In a matter of first impression in the Ninth Circuit, the court applied the Supreme Court’s Omnicare standard for pleading the falsity of a statement of opinion in City of Dearborn Heights Act 345 Police & Fire Retirement System v. Align Technology, Inc., — F.3d —, 2017 WL 1753276 (9th Cir. May 5, 2017). The Ninth Circuit decision builds on the momentum for the defense bar following the 2016 Second Circuit opinion in Tongue v. Sanofi, 816 F.3d 199 (2d Cir. 2016), correctly applies the rationale of Omnicare to Section 10(b) cases, and applies the Omnicare falsity analysis to an important category of statements of opinion: accounting reserves.
Following is an article I wrote for Law360, which gave me permission to republish it here:
Among securities litigators, there is no consensus about the importance of developments in securities and corporate governance litigation. For some, a Supreme Court decision is always supreme. For others, a major change in a legal standard is the most critical. For me, the key developments are those that have the greatest potential to significantly increase or decrease the frequency or severity of claims against public companies and their directors and officers.
Given my way of thinking, there are three developments in 2016 that stand out as noteworthy:
- The persistence of securities class actions brought against smaller public companies primarily by smaller plaintiffs’ firms on behalf of retail investors—a trend that began five years ago and now appears to represent a fundamental shift in the securities class action landscape.
- The 2nd Circuit’s robust application of the Supreme Court’s Omnicare decision in Sanofi, illustrating the significant benefits of Omnicare to defendants.
- The demise of disclosure-only settlements under the Delaware Court of Chancery’s Trulia decision and the 7th Circuit’s subsequent scathing Walgreen opinion by Judge Posner.
I discuss each of these developments in detail, and then list other 2016 developments that I believe are important as well.
1. The Securities Class Action Landscape Has Fundamentally Changed
The Private Securities Litigation Reform Act’s lead plaintiff process incentivized plaintiffs’ firms to recruit institutional investors to serve as plaintiffs. For the most part, institutional investors, whether smaller unions or large funds, have retained the more prominent plaintiffs’ firms, and smaller plaintiffs’ firms have been left with individual investor clients who usually can’t beat out institutions for the lead-plaintiff role. At the same time, securities class action economics tightened in all but the largest cases. Dismissal rates under the Reform Act are pretty high, and defeating a motion to dismiss often requires significant investigative costs and intensive legal work. And the median settlement amount of cases that survive dismissal motions is fairly low. These dynamics placed a premium on experience, efficiency, and scale. Larger firms filed the lion’s share of the cases, and smaller plaintiffs’ firms were unable to compete effectively for the lead plaintiff role, or make much money on their litigation investments.
This started to change with the wave of cases against Chinese companies in 2010. Smaller plaintiffs’ firms initiated the lion’s share of these cases, as the larger firms were swamped with credit-crisis cases and likely were deterred by the relatively small damages, potentially high discovery costs, and uncertain insurance and company financial resources. Moreover, these cases fit smaller firms’ capabilities well. Nearly all of the cases had “lawsuit blueprints” such as auditor resignations and/or short-seller reports, thereby reducing the smaller firms’ investigative costs and increasing their likelihood of surviving a motion to dismiss. The dismissal rate was low, and limited insurance and company resources have prompted early settlements in amounts that, while on the low side, appear to have yielded good outcomes for the smaller plaintiffs’ firms.
The smaller plaintiffs’ firms thus built up momentum that has kept them going, even after the wave of China cases subsided. For the last several years, following almost every “lawsuit blueprint” announcement, a smaller firm has launched an “investigation” of the company, and they have initiated an increasing number of cases. Like the China cases, these cases tend to be against smaller companies. Thus, smaller plaintiffs’ firms have discovered a class of cases—cases against smaller companies that have suffered well-publicized problems (reducing the plaintiffs’ firms’ investigative costs) for which they can win the lead plaintiff role and that they can prosecute at a sufficient profit margin.
As smaller firms have gained further momentum, they have expanded the cases they initiate beyond “lawsuit blueprint” cases—and they continue to initiate and win lead-plaintiff contests primarily in cases against smaller companies brought by retail investors. To be sure, the larger firms still mostly can and will beat out the smaller firms for the cases they want. But it increasingly seems clear that the larger firms don’t want to take the lead in initiating many of the cases against smaller companies, and are content to focus on larger cases on behalf of their institutional investor clients.
The securities litigation landscape now clearly consists of a combination of two different types of cases: smaller cases brought by a set of smaller plaintiffs’ firms on behalf of retail investors, and larger cases pursued by the larger plaintiffs’ firms on behalf of institutional investors. This change—now more than five years old—appears to be here to stay.
In addition to this fundamental shift, two other trends are an indicator of further changes to the securities litigation landscape.
First, the smaller plaintiffs’ firms often file cases against U.S. companies in New York City or California—regardless where the company is headquartered—diverging from the larger plaintiffs’ firms’ practice of filing in the forum of the defendant company’s headquarters. In addition to inconvenience, filing cases in New York City and California against non-resident companies results in sticker-shock, since defense firms based in those venues are much more expensive than their home town firms. The solution to this problem will need to include greater defense of cases in New York City and California by a more economically diverse set of defense firms.
Second, plaintiffs’ firms, large and small, are increasingly rejecting the use of historical settlement values to shape the settlement amounts. This practice is increasing settlement amounts in individual cases, and will ultimately raise settlement amounts overall. And it will be increasingly difficult for defendants and their insurers to predict defense costs and settlement amounts, as more mediations fail and litigation proceeds past the point they otherwise would.
2. Sanofi Shows Omnicare’s Benefits
In Tongue v. Sanofi, 816 F.3d 199 (2nd Cir. 2016), the Second Circuit issued the first significant appellate decision interpreting the Supreme Court’s decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015). Sanofi shows that Omnicare provides powerful tools for defendants to win more motions to dismiss.
As a reminder, the Supreme Court in Omnicare held that a statement of opinion is only false under the federal securities laws if the speaker does not genuinely believe it, and is only misleading if it omits information that, in context, would cause the statement to mislead a reasonable investor. This ruling followed the path Lane Powell advocated in an amicus brief on behalf of Washington Legal Foundation.
The Court’s ruling in Omnicare was a significant victory for the defense bar for two primary reasons.
First, the Court made clear that an opinion is false only if it was not sincerely believed by the speaker at the time that it was expressed, a concept sometimes referred to as “subjective falsity.” The Court thus explicitly rejected the possibility that a statement of opinion could be false because “external facts show the opinion to be incorrect,” because a company failed to “disclose some fact cutting the other way,” or because the company did not disclose that others disagreed with its opinion. This ruling resolved two decades’ worth of confusing and conflicting case law regarding what makes a statement of opinion false, which had often permitted meritless securities cases to survive dismissal motions. Omnicare governs the falsity analysis for all types of challenged statements. Although Omnicare arose from a claim under Section 11 of the Securities Act, all of its core concepts are equally applicable to Section 10(b) of the Securities Exchange Act and other securities laws with similar falsity elements.
Second, Omnicare declared that whether a statement of opinion (and by clear implication, a statement of fact) was misleading “always depends on context.” The Court emphasized that showing a statement to be misleading is “no small task” for plaintiffs, and that the court must consider not only the full statement being challenged and the context in which it was made, but must also consider other statements made by the company, and other publicly available information, including the customs and practices of the relevant industry.
A good motion to dismiss has always analyzed a challenged statement (of fact or opinion) in its broader factual context to explain why it’s not false or misleading. But many defense lawyers unfortunately leave out the broader context, and courts have sometimes taken a narrower view. Now, this type of superior, full-context analysis is clearly required by Omnicare. And combined with the Supreme Court’s directive in Tellabs that courts consider scienter inferences based not only on the complaint’s allegations, but also on documents on which the complaint relies or that are subject to judicial notice, courts clearly must now consider the full array of probative facts in deciding both whether a statement was false or misleading and, if so, whether it was made with scienter.
Due to the importance of its holdings and the detailed way in which it explains them, Omnicare is the most significant post-Reform Act Supreme Court case to analyze the falsity element of a securities class-action claim, laying out the core principles of falsity in the same way that the Court did for scienter in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007). If used correctly, Omnicare thus has the potential to be the most helpful securities case for defendants since Tellabs, providing attorneys with a blueprint for how to structure their falsity arguments in order to defeat more complaints on motions to dismiss.
The early returns show that Omnicare is already helping defendants win more motions to dismiss. The most significant such decision is Sanofi. In Sanofi, the Second Circuit became the first appeals court to discuss Omnicare in detail, and to examine the changes that it brought about in the previously governing law. Sanofi was not, as some securities litigation defense lawyers have claimed, a “narrow” reading of the Court’s decision. Rather, it was a straightforward interpretation of Omnicare that emphasized the Supreme Court’s ruling on falsity, and the intensive contextual analysis required to show that a statement is misleading. It correctly took these concepts beyond the Section 11 setting and applied them to allegations brought under Section 10(b).
Statements about Lemtrada, a drug in development for treatment of multiple sclerosis, were at issue in the case. Sanofi and its predecessor had conducted “single-blind” clinical trials for Lemtrada (studies in which either the researcher or the patient does not know which drug was administered), despite the fact that the U.S. Food and Drug Administration had repeatedly expressed concerns about these trials and recommended “double-blind” clinical studies (studies in which both the researcher and the patient do not know which drug was administered).
The plaintiffs alleged that Sanofi’s failure to disclose FDA’s repeated warnings that a single-blind study might not be adequate for approval caused various statements made by the company to be misleading, including its projection that FDA would approve the drug, its expressions of confidence about the anticipated launch date of the drug, and its view that the results of the clinical trials were “unprecedented” and “nothing short of stunning.” Although FDA eventually approved Lemtrada without further clinical trials, the agency initially refused approval based in large part on the single-blind studies concern, causing a large drop in the price of Sanofi stock.
