Pomerantz LLP

March/April 2019

The Institute For Legal Reform's Latest Attack on Shareholders


Each year around this time, corporate-backed lobbyists issue reports in order to reinvigorate their endless crusade against investor protections. Most recently, the U.S. Chamber of Commerce’s Institute for Legal Reform published a paper urging Congress to consider further limits on securities litigation, including an unprecedented damages cap that would severely curtail the ability of institutional investors to recover losses. Titled “Containing the Contagion,” the paper places ideology above fact, ignoring the actual statistics regarding securities litigation and its beneficial impact on holding perpetrators of fraud responsible to their victims.

Even a cursory review of the Institute’s arguments shows their fallacy. First, the Institute claims securities fraud cases have “exploded.” The data cited tells a different story. Last year, 221 non-M&A securities fraud class actions were filed, only slightly more than 214 in the prior year, and somewhat above an average of 182 cases over the past 20 years. Higher, yes, but well below the prior high of 242.

More importantly, the Institute does not address the rise in corporate fraud driving the uptick in securities fraud litigation. Each month brings new revelations of corporate misconduct, suggesting that Congress needs to increase, not cut, investor remedies. From LIBOR-rigging to Petrobras to the Billion Dollar Whale to Theranos, fraud has become more frequent and brazen in recent years. Startups and life sciences companies have hit investors especially hard. Embracing Silicon Valley’s “fake it until you make it” culture, many of these companies show little hesitation to tell investors whatever is necessary to raise capital, whether truthful or not.

While the Institute would prefer to blame lawyers rather than fraud perpetrators for the uptick in filings, facts do not support that conclusion. Dismissal rates for securities fraud cases have dropped substantially since 2015, reflecting the strong factual underpinning for recent cases. Further, securities fraud cases are filed in only a tiny minority of statistically significant stock drops, not indiscriminately. Once filed, courts apply one of the highest pleading standards under federal law, ensuring that only meritorious cases proceed. Courts also assess whether each pleading is frivolous, and must impose sanctions for those that are. The fact that courts have assessed thousands of complaints but only imposed a handful of sanctions demonstrates that current standards are working.

The Institute’s conclusions about M&A filings also defy logic. The paper cites an increase in federal M&A filings, the result of an ongoing shift in M&A lawsuits from Delaware state court to federal court. But, as Cornerstone Research confirmed in its most recent tally, the overall rate of M&A lawsuits has declined in recent years, slipping 11% below the average annual rate.

The Institute next takes aim at what it calls “eventdriven” litigation—a securities fraud lawsuit brought after an issuer has misrepresented a risk that comes to fruition. For example, if a medical device company misrepresented known safety defects, and patients later died, triggering investor losses, the Institute would call ensuing shareholder litigation “event-driven.” Any concerns about such litigation are overblown. Shareholders will only be able to sustain securities cases, however labeled, if they have a factual basis to properly allege scienter, falsity and loss causation. As a result, courts will quickly weed out any lawsuits based only on an unforeseen triggering event.

None of the Institute’s arguments supports the most drastic remedy it urges Congress to consider: a damages cap that would deprive institutional investors of compensation for injuries suffered as a result of securities fraud. Specifically, the Institute proposes that the damages payable by securities fraudsters be capped at an arbitrary, unspecified amount for all cases other than those arising from initial public offerings, and that small investors be prioritized in the allocation of those damages. To justify this proposal, the paper repeats the discredited claim that securities fraud litigation is just “pocket shifting” for large, diversified investors, supposing that the investors gain on securities litigation settlements but also lose when other companies in which they invest have to pay out settlements. No academic research has shown this to be the case. In fact, a recent study found a statistically significant rise in share prices when a corporate securities fraud defendant announces a settlement. As a result, institutional investors benefit both from receiving settlement proceeds, and from the boost in valuation when portfolio companies come clean with investors.

