that if an investor asserts a non-fiduciary duty claim that is clearly personal to him, it makes no difference whether the investor’s losses flowed from an injury to the company.

The Second Circuit Holds That Fraud That Perpetuates An Inflated Stock Price Is Actionable

Attorneys: Emma Gilmore and Marc Gorrie
Pomerantz Monitor November/December 2016

In a recent decision in the long-running Vivendi case, the Second Circuit has issued a landmark ruling adopting the so-called “price maintenance” theory of securities fraud. This theory holds that investors can recover for fraudulent statements that did not push up the price of a company’s securities, but maintained that price at an artificially inflated level.

The Vivendi case is 14 years old and counting, one of the longest running securities fraud cases ever. It is also one of the few securities fraud class actions that ever went to trial. That trial lasted three months and, in January of 2010, a jury returned a verdict for plaintiffs, finding that Vivendi had recklessly issued 57 public statements that misstated or obscured its true – and dire –financial condition.

But the jury’s verdict almost seven years ago was far from the end of the story. The Supreme Court subsequently issued its decision in Morrison, holding that the federal securities laws do not apply to foreign securities transactions. As a result, class members who purchased Vivendi stock on foreign exchanges were excluded from the case. Since Vivendi is a French company, that ruling wiped out the claims of many class members, and potentially billions of dollars in judgments went down the drain.

Before awarding damages to other individual class members, the district court allowed defendants to try to prove that some of them, specifically certain sophisticated institutional investors, did not rely on defendants’ misstatements in buying their shares and therefore could not recover damages either. That dispute is what led to the Second Circuit’s decision adopting the “price maintenance” theory.

Background. In 1998, Compagnie Générale des Eaux, the French utilities conglomerate, changed its name to Vivendi and transformed itself seemingly overnight into a global media conglomerate by aggressively acquiring diverse media and communications businesses in the United States and abroad. Vivendi financed these leveraged mergers and acquisitions by issuing stock, but by 2002 the company was “running critically low” of cash and in serious danger of being unable to meet its financial obligations.

Vivendi did not disclose this, but instead made numerous representations to the market suggesting that its business prospects were robust.

Eventually a series of credit downgrades revealing Vivendi’s cash problems sent the company’s shares tumbling, and securities litigation ensued.

By mid-2002, consolidated class actions were filed in the Southern District of New York against Vivendi and its former CEO, Jean Marie Messier, and CFO, Guillaume Hannezo. Plaintiffs alleged that Vivendi violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 in issuing “persistently optimistic representations” denying the company’s near-bankrupt state, and that the CEO and CFO were liable as controlling persons under Section 20(a) of the

Exchange Act. As noted above, in 2010 the jury found for the plaintiff class against Vivendi, but exonerated the two individual defendants.

After trial, the district court ruled that Vivendi should be given the opportunity to show that sophisticated financial institutions had not relied on their misrepresentations in purchasing their shares. Vivendi claimed that plaintiffs failed to prove reliance because its misrepresentations merely maintained its stock price, rather than pushing it up. In its view, unless the price of the company’s stock actually rose as a result of a misrepresentation, there was no price impact and, therefore, no reliance. In this view, maintaining a pre-existing inflated stock price does not constitute a price impact.

The reliance requirement asks whether there is a “proper” connection between a defendant’s misrepresentation and a plaintiff’s injury. To resolve the difficulties of proving direct reliance in the context of modern securities markets, where impersonal trading rather than face-to-face transactions are the norm, the Supreme Court has held that a prospective class of plaintiffs could invoke a rebuttable presumption of reliance by invoking the “fraud on the market theory,” which provides that “[a]n investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price,” where material information about the company (including  any fraudulent public statements) are reflected in the market price. Investors are all presumed to rely on the “integrity” of that market price when they purchase shares. Thus, part of what they are relying on, indirectly, are the fraudulent statements.

In Halliburton, however, the Supreme Court held that the fraud on the market theory creates only a presumption of reliance, and defendants are entitled to try to rebut that presumption in particular cases. In Vivendi the company argued that it had rebutted that presumption by showing that its stock price did not increase after most of the alleged misstatements, and therefore those misstatements had no effect on the investors’ decisions to invest.

The district court rejected that argument, accepting the so-called price maintenance theory. This theory, which is being debated in federal courts all over the country, holds that plaintiffs do not have to show that the fraudulent statements pushed the stock price up. Rather, the theory posits that fraud that artificially maintains the inflated market price of a stock does have a price impact and therefore supports investors’ claims that they relied on the integrity of the market price when they purchased their shares.

Vivendi appealed.

Second Circuit Decision. Delivering a major victory for investors, the Second Circuit, in its Vivendi decision, embraced the price maintenance theory for the first time. It joined the Eleventh and Seventh Circuits in rejecting the idea that a fraudulent statement, to be actionable, must always introduce “new” inflation into the price of a security. The Second Circuit analyzed Vivendi’s contention as resting on two premises: that the artificial inflation in the company’s share price caused by the market’s misapprehension of the company’s liquidity risk would not have dissipated had Vivendi remained silent and that Vivendi had the option to remain silent, thus permitting the preexisting inflation to persist. In other words, Vivendi argued that their fraudulent statements had no impact because its stock price would have remained inflated anyway had it just said nothing.

The Second Circuit rejected that argument. First, it held that it was not necessarily true that the stock price would have remained unchanged if Vivendi had said nothing:

Perhaps, in the face of silence, inflation could have remained unchanged. But it also could have plummeted rapidly, or gradually, as the truth came out on its own, no longer hidden by a misstatement’s perpetuation of the misconception. . . . It is far more coherent to conclude that such a misstatement does not simply maintain the inflation, but indeed “prevents [the] preexisting inflation in a stock price from dissipating.”

Second, it held that because it chose to issue statements about its financial condition, Vivendi had no option to remain silent about its liquidity problems:

Vivendi misunderstands the nature of the obligations a company takes upon itself at the moment it chooses, even without obligation, to speak. It is well established precedent in this Circuit that “once a company speaks on an issue or topic, there is a duty to tell the whole truth,” “[e]ven when there is no existing independent duty to disclose information” on the issue or topic.

Thus, far from being a “fabricated” and “erroneous” argument, as Vivendi labeled it, the Second Circuit said that the price maintenance theory prevents companies from “eschew[ing] securities-fraud liability whenever they actively perpetuate (i.e., through affirmative misstatements) inflation that is already extant in their stock price, as long as they cannot be found liable for whatever originally introduced the inflation. Indeed, under Vivendi’s approach, companies (like Vivendi) would have every incentive to maintain inflation that already exists in their stock price by making false or misleading statements.  After all, the alternatives would only operate to the company’s detriment: remaining silent, as already noted, could allow the inflation to dissipate, and making true statements on the issue would ensure that inflation dissipates immediately.” After discussing the theory with approval and at length, the Second Circuit concluded:

In rejecting Vivendi’s position that an alleged misstatement must be associated with an increase in inflation to have a “price impact,” we join in the Seventh and Eleventh Circuits’ conclusion that “theories of ‘inflation maintenance’ and ‘inflation introduction’ are not separate legal categories . . . Put differently, we agree with the Seventh and Eleventh Circuits that securities fraud defendants cannot avoid liability for an alleged misstatement merely because the misstatement is not associated with an uptick in inflation.

Wells Fargo Joins The Long List Of Misbehaving Banks

Attorney: H. Adam Prussin
Pomerantz Monitor September/October 2016

Although this was a tiny fraud, by bank standards, it hit home harder than most. Unlike the typical bank horror story, this one did not involve machinations in the sales of complex securities by one financial behemoth to another. Instead, it targeted regular retail customers of the bank, who were victimized by nickel and dime chiseling by over 5,000 low-level Wells Fargo employees. Because victims were mostly everyday people, this story cut through the election year noise and reminded us how bad these people are.

Despite the massive wealth of many banks, retail bank employees are among the lowest paid workers on earth, many earning around $10 an hour. In this case, Wells Fargo reportedly made their lives even more miserable by imposing extremely aggressive sales targets on them if they wanted to keep their jobs or, possibly earn a little Christmas bonus. These sales were supposed to  be generated by “cross-selling” additional accounts or services to existing Wells Fargo retail customers. While there is nothing wrong with a bank providing incentives to employees to boost sales, in this case these were really quotas, which were so high that employees usually could not meet them legitimately. So, according to the Consumer Finance Protection Bureau, some 5,300 or so Wells Fargo employees opened about 1.5 million unauthorized deposit accounts in the  name of unsuspecting customers and made about 565,000 unauthorized credit card applications, generating about $2.6 million in fees and enabling themselves to keep their jobs.

Years ago, Wells Fargo got wind of this illicit activity, and it apparently made their employees attend “ethics training” courses where they were repeatedly told to stop their fraudulent behavior. The bank supposedly hired more and more “risk managers” to try to prevent it as well. But the crazy sales quotas remained in place. Not surprisingly, then, the misbehavior continued for over five years. Reportedly, many Wells Fargo employees felt that they had no choice but to do whatever it took to meet the bank’s impossible sales quotas, or else face termination.

As is typical in cases involving bad bank behavior, once the wrongdoing was publicly exposed, only the little people were held responsible. So far, no one has identified a single member of management who got the axe for failing to prevent or stop this conduct.

Some have suggested that the bank should “claw back” bonuses that were awarded based on phony sales reports. Perhaps they should start by looking at Carrie Tolstedt, the divisional senior vice president for community banking, who was in charge of Wells Fargo’s 6,000 branches where the infractions took place. In the last three years, she was paid a total of $27 million. Although she stepped down in July, she remains employed by the bank until the end of the year. When she leaves, she will probably be able to take with her nearly $125 million in stock and options.

In the end, the bank agreed in September to pay a fine of $185 million. When this agreement was announced, the bank’s stock dropped about 7.5%, cutting its market capitalization by $19 billion.

On September 20, 2016, Charles Stumpf, CEO of Wells Fargo, testified before the Senate Banking Committee, and repeated his claim that this fraud was the work of a handful of “bad apples.” That argument did not sit well. Senator Elizabeth Warren blasted him, saying that “you should give back the money that you took while this scam was going on and you should be criminally investigated by both the Department of Justice and the Securities and Exchange Commission. This just isn’t right. A cashier who steals a handful of $20s is held accountable. But Wall Street executives almost never hold themselves accountable.”

Distinguished Federal District Judge Shira Scheindlin Retires

Attorney: Adam G. Kurtz
Pomerantz Monitor September/October 2016

Federal District Court Judge Shira Scheindlin of the Southern District of New York stepped down from the bench in April of 2016. Over the past two decades “Judge Scheindlin was one of the hardest working and scholarly judges that I had the honor of appearing before in court, as well as working with in law symposiums,” according to Pomerantz partner, Marc Gross. When appearing before Judge Scheindlin, Mr. Gross noted that “[s]he was always incredibly prepared, even on the most esoteric economic issues, asking pointed questions that kept witnesses and counsel on their toes.” Over the years, Mr. Gross and Judge Scheindlin have also appeared together at law symposiums, including the Annual Institute For Investor Protection Conference, to speak about securities fraud class actions.

Judge Scheindlin has had a 22-year history of presiding over important securities, antitrust and civil rights class action, cases, and writing landmark case law decisions. Several of them were cases in which Pomerantz represented investors and consumers. Most recently, Pomerantz had great success in an important securities fraud (Barclays) and antirust (NHL & MLB) cases that were before Judge Scheindlin.

In April 2015, in the “Dark Pool” Barclays’ securities fraud case, Judge Scheindlin denied defendant Barclays’ motion to dismiss, and in February 2016, granted plaintiffs’ motion for class certification and appointed Pomerantz as lead class counsel. This case concerns Barclays’ false statements regarding the integrity of its “dark pool,” an alternative trading platform that does not reveal the size and price of the anonymous trade. Judge Scheindlin’s case law decision was important because of its emphasis on the critical importance (“materiality”) to investors of management integrity. The decision not only granted class investors and Pomerantz a legal victory, it advanced the important legal standard that false and misleading statements about management integrity could be the foundation of a securities fraud case, even if the amount of money involved is not particularly great. Judge Scheindlin’s class certification decision is now on appeal before the Second Circuit Court of Appeals.

As one of her final orders, just before she stepped down from the bench, Judge Scheindlin granted final settlement approval “of a lawsuit brought by fans [against Major League Baseball and cable TV providers] over how games are broadcast, a crack in the dam the league and pay TV have built against unrestrained viewing,” according to an article entitled “MLB Settlement Gives Baseball Fans Viewing Options,” on Bloomberg.com. Pomerantz was co-lead class counsel. More specifically, the antitrust cases challenged MLB and NHL’s “black out” prohibitions of teams from broadcasting or streaming games outside their home and inside outer market territories. Judge Scheindlin concluded that the settlement – worth $200 million to consumers – will lower the price to watch baseball online and increase online viewing options so that (1) fans can watch a favorite team, without blackouts, by subscribing to cable TV and MLB.com; (ii) out of town fans can buy discounted single team online streaming packages; and (iii) hometown fans can stream to all devices. In the parallel NHL case, the NHL settled and agreed to provide NHL fans with previously unavailable single-team packages at prices well below the out-of-market bundled package.

However, Marc Gross says, “Judge Scheindlin’s greatest contribution was in the arena of social justice and civil rights. She was the first judge in the country to find that certain police tactics (in this case “stop and frisk”)  were applied in a discriminatory manner, and therefore, were unconstitutional. This was before the “choke hold” and police shooting deaths, and before Ferguson and Black Lives Matter. Her decision allowed New York City and its police to rapidly move forward to address questionable policing tactics, thereby undoubtedly helping to avoid much of the turmoil experienced by other cities.”

In the wake of her decision, the number of “stop and frisks” dropped from 685,000 in 2011 to 24,000 in 2015. In May 2016, Judge Scheindlin told Benjamin Weiser of The New York Times, “Think of the lives that that has changed, the lives that that has touched,the lives of people who  were stopped for no good reason and how intrusive that is.” The policy had “bred nothing but distrust,” she added. During this same period, major crime in NYC overall dropped 5.8% in the two years since Judge Scheindlin’s decision. “As we end [2015], the City of New York will record the safest year in its history, its modern history, as it relates to crime,” NYPD Commissioner Bratton said.

Judge Scheindlin has said, “I do what I think is right, and whether the circuit [appeals court], the press, the public or whoever think it’s right doesn’t matter. Should it? . . . What I hope to do are even more good works than I could accomplish here [as a Judge].”

 

Supreme Court To Revisit “Personal Benefit” Requirement For Insider Trading Convictions

Attorney: Omar Jafri
Pomerantz Monitor September/October 2016

The Supreme Court has agreed to hear a case next term involving the standards for insider trading convictions. At issue is whether the government must prove that a corporate insider (the tipper) received a personal benefit of a “pecuniary or similarly valuable nature” in exchange for disclosing confidential information to a remote tippee. In the case in which certification was granted, U.S. v. Salman, the Ninth Circuit held that the “personal benefit” requirement was satisfied when the tipper, Maher Kara, a former investment banker at Citigroup, leaked  confidential information about mergers and acquisitions in the healthcare industry to his older brother, Michael, who, in turn, passed it on to Maher’s brother-in-law, Salman.

Maher and Michael pled guilty and cooperated with the government during Salman’s trial. Maher testified that he willingly disclosed confidential information to “benefit” Michael and “fulfill whatever needs he had.” Michael testified that he told Salman that Maher was the source of the information, and that Salman agreed to “protect” Maher from exposure. The Ninth Circuit concluded that, in light of the parties’ close-knit relationships, Salman must have known that Maher intended to benefit his elder brother when he leaked the confidential information. Based on these facts, the Ninth Circuit upheld Salman’s conviction on the ground that Maher gave “a gift of confidential information to a trading relative or friend,” and there was sufficient evidence to conclude that Salman knew that Maher personally benefited from the disclosure.

In affirming Salman’s conviction, the Ninth Circuit relied on Dirks v. SEC, where the Supreme Court held that an insider trading conviction requires that the tipper must receive a personal benefit in exchange for leaking confidential information to a tippee. In Dirks, the Supreme Court defined a personal benefit to the tipper as a “pecuniary gain,” “a reputational benefit” or “a gift of confidential information to a trading relative or friend.”

In concluding that Salman’s conduct constituted “a gift of confidential information to a trading relative or friend,” the Ninth Circuit rejected Salman’s request to adopt the Second Circuit’s novel and restrictive approach towards insider trading cases. In U.S. v. Newman, the Second Circuit held two years ago that a close personal or familial relationship between the tipper and the tippee, without more, is not sufficient to show that the tipper obtained a personal benefit unless the government proves that the tipper received “ . . . at least a potential gain of a pecuniary or similarly valuable nature.” In October 2015, the Supreme Court denied the government’s request to review the Second Circuit’s decision in Newman.

In our view, the Second Circuit’s approach contradicts the Supreme Court’s holding in Dirks that a “gift of confidential information to a trading relative or friend” constitutes a personal benefit. The legal and ordinary definitions of the term “gift” do not contemplate an exchange, consideration or any kind of “pecuniary” or “similarly valuable” benefit in return. For over thirty years, convictions based on insider trading have been sustained even if the tipper did not receive a tangible benefit in exchange for breaches of fiduciary duties and the consequential disclosure of material, nonpublic information. Until Newman was decided in 2014, every Circuit held that the law does not require a tipper to obtain a pecuniary benefit, and every Circuit to rule on the issue since Newman has held the same. While the Second Circuit paid lip service to Dirks’ holding by acknowledging that its prior precedent broadly defined a personal benefit to include a “gift of confidential information,” the new rule it crafted in Newman has upended well-settled law and wreaked havoc on the justice system. Several high-profile convictions and guilty pleas entered in courts in the Second Circuit have been set aside based on Newman.

To the extent that the three-judge panel in Newman chose to adopt a more restrictive approach to provide clarity and certainty in the law, the effort seems to have failed. In a recent trial in New York City, a former investment banker was convicted of insider trading based on leaking confidential information about healthcare mergers to his father. The government argued that the defendant obtained a pecuniary benefit because his father paid certain expenses in connection with the defendant’s wedding. Defendant, however, claimed that the wedding expense payments were not a “pecuniary benefit” but were, instead, a “gift.” Friends and relatives give gifts to each other all the time. Drawing such distinctions brings us right back into a gray area subject to endless uncertainty.

In urging the Supreme Court to adopt the Second Circuit’s standard and limit convictions to instances where an insider obtains a “potential gain of a pecuniary or similarly valuable nature,” Salman argues that the Ninth Circuit’s approach raises separation-of-powers and Due Process concerns, and delegates to prosecutors the power to legislate by defining, on an ad hoc basis, the kinds of personal benefits that can make the difference between guilt and innocence. Over the last decade, the Supreme Court, including Justices on both sides of the ideological divide, has been increasingly receptive to these types of arguments when high-profile white collar criminal defendants or powerful politicians accused of corruption are involved. For example, two months ago, the Supreme Court overturned the conviction of Virginia’s ex-governor, in part, because it held that ingratiation and access in exchange for lavish gifts and money does not constitute corruption. That decision was unanimous. Whether it will influence the Court’s decision in Salman remains to be seen.

Oregon Court Holds Exorbitant Executive Compensation For Past Services Raises Doubt That Directors Exercised Valid Business Judgment

Attorney: Darya Kapulina-Filina
Pomerantz Monitor September/October 2016

In a recent victory before the Circuit Court of Oregon, the court upheld Pomerantz’s shareholder derivative complaint against the board of directors of Lithia Motors, Inc. The case stems from an agreement approved by the board for exorbitant compensation to be paid to Lithia’s founder and CEO, Sidney DeBoer, following his resignation. The compensation package entailed annual payments of $1,050,000 for the remainder of DeBoer’s life, a $42,000 car allowance, and continued reimbursement for premiums on DeBoer’s insurance policies. None of these payments were required by DeBoer’s existing employment agreement and, therefore, amounted to a going-away present from the company. The complaint we filed alleged that by approving this giveaway, the board breached its fiduciary duties of care and loyalty and committed waste of corporate assets, resulting in DeBoer’s unjust enrichment.

This is a derivative case, brought by shareholders on behalf of the corporation. Under Oregon law, which is analogous to Delaware law, a complaint in a derivative action must allege either that, prior to commencing the lawsuit, shareholders made a demand on the board to take corrective action to avoid litigation, or that demand was excused because it would be “futile” or an “idle gesture.” Plaintiffs are typically excused from making a demand if they can show specific facts demonstrating that there was reasonable doubt that (1) the majority of directors are disinterested or independent; or (2) the transaction was a valid exercise of business judgment (more on business judgment below). The plaintiff shareholders in Lithia did not make the pre-litigation demand on the board, but included facts in the complaint which we contended showed that demand would have been futile.

The board moved to dismiss our case, arguing that pre-suit demand was not excused and that, in any case, the complaint failed to state a claim for breach of fiduciary duties, corporate waste, or unjust enrichment. The court upheld each of our claims. It held that there is reasonable doubt as to the independence of three out of the seven Lithia directors named in the lawsuit, but three out of seven did not make up a majority. The court went on to analyze whether there was reasonable doubt that the challenged transaction was otherwise the product of a valid exercise of business judgment. The court found that plaintiffs met their “heavy burden” through “particularized facts” in the complaint showing that:

(1) DeBoer would receive his benefits in consideration of his prior services. The court agreed with plaintiffs that past services are not valid consideration for these payments.

(2) The board chose not to retain a compensation consultant and provided no analysis of what other departing executives typically receive.

(3) The board delegated full authority to director William Young to approve the final agreement, and Young had to practically force other members of the Compensation Committee to review the Transition Agreement.

(4) DeBoer’s Transition Agreement was not approved by the company’s audit committee.

(5) DeBoer’s compensation was disproportionately higher than designated in Lithia’s “Change of Control Agreement” which specifies compensation payable to him in the  event of a sale of all or substantially all of the assets of Lithia, any merger, consolidation or acquisition, or any change in the ownership of more than fifty percent (50%) of the voting stock.

Given these facts, the court found that “plaintiffs have plead particularized facts in their complaint which create a reasonabledoubt that the transaction was a product of validbusiness judgment . . . [and] plaintiffs raise a reason to doubt that the directors were adequately informed in making their decision.” As a result, the shareholders were excused from making a pre-litigation demand on the board.

The court went on to uphold each of plaintiffs’ substantive claims. As for our claims against DeBoer, It held that just because he did not personally vote on whether to approve his compensation, he was nonetheless potentially liable for a breach of fiduciary duties claim for “indirectly engaging in the transaction.” The court relied on the shareholders’ allegations that:

(1) DeBoer, owning 52% of the votes, admittedly can cause the company to enter into agreements with which other stockholders do not agree.

(2) DeBoer engaged in a self-dealing transaction.

(3) The board “generally failed to cleanse the taint of self-interest and should have obtained shareholder approval.”

The court upheld the waste of corporate assets claim, relying on plaintiffs’ allegations that the compensation in question was in exchange for past services and was beyond what the compensation committee deemed fair. It found that plaintiffs’ allegations “suggest an unreasonable exchange” because according to Lithia’s Change of Control Agreement, the Transaction Agreement over compensated DeBoer by 1,000%.

Finally, the court upheld plaintiffs’ unjust enrichment claim on the basis that DeBoer’s compensation was for past services rendered, for which DeBoer had already been compensated.

The Lithia decision is instructive to other shareholders who need to overcome the test for demand futility but are not able to establish that the majority of the board of directors were conflicted. Shareholders can overcome business judgment and establish doubt as to the board’s informed decision-making and valid exercise of judgment by detailing the insufficient manner in which directors handled the questioned transaction. Some aspects to highlight in a derivative complaint include:

• Were draft agreements presented to the board or committees (compensation committee, audit committee, special committee)?

• Were questions raised by the board or was the transaction rubber stamped for approval?

• What was the review process and duration of the evaluation of the transaction?

• Did the board retain an outside expert or consultant?

• Was a legal advisor retained to review the propriety of the transaction? The Lithia court cited a case involving executive compensation of the president of the Walt Disney Company where the compensation committee met for less than an hour, asked no questions, gave no presentations, did not engage an expert consultant, and approved the exorbitant payments.

• How does the transaction compare with others? Was any comparable transactions analysis made?

• What benefit does the transaction provide to the company and shareholders?

• Was shareholder approval obtained?

Although shareholders still face a heavy burden to overcome the business judgment rule in the context of a demand futility issue, the Lithia decision gives hope to shareholders that courts will not just assume the board took adequate measures in approving a questionable transaction such as excessive executive compensation payouts, but may scrutinize the board’s review process.

In doing so, they can even allege defendants’ federal-law violations for similar conduct.

 

Decision Certifying Class In Petrobras Case Heads To Second Circuit

Attorney: John A. Kehoe
Pomerantz Monitor September/October 2016

As the Monitor has previously reported, the court has appointed Pomerantz as lead counsel for a class of purchasers in the U.S. of securities issued by Petrobras, a Brazilian corporation engulfed in a massive corruption scandal. We were retained in this case, which is pending in the Southern District of New York, by lead plaintiff in the action, Universities Superannuation Scheme Ltd., and by a U.S. state retirement plan. Plaintiffs allege that the fraud that pervaded Petrobras artificially inflated the price of Petrobras securities by billions of dollars, while in the process hobbling the political and economic structure of Brazil, one of the world’s largest economies.

In February, Judge Rakoff certified a class of purchasers of Petrobras securities on a U.S. exchange or through other domestic transactions between January 22, 2010 and July 28, 2015 for claims arising under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. In addition, for claims asserted under Sections 11 and 12(a)(2) of the Securities Act of 1933, Judge Rakoff certified a class of purchasers of Petrobras debt securities in U.S. domestic transactions in/or traceable to public offerings that Petrobras conducted on May 15, 2013 and March 11, 2014.

The classes were limited to investors who engaged in securities transactions in the U.S. because of the Supreme Court’s decision several years ago in a case called Morrison v. Nat’l Australia Bank (“Morrison”), where the Court held that U.S. securities laws apply only to domestic transactions. The Petrobras class certification motion turned largely on whether the question of where each investor’s purchases occurred presents individual issues that would “predominate” over common questions in the case. In certifying the class, Judge Rakoff found that “the Morrison determination is administratively feasible” in a class action. In particular, Judge Rakoff determined that:

The criteria identified by [the Second Circuit], as relevant to the determination of whether a transaction was domestic, are highly likely to be documented in a form susceptible to the bureaucratic processes of determining who belongs in a class.  For example, documentation of ‘the placement of purchase orders’ is the sort of discrete, objective record routinely produced by the modern financial system that a court, a putative class member, or a claims administrator can use to determine  whether a claim satisfies Morrison.

In addition to challenging this finding, Petrobras also challenged Judge Rakoff’s finding that market efficiency for Petrobras securities was sufficient to satisfy the fraud-on-the-market theory. This theory makes it possible to establish the element of reliance, which is required for such claims, on a class-wide basis.

Petrobras filed an interlocutory appeal, and in June the Second Circuit agreed to hear Petrobras’ appeal, on an expedited basis.

Since that time, numerous amicus briefs from non-parties have been submitted in support of Judge Rakoff’s decision. Notably, the National Conference of Public Employee Retirement Systems (“NCPERS”) filed an amicus brief in support of class certification. NCPERS is the largest national, non-profit public pension trade association. With respect to the Securities Act claims related to the note purchases, and in particular with respect to the issue of whether determining whether a transaction occurred in the U.S., NCPERS asserts that the class as certified is sufficiently ascertainable through ordinary documentation that would be submitted during an administrative claims process, and that limiting the class to purchasers in domestic transactions does not render the class indeterminate, unfair to class members or defendants, or otherwise defective. Recognizing that the Supreme Court in Morrison and the Second Circuit in Absolute Activist Value Master Fund Ltd. v. Ficeto set forth straight-forward criteria for analyzing the domestic transaction requirement, NCPERS contends that the types of proof needed to establish the elements of a domestic transaction typically are readily available and amenable to the ordinary claims administration processes in securities cases.

Similarly, the State Board of Administration of Florida (“SBA”) also filed an amicus brief supporting the judge’s decision on the domestic versus foreign transaction issue, although its argument was far broader. The SBA, governed by a three-member Board of  Trustees that includes the Governor, Chief Financial Officer, and the Attorney General of the State of Florida, has over $170 billion in assets under management. The SBA argues that all trades in Petrobras notes, regardless of their origins, should properly be regarded as occurring in the United States because the notes are themselves housed at the Depository Trust Company (“DTC”), located in the United States, and all transactions in those notes occur through DTC’s process of “settlement,” when the notes are debited from the seller’s brokerage account and deposited into the buyer’s brokerage account. Such transactions bear all the hallmarks of title transfers and take place entirely within DTC’s self-contained electronic system in the New York area, making all trades within that system—including those in Petrobras notes—domestic. Transactions settling through DTC utilize the same method of transfer as all trades on domestic exchanges. This principle would render all trades in these securities automatically “domestic” and would eliminate this as an issue on class determination.

Amicus briefs have also been submitted by twelve distinguished securities law professors on the issue of market efficiency. They note that the fraud-on-the-market presumption of reliance has long been understood as placing a necessarily high burden on a defendant to prove that the alleged misrepresentation did not actually affect the stock’s market price, and that this burden should apply with equal force at the class certification stage. They contend that the Second Circuit should endorse this approach, as it best reflects the realities of the modern securities markets and the rationale behind the fraud-on-the-market doctrine.

Remarkably, another group of distinguished professors who teach, research, and write about the laws of evidence filed an amicus brief supporting certification as well. They argue that principles of the law of evidence dictate that, once plaintiffs have satisfied their burden of triggering the fraud-on-the-market presumption of reliance, the burden of persuasion shifts to the defendants to rebut that presumption by a preponderance of the evidence. Contrary to Petrobras’ argument, these evidence scholars, several of whom were involved in drafting the Federal Rules of Evidence, argue that with respect to the presumption of reliance under the securities laws, the congressional policy requires shifting the burden of persuasion to defendants in evaluating whether the presumption of reliance has been rebutted.

As the professors aptly note, Basic Inc. v. Levinson (“Basic”) and Halliburton Co. v. Erica P. John Fund recognize that such an allocation of the burden of persuasion is necessary to further Congress’s purpose underlying the securities laws: namely, to give investors reasonable protection when they buy and sell securities. Furthermore, the evidentiary scholars assert that the fraud-on-the-market presumption is triggered only on a substantial showing by plaintiffs, much greater than is required to trigger many other presumptions, and thus a defendant’s burden on rebuttal should be more substantial as well. Reference in Basic to the Advisory Committee note on the original version of Rule 301, which required a substantial rebuttal burden, supports the conclusion that a substantial rebuttal burden is required to rebut market efficiency. Indeed, most district courts have adopted the rule that defendants must rebut the presumption by a preponderance of the evidence.

Oral argument is scheduled for November 2, 2016.

Pomerantz Recognized As A Global Leader By The Legal 500

Pomerantz Monitor July/August 2016

Pomerantz is honored to have been chosen by The Legal 500 as a leading firm in 2016. The Legal 500 is the world’s largest legal source, with over 4.5 million viewers. It assesses law firms across the globe, selecting for its ranks only top-tier firms that are the most cutting-edge, innovative and successful.

Here’s what The Legal 500 has to say about Jeremy Lieberman, Pomerantz’s Co-Managing Partner:

 “In New York, Jeremy Lieberman is ‘super impressive – a formidable adversary for any defense firm.”

Patrick Dahlstrom, Pomerantz’s Co-Managing Partner, says, “We have been at the forefront of shareholders’ rights and recoveries for corporate malfeasance in the United States for over 80 years, and are honored to be recognized by The Legal 500 as we work to expand those rights and remedies to investors around the globe.”

Has The Curtain Finally Fallen On The Galanis Family Of Fraudsters?

Attorneys: H. Adam Prussin and Jessica N. Dell
Pomerantz Monitor July/August 2016

This month Jason Galanis and his father John Peter Galanis both entered guilty pleas for their roles in swindling Gerova Financial Group investors. They admitted to manipulating the company’s stock price using a maze of small companies and a straw buyer to conceal their involvement. They agreed to forfeit over $37 million in assets and will both be sentenced in December. Other alleged conspirators include Jason’s two brothers, Jared a n d Derek Galanis.

If the names sound familiar, it is because the family has bounced from one colorful financial scandal to the next for over thirty years. Five years ago, Pomerantz filed suit for Gerova Investors based on the same violations. That suit was successfully settled. The Galanii currently also face criminal charges alleging that they bilked $60 million from members of the Sioux Nation in South Dakota. In the last two decades, they have reportedly dabbled in gambling, porn, and Kosovo drug rings. It was reported that two months ago, while out on bail and facing criminal charges, Jason Galanis got drunk on an airplane and sent threatening texts to a former friend he thought was cooperating with federal investigators. His bail was consequently revoked.

Although Galanis Senior, the Bernie Madoff of the eighties, served years in prison, investors were never made whole. Throughout that decade, he faced a litany of charges, including stealing hundreds of millions from investors, and millions from the government in false tax deductions. In 1988 he was convicted on 44 felony counts and ultimately sentenced to 27 years in a federal prison. When the sentence was handed down, then U.S. Attorney Rudy U.S. Attorney Rudy Giuliani told the press he hoped it would send a message that: “those like Galanis...who are involved in multimillion-dollar frauds and corruption will realize that no matter how wealthy or how powerful they believe they are, no matter how complex their scheme, they too can be brought to justice.” If the sentence indeed had any deterrent effect, it was short-lived. Perhaps this time, by rounding them all up at once, we can hope again that U.S. District Attorney Bharara has succeeded in shuttering the Galanis family business for good. 

International Portfolio Monitoring And Its Increasing Importance To Pension Funds

Attorney: Jennifer Pafiti
Pomerantz Monitor July/August 2016

The United States sees hundreds of new securities class actions filed each year as well as approximately 100 class action settlements. For many institutional investors, the task of obtaining and tracking all this information is too complex and too expensive to do in-house; nevertheless, it remains essential that pension fund fiduciaries are regularly informed of the extent to which the value of the publicly traded investments they oversee may be diminished by financial misconduct. Increasingly, financial institutions have been turning, for help, to professional portfolio monitoring services.

Increasingly, fiduciaries must now also keep abreast of investor class actions filed abroad. In June 2010, the U.S. Supreme Court decided, in Morrison v. National Australia Bank, that U.S. federal securities law remedies were limited to investors that had purchased relevant securities only on a U.S. stock exchange. In the wake of this decision institutional investors began to realize that they could no longer limit their portfolio monitoring to activity in the U.S. They would need to have their global portfolio monitored by a team equally dedicated to both domestic and international monitoring services.

In the six years since the Morrison decision we have seen more and more litigation activity outside of the U.S.; in particular, (but not limited to) countries with collective redress procedures and securities laws closest to that of the U.S. In the past few years Australia, Canada, the Netherlands, and the United Kingdom have emerged as front runners for pursuing shareholder class actions outside of the U.S. for varying reasons. Here, we examine those merging venues to better understand them.

In Canada and Australia, class action procedures and pro-investor measures have recently combined to allow a steady stream of offering and open-market type claims to yield substantial recoveries.

The number of securities class actions initiated in Australia is growing. An essential feature of the Australian class action system is that there must be seven or more plaintiffs with claims arising out of the same or similar circumstances with substantial common issues of fact or law in question. Compared with many overseas jurisdictions, this is a fairly low threshold and makes Australia a class action friendly jurisdiction.

Australia is officially an “opt-out” jurisdiction (meaning that to be excluded from a class, the class member must formally exclude himself or herself from the class), and employs a “loser pays” system where the losing party may be liable for both their legal costs and that of the prevailing party. This often means that parties will bring in external litigation funders who will take a percentage of the class recovery if successful and hold the fee “risk” if the case is lost. This has effectively resulted in “closed classes” in which only those class members who have agreed to litigation funding are included in the class action and can participate in any recovery. To date, no securities class action filed against a publicly traded company in Australia has proceeded to judgment. Instead, the claims that have concluded have been settled outside the courtroom.

Last year, Canada saw only four new securities class action filings, whereas the U.S. sees roughly 150 new securities class actions filed each year. Most Canadian provinces have adopted an “opt-out” procedure whereby an investor is automatically included in the class unless they affirmatively “opt-out.” Like Australia, Canada has an active third-party litigation funding regime requiring investors to “opt-in” in order to participate in any recovery.

The Netherlands is a unique jurisdiction in that Dutch law enables the formation of settlement foundations (stichting) to bring collective redress for parties wishing to create a binding, European-wide settlement. Resembling the U.S. “opt-out” system, parties have the right to “opt-out” during the defined period set by the court.

An interesting component of the Dutch settlement system is that a significant connection between the conduct complained of and the Dutch jurisdiction is not required. This has led to the suggestion that foreign parties may flock to the Netherlands to seek redress. Notwithstanding this, the Netherlands is yet to be described as a hotspot for international securities class actions.

Unlike the other jurisdictions described above, the U.K. lacks a class action procedure. However, a group litigation mechanism exists whereby individual cases involving the same circumstances against the same defendants are grouped together. Only those claimants who are affirmatively named are included in the litigation and bound by the judgment (similar to “opt-in”). The U.K. adopts an unattractive “loser pays” system. The absence of litigation funders, changes in after-the-event insurance and the “loser pays” system have deterred investors from filing suit there. Nevertheless, the case currently proceeding in the U.K. against the Royal Bank of Scotland (“RBS”), in connection with its 2008 rights issue, is unprecedented in the U.K. and is being closely watched in terms of how the group litigation is being managed and how any loser-pays costs will be distributed. In recent years there has been much demand in the U.K. for a U.S.-style class action procedure to be introduced into legislation. Some argue that, at present, the U.K. government has no interest in changing legislation that would open the floodgates for investors to sue RBS – a bank in which the government has an 83% stake.

Determining whether to become involved in securities litigation outside the U.S. requires examination of near identical issues to be considered when taking affirmative action in the U.S., in addition to consideration of varying jurisdictional statutes of limitations, cost issues, and analysis of what types of losses are compensable.

It is prudent that pension fund fiduciaries are provided with both domestic and international portfolio monitoring services, coupled with comprehensive legal advice so that they can make informed decisions on what action, if any, they take to recover their losses.

Note: Pomerantz provides a no-cost portfolio monitoring service whereby clients receive monthly, personalized reports quantifying losses in new actions relating to the U.S. and worldwide, providing legal advice in respect of those losses and highlighting upcoming claims filing deadlines for settled securities class actions in which the fund is eligible to participate. For more information, please contact the author of this article at: jpafiti@pomlaw.com

Why Bother To Investigate Before Bringing A Derivative Action?

Attorney: Gabriel Henriquez
Pomerantz Monitor July/August 2016

State law allows shareholders to bring derivative actions, under certain circumstances, seeking recovery on behalf of their corporations. Usually those cases allege that the directors of the corporation have breached their fiduciary duties to the company. Typically the directors, not shareholders, have the responsibility of deciding whether to bring such cases. Shareholders can “demand” that directors bring such a case, but if they do that, and the directors refuse, it is next to impossible for shareholders to pursue their case. But there are exceptions to this “demand” requirement in cases where plaintiffs can show that demand would be “futile.”

Although one might assume that it would always be “futile” to demand that directors sue themselves, the law does not start with that assumption. To the contrary, Delaware courts, for example, require that plaintiffs plead specific facts establishing, in essence, that it is likely that the directors have done something wrong, justifying bringing an action against them. “Conclusory,” non-specific allegations are not enough. Unless shareholders have access to inside information from the company, it is often difficult to satisfy this standard; and courts have dismissed such cases with depressing regularity.

About 20 years ago, the Delaware Supreme Court started suggesting, in its opinions affirming dismissal of such cases, that the result might have been different if the shareholders had only done a better investigation of the facts before bringing the action. In particular, it pointed to Section 220 of the Delaware Corporation Act, which allows shareholders of Delaware corporations, before bringing a lawsuit, to demand the right to inspect the books and records of the corporation concerning potentially dubious transactions. Such inspections, the court noted, are the “tools at hand” that could in many cases provide the specific facts necessary to establish demand futility and allow a derivative case to go forward. The Delaware Chancery Court has exclusive jurisdiction to grant relief under Section 220.

But this prescription ignores the practicalities of derivative litigation. News of potential corporate wrongdoing typically leads to multiple lawsuits brought by shareholders, sometimes in different states. Because there is no law requiring that investors bring a books and records proceeding before filing a derivative case, some of these cases will be filed without a pre-filing inspection and they will proceed quickly, while shareholders who do file a books and records demand are still waiting for a resolution of that proceeding.

If all the relevant proceedings are brought in the same jurisdiction, such as Delaware, the courts will often stay the quick-filing cases to allow the books and records plaintiffs to catch up. But what happens if the first filed cases are brought out of state, are not stayed, and are dismissed on “demand futility” grounds before the books and records plaintiffs have had a chance to build their case?

Two recent opinions from Delaware’s Court of Chancery are likely to change the ground rules in such situations.

In cases involving Lululemon and Wal-Mart, plaintiffs who had not availed themselves of Section 220 filed “conclusory” complaints outside of Delaware that were dismissed for failure to make demand on the directors to bring an action. At the same time, two different sets of plaintiffs completed their books and records inspections and then filed their respective derivative complaints in Delaware. Because the Section 220 actions took several years to complete, by the time these investors were able to bring their actions, the other, out of state derivative cases had already been dismissed. With the benefit of their inspection of corporate records, the complaints in the Delaware actions were far more specific and detailed than the out of state complaints had been.

Nevertheless, the Chancery Court dismissed the Delaware derivative lawsuits because it found that the courts in the non-Delaware proceedings had already decided that demand on the directors to bring these claims was not excused. As a result, the Delaware plaintiffs gained nothing from their years’-long efforts to investigate the case by using Section 220.

In Lululemon, the company’s founder was accused of insider trading after unloading a bulk of his shares the day after finding out that the company’s CEO intended to resign, but before that information was released to the public. In order to investigate diligently, one of the shareholder plaintiffs, represented by Pomerantz, filed a Section 220 action demanding corporate records from Lululemon in May 2013. Another Section 220 action was brought by another shareholder plaintiff in Delaware in October later that year. On April 2, 2014, the Chancery Court ordered Lululemon to produce documents relating to the sale of shares that occurred just before the public announcement of the CEO’s resignation. In July 2015, the Delaware plaintiffs filed their derivative lawsuit against Lululemon for breaches of fiduciary duties.

The first derivative lawsuits against Lululemon alleging breaches of fiduciary duties were filed in New York federal court after Pomerantz filed its Section 220 action in Delaware. Separate New York suits by two shareholder plaintiffs were filed in August 2013, but an amended complaint consolidating the two was filed January 17, 2014. In response to the New York case, Lululemon filed a motion to dismiss, arguing that the New York plaintiffs failed to adequately allege demand futility. Pomerantz, on behalf of the Delaware plaintiffs, sought to intervene in the New York matter, requesting that the New York court stay the case pending resolution of the Section 220 action in Delaware, or in the alternative, to dismiss one of the breach of fiduciary duty claims without prejudice in order to allow it to move forward in Delaware.

The New York federal court denied Pomerantz’s requests and granted defendant’s motion to dismiss. Shortly thereafter, the Chancery Court in Delaware dismissed the Delaware derivative complaint, finding that the same claims and issues had already been adjudicated in New York.

The Lululemon decision comes on the heels of the Wal-Mart decision, rendered two months before, where diligent plaintiffs in Delaware got the short end of the stick following the dismissal of an analogous but poorly researched case in an Arkansas federal court. In 2012, a widely-publicized bribery scandal led shareholder plaintiffs to file lawsuits against Wal-Mart. In Delaware, the plaintiffs first filed a Section 220 action that took three years to resolve. They did not file their derivative action until July 2015. The Arkansas plaintiffs filed their derivative action without the benefit of making a books and records demand. Much like in Lululemon, Wal-Mart filed a motion to dismiss attacking the Arkansas plaintiffs’ failure to allege demand futility with sufficient facts. The Arkansas federal court agreed with Wal-Mart and dismissed the complaint; shortly thereafter, the Delaware Chancery Court dismissed its derivative complaint on the grounds of issue preclusion.

Key to both decisions was the finding that there is no presumption of inadequacy for fast-filing plaintiffs, and that the level of detail between the competing complaints is irrelevant to the issue preclusion analysis. In other words, diligent plaintiffs who sought books and records before suing are stuck with the results of the quick-filing cases.

At the time, the distinctive circumstances of the Wal-Mart case tempered arguments in favor of de-emphasizing Section 220 actions. Indeed, rarely do Section 220 actions drag on for three years. However, coupled with the Lululemon decision, plaintiffs faced with the prospect of multi-jurisdiction litigation need to analyze the practical benefits of filing an action quickly rather than waiting for a books and records action to conclude—even if the former goes against the advice of the Chancery Court to make use of the “tools at hand.”

The Supreme Court Allows Investors To Pursue State Law Claims In State Court

Attorney: Justin Nematzadeh
Pomerantz Monitor July/August 2016

Federal courts have exclusive jurisdiction over claims alleging violations of the Securities Exchange Act, such as securities fraud. But in some cases the same conduct can violate both the federal securities laws and state laws; and in some of those cases investors may choose, for a variety of tactical reasons, to bring their claims in state court, under state law only. Naturally, defendants look for ways to fight back. In class action cases, Congress passed a law a few years ago that effectively federalizes all state law cases challenging conduct that could have been pleaded as securities laws violations, whether investors pleaded federal claims or not. But that leaves open the question of when and whether claims brought by individual investors can proceed in state court.

In a case involving Merrill Lynch, the United States Supreme Court recently answered that question. It held that a state law case does not have to be brought in federal court just because defendants’ alleged conduct could also be a violation of the Securities Exchange Act.

In that case, former shareholders of Escala Group, Inc. sued Merrill Lynch and several other financial institutions for manipulating the price of Escala stock through “naked short sales” of its stock. In a typical short sale, the seller borrows stock from a broker, sells it to a buyer on the open market, and later purchases the same number of shares to return to the broker. The short seller pockets the potential stock price decline between the time of selling the borrowed shares and buying the replacement shares to pay back the broker’s loan.

But in a naked short sale, the seller has not borrowed the stock that he is selling short. In market manipulation cases, for example, defendants typically flood the market with a large number of sell orders, but it may not be possible to borrow enough shares to cover all these transactions. In those cases, the short seller may not be able to deliver the sold shares to the buyer when the transaction is scheduled to close. Naked short selling can drive down a company’s stock price, injuring investors. SEC regulations aim to curb market manipulation by prohibiting short sellers from intentionally failing to deliver securities.

In the Merrill Lynch case, plaintiffs sued defendants in New Jersey state court for naked short selling under several New Jersey statutes and common law causes of action. Although not alleging violations of the federal securities laws, the complaint catalogued past accusations against defendants for flouting securities regulations, couching the naked short-selling description in terms suggesting that defendants had again violated this regulation.

Defendants attempted to remove the case to federal court, plaintiffs objected, and the ensuing struggle played out all the way to the Supreme Court. There defendants argued that plaintiffs had explicitly or implicitly asserted that defendants had breached an Exchange Act duty, so the suit was “brought to enforce” that duty and gave federal court exclusive jurisdiction. Under this argument, the case would have remained in federal court even if plaintiffs had sought relief only under state law and could have prevailed without proving a breach of an Exchange Act duty. Plaintiffs countered by arguing that a suit is “brought to enforce” the Exchange Act’s duties only if the asserted causes of action were created by the Exchange Act, which was not the case here.

The Supreme Court adopted a middle ground, ultimately siding with plaintiffs and remanding the suit to state court. Adopting a “natural reading” of the exclusive jurisdiction provision, the Court held that it did not apply just because a complaint mentions a duty established by the Exchange Act. The Supreme Court held that exclusive federal jurisdiction applied only when a complaint (i) directly asserted an Exchange Act cause of action or (ii) asserted a state law cause of action that would require the plaintiff to demonstrate that defendants breached an Exchange Act duty. Plaintiffs’ suit would have fallen under the compass of the second prong of this interpretation if the New Jersey statutes made illegal “any violation of the Exchange Act involving naked short selling.”

Noting respect for state courts, the Supreme Court stated that its decisions reflected a “deeply felt and traditional reluctance . . . to expand the jurisdiction of federal courts through a broad reading of jurisdictional statutes.” Deference to state courts was stronger here to limit Section 27 of the Exchange Act’s mandated—rather than permitted— federal jurisdiction, depriving state courts of all ability to adjudicate claims. The Supreme Court stated that Congress likely contemplated that some complaints intermingling state and federal questions would be brought in state court by specifically affirming the capacity of state courts to adjudicate state law securities actions. Moreover, the exclusive jurisdiction provision does nothing to prevent state courts from resolving Exchange Act questions resulting from defenses or counterclaims.

After Merrill Lynch investors can avail themselves of the additional weapon of state court in suing for market manipulation by asserting causes of action under state laws that do not necessitate a showing of a federal-law breach. In doing so, they can even allege defendants’ federal-law violations for similar conduct.

Court Grants Final Approval Of $45 Million Groupon Settlement

Pomerantz Monitor July/August 2016

The Honorable Charles R. Norgle of the United States District Court for the Northern District of Illinois has granted final approval of the $45 million class settlement achieved in In re Groupon Securities Litigation, No 12 C 2450 (N.D. Ill.). The Pomerantz Firm was appointed lead counsel in 2012, and has vigorously litigated the case for nearly four years.“We are pleased to have reached this favorable settlement for class members,” Pomerantz partner Joshua Silverman stated.

The Pomerantz Firm reminds all investors who purchased shares in Groupon’s initial public offering, or between November 4, 2011 and March 30, 2012, that the Court has established a claims filing deadline of August 26, 2016.

Claims forms, class notice, and other important documents are available on the settlement website: www.grouponsecuritieslitigation.com.

Huge Appraisal Remedy Awarded In Dell Merger Case

Attorney: H. Adam Prussin
Pomerantz Monitor July/August 2016

In 2013, Michael Dell, the founder and CEO of computer manufacturer Dell, Inc., offered to take the company private at a price of $13.75 per share. Many investors were dissatisfied with the offer, but it was approved by a majority vote of the shareholders.