In an opinion issued before Omnicare, the district court dismissed the claims, in part because it found that plaintiffs had failed to plead that the challenged statements of opinion were subjectively false, under the standard employed by the Second Circuit in Fait v. Regions Financial Corp. The Second Circuit stated that it saw “no reason to disturb the conclusions of the district court,” but wrote to clarify the impact of Omnicare on prior Second Circuit law.
The court acknowledged that Omnicare affirmed the previous standard that a statement of opinion may be false “if either ‘the speaker did not hold the belief she professed’ or ‘the supporting fact she supplied were untrue.’” However, it noted that Omnicare went beyond the standard outlined by Fait in holding that “opinions, though sincerely held and otherwise true as a matter of fact, may nonetheless be actionable if the speaker omits information whose omission makes the statement misleading to a reasonable investor.”
In reality, Omnicare did not represent a change in Second Circuit law. Although Fait only discussed falsity, without considering what it would take to make an opinion “misleading,” prior Second Circuit law had been clear that “[e]ven a statement which is literally true, if susceptible to quite another interpretation by the reasonable investor, may properly be considered a material misrepresentation.” Kleinman v. Elan Corp., 706 F.3d 145 (2nd Cir. 2013) (citation and internal quotation marks omitted). Omnicare simply brought together these two lines of authority, by correctly clarifying that, like any other statement, a statement of opinion can be literally true (i.e., actually believed by the speaker), but can nonetheless omit information that can cause it to be misleading to a reasonable investor.
The Second Circuit highlighted the Omnicare Court’s focus on context, taking note of its statement that “an omission that renders misleading a statement of opinion when viewed in a vacuum may not do so once that statement is considered, as is appropriate, in a broader frame.” Since Sanofi’s offering materials “made numerous caveats to the reliability of the projections,” a reasonable investor would have considered the opinions in light of those qualifications. Similarly, the Second Circuit recognized that reasonable investors would be aware that Sanofi would be engaging in continuous dialogue with FDA that was not being disclosed, that Sanofi had clearly disclosed that it was conducting single-blind trials for Lemtrada, and that FDA had generally made clear through public statements that it preferred double-blind trials. In this broader context, the court found that Sanofi’s optimistic statements about the future of Lemtrada were not misleading even in the context of Sanofi’s failure to disclose FDA’s specific warnings regarding single-blind trials.
Under the Omnicare standards, the Second Circuit thus found nothing false or misleading about the challenged statements, holding that Omnicare imposes no obligation to disclose facts merely because they tended to undermine the defendants’ optimistic projections. In particular, the Second Circuit found that “Omnicare does not impose liability merely because an issuer failed to disclose information that ran counter to an opinion expressed in a registration statement.” It also reasoned that “defendants’ statements about the effectiveness of [the drug] cannot be misleading merely because the FDA disagreed with the conclusion—so long as Defendants conducted a ‘meaningful’ inquiry and in fact held that view, the statements did not mislead in a manner that is actionable.”
3. Companies May Regret the Decline of Disclosure-Only Settlements
In combination with the Delaware Court of Chancery’s decision in In re Trulia, Inc. Stockholder Litigation, 129 A.3d 884 (Del. Ch. 2016), Judge Posner’s blistering opinion In re Walgreen Company Stockholder Litigation, 2016 WL 4207962 (7th Cir. Aug. 10, 2016), may well close the door on disclosure-only settlements in shareholder challenges to mergers. That certainly feels just. And it may well go a long way toward discouraging meritless merger litigation. But I am concerned that we will regret it. Lost in the cheering over Trulia and Walgreen is a simple and practical reality: the availability of disclosure-only settlements is in the interests of merging companies as much as it is in the interests of shareholder plaintiffs’ lawyers, because disclosure-only settlements are often the timeliest and most efficient way to resolve shareholder challenges to mergers, even legitimate ones.
I am offended by meritless merger litigation, and have long advocated reforms to fix the system that not only allows it, but encourages and incentivizes it. Certainly, strict scrutiny of disclosure-only settlements will reduce the number of merger claims—it already has. Let’s say shareholder challenges to mergers are permanently reduced from 90% to 60% of transactions. That would be great. But how do we then resolve the cases that remain? Unfortunately, there aren’t efficient and generally agreeable alternatives to disclosure-only settlements to dispose of a merger lawsuit before the closing of the challenged transaction. Of course, the parties can increase the merger price, though that is a difficult proposition. The parties can also adjust other deal terms, but few merger partners want to alter the deal unless and until the alteration doesn’t actually matter, and settlements based on meaningless deal-structure changes won’t fare better with courts than meaningless disclosure-only settlements.
If the disclosure-only door to resolving merger cases is shut, then more cases will need to be litigated post-close. That will make settlement more expensive. Plaintiffs lawyers are not going to start to settle for less money, especially when they are forced to litigate for longer and invest more in their cases. And in contrast to adjustments to the merger transaction or disclosures, in which 100% of the cash goes to lawyers for the “benefit” they provided, settlements based on the payment of cash to the class of plaintiffs require a much larger sum to yield the same amount of money to the plaintiffs’ lawyers. For example, a $500,000 fee payment to the plaintiffs under a disclosure-only settlement would require around $2 million in a settlement payment to the class to yield the same fee for the plaintiffs’ lawyers, assuming a 25% contingent-fee award.
The increase in the cash outlay required for companies and their insurers to deal with post-close merger litigation will actually be much higher than my example indicates. Plaintiffs’ lawyers will spend more time on each case, and demand a higher settlement amount to yield a higher plaintiffs’ fee. Defense costs will skyrocket. And discovery in post-close cases will inevitably unearth problems that the disclosure-only settlement landscape camouflaged, significantly increasing the severity of many cases. It is not hard to imagine that merger cases that could have settled for disclosures and a six-figure plaintiffs’ fee will often become an eight-figure mess. And, beyond these unfortunate economic consequences, the inability to resolve merger litigation quickly and efficiently will increase the burden upon directors and officers by requiring continued service to companies they have sold, as they are forced to produce documents, sit for depositions, and consult with their defense lawyers, while the merger case careens toward trial.
Again, it’s hard to disagree with the logic and sentiment of these decisions, and the result may very well be more just. But this justice will come with a high practical price tag.
Additional Significant Developments
There were a number of other 2016 developments that I believe may also significantly impact the frequency and severity of securities claims against public companies and their directors and officers. These include:
- The ongoing wave of Securities Act cases in state court, especially in California, and the Supreme Court cert petitions in Cyan, Inc. v. Beaver County Employees Retirement Fund, No. 15-1439, and FireEye, Inc., et al., v. Superior Court of California, Santa Clara County, No. 16-744.
- The lack of a wave of cyber security shareholder litigation, and the conclusion in favor of the defendants in the Target and Home Depot shareholder derivative cases, which follows the dismissal of the Wyndham derivative case in 2014.
- The challenge to the SEC’s use of administrative proceedings, including Lynn Tilton’s tilt at the process.
- The Supreme Court’s decision on insider trading in Salman v. U.S. 137 S. Ct. 420 (2016), rejecting the 2nd Circuit’s heightened personal benefit requirement established in U.S. v. Newman, 773 F.3d 438 (2nd Cir. 2014).
- The persistence and intractability of securities class actions against foreign issuers after Morrison v. National Australia Bank, 561 U.S. 247 (2010).
- The 8th Circuit’s reversal of class certification under Halliburton II in IBEW Local 98 Pension Fund v. Best Buy Co., 818 F.3d 775, 777 (8th Cir. 2016).
- The 9th Circuit becoming the first appellate court to hold that Section 304 of Sarbanes-Oxley allows the SEC to seek a clawback of compensation from CEOs and CFOs in the event of a restatement even if it did not result from their misconduct. U.S. Securities & Exchange Commission v. Jensen, 835 F.3d 1100 (2016).
- The 2nd Circuit’s lengthy and wide-ranging decision in In re Vivendi, S.A. Securities Litigation, 838 F.3d 223 (2nd Cir. 2016), affirming the district court’s partial judgment against Vivendi following trial.
Following is an article we wrote for Law360, which gave us permission to republish it here:
The coming year promises to be a pivotal one in the world of securities and corporate governance litigation. In particular, there are five developing issues we are watching that have the greatest potential to significantly increase or decrease the exposure of public companies and their directors, officers, and insurers.
1. How Will Lower Courts Apply the Supreme Court’s Decision in Omnicare, Inc. v. Laborers Dist. Council Const. Industry Pension Fund?
If it is correctly understood and applied by defendants and the courts, we believe Omnicare will stand alongside Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), as one of the two most important securities litigation decisions since the Private Securities Litigation Reform Act of 1995.
In Omnicare, 135 S. Ct. 1318 (2015), the Supreme Court held that a statement of opinion is only false if the speaker does not genuinely believe it, and that it is only misleading if – as with any other statement – it omits facts that make it misleading when viewed in its full context. The Court’s ruling on what is necessary for an opinion to be false establishes a uniform standard that resolves two decades of confusing and conflicting case law, which often resulted in meritless securities cases surviving dismissal motions. And the Court’s ruling regarding how an opinion may be misleading emphasizes that courts must evaluate the fairness of challenged statements (both opinions and other statements) within a broad factual context, eliminating the short-shrift that many courts have given the misleading-statement analysis.
These are tremendous improvements in the law, and should help defendants win more cases involving statements of opinion, not only under Section 11, the statute at issue in Omnicare, but also under Section 10(b), since Omnicare’s holding applies to the “false or misleading statement” element common to both statutes. The standards the Court set should also add to the Reform Act’s Safe Harbor, and expand the tools that defendants have to defend against challenges to earnings forecasts and other forward-looking statements, which are quintessential opinions.