While unpopular among some special interests, private securities litigation has returned tens of billions of dollars to defrauded investors. Even after fees and expenses, private securities fraud litigation remains the most important source of recovery for defrauded investors, far outpacing the SEC. The Institute’s latest anti-investor positions may satisfy its backers, but they do not justify any rollback of investor protections.  

The Supreme Court's Unanimous Decision in Tims V. Indiana Represents A Decisive Victory for Criminal Justice Reform


In an era where many states and localities are trying to plug their budget deficits by imposing draconian “civil forfeitures” on alleged criminals, the Supreme Court’s unanimous decision in February in Tims v. Indiana is a decisive victory against some of the most egregious abuses stemming from this practice. In this case, defendant Tims argued that the state of Indiana imposed an excessive fine on him when it seized his sports utility vehicle, valued at $42,000, after he was arrested for selling heroin. The value of this SUV was more than four times the maximum $10,000 monetary fine assessable against Tims for his drug conviction. The Supreme Court, in an opinion authored by Justice Ruth Bader Ginsburg, overturned the forfeiture and, in the process, held that the Eighth Amendment’s Excessive Fines Clause applies to the states under the Fourteenth Amendment’s due process clause, because it is a safeguard “fundamental to our scheme of ordered liberty” with “deep roots in our history and tradition.”

Tims pleaded guilty in Indiana Court to selling heroin to undercover officers. In addition to sentencing Tims to a year of house arrest, five years’ probation, and assessing reasonable fines and fees, Indiana sought civil forfeiture of a $42,000 SUV Tims had purchased with the proceeds of an insurance policy he received when his father died. The trial court denied Indiana’s request, noting that the vehicle had been recently purchased (and was therefore not likely part of the proceeds of his crime) and was valued at more than four times the maximum fine. Therefore, the trial court determined that the seizure of the SUV would be grossly disproportionate to Tims’ crime and unconstitutional under the Eighth Amendment’s Excessive Fines Clause. The Court of Appeals affirmed, but the Indiana Supreme Court reversed, holding that the Excessive Fines Clause did not apply to state action. Tims appealed.

As Justice Ginsburg remarked, the Supreme Court has held, with only a handful of exceptions, that the Fourteenth Amendment’s Due Process Clause “incorporates” many of the protections in the Bill of Rights, thus rendering them applicable to the states. A Bill of Rights protection is incorporated if it is “fundamental to our scheme of ordered liberty.” In holding that the Excessive Fines Clause is “fundamental to our scheme of ordered liberty,” Justice Ginsburg traced the adoption of the prohibition against excessive fines back to the Magna Carta, the Virginia Declaration of Rights, and similar colonial-era provisions. Justice Ginsburg also noted that by the time the Fourteenth Amendment was ratified, 35 of the 37 states expressly prohibited excessive fines in order to guard against such fines being used to subjugate the newly freed slaves “and maintain the prewar racial hierarchy.” Justice Ginsburg further noted that historically, excessive fines were used to undermine other constitutional liberties.

Indiana argued that the Clause, as applied to in rem forfeitures (i.e. seizure of specific property), is neither “fundamental” nor “deeply rooted.” In Austin v. United States, the Court held that civil in rem forfeitures fall within the Excessive Fines Clause protection when they are at least partially punitive. While Austin arose in the federal context, the Court noted that when a Bill of Rights protection is incorporated, the protection applies identically to the federal government and the states.

The Court held that the proper question in determining whether the Fourteenth Amendment incorporates a protection contained in the Bill of Rights is whether the right guaranteed – rather than each and every particular application of that right – is fundamental or deeply rooted. Thus, regardless of whether application of the Excessive Fines Clause to civil in rem forfeitures is itself fundamental or deeply rooted, the conclusion that the Clause is incorporated remains unchanged. The Court remanded the case to the Indiana Supreme Court for determination of whether the seizure of Tims’ SUV was excessive under this standard.