Many shareholders who voted against the deal elected to pursue an appraisal remedy, which allows dissenters to ask the court to determine the “fair value” of their shares. Appraisal petitions are representative actions brought on behalf of all investors pursuing appraisal, meaning only one dissenting shareholder needs to file a petition and prosecute the appraisal case on behalf of others. An appraisal differs significantly from typical shareholder lawsuits challenging mergers. Most notably, they don’t involve claims of wrongdoing. It is not necessary, for example, to show that the directors who negotiated and approved the transaction were conflicted, were negligent, or in some other way breached their fiduciary duties to investors. In fact, in the Dell case the court determined that no such violation had occurred and that the directors did everything they could to seek competitive bids for the company. Here, no competing bidder could be found who could challenge Michael Dell’s bid.

Nevertheless, dozens of shareholders were convinced that the price Dell paid was not “fair value,” as defined by Delaware law, and sought appraisal of their shares. Several of them were declared ineligible to pursue this remedy because they had failed, for one reason or another, to comply with Delaware’s byzantine rules for pursuing appraisal. In the end, 20 institutional investors were allowed to pursue their claims.

This spring, the Delaware Chancery Court issued a bombshell ruling in the appraisal case, finding that the “fair value” of Dell’s shares was $17.62 each, about 22 percent above the merger price of $13.75. Put another way, the court found that the $22.9 billion paid in the merger undervalued the company by about $6 billion. However, because only 20 investors were deemed qualified to pursue their appraisal remedy, they will get only about $35 million as a result of the decision, leaving almost $6 billion “on the table.”

Embarrassingly, among the disqualified shareholders were clients of T. Rowe Price, a mutual fund manager that had vociferously opposed the merger. Price accidently voted its clients’ shares in favor of the transaction and thereby disqualified them from pursuing an appraisal remedy. As an act of contrition Price reimbursed its clients $194 million – a pretty costly mistake.

The Dell appraisal decision may well add fuel to a recent upsurge in appraisal cases resulting from going private mergers. Increasingly, hedge funds and other aggressive investors have been snatching up shares of companies that are the subject of a takeover or going private proposals, in the expectation that they will file an appraisal case and make a killing in the transaction. From January 2015 to date, appraisal petitions were filed in about 15% of transactions eligible for appraisal. The results in these cases have been pretty good: an article in a trade journal, Securities Law 360, surveyed appraisal cases during the past 6 years, and found that the courts awarded large judgments to investors, above the merger price, much of the time. For example, in the Dole Food deal, it awarded a 20% premium; In the Safeway deal, 26%; Canon, 17.6%; Hesco, 75.5%; Orchard Enterprises, 127.8%; 3M Cogent, 8.5%; Cox Radio, 19.8%; Am. Commercial Lines, 15.6%; Golden Telecom, 19.5%; and Sunbelt Beverage, 148.8%. On top of these large premiums, the courts also awarded hefty interest on these awards. The appraisal statute requires the court to award interest on the award at a relatively high rate.

Sweet.

POMTalk: Defined Benefit Plans Truly Benefit Public Employees

ATTORNEY: JENNIFER PAFITI
POMERANTZ MONITOR MAY/JUNE 2016

As I visit institutional investor clients across America, a frequent topic of discussion is a cost/benefit analysis of defined benefit vs. defined contribution plans. As I will more fully explain below, research and experience have demonstrated that public pension funds and the employees they serve likely do best contributing to a defined benefit plan coupled with a portfolio monitoring service.

Most state, municipal, and county workers are covered by a traditional defined benefit plan.

The financial crisis of 2008 and its aftermath led some public pension funds to consider shifting some or all of their pension systems from a defined benefit to a defined contribution plan. In fact, six states have replaced their traditional defined benefit plan with a mandatory hybrid plan (which requires participation in both a defined benefit and a defined contribution plan): Georgia, Michigan, Rhode Island, Utah, Tennessee, and Virginia.

Prior to the financial crisis, while feeling the glow of the stock market’s stellar performance of the 1990’s, Michigan and Alaska introduced plans requiring all new hires to participate solely in a defined contribution plan. Meanwhile, California, Indiana, and Oregon adopted hybrid plans. Colorado and Ohio have introduced optional defined contribution plans. Enrollment in these plans has been modest, with most workers choosing to continue to maintain the protection against investment risk and the promise of an annuity that defined benefit plans offer. In Alaska, however, despite the fact that nearly three quarters of its public employees are not covered by Social Security, all new hires are required to join a defined contribution plan. The result is that Alaskan state workers and teachers hired since July 2006 do not have any form of defined benefit protection.

According to a 2014 study by Alicia H. Munnell, Jean-Pierre Aubry, and Mark Cafarelli of the Center for Retirement Research of Boston College, what motivated states to introduce a defined contribution plan differed before and after the financial crisis. Before 2008, some saw it as a way to offer employees an opportunity to manage their own money and participate directly in a rapidly rising stock market. In contrast, after the financial crisis, cost and risk factors motivated some states to make the shift.

A 2016 study by Nari Rhee and William B. Fornia of the University of California, Berkeley, modeled how retirement income would fare for teachers on three types of pension: (1) the current defined benefit offering from the $186 billion California State Teachers Retirement System (“CalSTRS”) for hires since 2013; (2) an idealized 409(k) plan (similar to defined contribution); and (3) a cash balance plan with guaranteed 7% interest on contribution. The result, in a nutshell: for the vast majority of California teachers (six out of seven), the CalSTRS defined benefit pension provided greater, more secure retirement income compared to a 401(k)-style plan.

Apart from the rewards of defined benefit plans touted by numerous studies, a significant benefit available to these plans—that is not available to defined contribution plans -- is that their investment portfolios may be monitored by professionals who are expert in identifying and evaluating losses attributable to financial misconduct, and providing advice to institutional investors on how best to maximize their potential recoveries worldwide. The United States sees hundreds of new securities fraud class actions filed each year, as well as approximately 100 class action settlements. Institutional investors that do not engage a portfolio monitoring service run the risk of leaving money on the table by not participating in settlement recoveries or taking affirmative action to recover their losses when appropriate.

Public pension funds that offer a defined benefit plan coupled with a portfolio monitoring service get top marks for ensuring that their employees will enjoy a secure and amply funded retirement. 

POMShorts

POMERANTZ MONITOR MAY/JUNE 2016

CFPB Proposes Rule to Override Arbitration Clauses in Contracts for Financial Transactions.

As the Monitor has reported, the Supreme Court opened the door recently to allowing companies to enforce arbitration clauses in contracts with their customers, which would bar class actions. Because most consumer claims are too small to warrant prosecution on an individual basis, this tactic has the potential to insulate these companies from any avenue of redress.

On May 5, the Consumer Financial Protection Bureau issued a proposed rule that would restore customers’ rights to bring class actions against financial firms. The rule would apply to bank accounts, credit cards and other types of consumer loans. As reported in the Times, the new rules would mean that lenders could not force people to agree to mandatory arbitration clauses that bar class actions when those customers sign up for financial products. The changes would not apply to existing accounts, though consumers would be free to pay off their old loans and open new accounts that are covered. The rule would apply only to the consumer financial companies that the agency regulates. It would not apply to arbitration clauses tucked into contracts for cellphone service, car rentals, nursing homes or employment.

The rules are not subject to Congressional approval.

Labor Department Issues Rule Imposing Fiduciary Duty on Brokers Who Advise Clients Investing in Retirement Products or Accounts.

Acting under authority conferred by ERISA, the Labor Department has finally issued a rule requiring brokers who give retirement advice to clients to enter into contracts with them affirming that they have a duty to recommend transactions only when they are in the client’s best interest. The current rule requires only that the investments they recommend be “suitable” for the clients, leaving room for brokers to recommend investments that generate the biggest fees for themselves, rather than those that are best for their customers.

For years the financial services industry has warned that this rule change would impose an enormous burden on them and on investors as well, whose costs (they say) would increase. But, as Senator Elizabeth Warren pointed out recently in a letter to the SEC, some of the biggest objectors to the new rule have been telling their own shareholders that they have nothing to worry about if the fiduciary rule is adopted. That is like trying to have your cake and eating it too.

Warren sent her letter to the SEC because that agency has so far failed in its obligation to revise these rules for regular, non-retirement brokerage accounts and other advisory relationships, even though the Dodd Frank Act requires the agency to do so.

 Agencies Try To Rein In Executive Compensation.

In April the National Credit Union Administration unveiled its proposal to implement a provision of the Dodd-Frank Act by requiring that incentive compensation that top financial executives receive gets deferred for several years and that  firms put in clawback provisions so they can take back bonuses paid to executives responsible for significant losses or illegal actions.

The Dodd-Frank Act charged the NCUA, the Federal Reserve, the Federal Deposit Insurance Corp., the Federal Housing Finance Agency, the Office of the Comptroller of the Currency, and the U.S. Securities and Exchange Commission with writing rules or guidance that would restrict bonus and other incentive compensation for financial executives, in a bid to limit the temptation to take on excessive risk. Some of these other agencies, at least, are expected to echo the NCUA’s proposal.

U.S. financial regulators set up three different tiers for implementing rules, with executives at firms with $250 billion in assets facing the toughest restrictions, followed by those at firms with assets between $50 billion and $250 billion. Firms that have between $1 billion and $50 billion will be required to put in place risk-management, record-keeping and other monitoring tools.

 Nastiest Case in Delaware.

The Delaware courts, which handle serious matters of corporate governance, are well known for their decorum and high mindedness. But the Delaware Supreme Court is currently mulling the appeal in one of the nastiest, tackiest cases to hit that state in a long time. Alan Morelli, the former chairman of OptimisCorp., a California based healthcare company, is suing the directors who abruptly terminated him in 2012, after receiving accusations that Morelli had sexual relations with an employee and also sexually harassed her. Three of those directors filed their own action against the executive, claiming that in retaliation for their dismissal of him he launched a legal vendetta against them, using $12 million of company funds. After a six day trial last year, the Chancery Court dismissed Morelli’s claims against the directors, concluding that they were unproven. The vice chancellor added that his decision also reflected a sanction against Morelli for paying or threatening witnesses with criminal prosecution or civil action “based on questionable or baseless claims.” One female therapist who accused Morelli of sexual harassment later withdrew the claim, after receiving a promise of a $550,000 series of payments in exchange for her testimony.

During the argument of the appeal, Supreme Court Justice Strine asked whether Optimis is “one of the weirder companies that exists in the world,” observing that “one of the officers of the company was having a relationship with

Mr. Morelli’s ex-wife,” while Morelli, whose office was in his bedroom, was having relations with the employee who subsequently accused Morelli of harassment.

Eighth Circuit Makes it Too Easy to Rebut Presumption of Reliance

ATTORNEY: MURIELLE J. STEVEN WALSH
POMERANTZ MONITOR MAY/JUNE 2016

In a case called Halliburton II, the Supreme Court reaffirmed the validity of the presumption of reliance under the  fraud on the market theory,” which is critical to securities plaintiffs’ ability to show class-wide reliance on a company’s misstatements. But it also held that a defendant may rebut the presumption of reliance by showing that the alleged misstatements had no “price impact,” i.e. did not affect the price of the stock in question. Under Fed. R. Evid. 301, “the party against whom a presumption is directed has the burden of producing evidence to rebut the presumption,” but the rule does not specify how much evidence must be produced, and Halliburton II did not shed any light on this issue, either. This raises the question: how much evidence is enough to rebut the presumption? Is any showing enough?

In Best Buy, the Eighth Circuit recently handed down the first federal appellate decision to attempt to answer those questions. It is widely accepted that price impact may be proven by evidence showing that either the price increased after an alleged misstatement or that the price decreased after the truth was revealed. In Best Buy, plaintiffs met one but not both of these elements. Specifically, plaintiffs challenged three statements the company made on September 14, 2010. First, it issued an early morning earnings release saying that it was increasing its EPS guidance by ten cents. In response, the stock price opened for trading at a price higher than the previous day’s close. The next two statements were made later that morning in a conference call with analysts, when the CEO and CFO stated that the company’s earnings were “essentially in line with our original expectations for the year” and that it was “on track to deliver and exceed our annual EPS guidance.” The stock price did not increase after the conference call statements. The allegedly corrective disclosure occurred on December 14, 2010, when Best Buy announced a decline in its fiscal third quarter sales and a reduction in its 2011 fiscal year EPS guidance, causing a 15% stock price drop.

In an earlier decision, the district court held that the first misstatement, the early morning earnings release, was not actionable because it was a “forward-looking statement” with appropriate “cautionary language,” and was therefore covered by an Exchange Act “safe harbor” provision. The other two misstatements survived that motion and were the focus of the class certification motion, where defendants claimed that the misstatements did not move the market and that the presumption of class-wide reliance had therefore been rebutted.

In support of its class certification motion, plaintiffs submitted an expert report saying that Best Buy’s stock price had increased in reaction to all three September 14th statements, but did not parse how much of the increase was attributable to each individual statement. Defendants’ expert report said that there was no price impact from the conference call statements because the stock price increased only after the earlier morning press release, and not after the conference call occurred several hours later. In reply, plaintiff’s expert conceded that the conference call statements did not cause an immediate stock price increase, because it essentially just confirmed the representations in the previous early morning release. However, he said that the false statements that came afterwards maintained the artificially inflated price caused by that release.

The district court certified the class, recognizing that price impact (and therefore reliance) can be shown by a price decline in response to a corrective disclosure, and that defendants had failed to make any showing that Best Buy’s stock price did not in fact decrease after the negative news released on December 14th. The district court also found that the alleged misrepresentations could have prolonged the inflation of the price, or slowed the rate of fall, satisfying the “price maintenance” theory of “price impact.”

The Eighth Circuit reversed, pouncing on plaintiffs’ expert’s concession that the conference call statements did not move the stock price, and found that this was “strong evidence” sufficient to negate price impact and therefore class- wide reliance. The majority flatly rejected plaintiffs’ additional contention that the conference call statements caused a gradual increase in the stock price between September and December as “contrary to the efficient market hypothesis.” And the court largely ignored plaintiffs’ additional evidence of price impact, shown by the stock price decline after the corrective disclosure.

This decision is troublesome for several reasons.  Courts have generally found a presumption of reliance exists when shareholders show stock prices fell in response to a corrective disclosure. The Eighth Circuit did not follow that principle, focusing instead only on the front end of the supposed fraud, when misstatements had no obvious impact on the share price. The Eighth Circuit also explicitly rejected the price maintenance theory, which has been heavily relied upon by plaintiffs seeking to prove price impact where misstatements did not move the price of a company’s stock.

A decidedly pro-defendant decision, Best Buy shows that defendants facing securities fraud class actions can significantly narrow or eliminate liability during the class certification phase based on price impact arguments. If followed by other circuits, the decision could have significant negative consequences for securities actions, because false positive statements by a company often have little or no immediate impact on the company’s stock price.

Court Denies Motion to Dismiss Our Staar Surgical Complaint

ATTORNEY: MICHAEL J. WERNKE
POMERANTZ MONITOR MAY/JUNE 2016

Judge Fitzgerald of the Central District of California recently denied defendants’ motion to dismiss our action involving STAAR Surgical Company. The action alleges that the company, its CEO and its vice president of regulatory affairs violated section 10(b) of the Securities Exchange Act as well as section 20(a), the “control person” provision.

STAAR is an FDA regulated company that designs, manufactures and sells implantable lenses to correct vision problems. In March of 2014, the company told investors that it believed that it was in compliance with all applicable FDA regulations despite the fact that an FDA inspection of STAAR’s plant was ongoing at the time and the inspector had repeatedly told management that numerous and significant FDA violations had been found. These violations are particularly important to STAAR and its investors because STAAR had a major new lens that was going before the FDA Advisory Panel in mid-March, and these violations would likely delay its approval. The company did not disclose these reports of violations, and investors did not hear about them until the FDA posted them on its website months later. At that point, STAAR’s stock price plunged 17.5%

 Defendants’ main argument for dismissal was that at the time they made their representations of compliance the violation reports were only preliminary and had not been formalized in written notices. The court rejected that argument, holding that because the FDA inspector had repeatedly identified the violations orally to management, defendants would have known that their statements of compliance would mislead investors. The court also held that the company had a duty to disclose the subsequent Warning Letter from the FDA, which stated that the new lens would not be approved by the FDA until the violations were remedied. The court held that, even though the company did not make any further “compliance” representations when it received the Warning Letter, it nevertheless had a duty to correct its prior statement on that subject.

 This opinion is significant because it shows that a statement of compliance can be misleading as a result of the FDA inspector orally identifying violations. Prior cases had dealt with the company having receipt of a written notice of violation or Warning Letter.

New York Adopts Delaware Standards for Going Private Mergers

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR MAY/JUNE 2016

In a case called the Kenneth Cole Shareholder Litigation, the New York Court of Appeals adopted, as the rule in New York, the MFW decision of the Delaware Supreme Court. There, the Delaware court held that, for claims seeking damages, the business judgement rule can protect the decision of a board of directors to accept a going private merger if certain conditions are met. Ordinarily, such decisions are reviewed under the “entire fairness” test, a very pro-plaintiff standard. The MFW court held that the business judgment rule can apply instead, provided that a series of shareholder protections exist: the merger was approved by both a special committee of independent directors and a majority of the minority shareholders; the special committee was independent and was free to reject the offer and to hire its own advisers; and the vote of the minority was informed and uncoerced. To survive a motion to dismiss, the complaint must allege facts showing that the transaction lacked one or more of these shareholder protections.

Meanwhile, the Delaware Supreme Court has itself recently extended the MFW decision to apply also to director decisions to approve mergers with unrelated entities. In such cases, where the complaint seeks damages, the entire fairness rule is inapplicable, but the courts have typically applied an intermediate standard of review, called enhanced scrutiny.” In a case called KKR, the court has now held that if the MFW conditions are met, the business judgment rule protects such decisions in post-closing actions as well. It added that under those circumstances, a showing of “gross negligence” by the directors is not sufficient to rebut the protection of the rule; “waste” has to be shown, which is an almost insurmountable burden.

Supremes: Statistical Averages Can Provide a Basis for Class-Wide Liability

ATTORNEY: AATIF IQBAL
POMERANTZ MONITOR MAY/JUNE 2016

In Tyson Foods v. Bouaphakeo, the Supreme Court upheld the use of statistical sampling evidence in class actions, at least where such evidence would have been admissible in an individual action. Defendants had argued that such statistical methods improperly treated each individual as if he or she matched a statistical average, thus manufacturing predominance by assuming away the very individualized differences that made class-wide litigation inappropriate in the first place. The Court rejected this premise and focused instead on the relevance of the statistical evidence to the substantive claim at issue. It held that, if a given class member could have used the statistical evidence to obtain a favorable jury verdict in an individual action, then the class could use it the same way. It was up to the jury to decide, in light of all of the evidence presented, whether the statistical average was probative of the situation of each class member.

Particularly under the specific facts of the case, this ruling was a straightforward application of evidentiary common sense. Nevertheless, it was generally seen as a significant victory for the plaintiffs’ bar.

The case involved workers at a pork processing plant who claimed they were not paid overtime for time spent putting on and taking off protective gear, in violation of federal law requiring compensation for such “donning and doffing”  time if it is “integral and indispensable” to their regular work. After the district court certified two classes of employees, the case went to trial and the jury awarded the classes $29 million in damages. On appeal, the defendant argued that the verdict should be thrown out because the classes never should have been certified.

To be certified as a class, the worker-plaintiffs had to prove that they could establish key elements of their claims through generalized, class-wide proof. This was easy for some elements: they all worked in the same plant, had similar job responsibilities, and were subject to essentially the same compensation policies. But the defendant insisted that individualized inquiries into each employee’s total donning and doffing time were necessary because different employees wore different gear and took varying amounts of time to don and doff the gear. It also argued that no class could be certified without proof that every member was injured, which required individualized inquiries into each employee’s time.

Federal law, to some degree anticipating this evidentiary problem, has long required employers to keep accurate records of employee work hours. But despite a 1998 federal court injunction against the very same slaughterhouse requiring it to record employee time donning and doffing protective gear, Tyson Foods had never done so. Instead, it had been compensating workers based on its own approximations of how long those activities should take.

Because there was no good individualized evidence, the worker-plaintiffs used what they called “representative evidence” to show how long workers in each department generally took to don and doff protective gear. Most significantly, they presented a study by an industrial relations expert who drew on a representative sample of 774 videotaped observations of workers and calculated the average time for workers in each department to don and doff their gear.

There are procedural mechanisms to ensure the reliability of this kind of evidence, but the defendant largely ignored them. It did not challenge the expert’s qualifications or statistical methodology. It rejected the workers’ proposal to bifurcate the trial into separate proceedings for liability and damages. While it argued at trial that the expert’s calculations were too high, it did not present a rebuttal expert with different calculations. Instead, in opposing class certification and also at trial, it insisted that it was fundamentally improper to assume that each employee donned and doffed for the same time as the average in the sample. It decried being subjected to a “trial by formula” and barred from raising unspecified “defenses to individualized claims.” And on appeal, it called for a categorical rule barring the use of representative sampling evidence in class actions.

The Supreme Court rebuffed this effort and categorically rejected the idea that class actions required their own special set of evidentiary rules. It emphasized that statistical sampling evidence is routinely used in all kinds of litigation and is often the only practicable means, for plaintiffs and defendants in individual as well as class actions, to collect and present relevant data. Thus, it held that class certification was proper as long as a reasonable jury could have believed that the employees spent roughly equal time donning and doffing. If so, it was for a trial jury to weigh the expert’s average-time calculations against the other evidence presented and to decide whether the statistical average was probative of the time actually worked by each employee.

While the utility of statistical averages in other class actions will vary, the main takeaway is that the issue must be considered in practical terms of how a reasonable jury resolving the underlying substantive claim would view the evidence. In many cases, statistical averages will be the most compelling evidence available and will say a great deal about each member of the class. This was particularly true in Tyson Foods because the defendant had never bothered to keep individualized records (despite being legally mandated to do so), and instead simply paid workers based on its own approximations of how long donning and doffing should take. But in other cases with stronger evidence of meaningful individualized variations, a jury might find statistical averages less useful.

Our Control Person Claims Upheld In Magnachip

Attorney: Michael J. Wernke
Pomerantz Monitor March/April 2016

In this case, defendant Magnachip had been forced to restate its earnings drastically after its revenue recognition policies had been found wanting. We settled our claims against all the other defendants in the litigation, except for Avenue Capital Management, which was, at one point, Magnachip’s majority shareholder. We had sued ACM under the “controlling person” provisions of the securities laws.

The district court has now substantially denied ACM’s motion to dismiss our claims against it.

The Court rejected ACM’s argument that it did not control MagnaChip because it was a minority shareholder for much of the Class Period. The Court held as adequate to allege control that ACM was a majority shareholder when the alleged fraud began; its appointees continued to serve on the Board of Directors even after its holdings declined; it continued to have significant influence over MagnaChip’s affairs; and ACM used its control to cash out its investment in MagnaChip at enormous profits.

Loss Causation and Disclosures of Investigations

Attorney: J. Alexander Hood II
Pomerantz Monitor March/April 2016

In many instances, the first indication of securities fraud is an announcement that a company is under investigation by some government authority—for example, the SEC, the Department of Justice, a U.S. Attorney’s office, or a state attorney general, to name a few. Frequently these announcements are immediately followed by significant stock drops, as the market reacts to the fact of the investigation, even before the investigation’s findings are disclosed. Because the market has already reacted to the bad news, it sometimes fails to react to subsequent news of the investigation’s findings or to disclosure of false statements by the company that the government was investigating. This non-reaction often reflects the fact that investors assumed the worst when the investigation was first announced, and thus do not react a second time to what is, in some sense, the same news, when the fraud at issue is subsequently confirmed.

For plaintiffs in securities fraud lawsuits, however, the market’s failure to react to news confirming the fraud can be a problem. To survive a defendant’s motion to dismiss, the complaint must show that the investor’s economic loss was caused by the revelation of the defendant’s fraud. Thus, when a company’s stock price plummets in reaction to news of an investigation and then barely moves when the fraud is subsequently confirmed, the company may argue that the only loss was caused by the announcement of an investigation, which the company would characterize as an intervening event, and that no losses were directly traceable to disclosure of news of the fraud itself.

Addressing these issues in Jacksonville Pension Fund v. CVB Financial Corporation, the Ninth Circuit Court of Appeals presented a sensible, context-specific view ofloss causation, holding that the announcement of an SEC investigation related to an alleged misrepresentation, coupled with a subsequent revelation of the inaccuracy of that representation, can serve as a corrective disclosure for the purposes of loss causation—in other words, that under such circumstances, the losses caused by the announcement of the investigation are recoverable, even if the stock fails to react to the subsequent confirmation of the fraud.

In 2008, CVB Financial Corporation was informed by the Garrett Group, a commercial real estate company that was CVB’s largest borrower, that Garrett would be unable to make payments on its loans from CVB. After the loans were restructured, Garrett again informed CVB in 2010 that it could not make the required payments and was contemplating bankruptcy. Nonetheless, in 2009 and 2010 SEC filings, CVB represented that  there was no basis for “serious doubt” about Garrett’s ability to repay its borrowings.

In 2010, the SEC served a subpoena on CVB, seeking information about the company’s loan underwriting methodology and allowance for credit losses. The day after CVB announced receipt of the SEC subpoena, the company’s stock dropped 22%, from $10.30 to $8.0 0per share, a loss of $245 million in market capitalization.

Analysts noted the probable relationship between the subpoena and CVB’s loans to Garrett. A month later, CVB announced that Garrett was unable to pay its loans as scheduled, wrote down $34 million in loans to Garrett, and placed the remaining $48 million in its non-performing category. On this news, however, the market barely reacted, and CVB’s stock price did not significantly fall.

As lead plaintiff in a consolidated action on behalf of CVB investors, Jacksonville Police & Fire Pension Fund filed a complaint in U.S. District Court for the Central District of California, alleging securities fraud by CVB and certain of its officers. However, the district court granted CVB’s motion to dismiss, holding that Jacksonville had failed to plausibly allege that the statements caused a loss to shareholders, given the market’s failure to react to CVB’s announcement that Garrett would be unable to pay its loans as scheduled.

On appeal, the Ninth Circuit reversed the district court’s decision on the loss causation issue. It agreed with the district court that the only significant fall in CVB’s share price occurred after the announcement of the SEC subpoena, and not after the disclosure that Garrett had failed to repay its loan. It noted that “the announcement of an investigation, standing alone and without any subsequent disclosure of actual wrongdoing, does not reveal to the market the pertinent truth of anything, and therefore does not qualify as a corrective disclosure.” However, the court held that in the case against CVB, the announcement of the SEC investigation did not stand alone; rather, the announcement was followed a month later by the company’s announcement that it was charging off millions in its Garrett loans. The market did not react to the subsequent news about the Garrett loans because the announcement of the SEC investigation foreshadowed the ultimate result. Commenting on the practical effects of its ruling, the Ninth Circuit observed that “any other rule would allow a defendant to escape liability by first announcing a government investigation and then waiting until the market reacted before revealing that prior representations under investigation were false.”

In short, the CVB Financial Corporation decision is a welcome and sensible development that removes a significant potential pleading obstacle to securities class actions in the Ninth Circuit.

Supremes: Rejected Offer Of Judgment Does Not Moot Claims Of Class Representative

Attorney: Louis C. Ludwig
Pomerantz Monitor March/April 2016

As we noted briefly in the last issue of the Monitor, in Campbell-Ewald Company v. Gomez, the Supreme Court ruled that a plaintiff’s claim cannot be mooted solely by an unaccepted settlement offer, including an offer of judgment pursuant to Federal Rule of Civil Procedure 68. Defendants had hoped that by offering the class representative – but not the class members – all the relief he or she had requested in the complaint, they could get rid of that representative and the class action as well.

The court’s ruling was widely seen on both sides of the bar as a victory for plaintiffs and their counsel. That reaction, however, was likely premature. Gomez leaves open the possibility that defendants could still “pick off” plaintiffs by actually paying or tendering them the amounts allegedly owed. Simply put, the “pick off” risk that bedeviled class action plaintiffs before Gomez remains at least theoretically intact in its wake.

Generally, Rule 68 allows a defendant to make an offer of judgment for a specified amount, including costs accrued   to date. If the plaintiff rejects the offer and the result obtained in the action is less than the amount of the rejected offer, the plaintiff must reimburse all of defendants’ costs incurred after the offer was made.

Turning down such an offer of judgment necessarily engenders risk, particularly for plaintiffs who choose to lead class actions, which, for various reasons, tend to incur higher costs on the path to trial. Even worse, defense lawyers have sharpened Rule 68 into a unique weapon known as the “pick-off” strategy,” which aims to quickly end potential class actions without ever getting to the merits of the claims.

The pick-off strategy typically plays out as follows: the named plaintiff in a class action is served with an offer of judgment for all the relief he or she personally seeks, separate from the class. Not wanting to sell out the class he or she represents, the named plaintiff rejects the Rule 68 offer in order to continue litigating for a favorable classwide outcome. Next, the defendant seeks the dismissal of the case on the basis that the offer provided the plaintiff with everything asked for in the complaint, leaving no “case or controversy” remaining to litigate. If that happens, the case cannot proceed on a class basis unless a new named plaintiff is willing to step forward. Even assuming that a new named plaintiff can readily be found, the successor is just as susceptible to the pick-off strategy as his or her predecessor.

Prior to Gomez, several federal appellate courts limited the pick-off strategy by making the effectiveness of a Rule 68 offer contingent on, variously, whether plaintiffs had been provided an opportunity to first file a motion for class certification or whether the offer actually preceded the filing of and/or ruling on a motion for class certification.

Gomez involved allegations of an unsolicited text message that violated the Telephone Consumer Protection Act (the “TCPA”). As a general matter, the TCPA places a $1,500 ceiling on statutory damages for a single violation. While Gomez was styled as a class action, the plaintiff, Gomez, had not filed a motion for class certification at the time defendant Campbell-Ewald (the advertising agency that sent the text message) served him with an offer of judgment for just over $1,500, plus reasonable costs. Gomez declined the offer by failing to accept it within the time provided. Subsequently, Campbell-Ewald prevailed on a motion for summary judgment on the ground that the offer of judgment mooted plaintiff’s individual claim.

The Court of Appeals for the Ninth Circuit reversed, holding, in part, that an unaccepted Rule 68 offer does not moot a plaintiff’s individual or class claims. As circuit precedent differed widely on these issues, certiorari was granted. The Supreme Court affirmed the Ninth Circuit, with the majority adopting Justice Elena Kagan’s dissent in Genesis HealthCare Corp. v. Symczyk, which reasoned that an “unaccepted settlement offer — like any unaccepted contract offer — is a legal nullity, with no operative effect.” The court concluded that the rejection could only mean that the settlement offer was no longer operative, and the parties “retained the same stake in the litigation they had at the outset.”

Nonetheless, the Gomez court’s focus on the offer-and acceptance dance of Contracts 101 led it to reserve, “for a case in which it is not hypothetical[,]” the question of whether defendants can continue to moot claims by making an actual payment of full relief. Justice Ruth Bader Ginsberg, writing for the majority, explained that a claim might be mooted under Rule 68 when a defendant “deposits the full amount of the plaintiff’s individual claim in an account payable to the plaintiff, and the court then enters judgment for the plaintiff in that amount.” Perhaps even more ominously, Chief Justice John Roberts described the majority’s “offers only”- circumscribed decision as “good news.”

With the recent passing of Justice Antonin Scalia and resultant 4-4 split on the Court, the possibility remains that defendants will try the tactic of full tenders of relief to named plaintiffs in class actions, and that the issue will likely find its way back to the High Court.

The securities plaintiff’s bar has not borne many such pickoff attempts, probably as an unintended consequence of the Private Securities Litigation Act of 1995 (“PSLRA”).

The PSLRA expressly creates an open competition for “lead plaintiff.” Although the investor with the largest losses usually wins that competition, it is only after a profusion of qualified plaintiffs has come forward following a nationwide notification process. Indeed, an entire informational infrastructure has arisen to provide investors with PSLRA-mandated notice of securities class actions. Moreover, unlike consumer class actions, where damages to individual class members may be relatively small, lead plaintiffs chosen in securities class actions typically hold hundreds of thousands or even millions of shares of company common stock, and have millions of dollars in individual damages. Thus, the act of picking off such plaintiffs would not only be extremely costly but would actually be futile owing to no shortage of potential replacements, and if it did work, it would result in thousands of individual shareholder claims being filed, swamping the courts. This would essentially amount to litigating thousands of shareholder claims on an individual basis. At least in the securities context, Gomez, a case about short-circuiting class actions, ironically ends up highlighting their economy, particularly from the vantage of the defendants’ bar. 

 

Executives Seeking To Avoid Securities Fraud Liability Must Plan Ahead

Attorney: Matthew L. Tuccillo
Pomerantz Monitor March/April 2016

A key element of any securities fraud claim is evidence of defendant’s scienter, or intent to defraud. One way to establish scienter is to show that a given defendant engaged in transactions (typically sales) in company securities during the alleged period of fraud. Indeed, a complaint that does not allege such transactions faces heightened scrutiny by the court on a motion to dismiss.

Executives trying to explain such transactions frequently point to the existence of a so-called Rule 10b5-1 stock trading plan, which, for example, could schedule automatic stock transactions at pre-determined intervals or at specific future times. Rule 10b5-1, enacted by the SEC in 2000, expressly states that a person’s transaction in a security is “not ‘on the basis of’ material nonpublic information” if it is demonstrated that “before becoming aware of the information, the person had…[a]dopted a written plan for trading securities.” See 17 C.F.R. 240.10b5 -1(c)(1)(i)(A)(3). Since then, the case law has strongly weighed in favor of executives who had sold company stock, even at the height of an alleged fraud, where the sales were made pursuant to such a trading plan, often ruling that stock trades made pursuant to the plan could not evidence scienter. 

However, one dogfight in which we frequently engage revolves around the circumstances and timing of a Rule 10b5-1 plan’s creation. In our experience, too often, executives chose either to adopt a new Rule 10b5-1 plan or to amend a pre-existing Rule 10b5-1 plan during the period of alleged fraud, frequently causing an increase in sales of company stock at inflated prices before the fraud gets revealed and the stock price corrected by such revelation. The executives later seek to hide behind the existence of such a plan as exonerating evidence of their lack of intent to profit from an alleged fraud, while we typically argue that the timing of its adoption or amendment negates that argument.

An important battleground on this issue has been the Second Circuit, which encompasses the U.S. federal district courts in Connecticut, Vermont, and most significantly, New York. For context, according to a recent report prepared by Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse, the Second Circuit alone accounted for 50 of the 189 (26.5%) securities class action lawsuits filed in 2015. Historically, we have relied upon a collection of lower court decisions from within the Second Circuit that discounted reliance by company insiders on Rule 10b5-1 plans adopted or amended during an alleged period of fraud. Included among them is George v. China Auto Sys., Inc., No. 11 Civ. 7533 (KBF), 2012 WL 3205062, at *9 (S.D.N.Y. Aug. 8, 2012), in which Pomerantz secured a ruling that Rule 10b5-1 trading plans entered into during the alleged period of fraud did not dispel the inference of the defendant executive’s scienter. Defendants, not surprisingly, have instead relied upon district court cases supporting the more generalized legal proposition that the existence of a Rule 10b5-1 plan undercuts the scienter inference, attempting to side-step the more nuanced factual issues surrounding the timing and circumstances of a plan’s adoption or amendment.

The Second Circuit Court of Appeals recently weighed in on this important issue, resolving it in favor of our  plaintiff side arguments in Employees’ Ret. Sys. of Gov’t of the Virgin Islands v. Blanford, 794 F.3d 297 (2d Cir. 2015).

Blanford concerned an alleged fraud regarding Green Mountain Coffee Roasters, Inc. and its Keurig brewing system, where investors were told that Green Mountain’s business was booming, with its inventory at “optimum levels” as it strained to meet high demand. In reality, it had been accumulating significant overstock of expiring and unsold product. During the alleged fraud, company insiders, including defendants Blanford (Green Mountain’s President/CEO/Director) and Rathke (its CFO/Secretary/Treasurer), sold company stock for millions of dollars in proceeds. Both Blanford and Rathke entered into new 10b5-1 trading plans just after one alleged misstatement (an earnings call), which permitted them to engage in significant sales shortly thereafter. The fraud was later revealed, causing Green Mountain’s stock price to plummet.

On these facts, the Second Circuit, citing Pomerantz’s decision in George v. China Auto Sys., among other precedent, rejected defendants’ argument that the 10b5-1 plan insulated them from an inference of scienter. Noting that Blanford and Rathke had entered into their 10b5-1 plans after an alleged misstatement (the earnings call) and after the fraudulent scheme began, the Second Circuit held: “When executives enter into a trading plan during the Class Period and the Complaint sufficiently alleges that the purpose of the plan was to take advantage of an inflated stock price, the plan provides no defense to scienter allegations.” Viewing the alleged facts holistically, the court held that defendants’ stock sales – including those made within the 10b5-1 plans – coupled with other alleged conduct (e.g., steps taken to conceal the true facts from investors), supported a strong inference of their scienter. Going forward, Blanford will be an important precedent, both in the Second Circuit and beyond, and we have already cited it to courts overseeing briefing on motions to dismiss our clients’ complaints.

 

Pomerantz Wins Class Certification In Two Major Cases: Barclays Investors Win Class Certification

Attorney: Tamar A. Weinrib
Pomerantz Monitor March/April 2016

The same day as the class cert ruling in Petrobras, February 2, 2016, Judge Scheindlin of the federal district court in the Southern District of New York, after a full evidentiary hearing, granted plaintiffs’ motion to certify a class of allegedly defrauded Barclays investors in the Strougo v. Barclays PLC securities litigation, and appointed Pomerantz as counsel for the class.

The case, which involves claims pursuant to Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, concerns defendants’ concealment of information and misleading statements over a three-year period regarding its management of its “LX” dark pool, a private trading platform where the size and price of the orders are not revealed to other participants. Even though the dark pool was just a tiny part of Barclays’ overall operations, Judge Scheindlin found that defendants’ fraud was highly material to investors because it reflected directly on the integrity of management. The court also found that reliance by class members on defendants’ omissions and misstatements could be presumed on a class-wide basis.

The court held that, under the Supreme Court’s Affiliated Ute doctrine, it was appropriate to presume that investors relied on the alleged material omissions, which involved defendants’ failure to disclose that they were operating their LX dark pool in a manner that did not protect Barclays’ clients’ best interests. Specifically, defendants failed to disclose that Barclays was not adequately protecting LX investors from “toxic” high frequency trading and were disproportionately routing trading orders back to LX. The court held that because LX constitutes a tiny fraction of Barclays’ business, a reasonable investor likely would have found the omitted misconduct far more material than the affirmative misstatements – because it reflected on management’s overall integrity. Indeed, it is for this reason that the court considered the omissions “the heart of this case.”

 

With respect to defendants’ affirmative misrepresentations, the court held that under the Supreme Court’s Basic “fraud on the market” doctrine, reliance by investors could also be presumed because Barclays’ stock trades in an efficient market. Its stock price would therefore have reflected defendants’ misrepresentations and omissions during the Class Period.

Of particular interest to Section 10(b) class action plaintiffs is the court’s rejection of defendants’ argument that to show market efficiency, plaintiffs must provide so-called “event studies” showing that the market price of the company’s stock price reacted quickly to the disclosure of new material information about the company. As in the Petrobras decision discussed in the previous article, though plaintiffs did in fact proffer an event study, the court held – consistent with a vast body of case law – that no one measure of market efficiency was determinative and that plaintiffs could demonstrate market efficiency through a series of other measures, which plaintiffs also provided here.

In so holding, the court observed that event studies are usually conducted across “a large swath of firms,” but “when the event study is used in a litigation to examine a single firm, the chances of finding statistically significant results decrease dramatically,” thus not providing an accurate assessment of market efficiency. The district court then found, following its extensive analysis, that plaintiffs sufficiently established market efficiency indirectly and thus direct evidence from event studies was unnecessary. Thus, the court went even further than the court in Barclays in downplaying the importance of event studies on class certification motions.

The district court also rejected defendants’ contention that certification should be denied because plaintiffs had supposedly failed to proffer a proper class wide damages model pursuant to the Supreme Court’s decision in Comcast. In rejecting that contention, the court recognized that the “Second Circuit has rejected a broad reading of Comcast” in its Roach v. T.L. Cannon Corp. decision. Indeed, the district court noted the Second Circuit’s finding in Roach that Comcast “did not hold that proponents of class certification must rely upon a classwide damages model to demonstrate predominance...[T]he fact that damages may have to be ascertained on an individual basis is not sufficient to defeat class certification.” The district court held that our expert’s proposal of using an event study and the constant dollar method to calculate damages is consistent with the theory of the case, and one that is typically used in securities class actions. The district court rejected defendants’ contention that plaintiffs should have proffered a model to identify and disaggregate confounding information as irrelevant, given that confoundinginformation would affect all class members the same.

Pomerantz Wins Class Certification In Two Major Cases: Class Certification Granted In Our Petrobras Case

Attorneys: H.Adam Prussin and Matthew C. Moehlman
Pomerantz Monitor March/April 2016

On February 2, 2016, Pomerantz achieved an important victory for investors when Judge Rakoff of the Southern District of New York certified two classes in our litigation against Petróleo Brasileiro S.A. – Petrobras, Brazil’s state run oil giant, concerning its involvement in one of the largest corruption and bribery scandals of the 21st century. One class consists of investors who purchased equity securities of Petrobras in the U.S. between 2010 and 2015. This class asserts fraud claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The other class consists of purchasers of debt securities Petrobras issued in public offerings in May 2013 and March 2014, who are alleging violations of Sections 11 and 12(a)(2) of the Securities Act of 1933. The lead plaintiff in the case is our client, Universities Superannuation Scheme.

The case concerns one of the most notorious securities frauds ever committed – a multi-year, multi-billion-dollar kickback and bid-rigging scheme. The scheme was allegedly orchestrated by former top Petrobras executives from at least 2004 onward, who systematically conspired to steer construction contracts to a cartel composed of 20-30 of Brazil’s largest contracting companies. The executives ensured that the contracts, padded by billions of dollars, were awarded to designated members of the cartel without any authentic competitive process. In return, the cartel kicked back hundreds of millions of dollars to the executives, who pocketed a cut of the bribe money, then gave the rest to their patrons in Brazil’s three ruling political parties. Revelations of this scheme decimated Petrobras’ stock price, devastating a class of investors. So far, five Petrobras executives have been convicted on criminal conspiracy and money-laundering charges, as well as a number of their confederates at the construction companies, and facilitating intermediaries.

As in many securities fraud cases, a central issue in the class certification motion was whether plaintiffs could establish that defendants committed “fraud on the market,” which allows investors to establish the element of reliance on a classwide basis. Failing this test would mean that reliance would have to be shown separately for each class member and that common questions would therefore not “predominate” over individual ones. To establish fraud on the market, plaintiff has to show that the securities in question trade on an efficient market, and that therefore defendants’ frauds affected the market price that each class member paid for purchasing Petrobras securities.

Courts have established a series of criteria for determining market efficiency, referred to as the “Cammer factors,” originally put together in a seminal case of that name. Most of these factors are indirect measures of market efficiency, including such things as the company’s market capitalization, the volume of trading in its securities, the typical bid-asked spread, the number of market makers in its shares and the number of analysts covering the company. The market for Petrobras securities easily passed all of these tests.

However, using an argument being pressed by defendants in most securities actions, the Petrobras defendants claimed that the most important Cammer factor is the “direct evidence” test, measured by how the market price of the company’s securities actually reacted to disclosure of unexpected news. This test, typically measured by socalled “event studies,” can be more difficult for investors to satisfy, because price movements in the real world can be affected by a host of market-moving information that can obscure the effects of the actual disclosure of the fraud. Defendants argued that this single factor trumps all the other Cammer factors and that it was not satisfied here because the market did not always react perfectly and instantaneously to unexpected disclosures. The district court held that plaintiff’s event studies were sufficient, and, more importantly, that perfect efficiency was not required:           

In assessing market efficiency, courts should not let the perfect become the enemy of the good. In this case, where the indirect Cammer factors lay a strong foundation for a finding of efficiency, a statistically significant showing that statistically significant price returns are more likely to occur on event dates is sufficient as direct evidence of market efficiency and thereby to invoke Basic’s presumption of reliance at the class certification stage. 

The court also rejected defendants’ argument that, because several large institutional investors had already “opted out” of the class, electing to pursue their own actions, investors were motivated to pursue their own actions and a class action was therefore unnecessary. To the contrary, the court determined that to deny class certification would plunge the courts into a morass of individual lawsuits and would do more harm than good.

Pomerantz News, At Home and Abroad

Pomerantz MonitorJanuary/February 2016

As part of its commitment to education, Pomerantz presented a moot court in January 2016 for advanced law students of Bar Ilan University in Israel. Daniel J. Kramer, Partner at Paul, Weiss, acted as counsel for the defense; Jeremy Lieberman as counsel for plaintiffs; and Marc Gross as judge. They argued Polycom, an actual securities fraud class action in which Pomerantz is lead counsel for the plaintiff class. The case alleges that the company was making positive statements about its operation and prospects, while it did not disclose that its CEO had submitted numerous false expense reports, claiming personal expenses as business expenses, and thereby misappropriating hundreds of thousands of dollars from the company.

 Meanwhile, on the home front, Pomerantz is proud to announce that Brenda Szydlo has joined the firm as Of Counsel in our New York office. Brenda has more than twenty-five years of experience in complex civil litigation in federal and state court on behalf of plaintiffs and defendants, with a particular focus on securities and financial fraud litigation, litigation against pharmaceutical corporations, accountants’ liability, and commercial litigation.

 Brenda is a 1988 graduate of St. John’s University School of Law, where she was a St. Thomas More Scholar and member of the Law Review. She received a B.A. in economics from Binghamton University in 1985.

SCOTUS Shorts

ATTORNEY: H. Adam Prussin
Pomerantz Monitor January/February 2016

 

 

 

The Supreme Court has just issued two very significant rulings. In the first one, it granted certiorari to review U.S. v. Salman, a criminal insider trading prosecution. The case turns on the question of what sort of personal benefit, if any, a “tippee” has to give to his “tipper” in exchange for the inside information before the tippee can be liable for trading on it. This issue received national attention a few months ago when the Second Circuit gave its answer to this question in U.S. v. Newman; but the Supremes denied cert in that case.

 In Salman, defendant Salman received the inside information from a close friend who, in turn, had heard it from his brother. The question is whether the personal relationship between the two brothers in itself satisfies the “personal benefit” requirement for insider trading, or whether the government also has to show that the tippee brother gave an additional, tangible benefit to his brother in exchange for the information. In its decision, the 9th Circuit held that no additional tangible benefit, beyond the personal relationship, was required. In Newman, the Second Circuit previously held otherwise. Curiously, the 9th Circuit’s opinion was written by Judge Rakoff, a District Court judge sitting by designation. Judge Rakoff sits in the Southern District of New York, which is part of the Second Circuit. Through this quirk of fate, Judge Rakoff got another circuit court to disagree, publicly, with the Second Circuit’s Newman decision, which is binding on him when he sits as a district judge in New York.

 

In the Supreme Court’s second ruling, Campbell Ewold, it struck a blow against a tactic increasingly used by defendants in class actions: trying to “moot” the claims of the class representative by offering to pay all of his claimed damages. If the representative’s claim is mooted (i.e., satisfied), his individual claim would be dismissed, and the class would have no representative. If the class could not find another representative, the whole class action would be dismissed. If this could work, the class action device could be eviscerated.

 

Fortunately, the Supremes said no, finding that a rejected offer of settlement does not wipe out the representative’s claim; but, unfortunately, they left open the question of whether this tactic could work if, instead of just offering to pay the claimed damages, the defendant actually pays the money into an account for the benefit of the plaintiff, such as an escrow account or the clerk’s office. To resolve that question, we may need “Campbell Ewold 2.”

 

 

Pomerantz, the oldest securities law firm in the United States, proudly celebrates its 80th birthday

Pomerantz was founded in 1936 by Abraham L. Pomerantz, who, during his legendary career, relentlessly fought to protect investor rights. In doing so, he secured numerous victories now enshrined in the laws applied to securities class actions and derivative lawsuits.

Abe’s trailblazing spirit lives on at Pomerantz – from our historic Supreme Court victory recognizing the right to a jury trial in derivative actions in 1970, to being appointed sole lead counsel in 2015 in the action against Brazilian oil giant, Petróleo Brasileiro SA – Petrobras, surrounding its conduct in one of the largest corruption and bribery scandals of the 21st century. Although our client did not suffer the largest financial loss, the court found that Pomerantz’s outstanding reputation and the client’s conduct in overseeing counsel represented the “gold standard” for institutional investors seeking to move for appointment as lead plaintiff.

We are celebrating our 80 years with a bang. Pomerantz acts as lead counsel in a closely-watched securities class action lawsuit against ChinaCast Education Corp., stemming from its CEO’s alleged misappropriation of $120 million in company funds. The Ninth Circuit recently revived the case – after its dismissal by a lower court – ruling that the CEO’s fraud could be imputed to ChinaCast, even though his alleged embezzlement and misleading of investors went against the company’s interests. The litigation will now return to the lower court for trial.

Pomerantz is co-lead counsel in a securities class action against S.A.C. Capital Advisors LLC, in which the court recently certified two classes of plaintiffs. The case arises from the most profitable insider-trading scheme ever uncovered, in which the defendants illegally gained profits and avoided losses of at least $555 million from trades in Elan Corporation plc and Wyeth Pharmaceuticals, Inc. securities and related options while in possession of material, non-public information.

In 2015, Pomerantz defeated defendants’ motion to dismiss the class action against Barclays plc for misstatements about its “dark pool.” The court found that, although revenues from Barclays’ dark pool were under 5% of company revenues – a statistical benchmark often used to assess materiality – the misrepresentations went to the heart of its reputation and were therefore actionable. The decision is a victory for investors for its recognition that corporate integrity and ethics are material factors upon which investors rely when purchasing securities, even where the mounts of money involved fall below a presumptive numerical threshold.

Pomerantz acts as lead counsel for investors in a securities class action against Groupon for alleged misconduct related to its 2011 initial public offering, a case in which we have won every substantive motion to date. One of the most important milestones was our defeat of a defense motion to disqualify the plaintiffs’ class certification expert in March 2015. The defense argued that he was unreliable as he failed to conduct put-call parity and short lending fee analyses. We disagreed, citing the landmark U.S. Supreme Court ruling in Halliburton. After an extensive evidentiary hearing, the court sided with Pomerantz, holding that such tests were unnecessary because they addressed an extreme variation of market efficiency that “was squarely rejected by the Halliburton court.”