Indeed, if used correctly, Omnicare should also help defendants gain dismissal of claims brought based on challenged statements of fact, because of its emphasis on the importance of considering the entire context of a statement when determining whether it was misleading. For example, the Court emphasized that whether a statement is misleading “always depends on context,” so a statement must be understood in its “broader frame,” including “in light of all its surrounding text, including hedges, disclaimers, and apparently conflicting information,” and the “customs and practices of the relevant industry.”
A good motion to dismiss has always analyzed a challenged statement (of fact or opinion) in its broader factual context to explain why it was not misleading. But many defense lawyers unfortunately choose to leave out this broader context, and as a result of this narrow record, courts sometimes take a narrower view. With Omnicare, this superior method of analysis is now explicitly required. This will be a powerful tool, especially when combined with Tellabs’s directive that courts must weigh scienter inferences based not only on the complaint’s allegations, but also on documents on which the complaint relies or that are subject to judicial notice.
Omnicare bolsters the array of weapons available to defendants to effectively defend allegations of falsity, and to set up and support the Safe Harbor defense and arguments against scienter. Because of its importance, we plan to write a piece critiquing the cases applying Omnicare after its one-year anniversary in March.
2. Will Courts Continue to Curtail the Use of 10b5-1 Plans as a Way to Undermine Scienter Allegations?
All successful securities fraud complaints must persuade the court that the difference between the challenged statements and the “corrective” disclosure was the result of fraud, and not due to a business reversal or some other non-fraudulent cause. Because few securities class action complaints contain direct evidence of fraud, such as specific information that a speaker knew his statements were false, most successful complaints include allegations that the defendants somehow profited from the alleged fraud, such as through unusual and suspicious stock sales.
Thus, stock-sale allegations are a key battleground in most securities actions. An important defensive tactic has been to point out that the challenged stock sales were made under stock-sale plans under SEC Rule 10b5-1, which provides an affirmative defense to insider-trading claims, if the plan was established in good faith at a time when they were unaware of material non-public information. Although Rule 10b5-1 is designed to be an affirmative defense in insider-trading cases, securities class action defendants also use it to undermine stock-sale allegations, if the plan has been publicly disclosed and thus subject to judicial notice, since it shows that the defendant did not have control over the allegedly unusual and suspicious stock sales.
Plaintiffs’ argument in response to a 10b5-1 plan defense has always been that any plan adopted during the class period is just a large insider sale designed to take advantage of the artificial inflation in the stock price. Plaintiffs claim that by definition, the class period is a time during which the defendants had material nonpublic information – although they often manipulate the class period in order to encompass stock sales and the establishment of 10b5-1 plans.
There have been surprisingly few key court decisions on this pivotal issue, but on July 24, 2015, the Second Circuit held that “[w]hen 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.” Employees’ Ret. Sys. of Gov’t of the Virgin Island v. Blanford, 794 F.3d 297, 309 (2d Cir. 2015).
Plaintiffs’ ability to plead scienter will take a huge step forward if Blanford, decided by an important appellate court, starts a wave of similar holdings in other circuits.
3. Will Delaware’s Endorsement of Forum Selection Bylaws and Rejection of Disclosure-Only Settlements Reduce Shareholder Challenges to Mergers?
For the past several years, there has been great focus on amending corporate bylaws to try to corral and curtail shareholder corporate-governance claims, principally shareholder challenges to mergers. Meritless merger litigation is indeed a big problem. It is a slap in the face to careful directors who have worked hard to understand and approve a merger, and to CEOs who have worked long hours to find and negotiate a transaction that is in the shareholders’ best interests. It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally. It is proof that the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.
In 2015, the Delaware legislature and courts took significant steps to curb meritless merger litigation.
First, the legislature added new Section 115 to the Delaware General Corporation Law (“DGCL”), which provides:
The certificate of incorporation or the bylaws may require, consistent with applicable jurisdictional requirements, that any or all internal corporate claims shall be brought solely and exclusively in any or all of the courts in this State.
This provision essentially codified the holding in Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), in which the Delaware Court of Chancery upheld the validity of bylaws requiring that corporate governance litigation be brought only in Delaware state and federal courts. The Delaware legislature also amended the DGCL to ban bylaws that purport to shift fees. In new subsection (f) to Section 102, the certificate of incorporation “may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an internal corporate claim.” See also DGCL Section 109(b) (similar).
Second, in a series of decisions in 2015, the Delaware Court of Chancery rejected or criticized so-called disclosure-only settlements, under which the target company supplements its proxy-statement disclosures in exchange for a payment to the plaintiffs’ lawyers. See Acevedo v. Aeroflex Holding Corp., et al., C.A. No. 7930-VCL (Del. Ch. July 8, 2015) (TRANSCRIPT) (rejecting disclosure-only settlement); In re Aruba Networks S’holder Litig., C.A. No. 10765-VCL (Del. Ch. Oct. 9, 2015) (TRANSCRIPT) (same); In re Riverbed Tech., Inc., S’holder Litig., 2015 WL 5458041, C.A. No. 10484-VCG (Del. Ch. Sept. 17, 2015) (approving disclosure-only settlement with broad release, but suggesting that approval of such settlements “will be diminished or eliminated going forward”); In re Intermune, Inc., S’holder Litig., C.A. No. 10086–VCN (Del. Ch. July 8, 2015) (TRANSCRIPT) (noting concern regarding global release in disclosure-only settlement).
We will be closely watching the impact of these developments, with the hope that they will deter plaintiffs from reflexively filing meritless merger cases. Delaware exclusive-forum bylaws will force plaintiffs to face the scrutiny of Delaware courts, and the Court of Chancery has indicated that it may no longer allow an easy exit from these cases through a disclosure-only settlement. And with cases in a single forum, defendants will now be able to coordinate them for early motions to dismiss. Thus, the number of mergers subject to a shareholder lawsuit should decline – and the early returns suggest that this may already be happening.
Yet defendants should brace for negative consequences. Plaintiffs’ lawyers will doubtless bring more cases outside of Delaware against non-Delaware corporations, or against companies that haven’t adopted a Delaware exclusive-forum bylaw. And within Delaware, plaintiffs’ lawyers will tend to bring more meritorious cases that present greater risk, exposure, and stigma – and while Delaware is a defendant-friendly forum for good transactions, it is a decidedly unfriendly one for bad ones. If disclosure-only settlements are no longer allowed, defendants will no longer have the option of escaping these cases easily and cheaply. This means that those cases that are filed will doubtless require more expensive litigation, and result in more significant settlements and judgments. Thus, although the current system is undoubtedly badly flawed, many companies may well look back on the days of this broken system with nostalgia, and conclude that they were better off before it was “fixed.”
4. Will Item 303 Claims Make a Difference in Securities Class Actions?
The key liability provisions of the federal securities laws, Section 10(b) of the Securities Exchange Act of 1934 and Section 11 of the Securities Act of 1933, both require that plaintiffs establish a false statement, or a statement that is rendered misleading by the omission of facts. Over the last several years, plaintiffs’ lawyers have increasingly tried to bypass this element by asserting claims for pure omissions, detached from any challenged statement.
Plaintiffs base these claims on Item 303 of SEC Regulation S-K, which requires companies to provide a “management’s discussion and analysis” (MD&A) of the company’s “financial condition, changes in financial condition and results of operations.” Item 303(a)(3)(ii) indicates that the MD&A must include a description of “any known trends or uncertainties that have had or that the [company] reasonably expects will have a material … unfavorable impact on net sales or revenues or income from continuing operations.”
Both Section 10(b) and Section 11 prohibit a false statement or omission of a fact that causes a statement to be misleading, while Section 11 also allows a claim based on an issuer’s failure to disclose “a material fact required to be stated” in a registration statement. 15 U.S.C. § 77k(a) (emphasis added). Item 303 is one regulation that lists such “material fact(s) required to be stated.” Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114, 120 (2d Cir. 2012). Based on this unique statutory language, Section 11 claims thus appropriately can include claims based on Item 303.
Last year, in Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2d Cir. 2015), the Second Circuit held that Item 303 also imposes a duty to disclose for purposes of Section 10(b), meaning that the omission of information required by Item 303 can provide the basis for a Section 10(b) claim. This ruling is at odds with the Ninth Circuit’s opinion in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014), in which the court held that Item 303 does not establish such a duty. The U.S. Supreme Court declined a cert petition in NVIDIA.
Claims based on Item 303 seem innocuous enough, and even against plaintiffs’ interest. Plaintiffs face a high hurdle in showing that information was wrongfully excluded under Item 303, since they must show that a company actually knew: (1) the facts underlying the trend or uncertainty, (2) those known facts yield a trend or uncertainty, and (3) the trend or uncertainty will have a negative and material impact. In virtually all cases, these sorts of omitted facts would also render one or more of defendants’ affirmative statements misleading, and thus be subject to challenge regardless. Moreover, in Section 11 cases, Item 303 injects knowledge and causation requirements in a statute that normally doesn’t require scienter and only includes causation as an affirmative defense.
Why, then, have plaintiffs’ counsel pushed Item 303 claims so hard? We believe they’ve done so to combat the cardinal rule that silence, absent a duty to disclose, is not misleading. Companies omit thousands of facts every time they speak, and it is relatively easy for a plaintiff to identify omitted facts – but much more difficult to explain how those omissions rendered an affirmative statement misleading. Plaintiffs likely initially saw these claims as a way to maintain class actions in the event the Supreme Court overruled Basic v. Levinson as a result of attacks in the Amgen and Halliburton cases. And even though the Supreme Court declined to overrule Basic in Halliburton II, the Court’s price-impact rule presents problems for plaintiffs in some cases. As a result, plaintiffs may believe it is in their strategic interests to assert Item 303 claims, which plaintiffs have contended fall under the Affiliated Ute presumption of reliance, rather than under Basic.