The Tims decision was cheered by advocates of criminal justice reform who have argued that civil asset forfeiture laws create an incentive for abuse. In many places, such laws facilitate the seizing of assets from individuals who have not been convicted of or even charged with a crime, and require only a tenuous connection between the crime and the seized asset. For example, in January 2019 an investigation conducted by The Greenville News and Anderson Independent Mail uncovered that the South Carolina police seized more than $17 million over a three year period through civil asset forfeiture. The investigation concluded that a review of the cases demonstrates that the “police are systematically seizing cash and property—many times from people who aren’t guilty of a crime— netting millions of dollars each year” and that “nearly a fifth of the 4,000 people who had their property seized by South Carolina police between 2014 and 2016 were never arrested nor even charged with a related crime.”

Additionally, critics of civil asset forfeiture laws contend that they are disproportionally harmful to lower-income communities and communities of color. For example, an investigation conducted by The Washington Post concluded that “of the 400 court cases examined where people challenged seizures and received money back, the majority were Black, Hispanic or another minority.” Another investigation found that Philadelphia cash forfeitures disproportionally target African-Americans who, while making up 44% of the population, are subject to an astounding 71% of forfeitures without conviction.

Critics of the Tims decision argue that the ruling will create financial challenges to police departments that have come to rely on civil forfeitures as a way to finance police operations. After Tims, they will have to look elsewhere for their funds.

Section 14(a) And Inadequate Risk Disclosures


In Jaroslawicz v. M&T Bank Corporation, the Third Circuit Court of Appeals recently held that allegations that defendants failed to disclose M&T Bank Corporation’s (“M&T”) compliance violations in a proxy statement issued in connection with M&T’s merger with Hudson City Bancorp (“Hudson”) could be a violation of Section 14(a) of the Exchange Act, which prohibits proxy fraud. The Court explained that the omission of information from a proxy statement violates Section 14(a) and the Securities and Exchange Commission (“SEC”) Rule 14a-9 if, among other reasons, “the SEC regulations specifically require disclosure of the omitted information.” The parties therefore agreed that Section 14(a) required the Joint Proxy to comply with Item 503(c) of SEC Regulation S-K. Item 503(c), in turn, requires issuers to “provide under the caption ‘Risk Factors’ a discussion of the most significant factors that make the offering speculative or risky.”

The parties disagreed, however, over whether M&T’s alleged past consumer violations posed a risk to regulatory approval of the merger and whether M&T had adequately disclosed the risk of M&T’s Bank Secrecy Act/Anti-Money Laundering (“BSA/AML”) deficiencies.  The Third Circuit concluded that the complaint plausibly alleged that M&T’s consumer violations “made the upcoming merger vulnerable to regulatory delay” and that the defendants did not adequately disclose the risk of M&T’s BSA/AML compliance violations. The Court’s decision thus emphasizes the breadth of factors that must be disclosed under Item 503(c) and the highly specific level at which defendants must disclose that information or be subject to liability under the federal securities laws.

According to the District Court, Item 503(c) did not require the defendants to disclose M&T’s consumer violations because the complaint did not adequately allege that those past violations posed a significant risk to the merger at the time the Joint Proxy was issued. In addition, the District Court held that M&T adequately disclosed the risk that its BSA/AML deficiencies posed to the merger by describing the general risk of regulatory oversight related to BSA/AML compliance issues. The Third Circuit disagreed with both of these conclusions.

First, the Third Circuit held that Item 503(c) required disclosure of M&T’s consumer rights violations because “[d]espite the fact that M&T had ceased [those violations], it is plausible that the allegedly high volume of past violations made the upcoming merger vulnerable to regulatory delay.” The Court then assessed whether the proxy materials adequately disclosed this risk factor as required by Item 503(c). As the Third Circuit explained, “generic disclosures which could apply across an industry are insufficient. Rather, adequate disclosures are companyspecific. They include facts particular to a company, such as its financial status, its products, any ongoing investigations, and its relationships with other entities.” The Court concluded that the plaintiffs plausibly alleged that the Joint Proxy’s disclosures concerning consumer violations, which “discussed the regulatory framework facing consumer banks” in general—but did not mention M&T’s fraudulent practices or the Consumer Financial Protection Bureau’s investigation into them—“were too generic to be adequate.”