We are lead counsel in a securities class action against Walter Investment Management Corporation, in which the court dismissed our original complaint, while granting leave to file an amended complaint. Pomerantz then prevailed, overcoming the difficult burden to prove, in the motion to dismiss phase, that disclosure of a government investigation of and proposed enforcement action against the company satisfied the requirement for loss causation. Given the Myers/Loos standard prevailing in the Ninth and Tenth Circuits, which strictly limits the circumstances under which the announcement of a government investigation can be said to cause a loss, this victory is significant.

 

 

Auditing the Auditors

ATTORNEY: Joshua B. Silverman
Pomerantz Monitor January/February 2016

 

Investors rely on auditors to insure the integrity of corporate financial statements, but have little insight into the individual auditors themselves. That is about to change. A new rule adopted by the Public Company Accounting Oversight Board (PCAOB) will soon provide investors with much more transparency into the audit partners conducting the audit, and whether the audit firm outsourced substantial audit work.

Currently, auditors hide behind a mask of anonymity. They sign the opinion letters that go into SEC filings under the firm name only. But as recent PCAOB inspection reports confirm, even “big four” auditors produce shoddy audits with alarmingly high frequency. In its most recent inspection, the PCAOB found that KPMG was deficient in 54% of inspected audits. The remaining “big four” were only modestly better: EY 36%, PwC 29%, Deloitte 21%.

According to PCAOB chair James Doty, many of those bad audits were produced by particular engagement partners. In a recent statement, he explained that “PCAOB inspections have revealed that, even within a single firm, and notwithstanding firm-wide or network-wide quality control systems, the quality of individual audit engagements varies. There are numerous factors required to achieve a high quality audit, but the role of the engagement partner in promoting quality, or allowing it to be compromised, is of singular importance to the ultimate reliability of the audit.”

SEC enforcement actions confirm that some engagement partners are repeat offenders. For example, a recent action against Grant Thornton shows that the same partner, Melissa Koeppel, overlooked at least three major accounting frauds in public companies: headphone-manufacturer Koss, Assisted Living Concepts (ALC), and Broadwind. In its 2008 inspection of Grant Thornton, the SEC highlighted deficiencies in one of Ms. Koeppel’s audits. By the third quarter of 2010, Ms. Koeppel’s public company audit clients had restated financials four times, and Ms. Koeppel was on an internal monitoring list at Grant Thornton for partners with negative quality indicators. Her track record was so bad that Grant Thornton switched most of her audits to other engagement partners, but it kept her on the 2010 audit of ALC. Those financial statements had to be restated due to accounting irregularities that were brought to Ms. Koeppel’s attention by subordinates, but were ignored.

Investors will soon get a new tool to help identify bad auditors like Ms. Koeppel. A recently-adopted PCAOB rule will require audit firms to file forms indicating the name of the engagement partner. The rule also requires identification of other firms that assisted in the audit, and the extent of their participation.

While the rule is an improvement, it was watered down under heavy pressure from accounting industry lobbyists. The original proposal called for the engagement partner to be identified directly in SEC filings, either in the audit opinion itself or by the issuer. The current rule places the information in a separate form, so investors will have to look in multiple places to find information about the audit. But this additional hurdle is minor. Over time, it may not pose any problem at all, as financial information providers like Bloomberg and Reuters begin to link audit engagement partner  track record information into their profiles of corporate issuers.

 

Your Right to Know If Your Personal Information Has Been Hacked

ATTORNEY: Perry Gattegno
Pomerantz Monitor January/February 2016

In today’s digitized world, every day, nearly every consumer willingly or unwittingly shares sensitive personal information online. Almost as often, hackers successfully access corporate information databases, taking whatever data they can find.

Fortunately, nearly every state has data breach notification laws that apply to any entity that collects personally identifiable information. Those laws generally require the collecting entity to notify individuals when their personal information has been accessed by an unauthorized user. The first such law, enacted in California in 2003, set the model for data breach notification mechanisms by creating obligations for “any agency that owns or licenses computerized data that includes personal information.” In the case of a breach of security systems, the hacked company must disclose the breach to any California resident whose unencrypted personal information was, or is reasonably believed to have been, acquired by an unauthorized person.

The definition of personal information varies from state to state, but it generally includes names, telephone and Social Security numbers, home and e-mail addresses, and any information that falls under the umbrella of “personally identifiable information.” As defined by the California law, this extra information includes credit and financial data that creates access to private accounts, and driver’s license numbers. In California, only unencrypted information that has been transmitted to unauthorized persons must be reported, so California entities can obviate their reporting duties by encrypting all data.

Generally, the statutes include language requiring disclosure of the breach “without unreasonable delay,” (Connecticut, among others), “in the most expedient time possible” (Delaware, among many others) or “as soon as possible” (Indiana, among others). Most states allow the hacked company to wait until “delay is no longer necessary to restore the integrity of the computer system or to discover the scope of the breach,” or also to comply with a criminal or civil investigation by law enforcement. Some states, such as Louisiana, allow the breached entity not to notify consumers of a breach “if after a reasonable investigation the person or business determines that there is no reasonable likelihood of harm to customers.”

In the 13 years since the California law took effect, 47 states, as well as the District of Columbia, Guam, the U.S Virgin Islands and Puerto Rico, have enacted some form of data breach notification law. While they all authorize the local attorney general to enjoin violations and create civil and sometimes criminal penalties against violators, fewer than half the states also grant a private right of action to individuals whose data has been stolen. Civil penalties collectible by the state generally range from $100 to $2,500 per violation, while private rights of action generally permit aggrieved parties to recover actual damages, and often reasonable attorneys’ fees, from the hacked entity. These rights create a strong incentive to disclose these breaches to victims of a data breach. Illinois and California are among the states where a private right of action exists, while New York and Florida are among the states where there is no private right of action.

Nevertheless, holders of confidential data must also weigh the public relations nightmare that often accompanies data breaches, which are becoming high profile – and thus high-stakes – messes requiring immediate clean-up. Failing to comply with the relevant statute not only creates liability, it also causes embarrassment and discourages individuals from entrusting their data to the guilty party.

 Even those states that do not have a private right of action may have unfair trade practices statutes that may provide an alternative route to recovery. For instance, the Florida Deceptive and Unfair Trade Practices Act (FDUTPA) allows recovery of damages and attorneys’ fees for “unfair methods of competition, unconscionable acts or practices, and   unfair or deceptive acts or practices in the conduct of any trade or commerce.” Because FIPA, Florida’s data breach notification statute, defines a violation as an unfair or deceptive trade practice, the state statutory scheme essentially creates a single private right of action rather than FIPA creating a second one on top of the existing statute. FIPA merely creates a new category that falls under FDUTPA’s umbrella. The interplay around the country between analogous statutes varies by state.

Permitted methods of notification vary by state, but generally written notice, e-mail notice, or telephone/ fax notice are options if the breached entity has such consumer information in its possession. Some states permit alternatives in the vent that none of the previous methods are available, such as “Conspicuous posting of the notice on the Internet Web site page of the [breached] person or business, if the person or business maintains one” and “notification to major statewide media.”

Data breach notification laws confirm and crystallize the duties and obligations of entities that undertake to collect personally identifiable information of individuals. Even the best-intentioned holders of data may occasionally suffer unintentional breaches of information, but these laws incentivize stringent security and prompt action to mitigate harm wherever and whenever it might occur.

 

 

Court Upholds our Claims Against Lumber Liquidators

ATTORNEY: Michael J. Wernke
POMERANTZ MONITOR January/February 2016

Judge Allen of the Eastern District of Virginia recently denied defendants’ motion to dismiss our class action complaint against Lumber Liquidators Holdings, Inc. During the class period, the company, which sells hardwood and laminate flooring, reported record gross margins that were substantially higher than its major competitors’. Defendants represented that the major driver of these high margins was legitimate “sourcing initiatives” in China that supposedly reduced the cost of goods and cut out middlemen. In truth, however, the company’s high margins were due to importing cheap flooring made from illegally harvested wood and laminate that was contaminated with high levels of formaldehyde. When the truth emerged in a series of disclosures and events – including news of federal criminal charges for violations of the Lacey Act and the well-substantiated, televised broadcast by 60 Minutes of extensive wrongdoing -- the stock price plunged by 68%. In the aftermath, the board suspended the sale of Chinese laminate products, the CEO, CFO and the company’s “Head of Sourcing” abruptly resigned, and the company replaced its compliance officer.

The court held that the complaint adequately alleged that defendants’ statements were false: its increased margins were not due to legitimate “sourcing initiatives,” or to the company’s efforts to work with mills to produce flooring that meets their “high quality standard,” or to policies to ensure regulatory compliance, as the company had said. In fact, the company later admitted that its Chinese suppliers failed to adhere to regulations and that it did not build a compliance team in China until December 2014.

The court also held that the complaint raised a strong inference of scienter, because defendants had access to non-public information suggesting that their statements were false; third parties easily discovered the regulatory violations; defendants repeatedly discussed analyst calls regarding their personal involvement in the sourcing initiatives in China that were driving their margins higher; and defendants sold a majority of their stock during the class period. The court found that, given the importance and focus of the sourcing initiatives in China, it was part of the “core operations” of the business, another factor that supported the conclusion that management must have known the truth. Finally, the court imputed to management, and to the company, the knowledge of its head of sourcing.

Finally, the court found that the complaint adequately pleaded loss causation because the partial disclosures, when “taken together.... revealed the widespread scope of defendants’ allegedly fraudulent scheme.”

How Bad Does the Behavior Have to Be Before Shareholders Can Investigate It?

ATTORNEY: Anna Karin F. Manalaysay
Pomerantz Monitor January/February 2016

As the Monitor has previously reported, shareholders of Delaware corporations have a right to demand access to books and records of their company, provided that they have a “proper purpose” for doing so. One proper purpose is to investigate whether corporate officers and directors have violated their fiduciary duties. But merely expressing a desire to investigate such a possibility is not enough; the shareholder has to show that there are reasonable grounds to suspect that such a breach may have occurred. Many cases have explored the question of how much smoke there has to be to create a reasonable suspicion that there may well be a fire worth investigating.

Recently corporations have ratcheted up the argument. Now, they say, not only must there be grounds for suspicion of a breach, but that breach must be of the type that is compensable in damages. Since a books and records complaint is filed before there is any claim on file for breach of fiduciary duty, this argument requires that the court forecast the type of claim that might be made in the future.

Delaware law provides broad protections for directors against damage claims based merely on violations of the duty of care; only much more serious violations, such as breaches of the duty of loyalty, are compensable in damages. To escalate a claim of carelessness into a duty of loyalty claim, the shareholder must be able to show extreme misconduct -- the type of conduct that is hard to plead without company records to provide the crucial details. Those, of course, are the very details that the inspection provisions of Delaware law were intended to provide. It is to obtain such information that the shareholders bring a books and records proceeding in the first place. This question is now being considered by the Delaware Supreme Court in a case involving the AbbVie corporation, in which oral argument was heard on November 4, 2015.

In the action, Southeastern Pennsylvania Transportation Authority (“SEPTA”), a shareholder of AbbVie, sought access to AbbVie’s books and records relating to AbbVie’s failed $55 billion merger with Shire. Plaintiff claimed that it had a proper purpose because it wanted to investigate whether the AbbVie directors breached their fiduciary duties in connection with the approval of that merger.

The goal of the merger was to allow AbbVie to take advantage of Jersey’s more favorable tax laws, since Shire is incorporated in Jersey, a tiny island principality off the coast of Normandy that is controlled by England. If the merger had been consummated, AbbVie’s tax rate for 2016 would have dropped from about 22 percent to roughly 13 percent. About two months after the announcement of the merger, the Treasury Department and Internal Revenue

Service, alarmed over the possible drop in tax revenues from such “inversion” transactions, vowed to take action to deter American companies from acquiring foreign competitors to avoid domestic taxes. The AbbVie board responded by withdrawing its recommendation that stockholders vote in favor of the deal. The AbbVie board ultimately terminated the deal and paid Shire a $1.6 billion contractual termination fee.

SEPTA argued that it had a right to investigate the question of whether AbbVie would not have had to pay $1.6 billion if the AbbVie board had properly evaluated the risks of the merger, as required by their fiduciary duty. SEPTA demanded that AbbVie produce board minutes, correspondence, and other documents to investigate potential corporate wrongdoing.

In denying the books and record demand, Vice Chancellor Glasscock inferred that they were seeking an investigation to aid in future derivative litigation against the directors.

The court then held that if a plaintiff’s sole purpose for seeking inspection was to decide whether to bring derivative litigation to recover for alleged corporate wrong- doing, a proper purpose exists only if the plaintiff has demonstrated that the possible wrongdoing would be compensable in damages, and was not barred by the “raincoat” protections of Delaware law. Because SEPTA did not show that the conduct it was investigating could possibly rise to the level of a duty of loyalty claim, the court dismissed the inspection demand.

On appeal, SEPTA argued that the lower court’s decision essentially puts stockholders in the impossible situation of having to show exactly how serious the potential breaches of fiduciary duty might be before they could gain access to the records they would need to make that decision. AbbVie countered that without such detailed information, SEPTA was engaged in a mere fishing expedition, which the books and records statute does not allow.

Even if the appeal is denied, however, the Vice Chancellor, on several occasions, specifically noted that SEPTA sought inspection solely to investigate whether to bring derivative litigation, and that in order to state a proper purpose the claims must be non-exculpated. An exculpatory provision, however, does not bar all derivative litigation, and, accordingly, even in the face of an exculpatory provision, under certain circumstances investigating potential derivative litigation may still be a proper purpose. For example, claims seeking injunctive relief, such as an order barring consummation of a merger, or requiring additional disclosures, are not exculpated and therefore could be explored in a document inspection. At the early stage where a books and records case is filed, the plaintiff shareholder has not yet made any specific claims of actual wrongdoing, and can posit that, depending on what the documents may show, all sorts of non-exculpated relief could be possible.

Where's The Accountability?

Attorney: Tamar A. Weinrib
Pomerantz Monitor November/December 2015

At a conference last year, SEC Chair Mary Jo White began by asserting that “strong enforcement of our securities laws is critical to protecting investors and maintaining their confidence and to safeguarding the stability of our markets.” She went on to suggest that one of the SEC’s primary roles is to “bring wrongdoers to account and to send the strongest possible message of deterrence to would-be fraudsters.”

However, often the message sent is hardly one of deterrence. Many an SEC settlement amounts to nothing more than a mere “cost of business” for the wrongdoer, which is ultimately borne by the shareholders, particularly where the settlement terms do not require any accountability. Indeed, it was for precisely this reason that Judge Rakoff initially rejected the SEC’s $285 million settlement with Citigroup in 2011 that stemmed from the bank’s sale of mortgage-backed securities that cost investors $700 million but yielded a $160 million profit for the bank. Judge Rakoff referred to the settlement, which required no admission of wrongdoing, as “pocket change.”

Although the SEC has obtained admissions of wrongdoing in some cases, the Citigroup settlement was not unique in its failure to require Citigroup to either admit or deny liability (indeed Judge Rakoff rejected a settlement between the SEC and Bank of America in 2009 for similar reasons) but it prompted Judge Rakoff to proclaim that it “is neither fair, nor reasonable, nor adequate, nor in the public interest.” Just last month, the SEC entered into yet another settlement with two units of Citigroup that holds no one at the bank accountable for selling municipal bonds to wealthy clients for six years as a safe money option despite the innate risk resulting from considerable leverage, which caused investors to lose an estimated $2 billion. This settlement, for $180 million, like the settlement in 2011, did not require Citigroup to either admit or deny wrongdoing. Once again, it is the innocent investors who will bear the settlement cost.

The SEC is not alone in its zeal to settle claims with no accountability. The New York State Attorney General announced a settlement with Bank of America and former CEO Ken Lewis in 2014 over statements made in connection with the 2008 BofA and Merrill Lynch merger. Specifically, the SEC accused BofA of failing to reveal the truth about $9 billion in losses at Merrill Lynch before voting to approve the merger. After the merger, BofA needed a federal bailout partly because of the increasing losses at Merrill Lynch, and investors suffered when shares took a nosedive. The $25 million settlement did not require any admission of wrongdoing by either BofA or Lewis. Moreover,

BofA ultimately paid the $10 million of the settlement amount that Lewis was supposed to pay. In other words,

Lewis walked away from the settlement unscathed and therefore undeterred. Settlements such as these are ineffectual at deterring future misconduct by either the settling party or other entities and executives.

The question, however, is what the consequences are of the alternative. There exists a particularly sharp double-edged sword when considering the nature of the “deterrent.” The obvious concern is that if regulators continue to enter settlements that require no admissions of wrongdoing, those settlements will unlikely deter future misconduct but rather create a cost of business that further victimizes, rather than protects, investors. However, on the flip side, if regulators were to require admissions of wrongdoing as a condition to any settlement, the risk is that far fewer such actions/investigations would result in a settlement. Companies hesitant to admit any wrongdoing lest an investor or other party use that admission against it in a private lawsuit will not as readily agree to settle, which will undoubtedly result in protracted and costly litigation with uncertain outcomes. The question is what is the true goal --- to deter future misconduct as regulators consistently proclaim or to settle as many actions as possible, thereby avoiding the costs of lengthy litigation and the withering of budgetary constraints?

 Perhaps the greatest deterrent to securities fraud would be criminal prosecutions of individual wrongdoers, which is the prerogative of the Justice Department. The track record there has, if anything, been even spottier. The recent spate of insider trading convictions has been drastically undermined by the Second Circuit’s landmark ruling in the Newman case, which raises the bar dramatically for insider trading convictions. Other types of securities fraud criminal convictions of individuals are almost completely nonexistent.

 

Shareholder Approval Of Merger Held To Eliminate Claims Against Conflicted Investment Bankers

Attorney: Matthew C. Moehlman
Pomerantz Monitor November/December 2015

On October 29, 2015, Vice Chancellor Parsons of the Delaware Court of Chancery dismissed the sole remaining claim in In re Zale Corporation Stockholder Litigation, the shareholder suit arising from Zale’s 2014 merger with Signet Jewelers Ltd. The Zale opinion, in which Parsons reversed his own earlier ruling in light of binding new precedent from the Delaware Supreme Court, serves as a blunt reminder to investors that Delaware courts are highly reluctant to meddle with the decisions of corporate boards.

In the suit, the Zale plaintiffs had alleged that they were cashed out of their investment at an unreasonably low price due to the involvement of a conflicted financial advisor, Bank of America Merrill Lynch. Zale’s Board of Directors retained Merrill Lynch to advise it as to the financial fairness of the merger. In accepting the engagement, Merrill Lynch failed to inform the Board that it had recently met with Signet to pitch an acquisition of Zale. Notably, the same Merrill Lynch investment banker who led the team advising Zale’s Board had also led the team that pitched to Signet. Further, in the pitch meeting, Merrill Lynch had suggested that Zale pay no more than $21 per share for Zale, and ultimately, the merger was approved by Zale’s Board for an acquisition price of $21 per share. Finally, while Merrill Lynch ultimately informed the Board of its meeting with Signet, it waited to do so until after the merger was announced.

On those allegations, the plaintiffs asserted a claim for breach of fiduciary duty against the Board for insufficiently vetting Merrill Lynch for potential conflicts of interest, and against Merrill Lynch for aiding and abetting the Board’s breach by concealing the conflict from it. Plaintiffs sued Merrill Lynch as aiders and abettors because the bankers owed no fiduciary duties to shareholders.

Initially, Vice Chancellor Parsons found that the plaintiffs had plausibly alleged that Zale’s Board had breached its duty of care to shareholders by not ferreting out Merrill Lynch’s conflict. Parsons noted that Zale had “rather quickly decided to use Merrill Lynch, the only candidate they considered,” and did not ask probing questions designed to detect conflicts of interest, such as whether the bank had made any presentations regarding Zale to prospective buyers within the last six months. Nevertheless, Parsons dismissed the Board from the suit due to an exculpatory charter provision—a protection permitted by Delaware statute that insulates directors from damage claims based on breach of their duty of care. But Parsons sustained the aiding and abetting claim against Merrill Lynch for failing to promptly disclose its meeting with Signet to the Board, which potentially allowed Signet to have the upper hand in negotiations.

However, the day after Parsons issued his opinion, the Delaware Supreme Court undercut it. Specifically, in Corwin v. KKR Financial Holdings LLC, the high court held that a fully-informed vote by an uncoerced majority of disinterested stockholders invoked the deferential “business judgment” standard of review. Practically speaking, business judgment review precludes second guessing of Board decisions, and its application is typically outcome-determinative against shareholder plaintiffs.

The Zales-Signet merger had been approved by 53% of Zale’s shareholders. Accordingly, under Corwin, Parsons should have evaluated the Board’s conduct in vetting Merrill Lynch under the business judgment standard. Parsons had instead applied the stricter “enhanced scrutiny” standard of review. Parsons held that enhanced scrutiny was appropriate under the Delaware Supreme Court’s 2009 decision in Gantler v. Stephens, which he found did not mandate business judgment review where a shareholder vote was statutorily required. Corwin clarified that Parsons had misread Gantler. Corwin said where the approving shareholders were disinterested, fully-informed and uncoerced, it did not matter whether their vote was required or purely voluntary—business judgment was the standard of review. Corwin thus made it exceptionally difficult to find that Zale’s Board had breached its duty of care to shareholders. And because Merrill Lynch’s liability as an aider and abettor was predicated on the Board’s duty breach, the Corwin holding benefitted it as well.

So, after politely holding off for three days —no doubt to give the Zale plaintiffs time to wind up their affairs and come to terms with the inevitable—Merrill Lynch moved for reargument in light of the holding in Corwin. Parsons saved Merrill Lynch the trouble, reconsidering his earlier ruling and dismissing the bank from the case. Perhaps showing his ambivalence at the result, he observed that, “The conduct of Merrill Lynch in this case is troubling, and it was disclosed only belatedly to the Zale Board.”

In a broad sense, the Zale opinions, and the holding in Corwin, illustrate the substantial protections that Delaware continues to afford the directors of companies incorporated there—estimated to be 50% of all U.S. public corporations. By clarifying that banker conflicts may be scrutinized less after a merger receives shareholder approval, it also marks an important qualification to the series of scathing banker conflict opinions that have boiled out of the Court of Chancery in recent years.

For example, in In re Del Monte Foods Co. Shareholders Litigation, Vice Chancellor J. Travis Laster found that Del Monte’s financial advisor Barclays PLC had “secretly and selfishly manipulated the sales process to engineer a transaction that would permit Barclays to obtain lucrative buy-side financing fees.” Likewise, in In re El Paso Corporation Shareholder Litigation, former Chancellor, now Chief Justice of the Delaware Supreme Court, Leo Strine skewered El Paso Board advisor Goldman Sachs for “troubling” conduct that led him to conclude that the transaction was “tainted by disloyalty.” And in In re Rural/Metro Corporation Stockholders Litigation, Vice Chancellor Laster took aim at RBC Capital for steering Rural/Metro’s Board to consummate a deal with an acquirer that RBC secretly hoped would hire it to provide financing for the transaction.

Such rulings are salutary because they recognize that bankers wield considerable influence in merger transactions, and that a self-interested sell-side banker can prevent shareholders from realizing maximum value when cashed out of their investments. As the outcome in Zale shows, Corwin makes it that much more difficult to show director liability after a merger has been consummated. The further rub for investors is that, after Corwin, bankers enjoy more flexibility to act selfishly and against shareholders’ interests —so long as they make the perfunctory disclosures, the deal gets done, and the merger is approved.

 

Petrobras Court: Opt-Outs Beware

Attorney: Mark B. Goldstein
Pomerantz Monitor November/December 2015
 

As reported in previous issues of the Monitor, Pomerantz is lead counsel in a class action lawsuit against the Brazilian oil giant Petrobras. Lead Plaintiff Universities Superannuation Scheme Limited and additional institutional plaintiffs allege securities fraud violations that stem from a large-scale undisclosed bribery and money-laundering scheme that caused tens of billions of dollars of damages to shareholders. On July 9, 2015, the court denied most of defendants’ motions to dismiss, upholding, most notably all of our Securities and Exchange Act claims. The class includes investors who purchased their Petrobras shares after January 22, 2010.

Some investors had decided to opt out of our class action, and to file individual suits. Defendants moved to dismiss their claims as well; and on October 19, 2015, Judge Jed S. Rakoff of the Southern District of New York dismissed their claims “to the extent such claims under Section 10(b) of the Exchange Act cover purchases prior to June 2, 2010, on the ground that such claims are barred by the statute of repose.”

In our class action, by contrast, the court upheld claims going back six months earlier, to January 22, 2010. Therefore, by opting out, these individual plaintiffs forfeited six months’ worth of claims.

 The statute of repose for the Exchange Act bars claims brought more than five years after the occurrence of the fraud. The fraud is deemed to have occurred on either the date the investor purchased the stock or the date of the act or transaction constituting the violation.

 Unlike a statute of limitations, the statute of repose is not concerned with when the investor discovers that he or she has a claim for securities fraud. It acts as a bar to all claims under the securities laws and begins to run from the date the investor purchased the security or from the date of the act or transaction constituting the violation. This five year period had not yet run on any of our claims when we brought our class action.

In opposing the motion to dismiss, the opt-out plaintiffs argued that the statute of repose should be tolled (stopped) for the period these plaintiffs were part of the class. In a case called American Pipe the Supreme Court held that such tolling applied to the statute of limitations: “the commencement of a class action suspends the applicable statute of limitations as to all asserted members of the class.” There currently exists a split among the circuits regarding whether the American Pipe doctrine applies to plaintiffs who elect to opt out of a pending class action prior to a decision on class certification, and a number of district courts, the Sixth Circuit, and the First Circuit have held that tolling of the statute of limitations is not available in such circumstance.

 However, in a case called IndyMac, the Second Circuit held two years ago that the statute of repose under the Exchange Act is not covered by American Pipe tolling. In particular, the Second Circuit ruled, “in contrast to statutes of limitations, statutes of repose create a substantive right in those protected to be free from liability after a legislatively- determined period of time.” The reasoning is that the statute of repose allows issuers and underwriters of securities to know, by a date certain, when all potential claims arising out of a particular securities issuance have been extinguished. This holding was followed by Judge Rakoff when he dismissed the opt-out plaintiffs’ claims covering Petrobras purchases prior to June 2, 2010.

While there may sometimes be good reasons for institutions with large claims to opt out of a class and bring their own actions, they do so at the risk that they will lose some of their claims because of the statute of repose.

Pomerantz Beats The “Adverse Interest” Exception Again

Attorneys: Marc C. Gorrie and Emma Gilmore
Pomerantz Monitor November/December 2015

A few months ago the Monitor reported that Pomerantz had defeated a motion to dismiss our Petrobras action, persuading the District Court to reject a defense based on the so-called “adverse interest” rule. There we persuaded the court that the company, Petrobras, a Brazilian company, could be responsible for frauds committed by its senior executives. Contrary to the company’s arguments, the court concluded that Petrobras derived some benefits from the frauds and its interests were therefore not entirely adverse to those of the individual wrongdoers.

Now we have prevailed over that defense again, this time in a case involving a Chinese company, ChinaCast. In a resounding victory for the firm and the class of investors we represent, the United States Court of Appeals for the Ninth Circuit, in a question of first impression, unanimously held that a senior corporate employee’s fraud is imputed to the corporation even when the fraud actually is completely adverse to the company’s interests. ChinaCast is a for-profit, post-secondary education and e-learning service provider that gives courses online and on three physical campuses in China. Founded in 1999, its shares traded on the NASDAQ Global Select Market, at one time boasting a market capitalization of over $200 million. In March of 2011 ChinaCast filed a Form 10-K with the Securities and Exchange Commission in which it disclosed that its out-side accounting firm, Deloitte Tohmatsu CPA, Ltd., had identified “serious control weaknesses” in its financial oversight systems.

Both sides in our case essentially agreed on the underlying facts. A massive fraud occurred at ChinaCast when its CEO and founder, Ron Chan Tze Ngon, looted the company and brought it to financial ruin. Chan improperly transferred $120 million of corporate assets to bank accounts that he and his associates controlled, allowed a vice president to transfer $5.6 million in Company funds to his son, transferred control of two colleges outside of the Company, and pledged $37 million in company funds to secure loans unrelated to ChinaCast’s business.

Afterwards, Chan and ChinaCast’s CFO Antonio Sena failed to disclose this critical information to investors. Instead, through a series of earnings calls and SEC filings, they assured the market of ChinaCast’s financial stability and sound accounting controls. When the extent of the scheme was finally uncovered in early 2012, ChinaCast’s Board of Directors removed Chan as CEO, and Sena stepped down. Several class action suits were commenced on behalf of investors in the Central District of California in September 2012, and Pomerantz was appointed Lead Counsel for the class.

The district court dismissed plaintiff’s claims on the grounds that scienter, a “bedrock requirement” of a suit brought under Section 10(b) of the Securities Exchange Act of 1934, was not adequately pled against ChinaCast. Scienter requires a plaintiff to plead facts creating a “strong inference” that the corporation acted with “intent to deceive, manipulate, or defraud.” The district court found that the actions and intentions of Chan and his accomplices, however detestable, could not be imputed to ChinaCast under the “adverse interest” rule.

The general rule in securities fraud cases is that a corporate executive’s scienter is imputed to the company, as the company can only act, and formulate intent, through its employees. Where the executive is high enough in the corporate hierarchy, such as CEO Chan was here, his knowledge is the knowledge of the company. However, the adverse interest exception precludes imputation of knowledge where the employee acts solely in his own interest, injuring the corporation. The district court held that Chan’s frauds benefited himself at the expense of the corporation, and therefore satisfied the adverse interest exception to the imputation rule.

On appeal, the Ninth Circuit reversed this ruling. Pomerantz managing partner Marc Gross persuaded the court that a longstanding exception to the adverse interest exception applied. Known as the “apparent authority” or “innocent third party” exception to the exception, this doctrine “holds where a person reasonably relies upon the apparent authority of an agent, that misconduct of the agent is therefore imputed to the corporation, in this case the CEO and the company,” even if the misconduct is detrimental to the company. Pomerantz argued that imputing knowledge when innocent third parties are involved advances public policy goals in that it is the company that has selected and delegated responsibility to its executives, the doctrine creates incentives for corporations to do so carefully and responsibly.

The Ninth Circuit agreed, holding that “the adverse interest rule collapses in the face of an innocent third party who relies on the agent’s apparent authority.” In other words, a corporation can be held liable to investors even where officer’s actions are adverse to that corporation’s interest when they rely in good faith on that officer’s representations.”

The Ninth Circuit’s opinion is significant because it adopts a bright-light rule where, on a well-pled complaint, “having a clean hands plaintiff eliminates the adverse interest exception in fraud on the market suits because a bona fide plaintiff will always be an innocent third party.”

Managing Partner Marc Gross, who argued before the Ninth Circuit panel, stated that Pomerantz is “very pleased that the Ninth Circuit has made clear that corporations are accountable for defrauding investors, as they should be, even when the company’s own coffers have been looted by its own officers. After all, the corporation hired the officers and should be held responsible for how their misconduct impacts innocent investors."

The Importance of Being Advanced

Attorney: Gustavo F. Bruckner
Pomerantz Monitor September/October 2015

Delaware is the state of incorporation for over 50% of all publicly traded corporations in the United States and 60% of the Fortune 500 companies. Delaware court decisions on issues of corporate law thus have far-reaching ramifications. A series of cases involving the rights of corporate directors for advancement and indemnification of legal fees shows just how important these rights are considered, even when they involve corporate wrongdoers. When a director is sued for his actions as a director, he may be entitled not only to be reimbursed for his defense costs after the case is over, but to have these costs paid immediately, even before there is a determination as to whether the case has merit and before it is decided whether or not he should be indemnified.

Although a seat on a corporate Board of Directors can be prestigious and often lucrative, it carries with it certain risks -- including the risk of liability for breaching fiduciary duties. Yet, because directors are not usually executives, they don’t always have the same level of involvement and awareness of the affairs of a company that day-to-day management has. Generally, the Business Judgment Rule protects a director from personal liability to the corporation and its stockholders for an unwise corporate decision so long as the director acted in good faith, was reasonably informed and believed the action taken was in the best interests of the corporation. Delaware General Corporation Law section 145 provides that corporations shall indemnify officers and directors (that is, pick up their defense costs incurred in successfully defending claims of corporate governance breaches). The Delaware courts have previously held that “the statute requires a corporation to indemnify a person who was made a party to a proceeding by reason of his service  to the corporation and has achieved success on the merits or otherwise in that proceeding [mandatory indemnification]. At the other end of the spectrum, the statute prohibits a corporation from indemnifying a corporate official who was not successful in the underlying proceeding and has acted, essentially, in bad faith.” In between, a corporation has the flexibility to indemnify its officers and directors, if they acted in good faith and without a reasonable belief that their conduct was criminal (permissive indemnification).

Since these costs cannot be determined until after the case is over, Delaware has also allowed corporations to agree to advance defense costs to officers and directors who find themselves defendants in such cases. This is seen as a way to attract top talent otherwise frightened of potential litigation. The advancement is usually subject to an “undertaking” by the director to repay any advancement if the director is ultimately not found to be entitled to indemnification. The law allows a corporation more latitude to provide advancement to current officers, but allows more conditions to be imposed on the benefit granted to former directors and officers, thus making an important distinction between current and former officers.

In Holley v. Nipro Diagnostics, Inc., the Delaware Chancery Court affirmed last year how seriously it takes these obligations to advance defense costs. Holley was the founder and Chairman of a medical device manufacturer, Home Diagnostics, that was acquired by Nipro in 2010. Pursuant to the acquisition, Nipro assumed Home Diagnostics’ advancement obligations to Holley “to the maximum extent permitted under the General Corporate Law of Delaware” for the costs of defending claims asserted against Holley “by reason of the fact” that he was a director of the Company. Soon after the merger closed, the SEC began an investigation into insider trading and initiated a civil enforcement action against Holley for disclosing non-public information to friends and family. Holley sought and received advancement of defense costs related to the SEC investigation. A month later, Holley was indicted on charges of criminal securities fraud. The SEC civil action was stayed pending resolution of the criminal action. After successfully getting the court to dismiss two of the criminal counts, Holley pled guilty to two additional counts and in exchange the government agreed to dismiss the three remaining counts. Thereafter the SEC civil enforcement action resumed and Holley sought advancement of his costs of defending that action. When Nipro refused, Holley brought suit.

Nipro argued that Holley was not entitled to advancement for the following reasons: he was not a party to the SEC enforcement action “by reason of the fact” that he was a director, but rather due to personal misconduct; since he pled guilty to insider trading he could not be indemnified and thus advancement would not be permissible; and public policy grounds. The Court rejected Nipro’s arguments. First, the Court found that the SEC investigation focused on the breadth and depth of inside information Holley possessed as a result of his position. The Court also held that “in advancement cases, the line between being sued in one’s personal capacity and one’s corporate capacity generally is drawn in favor of advancement with disputes as to the ultimate entitlement to retain advanced funds being resolved later at the indemnification stage.” The Court made clear that the right to advancement is separate and apart from the right to indemnification, with the right to advancement not dependent on the right to indemnification.  Nevertheless, the Court held that notwithstanding the guilty plea, Holley might be entitled to indemnification since the guilty plea did not necessarily preclude success on the SEC claims, which alleged misconduct beyond that encompassed in his guilty plea. The Court rejected the public policy arguments on the same grounds. To emphasize the importance of this issue, the Court also awarded Holley the fees incurred in litigating his advancement claims.

A few months later the Chancery Court once again reached the same conclusion in Blankenship v. Alpha Appalachia Holdings, Inc. Blankenship was CEO and Chairman of Massey Energy Company when a massive explosion at one of Massey’s mines killed twenty-nine miners. Blankenship retired soon thereafter and Massey was acquired by Alpha Natural Resources. As part of the merger, Massey asked Blankenship to sign a new undertaking which added language that Massey’s advancement of expenses was contingent upon Blankenship’s representation that he “had no reasonable cause to believe that his conduct was ever unlawful.” After the merger, Blankenship incurred legal expenses, which Massey paid, arising out of the government’s investigation of the mine explosion. When the government later criminally indicted Blankenship, Massey and Alpha determined that Blankenship breached his undertaking and ceased advancing the costs of his defense. Blankenship brought suit and, in a post-trial opinion, the Court found in his favor. Emphasizing the importance of advancement, the first sentence of the opinion states, “this advancement action involves some unusual facts but an all too common scenario: the termination of mandatory advancement to a former director and officer when trial is approaching and it is needed most.” The Court went on to find that the revised undertaking could not justify terminating advancement in the middle of Blankenship’s defense. Massey’s advancement obligations to Blankenship under its charter survived Alpha’s acquisition of Massey under the terms of the Merger Agreement between those parties. Because Massey’s charter required it to advance costs to the maximum extent provided by Delaware law, Massey could not then condition its advancement obligations on anything other than an undertaking to repay the expenses if it is later determined that indemnification is not appropriate. The Court also awarded Blankenship his reasonable expenses incurred in litigating the advancement action. These results comport with a spate of cases since Holley involving claims for advancement that have ended with similar results.

Most recently the court did find there are limits to advancement, in two cases over two consecutive weeks. In Lieberman v. Electrolytic Ozone, the Chancery court found that post-employment conduct did not entitle former officers to advancement. Lieberman and Lutz were the CEO and VP Engineering, respectively, of Electrolytic Ozone. They had signed non-disclosure and non-compete agreements. In December 2013 they were terminated as part of a consolidation of operations. Electrolytic also terminated a 10-year supply contract with Franke Foodservice Systems two years into the contract. Franke initiated arbitration against Electrolytic for breach of the supply agreement. Lieberman and Lutz went to work for Franke in February 2014. In June 2014, Electrolytic raised third-party claims against Lieberman and Lutz for breach of their employment, non-disclosure and non-compete agreements.

Lieberman and Lutz brought suit after Electrolytic refused to provide them advancement. The Court held that Lieberman and Lutz could only be entitled to advancement of fees for litigation brought “by reason of the fact” that they served as EOI directors, officers or employees. Although the Court said the test is broadly construed, it found that the “arbitration claims are confined to post-termination actions and do not depend on [Lieberman and Lutz’s] use of corporate authority or position.” The Court went on to note that Electrolytic’s contractual claims were derived from specific contractual obligations that were allegedly breached post-termination. Thus Lieberman and Lutz were not entitled to advancement.

In Charney v. American Apparel, Inc., the Court held that the permissive indemnification written into a post-employment standstill agreement was not as broad as the indemnification
granted under the law. Charney, founder and former CEO/chairman of American Apparel, was forced out of the company after revelations of sexual harassment and initiation of lawsuits emanating from such allegations. He was suspended as the company’s chief executive officer in June 2014, resigned as a director of the company in July 2014 and was terminated for cause as CEO in December 2014. Thereafter, the company brought suit against Charney, alleging that after he was no longer CEO he violated the nomination, standstill and support agreement under which he agreed to not disparage the company or to run a proxy contest for the company’s board of directors. Charney sought advancement of his legal expenses in defending against the case under an indemnification agreement he had with American Apparel, which mandates the advancement of legal costs “related to the fact” that Charney was a director or officer of the company.

The Court concluded that these claims did not involve any alleged “use or abuse of corporate power as a fiduciary of American Apparel,” and thus Charney could not be entitled to indemnification under the terms of the contract. Additionally, the company’s charter only mandates advancement for current officers and directors. Therefore, the Court found that Charney could not receive advancement.

However, the facts in Charney and Lieberman differ from most advancement cases in that the questionable conduct occurred when those seeking advancement were no longer directly employed by the company. In contrast, Blankenship sought advancement when he was no longer employed by the company but it was to defend conduct that occurred while he was still employed. And as Holley v. Nipro shows, even criminal behavior may not be sufficient to preclude advancement.

District Court Upholds Our Claims Against Galena Biopharma

Attorney: Jennifer Banner Sobers
Pomerantz Monitor September/October 2015

In August, Pomerantz won an important victory for investors against Galena Biopharma, certain of its officers and directors, and others when the district court of Oregon largely rejected defendants’ motion to dismiss the action. 

The complaint alleges that defendants manipulated the market price of Galena stock when Galena hired Dream-Team, a promotional consulting company, to publish bullish articles to inflate Galena’s stock. According to the complaint, DreamTeam published articles on websites touting Galena and falsely claiming that the articles were written by established, credible investment professionals, whereas in fact the articles were paid promotions using a variety of aliases for the “authors”. Investors reading the many varied web and social media positive postings about Galena could conceivably be convinced that they should invest in the company. While Galena stock was being pumped up, Galena’s officers dumped large amounts of company stock, reaping enormous profits. In short, this was a classic “pump and dump” scheme.

Defendants’ motion to dismiss relied primarily on the argument that under a recent Supreme Court case, Janus Cap. Grp. Inc. v. First Derivative Traders, only the “maker” of a statement can be held liable for alleged misrepresentations and omissions in violation of the securities laws. Here, they claimed, only the individual authors of the articles hired by the third party stock promoters were “makers” of these statements In response, we argued that, under Janus, the maker of a statement is not just the person identified as the author, but the person or entity with ultimate authority over the content and communication of the statement. Since Galena officers had final authority over the articles and had to approve the content before they were published, Galena and its officers were the “makers” of the allegedly false statements. 

The District Court agreed with us and refused to extend the holding of Janus to say that only the individual authors were “makers” of the statements. The Court noted that if it were to consider the individual authors as the makers of those statements, then companies could avoid liability under the securities laws by paying third parties to write and publish false or misleading statements about the company, even when the company retains final decision    making authority over content.

Defendants also argued that the articles were written by and attributed to the individual authors, and under Janus, the attribution within the articles serves to prove that the authors are the “makers” of the statements. The District Court did not agree. The Supreme Court in Janus noted that in the “ordinary case” attribution within a statement is strong evidence that the statement was made by the party to whom it is attributed. However, the District Court found that this case is not ordinary and attributions under false aliases like “Kingmaker” and “Wonderful Wizard” are meaningless, as no reasonable reader would believe that the statements were made by people with those names. Moreover, the purported biographies associated with the author aliases were allegedly false. Thus, the District Court found that the attribution was not strong evidence that the false aliases were the “makers” of statements contained in the articles.

However, the District Court did hold that Galena, as the only party that had ultimate authority over the published articles, was the maker of these statements, and not also the DreamTeam as we argued. The Court noted that the lesson of Janus is that where legally distinct entities are involved, only one entity has the final say in what, if anything, is published.

Defendants’ motion to dismiss also invoked the so-called “truth on the market defense,” arguing that defendants’ alleged misstatements could not have been material because corrective information was already disclosed to the market. This “corrective” information was supposedly revealed by an obscure website, which disclosed that one of the stock promoters touting the company was receiving compensation from Galena.

The District Court rejected that argument, holding that it is not reasonable for investors to have to research every stock promotion-related website to make sure that each company recommended by purportedly independent analysts and investors has not hired a promotional firm to engage in secret stock promotions. Moreover, as alleged in the complaint, further evidence that the paid promotional campaign was not already incorporated into Galena’s stock price was that after articles revealing the fraudulent scheme were published, the company’s stock price dropped significantly. Defendants in securities cases often attempt to rebut materiality allegations by showing that corrective information was published on some obscure website or in an article that is not widely circulated. Thus, the District Court’s finding on this point is an important victory for investors.

Update: Another Go-Around For Loss Causation In The Ninth Circuit

Attorney: Michele S. Carino
Pomerantz Monitor September/October 2015

Ten years ago, in its seminal decision in Dura Pharmaceuticals, Inc. v. Broudo, the Supreme Court held that in a securities fraud case the plaintiffs must allege facts establishing “loss causation,” meaning that the misrepresented or omitted facts actually caused losses for investors. This can occur, for example, when the company makes a “corrective disclosure” that reveals new or previously concealed information concerning the true state of the company’s affairs, which then causes the price of its stock to drop.

Since then, there has been a great deal of discussion as to how to apply the Dura rule, especially in cases where there has not been a single, or obvious, corrective disclosure. Recently, the Ninth Circuit has been asked to provide  some much-needed clarity in this area.

In August, in Smilovits v. First Solar Inc., a federal district court in Arizona certified for immediate interlocutory appeal the issue of the correct standard to apply for pleading loss causation in cases where the company does not explicitly “correct” any previous disclosures – i.e. admit that they were false or misleading. In such cases, two conflicting standards have emerged in the Ninth Circuit post-Dura, which the district court concluded would yield contradictory results in the case before it. First Solar involves allegations that the defendants withheld information about certain manufacturing defects in their products. Eventually, those defects started to affect the company’s financial condition, and its stock began to decline, falling from nearly $300 per share to less than $50 per share. Plaintiff identified six stock price declines following announcements of disappointing financial results. Although plaintiff claimed that the poor results were actually caused by these undisclosed manufacturing defects, the company did not admit it.

Applying the test articulated in Nuveen Mun. High Income Opportunity Fund v. City of Alameda, plaintiff contended that loss causation is satisfied “by showing that the defendant misrepresented or omitted the very facts that were a substantial factor in causing the plaintiff’s economic loss.” On the other hand, defendants urged the court to adopt a much narrower view, which would require not only that the misrepresented or omitted facts caused the loss, but that the company admitted that its previous statements were wrong.

In support of this argument, defendants relied on another line of Ninth Circuit case law beginning with Metzler Investment GMBH v. Corinthian Colleges, Inc. The Metzler line of cases requires a showing that “the market learn[ed] of a defendant’s fraudulent act or practice, the market react[ed] to the fraudulent act or practice, and plaintiff suffer[ed] a loss as a result of the market’s reaction.” According to defendants, since First Solar’s poor earnings announcements were not accompanied by any revelation of a prior fraud, plaintiff could not demonstrate the requisite “causal connection” between defendants’ alleged misrepresentation or omission and plaintiff’s loss.

The district court ultimately determined that Nuveen stated the better rule, holding that the requirements of proximate cause are satisfied so long as the misrepresented fact led to the plaintiff’s loss. Thus, it does not matter whether the company reveals that it has committed a fraud. As the district court explained: “If the plaintiff can prove that the drop in revenue was caused by the misrepresented fact and that the drop in his or her stock value was due to the disappointing revenues, the plaintiff should be able to recover. A causal connection between the ‘very fact’ misrepresented and the plaintiff’s loss has been established.”

An affirmance in First Solar by the Ninth Circuit potentially would have far-reaching implications, because it would prevent companies from averting liability simply by refusing to admit that misstatements had been made. It might also put an end to the ongoing dispute over whether the announcement of governmental investigation, followed by a drop in a company’s stock price, satisfies the loss causation test under Dura. The Ninth Circuit has adopted the reasoning in Loos v. Immersion, which like Metzler, holds that disclosure of an investigation is insufficient to establish loss causation, because “[t]he announcement of an investigation does not ‘reveal’ fraudulent practices to the market,” but only the possibility that a fraud may have occurred. Loos requires something “more” – presumably, some revelation or actual accusation of fraud. However, as the First Solar court recognized, application of Nuveen in cases like Loos yields a completely different outcome, so long as plaintiffs establish that the ‘very fact’ misrepresented, e.g., the undisclosed fraudulent conduct prompting the investigation, caused the stock to decline in value.

The First Solar approach also makes eminent sense as a policy matter. Requiring revelation of fraud before losses are actionable rewards defendants who issue bare bones disclosures or time the announcement of poor financial results to coincide with other events, even though they may have knowledge of the real causes of the company’s difficulties. When and if an actual fraud is revealed, there may be no subsequent price decline, as the market has already incorporated and accounted for the previously-disclosed bad news, and therefore, there is no actionable corrective disclosure. Thus, defendants who succeed at concealing fraud are most likely to be insulated from liability. That is the exact opposite result sought to be achieved by the federal securities laws. We will have to wait to see if the Ninth Circuit agrees.

 

Leakage Theory is No Longer Just a Theory

Attorney: Michael J. Wernke
Pomerantz Monitor September/October 2015

It all started ten years ago with a question posed by  Justice Stevens during oral arguments in Dura Pharm., Inc. v. Broudo: “What if the information leaks out and there’s no specific one disclosure that does it all and the stock gradually declines over a period of six months?” Until last month, this question remained in the “what if” category of securities fraud jurisprudence. We now have an answer. In Dura, the Supreme Court held that a plaintiff in a securities fraud action must plead the element of loss causation, i.e. that the company’s stock price declined once the truth was revealed through a corrective disclosure. At trial, the plaintiff must ultimately prove that the decline in stock price was a result of the fraud – not market, industry or company-specific nonfraud factors. Since Dura, courts have universally held that loss causation can be established even if the truth is revealed through multiple “partial” corrective disclosures that drove the stock price down.

Courts have also acknowledged that, in theory, a company’s stock price could decline as a result of the truth “leaking” into the market without any actual disclosures of the fraud. For example, the stock price may move because insiders traded on the inside fraud related information prior to a disclosure, or because investors gradually lost confidence in the company’s previous misrepresentations even though the truth was not yet officially disclosed. However, in practice, courts have until now required plaintiffs to connect any decline in stock price to an identifiable “corrective” disclosure. 

The Seventh Circuit’s June 21, 2015 decision in Glickenhaus & Co. v. Household InternationalInc. has lifted that restriction, creating the possibility that investors may recover losses resulting from the gradual decline in a company’s stock price that is not directly connected to any corrective disclosure, but which can be attributed indirectly to the unraveling of the underlying fraud. 

In Household, the defendants appealed to the Seventh Circuit a jury verdict finding them liable for securities fraud on the basis that the causation/damages model adopted by the jury failed to establish loss causation. The plaintiffs had presented two models to the jury. The first, a “Specific Disclosure Model,” identified fourteen partial corrective disclosures that revealed the truth to the market and calculated the price declines that followed within the next day, removing price movements attributable to market and industry factors. This model determined that disclosure of the fraud led directly to investor losses of $7.97 per share. The second analysis, the “Leakage Model,” attributed to the fraud all the price declines during the year-long period of partial disclosures, except for declines caused by market or industry factors. Using this model, plaintiffs calculated that losses per share were $23.94. The jury adopted the Leakage Model and damages were ultimately determined to be $2.46 billion.