But whatever plaintiffs’ rationale, Item 303 is largely a red herring. Although it shouldn’t matter to securities litigation, it will matter, as long as plaintiffs continue to bring such claims. And they probably will continue to bring them, given the current strategic considerations, and the legal footing they have been given by key appellate rulings in Panther Partners and Stratte-McClure. Defense attorneys will have to pay close attention to these trends and mount sophisticated defenses to these claims, to ensure that Item 303 claims do not take on a life of their own.
5. Cyber Security Securities and Derivative Litigation: Will There Be a Wave or Trickle?
One of the foremost uncertainties in securities and corporate governance litigation is the extent to which cyber security will become a significant D&O liability issue. Although many practitioners have been bracing for a wave of cyber security D&O matters, to date there has been only a trickle.
We remain convinced that a wave is coming, perhaps a tidal wave, and that it will include not just derivative litigation, but securities class actions and SEC enforcement matters as well. To date, plaintiffs generally haven’t filed cyber security securities class actions because stock prices have not significantly dropped when companies have disclosed breaches. That is bound to change as the market begins to distinguish companies on the basis of cyber security. There have been a number of shareholder derivative actions asserting that boards failed to properly oversee their companies’ cyber security. Those actions will continue, and likely increase, whether or not plaintiffs file cyber security securities class actions, but they will increase exponentially if securities class action filings pick up.
While the frequency of cyber security shareholder litigation will inevitably increase, we are more worried about its severity, because of the notorious statistics concerning a lack of attention by companies and boards to cyber security oversight and disclosure. Indeed, the shareholder litigation may well be ugly: The more directors and officers are on notice about the severity of cyber security problems, and the less action they take while on notice, the easier it will be for plaintiffs to prove their claims.
We also worry about SEC enforcement actions concerning cyber security. The SEC has been struggling to refine its guidance to companies on cyber security disclosure, trying to balance the concern of disclosing too much and thus providing hackers with a roadmap, with the need to disclose enough to allow investors to evaluate companies’ cyber security risk. But directors and officers should not assume that the SEC will announce new guidance or issue new rules before it begins new enforcement activity in this area. All it takes to trigger an investigation of a particular company is some information that the company’s disclosures were rendered false or misleading by inadequate cyber security. And all it takes to trigger broader enforcement activity is a perception that companies are not taking cyber security disclosure seriously. As in all areas of legal compliance, companies need to be concerned about whistleblowers, including overworked and underpaid IT personnel, lured by the SEC’s whistleblower bounty program, and about auditors, who will soon be asking more frequent and difficult questions about cyber security.
Of course, there are a number of other important issues that deserve to be on watch lists. But given the line we’ve drawn – issues that will cause the most volatility in securities litigation liability exposure – we regard the issues we’ve discussed as the top five.
And the top one – whether lower courts will properly apply Omnicare – is a rare game-changer. If defense counsel understands and uses Omnicare correctly, and if lower courts apply it as the Supreme Court intended, securities litigation decisions will be based on reality, and therefore far fairer and more just. But if either defense counsel or lower courts get it wrong, companies and their directors and officers will suffer outcomes that are less predictable, more arbitrary, and often wrong.
Does Item 303 of Regulation S-K matter in private securities litigation? In Stratte-McClure v. Morgan Stanley, 776 F.3d 94 (2nd Cir. 2015), the Second Circuit held that Item 303 imposes a duty to disclose for purposes of Section 10(b), meaning that the omission of information required by Item 303 can provide the basis for a Section 10(b) claim. This ruling is at odds with the Ninth Circuit’s opinion in In re NVIDIA Corp. Securities Litigation, 768 F.3d 1046 (9th Cir. 2014), in which the court held that Item 303 does not establish such a duty. The U.S. Supreme Court declined a cert petition in NVIDIA.
I’m glad the Supreme Court didn’t take the case, because while this issue seems important, it really isn’t – as a practical matter, a claim under Item 303 doesn’t add much, if anything, to a plain vanilla claim alleging that a statement was misleading for omitting the same information.
Evolution of the Legal Issue
SEC forms, under both the Securities Act and the Exchange Act, require the disclosure of various items described in SEC Regulation S-K. Some of the most important disclosures are found in S-K Item 303(a), which includes “management’s discussion and analysis” (MD&A) of the company’s “financial condition, changes in financial condition and results of operations.” And Item 303(a)(3)(ii) indicates that the MD&A must include a description of “any known trends or uncertainties that have had or that the [company] reasonably expects will have a material … unfavorable impact on net sales or revenues or income from continuing operations.” This is a high hurdle for a plaintiff to clear: a company must actually know: (1) the facts underlying the trend or uncertainty, (2) those known facts yield a trend or uncertainty, and (3) the trend or uncertainty will have a negative and material impact.
The key liability provisions of the federal securities laws, Section 10(b) of the Securities Exchange Act of 1934 and Section 11 of the Securities Act of 1933, prohibit a false statement or omission of a fact that causes a statement to be misleading. In addition, the text of Section 11 allows a claim to be based on the issuer’s failure to disclose “a material fact required to be stated” in a registration statement. 15 U.S.C. § 77k(a) (emphasis added). One such requirement is Item 303. Panther Partners Inc. v. Ikanos Communications, Inc., 681 F.3d 114, 120 (2nd Cir. 2012). Based on this statutory language – which is unique to Section 11 – Section 11 claims thus appropriately can include claims based on Item 303.
Panther Partners is the decision that has fueled plaintiffs’ counsel’s use of Item 303. In Panther Partners, the Second Circuit held that Item 303 required the issuer, Ikanos Communications, to disclose information about a high product defect rate, and that the omission of this information from a registration statement gave rise to a cause of action under Section 11. There are two important facets of the decision that have largely been forgotten. First, the court emphasized Section 11’s language, which isn’t present in the statute or decisions under Section 10(b), that an issuer must disclose “a material fact required to be stated” in a registration statement. Second, the court was troubled by the fact that the company’s risk factor about product defects suggested there were no defects when, in fact, there were:
In light of these allegations, the Registration Statement’s generic cautionary language that “[h]ighly complex products such as those that [Ikanos] offer[s] frequently contain defects and bugs” was incomplete and, consequently, did not fulfill Ikanos’s duty to inform the investing public of the particular, factually-based uncertainties of which it was aware in the weeks leading up to the Secondary Offering.
Id.at 122. I could make a strong argument that the driver of the court’s decision was a false or misleading risk factor, and Item 303 was just the way the court articulated its conclusion. As I’ve written, courts are often troubled by boilerplate risk factors, especially those that cast as hypothetical risks that have materialized.
In NVIDIA, plaintiffs alleged that several of NVIDIA’s SEC filings contained materially false and misleading statements because they omitted information relating to a defect in NVIDIA’s graphics processing unit (“GPU”) chips. Plaintiffs also argued that certain omissions in filing statements were actionable under Section 10(b) because the chip defects constituted a “known trend” under Item 303 – but did not present this theory in the complaint itself.
The district court found that plaintiffs had pled “at least one” material misrepresentation – a risk factor saying that defects “might occur,” which falsely suggested that NVIDIA was not already aware of the same defect in other products. The district court did not inquire into whether any of the other specific statements were also materially misleading. Nonetheless, the district court dismissed the complaint on the ground that plaintiffs had failed to plead scienter. The district court opinion only mentioned Item 303 briefly, as it was not (yet) a centerpiece of plaintiffs’ theory.
Before the Ninth Circuit, plaintiffs argued that the district court should have considered scienter in the context of Item 303, focusing on whether defendants had acted with scienter in violating that rule. The Ninth Circuit rejected this line of argument on the ground that Item 303 does not establish an independent duty of disclosure for the purposes of Section 10(b). The Ninth Circuit did not consider whether plaintiffs had successfully pled a material misrepresentation (as the district court had found), focusing instead on scienter, and affirming the district court’s judgment on this ground.
Shortly thereafter, the Second Circuit, in Stratte-McClure, held that Item 303 does establish an independent duty of disclosure for purposes of Section 10(b). The court began with the cardinal rule that silence, absent a duty to disclose, is not actionable, and such a duty is created when a company omits facts that make a statement misleading. 768 F.3d at 101-02. The court then grappled with whether omission of facts required to be disclosed under Item 303 creates a duty of disclosure for purposes of Section 10(b). In analyzing this issue, the court relied on the Panther Partners holding, though the court compared Section 10(b)’s requirements to Section 12(a)(2) of the 1933 Act, which does not contain Section 11’s unique statutory language, i.e., Section 11 makes actionable not just a false or misleading statement, but also a failure to disclose “a material fact required to be stated” in a registration statement.
The court’s comparison of Section 10(b) to Section 12(a)(2) instead of to Section 11 resulted in a large legal leap. The court in Panther Partners stated that “[o]ne of the potential bases for liability under §§ 11 and 12(a)(2) is an omission in contravention of an affirmative legal disclosure obligation” (i.e. making actionable the omission of “a material fact required to be stated” in a registration statement). 681 F.3d at 120. But, in fact, only Section 11, and not Section 12(a)(2), contains that provision. Instead, Section 12(a)(2), like Section 10(b), imposes liability for a false or misleading statement, and doesn’t contain the alternative basis of liability for a failure to disclose “a material fact required to be stated ….” As a result, Stratte-McClure doesn’t fairly portray the rationale for the holding in Panther Partners.
Nevertheless, the court in Stratte-McClure supplied a separate basis, grounded in Section 10(b)’s requirement of a false or misleading statement, for concluding that Item 303 supplies a duty to disclose that can be actionable under Section 10(b):
Due to the obligatory nature of [Item 303], a reasonable investor would interpret the absence of an Item 303 disclosure to imply the nonexistence of “known trends or uncertainties … that the registrant reasonably expects will have a material … unfavorable impact on … revenues or income from continuing operations.” … It follows that Item 303 imposes the type of duty to speak that can, in appropriate cases, give rise to liability under Section 10(b).