As for M&T’s BSA/AML deficiencies, the Court held that “it is plausible that the[] boilerplate disclosures were too generic to communicate anything meaningful about this specific risk to the merger.” For example, although the Joint Proxy mentioned AML compliance requirements at a general level, it did not describe M&T’s “Know Your Customer” program, the bank’s alleged deficiencies, or the Federal Reserve Board’s investigation into them. Fur - thermore, because M&T’s supplemental disclosure of the Federal Reserve Board’s identification of these deficien - cies, which M&T noted would likely delay the merger, was made, at most, six days before the shareholder vote on the merger, the adequacy of these supplemental disclosures “raise[d] a fact issue, which preclude[d] dismissal of the BSA/AML allegations.”

The Court therefore concluded that the complaint ad - equately alleged a violation of Item 503(c)—and, by extension, Section 14(a)—and vacated the District Court’s dismissal of the mandatory-disclosure claims relating to M&T’s consumer rights violations and its BSA/AML deficiencies.

The Court, however, rejected claims that the defendants had failed to disclose information that might have contradicted their expressed opinions of confidence that the merger would be approved expeditiously. Plaintiffs alleged that defendants violated their duty to disclose facts that allegedly would have shown that they had little or no basis for these opinions. In its decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, the Supreme Court held that defendants have a duty to disclose information that forms the basis for their opinions when the omission of that information makes the opinion statements at issue misleading to a reasonable person. The Court here determined that the complaint did not allege specific undisclosed facts about the defendants’ knowledge of, or investigation into, M&T’s compliance violations that would have belied their stated opinion that the merger should obtain regulatory approvals in a timely manner.

Although this case dealt specifically with a claim brought under Section 14(a) of the Exchange Act, the Court applied the same standard that other circuits have applied to determine what disclosures Item 503(c) requires under the Securities Act. While these separate statutory provi - sions might cover different securities filings or participants, the Court explained that those distinctions are immaterial for purposes of determining the content of the disclosures required by Item 503(c). The Third Circuit’s decision in M&T helpfully sets out the standard for the duty to dis - close risk factors under Item 503(c), the violation of which gives rise to liability in connection with covered securities filings, including under Section 14(a) of the Exchange Act and Sections 11 and 12 of the Securities Act. In particular, the Court made clear the SEC’s concern that “inadequate disclosure—particularly in the form of disclosing only generic risk factors—presents a persistent problem.” Defen - dants must therefore disclose all of the most significant risk factors in a company-specific way, rather than relying on the common—but insufficient—practice of providing generic warnings that could apply to any company or an industry as a whole.

Courts Tackle Merger Proxy Rules Supremes To Determine Fate of Merger Litigation


Section 14(e) of the Exchange Act prohibits fraudulent, deceptive, and manipulative acts in connection with a tender offer. Mergers are often implemented through tender offers, which are accompanied by offering statements and recommendations from the target corporation.

On January 4, 2019, the Supreme Court granted certiorari in Varjabedian v. Emulex Corp., to review the Ninth Circuit’s holding that to state a claim under Section 14(e), shareholders need allege only that a misrepresentation or omission in connection with a tender offer was negligent. This case is of critical importance to the future of securities litigation relating to mergers. The Court could significantly expand Section 14(e) claims by siding with the Ninth Circuit (and against five other circuit courts) by holding that Section 14(e) requires only allegations of negligence, rather than proof of scienter (i.e., the intent to defraud). Alternatively, the Court might decide that no private right of action exists under Section 14(e) at all, and so significantly curtail merger-related securities litigation.