In their appeal, the defendants argued that the Leakage Model was flawed because it included price declines that did not immediately follow any of the partial disclosures of the fraud. While the Leakage Model eliminated market and industry factors, it did not identify and eliminate the effect of company-specific, nonfraud news on the stock price, which may have contributed to the decline in stock price during the periods between the fourteen partial corrective disclosures. Instead, plaintiff’s expert testified in general terms that he considered the issue but was unable to conclude that non-fraud news would have altered the analysis. The question before the court was whether that was enough or whether the model itself must fully account
for the possibility that company-specific, nonfraud factors affected the stock price.

The court refused to answer simply “yes” or “no,” as doing so would create an unfair advantage for plaintiffs or defendants. Accepting the defendants’ position would likely doom the leakage theory because it may be “very difficult, if not impossible,” for any statistical model to separate damage caused by “leakage” from damage caused by release of company-specific news unrelated to the fraud. On the other hand, if it’s enough for an expert to offer a conclusory opinion that no company-specific, nonfraud related information affected the stock price, then plaintiffs may be able to easily evade their burden of proving that the loss for which they seek recovery was a result only of the alleged fraud.

The court chose a middle ground, creating burden-shifting process to be used at trial. It held that if the plaintiffs’ expert testifies in a nonconclusory fashion that no company-specific, nonfraud related information contributed to the decline in stock price, then the burden shifts to the defendants to identify some significant, company-specific, nonfraud related information
that could have affected the stock price. If the defendants can, then the burden shifts back to the plaintiffs to account for that specific information or provide a model that doesn’t suffer from the same problem. Significantly, the court stated that one solution for the plaintiffs would be to simply exclude from the model’s calculation any stock price movements directly related to the company-specific nonfraud information identified by the defendants. 

While the defendants won the battle – the case was remanded to the trial court – investors may have won the war. Plaintiffs’ recoveries in a securities fraud action are no longer limited to stock price declines immediately following specific disclosures of the fraud. Moreover, the
Seventh Circuit provided a clear roadmap for the creation and use of a leakage model that can withstand judicial scrutiny (at least in the Seventh Circuit). 

Notably, this decision came only a year after the Supreme Court’s decision in Halliburton II, which dialed back the more rigid views of market efficiency which had previously been employed by many of the lower courts, and installed a similar burden-shifting process for that analysis. The Seventh Circuit’s decision could be viewed as a road marker in a forming trend of courts taking a more practical view of how securities markets function and investors’ burdens in proving their losses from frauds.

 

Ninth Circuit Refuses to Follow Second Circuit's Insider Trading Decision

Attorney: Leigh Handelman Smollar
Pomerantz Monitor July/August 2015

In a controversial decision written by Manhattan U.S. District Judge Rakoff, sitting by designation, the 9th Circuit recently upheld an insider trading conviction and, in the process, refused to follow the standard established by the Second Circuit in its Newman opinion decided in 2014. That case made it more difficult to convict recipients of inside information (“tippees”) by requiring the govern-ment to show that the tippee was not only aware that the information came from a corporate insider, but also that he or she knew that the insider (the “tipper”) had received a tangible benefit in exchange for leaking the information, a benefit that was “objective, consequential and rep-resents at least a potential gain of a pecuniary or similarly valuable nature.” Newman rejects the theory that leaking to enhance a personal, family or business relationship satisfies the personal benefit requirement. Several guilty pleas obtained from tippees were overturned based on the decision.

The Newman case involved tippees who were several layers removed from the tipper’s original disclosure of inside information. When inside information is passed around an investment firm, for example, it may be difficult to prove that someone way down the information food chain was aware of the original source of the leak and that the tipper had received a personal benefit.

In U.S. v. Salman, decided July 6, 2015, the 9th Circuit has refused to follow Newman. In that case Salman’s brother- in-law leaked inside information to his own brother, who in turn, shared that information with Salman. The evidence at trial showed that Salman knew that his brother-in-law was the original source of the inside information.

But the evidence also showed that Salman did not know about any tangible economic benefit received by his brother-in-law in exchange for leaking the information.

But the 9th Circuit disagreed with the Second Circuit in Newman and affirmed the conviction anyway. The court held that the “personal benefit” requirement did not require that the tipper receive a financial quid pro quo. Instead, it held that it was enough that Salman “could readily have inferred [his brother-in-law’s] intent to benefit [his brother].” In declining to follow Newman, the court noted that if the standard required that the tipper received something more than the chance to benefit a close family member, a tipper could provide material non- public information to family members to trade on as long as the tipper “asked for no tangible compensation in return.”

Are Airlines Conspiring to Keep Prices High?

Attorney: Jayne A. Goldstein
Pomerantz Monitor July/August 2015

Since 1978, when Congress enacted the Airline Deregulation Act (“ADA”), the domestic airline industry has been deregulated. The Act did away with govern-mental control over fares, routes and market entry of new airlines, leaving market forces to dictate these aspects of the industry, and causing the airlines to compete over fares, routes and seats.

Times have changed. Since 2005, with the merger of US Airways and America West, the airline industry has been significantly consolidated. The Delta and Northwest merger followed in 2008, the United and Continental merger in 2010, and the Southwest and AirTran merger in 2011. Most recently, American and US Airways merged in 2013, creating the biggest airline in the world. Today, American, United, Southwest and Delta account for over 80% of the domestic airline market. So much concentration of market power makes it easier for the few remaining behemoth competitors to rig the market.

On June 11, 2015, the New York Times published the article, “‘Discipline’ for Airlines, Pain for Fliers,” in which it revealed that airlines had discussed maintaining “discipline” at a recent industry conference at the International Air Transport Association (“IATA”) held in Miami earlier that month. “Discipline” in this context is a euphemism for limiting flights and seats, raising prices and increasing profit margins. At the meeting, Delta Airline’s president, Ed Bastian, stated that Delta was “continuing with the discipline that the market place is expecting.” Also at this meeting, American Airlines’ chief, Dough Parker, stated that the airlines had learned their lessons from past price wars: “I think everybody in the industry understands that,” he told Reuters. In May 2015, Defendant Southwest’s chief executive, Gary C. Kelly, had considered breaking ranks and announced that Southwest would expand capacity in 2015-2016 by as much as 8 percent. However, after coming under fire at the IATA conference in June 2015, Mr. Kelly changed his position, stating, “We have taken steps this week to begin pulling down our second half 2015 to manage our 2015 capacity growth, year-over- year, to approximately 7 percent.”

The “discipline” is paying off; it is projected that airline industry profits will more than double in 2015, to a record nearly $30 billion. When airlines (or other companies) collude to restrict capacity in their routes and seats, they are subject to violating the antitrust laws. When companies are not competing in the marketplace, consumers foot the bill with high prices.

Several senators called for a federal investigation of U.S. airline prices, which have not come down, despite the fact that the price of jet fuel has fallen dramatically. In mid-June, Senator Richard Blumenthal (D-Conn.) asked the Department of Justice to investigate possible collusion and anti-competitive behavior by U.S. airline companies following the meeting of top executives at the IATA annual conference. It appears that the Department of Justice heard the senators’ requests, and is now investigating whether American, United, Southwest and Delta colluded to restrain capacity and drive up fares, an antitrust violation. On July 1, 2015, the airlines confirmed that the DOJ had requested information from them about capacity and other matters.

In the wake of alleged collusion among the airlines, numerous lawsuits have been filed. On July 10, 2015, Pomerantz instituted an antitrust class action on behalf of direct purchasers of airline tickets against American, United, Southwest and Delta. The case is pending in the Northern District of Illinois.

 

Delaware Ban on Fee-Shifting ByLaws Signed Into Law

Attorney: Samuel J. Adams
Pomerantz Monitor July/August 2015

In a victory for shareholder rights, Delaware’s Governor recently signed into law a bill that prohibits fee-shifting bylaws for Delaware-incorporated publicly traded corporations. The bill was passed in response to a growing number of Delaware stock corporations that had recently begun adopting fee-shifting provisions that sought to pass defense costs on to unsuccessful shareholder plaintiffs or, in some cases, even plaintiffs that were only partly successful in a lawsuit for breach-es of fiduciary duty or other similar claims. Because shareholder plaintiffs – like plaintiffs in all other kinds of actions – almost never prevail on all counts asserted in a complaint, the specter of crushing financial liability from such bylaws threatened to choke off almost all shareholder litigation, regardless of the merits.

The increasing number of fee-shifting bylaws adopted by Delaware corporations stemmed from the Delaware Supreme Court’s decision last year in ATP Tour v. Deutscher Tennis Bund, which upheld a fee-shifting bylaw enacted by a private company. In that decision, the court held that a private Delaware corporation may adopt a bylaw which shifts all litigation expenses to a member plaintiff who does not obtain “a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought.” While the ATP court did not weigh in on whether such a bylaw would be permissible in the context of a public company, some public corporate boards of directors sensed an opening. With dozens of public companies adopting such fee-shifting provisions, action was needed by either the legislature or the judiciary in order to clarify the enforceability of these bylaws.

Earlier this year, prior to Delaware’s enactment of the fee-shifting bylaw prohibition, Pomerantz was on the vanguard of the fight against fee-shifting provisions in a case of first impression in Strougo v. Hollander. In that opinion, the first to address fee-shifting provisions following ATP, the Delaware Court of Chancery found that a fee-shifting bylaw was inapplicable to a share-holder plaintiff and the class where the bylaw was adopted after a plaintiff had been forcibly cashed out through a reverse stock split. While not explicitly ruling on the broader issue of the applicability of fee-shifting bylaws generally to public corporations, Chancellor Bouchard found that the bylaw in that instance did not apply to the shareholder plaintiff both because the bylaw was adopted after the plaintiff had been forcibly cashed out as a shareholder, and also because Delaware law does not authorize bylaws that regulate the rights or powers of a stockholder whose equity interest in a corporation had been eliminated before the bylaw was adopted.

In enacting the bill, the Delaware legislature recognized the chilling effect that fee-shifting bylaws would likely have on the ability of shareholders to voice certain challenges to corporations in court. Because many public companies chose to incorporate in Delaware, the Delaware courts and judiciary have a substantial influence on corporate governance. The synopsis of the bill itself states that the prohibition on fee-shifting provisions was enacted “in order to preserve the efficacy of the enforcement of fiduciary duties in stock corporations.” While many believed that the Delaware courts would have ultimately invalidated fee-shifting bylaws for public companies, the bill obviated the need for the courts to weigh in on the issue. As a consequence, shareholder plaintiffs can seek to hold corporate fiduciaries accountable without the risk of liability to corporate defendants for potentially millions of dollars in attorneys’ fees.

In a compromise, the recently-enacted bill also affirmed the enforceability of forum selection bylaws which seek to dictate the exclusive court in which plaintiffs may file certain types of shareholder litigation, such as those asserting claims for breaches of fiduciary duty. In many cases, shareholder plaintiff can elect to file such litigation in either a public company’s state of incorporation or the state of a corporation’s head- quarters. For Delaware public companies that wish to limit such litigation to a particular venue, the Delaware legislature clarified that such forum selection clauses are enforceable, so long as Delaware is selected as the exclusive forum for such litigation.

Our Walter Case Survives Motion To Dismiss

Attorney: Murielle Stevens Walsh
Pomerantz Monitor July/August 2015

Judge Ungaro of the U.S. District Court for the Southern District of Florida has recently denied the motion to dismiss our complaint against Walter Investment Management and several of its officers.

The case alleges that the defendants misrepresented that the company had sound internal controls and was in compliance with federal regulations regarding mortgage servicing, when in fact one of the company’s primary subsidiaries, Green Tree Servicing, had engaged in rampant violations of federal consumer laws. Walter’s stock price declined when the company revealed that the government was investigating it for these violations. Defendants initially moved to dismiss our original complaint, arguing that the disclosure of the investigation was not enough to establish loss causation, a requirement for a securities fraud claim. The court agreed, because under applicable 11th Circuit standards, the disclosure of a government investigation and possible government action, standing alone, were not enough to establish loss causation. The theory is that an investigation means that there is merely some possibility that violations had occurred, which the court held is not certain enough to amount to a “corrective disclosure” that the company’s statements about legal compliance were wrong. The court did, however, grant us leave to amend the complaint.

Our second amended complaint included the new allegation that the government announced that it had decided to bring an enforcement action against the company to seek injunctive relief and fines. Importantly, analysts factored this development into their price target for Walter stock. We included these facts in our amended complaint; and the judge found that this disclosure was sufficient to establish loss causation – even though the initiation of a lawsuit by itself is not tantamount to a “corrective disclosure” either, because the company still could prevail at trial. But the Court held that the bringing of the government action moved the potential losses much closer to reality.

Ultimately, the company settled the government case, agreeing to injunctive relief and the payment of fines. 

Whether disclosure of an investigation satisfies the “loss causation” requirement is a contentious issue in securities fraud litigation. Typically, it is such disclosures that actually trigger most of the losses; after that point, the market factors into the market price much of the risk of eventual litigation and its consequences.

 

Omnicare

Attorneys: Jessica N. Dell and H. Adam Prussin
Pomerantz Monitor July/August 2015

In March, the Supreme Court, in a case called Omnicare, tackled the issue of when statements of opinion that appear in a registration statement can violate Section 11 of the Securities Act. Section 11 creates a private right of action for investors who purchased shares in an initial public offering when the registration statement contained materially false or misleading information. Unlike theantifraud provisions of the Exchange Act, Section 11 does not require that the investor show that the issuer, or the directors who signed the registration statement, had a culpable state of mind. If the registration statement was wrong, defendants are liable. The company is subject to strict liability; the directors can escape liability only if they can establish an affirmative defense.

In Omnicare the registration statement expressed the belief that the rebates Omnicare was receiving from suppliers were legal. In its decision below, the Sixth Circuit had held that under Section 11 a statement of opinion or belief can violate Section 11 if the opinion or belief turned out to be wrong – even if the issuer and its directors sincerely believed it at the time.

The Supreme Court rejected that view, holding that statements of opinion or belief are not “misstatements of fact” for purposes of Section 11. “Most important, a statement of fact (‘the coffee is hot’) expresses certainty about a thing, whereas a statement of opinion (‘I think the coffee is hot’) does not.” Because statements of opinion do not convey certainty about the subject, the Court rejected the contention that an expression of opinion or belief can be a misstatement of fact simply because it turned out to be wrong. Instead, the Court held that beliefs or opinions can be misstatements of fact only if the issuer did not really believe them at the time. While opinions themselves may be subjective, whether one holds them or not is an objective fact. In Omnicare, defendants clearly believed what they had said, so there was no misstatement of fact.

But the Court’s opinion did not stop there. It also held that a reasonable investor is entitled to assume that the issuer had a basis for the opinion or belief it is conveying. For example, if the issuer says that it believes that certain of its business practices are in compliance with applicable law, as Omnicare did here, it would also have to disclose whether it had formed that belief without consulting a lawyer, or if its lawyers had given contrary advice. Omissions can render those statements misleading if “the investor … identifies particular (and material) facts going to the basis for the issuer’s opinion—facts about the inquiry the issuer did or did not conduct or the knowledge it did or did not have—whose omission makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context.”

This issue is going to be the focus of future litigation over Section 11 liability for statements of opinion or belief. What type of foundation can investors reasonably assume a company has for such statements, and what qualifies as a material fact that had to be disclosed because it might undermine that assumed foundation? Time will tell.

 

Petrobras: The Whole Barrel is Tainted, Not Just Four Rotten Apples

Attorney: Justin Nematzadeh
Pomerantz Monitor July/August 2015

On July 9, 2015, Pomerantz won a significant victory for investors against Petrobras, the Brazilian energy giant, and four of its senior executives, when the district court rejected defendants’ motion to dismiss the action. For years Petrobras has been embroiled in a massive scandal, as prosecutors there have been pursuing the largest corruption investigation in that country’s history.In 2009 Petrobras had a market capitalization of $310 billion; now, since this massive scheme came to light, itis down to $55 billion. As the Monitor previously reported, the scheme involved overcharging Petrobras for goods and services, with the excessive payments being used to bribe a host of Petrobras and government officials.This scheme was allegedly orchestrated by four Petrobras officials, all of whom are defendants in our action.

The heart of the company’s motion was its contention that scienter, or knowledge, of the wrongdoing was limited to four “rogue” officers of the company, and that their knowledge cannot be “imputed,” or attributed, to the company, under the so-called “adverse interest” theory. Normally, a company is deemed to know what its senior executives know; but if those executives are acting for their own personal interests, and contrary to the interests of their company, they are acting outside the scope of their employment and their knowledge is not imputed to the company. Here, defendants argued that the officers’conduct was adverse to the company’s interests because the scheme diverted cash from the company, as a result of the overcharges the company paid, and into the pockets of the four individual defendants and various corrupt politicians and other conspirators. In addition, by artificially inflating asset values on Petrobras’ balance sheet,defendants argued that the individuals harmed the company by causing it to pay excessive prices that were reflected in the carrying value of those assets.

But, as senior Pomerantz partner Jeremy Lieberman explained to the Court at the hearing on the motion to dismiss, knowledge of the scheme was not limited to the four “rotten apples,” but was, in fact, widely disseminated in the company. Most notably, perhaps, he highlighted evidence showing that the Petrobras board was aware of the over billing scheme. Moreover, he argued that the adverse interest exception applies only when the company receives no benefit what-soever from the misconduct. Here,in contrast, the beneficiaries of the scheme were officials of the Brazilian government – which owns 51% of Petrobras’ stock. Moreover, by failing to correct the company’s fraudulent financial statements,the defendants were benefiting Petrobras by avoiding a massive write-down of the company’s assets.

Defendants also argued that the scheme was immaterial because its payments to contractors were inflated by only 3% and that the four conspirators received kickbacks amounting to a small portion of this 3%. As a result, when the scheme was disclosed Petrobras was forced to write off only $2.5 billion of property, plant and equipment on its balance sheet, about 8% of the total assets. In fact, however, our well-founded allegations showed that Petrobras was over billed by about 20%, not 3%, and that the $2.5 billion write-down reflected only a small fraction of the actual impact of the fraudulent scheme.

 

Pomerantz Shatters the Glass Ceiling

Pomerantz Monitor, May/June 2015

 Pomerantz LLP is once again at the vanguard of the legal field. In a recent report, Law 360 has ranked the firm No. 1 in Top Law Firms for Women: Class Action Securities Firms. Pomerantz is proud to boast a 40% rate of female partners, 40% rate of female Of Counsel, and a 50% rate of female associates. These numbers put Pomerantz near the head of women overall in law firms in the United States, and at the forefront of women in class action securities firms in particular. 

Managing Partner Marc I. Gross shared his thoughts on this distinction, stating, “Pomerantz is proud that its efforts to maintain a diversified staff of attorneys and partners has been so successful. We hope other firms will follow.”

Pomerantz is no stranger to cutting edge accomplishments in the legal field, consistently finding new and innovative ways to fight for our clients’ rights; we are proud of this latest recognition of our success. At a time when the gender gap in America’s workforce is a source of national controversy, Pomerantz strongly stands by our hiring practices, which ensure the best attorneys are chosen for the job of representing our clients. 

Partner Murielle Steven Walsh says, “As a young associate at Pomerantz, I was mentored by a women partner. That experience had a positive impact on my development as an attorney.” Ms. Steven Walsh has prosecuted highly successful securities class action and corporate governance cases, and has argued, and won, cases before the Second Court of Appeals. 

Among recent accolades for Pomerantz attorneys, Partner Jayne Goldstein, who heads Pomerantz’s Florida office, was featured in a recent Law 360 article, “The Female Attorneys You Admire”; and Tamar A. Weinrib, Of Counsel, was chosen as a New York Metro Rising Star in 2014. 

Pomerantz looks forward to keep pushing the envelope in this arena and others as we continue the legacy our founder, Abe Pomerantz, began almost 80 years ago.  

 

Subprime Redux – Will Securitized Subprime Auto Loans Cause the Next Financial Crisis?

ATTORNEY: C. DOV BERGER
POMERANTZ MONITOR, MAY/JUNE 2015

 


Much of the blame for the 2008 financial crisis belongs to subprime mortgage lending - making loans to people who had difficulty maintaining the repayment schedule, and then bundling those loans into securities and selling them to investors. Now some observers are concerned that a recent jump in subprime auto loans could also mean disaster for markets.

Right after the financial collapse auto loans almost dried up completely, threatening the auto industry. But since then the subprime auto loan market has sprung back to life, as millions of Americans with tarnished credit easily obtained auto loans. According to the Federal Reserve Bank of New York, the number of auto loans made to borrowers with credit scores below 660 has nearly doubled since 2009 – a much greater increase than in any other loan type. Some sources place the increase at an even greater figure. According to the New York Times, in the five years since the immediate aftermath of the financial crisis, roughly one in four new auto loans last year went to borrowers considered subprime. Figures from two consumer credit tracking firms, Experian and TransUnion, show record amounts of auto loans on the books at the end of 2014. Not only were drivers buying more cars than any year since 2006, but they were spending more on each car they bought. 

The subprime auto loan market has some characteristics in common with the mortgage loan market. Risky sub-prime auto loans are being bundled into complex bonds and then sold by banks to insurance companies, mutual funds and public pension funds, just like subprime mortgage loans were in the late 2000s. Also, many subprime auto lenders are loosening credit standards and focusing on the riskiest borrowers. Recently, there have been a number of claims of abuse or outright fraud, as some lenders are accused of forging data on their customers’ loan applications, or committing borrowers into loans with terms substantially different than what had been negotiated. But most are hesitant to call the rise in subprime auto lending a bubble. 

Luckily, the overall auto loan market is comparatively small -- $900 billion -- compared to $8 trillion of mortgage loans. Subprime currently makes up about 30% of overall car loans. A higher rate of auto loan defaults probably won’t cause a market decline on a scale comparable to the mortgage crisis. Second, according to some economists, borrowers tend to make car payments a higher priority than mortgage payments or credit card bills, since they need their cars to get to work, school and for many other daily necessities.

Still, the rise in subprime auto loans has caught the attention of regulators. This past summer, federal prosecutors began a civil investigation into the packaging and selling of questionable auto loans to investors. The probe is focusing on whether checks and standards were neglected as the subprime auto loan market surged and whether some borrowers’ loan applications had false information about income and employment. In addition, investigators want to know how the loans, which were pooled and assembled into securities, were represented to investors and whether the lenders fully disclosed to investors the credit-worthiness of the borrowers. 

One company that has been targeted during the investigation is the finance subsidiary of General Motors G.M. Financial Company. In August, the company disclosed that it had received a subpoena from the U.S. Department of Justice directing it to produce certain documents related to its origination and securitization of subprime automobile loan contracts since 2007. The United States attorney for the Southern District of New York is also looking into G.M. Financial, as well as other auto finance companies. 

G.M. Financial, has been one of the largest sellers of auto loan backed bonds, selling a total of $65 billion in securities. This year, G.M. Financial sold investors roughly $730 million in bonds made up of auto loans that carried an average annual interest rate of about 13 percent. Standard & Poor’s gave most of the bonds an AAA rating, but given what we know now about the ratings agencies, that rating is highly suspect. 

With total loans expected to cross the $1 trillion mark by the end of this year or early in 2016, this issue won’t disappear anytime soon. So far, the rise in subprime auto lending hasn’t slowed investors’ appetite for auto loan backed bonds, and most analysts don’t expect a rise in borrower defaults to cause a catastrophic market meltdown like the subprime mortgage crisis. On the regulatory front, aside from a settlement by one auto loan finance company over accusations that it increased the cost of auto loans for minority borrowers, there haven’t been any formal charges brought. However, regulators are clearly taking a closer look and should charges be brought in the future, it could dramatically change the way investors feel about buying securities back by subprime auto loans.

Pomerantz Takes a Bite Out of For-Profit College Scheme in Corinthian Colleges

ATTORNEY: STAR M. TYNER
POMERANTZ MONITOR, MAY/JUNE 2015

On April 22, 2015, in Erickson v. Corinthian Colleges, Inc., Pomerantz scored a significant victory for investors against the much-criticized and poorly regulated for-profit college industry, when Chief Judge George King of the Northern District of California denied the defendant’s motion to dismiss the action. 

Corinthian Colleges was historically one of the largest for-profit college systems in the country, and when our firm filed an amended complaint in the case, the company was operating 111 campuses in 25 states. For-profit colleges are big business, making most of their profits from federal student aid programs. However, many for-profit colleges have come under fire in recent years for their deceptive practices (especially for their promises to adult students regarding the potential for gainful employment upon graduation), leading President Obama to implement new federal student loan and job placement guidelines. 

Our amended complaint alleges that Corinthian was misrepresenting its job placement rates, compliance with applicable regulations, and enrollment statistics. Our complaint relied on a host of sources: in addition to testimony from 15 confidential witnesses from all over the company, we also relied on documentary evidence cited in the California Attorney General’s complaint against the company (showing that job placement data was manipulated, errors were rampant, and placements were not verified consistently) and a Congressional report criticizing the for-profit college industry (especially with respect to Corinthian’s practice of constantly “churning” its student body to keep up enrollment rates, by enrolling massive numbers of new students each year to hide the fact that so many previous enrollees had dropped out after a short time). While the Court dismissed the regulatory compliance statements as too vague to be actionable, it upheld the job placement rate and enrollment statistic misrepresentations. 

The Court put all our allegations under a microscope and determined that the specific facts we alleged supported our claims that many of defendants’ public statements were false, and that the senior executive defendants knew it.

In addition, the Court agreed that we sufficiently alleged loss causation because public disclosures of the Attorney General’s lawsuit and the Congressional report raising these allegations led directly to significant drops in the market price for Corinthian’s securities.

This victory is especially noteworthy because Judge King has dismissed two prior lawsuits against Corinthian with similar allegations and because pleading loss causation in the Ninth Circuit has become particularly difficult in the wake of a recent decision by that court in another case.

How a Landmark Securities Case Helped Certify an Antitrust Class

ATTORNEY: MARK GOLDSTEIN
POMERANTZ MONITOR, MAY/JUNE 2015

Pomerantz currently acts as co-lead counsel for a class of third party payors and consumers in the antitrust action involving heartburn medication Nexium. The plaintiffs in this action allege that the branded dug company, AstraZeneca, and several generic drug makers violated antitrust laws by entering into agreements to delay entry of a generic version of Nexium. This type of case is often referred to as a pay-for-delay case where because the manufacturer of the brand name drug typically pays generic drug manufacturers to delay their entry to the market with a generic version of the brand drug. Such agreements have an obvious anti-competitive effect. 

These cases have been a hot topic in the legal community because the Supreme Court recently reviewed these types of cases and established a standard for analysis of such agreements. In June, 2013, the Supreme Court, in FTC v. Actavis, ruled that such pay-to-delay arrangements can run afoul of antitrust laws under a rule of reason analysis. The Court held that if plaintiffs could show that the brand name manufacturer made a large and unjustified payment to the generic drug makers that could be a violation of the antitrust laws. 

In late 2013, the District of Massachusetts granted plaintiffs’ motion for class certification of our Nexium case, finding that the “plaintiffs had adequately shown that (1) “prices [during the class period] for esomeprazole [the chemical name for Nexium] continued [to be] artificially high as a result of the defendants’ reverse payment agreements,” and (2) “that all class members have been exposed to purchasing or paying for [the drug] at a supracompetitive price.” The District Court also concluded that even though some members of the class did not suffer injury as a result of the alleged antitrust violation that was irrelevant because the vast majority of class members had been injured. 

Defendant appealed the District Court’s class certification ruling to the United States First Circuit of Appeals on the sole ground that the class included members who were not injured by the agreements. Defendants specifically gave the example that some individual consumers would continue to purchase branded Nexium for the same price even after generic entry – so called brand loyalists. Defendants relied on the First Circuit’s previous decision in In re New Motor Vehicles Canadian Export Antitrust Litigation, arguing that to obtain class certification Plaintiffs must show that, “each class member was harmed by defendant’s practice.” 

The First Circuit ultimately rejected that argument, concluding that “class certification is permissible even if the class includes a de minimis number of uninjured parties.” On the topic of the requirement that all class members be harmed the court stated, “[t]o the extent that New Motor Vehicles is read to impose such a requirement, it has been overruled by the Supreme Court’s Halliburton decision. But, in fact, New Motor Vehicles imposes no such requirement. 

In Halliburton, the Supreme Court addressed the treatment of potentially uninjured class members. Halliburton was a landmark securities case that reviewed the presumption of reliance in securities cases. Halliburton found that a securities class can presume that the investors relied on defendant’s misrepresentation when deciding to purchase or sell a stock rather than prove direct reliance of defendant’s misrepresentations for each individual class member and defendants can rebut this presumption. The Supreme Court stated, “[w]hile [the rebuttal] has the effect of leaving individualized questions of reliance in the case, there is no reason to think that these questions will overwhelm common ones and render class certification inappropriate under Rule 23(b)(3).” As a result, the First Circuit in In re Nexium, found that because Halliburton “contemplated that a class with uninjured members could be certified if the presence of a de minimis number of uninjured members did not overwhelm the common issues for the class,” the Nexium class can also be certified despite a de minimis number of uninjured members.  

Our Securities Fraud Case Survives Barclays’ Motion to Dismiss

ATTORNEYS: H. ADAM PRUSSIN, EMMA GILMORE
POMERANTZ MONITOR, MAY/JUNE 2015  

Pomerantz largely defeated defendants’ motion to dismiss our complaint against Barclays bank and several of its officers and directors. Our action accuses Barclays of making false and misleading statements about the operations of its “dark pool.” A “dark pool” is an alternative trading system that does not display quotations or subscribers’ orders to anyone other than to employees of the system. Dark pools were first established to avoid large block orders from influencing financial markets and to ensure trading privacy. Trading in dark pools is conducted away from public exchanges and the trades remain anonymous, lowering the risk that the trade will move the market price. About 15% of U.S. equity-trading volume is transacted in dark pools.

Precisely because these trades are conducted “in the dark,” institutional investors trading in these venues rely upon the honesty and integrity of their brokers and the dark pool operators to act in their clients’ best interest.

If given information about impending customer trades, high frequency traders in the dark pools can trade ahead of those customers and then profit at their expense by reselling the shares to complete the order. Studies seem to show that, as of 2009, high frequency trading accounted for 60%-73% of all U.S. equity trading volume. Keeping such traders away from the dark pools could help protect other investors from their front-running and other predatory trading practices.

After a series of scandals, and in particular disclosure of its manipulation of the LIBOR benchmark interest rates, Barclays commissioned an independent investigation of itself. As a result of the findings, it publicly pledged, among other things, to act with transparency and to impose strict controls over trading in its dark pool. These pledges, it turns out, were a sham. Barclays actually embarked instead on a campaign to make itself the largest dark pool in the industry, by hook or by crook.

An investigation by the New York Attorney General revealed that, in order to grow the dark pool, Barclays increased the number of orders that it, acting as broker, executed in the pool. This required that Barclays route more client orders into the dark pool, and ensure that there was sufficient liquidity to fill those orders. To convince the market of the safety of trading in its dark pool, Barclays represented that it would monitor the “toxicity” of the trading behavior in its dark pool and would “hold traders accountable if their trading was aggressive, predatory, or toxic.” Such “toxic” trading activity included high frequency trading, which it pledged to keep out of its dark pool.

But these alleged controls were illusory. One former director explained that Barclays “purports to have a toxicity framework that will protect you when everybody knows internally that [they don’t]”. Another former director described these controls as “a scam.” Our complaint alleged that Barclays representations about establishing a monitoring program to eliminate “toxic” trading from the dark pool were misleading because Barclays did not disclose that it did not eliminate traders who behaved in a predatory manner, did not restrict predatory traders access to the dark pool, did not monitor client orders continuously, and did not monitor some trading activity in the pool at all. In fact, plaintiffs allege, Barclays encouraged predatory traders to enter the dark pool.

The court’s decision is significant because of its emphasis on the importance to investors of corporate integrity. Barclays' motion to dismiss relied heavily on the contention that its misrepresentations about the dark pool were immaterial to investors because revenues from the dark pool were far less than 5% of the company’s total revenues. This figure is a statistical benchmark often used to assess materiality. In fact, revenues from the dark pool division contributed only 0.1% of Barclays total revenues. The court rejected Defendants’ myopic view of materiality and found that the misrepresentations went to the heart of the firm’s integrity and reputation, which had been jeopardized by its past well-publicized transgressions. The court’s decision means that misrepresentations about management’s integrity can be actionable even if the amounts of money involved in these transgressions falls below a presumptive numerical threshold. 

The court also held that Defendant William White, the Head of Barclays’ Equities Electronic Trading, was a sufficiently high-ranking official that his intent to defraud could be imputed to the company itself. The court explained that “there is strong circumstantial evidence of conscious misbehavior or recklessness on [his]part. “Not only was White the source of many of the allegedly false allegations about [the dark pool] but he was the head of Equities Electronic Trading at Barclays, “the driving force behind the Company’s goal to be the number one dark pool,” and he “held himself [out] to the public as intimately knowledgeable about LX’s functions and purported transparency.” 

 

 

Product Hopping, Big Pharma and the High Cost of Prescription Drugs

ATTORNEY: ADAM KURTZ
POMERANTZ MONITOR, March/April 2015

The Monitor has been reporting for years on so-called “pay for delay” schemes used by brand name drug manufacturers to stave off generic competition. Such schemes are subject to antitrust challenge as unlawful restraints of trade, and the Firm has been pursuing such cases vigorously.

Now there is a new scheme, called “product hopping.” In the classic version of this anticompetitive scheme, brand name manufacturers come out with a “new” version of their drug and stop production of the previous version altogether, forcing everyone taking that drug to switch to the new version, even if isn’t any better. The newly introduced drug likely has only minor changes from the existing one (e.g., from tablet to capsule; from immediate to extended release) and does not provide any improvement in its therapeutic benefits. But, since there are no generic competitors for the new version, the brand manufacturer can continue to reap monopoly profits for years to come. By the time a generic of the original formula enters the market, there is no longer a demand for the original brand formula, because it has been discontinued. State laws that require generic substitution do not apply because the new brand drug is slightly different that the original. As a result of a successful product hopping scheme, generic competition—which reduces brand drug prices by about 90%—will be eliminated.

The pushback is beginning against product hopping. Notably, a New York Federal District Court recently granted an injunction stopping a brand name pharmaceutical company, Actavis, from discontinuing sales of its popular Alzheimer drug Namenda IR. The court concluded that the move was an unlawful product hopping scheme intended to switch vulnerable Alzheimer’s patients from the existing Namenda formula, which will face generic competition in 2015, to a newer, slightly different formula, which will not have generic competition until 2029. By removing original Namenda from the market, Actavis would have forced Alzheimer’s patients to switch to the new drug, with all its attendant risks, and would eventually force them to pay billions of dollars more for the new brand name treatment.

New York Attorney General Eric T. Schneiderman successfully brought this antitrust case against Namenda’s manufacturer, Forrest Labs, (now owned by Actavis) alleging that the forced switch to a so-called new and improved version was nothing more than illegal attempt to maintain its $1.6 billion Namenda monopoly even after its patent expires. According to Schneiderman, “[a] drug company manipulating vulnerable patients and forcing physicians to alter treatment plans unnecessarily, simply to protect corporate profits, is unethical and illegal.” The federal district court agreed, although this decision is now on an expedited appeal before the United States Court of Appeals. Oral argument on the appeal is scheduled for April 13, 2015.

In the Namenda case, the brand drug company not only introduced a new once-a-day (extended release) capsule, but also announced that it intended to stop selling its original twice-a-day (instant release) tablet, which was soon to face generic competition. There is no therapeutic difference between the two formulations.

As another court defined the issue last year, “although the issue of product-hopping is relatively novel, what is clear from the case law is that simply introducing a new product on the market, whether it is a superior product or not, does not, by itself, constitute exclusionary [antitrust] conduct. The key question is whether the defendant combined the introduction of a new product with some other wrongful conduct, such that the comprehensive effect is likely to stymie competition, prevent consumer choice and reduce the market’s ambit.”

In particular, courts have increasingly found that where the brand drug company not only introduces a new drug version but also removes the original version of the drug from the market, it violates the antitrust laws. In cases involving the drugs Tricor and Doryx, the manufacturers introduced new versions of the drugs; stopped sales of the original versions; and removed unused inventory of the original formula from the market. In addition, in Tricor, the company changed the code for the original drug to ‘obsolete’ on an industry-wide database, which prevented pharmacies from filling Tricor prescriptions with a generic. In both cases, defendants’ exclusionary conduct restricted consumer choice. In the end, Tricor settled for in excess of $250 million, while Doryx is still pending.

More recently, In re Suboxone Antitrust Litig., allegations of another product hopping scheme were found sufficient to state an antitrust cause of action were the brand drug company not only introduced a new film version of the drug but made false safety claims about the original tablet version and threatened to remove the original version from the market. The court found that the “[t]he threatened removal of the tablets from the market in conjunction with the alleged fabricated safety concerns could plausibly coerce patients and doctors to switch from tablet to film.”

Pomerantz’s antitrust attorneys have been at the forefront of challenging anticompetitive conduct by pharmaceutical companies that seeks to block generic drugs, including product hopping schemes, pay-for-delay agreements and overall anticompetitive conspiracies that combine the two.

Is There Hope For Credit Rating Agencies?

ATTORNEY: Anna Karin F. Manalaysay
POMERANTZ MONITOR, MARCH/APRIL 2015

Anyone compiling a list of culprits in the U.S. subprime residential mortgage debacle of 2007-2008 would have to include the credit rating agencies at or near the top. Meant to provide investors with reliable information on the riskiness of various kinds of debt, the agencies have instead been accused of defrauding investors by giving triple-A ratings to mortgage-related securities so risky they were even considered doomed to fail by the banks that created them.

Why did this happen? Probably because the financial incentives for the ratings agencies have changed dramatically. In the past, credit rating agencies charged a subscription fee to subscribers to cover their rating activity. Then the practice changed, and the company or issuer being rated pays the fee. By switching to this business model, the ratings agencies assumed a crippling conflict of interest; for if they did not deliver high ratings regardless of the circumstances, issuers would shop around for a more compliant ratings agency the next time around.

The best-known credit rating agencies in the United States are Moody’s Investor Services, Standard and Poor’s, and Fitch. S&P issues nearly half of all credit ratings and together with Moody’s and Fitch, the so-called “Big Three” issue ninety-eight percent of the total ratings. On February 3, 2015, S&P agreed to pay $1.375 billion to settle lawsuits brought by the U.S. Department of Justice and 20 attorneys general concerning ratings S&P gave to certain mortgage securities just before the 2008 financial meltdown. So far, this has been the largest settlement involving a credit rating agency.

The press release issued by the Justice Department said the ratings at issue were given to residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) during the period 2004 to 2007. RMBS are created when a bank or other financial institution pools together mortgage loans. CDOs pool together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors.

The lawsuit filed by the Justice Department in 2013 alleged that S&P had engaged in a scheme to defraud investors by knowingly inflating the credit ratings it gave to RMBS and CDOs which resulted in substantial losses to investors and ultimately contributed to the worst financial crisis since the Great Depression. The Justice Department claimed that S&P’s rating decisions were not independent and objective as they were required to be but, rather, based in part, on its business concerns.

As a part of the settlement, S&P agreed to a statement of facts that contained an admission that its ratings for CDOs were partially made based on the effect they would have on S&P’s business relationship with issuers. It also admitted that, despite knowledge within the S&P organization in 2007 that many loans in RMBS transactions it was rating were delinquent and losses were probable, it continued to issue and confirm positive ratings.

As credit rating agencies were being blamed for feeding a subprime mortgage frenzy, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July 2010. Among its various provisions, Dodd-Frank outlined a series of broad reforms to the credit rating agencies market. Despite Dodd-Frank, however, some signs of trouble have re-emerged. In January 2015, for example, S&P paid nearly $80 million to settle accusations of the SEC that it orchestrated similar fraud in 2011, years after the financial crisis took place. S&P also agreed to take a one-year “timeout” from rating certain commercial mortgage investments at the heart of the case, an embarrassing blow to the rating agency. The pact is the SEC’s first-ever action against a major ratings firm.

The SEC has since issued new rules aimed to enhance governance, protect against conflicts of interest, and increase transparency. These rules, which went into effect January 1, 2015, require rating agencies such as S&P to: 

  • provide records of their internal control policies and rating methodology;
  •  prohibit their sales teams from participating in the rating process;
  • review, and revise if needed, ratings for companies that later hire one of the agency’s employees; and
  • file annual reports showing how the agencies monitor ratings, how ratings changed over time and whether evaluated companies eventually defaulted.

If a credit rating agency violates these rules, the SEC will suspend or revoke the agency’s registration — disciplinary action that may be effective in preventing further violations. However, while the regulations do attempt to keep rating activity under strict surveillance, they do not restructure the way rating agencies solicit business or receive payment. Thus, the inherent conflict of interest still exists since the agencies are paid by the same banks and companies they rate.

The SEC has thus far failed to maintain control and ensure rating agencies follow proper rating methodologies — the multiple accusations against S&P attest to these failures — but only the health of the future financial market will tell whether the recent regulations, coupled with the hefty consequences credit rating agencies such as S&P have had to face, will have a long-term stabilizing impact.

 

Pomerantz Wins Important Motion, Post-Halliburton

ATTORNEY: Joshua B. Silverman
POMERANTZ MONITOR, MARCH/APRIL 2015

When the Supreme Court issued its landmark decision in Halliburton v. Erica P. John Fund last summer, it did not give either side a total victory. Critically for investors, the Supreme Court reaffirmed the fraud-on-the-market presumption, which is necessary for class certification in most securities fraud actions. The presumption allows classwide proof of reliance, an element of Exchange Act claims, by demonstrating that the stock traded in an efficient market. In efficient markets, publicly-available information is incorporated into the stock price and traded on by all investors, so plaintiffs need not show that each class member actually heard or read the misrepresentations giving rise to the lawsuit. By reaffirming these principles, the Court ensured the continued viability of securities fraud class actions. However, at the same time, the decision offered defendants the ability to rebut the fraud-on-the-market presumption at the class certification stage by demonstrating that the alleged fraud did not affect the stock price.

Halliburton did not specify precisely how lower courts should determine market efficiency or lack of price impact. As lower courts begin to grapple with these issues, the early results are promising for investors. Thus far, district courts (and in one case, an intermediate court of appeals) have applied rational tests for both market efficiency and price impact, consistent with the principles set forth in Halliburton. 

The most important consequence of Halliburton may be to stabilize the law over what constitutes an efficient  market. In 1988, when the Supreme Court first recognized the fraud-on-the-market presumption, it declined to adopt any particular test for market efficiency. In the years that followed, most courts used the so-called “Cammer test,” which assessed, among other factors, trading volume, analyst coverage, and price movement following release
of important company-specific news. 

However, more recently defendants and their experts have urged courts to stack on top of the Cammer factors a litany of additional requirements lifted from the extreme end of academic debates about market efficiency. A significant minority of courts accepted these arguments, resulting in a patchwork of inconsistent standards. For example, some courts refused to certify cases involving stocks that moved in trends, theorizing that such trending—or serial correlation—was inconsistent with the belief of some academicians that efficient markets must be wholly unpredictable. Other courts looked to related options markets, holding that a lack of parity input and call options demonstrated constraints on arbitrage activity, and therefore showed market inefficiency. A few other courts suggested that impairments to arbitrage could also be found if the stock was difficult or expensive to sell short. 

Halliburton should put an end to these fringe academic tests. In its opinion, the Supreme Court emphasized that for purposes of the fraud-on-the-market presumption, market efficiency refers only to “the fairly modest premise that market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.” As one law professor explained, Halliburton demonstrates that “the efficiency question is not meant to be particularly rigorous.” District courts appear to get the message. Since Halliburton, no district court has cited serial correlation, lack of put-call parity, or short-lending costs as a basis for denying class certification in a securities fraud class action. 

Recently, Pomerantz won an important motion addressing the continued relevance of fringe academic market efficiency tests. In the Groupon securities litigation, where Pomerantz serves as lead counsel, defendants had argued that plaintiffs’ class certification expert was unreliable because he failed to conduct put-call parity and short lending fee analyses. After an extensive evidentiary hearing, the court sided with Pomerantz, holding that such tests were unnecessary because they addressed an extreme variation of market efficiency that “was squarely rejected by the Halliburton court.”

District courts have also applied reasonable, consistent tests when assessing the price impact defense recognized in Halliburton. They have thus far uniformly rejected defendants’ attempts to show lack of price impact by demonstrating that some or all of the misrepresentations did not move the stock at the time they were made. Instead, recognizing that misrepresentations are used to artificially maintain as well as boost share prices, courts in the Regions Financial, IntraLinks, and Best Buy litigations have all held that price impact can be found where the share price declines when the truth is revealed, even if the stock did not move at the time the false statements were issued. Best Buy has been appealed, so the Eighth Circuit will soon weigh in on the issue.

Defendants have been equally unsuccessful in attempts to persuade courts to disregard price movement, where it does occur, by claiming it was caused by something other than the alleged fraud. For example, in Catalyst Pharmaceuticals, the court rejected expert testimony that the truth was already known to the market. Such evidence, the court held, did not disprove price impact but instead addressed whether the omitted information was material, an issue reserved for the trier of fact. By strictly enforcing the Supreme Court’s requirement that defendants prove the absence of price impact instead of just proffering different explanations for price moves, lower courts have ensured that the exception to the fraud-on-the-market presumption did not swallow the rule.

Courts will continue to construe Halliburton in the coming months, particularly in the Best Buy appeal and Halliburton itself (where the issue of price impact was remanded to the district court). If they apply the measured reasoning seen in early cases, it will bring much-needed consistency and predictability to the class certification process.

 

 

Delaware Court Refuses to Apply Fee-Shifting Bylaw

ATTORNEY: Alla Zayenckik
POMERANTZ MONITOR, MARCH/APRIL 2015

Pomerantz achieved an important corporate governance victory for stockholders in March when Chancellor Bouchard of the Delaware Court of Chancery refused to apply a fee-shifting bylaw to plaintiff and the class in Strougo v. Hollander. Fee shifting bylaws impose on plaintiff shareholders and their counsel the defendants’ entire litigation costs, unless the action achieves a complete victory, including an award of the entire remedy sought in the action. Such bylaws, if widely adopted, would foreclose virtually all shareholder litigation, regardless of the merits. Last year, in a case called ATP, the Delaware Supreme Court held that such bylaws can be legally enforceable, at least in some circumstances.

In Strougo v. Hollander, a closely-watched test case, Chancellor Bouchard issued the first Delaware opinion to address fee-shifting bylaws since the Supreme Court’s ATP decision last year. The Chancellor found that defendants cannot bind plaintiff and the class to a fee-shifting bylaw adopted after plaintiff had been forcibly cashed out through a reverse stock split.

Accepting the arguments proffered by Pomerantz partner Gustavo F. Bruckner, head of Pomerantz’s corporate governance practice, the Court found the bylaw inapplicable as to plaintiff and the Class under both Delaware contract and corporate law. Chancellor Bouchard explained that the Bylaw does not apply for two related reasons: (i) the Board adopted the bylaw after plaintiff’s interest in the company was eliminated by the reverse stock split; and (ii) Delaware law does not authorize a bylaw that regulates the rights or powers of former stockholders who were no longer stockholders when the bylaw was adopted.

The Chancellor found that “[A] stockholder whose equity interest in the corporation is eliminated in a cash-out transaction is, after the effective time of that transaction, no longer a party to [the] flexible [corporate] contract. Instead, a stockholder whose equity is eliminated is equivalent to a non-party to the corporate contract, meaning that former stockholder is not subject to, or bound by, any bylaw amendments adopted after one’s interest in the corporation has been eliminated.”

The Chancellor also commented on the underlying merits of the case and the effect of fee-shifting bylaws. He wrote “the Bylaw in this case would have the effect of immunizing the Reverse Stock Split from judicial review because, in my view, no rational stockholder—and no rational plaintiff’s lawyer—would risk having to pay the Defendants’ uncapped attorneys’ fees to vindicate the rights of the Company’s minority stockholders, even though the Reverse Stock Split appears to be precisely the type of transaction that should be subject to Delaware’s most exacting standard of review to protect against fiduciary misconduct.”

Prior to the Chancellor’s ruling, on March 6, 2015, the Council of the Corporation Law Section of Delaware State Bar Association issued proposed amendments to the Delaware General Corporation Law that would ban fee-shifting provisions from a company’s bylaws or charter. If enacted, the amendments will become effective on August 1, 2015.

Pomerantz Appointed Lead Counsel in Historic Petrobras Securities Class Action

ATTORNEY: Francis P. McConville
POMERANTZ MONITOR, MARCH/APRIL 2015

Pomerantz will take the helm on a consolidated group of securities class actions over revelations of rampant corruption at Petroleo Brasileiro SA (“Petrobras”), according to an order issued March 4, 2015 by New York U.S. District Judge Jed S. Rakoff. We were selected as lead counsel by lead plaintiff Universities Superannuation Scheme Ltd. (“USS”).

USS was chosen over three other candidates for lead plaintiff: the SKAGEN-Danske group, made up of three European asset managers; a group of three State Retirement Systems; and an individual investor.

The class action against Petrobras, brought on behalf of all purchasers of common and preferred American Depositary Shares (“ADSs”) on the New York Stock Exchange, as well as purchasers of certain Petrobras debt, principally alleges that Petrobras and its senior executives engaged in a multi-year, multi-billion dollar money-laundering and bribery scheme, which was, of course, concealed from investors. Senior management has openly admitted its culpability. In testimony released by a Brazilian federal court, the executive in charge of Petrobras’ refining division confessed that Petrobras accepted bribes “from companies to whom Petrobras awarded inflated construction contracts” and “then used the money to bribe politicians through intermediaries to guarantee they would vote in line with the ruling party while enriching themselves.” These illegal acts caused the company to overstate assets on its balance sheet, because the overstated amounts paid on inflated third party contracts were carried as assets on the balance sheet.

As of November 2014, the Brazilian Federal Police had arrested at least 24 suspects in connection with Petrobras’ money laundering and bribery schemes; and Brazil’s president, who was a senior Petrobras executive during the relevant period, has also been engulfed in this scandal. As a result of the fraudulent scheme, Petrobras may be forced to book a $30 billion asset writedown in order to reduce the carrying value of some of its assets. That impairment would equal approximately 42% of the company’s market value.