776 F.3d at 102 (citations omitted). In other words, a company that fails to disclose information required to be disclosed by Item 303 has misled investors by creating an impression of a state of affairs (that there are no materially negative trends or uncertainties) that differs from the one that actually exists (that there are such trends or uncertainties). Thus, what the court implicitly held is that an Item 303 omission makes the whole set of the company’s affirmative statements misleading.
Item 303’s Lack of Practical Impact
The Item 303 issue is certainly interesting. My colleagues and I have had lively discussions about the questions it raises. But we keep concluding that it doesn’t really add anything.
We first reached this conclusion in a roundabout way in a case a few years ago. There were two offerings at issue, and just after Panther Partners, plaintiffs’ counsel featured the Item 303 allegations. We drafted a detailed motion to dismiss section on the Item 303 issue. As we evaluated our arguments in light of the page limit, we kept shortening the Item 303 argument. In the end, we decided that the Item 303 claim was redundant: the court wasn’t going to deny the motion to dismiss under Item 303 without also finding that the plaintiffs had sufficiently pleaded a false statement and scienter, because the plaintiffs challenged many statements and pleaded scienter using the same allegations that formed the basis of the Item 303 claim. So in the filed version of the motion, the argument became a fraction of the size of the original one. And in the reply brief, the Item 303 argument was in a short footnote.
Since then, the plaintiffs’ bar’s focus on the issue, and various court decisions, and even a cert petition, have kept me re-thinking the importance of Item 303 to securities claims. But I haven’t changed my view that Item 303 is redundant: very rarely, if ever, would there be an omitted fact that gives rise to an Item 303 claim without also rendering false or misleading one or more challenged statements; and the knowledge required under Item 303 is at least as great as is necessary to establish scienter. Even under Section 11, where the unique statutory language allows for a claim, Item 303’s multiple knowledge requirements, if appropriately applied, make the claim difficult to plead and prove.
The NVIDIA case provides a good illustration. Recall that the plaintiffs alleged that NVIDIA made false statements related to a defect in its GPU chips, and argued that the chip defects constituted a known trend under Item 303. The complaint challenged many statements, and the district court concluded that “at least one” was misleading as a result of the defects:
* “Our core businesses are continuing to grow as the GPU becomes increasingly central to today’s computing experience in both the consumer and professional market segments.”
* “Fiscal 2008 was another outstanding and record year for us. Strong demand for GPUs in all market segments drove our growth. Relative to Q4 one year ago, our discrete GPU business grew 80%.”
* “As we have in the past, we intend to use this [R&D] strategy to achieve new levels of graphics, networking and communications features and performance and ultra-low power designs, enabling our customers to achieve superior performance in their products.”
* “[W]e believe that close relationships with OEMs, ODMs and major system builders will allow us to better anticipate and address customer needs with future generations of our products.”
* “The growth of GPUs continues to outpace the PC market. We shipped 42 percent more GPUs this quarter compared to the same period a year ago, resulting in our best first quarter ever. … We expect this positive feedback loop to continue to drive our growth.”
* “In the past, we have discovered defects and incompatibilities with customers’ hardware in some of our products. Similar issues in the future may result in delays or loss of revenue to correct any defects or incompatibilities.”
* “If our products contain significant defects our financial results could be negatively impacted, our reputation could be damaged and we could lose market share.”
* In a statement disclosing the defects: “We are evaluating the potential scope of this situation, including the nature and cause of the alleged defect and the merits of the customer’s claim, and to what extent the alleged defect might occur with other of our products.”
This list of challenged statements illustrates that companies affirmatively say many things on the subject matter of an omission sufficient to yield an Item 303 claim. Indeed, it’s hard to imagine a case in which an issue is so major as to require Item 303 disclosure but isn’t something about which the company has spoken.
And given that is the case, and Item 303’s disclosure requirements are infused with knowledge requirements, it also would be an anomalous case in which there is an Item 303 violation but not scienter. For example, if a company violates Item 303 by not disclosing that its biggest customer is switching suppliers next quarter, and proceeds to say things about its business and financial outlook as it of course would, it has made misleading statements with intent to defraud. The Item 303 claim adds nothing. Stratte-McClure, on its face, is an anomalous case. After concluding that Morgan Stanley had a duty to disclose certain facts about subprime lending that were likely to cause material trading losses, the court concluded that the failure to disclose those facts wasn’t done with scienter. The analysis is fact-specific and technical. Suffice it to say that I could easily re-write the opinion, using the court’s own scienter analysis, to conclude that no disclosure was required under Item 303 in the first place – it’s really a matter of six of one, half a dozen of another.
Why, then, have plaintiffs’ counsel pushed Item 303 claims so hard? I believe it’s mostly to combat the cardinal rule that silence, absent a duty to disclose, is not misleading. Companies omit thousands of facts every time they speak, and it’s relatively easy for a plaintiff to identify omitted facts – but it’s analytically difficult work, and often unsuccessful, to challenge affirmative statements.
Another important reason is defendants’ attack on the fraud on the market presumption of reliance over the past several years – first to the legitimacy of Basic v. Levinson, which gave rise to securities class actions, and now to its viability in specific cases under the price-impact rule of Halliburton II. Claims of pure omission under Item 303 arguably would fall under the Affiliated Ute presumption of reliance, rather than under Basic, which would make class certification easier and more certain. But the court’s reasoning in Stratte-McClure that an Item 303 violation makes what the company said misleading would make the claim a statement-based claim that would be evaluated under Basic, not Affiliated Ute.
Whatever the reason, I hope parties and courts don’t waste time litigating over Item 303 further. It just doesn’t matter.
This year will be remembered as the year of the Super Bowl of securities litigation, Halliburton Co. v. Erica P. John Fund, Inc. (“Halliburton II”), 134 S. Ct. 2398 (2014), the case that finally gave the Supreme Court the opportunity to overrule the fraud-on-the-market presumption of reliance, established in 1988 in Basic v. Levinson.
Yet, for all the pomp and circumstance surrounding the case, Halliburton II may well have the lowest impact-to-fanfare ratio of any Supreme Court securities decision, ever. Indeed, it does not even make my list of the Top 5 most influential developments in 2014 – developments that foretell the types of securities and corporate-governance claims plaintiffs will bring in the future, how defendants will defend them, and the exposure they present.
Topping my Top 5 list is a forthcoming Supreme Court decision in a different, less-heralded case – Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund. Despite the lack of fanfare, Omnicare likely will have the greatest practical impact of any Supreme Court securities decision since the Court’s 2007 decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007). After discussing my Top 5, I explain why Halliburton II does not make the list.
5. City of Providence v. First Citizens BancShares: A Further Step Toward Greater Scrutiny of Meritless Merger Litigation
In City of Providence v. First Citizens BancShares, 99 A.3d 229 (Del. Ch. 2014), Chancellor Bouchard upheld the validity of a board-adopted bylaw that specified North Carolina as the exclusive forum for intra-corporate disputes of a Delaware corporation. The ruling extended former Chancellor Strine’s ruling last year in Boilermakers Local 154 Retirement Fund v. Chevron, 73 A.3d 934 (Del Ch. 2013), which validated a Delaware exclusive-forum bylaw. These types of bylaws largely are an attempt to bring some order to litigation of shareholder challenges to corporate mergers and other transactions.
Meritless merger litigation is a big problem. Indiscriminate merger litigation is a slap in the face to careful directors who have worked hard to understand and approve a merger, or to CEOs who have spent many months or years working long hours to locate and negotiate a transaction in the shareholders’ best interest. It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally. And we know the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.
Two years ago, I advocated for procedures requiring shareholder lawsuits to be brought in the company’s state of incorporation. Exclusive state-of-incorporation litigation would attack the root cause of the merger-litigation problem: the inability to consolidate cases and subject them to a motion to dismiss early enough to obtain a ruling before negotiations to achieve settlement before the transaction closes must begin. Although the problem is virtually always framed in terms of the oppressive cost and hassle of multi-forum litigation, good defense counsel can usually manage the cost and logistics. Instead, the bigger problem, and the problem that causes meritless merger litigation to exist, is the inability to obtain dismissals. This is primarily so because actions filed in multiple forums can’t all be subjected to a timely motion to dismiss, and a dismissal in one forum that can’t timely be used in another forum is a hollow victory. If there were a plenary and meaningful motion-to-dismiss process, less-meritorious cases would be weeded out early, and plaintiffs’ lawyers would bring fewer meritless cases. The solution is that simple.
Exclusive litigation in Delaware for Delaware corporations is preferable, because of Delaware’s greater experience with merger litigation and likely willingness to weed out meritless cases at a higher rate. But the key to eradicating meritless merger litigation is consolidation in some single forum, and not every Delaware corporation wishes to litigate in Delaware. So I regard First Citizens’ extension of Chevron to a non-Delaware exclusive forum as a key development.
4. SEC v. Citigroup: The Forgotten Important Case
On June 4, 2014, in SEC v. Citigroup, 752 F.3d 285 (2d Cir. 2014), the Second Circuit held that Judge Rakoff abused his discretion in refusing to approve a proposed settlement between the SEC and Citigroup that did not require Citigroup to admit the truth of the SEC’s allegations. Judge Rakoff’s decision set off a series of events that culminated in the ruling on the appeal, about which people seemed to have forgotten because of the passage of time and intervening events.
Once upon a time, way back in 2012, the SEC and Citigroup settled the SEC’s investigation of Citigroup’s marketing of collateralized debt obligations. In connection with the settlement, the SEC filed a complaint alleging non-scienter violations of the Securities Act. The same day, the SEC also filed a proposed consent judgment, enjoining violations of the law, ordering business reforms, and requiring the company to pay $285 million. As part of the consent judgment, Citigroup did not admit or deny the complaint’s allegations. Judge Rakoff held a hearing to determine “whether the proposed judgment is fair, reasonable, adequate, and in the public interest.” In advance, the court posed nine questions, which the parties answered in detail. Judge Rakoff rejected the consent judgment.