In Emulex, a shareholder of Emulex Corp. brought a Section 14(e) class action against the company following the merger of Emulex and Avago Technologies Wireless Manufacturing, Inc., two companies that sold storage adapters, network interface cards, and related products. Pursuant to the terms of a merger agreement, the Avago merger sub had initiated a tender offer for Emulex’s outstanding stock to obtain control of Emulex. In connection with this tender offer, Emulex issued a statement to shareholders recommending that they accept the offer. This statement included a summary of a non-public analysis Emulex had commissioned from Goldman Sachs of the fairness of the proposed merger. Goldman Sachs’s original fairness analysis included a comparison of the premium shareholders would receive in the tender offer and the premium of previous offers for similarly situated companies, and concluded that the premium, while below average, was within the normal range. Emulex omitted this analysis of premiums from its summary of Goldman Sachs’s fairness analysis. The complaint alleged that this omission rendered Emulex’s tender offer statement misleading, in violation of Section 14(e). The district court dismissed the complaint on the ground that it failed adequately to allege scienter.

The Ninth Circuit reversed the district court’s decision and held that only negligence, rather than scienter, need be pleaded to state a claim under Section 14(e). The Court noted that Section 14(e) contains two clauses, each prohibiting different conduct: the first clause prohibits “mak[ing] any untrue statement of material fact” and misleading omissions, while the second clause prohibits “engag[ing] in any fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer. ...” Each clause proscribes different conduct, as otherwise one clause would be superfluous. The Court then noted that the Supreme Court, in Aaron v. SEC, in interpreting the wording of Section 17(a)(2) of the Securities Act— which is nearly identical to the wording in the first clause of Section 14(e) —had held that that language did not require a showing of scienter.

The Ninth Circuit also addressed the Supreme Court’s holding, in Ernst & Ernst v. Hochfelder, that claims under Section 10(b) of the Exchange Act and Rule 10b-5 must allege scienter. The Court in Ernst expressly held that language nearly identical to that in the first clause of Section 14(e) could be read as proscribing negligent conduct, not merely intentional conduct. Nevertheless, the Ernst Court concluded that SEC Rule 10b-5 requires a showing of scienter because the enabling statute, Section 10(b) of the Exchange Act, permits the SEC to regulate only “manipulative or deceptive device[s],” and manipulation and deception are intentional acts. 15 U.S.C. § 78j(b). As the SEC cannot proscribe a broader range of conduct than permitted by the enabling statute, the Court interpreted Rule 10b-5 to prohibit only intentional conduct.

In concluding that Section 14(e) requires only negligent conduct, the Ninth Circuit broke with the Second, Third, Fifth, Sixth, and Eleventh Circuits, all of which previously had held that Section 14(e) required scienter. The Ninth Circuit disagreed with the analysis of those other circuits and held that they had failed to apply the holdings in Aaron and Ernst. The other circuits each had interpreted the language of Section 14(e) with reference to Rule 10b-5 and had concluded that because language in the latter had been found to require scienter, the former should as well. Yet these cases, the Ninth Circuit found, failed to recognize that the language in Rule 10b-5 required scienter only because the enabling statute limited scope of the Rule to intentional conduct. Circuit cases decided after Aaron and Ernst failed to recognize that the Supreme Court twice had interpreted language nearly identical to that in Section 14(e) to encompass negligent conduct.

Following the Delaware Court of Chancery’s 2016 ruling in Trulia that required greater scrutiny of cases alleging insufficient disclosures relating to a merger, shareholders increasingly have chosen to bring their merger-related claims in federal rather than state court. If the Supreme Court adopts the Ninth Circuit’s reasoning in Emulex and permits Section 14(e) cases to proceed based merely on allegations of negligence, federal merger-related securities litigation likely will increase even more significantly. However, the Court, with its additional conservative members, may be loath to endorse such a result and may simply adopt the holdings of the five circuits that have found that Section 14(e) requires scienter. However, the Court may take this case as an opportunity to address whether there is an implied private cause of action under Section 14(e) at all. If the Court finds that no implied private cause of action exists under Section 14(e), the holding may result in a significant curtailment of merger-related securities litigation. Moreover, this holding may encourage companies to use the tender offer more often for business combinations (in place of traditional mergers with board approval) so as to avoid private litigation, and so may curtail merger-related litigation even further.