USS was not the lead plaintiff applicant with the largest losses from the fraud. Indeed, the SKAGEN-Danske group, with purported losses exceeding $222 million, asserted by far the largest losses of all the competing lead plaintiff applicants. However, although the securities laws establish a rebuttable presumption in favor of the appointment as lead plaintiff of the movant with the “largest financial interest” in the litigation, that movant must also “otherwise sastisf[y] the requirements of Rule 23 of the Federal Rules of Civil Procedure” under the Private Securities Law Reform Act (“PSLRA”).

In particular, USS and Pomerantz argued that the SKAGENDanske and State Retirement Systems were artificial groupings put together by counsel trying to win the lead counsel position, and were plagued by numerous deficiencies rendering them inadequate to represent the Class. Although the PSLRA states that a lead plaintiff may be a “group of persons,” to allow an aggregation of unrelated plaintiffs (asset managers and pension funds, in this instance) to serve as lead plaintiffs defeats the purpose of preventing lawyer-driven litigation. In stark contrast, USS, the largest pension fund as measured by assets in London, opted to move for appointment as sole lead plaintiff, in order to allow it full and independent control of its counsel and the prosecution of the litigation. In fact, prior to engaging the Pomerantz firm, USS spent over 50 hours of in-house attorney time determining whether to step forward as lead plaintiff. To assist its decision making process, USS retained outside counsel at its own expense to assist it in deciding whether to enter the action.

Moreover, the record in this case demonstrated that the SKAGEN-Danske Group – with SKAGEN showing a net gain on Petrobras common ADSs – had interests that could be deemed antagonistic to purchasers of Petrobras common ADSs. In this case, the large losers in Petrobras preferred ADSs, such as the SKAGEN-Danske Group, potentially have interests antagonistic to common ADS purchasers because of the unique qualities of each security and the potential threats facing the capital structure of Petrobras. USS, with the single largest losses of PBR common ADSs among the various lead plaintiff movants, thus presented the court with an attractive and safe option for potential lead plaintiff.

At bottom, USS argued that it was the ideal plaintiff envisioned by Congress when it enacted the PSLRA. No other movant had demonstrated the willingness and ability to adequately oversee counsel and vigorously prosecute the claims against Petrobras on behalf of the Class. Critically, USS was the only movant not overwhelmed by various inadequacies and unique defenses. Nor did USS have any ties to potentially relevant political contributions or curious arrangements with counsel, which have heretofore afflicted the alternative lead plaintiff groupings.

Accordingly, the independence and diligence evidenced by USS and Pomerantz during the lead plaintiff process ultimately paid off. As articulated during the briefing process, USS’s conduct represented the “gold standard” for institutional oversight of proposed lead counsel, and represents the model for institutional investors seeking to file future applications for appointment as lead plaintiff in securities class actions.

SEC Reverses Its Own Whole Foods Ruling

ATTORNEY: H. Adam Prussin
POMERANTZ MONITOR, JANUARY/FEBRUARY 2015

As we have been reporting for years, corporate America has been at war with activist investors who want the right of “proxy access,” which would allow them to propose nominees for director that can appear on the companies’ own proxy statements. Not too long ago, the SEC backpedaled from a proposed rule that would have granted automatic proxy access to investors who had held a certain percentage of the company’s outstanding shares for an extended period of time. This proposal is now in seemingly eternal limbo.

Instead, investors have sought to put the issue of proxy access to a shareholder vote on a company by company basis. For example, Scott M. Stringer, the New York City comptroller and overseer of five city pension funds with $160 billion in assets, recently put forward proposals at 75 companies that would allow shareholders to nominate directors. In response to these and other similar efforts, some companies have tried to pre-empt those requests by proposing, instead, their own watered-down version of similar proposals – typically with much higher threshold requirements the shareholder would have to meet. An SEC rule states that a shareholder proposal can be excluded if it “directly conflicts with one of the company’s own proposals to be submitted to shareholders at the same meeting.”

Whole Foods is a case in point. A Whole Foods investor proposed that investors holding 3 percent of the grocer’s shares for at least three years be allowed to nominate directors at the company. Whole Foods asked for permission to exclude the proposal last fall, saying that it planned to put its own proposal on director elections to a shareholder vote. Under management’s proposal, an investor interested in nominating directors had to own a far larger stake and to have held it for much longer than in the investor’s proposal.

In its original ruling, issued December 1, the SEC staff granted a no action letter to Whole Foods, allowing it to exclude the shareholder proxy access proposal. Shortly afterwards, 18 other companies asked for no action letters permitting them to do the same. This caused a backlash from institutional investors who viewed this tactic as a too-convenient way for companies to avoid putting more aggressive proxy access proposals to a shareholder vote, and who began asking the SEC to revisit its Whole Foods decision.

On January 16, the SEC announced that it had reversed its Whole Foods decision. In a public statement, SEC Commissioner Mary Jo White said that questions had arisen about “the proper scope and application” of the SEC rule on which its staff had relied when making the decision. She also said she had directed the staff to review the rule and report its findings to the full commission. While its review is underway, the SEC said it would make no rulings on requests for no action letters involving shareholder proposals that are similar to those made by management.

Many view this development as handwriting on the wall, predicting that this preemption tactic is going to be prohibited or at least severely curtailed. Still, without a ruling one way or the other just yet, companies will have to decide for themselves whether to include such proposals in their upcoming proxy statements this spring.

 

Agencies Shifting Many Enforcement Actions to In-House Administrative Courts

ATTORNEY: Emma Gilmore
POMERANTZ MONITOR, JANUARY/FEBRUARY 2015

The Securities and Exchange Commission and the Commodity Futures Trading Commission have recently signaled that they intend to bring many future enforcement actions in administrative courts rather than federal courts. Kara Brockmeyer, the chief of the Division’s Foreign Corrupt Practices Act Unit, said at a legal conference in Washington held in October that bringing cases as administrative proceedings “is the new normal.”

While both venues have always been available for such actions, the Dodd-Frank Act expanded the powers of administrative courts, allowing them to impose remedies similar to those available in federal court, including the imposition of monetary penalties. The shift has stirred a flurry of public debates on the fairness of the administrative procedures.

Critics argue that the administrative procedure mechanism deprives defendants of constitutional and procedurals advantages, as discovery is limited (essentially precluding depositions, except to preserve evidence); the Federal Rules of Evidence do not apply (even hearsay is admissible); and there is no right to a jury. Those critics also point out that the initial factfinder is an SEC employee, and is therefore presumably biased in the SEC’s favor. They argue that while a defendant can appeal the administrative decision to a federal court of appeals, the court is likely to defer to the administrative agency. Among the fierce critics of such administrative proceedings is Southern District of New York Judge Jed S. Rakoff, who, in a speech last November, argued that “the law in such cases would effectively be made, not by neutral federal courts, but by SEC administrative judges,” saying that administrative proceedings are compromised by “informality” and “arguable unfairness.”

Another federal judge, Lewis A. Kaplan of the Southern District of New York, takes a decidedly different view. He recently held that a defendant’s right to appeal to a federal court at the end of the procedure would suffice to address any injustice or due process violations committed in the administrative proceeding. He concluded that “Congress has provided the SEC with two tracks on which it may litigate certain cases. Which of those paths to choose is a matter of enforcement policy squarely within the SEC’s province,” and the SEC is “especially competent…to determin[e] which…cases are appropriately brought in a district court and which in an administrative proceeding.” (emphasis in original).

In similar vein, the SEC’s Enforcement Division Director Andrew Ceresney defended the agency’s recent shift. “It’s not the case there is no more activity in district court; there is. Having said that, it is certainly the case we’re going to use [administrative] proceedings more often. Why is that? Because Congress gave us the authority under Dodd-Frank to obtain the same remedies in administrative proceedings as we can obtain in district courts,” Ceresney said. He argued at a November 7 conference sponsored by the Practicing Law Institute (“PLI”) that the administrative proceedings process is not only fair to defendants, but also constitutes a more efficient means to reach a resolution. dministrative proceedings are relatively fast, with rulings usually handed down within 300 days of the case being filed, as opposed to years for the typical federal-court case. Ceresney insisted that cases are heard by judges who are seasoned, sophisticated fact finders in the securities field.

At that same PLI conference, CFTC’s Enforcement Division Director Aitan Goelman said a streamlined enforcement proceeding is necessary because his agency is financially constrained and does not have the money to engage in lengthy litigations. The CFTC is mulling a “best-offer” settlement agreement very early in the proceeding in hopes of streamlining the resolution of enforcement disputes.

Another likely reason for the forum shift may be, as the Wall Street Journal recently reported, that the SEC’s win rate in recent years is “considerably higher” in administrative forums than in federal courts. In the 12 months through September 2014, the SEC won all six contested administrative hearings where verdicts were issued, but only 61%—11 out of 18—federal-court trials. Previous years showed the same pattern: the agency won nine of 10 contested administrative proceedings in the 12-month period through September 2013 and seven out of seven in the 12 months through September 2012, according to SEC data. The SEC won 75% and 67%, respectively, of its trials in federal court in those years.

Given the SEC’s success rate in such forum, this shift can prove beneficial to private litigants. Assuming the administrative procedures are fair and do not violate a defendant’s due process rights (and given the administrative law judges’ specialized knowledge of securities laws), appeals courts are likely to affirm the administrative law decisions. SEC-favorable decisions can in turn be employed as highly persuasive authority by private plaintiffs in actions brought against distinct defendants but under analogous fact patterns.

 

Court Upholds Our Claims Challenging Going Private Transactions

ATTORNEY: Gustavo F. Bruckner
POMERANTZ MONITOR, JANUARY/FEBRUARY 2015

When a controlling shareholder, who also happens to be the CEO of the company, proposes to take the company private, the situation is ripe for abuse. That’s exactly what we believe occurred in the case of Zhongpin Inc., a Delaware company headquartered in China.

In 2013 Xianfu Zhu, Zhongpin’s CEO, who owned 17.3% of the company’s shares, offered to acquire all shares of the company that he did not own for $13.50 per share. Even though there was another, higher offer for the company on the table, Zhu refused to raise his price, stating that he would not remain as CEO if an alternate bidder acquired a majority stake, would not engage in discussions with third-party investors interested in acquiring the company and would withdraw his proposal if the special committee of the Board formed to consider his offer did not approve it within several days.

The special committee retained Barclay’s Bank to act as financial advisor on the transaction, but it later resigned without ever rendering a fairness opinion. Nonetheless, the special committee approved the deal, and a tiny majority of unaffiliated shareholders ratified it.

Pomerantz is co-lead counsel representing shareholders in a class action in Delaware that seeks damages for investors injured by this self-dealing transaction. Defendants moved to dismiss our action, arguing that Zhu was not a controlling shareholder of Zhongpin because he owned only 17.3% of its shares, and that he therefore did not owe fiduciary duties to other shareholders.

Late last year, in a victory for shareholders, Pomerantz successfully argued that even a 17.3% shareholding stake could be sufficient to assert control, and that the transaction therefore had to be evaluated under the “entire fairness” standard. The Chancery Court rejected the motion to dismiss and the case will proceed to trial.

Because they manage the business for the benefit of the shareholders, corporate directors and officers occupy a fiduciary relationship to both the corporation and its shareholders; but shareholders do not normally owe fiduciary duties to other shareholders. However, when a shareholder “controls” the company, courts have found that he or she owes similar duties as directors to the other shareholders. That is because a controlling shareholder can dominate and control the conduct of the Board and will be held to have indirectly acted in a managerial capacity and thus to have assumed the burden of fiduciary responsibility.

The issue of whether Zhu had control was therefore at the heart of defendants’ motion to dismiss. Under Delaware law, clearly a shareholder owning a majority of a corporation’s stock would be considered a controlling shareholder since with one share more than 50%, such a shareholder could place its own designees on the Board and assure every corporate decision is decided in its favor. Courts have found that some large holders, albeit less than majority holders, may still be considered controlling shareholders if they exert actual control over the Board. That is, they have the power to elect their slate of directors, to adopt or reject fundamental transactions proposed by directors or exercise control over the corporation’s business affairs.

The fact that Zhu was CEO and owned a 17.3% stake was not enough to give him control over the board. In fact, Delaware courts had previously dismissed similar claims of control in other cases where the allegedly controlling shareholder held such a small stake.

In our case, the court held that “Plaintiffs do not need to prove that Zhu was a controlling stockholder in order to withstand the motions to dismiss. Rather, Plaintiffs must plead facts raising the inference that Zhu could control Zhongpin.” The court also held that “while most owners of 17% of a corporation’s stock are not controllers, a plaintiff may argue that given the circumstances of a particular case, such a sizeable stockholder actually exercises control.”

Here the court held that the circumstances supported just such an inference. During the sales process, the company filed its annual report which stated that Zhu “has significant influence over our management and affairs and could exercise his influence against” the best interests of shareholders. The annual report referred to him as the “controlling shareholder” and also stated that as a result of his alliances, and pursuant to the company’s By-Laws, he could “exercise significant influence” over the company, including election of directors, selection of senior management, amount of dividend payments, the annual budget, changes in share capital and preventing a change of control. The court concluded that “Zhu exercised significantly more power than would be expected of a CEO and 17% stockholder” and that “one can reasonably conceive that Zhu could ‘control the corporation, if he so wishe[d].”  Under the circumstances, the court held, Zhu’s dominance “left the company with no practical alternatives other than to accept his proposal.”

This has implications for challenges to buy-out proposals submitted by controlling shareholders. Courts seek to protect minority shareholders from the whims and self-interest of controlling shareholders just as they do from the self-interest of corporate directors.

Typically when a shareholder, unhappy over the sale of the company, brings an action against the company’s board of directors to challenge the transaction, a court will defer to the business judgment of the company’s board of directors. The “business judgment rule,” as this protection is known, affords corporate officers and directors who are not subject to self-dealing conflicts of interest immunity from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence. In such a situation, the shareholder-plaintiff has the high burden of proving that the directors’ actions were not made in good faith in order to successfully challenge the transaction.

However, if the directors should have self-interests in the transaction, the burden shifts to the director-defendants to prove the “entire-fairness” of the transaction. The court will also impose the heightened scrutiny of the entire fairness standard of judicial review over the transaction.

Similarly, when a controlling shareholder engages in a self-dealing transaction with its controlled corporation, entire fairness review will apply. That is the standard the court applied here.

 

Second Circuit Rains on Preet Bhahara’s Insider Trading Parade

ATTORNEY: Jennifer Sobers
POMERANTZ MONITOR, JANUARY/FEBRUARY 2015

Manhattan U.S. Attorney Preet Bharara has dedicated the last five years to cracking down on insider trading, putting dozens of Wall Street traders behind bars. He has had a nearly undefeated record, with over 80 convictions. But then, in December, came U.S. v. Newman, which reversed two convictions directly, led to the dismissal of four guilty pleas, and threatens to make future insider trading convictions far more difficult to obtain.

It seems inconceivable that in 2015 there is still no statute expressly prohibiting insider trading. Instead, courts have analyzed insider trading as a species of securities fraud. 

The Supreme Court has espoused two theories of insider trading – the classical and misappropriation theories. The classical theory applies when a corporate insider trades on, or discloses, confidential company information, in violation of his fiduciary duty to the company and its shareholders. This rule prevents corporate insiders from taking unfair advantage of uninformed shareholders.

The misappropriation theory applies when outsiders, who do not have any fiduciary duty or other relationship to a corporation or its shareholders, gain access to confidential corporate information and trade on it or leak it to others. If, for example, an employee of Company A learns that it intends to acquire company B, and misappropriates that information to trade in shares of Company B, he is culpable even though he owed no duty to shareholders of Company B. That is because he breached his fiduciary duty to his own company, the source of the information, by misusing it for his own purposes.

Courts have expanded insider trading liability to reach situations where the insider or misappropriator in possession of material nonpublic information (“tipper”) discloses the information to another person (“tippee”) who then trades on the basis of the information before it is publicly disclosed. Courts have held that the elements of tipping liability are the same regardless of whether the tipper’s duty arises under the classical or the misappropriation theory. A tipper must have breached a fiduciary duty and must have received an improper benefit in exchange for leaking the information. Tippees, who are often Wall Street brokers, traders, and hedge fund executives, can also be liable for trading on leaked material non-public information if they knew that the leak was a breach of fiduciary duty. Some question remained, however, as to whether they also had to know that the tipper had received an improper benefit.

In Newman, decided in December, the Second Circuit rocked the insider trading legal landscape. The case involves tippees who were several layers removed from the original leak. The three-judge panel held that in order for a tippee in a “classic” insider trading case to be convicted she must have known not only that an insider disclosed the confidential information, but also that she received, in exchange, a significant personal benefit. In finding that evidence lacking here, the Court reversed the convictions of former Level Global Investors L.P. manager Anthony Chiasson and former Diamondback Capital Management, LLC manager Todd Newman, finding that there was no evidence they knew they were trading on information from insiders, or that those insiders received any benefit in exchange for such disclosures. And in a fairly bold step, the Second Circuit instructed the district court on remand to dismiss the Newman and Chiasson indictments with prejudice, as oppose to conducting a new trial.

The case turned on the fact that Newman and Chiasson were three or four levels removed from the corporate insiders who improperly leaked Dell and NVIDIA’s earnings numbers, and claimed that they had no idea that the information came from insiders, much less that those insiders had breached any duty by disclosing the information, or that they had received an improper benefit for disclosing it.

The district court did not instruct the jury that Newman and Chiasson, to be convicted, had to have known about a personal benefit received by the insider. The jury returned a verdict of guilty on all counts. The Second Circuit held that this was error, holding that the tippee had to know that the tipper disclosed confidential information in exchange for personal benefit. In rejecting the government’s position as a “doctrinal novelty,” the court concluded that disclosing confidential information, even if in breach of a fiduciary duty, is not enough, because “although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.”

Newman will be a significant obstacle in many future prosecutions, particularly where, as in these cases, the tip was passed along by the original tippee to others both inside and outside the tippee’s organization. These recipients may have no idea who the original source of the information is, much less his motivations for leaking that information.

Compounding this difficulty is the court’s analysis of what does, and does not, constitute a “personal benefit” that triggers insider trading liability. In the past, some courts have been satisfied with de minimus showing of benefits, including such things as “friendship” as a culpable motivation. The Second Circuit obviously now requires more. The personal benefits received in exchange for the Dell tips were such intangible things as: the tipper giving career advice and assistance to the tippee, a fellow business school alumnus, which included discussing the qualifying examination in order to become a financial analyst, and editing the tipper’s resume and sending it to a Wall Street recruiter. The Second Circuit found that the evidence of personal benefit was even more scant in the NVIDIA chain, where the tipper and tippee were merely casual acquaintances who met through church and occasionally socialized together, and the tippee even testified during cross examination that he did not provide anything of value to the tipper in exchange for the information.

The Second Circuit decided that these facts do not evidence a tangible quid pro quo between tipper and tippee. That is, an inference of personal benefit based on the personal relationship between the tipper and tippee is not permissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature. The government may not prove the receipt of personal benefit by the mere fact of a friendship, or that individuals were alumni of the same school or attended the same church. To hold otherwise, the court reasoned would render the personal benefit requirement a nullity.

Moreover, the Second Circuit found it inconceivable to conclude, beyond a reasonable doubt, that Newman and Chiasson were aware of a personal benefit, when tippees higher up in the tipping chains disavowed any such knowledge. The Court appeared even more skeptical about the liability of the tippees when the tippers themselves had not been criminally charged (and in the case of the Dell tipper, neither administratively nor civilly charged).

This Second Circuit decision may well lead to fewer insider trading prosecutions of remote tippees such as Newman and Chiasson. Already, a number of high-profile district court cases were put on hold awaiting this decision from the Second Circuit. For example, the sentencing of Danny Kuo, a former research analyst at Whittier Trust Co. who pleaded guilty to also trading on illegal tips and sharing information about Dell and NVIDIA, was adjourned on July 1 and rescheduled to within 48 hours of this Second Circuit decision. Kuo was two levels removed from the inside tipper in the NVIDIA chain, which although not as far down the chain as Newman and Chiasson, nevertheless, is remote enough to beg the question of whether Kuo knew the original tipper received a personal benefit from disclosing the insider information. To date, the parties are still considering the effects of the decision on Kuo’s case and have asked the judge for additional time to provide the court with a proposed course of action.

Most recently in January, a federal judge in Manhattan vacated the guilty pleas of four remote tippees charged with trading on inside information involving shares of IBM, and delayed the trial of a fifth man who pleaded not guilty, citing the Second Circuit opinion. Prosecutors in the case argued that because the confidential information came from an outside lawyer, the claim relied on the misappropriation theory of insider trading, to which the Newman decision did not apply. The judge disagreed, finding that the elements of tipping liability are the same, regardless of whether the tipper’s duty arises under the classical or the misappropriation theory. The district judge further stated that the Second Circuit’s unequivocal statement on the point is part of a “meticulous and conscientious effort by the Second Circuit to clarify the state of insider-trading in this Circuit” and as such, the opinion “must be given the utmost consideration.” Bharara, perhaps confident that the district judge would not apply what he called “Newman’s novel holding” to this misappropriation case, conceded in an earlier letter to the judge that if the court found that Newman applies, then the court should dismiss the indictments because the government’s otherwise-sufficient proof would no longer suffice under the Newman definition of a personal benefit. The district judge has yet to decide whether the charges in that case should be dismissed.

The ripple effects of the Second Circuit decision are being felt outside of New York, as defendants in insider trading cases in Boston and California have already tried to take advantage of the ruling. Courts around the country may increasingly have to grapple with Newman, as they often look to the Second Circuit for guidance on insider trading.

Undoubtedly, this turn of events is what led Bharara to recently challenge the Second Circuit ruling. He requested both that the same panel of judges that issued the ruling revisit its decision and, as an alternative, for every judge on the United States Court of Appeals for the Second Circuit to hear the case, a process known as en banc review; and the SEC has also filed a brief supporting a reversal of Newman. In his petition, Bharara contended that the Court’s ruling “threatens the effective enforcement of the securities laws.” Specifically, he argued that the “panel’s erroneous definition of the personal benefit requirement will dramatically limit the government’s ability to prosecute some of the most common culpable and market threatening forms of insider trading.”

Some scholars are of the view that the insider trading landscape may be well-served by concrete laws. Courts very rarely grant en banc review, particularly where the panel’s decision was unanimous. It seems Bharara may welcome the Congressional support in his quest to prosecute inside traders at all levels.

Pom Shorts

ATTORNEY: H. Adam Prussin
Pomerantz Monitor, November/December 2014   

PENSION PLANS SEEK RIGHT TO NOMINATE DIRECTORS. 
A band of institutional shareholders is mounting the first push ever at 75 United States companies to allow investors to hire and fire directors directly. Leading the drive is Scott M. Stringer, the New York City comptroller, who oversees five municipal public pension funds with $160 billion in assets. He announced that his office will submit a proposal to each of the 75 companies, asking the company to adopt a bylaw allowing shareholders who have owned at least 3% of its stock for three years or more to nominate directors for election to the board. Among those 75 companies are eBay, Exxon Mobil, Monster Beverage and Priceline. State pension plans in California, Connecticut, Illinois and North Carolina are reportedly also supportive of these efforts. 

So far this year, shareholder activists had a success rate of 72 percent in proxy fights, up from 60 percent in 2013, according to FactSet SharkRepellent, a research firm. Notably: 

STARBOARD VALUE LP WON ALL 12 DIRECTOR SEATS AT OLIVE GARDEN. 
In our last issue we discussed the proxy battle launched by Starboard to win control over the board of Darden Restaurants, which owns the Olive Garden chain. Both of the top proxy advisory firms, Institutional Shareholder Services and Glass Lewis, recommended that investors vote for all 12 of Starboard’s nominees -- and that’s exactly what they did, ousting the entire incumbent board. Rest assured, Olive Garden will be salting its pasta from here on out. 

BIG BANKS PAY BILLIONS MORE IN FINES, AS NEW INVESTIGATIONS ARE LAUNCHED INTO OTHER MISCONDUCT. 
So what else is new? It seems like every issue of the Monitor contains news of another multi-billion-dollar settlement of government claims of wrongdoing by our ne’er-do-well banks, and this issue is no exception. This time Citibank, JPMorgan Chase Bank, Royal Bank of Scotland, HSBC Bank and UBS have agreed to pay $4.3 billion to settle claims involving foreign currency transactions. Their currency traders allegedly attempted to manipulate benchmark rates known as the World Markets/Reuters Closing Spot Rates, the most widely referenced benchmark, which is used to establish relative values of different foreign currencies. Often they used information about imminent trades by their own customers to trade ahead of them and reap profits at their expense. The government is reportedly also considering criminal prosecutions against individual traders. 

No sooner were the settlements announced than we heard news that government agencies are investigating various banks, once again including JPMorgan Chase, for trying to collect on loans that have been discharged in bankruptcy. The banks allegedly tried to coerce borrowers to pay those discharged loans by continuing to report the loans to credit reporting agencies as if they were still in default.

Delaware Court Cleans RBC’s Clock

ATTORNEY: Ofer Ganot
POMERANTZ MONITOR, NOVEMBER/DECEMBER 2014

The Delaware Chancery Court is extremely unhappy, to say the least, with financial advisors, hired to advise a company on a potential going-private transaction, who have hidden conflicts of interest that taint their advice to the detriment of the company’s public stockholders. We saw this in the In Re Del Monte Foods Company Shareholder Litig. decided by the Delaware Supreme Court in 2011. Now we see it again, in spades, in the In Re Rural Metro Corporation Stockholders Litig

There, Vice Chancellor Laster has come down hard on RBC Capital Markets (“RBC”), which advised Rural Metro that its acquisition by Warburg was fair to its stockholders when, in fact, the offering price undervalued the company by over $91 million. 

Warburg’s acquisition of Rural Metro was announced in March 2011. The total value of the acquisition was approximately $438 million. Two stockholders filed lawsuits challenging the merger, contending that the members of the Rural Metro board breached their fiduciary duties in connection with the merger, and that the company’s financial advisors, RBC (which acted as Rural Metro’s lead financial advisor) and Moelis & Company (which acted as Rural Metro’s secondary financial advisor) aided and abetted the directors in breaching their fiduciary duties. 

The court held two trials – one on the question of liability, decided last March, and the other, decided in October, on apportioning responsibility among the various defendants, including the directors of Rural Metro. At the end of the day, the court held that RBC was almost completely to blame, and accordingly ordered it to pay Rural Metro stock-holders 83% of their total damages, about $76 million. 

What did RBC do wrong? In the court’s view, RBC created a conflict for itself by trying to earn multiple fees, from multiple parties, in the same deal. It offered to provide financing to Warburg to help finance its acquisition of Rural Metro, while at the same time advising the company that the acquisition was fair and should be approved. 

Making matters worse, it also offered to finance an acquisition of Rural Metro’s lone national competitor -- AMR (and its parent company EMS) -- and scheduled the two bidding processes to occur simultaneously. While this was designed to maximize the fees RBC could potentially earn, this was a disastrous strategy for Rural Metro, because bidders could not make offers or even get involved in merger talks and discovery for both companies at the same time, and as a result fewer potential buyers for Rural Metro came forward to bid. The last straw was RBC providing a fundamentally misleading analysis of the fairness of Warburg’s offer, which Rural Metro’s directors then included in the proxy statement seeking stockholder approval. 

The court decided that RBC was 100% responsible for the disclosure violations, which concerned its own financial analyses of Rural Metro’s acquisition. The court also decided that with respect to some of the other breaches of fiduciary duties, RBC had “unclean hands” because it committed “fraud on the board” of Rural Metro, misleading it about its financial analyses, talking it into a disastrous sale strategy, and concealing its conflicts of interest. In such cases, the court held, the advisers may not be entitled to contribution from the other de-fendants. This holding may have the most far-reaching consequences for financial advisors, because it ratchets up their exposure in cases where they mislead the directors.

The court’s analysis resolved several legal issues of first impression under Delaware law, resulting in a 95- page opinion dealing with questions of relative fault, and relative liability, of multiple defendants in a breach of fiduciary duty case. Complicating matters was that other defendants, including the Rural Metro directors, had settled the claims against them prior to trial, triggering complex issues relating to settlements involving some, but not all, “joint tortfeasors.” When such partial settlements happen, the non-settling defendants have the difficult job of proving that it was really the other guys -- those who settled -- who were primarily to blame for what happened and paid less than their fair share in their settlement. In this case, RBC failed at that job and will suffer the consequences.



Investigations As Loss Causations

ATTORNEY: Louis C. Ludwig
POMERANTZ MONITOR, NOVEMBER/DECEMBER 2014

The announcement that government agencies have commenced investigations of possible wrongdoing, particularly SEC and FCPA inquiries, has long played an important role in kicking off securities fraud litigation. Recently, however, the universe of these triggering investigations has expanded to include alleged violations of the Lacey Act involving the importation of illegally logged wood from Russia and China; alleged violations of payday lending rules by the U.K.’s Office of Trading; alleged violations of the International Traffic in Arms Regulation; civil investigative demands regarding Medicare fraud; FTC, DOJ, and Senate Finance Committee investigations; and even Chinese governmental investigations of possible corruption. It has been estimated that such cases triggered nearly 10% of securities class action lawsuits filed in 2013. 

This rise in the filing of these “investigation follow-on” actions has drawn increased judicial scrutiny, specifically in regard to loss causation. To state a claim under Section 10(b) of the Exchange Act, a plaintiff must demonstrate, among other things, that the public disclosure of a misrepresentation caused plaintiff’s complained-of financial loss (or “loss causation”). To satisfy this requirement, there usually has to be a “corrective disclosure” of the true facts which, in turn, causes the losses. The question, then, is whether the announcement that an investigation has begun amounts to a “corrective disclosure.” 

In August, the Ninth Circuit issued Loos v. Immersion Corp., which holds that the “announcement of an investigation, standing alone, does not give rise to a viable loss causation allegation[,]” even though the announcement was accompanied by a drop in share price. To reach this outcome, the Ninth Circuit reasoned that the announcement of investigation disclosed only the “risk” or “potential” for widespread fraudulent conduct, and did not “reveal” fraudulent practices to the market. As stated in Meyer v. Greene, a 2013 Eleventh Circuit opinion followed by the Immersion court, “the announcement of an investigation reveals just that-an investigation-and nothing more.” 

In September, the Ninth Circuit amended its opinion in Immersion to clarify that the court did “not mean to suggest that the announcement of an investigation can never form the basis of a viable loss causation theory.” The court added that “[t]o the extent an announcement contains an express disclosure of actual wrongdoing, the announce-ment alone might suffice” to support loss causation by itself. But what happens if the fraud hinted at by an investigation isn’t confirmed for months, or even years? 

The optimistic take is that if an investigation ultimately bears fruit, loss causation may be shown in hindsight. Interestingly, the Immersion plaintiff argued this exact point, claiming vindication by way of post-class period disclosures that Immersion’s financial statements were unreliable and would have to be restated. Unfortunately, the Ninth Circuit deemed that argument waived because plaintiff failed to raise it before the district court or in his complaint, so it’s uncertain how it would play out on the merits. We do know that the amended Immersion opinion states that its holding doesn’t affect investigatory announcements bolstered by a “subsequent disclosure of actual wrongdoing[,]” implying that such fact patterns are actionable. This appears to validate the Immersion plaintiff’s claim that later revelations “‘solidif[ied] the causative link’ between the fraud and his loss.” He simply failed to plead that link in time. 

If this reading is correct, it raises an additional question: with a two-year statute of limitations governing Exchange Act claims, and with investigations notoriously slow to resolve, should a potential 10(b) plaintiff faced with an investigatory announcement, but no definitive “corrective disclosure” or admission of wrongdoing, file anyway? On one hand, the claim would be preserved – a plaintiff could “wait-and-see,” then, provided that the fraud was ultimately confirmed, argue that the investigation heralded a later “materialization of the risk.” On the other hand, the court could run out of patience prior to the needed corrective disclosure and dismiss the complaint. The difficulty here is that statutes of limitations typically do not start to run until the cause of action “accrues,” which means that enough facts are disclosed to allow investors to file a claim. If there is uncertainty as to whether disclosure of an investigation is sufficient to support a claim, a plaintiff who does not file a case right away risks falling afoul of the statute of l imitations, resulting in the claim being time-barred. 

Practically, the best advice for plaintiffs is to take Immersion at its word and avoid pleading an announcement of investigation as a stand-alone basis for loss causation. Multiple disclosures are often simply unavailable, but as Immersion shows, they should be ferreted out in the pre-filing in-vestigation and pleaded whenever possible. This is demonstrated by Public Employees Retirement System of Mississippi et al. v. Amedisys, Inc., issued by the Fifth Circuit in October as the first decision to grapple with Immersion. In contrast to Immersion, the Fifth Circuit upheld the complaint in Amedisys, which alleged, as corrective disclosures, the announcement of investigations by the DOJ, SEC, and Senate Finance Committee, along with the following additional disclosures: a report published by Citron Research raising questions about Amedisys’s billing; executive resignations; and a number-crunching WSJ article con-cluding that Amedisys was “taking advantage of the Medicare reimbursement system.” While opining that some of these allegations, standing alone, would be insufficient to show loss causation, the court held that the multi-ple partial disclosures “collectively constitute and culminate in a corrective disclosure that adequately pleads loss causation...” In sum, Immersion and Amedisys teach that there is strength in numbers. 

As a postscript, a Pomerantz case, In re LifeLock Sec. Litig. (D. Ariz.), will be the first test of Immersion at the district court level nationwide. Plaintiff alleges that LifeLock de-liberately turned off “identity theft prevention” alerts to elderly customers in violation of a 2010 settlement with the FTC that required ongoing compliance (and honesty with consumers). After a whistleblower came forward, the FTC re-opened its inquiry into LifeLock, causing shares to drop. In their pending motion to dismiss, defendants argue for a broad reading of Immersion, in which investigatory announcements are presumptively ill-suited to support an allegation of loss causation. Plaintiff contends that the renewed investigation didn’t merely portend a “risk” of fraud, but was instead a materialization of LifeLock’s noncompliance with the FTC settlement. Most importantly, the complaint also pleads additional disclosures, making the upcoming ruling not only a test of Immersion, but of the countervailing approach on display in Amedisys as well.



Pomerantz Achieves Additional Victories for BP Investors

ATTORNEY: H. Adam Prussin
POMERANTZ MONITOR, NOVEMBER/DECEMBER 2014

BP p.l.c. is a U.K. corporation with substantial U.S. operations. Its common stock trades on the London Stock Exchange (LSE), while its American Depository Shares (ADS) trade on the New York Stock Exchange (NYSE). In April 2010, the Deepwater Horizon offshore drilling rig chartered to BP exploded and sank, killing 11 people and spilling roughly five million barrels of crude oil into the Gulf of Mexico before the blown well was capped. 

Since 2012, Pomerantz has been pursuing ground-breaking claims on behalf of nearly three dozen institutional investors to recover losses in both BP securities stemming from allegedly fraudulent pre-spill statements about BP’s safety reforms and post-spill statements about the scope of the spill. 

The challenge has been to craft a legal strategy that would permit our clients to pursue claims for their LSE-traded BP shares in U.S. courts, notwithstanding the U.S. Supreme Court’s 2010 decision in Morrison v. Nat’l Australia Bank Ltd., which foreclosed use of the U.S. federal securities laws to pursue claims over foreign-traded securities. Throughout the litigation, BP has sought to get the cases dismissed, for litigation in foreign courts with disadvantageous rules, relying on Morrison and a litany of factual and legal arguments. As the Monitor reported last year, Pomerantz already defeated BP’s motion to dismiss claims brought by our first tranche of clients, three U.S. public pension funds. 

This time, in a series of landmark rulings by U.S. District Judge Keith P. Ellison of the Southern District of Texas in October 2014, Pomerantz defeated BP’s motion to dismiss claims brought by our second tranche of clients. Specifically, the court rejected BP’s attempts to: (i) dismiss foreign investors’ lawsuits so as to require them to be litigated abroad; (ii) extend the reach of a U.S. federal law so as to require dismissal of both foreign and domestic investors’ English common law claims, and (iii) shorten the time periods within which a U.S. federal securities claim (for our clients’ ADS losses) could be filed. Each of these cutting-edge victories preserved claims for our clients. 

Pomerantz Secures Rights of Foreign Investors to Sue in U.S. Courts

In the most significant October 2014 ruling, Pomerantz has now established the right of foreign investors who  purchased foreign-traded shares of a foreign corporation to pursue foreign-law claims for securities fraud losses in a U.S. court. This hard-fought outcome represents the first time after the Supreme Court’s Morrison decision that such claims have been permitted to proceed in a U.S. court. 

A year ago, Pomerantz defeated BP’s motion to dismiss similar claims by U.S.-based pension funds, when Judge Ellison held that their claims had sufficient ties to the U.S. to warrant adjudication here – rather than in England – even after he decided to apply English common law. At that time, facing only U.S. plaintiffs, he also did not credit BP’s arguments that Morrison or the U.S. Constitution prohibited such an outcome as impermissible regulation of foreign commerce. 

This time, BP, once again invoking the Morrison holding, sought to dismiss the cases of Pomerantz’s foreign clients under the same forum non conveniens doctrine, so that they would have to litigate their cases in English courts. Given the English system’s restrictions on contingent fee litigation and its imposition of a “loser pays” approach on legal fees, this argument posed a serious threat to the viability of our clients’ cases. BP’s argument, boiled down, was that because these clients were “foreign,” their cases necessarily had a stronger nexus to England – even though many of our “foreign” clients hailed from nations outside the U.K. (and indeed outside of Europe). 

After extensive briefing, Pomerantz Partner Matthew Tuccillo argued against dismissal in a multi-hour hearing in July 2014. He successfully argued that Pomerantz’s foreign clients deserved the same deference on their choice of forum as our U.S. clients. Drawing upon extensive advance due diligence that he and Pomerantz Associate Jessica Dell had conducted with the outside investment management firms that serviced our clients, Mr. Tuccillo then persuaded Judge Ellison that our foreign plaintiffs’ cases had considerable ties to the U.S., such that BP had not met its burden to disrupt their forum choice.

Pomerantz Defeats BP’s Attempt To Extend SLUSA Dismissal to Foreign Law Claims 

BP also argued that the Securities Litigation Uniform Standards Act (or “SLUSA”), which in certain instances requires dismissal of securities claims brought under U.S. state law, should be extended to apply to foreign-law claims. Under BP’s interpretation, SLUSA would have mandated dismissal of the English common law claims of all of Pomerantz’s foreign clients and U.S. non-public clients. 

Here, Pomerantz forcefully argued that the Exchange Act of 1934 expressly defined the “State” law claims to which SLUSA applies as those brought under the laws of “any State of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, or any other possession of the United States.” As Mr. Tuccillo argued to Judge Ellison in July, “Defendants ask this Court to do nothing less than to rewrite, selectively, an unambiguous statute that was duly elected by Congress to suit their purposes, and the Court should decline to do so.” Judge Ellison agreed. 

Judge Ellison also rejected BP’s argument that the original pleading of Texas law claims (later amended to be English law claims) and/or the use of Texas choice of law rules to identify English law as the governing substantive law served to trigger SLUSA’s dismissal provisions. In doing so, he validated our read of the existing split in the national case law on SLUSA’s application. 

These rulings were significant, as they preserved the lawsuits of dozens of BP plaintiffs, including both foreign and domestic institutions represented by Pomerantz and other firms. 

Pomerantz Establishes a Broader Time Period for Exchange Act Claims

The court also ruled in Pomerantz’s favor as regards the U.S. federal securities claims being pursued by some of our foreign and domestic clients who purchased BP’s ADS on the NYSE. Normally, the pendency of a class action will serve to toll the applicable statute of limitations for individual plaintiffs who may later pursue the same claim. Here, a parallel class action has sought to pursue, on a class-wide basis, a claim under Section 10(b) of the Exchange Act for losses in BP’s NYSE-traded ADS (although, notably, the court has more recently failed to certify most of the proposed class). 

BP had argued that Pomerantz’s clients waived this tolling by filing their individual lawsuits prior to the adverse decision on class certification in the class action. BP also argued that in any event, the statute of repose for our clients’ Exchange Act Claims, which is normally intended to be the “outside” date by which a claim must be filed, was never tolled. These arguments, if credited, would have served to bar as untimely our clients’ Exchange Act claims. 

Judge Ellison sided with us on both arguments, thereby preserving tolling of both the statute of limitations and the statute of repose. The repose ruling in particular was significant, because there is a deep divide in the case law nationally, and the Supreme Court had been poised to hear the issue this term (before the case raising it was settled). These rulings permit our clients to continue to file Exchange Act claims regarding their BP ADS losses, a very valuable right in the wake of Judge Ellison’s decisions denying class certification for most of the time period at issue in the parallel class action.

The Path Ahead

Together, these landmark rulings have highlighted a new path toward recovery in U.S. courts for foreign investors pursuing foreign law claims regarding their losses in foreign-traded securities. Ever since Morrison was decided in 2010, no other case like this has survived. 

Pomerantz serves on a court-appointed Steering Committee overseeing all individual actions against BP by institutional investors and serves as the sole liaison with the court and BP. Our third tranche of plaintiffs’ cases is already on file, and discovery is anticipated to commence in all cases in the near future. 

Pomerantz currently represents nearly three dozen institutional plaintiffs in the BP litigation, including U.S. public and private pension funds, U.S. limited partner-ships and ERISA trusts, and pension funds from Canada, the U.K., France, the Netherlands, and Australia. The BP litigation is overseen by Partners Marc Gross, Jeremy Lieberman, and Matthew Tuccillo. 

To Salt or Not to Salt, That Is the Question

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014

Starboard Value LP, a hedge fund, is trying to take over Darden Restaurants, the parent company of Olive Garden restaurants. Recently it made history, of a sort, when it sent out a 300 page proxy statement asking shareholders to vote for its 12 nominees to the Darden board. Its solicitation was a soup to nuts critique of everything it believes is wrong with Olive Garden and its recipe for fixing it all. What makes it noteworthy is its scathing attack on the restaurants themselves. Most notable: it expresses outrage that Olive Garden does not add salt to the water it uses for cooking its pasta, a practice it believes to be universal everywhere else. Starboard characterized this non-salting as an “appalling decision [that] shows just how little regard management has for delivering a quality experience to guests.” This generated a lot of buzz from casual observers who could care less about Starboard’s takeover efforts. Most people apparently agree that failing to salt the water is a serious faux pas.

Not content with pouring salt on this open wound, Starboard also criticized Olive Garden for oversupplying guests with unlimited breadsticks and salad. While not saying much about the salting issue, Darden did vigorous¬ly debate the issue of the endless breadsticks. Starboard had contended that Olive Garden was wasting millions of dollars by delivering more breadsticks to each table than customers normally eat, though it has said it doesn’t want to get rid of unlimited breadsticks. Darden’s rejoinder: its breadstick generosity “an icon of brand equity since 1982″ and claims that it “conveys Italian generosity.” 

Institutional Shareholder Services and Glass Lewis, the two leading proxy advisory firms, have both rec-ommended that their institutional clients vote in favor of all 12 Starboard nominees. The vote is next month. 

We’ve been to Olive Garden. Salt and breadsticks are the least of their problems.

Is Da Fix In?

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR: SEPTEMBER/OCTOBER 2014

About two years ago, the Commodities Futures Trading Commission started an investigation into whether the world’s largest banks had conspired to manipulate ISDA¬fix, a benchmark similar to LIBOR, which in this case is used to set rates for trillions of dollars of complex financial products, such as interest-rate swaps. Much of the evidence collected by the CFTC seems to have been provided as a byproduct of the LIBOR rate-fixing investigation. Pomerantz currently represents a number of banks and financial institutions in a class action on behalf of lenders arising out of the LIBOR rate-rigging scandal.

A few weeks ago, the press reported that the CFTC reported to the Justice Department that it had found evidence of criminal collusion in manipulating ISDAfix rates. 

Here we go again. 

Until this year, the dollar-denominated version of the ISDAfix rate was set daily by ICAP, a brokerage firm, based on price quote data submitted by banks. Once the CFTC started investigating, ICAP lost that central role.

Bloomberg News reported last year that the CFTC had found evidence that traders at Wall Street banks had instructed brokers to buy or sell as many interest-rate swaps as necessary to rig ISDAfix, by moving it to a predetermined level. Doing so helped banks reap millions of dollars in trading profits, at the expense of companies and pension funds.

Since then, the Alaska Electrical Pension Fund has filed a civil action accusing 13 banks, including Barclays, Bank of America and Citigroup, of conspiring to fix ISDAfix. The Fund claimed the banks did this in order to manipulate payments to investors on the derivatives. The banks’ alleged actions affected trillions of dollars of financial instruments tied to ISDAfix, including so-called “swap¬tions,” which enable institutions to hedge against moves in interest rates. By fixing the rate, the banks apparent¬ly hoped to profit on transactions in these instruments.

The Alaska Fund further alleges that the banks coordi¬nated their scheme through electronic chat rooms and other private communications channels, and the result was that, as far back as 2009, they often submitted identical rate quotes to ICAP, down to the thousandth of a ratings point. The Fund alleges that “even if reporting banks always responded similarly to market conditions, the odds against contributors unilaterally submitting the exact same quotes down to the thousandth of a basis point are astronomical. Yet, this happened almost every single day between at least 2009 and December 2012.” 

The Feds want to throw some people in jail to show that they are tough on Wall Street after all. Maybe they have found some ripe targets.



Pomerantz Defeats Motion to Dismiss in Accounting Row

POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014

Pomerantz recently scored a significant win for investors in a securities class action involving Avid Technology, a software company. Our complaint alleges that Avid, certain of its officers and directors and its long-time outside auditors Ernst & Young committed accounting fraud. On June 27, 2014, U.S District Judge William Young of the District of Massachusetts denied motions to dismiss filed by all the defendants.

This case presents a rare victory for investors on a motion to dismiss where a company has announced that it will have to file restated financial results but, over a year later, had still failed to file them when the complaint in the action was filed (well after the filing of the complaint). In such cases it is often much harder to plead the fraud in sufficient detail, because it is not until the restatements are issued that the company spells out in detail what was wrong with those original results, and why. Even more importantly, the court refused to let Avid’s auditors off the hook for restatements that, when they come, will affect three years’ worth of software contract revenues.

In 2013, Avid announced that it would restate three years’ worth of financial results because it had improperly recognized revenue from post-contract customer support (“PCS”). Avid revealed that it improperly recognized PCS up front, rather than ratably over the life of the contracts, as accepted accounting standards require. Delayed recognition of PCS in this manner is a fundamental accounting rule for software companies such as Avid. Its announcement said that it would conduct a comprehensive review of the accounting treatment for five years’ worth of software contracts.

Avid had not restated its financial results as of the filing of the complaint. The company tried to take advantage of its own delays, claiming that the allegations were not specific enough because they did not identify specific PCS contracts that were mishandled. We were forced to rely on Avid’s disclosures when it originally announced the need to restate its financials, which were not very specific. However, Judge Young was persuaded that Avid’s repeat¬ed statements about proper revenue recognition practic¬es with respect to PCS sufficiently alleged that material misstatements had been made.

With respect to scienter, the court highlighted statements found in con¬ference call transcripts in which Avid’s CEO demonstrated his knowledge of PCS accounting requirements, as well as allegations from a confidential witness who claimed that the CEO himself decided to recognize PCS up front, rather than ratably. The Court also found persuasive our argument that a compelling inference of scienter was bolstered by the magnitude of the restatement—especially considering that, even though a year had passed since announcing the restatement, the restatements was not complete at the time of the motion to dismiss.

Finally, the Court did not let Ernst & Young, Avid’s long-time outside auditors, escape responsibility. The court was persuaded that the length and magnitude of the errors, the systematic lack of internal controls, and the long-standing relationship between the auditors and Avid sufficiently alleged recklessness as to the auditors. 

Avid recently filed the restated financial results, and the changes were massive. Before 2011, Avid’s net accu-mulated losses were $495.3 million; after the restatement, Avid’s pre-2011 net losses total $1.246 billion, reflecting a previously-reported understatement of net losses of 60%. Avid made public, only last week, the fact that the restate¬ment dates back to 2005, restates almost $900 million of previously-reported revenues, and involves a whopping 5 million transactions—apparently all, or nearly all, of Avid’s software contracts since 2005. Because Avid’s restate¬ment and on-going internal control failures are broader and deeper (and have come to light later in time) than we could have anticipated, we likely will amend the complaint to encompass the massive fraud revealed by the restatement. 

Pomerantz currently is engaged in discovery with the company and its auditors. Depositions are set to begin shortly.

Fifth Circuit Revives Our Houston American Case

ATTORNEY: MURIELLE STEVEN WALSH
POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014 

Pomerantz recently prevailed in an appeal before the Fifth Circuit In re Houston American Sec. Lit. The court reversed and remanded district Judge Harmon’s order dismissing the complaint.

The case involves misrepresentations by Houston American, a Texan oil drilling company, about the amount of its recoverable oil reserves, as well as the success of the company’s oil drilling efforts in a particular region, the so-called “CPO4 Block.” In November 2009, the company made the extraordinary claim that the CPO4 Block contained 1-4 billion barrels of recoverable oil reserves. Later, after it began drilling in the block, Houston American represented to investors that the drilling was producing significant “hydrocarbon shows,” which generally indicate the presence of oil.

The case alleges that, in fact, the company had never conducted any of the necessary tests to substantiate its estimate of recoverable oil, and that company executives were aware of significant problems concerning the drilling operations which conflicted with positive statements they made about the drilling. Houston American eventually admitted that it had abandoned drilling efforts in CPO4, and that the SEC was investigating what had happened.

The district court dismissed the complaint, holding that it failed to substantiate either of the required elements of scienter or loss causation. With respect to scienter, it accepted allegations by our confidential witnesses that the individual defendants were aware of serious problems with their drilling operations when they made positive statements about them to investors; and it also accepted the allegation that the defendants had no reasonable basis for their assertion that the CPO4 block had billions of barrels in recoverable oil reserves.

The court nonetheless found that defendants’ decision to invest additional money into the drilling ($5 million of corporate funds, not their own), somehow negated any inference of scienter as a matter of law. The district court reasoned that it would make no sense for the defendants to invest additional money in a venture if they didn’t believe it would ultimately be successful. In reversing, the Fifth Circuit emphasized that defendants’ personal beliefs about the ultimate success of their operations are irrelevant because they were aware of, but concealed, negative information that was inconsistent with those professed beliefs.