The rejection order rested, in part, on the court’s determination that any consent judgment that is not supported by “proven or acknowledged facts” would not serve the public interest because:
- the public would not know the “truth in a matter of obvious public importance”, and
- private litigants would not be able to use the consent judgment to pursue claims because it would have “no evidentiary value and no collateral estoppel effect”.
The SEC and Citigroup appealed. While the matter was on appeal, the SEC changed its policy to require admissions in settlements “in certain cases,” and other federal judges followed Judge Rakoff’s lead and required admissions in SEC settlements. Because of the SEC’s change in policy, many people deemed the appeal unimportant. I was not among them; the Second Circuit’s decision remained of critical importance, because the extent to which the SEC insists on admissions will depend on the amount of deference it receives from reviewing courts – which was the issue before the Second Circuit. It stands to reason that the SEC would have insisted on more admissions if courts were at liberty to second-guess the SEC’s judgment to settle without them. Greater use of admissions would have had extreme and far-reaching consequences for companies, their directors and officers, and their D&O insurers.
So it was quite important that the Second Circuit held that the SEC has the “exclusive right” to decide on the charges, and that the SEC’s decision about whether the settlement is in the public interest “merits significant deference.”
3. Wal-Mart Stores, Inc. v. Indiana Elec. Workers Pension Trust Fund IBEW: Delaware Supreme Court’s Adoption of the Garner v. Wolfinbarger “Fiduciary” Exception to the Attorney-Client Privilege Further Encourages Use of Section 220 Inspection Demands
On July 23, 2014, the Delaware Supreme Court adopted the fiduciary exception to the attorney-client privilege, which originated in Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970), and held that stockholders who make a showing of good cause can inspect certain privileged documents. Although this is the first time the Delaware Supreme Court has expressly adopted Garner, it had previously tacitly adopted it, and the Court of Chancery had expressly adopted it in Grimes v. DSC Communications Corp., 724 A.2d 561 (Del. Ch. 1998).
In my view, the importance of Wal-Mart is not so much in its adoption of Garner – given its previous tacit adoption – but instead is in the further encouragement it gives stockholders to use Section 220. Delaware courts for decades have encouraged stockholders to use Section 220 to obtain facts before filing a derivative action. Yet the Delaware Supreme Court, in the Allergan derivative action, Pyott v. Louisiana Municipal Police Employees’ Retirement System (“Allergan”), 74 A.3d 612 (Del. 2013), passed up the opportunity to effectively require pre-litigation use of Section 220. In Allergan, the court did not adopt Vice Chancellor Laster’s ruling that the plaintiffs in the previously dismissed litigation, filed in California, provided “inadequate representation” to the corporation because, unlike the plaintiffs in the Delaware action, they did not utilize Section 220 to attempt to determine whether their claims were well-founded. Upholding the Court of Chancery’s presumption against fast-filers would have strongly encouraged, if not effectively required, shareholders to make a Section 220 demand before filing a derivative action.
In Wal-Mart, however, the Delaware Supreme Court provided the push toward Section 220 that it passed up in Allergan. Certainly, expressly adopting Garner will encourage plaintiffs to make more Section 220 demands. That should cause plaintiffs to conduct more pre-filing investigations, which will decrease filings to some extent. But increased use of 220 also means that the cases that are filed will be more virulent, because they are selected with more care, and are more fact-intensive – and thus tend to be more difficult to dispose of on a motion to dismiss.
2. City of Livonia Employees’ Retirement System v. The Boeing Company: Will Defendants Win the Battle but Lose the War?
On August 21, 2014, Judge Ruben Castillo of the Northern District of Illinois ordered plaintiffs’ firm Robbins Geller Rudman & Dowd to pay defendants’ costs of defending a securities class action, as Rule 11 sanctions for “reckless and unjustified” conduct related to reliance on a confidential witness (“CW”) whose testimony formed the basis for plaintiffs’ claims. 2014 U.S. Dist. LEXIS 118028 (N.D. Ill. Aug. 21, 2014).
I imagine that some readers may believe that, as a defense lawyer, I’m including this development because one of my adversaries suffered a black eye. That’s not the case at all. Although I’m not in a position to opine on the merits of the Boeing CW matter, I can say that I genuinely respect Robbins Geller and other top plaintiffs’ firms. And beware those who delight in the firm’s difficulties: few lawyers who practice high-stakes litigation at a truly high level will escape similar scrutiny at some point in a long career.
But beyond that sentiment, I have worried about the Boeing CW problem, as well as similar problems in the SunTrust and Lockheed cases, because of their potential to cause unwarranted scrutiny of the protections of the Private Securities Litigation Reform Act. I believe the greatest risk to the Reform Act’s protections has always been legislative backlash over a perception that the Reform Act is unfair to investors. The Reform Act’s heavy pleading burdens have caused plaintiffs’ counsel to seek out former employees and others to provide internal information. The investigative process is often difficult and is ethically tricky, and the information it generates can be lousy. This is so even if plaintiffs’ counsel and their investigators act in good faith – information can be misunderstood, misinterpreted, and/or misconstrued by the time it is conveyed from one person to the next to the next to the next. And, to further complicate matters, CWs sometimes recant, or even deny, that they made the statements on which plaintiffs rely. The result can be an unseemly game of he-said/she-said between CWs and plaintiffs’ counsel, in which the referee is ultimately an Article III judge. At some point, Congress will step in to reform this process.
Judge Rakoff seemed to call for such reform in his post-dismissal order in the Lockheed matter:
The sole purpose of this memorandum … is to focus attention on the way in which the PSLRA and decisions like Tellabs have led plaintiffs’ counsel to rely heavily on private inquiries of confidential witnesses, and the problems this approach tends to generate for both plaintiffs and defendants. It seems highly unlikely that Congress or the Supreme Court, in demanding a fair amount of evidentiary detail in securities class action complaints, intended to turn plaintiffs’ counsel into corporate ‘private eyes’ who would entice naïve or disgruntled employees into gossip sessions that might help support a federal lawsuit. Nor did they likely intend to place such employees in the unenviable position of having to account to their employers for such indiscretions, whether or not their statements were accurate. But as it is, the combined effect of the PSLRA and cases like Tellabs are likely to make such problems endemic.
Rather than tempt Congress to revisit the Reform Act’s protections (which defendants should want to avoid) and/or allow further unseemly showdowns (which plaintiffs and courts should want to avoid), plaintiffs, defendants, and courts can begin to reform the CW process through some basic measures, including requiring declarations from CWs, requiring them to read and verify the complaint’s allegations citing them, and requiring plaintiffs to plead certain information about their CWs. As I’ve previously written, these reforms would have prevented the problems at issue in the Boeing, SunTrust, and Lockheed matters, and would result in more just outcomes in all cases.
1. Omnicare: In My Opinion, the Most Important Supreme Court Case Since Tellabs
Omnicare concerns what makes a statement of opinion false. Opinions are ubiquitous in corporate communications. Corporations and their officers routinely share subjective judgments on issues as diverse as asset valuations, strength of current performance, risk assessments, product quality, loss reserves, and progress toward corporate goals. Many of these opinions are crucial to investors, providing them with unique information and insight. If corporate actors fear liability for sharing their genuinely held beliefs, they will be reluctant to voice their opinions, and shareholders would be deprived of this vital information.
The standard that the federal securities laws use to determine whether an opinion is “false” is therefore of widespread importance. Although this case only involves Section 11, it poses a fundamental question: What causes an opinion or belief to be a “false statement of material fact”? The Court’s answer will affect the standards of pleading and proof for statements of opinion under other liability provisions of the federal securities laws, including Section 10(b), which likewise prohibit “untrue” or “false” statements of “material fact.”
In the Sixth Circuit decision under review, the court held that a showing of so-called “objective falsity” alone was sufficient to demonstrate falsity in a claim filed under Section 11 of the Securities Act – in other words, that an opinion could be false even if was genuinely believed, if it was later concluded that the opinion was somehow “incorrect.” On appeal, Omnicare contends, as did we in our amicus brief on behalf of the Washington Legal Foundation (“WLF”), that this ruling was contrary to the U.S. Supreme Court’s decision in Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1095 (1991). Virginia Bankshares held that a statement of opinion is a factual statement as to what the speaker believes – meaning a statement of opinion is “true” as long as the speaker honestly believes the opinion expressed, i.e., if it is “subjectively” true.
Other than a passing and unenthusiastic nod made by plaintiffs’ counsel in defense of the Sixth Circuit’s reasoning, the discussion at the oral argument assumed that some showing other than so-called “objective falsity” would be required to establish the falsity of an opinion. Most of the argument by Omnicare, the plaintiffs, and the Solicitor General revolved around what this additional showing should be, as did the extensive and pointed questions from Justices Breyer, Kagan, and Alito.
It thus seems unlikely from the tone of the argument that the Court will affirm the Sixth Circuit’s holding that an opinion is false if it is “objectively” untrue. If the pointed opening question from Chief Justice Roberts is any indication, the Court also may not fully accept Omnicare’s position, which is that an opinion can only be false or misleading if it was not actually believed by the speaker. It seems more probable that the Supreme Court will take one of two middle paths – one that was advocated by the Solicitor General at oral argument, essentially a “reasonable basis” standard, or one that was advanced in our brief for the WLF, under which a statement of opinion is subjected to the same sort of inquiry about whether it was misleading as for any other statement. Under WLF’s proposed standard, plaintiffs would be required to demonstrate either that an opinion was false because it was not actually believed, or that omitted facts caused the opinion – when considered in the full context of the company’s other disclosures – to be misleading because it “affirmatively create[d] an impression of a state of affairs that differs in a material way from the one that actually exists.” Brody v. Transitional Hosps. Corp., 280 F.3d 997, 1006 (9th Cir. 2002).
Such a standard would be faithful to the text of the most frequently litigated provisions of the federal securities laws – Section 11, at issue in Omnicare, and Section 10(b) – which allow liability for statements that are either false or that omit material facts “required to be stated therein or necessary to make the statements therein not misleading . . . .” At the same time, this standard would preserve the commonsense holding of Virginia Bankshares – that an opinion is “true” if it is genuinely believed – and prevent speakers from being held liable for truthfully expressed opinions simply because someone else later disagrees with them.
Why Halliburton II is Not a Top-5 Development
After refusing to overrule Basic, the Halliburton II decision focused on defendants’ fallback argument that plaintiffs must show that the alleged misrepresentations had an impact on the market price of the stock, as a prerequisite for the presumption of reliance. The Court refused to place on plaintiffs the burden of proving price impact, but agreed that a defendant may rebut the presumption of reliance, at the class certification stage, with evidence of lack of price impact.
Halliburton II has a narrow reach. The ruling only affects securities class actions that have survived a motion to dismiss – class certification is premature before then. It wouldn’t be economical to adjudicate class certification while parties moved to dismiss under Rule 12(b)(6) and the Reform Act, and adjudicating class certification before rulings on motions to dismiss could result in defendants waiving their right to a discovery stay under the Reform Act. Moreover, most securities class actions challenge many statements during the class period. Although there could be strategic defense benefit to obtaining a ruling that a subset of the challenged statements did not impact the stock price – for example, shortening the class period or dismissing especially awkward statements – a finding that some statements had an impact would support certification of some class, and thus would allow the case to proceed.
Defendants face legal and economic hurdles as well. For example, in McIntire v. China MediaExpress Holdings, Inc., 2014 U.S. Dist. LEXIS 113446, *40 (S.D.N.Y. Aug. 15, 2014), the court held that a “material misstatement can impact a stock’s value either by improperly causing the value to increase or by improperly maintaining the existing stock price.” Under this type of analysis, even if a challenged statement does not cause the stock price to increase, it may have kept the stock price at the same artificially inflated level, and thus impacted the price. Plaintiff-friendly results were predictable from experience in the Second and Third Circuits before the Supreme Court’s rulings in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), and Halliburton II. Despite standards for class certification that allowed defendants to contest materiality and price impact, defendants seldom defeated class certification.
Halliburton II may also be unnecessary; it is debatable whether the decision even gives defendants a better tool with which to weed out cases that suffer from a price-impact problem. For example, cases that suffer from a price-impact problem typically also suffer from some other fatal flaw, such as the absence of loss causation or materiality. Indeed, the price-impact issue in Halliburton was based on evidence about the absence of loss causation.
Yet defendants no doubt will frequently oppose class certification under Halliburton II. But they will do so at a cost beyond the economic cost of the legal and expert witness work: they will lose the ability to make no-price-impact arguments in settlement discussions in the absence of a ruling about them. Now, defendants will make and obtain rulings on class certification arguments that they previously could have asserted would be resolved in their favor at summary judgment or trial, if necessary. Plaintiffs will press harder for higher settlements in cases with certified classes.
In addition to Halliburton II, there were many other important 2014 developments in or touching on the world of securities and corporate governance litigation, including: rare reversals of securities class action dismissals in the Fifth Circuit, Spitzberg v. Houston American Energy Corp., 758 F.3d 676 (5th Cir. 2014), and Public Employees’ Retirement System of Mississippi v. Amedisys, Inc., 769 F.3d 313 (5th Cir. 2014); the filing of cybersecurity shareholder derivative cases against Target (pending) and Wyndham (dismissed); a trial verdict against the former CFO of a Chinese company, Longtop Financial Technologies; the Second Circuit’s significant insider trading decision, United States v. Newman, — F.3d —, 2014 U.S. App. LEXIS 23190 (2d Cir. Dec. 10, 2014); increasingly large whistleblower bounties, including a $30 million award; the Supreme Court’s SLUSA decision in Chadbourne & Parke LLP v. Troice, 134 S. Ct. 1058 (2014); the Delaware Supreme Court’s ruling on a fee-shifting bylaw in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), and the resulting legislative debate in Delaware and elsewhere; the Supreme Court’s ERISA decision in Fifth Third Bancorp v. Dudenhoeffer, 134 S. Ct. 2459 (2014); the Ninth Circuit’s holding that the announcement of an internal investigation, standing alone, is insufficient to establish loss causation, Loos v. Immersion Corp., 762 F.3d 880 (9th Cir. 2014); the Ninth Circuit’s rejection of Item 303 of Regulation S-K as the basis of a duty to disclose for purposes of a claim under Section 10(b), In re NVIDIA Corp. Sec. Litig., 768 F.3d 1046 (9th Cir. 2014); and the Ninth Circuit’s holding that Rule 9(b) applies to loss-causation allegations, Oregon Public Employees Retirement Fund v. Apollo Group Inc., — F.3d —, 2014 U.S. App. LEXIS 23677 (9th Cir. Dec. 16, 2014).
Yesterday’s Supreme Court decision in Halliburton Co. v. Erica P. John Fund, Inc. (Halliburton II) may well have the lowest impact-to-fanfare ratio of any Supreme Court securities decision. Despite the social-media-fueled frenzy within the securities bar leading up to the decision, the Court’s decision will effect little change in class certification law and practice in most securities class actions.
Most of the fanfare concerned whether the Court would overrule the fraud-on-the-market presumption of reliance established in its 1988 decision in Basic v. Levinson. But the Court refused to overrule Basic. Instead, the core of the Halliburton II decision focused on defendants’ fallback argument that plaintiffs must show that the alleged misrepresentations had impact on the market price of the stock, as prerequisite for the presumption of reliance. The Court refused to place on plaintiffs the burden of proving price impact, but agreed that a defendant may rebut the presumption of reliance at the class certification stage, with evidence of lack of price impact.
The Court’s ruling, which in the lead-up to the decision has been called the “middle ground” between overruling Basic or affirming the Fifth Circuit, is a well-reasoned decision, and reaches a good practical result. Overruling Basic would have led to a securities-litigation train wreck. Affirming the Fifth Circuit would have been legally dubious. But the legal middle ground of allowing a defendant to demonstrate a lack of price impact captures class-certification arguments that defendants have been making for many years, although they have often been framed as arguments about materiality or loss causation. Thus, the Court’s ruling allows defense attorneys to contest the right issue on class certification, by demonstrating that the market just didn’t care about the challenged information. Although I believe the ruling will not have an impact on the merits of most cases, it sets up an analytically sound framework for addressing arguments that did not fit well in other doctrinal buckets.
And, for those of us who litigate securities class actions full time, the Court’s decision to revisit Basic set up the Super Bowl of securities litigation. The road to Halliburton II was long. I trace it below, before discussing and analyzing Halliburton II. (Kevin LaCroix’s post on Halliburton II in The D&O Diary contains a good discussion of the background and issues as well.)
The Fraud-on-the-Market Presumption: From Basic to Halliburton I to Amgen to Halliburton II
All of the Halliburton hubbub is about reliance, which is an essential element of a Section 10(b) claim. Absent some way to harmonize individual issues of reliance, class treatment of a securities class action is not possible; individual issues would overwhelm common ones, precluding certification under Federal Rule of Civil Procedure 23(b)(3). In Basic, the Supreme Court provided a solution: a rebuttable presumption of reliance based on the fraud-on-the-market theory, which provides that a security traded on an efficient market reflects all public material information. Purchasers (or sellers) rely on the integrity of the market price, and thus on a material misrepresentation. Decisions following Basic have established three conditions to its application: market efficiency, a public misrepresentation, and a purchase (or sale) between the misrepresentation and the disclosure of the “truth.”
Over the years, defendants have argued that, absent a showing by plaintiffs that the challenged statements were material, or upon a showing by defendants that they were not, the presumption is not applicable or has been rebutted. And, in a twist on such arguments, defendants sometimes argued that the absence of loss causation rebutted the presumption. In Erica P. John Fund, Inc. v. Halliburton Co. (Halliburton I), the Supreme Court unanimously rejected loss causation as a condition of the presumption of reliance.
In Halliburton I, the defendants did not dispute that proof of loss causation is not required for the fraud-on-the-market presumption to apply. Instead, they argued to the Supreme Court that, although the Fifth Circuit ruled on loss-causation grounds, it really ruled that the absence of loss causation means that the challenged statements were not material because the challenged statements did not impact the price of Halliburton’s stock, and a lack of materiality defeats the application of the presumption. The Supreme Court disagreed: “Whatever Halliburton thinks the Court of Appeals meant to say, what it said was loss causation: ‘[EPJ Fund] was required to prove loss causation, i.e., that the corrected truth of the former falsehoods actually caused the stock price to fall and resulted in the losses.’ . . . . We take the Court of Appeals at its word. Based on those words, the decision below cannot stand.”
But the Court explicitly left the door open for the argument that plaintiffs must prove materiality for the presumption of reliance to apply. Later, the Court granted certiorari in Amgen Inc. v. Connecticut Retirement Plans to review the Ninth Circuit’s decision that plaintiffs are not required to prove materiality for the presumption to apply, and that the district court is not required to allow defendants to present evidence rebutting the applicability of the presumption before certifying a class.
In a majority opinion authored by Justice Ginsburg, and joined by Chief Justice John Roberts and Justices Breyer, Alito, Sotomayor, and Kagan, the Amgen Court concluded that proof of materiality was not necessary to demonstrate, as Rule 23(b)(3) requires, that questions of law or fact common to the class will “predominate over any questions affecting only individual members.” The Court reasoned that this was because: 1) materiality was judged according to an objective standard that could be proven through evidence common to the class, and 2) a failure to prove materiality would not just defeat an attempt to certify a class, it would also defeat all of individual claims, because it is an essential element to a claim under Section 10(b).