The district court had also held that plaintiffs had not sufficiently pleaded that their losses were directly caused by the misrepresentations, as opposed to “other economic factors.” The Fifth Circuit found that this too, was an error, because it imposed a heightened pleading requirement for loss causation that is not required under the Supreme Court’s decision in Dura.

A few weeks after the Fifth Circuit decision came down, the SEC filed a formal complaint against Houston American and its executives, alleging securities fraud.

 

Pomerantz Defeats Motion to Dismiss Delcath

Attorney: Tamar A. Weinrib
Pomerantz Monitor September/October 2014

 

On June 27, 2014 Judge Schofield of the U.S. District Court for the Southern District of New York denied defendants' motion to dismiss our case against Delcath Systems, Inc., in whichPomerantz is sole lead counsel.

Delcath is a specialty pharmaceutical and medical device company focused on oncology. The case concerns the company’s development of the "Melblez Kit," a device designed to deliver targeted high doses of melphalan (a chemotherapeutic agent) to treat certain types of liver cancer. A key part of the kit is a filter, the purpose of which is to remove the toxic byproducts of the melphalan before they reenter the bloodstream from the liver, thus preventing exposure to toxic levels of melphalan which can lead to severe and often fatal side effects. 

The FDA ultimately refused to approve the Melblez Kit, causing the market price of Delcath’s stock to plummet. Our complaint alleges that the company knowingly failed to disclose to investors that the filter it had used during the clinical trial had not sufficiently removed the toxicities from the blood, resulting in far more deaths and other serious adverse events than those caused by other available treatment methods.

Specifically, during of the clinical trial the company used a filter (the “Clark” filter) that had only been tested “in vitro,” and not on live subjects, prior to its inclusion in Phase III oftesting on humans. Those in vitro tests, however, failed to detect flaws in the Clark filter. After receiving a Refusal to File letter from the FDA in response to its first New Drug Application (“NDA”) for the Melblez Kit, which cited major deficiencies in the NDA including incomplete information regarding serious adverse reactions, as well as manufacturing and quality control issues, Delcath filed a second NDA purporting to correct these major flaws.

The second NDA, however, sought approval of the Melblez Kit with yet another new filter, the Generation 2 filter, which the Company had, once again, tested in vitro, even though it knew those same in vitro tests had failed to detect critical deficiencies in the Clark filter. The company never tested the Generation 2 filter on humans. Defendants did not disclose to investors that they developed the Generation 2 filter, and included it in the second NDA, because of the unprecedented toxicities caused by the Clark filter.  

The FDA convened an advisory panel to review the new NDA, and that panel unanimously recommended that the agency not approve the Melblez Kit, because the risk of harm outweighed the Kit's potential benefit. The FDA relied on this recommendation and ultimately rejected the second NDA.

The court found that defendants should have informed investors that the severity and frequency of the serious adverse events far surpassed those resulting from other available treatments and that no patients in the control group died during the Phase III trial. The court held that the omitted facts about the relative toxicity of defendants’ product caused the FDA to reject the Melblez Kit. The court also found that the Complaint sufficiently pled scienter by alleging that defendants "knew facts or had access to information suggesting that their public statements were not accurate." 

Specifically, the court held that the following factors created a compelling inference of scienter: 1) Delcath is a small company focused on one product; 2) FDA approval of the Melblez Kit hinged on the Phase III trial results; 3) confidential witnesses all corroborated that Delcath's CEO, defendant Hobbs, made all the company's decisions, including those relevant to the Melblez Kit; 4) Hobbs' public statements indicated that he was familiar with the trial data; 5) the company proposed a new and relatively untested filter, the Generation 2 filter, in its revised NDA, rather than the Clark filter used in the Phase III trials, suggesting that defendants knew that the results of its Phase III trials were not as strong as they represented in public statements; and 6) the FDA, and the Advisory Panel it convened, both made scathing comments about the Phase III trial results, and ultimately rejected the Melblez Kit NDA as a result.

With regard to loss causation, the court found that defendants' argument that the drop in stock price was caused by the FDA's rejection of the NDA rather than the revelation of a fraud "is a factual argument for a later day and does not diminish the sufficiency of the Complaint."

The decision is notable as it requires pharmaceutical companies going through the FDA approval process for clinically tested drugs or devices to give investors a complete picture of specific known risks that may impact approvability, and not hide behind generalized risk warnings, particularly where the company opts to speak about the trial results.

The discovery process has begun and Lead Plaintiff will file its motion for class certification in October.
 

Supremes to Police: Keep Your Hand off that Cell Phone

Attorney: JAYNE A. GOLDSTEIN
Pomerantz Monitor, July/August 2014

In an unanimous decision issued on June 25, the Supreme Court held that in most cases the police must obtain a search warrant prior to searching an arrestee’s cell phone. This opinion will affect many of our police organization clients, by hampering the ability of their members to obtain evidence when making an arrest. 

The “search incident to arrest” doctrine allows police to search, without a warrant, the area within the arrested person’s immediate control, to protect officer safety or to prevent escape or the destruction of evidence. The question here was whether an officer is also routinely allowed to rummage through all the files on the arrested person’s cell phone without a search warrant. The Court said no, recognizing that “modern cell phones, as a category, implicate privacy concerns far beyond those implicated by the search of a cigarette pack, a wallet or a purse.” 

The Court recognized that cell phones are repositories of huge amounts of personal information, such as personal messages, bank statements, photographs, notes, mail, lists of contacts and/or prescriptions. “The sum of an individual’s private life can be reconstructed through a thousand photographs labeled with dates, locations, and descriptions; the same cannot be said of a photograph or two of loved ones tucked into a wallet.” In short, “more or two of loved ones tucked into a wallet.” In short, “more than 90% of American adults who own a cell phone keep on their person a digital record of nearly every aspect of their lives…” In order to address safety concerns of the police during an arrest, the police remain free to examine “the physical aspects of a phone to ensure that it will not be used as a weapon,” but once secured, “data on the phone can endanger no one.” To prevent the suspect from destroying evidence on the phone, the Court said that police could remove the phone’s battery or could place the phone in an enclosure that would prevent it from receiving radio waves. The Court also left open the possibility that in exigent circumstances the police could search the phone immediately. 

However, our police officer clients tell us that, at times, immediate access to information contained on a cell phone could be crucial, leading, e.g., to the rapid capture of an accomplice through the reading of text messages, and waiting for a search warrant could permit the accomplice to get away. This ruling will surely lead to more cell phones being seized, to preserve them for possible future searches after a warrant is obtained.

Data Breach: A 21st Century Consumer Problem

ATTORNEY: Mark B. Goldstein
Pomerantz Monitor, July/August 2014

Pomerantz is representing a class of Target customers who were victimized by a widely-publicized hacking incident late last year. Thieves were able to sneak into customer data files maintained by the company and steal 40 million credit and debit cards numbers and 70 million customer records. Target announced the breach last December and said that consumers who shopped at Target between November 27 and December 15, 2013 were victimized. 

Since then there have been many similar breaches at other companies, including Sally Beauty, Michaels Crafts, and the popular Chinese restaurant chain P.F. Chang’s. Typically, thieves steal card data by hacking into cash registers at retail locations and installing malware that covertly records data when consumers swipe credit and debit cards through the machines. Often, the perpetrators re-encode the data onto new counterfeit cards and use them to buy expensive goods that can be resold for cash. Since last year, the cost of data breaches have risen on average 15%, to $3.5 billion. 

In response, consumers have filed class actions against the companies whose data bases were breached. Consumers and banks have filed more than 90 cases against Target, most of which allege that Target negligent¬ly failed to implement and maintain reasonable security procedures to protect customer data and that it knew, or should have known, about the security vulnerabilities when dealing with sensitive personal information. The cases also allege that Target did not alert customers quickly enough after learning of the security issue. Target did not disclose the data breach until weeks after it was announced by a security blogger. Then, Target revealed weeks later that even more customers were affected than originally announced. 

More recently, consumers sued P.F. Chang’s, alleging that it “failed to comply with security standards and allowed their customers’ financial information to be compromised, all in an effort to save money by cutting corners on security measures that could have prevented or mitigated the security breach that occurred.” The complaint claims that P.F. Chang’s failed to disclose the extent of the security breach and notify its affected customers in a timely manner. 

Data breach lawsuits are a relatively new phenomenon, so there is new law to be made here. There are practices that can cut down on these breaches. Most notably, since the Target breach, there has been much discussion of adopting the European-style “chip and pin” credit cards, whose information is more difficult to hack. These cards use a computer chip embedded in the smartcard, and a personal identification number that must be supplied by the customer. The benefit of the chip and pin system is that cloning of the chip (i.e. reproducing it on a counterfeit card) is not feasible. Only the magnetic stripe can be copied, and a copied card cannot be used on a PIN terminal. The switch to chip and pin credit cards in Europe has cut down theft dramatically. France has cut card fraud by more than 80% since its introduction in 1992. Chip and pin cards are yet to be adopted universally by American vendors. 

In the meantime, consumers should be vigilant with their credit card use, and frequently check their credit card statements. Additionally, consumers subject to data breach should act immediately and cancel their credit cards to limit their vulnerability.



BNP Paribas Joins the Bank Perp Walk

Attorney: MICHELE S. CARINO
Pomerantz Monitor, July/August 2014

On June 30, BNP Paribas, France’s biggest bank and one of the five largest banks in the world, pled guilty to charges that it conspired to violate the International Economic Powers Act and the Trading with the Enemy Act. It agreed to forfeit approximately $8.9 billion traceable to its misconduct. This is the largest amount paid by any bank to settle allegations brought by the U.S. government and bank regulators. 

According to the Statement of Facts the Justice Department filed in the U.S . District Court in the Southern District of New York, from at least 2004 through 2012, BNP processed thousands of transactions through the U.S. financial system on behalf of banks and entities located in countries subject to U.S. sanctions, including Sudan, Iran, and Cuba. BNP structured the transactions to help clients move money through U.S. financial institutions while avoiding detection by U.S. authorities and evading sanctions. The practices were deliberate and pervasive, involving, for example, intentionally deleting references to sanctioned countries in order to prevent the transactions from being blocked, and using non-embargoed, non-U.S. “satellite banks” and complicated, multistep transfers to disguise the origin of the transactions. 

To make matters worse, U.S. authorities uncovered substantial evidence that senior executives knew what was happening and did nothing about it. In fact, in 2006, BNP issued a policy for all its subsidiaries and branches that “if a transaction is denominated in USD, financial institutions outside the United States must take American sanctions into account when processing their transac¬tions.” Then, in 2009 and 2010, when the U.S. DOJ and New York County District Attorney’s Office contacted BNP to express concern, the bank was less than cooperative in responding to requests for documents from BNP’s offices in Geneva. Overall, BNP allegedly processed 2,663 wire transfers totaling approximately $8.3 billion involving Sudan; 318 wire transfers totaling approximately $1.2 billion involving Iran; 909 wire transfers totaling approximately $700 million involving Cuba; and 7 wire transfers totaling approximately $1.5 million involving Burma. The New York Department of Financial Services places the estimates much higher, contending that a total of $190 billion of dollar-based transactions were concealed between 2002 and 2012. 

BNP potentially faced criminal, civil, and regulatory actions by various U.S. authorities involving potential penalties of about $19 billion. The $8.9 agreed-upon fine resolves all these related actions and ensures that BNP will not be subject to further prosecution for violations of U.S economic sanctions laws and regulations. While BNP may temporarily suspend payment of dividends to shareholders and may have to take steps to shore-up its capital ratio, the fine is not expected to have any long-term financial repercussions. Notably, BNP’s stock rose 3.6% the day the settlement was announced. 

But the plea agreement contains significant non-financial provisions. Specifically, BNP faces a five-year probationary period and is required to enhance it compliance policies and procedures. An independent monitor will be installed to review BNP’s compliance with the Bank Secrecy Act, Anti-Money Laundering Statute, and economic sanctions laws. In addition, BNP is banned from U.S. dollar-clearing operations through its New York Branch and other U.S. affiliates for one year for certain lines of business for certain BNP offices implicated in the conspiracy. BNP is not permitted to shuffle clients to other BNP branches or affiliates to circumvent this ban. This means that client relationships may be damaged, as clients take their business elsewhere. Furthermore, although there have not been any individual criminal prosecutions to date, 13 individuals were terminated and 32 others were disciplined as a result of the investigations and Plea Agreement. 

These measures are more likely to prompt reform, because they are implemented over a longer time period, require replacement of personnel, and change the way the business operates. They also signal to the industry what is required in this new regulatory environment. The fact that Deutsche Bank, itself a target of investigators, recently announced that it would be hiring 500 new employees in the U.S. in compliance, risk, and technology is not a coincidence. Other banks likely will follow suit. If that occurs, it may be the most positive result to come out of the BNP settlement for all investors.

Lawsuits Against GM are Mounting

Pomerantz Monitor, JULY/AUGUST 2014

Last February, General Motors decided to recall certain models due to defects in the ignition switches that can cause the engine and electrical system to shut down while the vehicle is in motion. If that happens, essential safety features such as airbags, power brakes, and pow¬er steering are all cut off. Since then, GM has recalled approximately 6 million cars due to the faulty ignition switch and nearly 29 million worldwide for a range of defects. 

Similar to the cases filed in the wake of the Toyota recalls, at least 85 lawsuits have been filed against GM seeking recovery of the declines in resale value on the recalled vehicles caused by revelation of the ignition-switch defect. With such lawsuits pending all over the country, in May a court in Chicago sent all of them to New York for consolidated pretrial proceedings. 

But many of these cases may not go forward at all. GM has claimed that economic loss cases are barred by a “discharge” order entered in its bankruptcy case in 2009 that, it argues, insulates the company from depreciation-related liability claims for automobiles sold before 2009. Plaintiffs’ lawyers claim this violates constitutional due-process rights, since GM allegedly knew about the ignition-switch problems at the time of the bankruptcy but kept them secret for years. A ruling on this issue is expected by the end of the summer. 

 GM also has to contend with its own shareholders, some of whom have sued the company and its top executives and board members. On March 21, 2014, Pomerantz filed the first and (so far) only securities class action in the Eastern District of Michigan on behalf of shareholders who purchased GM stock between November 17, 2010—the date of GM’s $20.1 billion initial public offering—and March 10, 2014. According to the complaint, GM’s misstatements and omissions about the ignition-switch defect resulted in “significant reputational and legal exposure” and caused the share price to tank “wiping out billions in shareholder value” when the true extent of the defect was disclosed. Four movants filed motions seeking appointment as lead plaintiff in the securities class action, including clients represented by Pomerantz. 

Oral argument is scheduled in August 2014.

Supremes Finally Weigh in on Crucial Securities Law Issues

ATTORNEY: H. ADAM PRUSSIN
POMERANTZ MONITOR, JULY/AUGUST 2014

At the end of its term in June, the Supreme Court issued two significant rulings relating to securities laws issues. 

 The main event was the decision in Halliburton, which addressed the continued viability of the “fraud on the market” presumption in securities fraud cases. Without the benefit of that presumption, most securities cases could not be certified as class actions. 

After the oral argument in Halliburton in March, we pre­dicted that the Court would not throw out the fraud on the market presumption, but would probably allow defendants to try to rebut that presumption at the class certification stage, if they could show that the fraud did not actually distort the market price of the company’s stock. Our pre­diction was right. In June, the Court issued its ruling, and now “price impact” will be a potential issue on class certification motions. If the company made significant misrepre­sentations about its business or financial results, it will be strange indeed if that had no effect on the price of its stock. 

Typically, when allegedly false statements are released by the company, they do not have any immediate effect on the stock price, because they do not deviate much from previously disclosed information. It is the bad information, which is covered up or falsified, that has the impact, and that impact can be measured when the truth finally does come out, in the so-called “corrective disclosure.” We be­lieve that defendants, in order to rebut the fraud on the market presumption, are going to have a heavy burden to prove that the corrective disclosures had no significant effect on the market price of the company’s stock, and that any price movements that did occur at that time were caused completely by market-wide fluctuations in share prices, by general market conditions, or by some other “bad news” unrelated to the fraud. 

The Court’s other decision came in Fifth Third Bancorp, which concerns the requirements for pleading a breach of fiduciary duty claim under ERISA against retirement plan trustees who continued to invest assets into stock of the employer company despite warning signs of impending catastrophe. 

Under ERISA, trustees of retirement plans have an obligation to act with prudence in investing plan assets or in making investment recommendation to plan participants. In one sense, such claims are easier to win than run of the mill securities fraud claims because there is no scienter requirement. 

But what level of knowledge actually is needed to trigger culpability for trustees? In the past, the courts gave the trustees of an employee stock ownership plan (“ESOP”) a “presumption of prudence” when they decided to invest, or continue to invest, in company stock. To overcome that presumption, they previously required that plaintiff plead, with particularity, that the trustees ignored facts showing that the company was on the brink of financial collapse. The only open question, we thought, was whether the presumption of prudence applied at the motion to dismiss stage, or only later, at trial. 

We thought wrong. To everyone’s surprise, the Court has now thrown the presumption of prudence out the window not only at the pleading stage of the case, but at every stage of the case. 

Instead, the Court set forth a new set of considerations. It held that ERISA claims cannot be based on the theory that the trustees ignored publicly available information about the company or its line of business. But where, as in most cases, the trustees (who are typically company executives) had adverse non-public information about the company, courts must balance the requirements of prudence with the laws against trading on inside information, and with the possible adverse consequences to the company if its ESOP suddenly stops buying company shares. 

In other words, it is going to take years to figure this out.

Fannie Mae and Freddie Mac Secure $9.3 Billion Settlement With B of A

ATTORNEY: JESSICA N. DELL
Pomerantz Monitor, May/June 2014

In March, Bank of America (“BofA”) agreed to pay $9.3 billion to settle four settle lawsuits filed by the Federal Housing Finance Agency (“FHFA”). The lawsuits alleged that the bank misrepresented risks inherent in billions of dollars in mortgage-backed securities that it sold to Fannie Mae and Freddie Mac. Under the terms of the settlement, BofA subsidiaries Countrywide Financial Corp and Merrill Lynch will pay $5.83 billion and repurchase another $3.2 billion in mortgage-backed securities, FHFA said. 

As many will recall, FHFA filed these lawsuits among seventeen similar cases in its capacity as conservator for Fannie Mae and Freddie Mac, after it was reported that Fannie and Freddie lost up to $30 billion in the subprime mortgage market. Cases were brought against all the big banks: JPMorgan, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, and UBS. To date, the lawsuits have recovered more than $20 billion. Seven of those cases are still pending. The recovery is impressive, but brings renewed scrutiny to the whole fiasco, including the unclean hands of some Fannie and Freddie executives, who had long insisted that Fannie and Freddie’s involvement with subprime loans was minimal. We now know that Daniel Mudd and Richard Syron, chief executives of Fannie and Freddie, were aware of the exposure and the risks. Internal documents released at Congressional hearings showed that both ignored repeated warnings from internal risk officers. In March 2006, Enrico Dallavecchia, Fannie Mae’s chief risk officer, wrote to CEO Daniel Mudd to say, “Dan, I have a serious problem with the control process around subprime limits.” 

Fannie’s role goes back to the beginning of the subprime phenomenon. The New York Times journalist Gretchen Morgenson reported that Fannie had actually recruited Countrywide to make the loans to help fulfill Fannie’s own “affordable housing” goals. In return, Countrywide was given a discount on fees. By 2004, Countrywide was Fannie’s top mortgage supplier, accounting for 26 percent of the loans purchased by Fannie. Fannie executives were also among the dozens of employees who enjoyed steeply discounted mortgage rates from Countrywide. The House Oversight and Government Reform Committee found that 153 “VIP loans” had been issued to 27 employees. 

When the government took over and ousted the executives, Fannie and Freddie appeared to be winding down and out. But wait. Mel Watt, head of FHFA, just signaled that Fannie and Freddie may not be exiting the mortgage industry, but instead might be enjoying something of a renaissance. As the Times reported, in a quote attributed to Jim Parrott of the Urban Institute, “(Watt’s) message was he will turn from focusing on the enterprises as institutions in intentional decline to institutions that should be better prepared to form the core of our system for years to come… this shift in focus ripples through the many decisions announced in the speech and signals a watershed moment in the brief history of the agency.” 

The BofA settlement plays a significant role in the appearance of renewal: of the $5.7 billion Fannie Mae reported as comprehensive income for the first quarter, $4.1 billion was revenue from legal settlements, nearly double the $2.2 billion that Fannie had garnered in 2013. Freddie Mac also reported $4.9 billion in benefits from legal settlements. 

This is only the latest in a seemingly endless cycle of banking industry misdeeds. In addition to misrepresentations about mortgage backed securities, we have money laundering, manipulations of LIBOR, aiding and abetting tax evasion, circumventing the sanctions on Iran, the London Whale fiasco, and a host of other high crimes and misdemeanors. That public outrage has somewhat waned on the matter might be attributed to sheer exhaustion. We have not seen the last of it. Not by a long shot.


The Struggle Over the Use of Confidential Witnesses

ATTORNEY: LEIGH H. SMOLLAR
Pomerantz Monitor, May/June 2014

In 1995, Congress passed the PSLRA to eliminate what it considered to be abusive practices in federal securities litigation. Among other things, it raised plaintiffs' burden in pleading federal securities fraud actions. It heightened the standard to plead scienter, requiring that the complaint plead facts "giving rise to a strong inference that the defendants acted with the required state of mind." At the same time, it instituted an automatic discovery stay until resolution of the defendant's motion to dismiss. In combination, these requirements can pose a significant hurdle to securities plaintiffs in making sufficiently specific allegations of wrongdoing. 

Plaintiffs often attempt to meet this burden by relying on statements from former company insiders. Because they often are wary of the possibility of retaliation from their former employers, or because they are still employed, or hope to be employed, in the same line of business, they typically demand that their names be kept confidential, and complaints usually refer to them as “CWs,” or confidential witnesses. Ultimately, their names must be disclosed to defendants, which must be relayed to the CW at the time of the interview. In ruling on motions to dismiss, some federal judges have expressed discomfort in relying on statements of anonymous CWs, worrying that they may not be in a position to know what they are talking about, or that they may be disgruntled former employees looking for revenge while hiding behind a smokescreen of anonymity. Other federal judges believe that CWs are reliable where there is strength in the number of confidential witnesses, their corroborative aspects, and the specific descriptions of each of them. Many cases have required that allegations based on information from CWs must disclose enough about them to substantiate that they were in a position to know what they are talking about. This requirement, of course, makes it easier for the former employers to figure out their identity. Once that happens, defendants have often tried to discredit their allegations or even to contact them to pressure them to “recant.” Southern District of New York Judge Jed Rakoff, a leading jurist in securities litigation, has noted that heightened pleading standards in securities class actions have left confidential plaintiffs' witnesses in a tough spot—sometimes lured by plaintiffs lawyers to exaggerate wrongdoing, and/or unfairly pressured by defendants to recant truthful allegations. 

Defense attorneys have different theories on what can be done to alleviate these concerns; however, many of these “theories” are not practical, such as, for example, requiring plaintiffs’ lawyers to include a sworn declaration from a confidential witness verifying the allegations in the complaint. Such disclosures would reveal the name of the signatory, defeating the protection of confidentiality. As Judge Rakoff noted, once the identities of confidential witnesses are known, they can then be “pressured into denying outright the statements they had actually made.” In fact, fear of retaliation by the former employer accounts for most of witness recantation. Moreover, any requirement that former employees sign a formal legal document, especially under oath, would have a chilling effect on their willingness to reveal what they know. 

Defense attorneys have also suggested that plaintiffs’ lawyers themselves, and not just investigators, participate in the witness interviews. While this might help ensure that the complaint’s summary of CW allegations is accurate, it would be impractical. The involvement of a lawyer, rather than an investigator alone, would be a deterrent for some CWs. Investigators would have to coordinate meetings among counsel and the witnesses, making information collection much more burdensome and time-consuming. 

There are, however, some steps that plaintiffs’ counsel can take to make the CW process more reliable. Investigators should be required to state clearly that they work for a law firm adverse to the former employer, and that they do not represent the witness. They should also be required to ensure that the witness is not currently employed with the defendants and that there is no confidentiality agreement that precludes disclosure. Counsel should also make sure that the information from the CW is consistent with all of the other evidence gathered in the case. The court’s decision in Tellabs III provides that corroborating evidence is the key to CW allegations. Because the Reform Act requires plaintiffs to plead the details of the CW’s position and ability to know the facts alleged, the defendants often can figure out who the CWs are, and “reach out” to them. As Judge Rakoff has stated, the witness often feels pressure to recant or water down what s/he has said. If defendants succeed in this effort and the complaint is dismissed, defendants often file a Rule 11 motion seeking sanctions against plaintiff’s counsel. Such “recantation” should not be the basis for a Rule 11 motion. Plaintiffs’ attorneys should not be deterred by defendants’ latest attempt to dismiss valid securities fraud cases through Rule 11 motions. However, plaintiffs’ counsel should take care to ensure that the allegations in any complaint are accurate, and move for cross-sanctions where appropriate.

 

Lululemon Ordered to Produce Records of Its Stock Trading Plan

ATTORNEY: SAMUEL J. ADAMS
Pomerantz Monitor, May/June 2014

In a dishearteningly familiar scenario, a couple of years ago the chairman of lululemon athletica dumped a large number of company shares he owned, a few hours before the company announced that its CEO was resigning. By trading ahead of the news, the Chairman saved about $10 million. In defending himself from the charge that he traded the shares on inside information, the company’s chairman had publicly claimed that he had sold a big block of his company stock pursuant to his 10b5-1 stock trading plan, and not because he had inside information about impending bad news. 

Pomerantz represents a shareholder of lululemon, and we and our client were interested in finding out whether the chairman’s assertions were true. So we brought a “books and records” action, asking to inspect the company’s records relating to the plan and to this particular transaction. 

Deciding an issue of first impression in Delaware, the Chancery Court recently granted our request, holding that the circumstances of this transaction raised enough suspicion to warrant inspection. The importance of the inside information was beyond dispute. The company, which is known for its yoga apparel, had recently announced a highly embarrassing recall of approximately 17 percent of its women’s workout pants. News of the recall caused the price of lululemon common stock to drop almost 7% within two days, which, in turn, led to the resignations of several key executives and the termination of the company’s Chief Product Officer.

Then came the big blow: soon afterwards, the company’s Chief Executive Officer announced his resignation. That news caused lululemon’s stock to drop almost 22% in the span of a few days. The same day that the lululemon Board of Directors learned of the CEO’s imminent departure, but prior to any public announcement of it, lululemon’s chairman sold over 600,000 shares of company stock for more than $49.50 million. Had he waited to sell until after the public announcement, he would have received a little more than $39 million—approximately $10 million less. This looks a lot like insider trading.

Delaware law allows stockholders of public companies to inspect certain corporate documents, if the stockholder can assert a proper purpose and satisfy other technical requirements. After lululemon refused our requests, Pomerantz filed a complaint, known as a Section 220 action, to compel lululemon to produce certain documents relating to the stock trading plan. Delaware courts have encouraged stockholders to file Section 220 actions as investigatory tools before commencing other forms of litigation, such as derivative actions. 

In response to the Section 220 action, lululemon argued that stockholders had no basis to question the chairman’s stock sales because the trades were executed by the chairman’s broker, who was granted sole discretion under a trading plan to sell shares on behalf of the chairman over a period of time. The plan, known as a 10b5-1 stock trading plan, is implemented by corporate insiders in an attempt to insulate themselves from allegations of insider trading.

Pomerantz, on the other hand, pointed to the fact that the stock sale at issue here was the single largest stock sale conducted on the chairman’s behalf since the establishment of his pre-arranged stock trading plan in late 2012, raising suspicions as to both the timing and the size of the sale.

The Court found that the 10b5-1 stock trading plan did not preclude potential liability for insider trading. The Court also found that there were “legitimate questions as to the propriety” of the sale and ordered the production of certain related documents. In addition to acknowledging that the chairman’s sale was the single largest he had made under the 10b5-1 stock trading plan, the Court also inferred that the number of shares sold was the maximum amount that the chairman could have sold in any one month under the terms of the 10b5-1 plan. These facts allowed the Court to infer a “credible basis” that wrongdoing may have taken place in connection with the June 7, 2013 stock sale. Accordingly, the Court ordered lululemon to produce the 10b5-1 trading plan, as well as certain other documents relating to the stock sale.

The Court’s holding that the mere existence of a 10b5-1 trading plan will not serve as an absolute defense for defendants and will not preclude a finding of a credible basis for an inference of wrongdoing, was an important victory for stockholders of public companies.

 

Delaware Court Raises the Bar in Controlling Shareholder Transactions

Pomerantz Monitor, May/June 2014

It is long-established law that where a transaction involving self-dealing by a controlling shareholder is challenged, the transaction will be reviewed under a standard referred to as “entire fairness.” That standard places the burden on the defendant to prove that the transaction with the controlling shareholder was entirely fair to the minority stockholders, including not only a fair price but a fair process for negotiating the transaction. 

Twenty years ago, the Delaware Supreme Court was presented with the question of whether the business judgment rule might apply to transactions with a controlling shareholder if the transaction was approved either by a special committee of independent directors, or by an informed vote of the majority of the minority shareholders. The Court said no, but that in such cases the burden of proof on the issue of the entire fairness of the transaction would be shifted to the plaintiff shareholders. While this may sound like splitting hairs, in fact the question of which standard — entire fairness or business judgment — will be applied usually determines the outcome of the case.

Now, in Kahn v. M&F Worldwide Corp., the Delaware Supreme Court was presented with a case where the controlling shareholder had used both protective devices: the transaction had to be approved both by an independent special committee and by the minority shareholders. The question was: What is the appropriate standard of review now? 

The Court concluded that those provisions, taken together, neutralized the influence of the controlling shareholder and the highly deferential business judgment standard of review should apply. This creates a much higher barrier for plaintiffs to overcome. They will now have the burden of proving that the challenged transaction was so egregious that it could not have been a result of sound business judgment. 

To demonstrate that the business judgment rule should apply, the controlling shareholder will have to agree at the outset that the completion of the merger will be contingent on the approval of a special committee and approval of the majority of the minority shareholders. Then, defendant must show that: 

  • The special committee was composed of independent directors;
  • The special committee was empowered to reject the controlling shareholder’s proposal, and is free to engage its own legal and financial advisors to evaluate the proposal;
  • The special committee met its duty of care in negotiating a fair price; •    The majority of the minority shareholders was informed; and
  • There was no coercion of the minority. 

The Court reasoned that the dual protections of the special committee and the majority of the minority “optimally protects the minority stockholders in controller buyouts.” It concluded that the controlling shareholder knows from the inception of the deal that s/he will not be able to circumvent the special committee’s ability to say no, and that s/he will not be able to dangle a majority of the minority provision in front of the special committee in order to close the deal late in the process, but will have to make a price move instead. 

While this ruling may serve as a setback to plaintiffs in certain cases, the business judgment standard of review will only apply when all of the above criteria are met. Defendants may be unwilling to condition the completion of the transaction at the outset on the approval of a special committee and a majority of the minority shareholders, as this might create too much uncertainty and risk around the proposed transaction.

 

Court Strikes Down “Cross-Listed Shares” Theory

ATTORNEY: C. DOV BERGER
Pomerantz Monitor, May/June 2014

In 2010, the United States Supreme Court handed down its landmark decision in Morrison v. National Australia Bank, which held that United States federal securities laws only apply to transactions in securities listed on U.S. exchanges, or to securities transactions that take place in the U.S. The ruling has been interpreted to bar recovery under the U.S. federal securities laws by investors who bought shares on foreign exchanges. As previously reported in the Monitor (Volume 10, Issue 6, November/December 2013), Pomerantz has led the effort to seek alternative paths to recovery in the U.S. courts, including via pursuit of common law claims against issuers like British Petroleum and corporate executives charged with securities fraud. 

But what about instances where a security is listed both in the U.S. and on a foreign exchange, and the investor bought his shares overseas? A case in point is City of Pontiac Policemen's & Firemen's Ret. Sys. v. UBS AG, No. 12-4355-cv (2d. Cir.), a securities class action against Swiss Investment Bank UBS AG by foreign and domestic institutional investors that bought shares of UBS stock on the SIX Swiss Exchange. 

The complaint alleged that UBS failed to disclose that its balance sheet had inflated the value of billions of dollars in residential mortgage-backed securities and collateralized debt obligations. It alleged that when the market for those securities dried up, UBS eventually had to recognize a loss of $48 billion. The complaint also alleged that the bank made misleading statements claiming that it was in compliance with U.S. tax laws, only to be forced to settle tax fraud claims with federal authorities for a penalty of $780 million.

Although the plaintiffs had bought UBS shares on a foreign exchange, they invoked the so-called “Listing Theory,” which posits that since shares of UBS are traded on both the Swiss Exchange and in the U.S. on the New York Stock Exchange, all purchasers of UBS shares should be protected by the U.S. federal securities laws, regardless of which exchange they used to purchase their shares. The plaintiffs also invoked the “Foreign-Squared Claims Theory,” which posits that the place where the buy order was placed should control, rather than the location of the exchange where the trade was ultimately executed. The buy orders for some of the purchases of UBS shares at issue had been placed in the U.S. Under this theory’s rationale, such transactions should satisfy the second prong in Morrison, which applies the U.S. federal securities laws to “transactions” that take place in the U.S.

However, the District Court rejected both theories, holding that (1) reading Morrison as a whole, the limitation precluding U.S. securities laws from applying on foreign transactions should apply even when the foreign issuer also lists shares on a U.S. Exchange, and (2) the mere placement of a buy order in the U.S. is too tenuous a connection for the U.S. securities laws to apply to claims for losses related to a securities trade. The Second Circuit affirmed that ruling on appeal on May 6, 2014, in an opinion that aligns with the dominant interpretations of Morrison, whereby investors that had purchased UBS securities on the NYSE could have sought remedies under the U.S. federal securities laws, while those who had purchased UBS securities on the Swiss Exchange could not do so. The decision, a victory for dual-listed issuers, further curtails investor rights and remedies under the U.S. federal securities laws barring an appeal to the U.S. Supreme Court. 

As their rights to seek recovery under U.S. law for foreign-listed securities evaporate in the wake of Morrison, investors can only try to convince Congress to revise the federal securities laws so as to restore, in whole or in part, the protections they once offered. Otherwise, under certain circumstances, they may seek to pursue common law claims such as those pursued by Pomerantz against BP. Until then, investors will have to further weigh the benefits of buying shares of dual-listed companies on foreign exchanges, which may include better prices or lower transaction costs, against the possibility of losing the protection of U.S. federal securities laws in the U.S. courts. The UBS ruling could have added significance if it is followed in other U.S. federal Circuits.

 

 

Rise in “Dissenting Shareholder” Merger Conditions

ATTORNEY: ANNA KARIN F. MANALAYSAY
Pomerantz Monitor, March/April 2014 

The increasing frequency of appraisal proceedings has led directly to a significant change in Delaware law and practice, most notably to the increasing use of dissenting-shareholder conditions in merger agreements. These provisions allow an acquirer to back away from the merger if holders of more than a specified percentage of outstanding shares exercise their appraisal rights. Without this condition, the acquirer would have to go through with the merger even if there are a large number of dissenting shares, thereby running the risk of having to pay a lot more than what it had bargained for. In Delaware, valuation of the target company’s stock in an appraisal proceeding requires a court to “determine the fair value of the shares exclusive of any element of value arising from the accomplishment or expectation of the merger” but taking into account “all relevant factors.” 

Historically, the appraisal remedy has been pursued infrequently because the appraisal process is complex and potentially risky for the dissenting shareholder. Shareholders seeking appraisal must be prepared to invest considerable time and expense in pursuing their rights. Even when the process goes quickly, dissenters face the risk that the court will undervalue the company and their shares. Dissenters must initially bear all their litigation expenses and do not receive payment until finally ordered by the court, and then only receive reimbursement depending on the number of other dissenters, each of whom must pay his or her share of the costs. Absent a group of dissenters who can share costs and (most importantly) legal and expert witness fees, the cost of an appraisal is prohibitively expensive except for holders with large stakes. 

Despite these obstacles, the appraisal remedy is becoming more and more popular, at least in Delaware. One reason is that appraisal valuations have exceeded the merger price in approximately 85% of cases litigated to decision. Another is that even if the court’s valuation is lower than the merger price, dissenters can still come out ahead because these awards include interest at a rate of 5% above the Federal Reserve discount rate. According to recent academic studies, last year the value of appraisal claims was $1.5 billion, a ten-fold increase in the past ten years; and more than 15 percent of takeovers in 2003 led to appraisal actions by dissenters.Recent changes to Delaware law encourage the appraisal remedy by allowing shareholders to exercise their appraisal rights even prior to the consummation of the merger, at the conclusion of the first step in the transaction. Mergers often are completed in two steps. In step one, the acquirer launches a tender or exchange offer for any and all outstanding shares. Upon the close of that transaction, the acquirer then scoops up any shares not tendered in the offer by way of a second-step merger. 

A “short-form” merger does not require stockholder approval of the second-step merger, but can be used only if the acquirer buys at least 90 percent of the target’s stock after the step one. If the acquirer gets less than 90 percent, it has to use a “long-form” merger, which requires it to mail a proxy statement to all remaining shareholders and hold a stockholder meeting to approve the merger. Delaware recently enacted a new law that permits parties entering merger agreements after August 1, 2013, to agree to eliminate the need for a stockholder vote for a second-step merger if certain conditions are met, including receiving tenders of at least 50% of the shares. At the same time, Delaware amended its appraisal statute to provide that in connection with a merger under the new law a corporation can send the required notice of the availability of appraisal rights to its stockholders prior to the closing of the offer, and can require them to decide immediately whether to exercise their appraisal rights. In response to these changes, Delaware corporations have begun notifying their stockholders that all demands for appraisal must be made no later than when the first-step offer is consummated. 

The significance of these changes is that acquirers will now know, before they buy a single share of the target, how many shareholders are going to exercise their appraisal rights. This development, in turn, makes it possible for an acquirer to include a dissenting-shareholders condition to its obligation to consummate even step one of the deal, which, is, effectively, a condition to doing the entire deal. 

With the rising popularity of appraisal litigation and recent changes to the DGCL, a dissenting-shareholders condition will likely become a common feature in merger agreements.

 

Appraisal is the New Black

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, March/April 2014 

For decades, appraisal has been viewed as an antiquated, seldom-used procedure that “dissenting” shareholders can use if they believe that their company is being sold for an inadequate price. Instead of accepting the merger price, dissenters can ask a court to determine the “fair value” of their shares. But they rarely do. 

Until now. As highlighted in a recent New York Times Dealbook article, the “new, new thing on Wall Street is appraisal rights,” particularly in the hands of hedge fund investors who can easily afford the costs. 

The Dell management buyout may have been the start of this trend. There were months of wrangling between the buyout group and a “special committee” of disinterested directors, who were unable to scare up any legitimate competing offers from any third parties, despite intensive efforts to shop the company and lots of noise from Carl Icahn. Then, the deal finally went through, at a total cost of $24.9 billion. About 2.7 percent of shareholders exercised appraisal rights, including institutional investor T. Rowe Price. A much bigger percentage of dissenters appeared in the wake of the Dole Food management buyout of last fall. According to Dealbook, most investors were underwhelmed by the merger price, and in the end, only 50.9 percent of the shares voted to approve the merger. Four hedge funds reportedly bought about 14 million shares when the buyout proposal was first announced, and they have now exercised their appraisal rights. In all, about 25 percent of Dole’s public shareholders have sought appraisal -- an astonishing number. These four dissenting hedge funds have engaged in this same tactic several times in the past, and a nascent cottage industry in appraisal rights is developing. As discussed in the following article, this has led to significant changes in Delaware law and practice, to help acquirers back away from a merger agreement if too many shareholders choose to dissent. Acquirers are going to think twice if they can’t predict how much they are actually going to have to pay to buy a company. 

The threat of appraisal actions is probably a good thing, especially in the context of management buyouts, where the odds are heavily stacked against the public shareholders. It is useful for these insiders to know that, if they try to cut too good a deal for themselves, savvy financial institutions can take them to the cleaners in appraisal proceedings.

 

When Corporate Internal Investigations Become Part of the Problem

ATTORNEY: JOSHUA B. SILVERMAN
Pomerantz Monitor, March/April 2014 

When a company uncovers evidence of accounting improprieties or executive misconduct, or when the government does it for them, a common step is for the company to conduct an “independent” internal investigation. The American Institute of Certified Public Accountants has gone so far as to say that an audit committee must initiate an internal investigation when fraud is detected. A proper investigation, followed by a candid report of findings to investors, can play a critical role in rebuilding investor confidence. However, all too frequently internal investigations are used to hide the truth and protect those responsible. For example, the Office of the Comptroller of Currency (OCC) recently charged that a JP Morgan internal investigation into the bank’s handling of Madoff funds was designed to conceal the knowledge of key witnesses. After spending time with JP Morgan’s lawyers, the government said that the witnesses demonstrated “a pattern of forgetfulness.” 

Even worse, because the investigation had been conducted by lawyers, JP Morgan claimed that the details of the investigation were protected by attorney-client privilege. On that basis, JP Morgan refused to produce the notes from interviews of 90 bank employees following Madoff’s arrest. OCC lawyers argued that the privilege did not apply because it was being used to perpetuate a fraud. However, the argument failed because the OCC could not establish what the newly-forgetful witnesses told their lawyers, or what the lawyers told them to say to investigators. 

In December, 2013, the OCC dropped its attempt to discover details regarding JP Morgan’s internal investigation. A month later, JP Morgan agreed to pay a civil penalty of $350 million to the OCC. The deal represented the largest fine ever paid to the OCC, but it also ensured that the facts surrounding the internal investigation would forever remain private. Where the investigators’ report cannot be manipulated from the outset, companies sometimes contrive to conceal the results. In the AgFeed Industries, Inc. securities litigation, for example, Pomerantz uncovered evidence of an attempt to bury the findings of an internal investigation. In that case, the chairman of the committee investigating rampant fraud at the company testified that investigative committee lawyers and other committee members refused to produce a report to investors because the lawyers – who also represented management at the time – believed that the findings would expose management to litigation. As a result, the full breadth of the fraud was concealed for years. 

In a recent editorial in the Financial Times, short seller Carson Block questioned why these independent investigations so routinely failed to identify even blatant cases of fraud: “Time and again, investigators report that they have found no evidence to support claims of wrongdoing. The question that investors need to ask themselves is: how hard did these investigators look for clues that might have revealed something was amiss?” On his website, Block named names. Concentrating on U.S.-listed Chinese firms, Block identified seven independent investigations that purported to clear management despite obvious signs of fraud that caused investors to lose most of their investment: China Agritech, ChinaCast Education, China Integrated Energy, China Medical Technologies, Duoyuan Global Water, Sino Clean Energy, and Silvercorp. 

The OCC’s charges in the JP Morgan case and the list of improper independent investigations published by Carson Block both confirm a disturbing trend. One possible reason for the trend: outside law firms, which often turn internal investigations into a lucrative practice area. Shielding management is the safe play for the investigating law firms. If they candidly exposed wrongdoing to investors, what company is going to hire them the next time around?

 

Supreme Court Upholds Claims Arising From Stanford Ponzi Scheme

ATTORNEY: EMMA GILMORE
Pomerantz Monitor, March/April 2014 

In a 7-2 decision issued on February 26, 2014, the United States Supreme Court resolved a circuit split over the application of the Federal Securities Uniform Standards Act of 1998 (“SLUSA”). This act bars class actions alleging state law claims of common law fraud “in connection with” the sale of a SLUSA-defined ”covered security”. The decision clears the way for investors to seek recovery under state law from the law firms of Proskauer Rose and Chadbourne and Parke, and other secondary actors, of just under $5 billion they paid for certificates of deposit administered by Stanford International Bank Ltd. The decision marked a win for the plaintiffs’ bar. The plaintiffs alleged that convicted swindler Allen Stanford ran a multibillion dollar Ponzi scheme, selling investors bogus certificates of deposit issued by the bank. These certificates are not “covered securities” as defined by SLUSA. However, the proceeds of the offer were supposed to be invested in “covered securities” that were conservative investments. Stanford never bought the covered securities. Instead he used the investors’ money to repay old investors, maintain a lavish lifestyle, and to finance highly-speculative real estate ventures. 

The Court defined the crux of the claim as “whether SLUSA applies to a class action in which the plaintiffs allege (1) that they ‘purchase[d]’ uncovered securities (certificates of deposit that are not traded on any national exchange), but (2) that the defendants falsely told the victims that the uncovered securities were backed by covered securities.” The key phrase in SLUSA, according to the majority opinion, was its prohibition of state law class actions arising “in connection with” the purchase of a covered security. The majority interpreted that phrase narrowly, holding that an actual sale of a covered security has to occur for SLUSA to apply, and not just a promised sale. The majority observed that a broader interpretation would directly conflict with matters primarily of state concern the fact that the certificates were allegedly backed by covered securities was an insufficient connection to covered securities to bring the case within SLUSA’s reach. 

In a dissention opinion, Justices Anthony Kennedy and Samuel Alito warned that the majority’s ruling could hamper SEC’s enforcement efforts, because Section 10(b) of the Securities Exchange Act, under which the SEC brings enforcement actions, also uses the phrase “in connection with the purchase or sale of any security.” The majority found that concern unfounded, however, saying the SEC failed to identify any enforcement action filed in the past 80 years that would be foreclosed by the ruling. Indeed, the SEC had already successfully sued Stanford and his accomplices over the certificates of deposit. “The only difference between our approach and that of the dissent,” Justice Breyer added, “is that we also preserve the ability for investors to obtain relief under state laws when the fraud bears so remote a connection to the national securities market that no person actually believed he was taking an ownership position in that market.” 

Securities law experts are backing the majority’s limited ruling. “The opinion is imminently correct as a matter of common sense and legal policy,” said Donald Langevoort, a professor of law at Georgetown University. Langevoort said he was “very surprised” the SEC tried to argue that a ruling for the plaintiffs may curtail the government’s enforcement powers.

Supreme Court Has a Full Plate of Securities Cases

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, March/April 2014 

Halliburton.
In our last issue, we devoted much space to discussion of Halliburton, which presents the issue of whether the “fraud on the market” theory, which underpins much of securities class action practice, is still the law of the land. As we said, since the Court’s decision in Basic v. Levinson about 25 years ago, securities class action plaintiffs have relied on this theory to obtain class certification. The theory helps investors establish the essential element of reliance on a class wide basis. It presumes that all investors rely on the market price of a security as reflecting all available material information about the security, including defendants’ alleged misrepresentations. By agreeing to reconsider this question, the Court threw the securities bar, on both sides, into a frenzy. 

On March 5, the Supremes held oral argument in Halliburton, and most observers thought that the Justices seemed unwilling to throw out Basic altogether. Instead, it seems likely that they intend to tweak it a bit, by allowing defendants to rebut the fraud on the market presumption at the class certification stage, with evidence that the false or misleading statements issued by the company did not actually distort the market price of its stock. If this prediction is accurate, investors will be able to live with the new Halliburton rule, and corporations will have to. 

Indymac.
Another venerable Supreme Court precedent in the class certification arena is American Pipe, a 1974 decision concerning the statute of limitations. In that case, plaintiffs filed a class action, but after the statute of limitations had expired the court refused to certify the class, and various would-be class members then tried to file individual claims. The Court held that for those people the statute of limitations was “tolled” – stopped running– while the class certification motion was still pending. That ruling made it unnecessary for potential plaintiffs to start filing individual lawsuits to protect themselves while the class certification motion was still undecided. Under American Pipe, only if class certification is denied would individual actions be necessary in order to protect a plaintiff’s rights from expiring. 

American Pipe talks about limitations periods which start to run when plaintiffs knew, or should have discovered, facts establishing their claim. The new case, Indymac, involves a so-called statute of repose, which in this case says that, under §11 of the Securities Act, the action must be brought within three years after the initial public offering that is the subject of the action, regardless of when investors knew or should have known of their claim. 

Class certification motions are usually not decided within three years, so the same problem that caused the Court to create the American Pipe tolling rule would arise with statutes of repose: as the three year limitation approaches, if the class certification motion is still not decided, individual investors would have no choice but to file individual actions in order to protect themselves from expiration of the “repose” period. A multitude of separate, duplicative lawsuits is not something investors or the courts want to see. 

All appeals courts that have considered the question until last summer had concluded that the three year statute of repose for §11 is tolled by the pendency of a class action motion; but then, in Indymac, the Second Circuit disagreed, setting up this Supreme Court appeal. 

Fifth Third Bancorp.
This case, to be argued in April, concerns the duties of fiduciaries of employee benefit plans governed by ERISA. Many of those plans invest participants’ contributions in stock of the employer corporation, or provide employer stock as an investment option. If the corporation then makes a “corrective” disclosure of negative information, plan participants who invested in company stock can suffer big losses. Sometimes they bring class actions against plan fiduciaries for ignoring warning signs that something was amiss. 

The issue the Court will consider in Fifth Third Bancorp is what plaintiffs in these cases must plead in order to survive a motion to dismiss. ERISA imposes on plan fiduciaries the obligation to act prudently and reasonably. Under one line of cases, plaintiffs must plead facts sufficient to rebut a presumption that the fiduciaries acted reasonably. In cases involving allegedly imprudent investments in company stock, the facts alleged have to show that the company was in dire straits for that presumption to be rebutted. In Fifth Third Bancorp, however, the Sixth Circuit held that this presumption of prudence does not apply at the motion to dismiss stage, but only later, when there is a fully developed evidentiary record. According to the Sixth Circuit, a plaintiff need only allege that “a prudent fiduciary acting under similar circumstances would have made a different decision”. Class actions against plan fiduciaries are a regular accompaniment to securities fraud litigations. Whatever the Court holds will have a major impact in the industry.

JPMorgan Chase Admits that it Covered Up the Madoff Ponzi Scheme

Pomerantz Monitor, January/February 2014 

This January, Federal District Judge Jed Rakoff published an essay in The New York Review of Books that reverberated in the financial community. He noted that, five years after the market crash of 2008 that caused millions of people to lose their jobs, “there are still millions of Americans leading lives of quiet desperation: without jobs, without resources, without hope.” Yet the Wall Street malefactors who caused this catastrophe have never been called to account. “Why,” he asked, “have no high-level executives been prosecuted?” Many of us have asked the same question. After all, after previous periods of financial scandal, several big time honchos spent years staring at the inside of a jail cell. Just ask Dennis Koslowski and Jeffrey Skilling, to name only two. The JPMorgan Chase case shows how much things have changed. The bank has confessed to a litany of misconduct, including fraud in connection with its sale of mortgage-backed securities, and allowing its “London Whale” trader to run amok, causing the company to lose billions of dollars, and then covering it up. Now, on almost the same day as Judge Rakoff’s essay was published, JPMorgan Chase has fessed up again, admitting that it committed two criminal violations when it covered up its knowledge of Bernard Madoff’s $65 billion Ponzi scheme, which was run through Madoff’s bank accounts at the bank. According to prosecutors, JPMorgan’s actions amount to “programmatic violation” of the Bank Secrecy Act, which requires banks to maintain internal controls against money laundering and to report suspicious transactions to the authorities. According to Preet Bharara, the U.S. Attorney for the Southern District of New York, JPMorgan’s “miserable” institutional failures enabled Madoff “to launder billions of dollars in Ponzi proceeds.” To resolve these Madoff cases, JPMorgan agreed to pay more than $2.6 billion in various settlements with federal authorities. At the same time, it also filed two settlements in private actions totaling more than $500 million – one for $325 million with the trustee liquidating the Madoff estate, and the other for $218 million to settle a class action. 

Interestingly, the federal prosecutors credited the trustee’s team with discovering many of the unsavory facts of the bank’s involvement. 

These payouts bring to nearly $32 billion the total that JPMorgan has reportedly paid in penalties to federal and state authorities since 2009 to settle a litany of charges of misconduct. Most notably it came to a record $13 billion settlement just months ago with federal and state law enforcement officials and financial regulators, over its underwriting of questionable mortgage securities before the financial crisis. 

And yet, no one at the bank has been criminally prosecuted for any of this. The deal reached by JPMorgan with prosecutors in the Madoff case stopped short of a guilty plea, and no individual prosecutions were announced. Instead, the bank entered into a deferred prosecution agreement, which suspends a criminal indictment for two years on condition that the “too big to fail” and “too big to jail” bank overhauls its money laundering controls. Even so, this is reportedly the first time that a big Wall Street bank has ever been forced to consent to a non-prosecution agreement. 

Given what JPMorgan Chase admits happened here, it is amazing that there were no prosecutions of individuals. According to documents released by the U.S. Attorney’s office, the megabank’s relationship with Madoff stretched back more than two decades, long before Madoff was arrested in 2008. One document released by prosecutors outlining the megabank’s wrongdoing observed that “The Madoff Ponzi scheme was conducted almost exclusively through” various accounts “held at JPMorgan.” 

By the mid-nineties, according to an agreed statement of facts released by prosecutors, bank employees raised concerns about how Madoff was able to claim remarkably consistent market-beating returns. Indeed, one arm of the bank considered entering into a deal with Madoff’s firm in 1998 but balked after an employee remarked that Madoff’s returns were “possibly too good to be true” and raised “too many red flags” to proceed. Then, in the fall of 2008, the bank withdrew its own $200 million investment from Madoff’s firm, without notifying either its clients or the authorities. 

Twice, in January 2007 and July 2008, transfers from Madoff's accounts triggered alerts on JPMorgan's anti-money-laundering software, but the bank failed to file suspicious activity reports. In October 2008, a U.K.-based unit of JPMorgan filed a report with the U.K. Serious Organised Crime Agency, saying that "the investment performance achieved by [the Madoff Securities] funds ... is so consistently and significantly ahead of its peers year-on-year, even in the prevailing market conditions, as to appear too good to be true — meaning that it probably is." But that information was not relayed to U.S. officials, as required by the Bank Secrecy Act. On the day of Mr. Madoff’s arrest in December 2008, a JPMorgan employee wrote to a colleague: “Can’t say I’m surprised, can you?” The colleague replied: “No.” 

In commenting on this latest settlement by the bank, Dennis M. Kelleher, the head of Better Markets, an advocacy group, observed that “banks do not commit crimes; bankers do.” Jailing people is the best way to deter future misconduct. If anyone thinks that huge fines are enough to deter misconduct by huge financial institutions, they should think again. Despite its huge penalties, JPMorgan just reported another multi-billion dollar quarterly profit, and announced that Chairman Jamie Dimon will receive a hefty raise. Obviously, it can afford to keep treating penalties as just another cost of doing business.



"Go-Shop" Provisions – Too Little, Too Late

ATTORNEY: OFER GANOT
Pomerantz Monitor, January/February 2014 

In a previous issue of the Monitor, we discussed potential problems the combination of certain “deal protection devices” may cause for shareholders wanting to receive the most they can get for their stock when their corporation receives an acquisition offer. 

In most merger transactions, the party making the offer wants to lock up the transaction as tightly as possible. The offeror, after all, has just finished negotiating the deal, usually after a long and expensive process of due diligence, and does not want its offer to be just the opening of an all-out bidding war with competing bidders. Offerors therefore typically condition their offer on the target agreeing to limit its ability to consider other offers. 

On the other side of the table sits the target company’s board of directors, which has fiduciary duties to the target company and its public shareholders. Among those is the duty to maximize shareholder value if the company is sold, and, to that end, to keep itself as free as possible to consider (or even to seek out) superior offers, should they be made (through what are known as “fiduciary out” provisions). 

This conflict is usually resolved through the adoption of multiple deal protection devices which are incorporated into the merger agreement between the target company and buyer. These devices can include, among other things, “no solicitation” provisions which restrict the target’s board of directors from soliciting and negotiating potentially superior offers; “matching rights” which essentially give the buyer a leg-up over any potential bidder, allowing it to match any superior offer made for the target company; and termination fees which require the target company to pay a significant amount (usually ranging between 3% and 4% of the total value of the transaction) to the buyer in the event the target’s board decides to pursue a superior offer. 

Sometimes the target’s board will negotiate what is known as a “go-shop period,” which is a period of time, usually between 30-45 days, during which the target’s board of directors is allowed to actively solicit superior offers from potential bidders without breaching the “no solicitation” mechanism. 

But there is an inherent flaw in this mechanism, which in most cases does not turn up any superior bids. More often than not, go-shop provisions are negotiated in lieu of a pre-signing market check. This usually happens when the buyer pressures the target’s board to accept its bid in a short period of time. The board, afraid that any delay may thwart this opportunity, may choose to skip a market check – a process that takes time – and instead enter into a merger agreement with the buyer, leaving itself the theoretical possibility of potentially securing a better offer after the deal with the buyer is already agreed upon and publicly announced. 

However, at that point, the target’s board has already approved the deal with the buyer, including the consideration to be paid for the target’s common stock. This acceptance by the target’s board sometimes leads to a number of insiders (including board members) entering into voting and support agreements pursuant to which they agree to vote their shares in favor of the deal with the buyer, and against any other deal. 

Moreover, the go-shop mechanism doesn’t necessarily neutralize the other deal protection devices in place including, without limitation, the termination fees and matching rights. This means that any potential bidder who is now interested in making an offer for the target company must assume significant time and expense just to be able to make a superior offer, knowing that the buyer can always simply match the bidder’s offer. Such potential bidder will also have to work harder to secure a majority supporting its offer, in light of any voting or support agreements entered into by target insiders. Even if the buyer chooses not to match, the new bidder must, directly or indirectly, incur the termination fees, thereby increasing even further the cost of such a transaction. 

It is no surprise, then, that the go-shop process usually produces zero competitive bids for the company. The hoops potential bidders must jump through are usually just too many, and they usually go on to search other opportunities, potentially leaving money on the table instead of in the target’s shareholders’ pockets. As a result, go-shop provisions are often dismissed as “too little, too late.” 

It should therefore be shareholders’ preference that a company undergo a significant and meaningful pre-signing market check, or outright auction, rather than negotiate a post-signing go-shop. Bidders are far more likely to materialize if the target hasn’t already signed a deal with someone else. Target boards have to weigh the risk that the offeror will walk away, with the risk that they will be foregoing possibly better offers. In other words, directors have to decide whether a bird in the hand is really better than two in the bush.



Threat to Shareholder Protections in Transactions with Controlling Parties

ATTORNEY: GUSTAVO F. BRUCKNER
Pomerantz Monitor, January/February 2014 

A recent Delaware Chancery Court decision, now on appeal before the Delaware Supreme Court, may dramatically lessen the customary safeguards for minority shareholders in controlling party transactions, such as going private mergers. 

In M&F Worldwide(“MFW”), Chairman Ronald Perelman offered to acquire the remaining 57% of MFW common stock he did not already own. As part of his proposal, Perelman indicated that he expected that the “board of Directors will appoint a special committee of independent directors to consider [the] proposal and make a recommendation to the Board of Directors,” and also noted that the “transaction will be subject to a non-waivable condition requiring the approval of a majority of the shares of the Company not owned by M&F or its affiliates.” 

Controlling shareholder transactions normally trigger the enhanced “entire fairness” standard of judicial review. This enhanced standard places a burden on the corporate board, and the controlling shareholder, to demonstrate that the transaction is inherently fair to the shareholders, by both demonstrating fair dealing and fair price. This is a very difficult standard for the company to meet. 

However, Delaware courts have held that the burden of proof on the issue of “entire fairness” can be shifted to the plaintiff challenger if the transaction has been approved either by an independent special committee of directors or by a positive vote of a majority of the minority shareholders. Independent committee and “majority of the minority” provisions are an attempt to assure that the company and its shareholders can exercise independent judgment in deciding to accept or reject the transaction. Although shifting of the burden of proof creates a higher hurdle for minority shareholders to surmount, it is not an impossible one, because the ultimate inquiry remains the same: the “entire fairness” of the transaction. 

Critically, even if these devices are used, Delaware courts have consistently held, up to now, that the business judgment rule does not protect the transaction. That rule, which protects most ordinary business decisions from shareholder challenge, is almost impossible for shareholders to overcome, because it provides that in making a business decision the directors of a corporation are presumed to have “acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” 

In his decision, Chancellor Strine (who was just nominated to become the next Chief Justice of the Delaware Supreme Court), ruled that where a transaction with a controlling person is conditioned on both negotiation and approval by an independent, special committee and a fully-informed, un-coerced vote of the majority of the minority, the proper standard of review is that of business judgment. According to Chancellor Strine, because Perelman conditioned the deal on implementation of procedural protections that essentially neutralized his controlling influence, the transaction is no different from routine corporate transactions in which the deferential business judgment standard is applicable. 

At oral argument, the Supreme Court seemed interested in the policy arguments both for accepting and rejecting the Chancellor’s reasoning. Chancellor Strine’s ruling, if adopted by the Supreme Court, could provide a roadmap for corporate boards to forestall litigation on even the most one-sided controlling shareholder transactions. Though too early to predict fully the repercussions of such a ruling, there is fear that institutional investors will use the power of the purse to reduce their holdings in controlled corporations over time, if their assets lose the valuable protections they are currently afforded.

Supremes About to Hear Historic Challenge to Fraud on the Market Theory

ATTORNEY: LOUIS C. LUDWIG
Pomerantz Monitor, January/February 2014

Twenty five years ago, in Basic Inc. v. Levinson, the Supreme Court adopted the so-called “fraud on the market” (“FOTM”) theory in securities fraud class actions. That theory holds that a security traded on an “efficient” market presumably reflects all public “material” information about that security, including any public misrepresentations by the defendants; and that in such cases investors rely on the market price as a fair reflection of the totality of information available. Because investors purchase their shares at the market price, assuming that that price reflects all available material information, it is fair to presume that all investors relied, indirectly, on defendants’ misrepresentations when they purchased their shares. 

Reliance is an essential element of securities fraud claims. The FOTM presumption allows investors to establish reliance on a class-wide basis, without having to show that each member of the class personally relied on defendants’ misrepresentations. If reliance had to be shown separately for each of the hundreds of thousands, or even millions, of investors, individual questions of reliance would overwhelm the case. In legalese, individual questions would “predominate” over common questions in the action, and it would be next to impossible to certify a class. The FOTM theory adopted in Basic is therefore a foundation of securities fraud class actions. The importance of class-wide reliance was apparent to the courts from the outset of the modern class action era in 1966. Just two years later, the Second Circuit rejected a defendant’s argument “that each person injured must show that he personally relied on the misrepresentations” because, the court concluded, “[c]arried to its logical end, it would negate any attempted class action under Rule 10b-5 ….” Because most investors do not suffer large enough losses from securities fraud to support prosecution of an individual action, class actions are often the only way for most investors to obtain redress for securities fraud. In recent years, some members of the Supreme Court have become more critical of securities fraud class actions, echoing Chamber of Commerce arguments that the mere act of certifying a class in a securities fraud action puts enormous financial pressure on defendants, forcing them to settle claims regardless of their merit. Before Halliburton, defendants had mounted a series of efforts to get the courts to make it harder to certify a class, arguing that plaintiffs should be forced to prove, at the class certification stage, that the misrepresentations were material (the Amgen case), or that they caused plaintiffs’ losses (an earlier Halliburton case). Both of those efforts failed. 

Those were merely the preliminary bouts; the main event is now here. For years, corporate interests have been mounting attacks on the FOTM theory, arguing that markets are not as efficient as economists previously thought. With the Supreme Court agreeing to revisit its decision in Basic, these well-funded efforts have finally paid off. On November 15, 2013, the Court granted certiorari in Halliburton Co. v. Erica P. John Fund. In Halliburton, the Supreme Court will decide two issues: 

 (1) Whether it should overrule or substantially modify the holding of Basic to the extent that it recognizes a presumption of class-wide reliance derived from the fraud-on-the market theory; and

(2) Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock. 

For everyone involved in litigating securities fraud class actions, the answers to these questions could be game-changers; and Pomerantz’s clients are among the potentially affected. If Basic is overruled and FOTM is jettisoned, securities fraud class actions as we have known them for a quarter century will be a thing of the past. 

Another possibility is that the Court will modify, rather than reject, Basic and FOTM. This possibility exists because FOTM theory actually consists of two distinct, but related, parts: first, “informational efficiency,” the idea that the market is capable of efficiently and speedily processing material information; and second, “price distortion,” whether fraudulent statements injected into the informationally-efficient market in a particular case actually distort a given security’s market price. After Basic was decided, courts weighing class certification in securities fraud cases focused primarily on informational efficiency, allowing the FOTM presumption of reliance to attach where that test was satisfied. By contrast, inquiries into price distortion were rare, if they occurred at all, on class certification motions. The Court could keep FOTM while requiring that plaintiffs establish both an informationally-efficient market, and some price distortion, perhaps using event studies of a type already much in use in securities fraud litigation. 

Defendants are arguing that the issue of price distortion is closely related to another element of a securities fraud claim, “loss causation,” proof that defendants’ misstatements, once corrected, caused the price of the stock to drop, causing plaintiff’s losses. A court that simply assumes price distortion also, to some extent, assumes loss causation. Second, the FOTM presumption is essentially predicated on another independent element of a securities fraud claim, “materiality.” By presuming reliance, courts presume the materiality of the alleged misstatement, and on the class certification motion defendants cannot offer rebuttal evidence negating materiality. Defendants argue that plaintiffs should not be entitled to such presumptions in their favor on a class certification motion. 

At the end of the day, at summary judgment or at trial, defendants will have their opportunity to rebut all these presumptions. But, the argument goes, that is too late, as a practical matter. Once a class is certified, defendants have a strong incentive to settle. Very few defendants have the chutzpah to take a “bet the company” securities fraud class action to trial. 

Even if the Court abrogates Basic and the FOTM theory completely, class actions will still be possible in cases involving failures to disclose (rather than misrepresentations), or involving violations of the Securities Act, which relates primarily to initial public offerings. In other cases, however, investors will be left to pursue individual actions, mostly on behalf of large institutional investors, and possibly in state court. Pomerantz’s current BP litigation, which alleges common law fraud and negligence claims stemming from over two dozen clients’ losses associated with BP common stock investments, provides a glimpse into what this post-Basic world might look like. In such cases, institutions with significant losses can pursue individual actions even without the FOTM presumption, if their advisors actually relied on defendants’ misrepresentations. 

Oral arguments in Halliburton are set for March 5, 2014. In the meantime, Pomerantz attorneys continue to work with economists, Supreme Court consultants, and the law firm that will argue the case, to craft an amicus brief that will support the continued viability of FOTM. Barring the outright affirmance of Basic, we will urge the Court to adopt an approach that leaves FOTM in place – as securities fraud class actions are untenable without some version of it – while adopting a limited inquiry into price distortion.

Pomerantz Reaches Major Healthcare Settlement With Aetna

Pomerantz Monitor, January/February 2013 

Readers of the Monitor may recall our reports on our $250 million settlement with Health Net, followed by our $350 million settlement with United Healthcare. Both actions involved underpayments by health insurers of claims for out-of-network medical services based on miscalculations of “usual, customary and reasonable,” or “UCR,” rates. The $350 million settlement with United Healthcare represented the largest cash settlement of an ERISA healthcare class action ever. 

We continued to pursue UCR claims against other healthcare insurers, and are now pleased to report that we have reached a settlement with Aetna, Inc. This settlement, in In re Aetna UCR Litigation, pending in the District of New Jersey, will -- once it is approved by the Court -- result in the reimbursement, through three settlement funds Aetna will create, of up to $120 million to providers and plan members who were also subjected to out-of-network underpayments based on miscalculated UCR rates. 

This settlement arises out of an action that alleged that Aetna used databases licensed from Ingenix, a wholly-owned subsidiary of United Healthcare, to set UCR rates for out-of-network services. We alleged the Ingenix databases were inherently flawed, statistically unreliable, and unable to establish proper UCR rates. Aetna, United Healthcare, and a number of other healthcare insurers had agreed to stop using the Ingenix databases pursuant to settlements with the New York Attorney General in 2009 simultaneous with Pomerantz’s settlement with United Healthcare. The settlement involves Aetna’s use of other non-Ingenix-based reimbursement mechanisms as well. 

The Aetna settlement represents another successful milestone for Pomerantz’s Insurance Practice Group. We are proud of this latest success in forcing managed care companies to follow the law. This settlement provides an opportunity for providers to obtain reimbursement for monies taken by Aetna in the guise of usual, customary and reasonable payments. It brings to a successful close years of litigation on behalf of providers, for whom we have long fought against the largest health insurers in the country, including Aetna. 

Pomerantz’s Insurance Practice Group represents hospitals, provider practice groups and providers in litigation involving such issues as recoupments and offsets, internal medical necessity policies that are inconsistent with generally accepted standards, and misrepresentations of insurance coverage.

Whistleblower Program Picks Up Steam

Pomerantz Monitor, November/December 2013 

The Whistleblower Bounty Program created by the Dodd-Frank Act mandates that the Securities and Exchange Commission (“SEC”) pay significant financial rewards to individuals who voluntarily provide the agency with original information about securities law violations. If the information provided leads to a successful enforcement action resulting in $1 million or more in sanctions, the whistleblower may receive between 10 and 30% of the sanctions collected. The SEC is required to maintain confidential treatment and anti-retaliation measures for tipsters. 

In a report issued by the SEC staff on November 15, the agency reported that it had received 3,238 tips in fiscal 2013, and had paid out $14.8 million in whistleblower awards that year, $14 million of which went to a single tipster in an award announced on October 1. In announcing the award, SEC Chair Mary Jo White stated that “Our whistleblower program already has had a big impact on our investigations by providing us with high quality, meaningful tips…. We hope an award like this encourages more individuals with information to come forward.” 

As more investigations are resolved, observers expect that more and greater awards will be granted. Currently, the SEC has over $400 million available for the program. 

While this program is new, it may ultimately supplement securities class actions in two important ways. The fundamental purpose of the Whistleblower program is to detect fraud. Unlike the basic purpose of securities class actions – to deter and hopefully monetarily punish fraud – the Whistleblower program incentivizes tipsters to come forward with information to the SEC – thus improving fraud detection. Generally, both corporate insiders (those with independent knowledge of misconduct from non-public sources) and corporate outsiders (those who detect misconduct through independent analysis and investigation of publicly available data) are incentivized to tip information to the SEC. 

Opponents of the program insist that, because the monetary incentives are so high, whistleblowers will turn first to the SEC before disclosing problems internally to obtain corrective action. However, SEC rules seek to preserve the attractiveness of internal reporting, and the SEC reports that most whistleblowers who have come forward since the program’s inception used internal channels of resolution before turning to the SEC. In addition, the SEC has indicated that its standard practice involves contacting the involved corporation directly upon receipt of a tip, describing the allegations, and giving the firm a chance to investigate the matter internally. On balance, the deterrent and detection benefits of the program, coupled with the SEC’s measures to encourage initial internal reporting, outweigh any incentive to simply run to the SEC first on the chance that a tip will result in a large reward.

The Purple Pill and “Pay for Delay”

ATTORNEY: JAYNE A. GOLDSTEIN
Pomerantz Monitor, November/December 2013 

Pomerantz is serving as interim co-lead counsel in an antitrust lawsuit against various pharmaceutical companies. We allege that the brand company, AstraZeneca, paid generic drug manufacturers Ranbaxy Pharmaceuticals, Teva Pharmaceuticals and Dr. Reddy’s Laboratories (“Generic Defendants”) to keep generic versions of the blockbuster drug Nexium from coming to market for six years or more. Nexium, a prescription medication commonly advertised as “the purple pill,” is used to treat heartburn and gastric reflux disease. Pomerantz represents consumers, self-insured insurance plans and insurance companies who were forced to pay monopoly prices for Nexium because there was no generic competition. 

Generic versions of brand name drugs contain the same active ingredient, and are determined by the Food and Drug Administration (“FDA”) to be just as safe and effective as their brand name counterparts. The only significant difference between them is their price: when there is a single generic competitor, generics are usually at least 25% cheaper than their brand name counterparts; and when there are multiple generic competitors, this discount typically increases to 50% to 80% (or more). The launch of a generic drug usually brings huge cost savings for all drug purchasers. 

We allege that in order to protect the $3 billion in annual Nexium sales from the threat of generic competition, AstraZeneca agreed to pay the Generic Defendants substantial sums in exchange for their agreement to delay marketing their less expensive generic versions of Nexium for as many as six years or more, i.e., from 2008 until May 27, 2014. 

Under the Hatch Waxman Act, the law which governs how generic pharmaceuticals come to market, when a generic drug manufacturer wants to sell a generic equivalent of a patented drug, it must file an Abbreviated New Drug Application (“ANDA”) which must certify either that (1) no patent for the brand name drug has been filed with the FDA; (2) the patent for the brand name drug has expired; (3) the patent for the brand name drug will expire on a particular date and the generic company does not seek to market its generic product before that date; or (4) the patent for the brand name drug is invalid or will not be infringed by the generic manufacturer’s proposed product (a so-called “Paragraph IV certification”). 

In the case of Nexium, the generic manufacturers filed a Paragraph IV certification. This filing gave the brand manufacturer forty-five days in which to sue the generic companies for patent infringement. If the brand company initiates a patent infringement action against the generic filer, the FDA will not grant final approval of the new generic drug until the earlier of (a) the passage of thirty months, or (b) the issuance of a decision by a court that the patent is invalid or not infringed by the generic manufacturer’s ANDA. In this case, AstraZeneca sued all three of the Generic Defendants. 

As an incentive to spur generic companies to seek approval of generic alternatives to branded drugs, the Hatch Waxman law rewards the first generic manufacturer to file an ANDA containing a Paragraph IV certification by granting it a period of one hundred and eighty days in which there is no competition from other generic versions of the drug. This means that the first approved generic is the only available generic for at least six months, a large economic benefit to the generic company. Brand name manufacturers can “beat the system” by claiming a valid patent even if such patent is very weak, listing and suing any generic competitor that files an ANDA with a Paragraph IV certification (even if the competitor’s product does not actually infringe the listed patents) in order to delay final FDA approval of the generic for up to thirty months. 

In Nexium’s case, when the Generic Defendants filed their Paragraph IV certifications they alleged, among other reasons, that the Nexium patents were not valid because Nexium was not significantly different from AstraZeneca’s prior drug, Prilosec. The active ingredient in Prilosec is omeprazole, a substance consisting of equal parts of two different isomers of the same molecule. 

Nevertheless, after receiving the Paragraph IV certifications from the Generic Defendants, AstraZeneca filed patent infringement litigation. Just as the thirty months was about to expire and generic Nexium would have been able to come to market, the companies settled the patent litigation. AstraZeneca used the strength of its wallet as opposed to the strength of its patents to obtain the Generic Defendants’ agreement to postpone the launch of their generic Nexium products. In light of the substantial possibility that AstraZeneca’s Nexium patents would be invalidated, in which case AstraZeneca would have been unable to keep generic versions of Nexium from swiftly capturing the vast majority of Nexium sales, AstraZeneca agreed to share its monopoly profits with the Generic Defendants as the quid pro quo for the Generic Defendants’ agreement not to compete with AstraZeneca in the Nexium market until May 27, 2014. 

These cases are commonly called either “pay for delay” or “reverse payment” cases. Until recently, the various federal appellate courts were divided on whether these “settlements” violated the antitrust laws by improperly prolonging the monopoly granted by the patent laws. In June of 2013, the U.S. Supreme Court held that such settlements are subject to antitrust scrutiny. 

The trial of this case is scheduled to begin on March 3, 2014.

Health Insurers’ “Recoupment” Tactic Derailed

Pomerantz Monitor, November/December 2013 

In Pennsylvania Chiropractic Ass’n v. Blue Cross Blue Shield Ass’n, Pomerantz’s Insurance Practice Group obtained summary judgment on behalf of our client health providers against Anthem and Independent Blue Cross in a recoupment case. Recoupment itself has been described as a “legal gray zone” that insurers exploited prior to Pomerantz’s challenges. Recoupment occurs when insurers such as Blue Cross Blue Shield (“BCBS”) pay claims initially and later decide that the claims should not have been paid, demanding repayment and claiming fraud. When the provider refuses to return the money, the insurer deducts the full amount from payment of future claims that are not challenged as improper. 

When these subsequent denials are made in the context of an employee health insurance plan, they are controlled by ERISA, which requires disclosure and appellate rights. In its decision, the court found that Blue Cross insurers violated ERISA by improperly denying beneficiary rights and making arbitrary and capricious benefit denials. The court also denied BCBS’s motion for summary judgment against several chiropractic associations, also represented by Pomerantz, for injunctive relief. This ruling paved the way for a December trial to modify the way Blue Cross obtains benefit recoupments from chiropractors across the country. 

This decision has national significance. As we stated to Law 360, an online legal publication: “The decision found for us on the merits of our claim that an insurer must comply with ERISA when seeking to recover previously paid health care benefits from providers. Given the hundreds of millions of dollars recouped by insurers every year, this decision will have widespread implications.” 

The decision follows Pomerantz’s successful trial verdict on behalf of other providers in another recoupment and fraud case in the District of Rhode Island, Blue Cross & Blue Shield of R.I. v. Korsen, and our win in yet another recoupment case in the Third Circuit in Tri3 Enterprises, LLC v. Aetna, Inc. We have other recoupment cases ongoing, the results of which we will report in future editions of the Monitor.

FIRREA: No, It’s Not a Disease, Unless You Are a Naughty Financial Institution

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, November/December 2013 

As JPMorgan Chase struggled to put the finishing touches on its $13 billion settlement with the federal government over its misadventures in the mortgage-backed securities area, a major ingredient in the government’s success seems to have come from out of nowhere – or, more precisely, from the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"). This provision, enacted in the wake of the savings and loan meltdown of the 80’s, has been pulled out of the mothballs to punish some of the misbehaving financial institutions that brought about the financial crisis of 2008. 

Section 951 of FIRREA authorizes the Justice Department to seek civil money penalties against persons who violate one or more of 14 enumerated criminal statutes (predicate offenses) that involve or “affect” financial institutions or government agencies. On April 24, 2013, the U.S. District Court for the Southern District of New York issued the first judicial interpretation of the phrase "affecting a federally insured financial institution" as used in FIRREA. In United States v. The Bank of New York Mellon, the DOJ sued the bank and one of its employees under FIRREA. Defendants allegedly schemed to defraud the bank’s custodial clients by misrepresenting that the bank provided "best execution" when pricing foreign exchange trades. The DOJ contended that the defendants' fraudulent scheme "affected" a federally insured financial institution—namely the bank itself—as well as a number of other federally insured financial institutions. The bank, on the other hand, contended that a federally insured financial institution may be "affected" by a fraud only if it were the victim of or an innocent bystander, but not if it were the perpetrator. 

The court disagreed, concluding that a federally insured financial institution could be "affected" by a fraud committed by its own employees, even though it may actually have profited from that fraud in the short run. The court reasoned that the fraud exposed the bank to a new or increased risk of loss, as shown by the fact that BNY Mellon had been named as a defendant in numerous private lawsuits as a result of its alleged fraud, which required it to incur litigation costs, exposed it to billions of dollars in potential liability, and damaged its business by causing a loss of clients, forcing BNY Mellon to adopt a less-profitable business model, and harming its reputation. 

Every fraud committed by bank employees could lead to such consequences; and because mail and wire fraud are very broad statutes that apply to virtually all fraudulent schemes, FIRREA has wide scope and potentially devastating impact. 

Other features of FIRREA also cause bankers to lose sleep. Although the DOJ has to prove that certain criminal statutes have been violated, the burden of proof is not “beyond a reasonable doubt” but, rather, only a “preponderance of the evidence.” The statute of limitations is ten years, which is important given that the five-year limitations period applicable to securities fraud and other statutes is expiring on many cases involving the 2008 financial meltdown. 

Finally, and most spectacularly, the potential penalties under FIRREA are astronomical. The statute authorizes penalties of up to $1.1 million per violation; for continuing violations, the maximum increases up to $1.1 million per day or $5.5 million per violation, whichever is less. That’s not much; but FIRREA allows the court to increase the penalty up to the amount of the pecuniary gain that any person derives from the violation, or the amount of pecuniary loss suffered by any person as a result of the violation. 

The DOJ has invoked this special penalty rule to seek more than $5 billion in civil money penalties in a current litigation involving fraud allegedly committed by the credit ratings agency Standard & Poors. 

The U.S. Attorney in Manhattan has now filed civil fraud actions against Wells Fargo, BNY Mellon and Bank of America, among others, and in October a jury found Bank of America liable. Finally, potential FIRREA liability reportedly has played a major role in convincing JPMorgan Chase to pony up $13 billion to settle with the DOJ.

A New Way to Curtail Class Actions?

ATTORNEY: MARK B. GOLDSTEIN
The Pomerantz Monitor, September/October 2013 

A recent decision by the Third Circuit has the potential to further restrain consumer and other types of class actions. Last August, in Carrera v. Bayer Corp., the Third Circuit reversed and remanded the certification of a class of Florida consumers who purchased Bayer's One–A–Day WeightSmart diet supplements. 

This was a potential class action by consumers claiming that Bayer falsely and deceptively advertised its supplement. When the District Court certified the class, Bayer appealed, arguing that class certification was improper because the class members were not “ascertainable”. This requirement means that “the class definition must be sufficiently definite so that it is administratively feasible to determine whether a particular person is a class member.” This is important because all class members have to be notified if a class has been certified or if a settlement has been reached, and because, if there is a recovery for the class, the court can determine who is entitled to share in it, and who isn’t. 

Here the class was to consist of everyone who purchased the supplement in Florida. Figuring out who these people are is no easy matter. In securities cases, for example, there are brokerage and other records identifying everyone who bought or owned a particular security at a particular time. Similarly, records are kept of everyone who purchases prescription drugs. But no one keeps a comprehensive list of everyone who buys consumer products like over the counter diet supplements. If such a list must exist in order to certify a class action, it will be a major roadblock in many cases. 

Plaintiffs here proposed that class members could be identified through retailers’ records of online sales and of sales made through store loyalty or reward cards. They also suggested that when class members file their individual proofs of claim to share in any recovery, they could submit affidavits attesting that they purchased WeightSmart and stating the amount they paid and the quantity purchased. 

The Third Circuit rejected those arguments, concluding that it could not know for certain whether retailers’ records would identify all or most of the class members. It also held that affidavits from people who claimed, without documentary proof, that they bought the product could be unreliable. 

It is too soon to know whether other Circuits will follow suit and adopt this standard for ascertainability. If they do that would be a problem. There are many products sold for which there is no comprehensive and authoritative source identifying all purchasers. In such cases, purchasers may have no feasible method for seeking recourse if defendants engage in deceptive or illegal conduct.

The Dust Starts to Settle After Halliburton

ATTORNEY:  MICHAEL J. WERNKE 
THE POMERANTZ MONITOR, SEPTEMBER/OCTOBER 2014

It has been a little over two months since the Supreme Court issued its decision in Halliburton Co. v. Erica P. John Fund, Inc., reaffirming the “fraud-on-the-market” presump­tion of class-wide reliance that makes most securities fraud class actions possible. Even in such a short period, we have seen significant developments in this area of the law.

In Halliburton, the Supreme Court declined to create a new requirement that the plaintiff, in order to invoke the fraud on the market presumption, had to demonstrate “price impact” at the class certification stage—i.e., that the misrepresentation actually affected the price of the stock. However, the Court did authorize defendants to try to defeat class certification by submitting “evidence showing that the alleged misrepresentation did not actually affect the stock’s market price.”

Since then, lower federal courts have begun interpreting Halliburton’s impact on current class certification stan­dards. In several cases the courts have concluded that it represents no fundamental change at all, particularly because even before Halliburton, many circuits had already permitted defendants to show the absence of price impact at the class certification stage.

More important are decisions of two courts that have addressed the question of whether Halliburton forecloses the so-called “price maintenance theory.” One textbook example of a fraud-on-the-market claim is that the defen­dant made misrepresentations that caused the market price of the company’s stock to move up, and that the price came back down only when the truth finally came out. In these cases the “price impact” occurred when the misleading financial information was first released.

The price maintenance theory, on the other hand, comes into play if the alleged fraud did not cause the price of the company’s stock to move up but, instead, prevented it from moving down. This can occur if the company falsely reports that its results are about the same as before, in line with market expectations, when in fact something bad has happened and the true results were really far worse.

Under this theory, the “price impact” of the fraud does not occur at the time of the misrepresentations, but only when the truth finally comes out and the price of the stock drops dramatically. If “price impact” is equated with price movement, and has to occur at the time of the misrepresentations, price maintenance cases – which are legion – will not qualify for the fraud on the market presumption.

The two courts that have ruled on this issue post-Halliburton have both concluded that price maintenance cases can qualify for the fraud on the market presumption. In a case involving Vivendi Universal, Judge Shira Scheindlin of the Southern District of New York denied the defendant’s request to make a renewed motion for judgment as a matter of law in light of Halliburton, reaffirming the continued viability of the price maintenance theory. The court emphasized that Halliburton made mention of how a plaintiff can prove price impact, but only discussed when a defendant can establish a lack of price impact.

Potentially even more important is a recent decision by the Eleventh Circuit in a case against Regions Financial, where the court also affirmed the continued validity of the price maintenance theory. The court rejected the defendant’s argument that a finding of fraud on the mar­ket always requires proof that the alleged misrepresenta­tions had an “immediate effect” on the stock price. In such situations, the court held, a plaintiff can satisfy the critical “cause and effect” requirement of market efficiency merely by identifying a negative price impact resulting from a corrective disclosure that later revealed the truth of the fraud to the market. The court explained that Halliburton “by no means holds that in every case in which such evidence is presented, the presumption will always be defeated.”

In upholding the price maintenance theory, the court in Regions reaffirmed that, under Halliburton, there is no sin­gle mandatory analytical framework for analyzing market efficiency, and district courts have flexibility to make the fact-intensive reliance inquiry on a case-by-case basis. This flexible approach to reliance is a boon to investors because plaintiffs may be able to use various tools to show an efficient market existed—even where there are a few number of traded shares, or where a company is not followed widely by analysts, or where the market is generally accepted to be inefficient.

Beyond its holding, the Eleventh Circuit’s decision can also be viewed optimistically by investors as potentially a first step in courts permitting plaintiffs to establish Basic’s presumption merely through evidence of a corrective disclosure’s price impact on a stock, rather than general market efficiency for the stock. In Halliburton, the Court rejected the “robust” view of market efficiency proposed by Halliburton. The Court emphasized that Basic’s presumption is based on the “fairly modest premise that market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices” and that the question of a market’s efficiency is not a yes/no “binary” question, but rather a spectrum analysis:

The markets for some securities are more efficient than the markets for others, and even a single market can pro­cess different kinds of information more or less efficiently, depending on how widely the information is disseminated and how easily it is understood. . . Basic recognized that market efficiency is a matter of degree. . .


In permitting defendants to present evidence of no price impact, the Court noted that market efficiency is merely indirect evidence of price impact, and defendants should be able to provide direct evidence of what plaintiffs seek to establish indirectly. Arguably, the door has now been opened for plaintiffs themselves to eschew the indirect method of market efficiency when there is clear evidence of price impact.

SEC Wrests Admissions in Settlement of Falcone Case

ATTORNEY: MURIELLE STEVEN WALSH
Pomerantz Monitor, September/October 2013 

The JPMorgan “London Whale” case is not the first time the SEC has insisted on admissions of wrongdoing as part of its settlement agreements. A few weeks earlier, for example, the SEC secured admissions as part of its settlement of charges against Hedge Fund manager Philip Falcone. 

The current push to insist on admissions of wrongdoing in these settlements can probably be traced to November of 2011, when Judge Rakoff of the Southern District New York famously rejected Citigroup’s $285 million settlement with the SEC, primarily because it did not contain any admission of wrongdoing by the bank. The judge found that the deal was "neither fair, nor reasonable, nor adequate, nor in the public interest." Judge Rakoff has been highly critical of settlements that allow defendants to neither “admit nor deny,” and has called them “a stew of confusion and hypocrisy unworthy of such a proud agency as the S.E.C.” 

Judge Rakoff was criticized as overstepping his bounds and challenging the authority of the SEC. Wall Street interests argued that admissions of wrongdoing in SEC settlements would encourage private investor litigation. Others pronounced that a requirement for admissions would make it difficult, if not impossible, for the SEC to settle cases. The Second Circuit is now reviewing whether, in fact, the court went too far. 

But regardless of the outcome of that appeal, Judge Rakoff’s opinion has had profound repercussions. When Mary Jo White was first appointed as the new SEC chair, she announced that henceforth the Commission would require admissions of wrongdoing as a condition to settlement in certain situations. 

Judge Rakoff’s colleague in the Southern District, Judge Marrero, recently approved a settlement between SAC Advisors and the SEC that also had no admissions of wrongdoing. However, he conditioned his approval on a finding by the Second Circuit in the Citigroup matter that district courts lack the authority to reject SEC settlements solely because of “admit or deny” policy. If the Second Circuit does not make such a finding, SAC will be back on the hook. 

The recent $18 million civil settlement between hedge-fund manager Philip Falcone and securities regulators is a case in point. Falcone and his hedge fund, Harbinger Capital Partners, had been accused of engaging in an illegal “short squeeze” to force short-sellers to sell distressed, high yield bonds at inflated prices, and favoring certain investors over others when granting redemption requests. An earlier agreement reached between Falcone and the SEC’s enforcement staff did not contain any admissions of wrongdoing. In a rare move, the SEC commissioners rejected the agreement and sent the parties back to the table. The new deal contains Falcon’s admissions of underlying facts of alleged improper behavior, specifically, that he had acted “recklessly” with regard to several market transactions. It does not, however, include admissions of specific securities law violations. Obviously, the facts can potentially be used as fodder in private litigation – in this case, an admission of reckless conduct has important ramifications for fraud claims. 

At the same time, Falcone won’t be limiting his legal options in other lawsuits that may follow on the heels of this settlement. As noted by James Cox, a law professor at Duke University School of Law, the admitted facts “may be helpful, but not perfectly helpful, to follow-on litigation."

Not So Fabulous After All

ATTORNEY: TAMAR A. WEINRIB
Pomerantz Monitor, September/October 2013 

In August, the SEC scored a much-needed win when a nine-member jury, after deliberating for two days, found Fabrice Tourre, a former Goldman Sachs bond trader once known as “Fabulous Fab,” liable on six of seven civil fraud charges. 

The SEC brought the action in 2010 against both Mr. Tourre and Goldman Sachs, accusing both of misleading investors about a complex mortgage-based financial product known as “Abacus 2007-AC1.” Abacus was a “collateralized debt obligation,” a financial vehicle based on a collection of underlying mortgage-related securities. Tourre played a major role in putting Abacus together; but he (and Goldman) allegedly failed to disclose to potential investors that hedge fund titan John Paulson, a key Goldman Sachs client, had also played a major role in selecting the securities underlying Abacus. Paulson’s involvement was critical because he himself made a huge bet against Abacus, selling millions of shares short, and made a killing when Abacus failed. In other words, the SEC claimed that Abacus was secretly designed to fail so that Paulson could make a killing at the expense of Goldman’s other clients. 

Goldman settled the SEC’s claims some time ago, agreeing to pay a $550 million fine, without admitting or denying wrongdoing. Abacus, and the large fine it generated, heavily damaged Goldman’s reputation, helping to earn it the sobriquet “great vampire squid.” 

Even after Goldman settled, Tourre fought on, and lost. Tellingly, his lawyers opted not to call any witnesses at trial, an interesting strategy which perhaps reflected the weakness of their case. The SEC called two witnesses, Laura Schwartz from the ACA Financial Guaranty Corporation, and Gail Kreitman, a former Goldman saleswoman, who testified that they were misled about who was investing in Abacus. Also key to Mr. Tourre’s downfall was a number of emails to his girlfriend, which he called “love letters,” in which he joked about selling toxic real estate bonds to “widows and orphans.” 

As of Monitor press time, Mr. Tourre was planning to ask the court at the end of September to either overturn his securities fraud verdict or grant a new jury trial. If the judge declines that request, the question will then become one of punishment. Mr. Tourre faces three potential remedies. First, the court can impose civil monetary penalties ranging from $5,000 to $130,000 for each violation. Second, the court can order that Mr. Tourre forfeit any profits he received from his violations, though it is unclear at this point what that would encompass. Third, Mr. Tourre could also face an administrative proceeding before the SEC, which could permanently bar him from any future association with the financial industry. One potential obstacle for the SEC in pursuing a bar, however, is that it obtained the power to do this when Congress passed the Dodd-Frank Act in 2010, three years after Mr. Tourre’s violations occurred. It is unclear whether the SEC’s authority to issue a bar applies retroactively. Given that Goldman continues to bankroll all of Mr. Tourre’s legal fees, it is likely he will appeal any bar order, challenging retroactivity, and continue to drag this case on further. 

Mr. Tourre is now enrolled in a doctoral economics program at the University of Chicago and seems to be gearing up for a future in academia. Other than damage to his reputation, which he has already incurred in spades, it is questionable whether a bar would make much of a difference. 

Meanwhile, the Tourre trial, though clearly a success for the SEC, has led many to question why the agency continues to pursue mid-level employees like Mr. Tourre while leaving the high-level executives unscathed. Mr. Tourre clearly did not commit these violations on his own.

Mergers Foreclose Derivative Litigation

ATTORNEY: SAMUEL J. ADAMS
Pomerantz Montitor, September/October 2013 

In a case involving the notorious Countrywide Corporation, with implications for derivative actions filed across the country, the Delaware Supreme Court, has declined to expand the circumstances under which a derivative action, brought on behalf of the injured corporation, can survive a merger of that corporation into another. Because mergers often happen while derivative suits are pending, and in fact are sometimes motivated by the directors’ desire to eliminate derivative claims against them, this decision will make it harder in many cases to hold directors of Delaware corporations accountable for their reckless mismanagement. 

As is well known, Countrywide played a major role in the financial crash of 2008, because it was probably the most prolific perpetrator of toxic mortgage securities. When the mortgage market imploded, Countrywide nearly collapsed and was sold under the gun to Bank of America (“B of A”) – the unlucky purchaser of last resort not only of Countrywide but also of equally ill-fated Merrill Lynch. If ever there were directors who deserved to be sued for destroying their company, the directors of Countrywide fit the bill. Yet, when they were sued by Countrywide shareholders, they claimed that the sale to B of A wiped out the plaintiffs’ claims. 

The directors were invoking the so-called “continuous ownership” rule, which says that in order to assert a derivative claim a plaintiff shareholder must have owned stock in the injured corporation continuously from the time of the alleged wrong until the resolution of the litigation. Should the corporation be sold in a cash-out merger before the litigation is resolved, the shareholder plaintiff would be divested of his holdings, and therefore his chain of continuous ownership would be broken. 

Here, plaintiffs sued the former directors of Countrywide in California federal court, claiming that they were responsible for allowing Countrywide to engage in a host of reckless and fraudulent mortgage practices. The District Court dismissed the derivative claims under the “continuing ownership” rule, holding that under Delaware law plaintiffs lost standing to pursue the derivative claims upon consummation of Countrywide’s Merger with B of A. Plaintiffs had argued that there was an exception to this rule in cases where it was the alleged wrongdoing that forced the company to enter into the merger in the first place. On appeal, the United States Court of Appeals for the Ninth Circuit asked the Delaware Supreme Court to consider, as a “certified question,” whether this exception actually existed and, if so, whether it applied here. The certified question was prompted, in part, by the fact that state and federal courts had reached divergent results in previous cases applying Delaware law in this situation. 

In a famous decision decades ago in Lewis v. Anderson, the Delaware Supreme Court recognized a “fraud exception” to the continuous ownership rule, allowing plaintiffs to litigate post-merger derivative claims “where the merger itself is the subject of a claim of fraud,” meaning that the merger served “no alternative valid business purpose” other than eliminating derivative claims. Although there is a very low threshold for finding a “valid business purpose” for a merger, it is a short step from this doctrine to the proposition that the exception should apply if the very fraud that was the subject of the derivative action also drove the corporation to enter into the merger. 

Arguing before the Delaware Supreme Court, plaintiffs, in a twist, urged the court to consider resolving the certified question by creating a new cause of action, which they referred to as a “quasi-derivative” claim. Defendants argued that there is “no need and no basis” to recognize an exception to the continuous ownership rule even where the conduct in question forced the company to merge with another company. 

The Delaware Supreme Court found in favor of defendants, holding that shareholders cannot pursue derivative claims against a corporation after a merger divests them of their ownership interest, even if a board's fraud effectively forced the corporation into the merger. However, the court was careful to note that shareholders who lose derivative standing in a merger may nonetheless have post-merger standing to recover damages from a direct fraud claim, should one be properly pleaded.

The Oxford Decision: the Silver Lining?

ATTORNEY: JENNIFER BANNER SOBERS
Pomerantz Monitor, July/August 2013 

Ten days before the American Express decision, the Supreme Court, in a case involving the Oxford health insurance company, unanimously affirmed an arbitrator’s decision to authorize class arbitration. He held that because the arbitration agreement stated that “all disputes” must be submitted to arbitration -- without specifically saying whether “all disputes” includes class actions -- nonetheless the agreement means that class action disputes can be arbitrated. 

This case was filed in court by a pediatrician in the Oxford “network” who alleged that Oxford failed to fully and promptly pay him and other physicians with similar Oxford contracts. The court granted Oxford’s demand that the case be arbitrated. The parties then agreed that the arbitrator should decide whether the contract authorized class arbitration. In finding that the contract did permit class arbitrations, the arbitrator focused on the language of the arbitration clause, which stated that “all” civil actions must be submitted to arbitration. Oxford tried to vacate the arbitrator’s decision, claiming that he exceeded his powers under the Federal Arbitration Act. The District Court denied the motion, and the Third Circuit affirmed. 

In agreeing with the lower courts, the Supreme Court held that when an arbitrator interprets an arbitration agreement, that determination must be upheld so long as he was really construing the contract. Whether this interpretation is correct is beside the point, as far as the courts are concerned. Judicial review of arbitrators’ decisions is far more constrained than the review of lower court decisions. 

This case may turn out to be the silver lining to the Supreme Court’s series of rulings curtailing class actions in arbitration. This decision will specifically benefit plaintiffs, including those, like the plaintiff here, whose claims lie in the health care arena. 

Moreover, the decision seems to narrow the effect of the court’s previous decision in 2010, which held that “silence” in an arbitration agreement usually means that the parties did not agree to arbitrate on a class-wide basis. To the extent that arbitrators in future cases interpret an agreement to arbitrate “all disputes” as including class-wide disputes, plaintiffs will be more likely in the future to have a realistic chance to have their claims resolved. That is, unless there is an explicit class action waiver. 

Many consumers are subject to arbitration agreements, including physicians who often have no choice but to accept such agreements if they want to be in-network providers for insurers. As Pomerantz and co-counsel argued in an amicus brief on behalf of the American Medical Association and the Medical Society of New Jersey in support of the pediatrician, without being able to arbitrate on a class-wide basis, physicians will have no effective means by which to enforce their contracts with insurers and challenge underpayments. The typical claim by a doctor against an insurer is relatively small. Prosecuting such small claims in individual arbitration is impossible, given that the cost of bringing an arbitration will almost always exceed the amount an individual doctor could potentially recover through arbitration. Moreover, individual arbitrations could not adequately address certain pervasive wrongful practices by insurers such as underpayment or delayed payment of claims and do not provide injunctive relief to stop such practices – a critical remedy sought in many class actions.

SEC Approves Use of Facebook and Twitter for Company Disclosures

Pomerantz Monitor, July/August 2013 

The Securities and Exchange Commission has issued a report that allows companies to use social media outlets like Facebook and Twitter to disclose material information as required by with SEC regulations, provided that investors are notified beforehand about which social media outlets the company will use to make such disclosures. In supporting the use of social media, the SEC stated that "an increasing number of public companies are using social media to communicate with their shareholders and the investing public. . .[w]e appreciate the value and prevalence of social media channels in contemporary market communications, and the commission supports companies seeking new ways to communicate." The new “guidance” is likely to change dramatically the way companies communicate with investors in the future. 

The SEC’s action actually began as an investigation into whether Netflix violated Regulation FD by disclosing financial information in the CEO’s personal Facebook page. Regulation FD requires companies to distribute material information in a manner reasonably designed to get that information out to the general public broadly and non-exclusively. It was designed to curtail preferential early access to information by institutions and other well-connected industry heavyweights. 

Netflix, as you may have heard, runs a service providing subscribers with online access to television programs and movies. In July of 2012, Netflix CEO Reed Hastings announced on his personal Facebook page that Netflix’s monthly online viewing had exceeded one billion hours for the first time. Netflix did not report this information to investors through a press release or Form 8-K filing, and a subsequent company press release later that day did not include this information either. The SEC claimed that neither Hastings nor Netflix had previously used his Facebook page to announce company financial information, and they had never before told investors that information about Netflix would be disseminated in Hastings’ personal Facebook page. The Facebook disclosure was nonetheless picked up by investors, and boosted the Netflix share price. 

In responding to the SEC investigation, Hastings contended that since his Facebook page was available to over 200,000 of his followers, he was in compliance with Regulation FD. The SEC ultimately refrained from bringing an enforcement action against Hastings or Netflix, stating in a press release that the rules around using social media for company disclosures had been unclear. 

Now the SEC has concluded that companies can comply with Regulation FD by using social media and other emerging means of communication, much the same way they can by making disclosures in their websites. The SEC had previously issued guidance in 2008, clarifying that websites can serve as an effective means for disseminating information to investors if they’ve been told to look there. The same caveat now applies to the use of social media. 

The SEC’s guidance brings corporate reporting into the social media age, where over one billion users of Facebook and 250 million on Twitter are sharing information. Indeed, a recent study suggests that while over 60% of companies will interact with customers using social media, very few use the medium to communicate business developments to investors. That could well be about to change dramatically.

Supreme Court Holds that “Pay-To-Delay” Deals Can Violate Antitrust Laws

ATTORNEY: ADAM G. KURTZ
Pomerantz Monitor, July/August 2013 

Last fall, we wrote about how brand name drug manufacturers have been paying large amounts of money to generic drug makers to induce them to delay bringing low-cost generic drugs to market. For years prior to this recent U.S. Supreme Court decision, many federal courts have refused to declare these pay-to-delay payments anti-competitive, or even subject them to the antitrust laws. 

On June 17, 2013, in a case involving the testosterone supplement Androgel, the U.S. Supreme Court handed healthcare consumers and union health and welfare funds a victory. Androgel, a treatment for low testosterone, had sales of $1 billion a year. It has no competition from generic alternatives. If there were generic competition, sales of the branded version would probably drop by 75% and its manufacturer, Solvay, would lose approximately $125 million in profits a year. To postpone generic competition, Solvay paid the generic company, Actavis, as much as $42 million a year to delay their competing generic version of Androgel until 2015. 

The Supreme Court ruled, 5-3, that such pay-to-delay deals are, in fact, subject to the antitrust laws. This is truly a big win, given the amount of healthcare costs involved. There were 40 such deals this past year alone, and they cost American consumers $3.5 billion a year in higher drug costs. The Androgel decision may not end pay-for-delay deals, but they will now be subject to the antitrust scrutiny. 

The legal arguments addressed by the Supreme Court were complicated and involved a clash between the antitrust and patent laws. On the one hand, the antitrust laws state that two competing companies cannot agree that one of them will stay out of the market. That is, the branded and generic company cannot agree to keep drug prices high by delaying introduction of a generic drug into the market. 

On the other hand, the patent laws give a company with a valid patent the right to exclude a competitor with a product that violates the patent. That is, a branded company can exclude a generic drug as long as the branded company had a valid patent. Pay-to-delay deals are part of a settlement in a patent infringement lawsuit, brought by the brand name manufacturer, alleging that the generic drug maker is violating the brand name patent. Settlements are generally encouraged as a good thing. 

In the end, the Supreme Court chose antitrust law over patent law and healthcare consumers over pharmaceutical companies in holding that, settlement or not, these deals can be struck down if they violate the antitrust laws. 

For years, Pomerantz – on behalf of health care consumers – and the Federal Trade Commission (“FTC”) have been fighting against pay-to-delay deals, arguing that they are anti-competitive and violate the antitrust laws. In fact, Pomerantz is co-lead counsel, on behalf of a putative end-payor class, in the companion case to the recently decided U.S. Supreme Court case, which is currently pending in the Northern District of Georgia. Now that the Supreme Court has agreed that pay-to-delay deals are not immune from the antitrust laws, Pomerantz will continue to represent vigorously our union health and welfare fund clients who end up paying unlawful supra-competitive prices for branded drugs as a result of these deals.

Appeals Court Grants Bail to Two Convicted of Insider Trading

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, July/August 2013 

Although it has had mixed results, at best, in cases related to the financial crisis of 2008, the government has done quite well in pursuing claims of criminal insider trading. For example, the U.S. Attorney in Manhattan has filed criminal charges against 81 defendants since he took office in 2009, and convicted 73 of them. Among them is former Galleon hedge fund boss Raj Rajaratnam, whose conviction and lengthy sentence were upheld by the Second Circuit in June. 

Insider trading may sound simple, but it isn’t. The federal courts have been struggling for decades to decide what inside information is, who may trade on it, and who can’t. If an investor or analyst calls someone up to ask how his company is doing, that can be legitimate information gathering, or it can be a violation. It all depends. 

One well-established element of an insider trading violation is that the tippee must know that the information is being disclosed in violation of the insider’s fiduciary duty. In one famous case, for example, someone disclosed that the company had received a takeover offer that had not yet been publicly disclosed. That kind of information is vital to the company; people working for the company cannot divulge it without breaching their fiduciary duties.

More recently, though, courts have been struggling with the question of whether the tippee also has to know that the person disclosing the information (the “tipper”) is receiving a “personal benefit” for disclosing it. If the tippee does know this, the Supreme Court held 30 years ago that he is liable; but the question now is, does the tippee have to know this in order to be liable? If the tippee is not paying for this information, he or she may not be aware that the tipper will benefit from the disclosure in some other way. 

This issue is coming to a head in a case now pending in the Second Circuit, which is hearing an appeal of an insider trading conviction involving two hedge fund managers. They did not pay for the information, and maintain that they did not know that the insiders were profiting from their disclosures in other ways. The trial court did not believe that this was a required element of the crime, and refused to instruct the jury on it. Defendants appealed on that issue. Defendants asked that they be granted bail pending their appeal. The trial court denied it, but the defendants appealed that decision as well. 

In late June, the Second Circuit granted their bail request. This has sent tongues wagging, because it may mean that the court is about to overturn the convictions and impose a “personal benefit” knowledge requirement for insider trading claims. 

This is happening just as the government is zeroing in on the biggest fish in the insider trading pond, Steve Cohen of SAC Capital Advisors. Several of his underlings have already pleaded guilty to insider trading charges, and SAC recently paid more than $600 million in a “no admit, no deny” settlement of insider trading charges with the SEC. Yet somehow, Cohen authorized this hefty settlement without obtaining an agreement from the feds that they would not seek additional punishments or remedies against either himself or the company. 

Perhaps he thought that, because it may be next to impossible for the feds to prove beyond a reasonable doubt that he had personal knowledge of the tippers’ motivation for revealing insider information, the would not pursue criminal charges against him. In this respect he is probably right. With the five year statute of limitations bearing down, the feds have reportedly given up on the idea of prosecuting Cohen on criminal charges. 

But he is not exactly getting a free pass. On July 19 the SEC brought an administrative action against him, seeking to bar him from the securities industry for life. The complaint alleges that Cohen ignored “red flags” of illegal insider trading by employees and allowed it to go on, violating his duty to supervise. 

And then, just before our press time, the feds announced that SAC Capital has been indicted. When and if that happens, it is all over. On Wall Street, an indictment is a death sentence.

SEC Weighs Companies' Disclosures of Their Political Expenditures

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, May/June 2013 

In the wake of the Supreme Court’s decision in Citizens United, a gusher of so-called “independent” spending by private groups and organizations flooded into the last election cycle, with much of it coming from corporations. 

In its decision, the Court assumed that any adverse effects of corporate or union cash entering politics could be ameliorated by public disclosure of where the money came from; and in August of 2011, a petition signed by two law professors was submitted to the SEC, asking it to adopt a rule requiring such disclosures. 

The petition has been publicly supported by the AFL-CIO; Public Citizens; the Corporate Reform Coalition, and some Democratic members of Congress. It has generated over half a million comments, the most the SEC has ever received on any proposed rule, and most of them reportedly want the SEC to act. 

But opponents are pushing back. Republicans have lined up against it, to the point of submitting a House bill seeking to prevent the SEC from adopting any disclosure rule. 

So far, the two SEC commissioners appointed by Democrats have come out publicly in support of such a rule, and the two appointed by Republicans have come out against. Mary Joe White, recently confirmed as the new SEC Chairman, has not yet taken a public position. Although the issue was on the Commission’s April agenda, no decision had been made as of Monitor press time. 

The business community, by and large, wants no part of such a rule, fearing that disclosure might provoke a backlash from interest groups, customers, shareholders, or even from the politicians they are targeting. Another possible motivation is the desire to disguise the underlying agendas of those advancing particular political positions. Voters are likely to react differently to an ad that ostensibly comes from an independent group they never heard of, rather than from a group that they know is heavily financed by corporate interests with a particular axe to grind. 

It might be in a company’s interest for its involvement in political activities to remain hidden, but the public at large may have an even greater interest in knowing who is really responsible for the political speech to which they are being subjected. Perhaps the Federal Election Commission would, in theory, be the more logical place to hash this out. But that agency is moribund, permanently paralyzed by partisan gridlock. 

Currently, companies don’t have to disclose their political expenditures unless the amounts involved are “material.” But in this context, “materiality” is in the eye of the beholder. Even if the amount contributed is not that significant compared to a corporation’s overall expenditures, it could be considered important by many investors depending on what candidate, or what issue, is being targeted. Moreover, amounts that are immaterial to a giant company like Apple or Exxon might have a huge impact in a political campaign. As huge as political expenditures have become by historical standards, they are still dwarfed by the amounts spent by businesses for other things. 

Typically, corporations make political expenditures by contributing to advocacy groups. The petitioners to the SEC estimate that about $1.5 billion in corporate cash has been funneled through such groups over the last five years. Some groups, such as political action committees, are required to disclose their contributors; but others, such as so-called 501(c)(4) groups, don’t. Increasingly, that is where the corporate cash is going: these groups spent hundreds of millions of dollars in the last election cycle, without disclosing where any of it came from. 

If the SEC staff proposes a rule, yet another political donnybrook is certain to follow, after which will be the inevitable court case. The Court of Appeals for D.C., which reviews challenges to agency rules, has become increasingly aggressive in blocking agency rules it doesn’t like, often demanding “cost benefit” analyses. 

We should hear something any day now. 

Reportedly, most of the candidates and issues promoted by the heaviest “independent” expenditures did not do well last time around. But there is no guaranty that secret money won’t swing elections sooner or later.

Private Equity Firms Fail to Get Antitrust Case Dismissed

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, May/June 2013 

Five years ago, investors sued 11 of the world’s largest private equity firms, including Kohlberg Kravis, TPG, Bain Capital, Apollo Capital Management and Goldman Sachs, on the grounds that defendants violated the antitrust laws by rigging the market for more than two dozen multibillion-dollar acquisitions of public companies, depriving those companies’ shareholders of billions of dollars they might have received in a true competitive bidding process. They claim that defendants had a gentlemen’s agreement not to outbid each other to acquire these companies. Defendants had tried nearly a dozen times in four years to get the suit tossed, with no luck. 

They were only partially successful this time. A federal judge in Boston has now refused to grant summary judgment dismissing the entire action. He narrowed the case significantly, however, dismissing all claims relating to 19 of the 27 deals that were targeted in the actions; and he dismissed JPMorgan Chase completely from the case. Nevertheless, he concluded that there was enough evidence of at least some collusion on eight of the deals among the rest of the defendants to take the case to trial. 

At the center of the case are “club deals,” acquisitions made by members of this “club” of private equity firms. Plaintiffs allege that there was a secret quid pro quo arrangement: If you don’t bid on my deal, I won’t bid on yours. 

In his summary judgment decision, Judge Harrington concluded that there was no grand conspiracy across all the 27 deals, but rather “a kaleidoscope of interactions among an ever-rotating, overlapping cast of defendants as they reacted to the spontaneous events of the market.” Yet he decided that there was enough evidence to sustain claims relating to 8 of the deals. 

As happens so often in litigation in the internet era, emails played a decisive role in this decision. Among them were comments from unnamed executives at Goldman Sachs and TPG in reference to the $17.6 billion takeover of Freescale Semiconductor by a consortium led by the Blackstone Group and the Carlyle Group. The Goldman executive said that no one sought to outbid the winning group because “club etiquette” prevailed. “The term ‘club etiquette’ denotes an accepted code of conduct between the defendants,” the judge wrote. “The court holds that this evidence tends to exclude the possibility of independent action.” 

Another email, from a TPG official said, “No one in private equity ever jumps an announced deal.” The judge also pointed to an e-mail sent by the president of Blackstone to his colleagues just after the Freescale deal was announced. “Henry Kravis [the co-founder of K.K.R .] just called to say congratulations and that they were standing down because he had told me before they would not jump a signed deal of ours.” 

The court singled out the $32.1 billion buyout of the hospital chain HCA as particularly problematic. K.K.R. expressly asked its competitors to “step down on HCA” and not bid for the company, according to an e-mail written by a then partner at Carlyle who is now the CEO of General Motors. One e-mail from Neil Simpkins of Blackstone Group to colleague Joseph Baratta said, “The reason we didn’t go forward [with a rival HCA bid] was basically a decision on not jumping someone else’s deal.” Baratta said, “I think the deal represents good value and it is a shame we let KKR get away with highway robbery, but understand decision.” 

KKR’s $1.2 billion investment in HCA has nearly doubled in value to $2 billion in four years.

Doing Well While Doing Good in Delaware

ATTORNEY: GUSTAVO F. BRUCKNER
Pomerantz Monitor, May/June 2013 

On April 18, 2013, Delaware Governor Jack Markell introduced legislation enabling the formation of public benefit corporations. Because Delaware is already the legal home of more than one million businesses, including many of the nation’s largest publicly traded corporations, this legislation, if adopted, has the potential to radically transform the corporate landscape. 

Public benefit corporations are socially conscious for-profit corporations. While not new, until recently most public benefit corporations were established by government, not the private sector. Social entrepreneurs, a growing sector of the economy, argue that the current system, with corporations focusing only on profits, almost assures a negative outcome for society. They have been pushing the corporate focus towards pursuit of a “triple bottom line” of people, planet and profits, with the mantra “doing well while doing good.” Shareholders who value socially responsibility seek to invest in companies that are serious about sustainability, and such companies want to differentiate themselves from competitors. While it may come as no surprise that California and Vermont allow for creation of public benefit corporations, so do Illinois, New York, and South Carolina. 

Some states have “constituency statutes” that explicitly allow corporate directors and officers to consider interests other than those strictly related to maximizing value for shareholders, including the interests of the community. Nearly a third of constituency statutes apply only in the takeover context, allowing directors to consider interests of employees, for example, in deciding how to respond to a takeover offer. On the other hand, directors of a public benefit corporation have an affirmative obligation to promote a specified public benefit. 

The proposed legislation identifies a public benefit as a positive effect, or a reduction of negative effects, on people, entities, communities or other non-stockholder interests. Such effects could include, but are not limited to, effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, and scientific or technological nature. 

Directors of a public benefit corporation would have to balance the financial interests of stockholders with the best interests of those affected by the corporation’s conduct, as well as the specific public benefits identified by the corporation. 

If enacted, the legislation will take effect on August 1, 2013.

Court Hears Argument in BP Case

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, May/June 2013 

As we have previously discussed in these pages, Pomerantz is currently representing several U.S. and foreign institutional investors seeking to recover investment losses caused by BP’s fraudulent statements issued prior to, and after, the April 20, 2010 Deepwater Horizon oil spill. Although the Supreme Court’s decision in Morrison v. National Australia Bank, Ltd. prevents investors from pursuing federal securities fraud claims for their BP common stock losses (because those shares traded on the London Stock Exchange), we are arguing that Texas state common law fills this enforcement void. 

On May 10, 2013, Judge Keith Ellison of the United States District Court for the Southern District of Texas held oral argument on BP’s motion to dismiss our claims. 

As we expected, much of the argument focused on the Dormant Commerce Clause, a Supreme Court doctrine which says that state statutes or regulations may not “clearly discriminates against interstate commerce in favor of intrastate commerce”; “impose a burden on interstate commerce incommensurate with the local benefits secured;” or “have the practical effect of ‘extraterritorial’ control of commerce occurring entirely outside the boundaries of the state in question.” BP argued that this doctrine prevented Texas state common law from reaching BP’s misconduct. In response, we pointed out that the doctrine did not apply to common law claims and that those claims targeted BP’s misstatements, not the underlying securities transactions on the London Stock Exchange. We also advanced a variety of policy-based arguments in support of our position. 

Although it is impossible to predict how the Court will come out on this issue, we believe that the oral argument advanced our cause. We expect the Court to issue a decision on the motion in the next few months.

Walking Dead Directors

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, May/June 2013 

Did you know that forty-one directors who last year failed to receive the votes of 50% of the shareholders, are still serving as directors? At Cablevision, for example, three directors are still sitting there even though they lost shareholder elections twice in the past three years, and were renominated in 2013. Two directors of Chesapeake Energy in Oklahoma, V. Burns Hargis, president of Oklahoma State University, and Richard K. Davidson, the former chief executive of Union Pacific, were opposed by more than 70 percent of the shareholders in 2012. Chesapeake requires directors receiving less than majority support to tender their resignations, which they did. The company said it would “review the resignations in due course.” The company refused to accept one of the resignations but, mercifully, they both left. Other cases where this has occurred, according to Institutional Shareholder Services, include Loral Space and Communications, Mentor Graphics, Boston Beer Company and Vornado Realty Trust. 

Our favorite story, though, involves Iris International, a medical diagnostics company based in Chatsworth, Calif. There, shareholders rejected all nine directors in May 2011. They all submitted their resignations, but then voted not to accept their own resignations. The nine stayed on the board until the company was acquired the following year. 

Many of these cases involve companies that do not require directors to receive a 50% majority vote to win election to the board.

Securities Fraud Cases Involving Foreign Companies Shift From Federal Courts

Pomerantz Monitor, March/April 2012  
by Robert J. Axelrod and Marc I. Gross

Two years ago, in the wake of the Supreme Court’s decision in Morrison concerning the extraterritorial application of United States securities laws, we noted that most legal commentators predicted a major decline in securities litigation. In that case the Supreme Court created a bright line rule that lawsuits alleging securities fraud involving companies whose securities were traded on a non-U.S. exchange could not be brought under U.S. law. This ruling extended even to cases where the conduct at issue – such as the alleged fraudulent misrepresentations – actually took place at a company’s U.S. headquarters.
 
Of course, many institutional investors routinely purchase securities on many different exchanges throughout the world. When a company whose stock trades on a non-U.S. exchange engages in securities fraud, are investors who purchased those securities outside the United States simply out of luck?
 
Class Cases Filed in Foreign Courts
The answer is decidedly “no.” Since the Supreme Court decided Morrison, we have seen an increase in securities actions brought in jurisdictions outside the United States. Some of these are class actions, or actions similar to U.S.-based class actions. Others are individual securities actions.
 
For example, there are by our count more than two dozen active securities class actions pending in Canada. A recent report by the consulting firm National Economic Research Associates confirms that last year alone, 15 securities class actions were filed there, the most ever. Similar actions are also pending in the Netherlands, Germany, and Israel. New laws allowing class actions were passed in Mexico, and England also allows “group actions,” which can be pursued on a representative basis, just like class actions.
 
A good example of the migration of securities fraud class actions is the action against Fortis, a financial services company based in Belgium. The plaintiffs in that action – some of the largest European pension funds, which purchased their Fortis securities on a foreign exchange – initially brought a class action in the U.S., but their case was dismissed by a U.S. court under Morrison. A year later they brought their case, which mirrors the allegations of the U.S. action, in a Dutch court.
 
There are a number of differences in the procedural and substantive law in these foreign jurisdictions, of course, including how damages may be calculated, whether attorneys fees can be shifted to the losing party, the rules for defining and certifying a class, and (particularly in the case of Canada) whether, as in the U.S., discovery is going to be held up until a motion to dismiss is decided. Whether it may be worthwhile to bring a securities fraud action in a foreign jurisdiction, whether the action should see certification of a class of all similarly situated investors or be brought as an individual action, and how to litigate and win whichever action is brought, are critical questions investors should ask their securities counsel. That counsel must also have relationships with the few securities practitioners in other countries who represent plaintiffs, rather than corporate clients, and who may be willing to forego hourly fees in favor of the contingent fee structure utilized by many U.S. based securities firms who represent institutional investors.
 
Individual Cases Under State Law
 
Morrison made clear that class actions for recovery of fraud related to damages arising from purchases abroad cannot be pursued under the federal securities laws. In so doing, the Supreme Court relied principally on the text of the 1934 Exchange Act. However, there is no such textual limitation for fraud claims arising under state statutory and common law. Thus, to the extent that a domestic investor purchased shares on a foreign exchange, and relied upon materials disseminated in the U.S., the injury arose in the U.S. at the place where the purchaser was misled -- not where the trade was executed. Thus, the case could be brought under the state law where the purchaser resided.
 
By the same token, if wrongdoing that contributed to the fraud occurred in a particular state (e.g., improper accounting for revenues by a U.S. subsidiary), that state should have an interest in protecting all persons injured by the misconduct, regardless of where they reside or purchased the shares. Under this rationale, even foreign investors could bring claims under the laws of the state where the subsidiary of the corporation was domiciled. These cases must be brought individually, not on a class basis, in order to avoid the federal statutory preemption of securities fraud class actions under SLUSA. There will likely be forum-non conveniens hurdles as well, but these obstacles should be minimal if class actions are otherwise pending for those who purchased ADRs of the same company on U.S. exchanges.

Delaware Takes On “Don’t Ask, Don’t Waive” Provisions

ATTORNEY: OFER GANOT
Pomerantz Monitor, March/April 2013 

In a previous issue of the Monitor, we discussed the relatively new concept in mergers and acquisitions of “don’t ask, don’t waive” provisions in standstill agreements between companies and potential acquirers. Under the law of Delaware and other states, the acceptance of a merger proposal by the target does not end the bidding process: directors must be free to consider better proposals that may come in after the merger agreement is signed, but before it is approved by shareholders. Bidders try to limit this risk by demanding “no solicitation” provisions in the merger agreement, preventing the target company from actively soliciting “topping” bids. 

However, coupling the no solicitation provisions with the don’t ask, don’t waive provisions essentially locks up the deal from all angles. Don’t ask, don’t waive provisions, set in advance of the actual bidding process, prevent bidders from increasing their bid for the target company – unless specifically invited to do so by the target’s board of directors – and from asking the target board to waive the prohibition. If losing bidders can’t make a topping bid for the target, nor ask its board to allow them to do so, and if the target can’t solicit or even consider post-merger-agreement bids, the deal is effectively locked up once the merger agreement is signed. In such a case, even if the merger agreement provides a grossly inadequate price, a court will be reluctant to enjoin its consummation for fear of killing the only offer that is actually on the table. 

Although in don’t ask, don’t waive situations the target can still consider unsolicited bids from bidders that were not part of the original bidding process and therefore never signed such standstill agreements, that doesn’t happen often. As we noted in our previous article, in the Delaware Court of Chancery’s recent ruling in the Celera Corporation litigation, Vice Chancellor Parson cast doubt on the legality of the combination of no solicitation and don’t ask, don’t waive provisions. “Taken together,” he said, these devices “are more problematic,” and that “[p]laintiffs have at least a colorable argument that these constraints collectively operate to ensure an informational vacuum” as to the best price reasonably available for the company, and that “[c]ontracting into such a state conceivably could constitute a breach of fiduciary duty.” 

In two more recent decisions, the Delaware Court of Chancery revisited this issue and reached different conclusions. In Complete Genomics, Vice Chancellor Laster echoed Judge Parsons, explaining that “by agreeing to this [“don’t ask, don’t waive”] provision, the Genomics board impermissibly limited its ongoing statutory and fiduciary obligations to properly evaluate a competing offer, disclose material information and make a meaningful merger recommendation to its stockholders.” The Court then enjoined the merger pending certain corrective disclosures and prevented the company from enforcing the standstill agreement with a certain bidder that contained this “don't ask, don't waive” provision, allowing it, if it chooses to do so, to make a topping bid. 

Three weeks later, in Ancestry.com, Chancellor Strine expressed a different view, holding that “don't ask, don't waive” provisions may actually be consistent with directors’ fiduciary duties to maximize shareholder value. Chancellor Strine stated that he was not “prepared to rule out that [the “don't ask, don't waive” provisions] can't be used for value-maximizing purposes” as long as the purpose allows the “well-motivated seller to use it as a gavel” as part of a meaningful sale process. According to the Court, if the “don’t ask, don’t waive” provisions are assigned to the winner of an auction process, allowing the winner to decide whether to let the losing bidders make a topping bid (highly unlikely), rather than left in the hands of target’s board, the Court was “willing to indulge that could be a way to make it as real an auction as you can.” 

If, on the other hand, the target’s board has the power to waive these provisions, and chooses not to waive them after signing a merger agreement with a buyer, there is “no reason to give any bid-raising credit” to this mechanism, “it has to be used with great care,” and the board has to disclose to its shareholders the fact that it continues to preclude certain potential bidders from making a superior bid for the company. Chancellor Strine cautioned board members employing don't ask, don't waive provisions to remain informed about the provisions’ potency, suggesting that a “nanosecond” after a definitive acquisition agreement was signed, he would have notified all parties subject to the provisions that they are waived, allowing them to make a superior offer. 

The court ultimately enjoined the deal at issue because the board did not disclose that certain bidders were foreclosed by a “don't ask, don't waive” provision, emphasizing that shareholders must be made aware of these provisions' effect if the provisions are to be used. 

The facts in Ancestry.com differed from those in Complete Genome, among other things, because the “don’t ask, don’t waive” provisions were already waived by the time Chancellor Strine had to rule on the issue. Would he, too, have enjoined such standstill agreements following the announcement of a merger -- as was the case in Complete Genome? That remains to be seen.

Second Circuit Hears Appeal of Citigroup Settlement Rejection

ATTORNEY: LOUIS C. LUDWIG
Pomerantz Monitor, March/April 2013 

In a decision heard around the world – or at least around Wall Street – in December of 2011, Federal District Judge Jed S. Rakoff famously rejected a settlement between the SEC and Citigroup. The SEC claims that, during the waning days of the housing bubble, Citi misrepresented facts when it sold investors over $1 billion of risky mortgage bonds that it allegedly knew would decline in value. Investors allegedly lost about $600 million on this deal. The same day the SEC filed its complaint, in October, 2011, it also filed a proposed “consent judgment”, a settlement agreement resolving those claims. The proposed deal called for $160 million in disgorgement (of fees and profits made by Citi on the deal), plus $30 million in interest and a civil penalty of $95 million. The settlement agreement did not require Citi to admit to any wrongdoing, allowing it to “neither admit nor deny” the charges, a staple provision of government settlement agreements. In addition to the financial penalties, the settlement would permanently restrain and enjoin Citigroup from future securities laws violations and would impose court-supervised “internal measures” designed to prevent recurrence of the type of securities fraud that (allegedly) occurred here. 

In deciding whether to approve a settlement between agencies and private parties, courts typically defer to the judgment of a federal agency, and rejections of settlements are rare. But Judge Rakoff is an exception to this rule: he is no rubber stamp for SEC settlements, and has used settlements to express his disdain for the SEC’s efforts to police the securities industry. Two years earlier, in 2009, he rejected a settlement between the SEC and Bank of America. 

In his decision in the Citi case, announced on November 28, 2011, Judge Rakoff did it again. He did not accept the “no admit, no deny” provision, and held that the settlement failed to provide the court with enough facts relating to the merits of the case “upon which to exercise even a modest degree of independent judgment.” He also noted that “there is an overriding public interest in knowing the truth,” and the reminded the SEC that it “has a duty ... to see that the truth emerges.” These comments leave the distinct impression that the judge was looking for a more or less definitive resolution of the allegations against Citi, as a price of a settlement. The opinion also rejected the $285 million in financial penalties, deriding it as mere “pocket change” for a bank Citi’s size, a penalty that would not deter future misconduct. 

The ruling has roiled the securities bar, to say the least. Any across-the-board requirement that defendants admit wrongdoing, or that the “truth” be established in order to settle a case, would make many cases almost impossible to settle. Such admissions or determinations could then be used by investors to recover even more in private lawsuits. Some have argued that, forced to try almost every case, federal agencies would be overwhelmed and the wheels of justice would come to a grinding halt. 

Others (the author included) have viewed the ruling as a long-overdue comeuppance to an agency that has not done enough to punish the miscreants who precipitated the financial crisis. The penalties imposed by the settlement would have no chance at all of reining in Citi’s bad behavior. 

Both the SEC and Citi appealed Judge Rakoff’s ruling to the Second Circuit. In his October 2011 ruling, Judge Rakoff had directed the parties to be ready for trial on July 16, 2012. On December 27, 2011, the SEC, joined by Citigroup, asked him to stay all proceedings, including the upcoming trial, pending determination of their appeals. When he denied the motions, Citi and the SEC appealed that decision as well; and in March 2012, the Second Circuit not only granted the stay, it expedited the appeals, chiding Judge Rakoff: “The district court believed it was a bad policy, which disserved the public interest, for the S.E.C. to allow Citigroup to settle on terms that did not establish its liability. It is not, however, the proper function of federal courts to dictate policy to executive administrative agencies[.]” 

In August, 2012, at the court’s direction, an attorney for Judge Rakoff filed a brief with the Second Circuit on his behalf, contending that he had never sought definitive proof of wrongdoing or an admission of Citigroup’s “liability” (as the court of appeals put it) but simply wanted to see some evidence before rendering a decision on a proposed settlement allegedly backed up by that same evidence. 

On February 8, 2013, the Second Circuit heard final argument on the merits, and comments from the judges seemed to confirm the impression that the Court intends to approve the settlement. The SEC – clearly emboldened by the first ruling in its favor – characterized the lower court’s ruling as being at odds with a century of judicial practice. Federal agencies’ decisions to settle cases, the SEC said, have historically been entitled to – and received – great deference. Citigroup agreed, arguing that, with respect to federal agencies, “the scope of a court’s authority to second-guess an agency’s discretionary and policy-based decision to settle is at best minimal.” At one point Judge Raymond Lohier “asked about deference and why an Article III judge would question the judgment of an executive agency that presumably reached its decision based on a sound review of the evidence.” When Judge Rakoff’s lawyer responded that the SEC was entitled to deference – but only to the point that they are wrong – his comment did not go over well. 

This appeal has thus largely turned into a referendum on how much deference a trial court should give to an agency proposing a settlement, and the extent to which the trial court can and should do its own review of the underlying evidence in the case, to test whether the agency has abused its discretion. 

Judge Rakoff’s ruling has spurred some federal judges elsewhere to demand more information before signing off on settlements brokered by the SEC and other government agencies, and even to question whether the “neither admit nor deny” clause is appropriate. And in the wake of Judge Rakoff’s ruling the SEC itself announced that it would no longer allow defendants to “neither admit nor deny” civil fraud or insider trading charges when, at the same time, they admit to or have been convicted of criminal violations. While this policy shift would have no impact on the Citigroup case – which lacked accompanying criminal charges – observers, including Edward Wyatt, writing in The New York Times, immediately noted a connection to Rakoff’s decision, which was then less than two months old. 

While the appeal was pending, Judge Rakoff presided over a jury trial of the agency’s claims against former Citigroup executive Brian Stoker in connection with in the same transaction that sparked the SEC’s initial complaint against Citi. After a full trial on the merits of these claims, the jury cleared Stoker of all wrongdoing. At this point, Judge Rakoff had more than enough information to evaluate the SEC’s settlement with Citigroup. By then, however, the significance of the case had moved well beyond the settlement itself to the role the courts are going to play in evaluating settlements proposed by the SEC and other agencies. 

The one silver lining here should be the existence – and persistence – of a vigorous plaintiff’s bar championing the rights of defrauded investors. Despite roadblocks like the Private Securities Litigation Reform Act of 1995 (devised as a “filter” to “screen out lawsuits”), the private shareholder class action remains investors’ – and the public’s – best hope of curtailing the financial sector’s worst excesses. The Supreme Court’s recent decision in Amgen v. Connecticut Retirement Plans bodes well for the future ability of investors to pool their limited resources to seek results the federally-designated “watchdogs” at the SEC appear either unwilling or unable to attain, a situation not likely to improve through the proposed handcuffing of the very courts meant to mete out justice.

Amgen Decision Favorable for Institutional Investors

ATTORNEY: MATTHEW L. TUCCILLO
Pomerantz Monitor, March/Apri 2013 

In order for a court to certify a case as a class action, it must usually determine that common questions “predominate” over questions that affect only individual class members. In securities fraud actions, plaintiffs must show, among other things, that investor “reliance” on defendants’ misrepresentations can be established on a class-wide basis. Otherwise, individual questions of reliance will “predominate”. 

A quarter century ago, in the landmark decision Basic v. Levinson, the Supreme Court adopted the so-called “fraud on the market” theory to address this problem. According to this theory, if the subject company’s stock trades on an “efficient market” (e.g. the NYSE), a court can presume that the market price of that company’s stock reflects all available information, including the facts misrepresented by the defendants. All investors presumably relied on the market price in buying their shares, reliance on the fraudulent statements can be established, indirectly, on a class-wide basis. The Basic decision held that the fraud on the market presumption was rebuttable by the defendant, but until recently that was interpreted to mean rebuttable at trial, not at the class certification stage. 

As the stakes have risen dramatically in securities fraud litigation, big corporations have been trying to find ways to make it more difficult for courts to certify class actions, since their settlement leverage drops precipitously once a class is certified. In the past few years they have been arguing that classes should not be certified unless plaintiffs can actually prove, and not merely allege, at the class certification stage that common questions will be established in their favor. For example, some defendants have argued that plaintiffs should have to prove, at a hearing, that the fraud actually caused investor losses on a class wide basis (“loss causation”). Such arguments would turn a class certification procedure into a “mini trial” on issues relating to the merits of the case, which would have to be re-litigated at trial. Last year, in Halliburton, the Supreme Court rejected the argument that loss causation should have to be proven at the class certification stage. 

Now, in Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds, the Supreme Court has rejected attempts to force a mini-trial on the fraud on the market contention at the class certification stage. Specifically, Amgen had argued that plaintiff should be required to prove, and not merely allege, that the fraudulent misrepresentations were material enough to affect the market price of its stock, and that it should be given a chance to rebut the basic presumption that the market price actually was affected by the fraud. If the fraud did not affect the market price, Amgen argued, plaintiff could never establish on a class-wide basis that the entire class relied on the fraudulent representations in buying their shares. Individual issues would predominate, so the argument went, making class certification inappropriate. 

In a victory for investors, the Supreme Court rejected Amgen’s arguments, holding that all a securities fraud plaintiff has to do -- at the class certification stage -- is plausibly allege facts showing that the fraud was material; and that defendants cannot attempt to rebut the fraud-on-the-market presumption at that stage in the case. 

Writing for a 6-3 majority that included Chief Justice Roberts and Justices Breyer, Alito, Kagan, and Sotomayor, Justice Ginsberg’s opinion holds that proof of materiality is not a class certification prerequisite. The question of whether fraudulent statements are material is provable (or not) through objective evidence common to all investors. Thus, even if defendants prevail on this issue at trial, they will do so in a manner that is common to the entire class, and as such, materiality is a common question to all class members. Moreover, if at trial the plaintiff failed to prove the common question of materiality, the result would not be a predominance of individual questions, but rather, the end of the litigation, because materiality is an essential element of each class member’s securities fraud claim. In that sense, the entire class lives or dies based on the common resolution of the question. 

In so holding, the majority rejected Amgen’s argument that materiality should be treated like certain other fraud on the market prerequisites (e.g., that the misrepresentations were public, that the market was efficient, and that the transaction at issue occurred between the misrepresentation and the time the truth was revealed), which do have to be proven at the class certification stage. The majority found these other issues relate solely to class certification and are not ultimate merits determinations for the entire class. It also rejected Amgen’s argument that barriers should be raised to class certification because the financial pressure of a certified class forces the settlement of even weak claims, finding it significant that Congress had addressed the settlement pressures of securities class actions through means other than requiring proof of materiality at the class certification stage. In so doing, Congress had rejected calls to undo the fraud on the market presumption of reliance. Finally, the majority noted that, rather than conserving judicial resources, Amgen’s position would require a time- and resource-intensive mini-trial on materiality at the class certification stage, which is not contemplated by the federal rules and which, if the class were to be certified, might then have to be replicated in full at trial. 

In separate dissents, Justice Thomas and Scalia expressed hostility toward certification of classes where the materiality of the alleged statements had not been established. Thomas and, in a separate concurrence, Alito also questioned the continued validity of the fraud-on-the-market theory, in light of more recent research questioning its premises. These remarks may only invite additional challenges to the fraud-on-the-market presumption itself in years to come.

Government Goes After Insider Trading

ATTORNEY: EMMA GILMORE
Pomerantz Monitor, January/February 2013 

Whatever one thinks of the government’s record in punishing Wall Street for fomenting the financial crisis, the success rate against insider trading has been strong. Ever since Preet Bahara was appointed U.S. Attorney for the Southern District of New York in 2009, he has focused heavily on insider trading cases. In a 2010 speech to a room jam-packed with white collar criminal defense attorneys, he declared that “unfortunately from what I can see, from my vantage point as the United States Attorney here, illegal insider trading is rampant.” 

The law imposes liability for insider trading on anyone who improperly obtains material non-public information and trades based on such information, and also holds liable any “tippee,” the person with whom the “tipper” shares the information, as long as the tippee knows the information was obtained in breach of a duty to keep the information confidential or abstain from trading. Since the beginning of Bharara’s tenure in 2009, his office has secured 69 convictions or guilty pleas of insider trading without losing a single case. Many of those cases were developed jointly or in parallel with the SEC, which has commenced over 200 enforcement actions of its own since 2009. 

Critical to the prosecutors’ unblemished record of securing insider trading convictions has been the aggressive use of wiretaps and of informants. Private plaintiffs contemplating insider trading lawsuits can benefit from the treasure-trove of incriminating evidence collected by the government that private parties cannot get themselves through the normal “discovery” process. 

Of the 75 people recently charged by Bharara’s office, until now the biggest fish caught were Raj Rajaratnam, a billionaire investor who once ran Galleon Group, one of the world’s largest hedge funds, and Rajat Gupta, a former McKinsey chief and Goldman Sachs director who allegedly fed inside information to Rajaratnam. 

Wiretaps were key to the case against Mr. Rajaratnam. The case broke when prosecutors, while investigating a hedge fund owned by Rajaratnam’s brother Rengan, uncovered a slew of incriminating e-mails and instant messages between Raj and his brother, and wiretapped their conversations. In a call, Rengan told his brother about his efforts to extract confidential information from a friend who was a McKinsey consultant. Rengan referred to the consultant as “a little dirty” and touted that he “finally spilled his beans” by revealing non-public information about a corporate client. Other powerful evidence obtained from wiretapped calls was used to place Rajaratnam squarely in the forefront of the insider trading scheme: “I heard yesterday from somebody who’s on the board of Goldman Sachs that they are going to lose $2 per share,” Rajaratnam said to one of his employees ahead of the bank’s earnings announcement. 

Rajaratnam was found guilty on all 14 counts levied against him, and was sentenced to 11 years in prison and fined $10 million. It was the longest-ever prison sentence for insider trading, a watershed moment in the government’s aggressive campaign to rout out the illegal exchange of confidential information on Wall Street. He is currently appealing his conviction to the Second Circuit. 

Gupta, for his part, was accused of passing a flurry of illegal tips to Rajaratnam, including advance news that Warren Buffet was going to invest $5 billion in Goldman Sachs. Gupta received a two-year prison sentence and was ordered to pay $5 million in fines. 

More recently, in what federal prosecutors describe as the most lucrative insider trading scheme, prosecutors and the SEC filed separate insider trading charges against Mathew Martoma, a portfolio manager at CR Intrinsic Investors. CR Intrinsic is an affiliate of SAC Capital Advisors, a $10 billion hedge fund founded by billionaire Steven Cohen, one of Wall Street’s most successful and prominent investors. 

Martoma is accused of illegally trading on confidential information ahead of a negative public announcement poised to disclose the results of a clinical trial for an Alzheimer’s drug jointly developed by Elan Corporation and Wyeth Ltd. Armed with confidential information, Martoma allegedly emailed Cohen requesting that they speak (“Is there a good time to catch up with you this morning? It’s important.”). Martoma and Cohen subsequently spoke by phone for approximately 20 minutes. The next day, Cohen and Martoma instructed SAC’s senior trader to quietly begin selling the Elan position. At day’s end, the trader e-mailed Martoma that he had sold 1.5 million shares of Elan, and that “obviously no one knows except you me and [Cohen].” A few days later, the senior trader e-mailed Cohen the results of the week’s activity: “We executed a sale of over 10.5 million ELN for [four internal Hedge Fund account names] at an avg price of 34.21. This was executed quietly and effectively over a 4 day period through algos and darkpools and booked into two firm accounts that have very limited viewing access. This process clearly stopped leakage of info from either in [or] outside the firm and in my viewpoint clearly saved us some slippage.” 

From one end of Wall Street to the other, people are wondering whether Martoma, facing the likelihood of serious jail time, will “flip” on Cohen, creating probably the most sensational insider trading case ever. There is no doubt that Martoma is facing intense pressure: reportedly, when confronted by an F.B.I. agent in his front yard, Martoma fainted. If Martoma is convicted of the charges, federal guidelines call for a stiff 15-19 year sentence. And, while no SEC charges have yet been brought against Cohen, the Commission recently issued a Wells notice to SAC Capital, indicating that the staff is probably going to recommend that the SEC take action against SAC.

Companies Fight to Keep Their Political Contributions Secret

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, January/February 2013 

In the wake of the Supreme Court’s 2010 Citizens United decision, which allowed corporations and unions to make unlimited expenditures for political purposes, a new battle has erupted to force companies to disclose these expenditures. Writing for the majority in that case, Justice Anthony Kennedy noted that prompt disclosure of political expenditures would allow stockholders and citizens to hold corporations accountable. Shareholders, he said, could determine whether the corporation’s financing of campaigns “advances the corporation’s interest in making profits.” But in many, perhaps most cases, disclosure and accountability are the last things that corporate managers want. 

Although dozens of major companies have voluntarily disclosed their political spending, most do not. Currently, the most common shareholder proposals submitted to public companies are those requesting information on political spending. Most, however, have not fared well. Many companies probably fear that revelation of their political expenditures would be an invitation to backlash from shareholders and others at the opposite end of the political spectrum. 

Months ago the “Committee on Disclosure of Corporate Political Spending,” headed by Professors Lucian Bebchuck of Harvard Law School and Robert M. Jackson of Columbia Law School, filed a rulemaking petition asking the SEC to adopt a disclosure rule for corporate political spending. Over 300,000 responses to this petition flooded the Commission, all but 10 of which supported it. The SEC recently announced that by April it plans to issue a Notice of Proposed Rulemaking to require disclosures of political spending. 

The Committee said that one of the main reasons for its proposal is that a significant amount of corporate political spending currently occurs under investors’ radar screen, particularly when public companies spend shareholder money on politics through intermediaries, who are never required to disclose the source of their funds. Investors clearly want to receive information about such spending. 

While we await action by the Commission, one investor, the New York State Comptroller Thomas P. DiNapoli, has taken matters into his own hands. He controls the New York State Common Retirement Fund, which holds about $378 million in stock of Qualcomm, one of the country’s largest makers of computer chips for mobile devices. After Qualcomm allegedly rebuffed his multiple requests for access to information on political spending, DiNapoli sued Qualcomm late last year in Delaware Chancery Court, seeking to allow him to review documents showing the company’s political expenditures. Mr. DiNapoli is trying to determine whether Qualcomm made corporate contributions to tax-exempt groups and trade associations that are not required to disclose their donors. Those groups poured hundreds of millions of dollars into the 2012 election, including money from large corporations seeking to avoid negative publicity or customer outcries. Although DiNapoli is a prominent Democratic politician, he cannot be accused of filing the petition for political purposes: Irwin Jacobs, Qualcomm’s controlling shareholder, is a prominent contributor to Democratic candidates and causes. 

Delaware, where Qualcomm is incorporated, has a statute that allows shareholders to gain access to corporate records, so long as they have a “proper purpose” for doing so. As we have noted previously in the Monitor, the question of what a shareholder has to show to establish a “proper purpose” has generated heated debate over the past few years, with corporations making some headway in raising the bar for shareholder access. 

Typically, shareholders have tried to gain access to company books and records to determine whether wrongdoing has occurred, such as breach of fiduciary duties by directors or executives. It is a novel question whether discovery of political activities is a proper purpose. Even if it can be a proper purpose in some cases, such as if the expenditures create some risk for the corporation, the next question is whether the investor will have to show some reason to be concerned in a particular case. Otherwise, the courts may view his request as simply a “fishing expedition.” 

The Council of Institutional Investors, an association of pension funds, foundations and endowments, supports Comptroller Di Napoli’s suit. Amy Borrus, deputy director of CII, reportedly has stated that the suit offers hope to investors stonewalled in their search for basic information about corporate political spending after Citizens United. “Shareholders have tried proxy proposals, and they’ve tried asking, but some companies are unfortunately resistant to providing basic disclosures," Borrus said Thursday. The present suit “certainly opens up a new avenue,” she said. 

If DiNapoli succeeds in obtaining this information, the next question will be whether he can publicly disclose it, allowing other shareholders and interested parties to weigh in on the appropriateness of the company’s actions.

"Muppet-Gate" Hits Goldman

Right on the heels of the embarrassing pasting it took in the El Paso decision discussed earlier in this issue, Goldman has been struck another blow. In an op-ed piece in The New York Times, Greg Smith, a now former Executive Director at Goldman Sachs, announced his resignation to all the world and set off a fire-storm. Burning his bridges behind him, Smith took a parting shot . . . 

“Collective Action” Permitted in Citibank Overtime Pay Case

ATTORNEY: MURIELLE STEVEN WALSH
Pomerantz Monitor, March/April 2012

A federal judge has conditionally certified a nationwide “collective action” in Pomerantz’s overtime pay case against Citibank, and has authorized us to send a notice to personal bankers who may have been affected by the misconduct we allege in our complaint.
 
We brought this case on behalf of Citi personal bankers (PBs) nationwide who we allege worked “off-the-clock” overtime but were not paid for it. This alleged conduct would violate the Fair Labor Standards Act (FLSA), as well as several state laws, including New York’s.
 
Under the relevant law, we had to make a “modest showing” that there are others who are “similarly situated” to our clients. Here, Citibank has at least 4,000 PBs, of whom we have been able to identify, so far, about two dozen employees who were not paid for overtime work. Citi argued that this was not enough.
 
To bolster our contention that there are a lot more PBs who were “similarly situated” we relied on evidence of dual-edged nationwide policies that created an environment that was ripe for FLSA/overtime violations. We argued that the court could infer from the existence of these policies that there are probably many more PBs who suffered the same fate as our clients. Citi had a nationwide job policy and high sales quotas that effectively forced PBs to work overtime to keep their jobs; but Citi also had a nationwide “no overtime” policy that strongly discouraged the incurring of overtime expenses. The natural result of these conflicting policies was that people worked overtime but were not paid for it, either because they were intimidated into underreporting their time, or in some instances, their managers altered their time records to show no overtime worked. Our plaintiffs testified that this in fact occurred.
 
Because the policies were carried out nationwide, it was reasonable to infer that there are many other PBs who are “similarly situated” to our clients. Citi argued that its policies were “facially lawful,” and that the court could not infer a pattern of FLSA violations simply because it had otherwise lawful policies that had conflicting goals. The Court disagreed.

Say on Pay is Having Its Day

ATTORNEY: H. ADAM PRUSSIN
Pomerantz Monitor, March/April 2012

Although only 45 companies – less than 2% of all publicly held companies – lost “say on pay” votes last year, the Wall Street Journal reports that many of those companies are going out of their way to do better this year. Jacobs Engineering and Beezer Homes, for example, have already obtained approval, after revamping executive pay, to bring it into better alignment with overall corporate performance. Beezer, in particular, got a new CEO, hired a new compensation consulting firm and adopted a new performance-based stock plan that stopped giving executives automatic restricted stock grants, and went to great lengths to consult with investors about compensation. As a result, at its annual meeting in February it received 95% shareholder approval of its pay plans. Jacobs did much the same thing (though it kept its CEO) and increased its shareholder “yea” vote from 45% last year to 96% at its annual meeting in January of this year.
 
Executive turnover at loser companies has been roughly twice the average rate. About 1 in 4 installed a new CEO after the vote, and about 1 in 5 put in a new CFO, both more than double the average turnover rate.
 
Corporate governance mavens will be looking ahead to votes later this spring at other loser companies from last year, including Hewlett Packard and Cincinnati Bell. H-P has a new CEO, Meg Whitman, who is pulling in $1 in compensation, and has reportedly held compensation discussions with 200 or so of its nearest and dearest institutional investor shareholders, in an effort to tie compensation more closely to corporate performance. Cincinnati Bell, which was sued by shareholders after losing last year’s vote, agreed to revamp disclosures and to dump its compensation consultants if it loses another say on pay vote.
 
The effect of say on pay votes is largely attributable to the attention that Institutional Investor Services (“ISS”), the proxy advisory firm, has been paying to this issue. The WSJ reports that a study published in the journal Financial Management concluded that a negative ISS recommendation on a management proposal influences between 13.6% and 20.6% of investor votes; and in 2011, ISS advised investors to vote “no” on pay proposals about 11% of the time. Some are predicting that the ISS will say “no” far more often this year than last. In one highly publicized incident, ISS got into a brawl with Disney over its pay packages. Disney won this won, by aggressively fighting back.
 
Also amplifying the impact of “say on pay” votes is the SEC ruling that executive compensation matters fall into the “Broker May Not Vote” category under its Rule 452. That means that brokers, who tend to vote reflexively with management, cannot vote shares held by their investor customers, if those customers have not sent them instructions on how to vote. This means that companies will have to work that much harder to secure investor “yea” votes on compensation.