The majority’s conclusion was dubious. Its chief flaw was its avoidance of the central question through circular reasoning. The materiality of a statement is an essential prerequisite for the application of the fraud-on-the market presumption that the Court developed in Basic, as a device to overcome the need to prove actual, individual reliance. In Basic, the Court used then-emerging economic theory to create a rebuttable presumption of reliance, based on the assumption that a security traded in an efficient market reflects all public material information, and that traders in that market rely on the market price, and thus on any material misrepresentations that are reflected in the price. The Amgen Court did not dispute that the materiality of a misrepresentation is necessary to create the fraud-on-the-market presumption, nor that the fraud-on-the-market presumption is essential to show under Rule 23 that common questions predominate for the class.
Instead, to avoid the logical conclusion that a showing of materiality was thus necessary to certify the class, the Court reasoned backwards: because plaintiffs must also show the materiality of the alleged misstatements in order to prove the underlying merits of a Section 10(b) claim, a finding that there was no materiality would defeat claims for all plaintiffs, whether brought as a class or individually. Therefore, the Court concluded, materiality (or the lack of it) was a “common question,” that should not be decided until summary judgment, or theoretically, trial.
The holding was properly subject to wide criticism, but the criticism was quickly displaced by intrigue. The Court’s opinions signaled a willingness to re-evaluate Basic, with four votes already supporting the view that the decision was “questionable,” and the other five failing to come to its defense. In addition, as I wrote following the Amgen argument, the justices seemed intrigued by Amgen’s argument that market efficiency depends on the type of specific information at issue.
The Holding in Halliburton II
That leads us back to Halliburton II. As Amgen was being litigated in the Supreme Court, the parties in Halliburton were briefing the plaintiffs’ class certification motion on remand. The district court certified a class, prior to the Supreme Court’s decision in Amgen. Halliburton sought and obtained Rule 23(f) certification from the Fifth Circuit, which affirmed, after the Supreme Court decided Amgen.
The Fifth Circuit held that a price-impact inquiry is more analogous to materiality than it is to the permissible prerequisites to the fraud-on-the-market presumption (market efficiency and a public misrepresentation). Based upon that view, the Fifth Circuit reasoned that while price impact is not an element, as is materiality, “a plaintiff must nevertheless prevail on this fact in order to establish loss causation.” Thus, “if Halliburton were to successfully rebut the fraud-on-the-market presumption by proving no price impact, the claims of all individual plaintiffs would fail because they could not establish an essential element of the action.” Because the Fifth Circuit believed that the absence of price impact would doom all individual claims, it concluded that price impact is not relevant to common-issue predominance and is therefore not relevant at class certification.
The Supreme Court vacated the Fifth Circuit’s decision and remanded with the decision issued yesterday. The Court’s opinion is remarkably straightforward. First, the Court refused to overrule Basic. The Court rejected Halliburton’s argument that Basic is inconsistent with modern economic theory, under which market efficiency is not a binary “yes or no” issue, finding that “Halliburton’s criticisms fail to take Basic on its own terms.” Halliburton II at 9. According to the Halliburton II Court, the Basic Court expressly refused to enter into such economic debate and instead “based the presumption on the fairly modest premise that market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.” Basic “thus does not rest on a “binary’ view of market efficiency.” Indeed, in “making the presumption rebuttable, Basic recognized that market efficiency is a matter of degree and accordingly made it a matter of proof.” Id. at 10.
Second, the Court rejected Halliburton’s argument that trading that is based on factors other than price undermines Basic’s premise that purchasers and sellers invest in reliance on the integrity of the market price. The Court held that “Basic never denied the existence” of investors that believe that the market price does not fully reflect public information, and, in any event, surmised that such investors do indeed “implicitly” rely on the integrity of the market price.
Third, the Court found that the presumption of reliance does not conflict with Rule 23 or the Court’s recent decisions ratcheting up the degree of proof at class certification: “Basic does not, in other words, allow plaintiffs simply to plead that common questions of reliance predominate over individual ones, but rather sets forth what they must prove to demonstrate such predominance.” Id. at 14.
Finally, the Court found that Halliburton’s concerns about the “serious and harmful consequences” that the Basic presumption produces are more appropriately addressed by Congress, which has already addressed them in part through the Private Securities Litigation Reform Act of 1995 and the Securities Litigation Uniform Standards Act of 1998.
Having refused to overrule Basic, the Court turned to Halliburton’s alternative arguments that (1) plaintiffs should be required to prove that a misrepresentation impacted the stock price as a condition to invoking the presumption of reliance; and (2) if plaintiffs do not bear the burden of proving price impact, defendants should be allowed to introduce evidence of lack of price impact to rebut the presumption. The Court refused to place the burden of proof on the plaintiffs: “By requiring plaintiffs to prove price impact directly, Halliburton’s proposal would take away the first constituent presumption,” i.e., that the misrepresentation was public and material and that the stock traded in a generally efficient market. In response to Halliburton’s concern that a misrepresentation might not impact the price of a stock even in an efficient market, the Court held that “Basic never suggested otherwise; that is why it affords defendants an opportunity to rebut the presumption by showing, among other things, that the particular misrepresentation at issue did not affect the stock’s market price.” Id. at 18.
But the Court did hold that defendants could rebut the presumption by proving at the class-certification stage that the misrepresentations did not impact the market price of the stock. The Court based its holding in part on the fact that price impact evidence is part of the market-efficiency determination. Given this, it found that plaintiffs’ argument that defendants may not introduce such evidence at class certification “makes no sense, and can readily lead to bizarre results.” The presumption is an “indirect proxy” of showing price impact, and “an indirect proxy should not preclude direct evidence when such evidence is available.” Id. at 20. In so holding, the Court distinguished Amgen: price impact “is ‘Basic’s fundamental premise.’ It thus has everything to do with the issue of predominance at the class certification stage.” Id. at 22 (quoting Halliburton I). In contrast, “materiality is a discrete issue that can be resolved in isolation from the other prerequisites.” Id.
The Court summarized its price-impact holding as follows:
Our choice in this case, then, is not between allowing price impact evidence at the class certification stage or relegating it to the merits. Evidence of price impact will be before the court at the certification stage in any event. The choice, rather, is between limiting the price impact inquiry before class certification to indirect evidence, or allowing consideration of direct evidence as well. As explained, we see no reason to artificially limit the inquiry at the certification stage to indirect evidence of price impact. Defendants may seek to defeat the Basic presumption at that stage through direct as well as indirect price impact evidence.
Id. at 22-23
Halliburton II is Important, but Will Not Impact the Merits of Many Cases
Halliburton II presented two very important issues: the viability of Basic, and the need to prove price impact. After the Court granted cert in Halliburton II, most defense lawyers seemed to actively hope that the Court would put an end to securities class actions. But after some time, most defense lawyers seemed to come around to the view that the end of Basic would result in a securities litigation train wreck, with plaintiffs’ firms filing individual and large collective actions that would be quite difficult and expensive to manage, while the government would also step up enforcement, since the federal and state governments wouldn’t allow under-regulation of the securities markets, at least for long. And those who still hoped for the end of Basic had their hopes dashed by the Halliburton II oral argument, in which the justices did not seem interested in overruling Basic, and instead seemed focused on the price-impact argument. Since that argument, most of the discussion has been about the potential price-impact ruling.
What impact will the price-impact ruling have? For starters, it’s important to remember that the ruling will only affect securities class actions that have survived a motion to dismiss – class certification is premature before then. It wouldn’t be economical to adjudicate class certification while parties moved to dismiss under Rule 12(b)(6) and the Reform Act, and adjudicating class certification before rulings on motions to dismiss could result in defendants waiving their right to a discovery stay under the Reform Act.
It’s also important to remember that most securities class actions challenge many statements during the class period. Although there could be strategic benefit to a ruling that a subset of the challenged statements did not impact the stock price – for example, shortening the class period or dismissing especially awkward statements – a finding that some statements had an impact would support certification of some class, and thus would allow the case to proceed.
It is impossible to say what percentage of the cases that survive motions to dismiss would be good candidates for price-impact disputes at class certification. To be sure, defendants will make price-impact arguments in most cases in which there is some basis to make the argument. But the number of cases in which there is a real issue, much less a knock-out blow, is likely relatively small. Some types of cases, such as biotech cases and cases involving companies with a low volume of public statements, tend to present fewer economic problems. More generally, the experience in the Second and Third Circuits before Amgen is cause for some skepticism. Despite standards for class certification that allowed defendants to contest materiality and price impact, defendants seldom defeated class certification.
It also is debatable whether a price-impact rule will weed out many more bad cases on a net basis. For example, cases that suffer from a price-impact problem typically also suffer from some other fatal flaw, such as the absence of loss causation or materiality. Indeed, the price-impact issue in Halliburton was based on evidence about the absence of loss causation. (Nevertheless, it may be helpful to have a cleaner legal argument to make about the underlying lack of logic to the claims.)
Defendants will lose an important feature of the pre-Halliburton II world: the ability to make no-price-impact arguments in settlement discussions in the absence of a ruling about them. Now, defendants will make and obtain rulings on class certification arguments that they previously could have asserted would be resolved in their favor at summary judgment or trial, if necessary. Plaintiffs will press harder for higher settlements in cases with certified classes. Prominent plaintiffs’ lawyers make this point in Alison Frankel’s blog about Halliburton II. The more sophisticated firms already think through price impact and related issues as they evaluate which cases to pursue, and I expect plaintiffs’ lawyers to make that point in the wake of Halliburton II as well.
Yet plaintiffs certainly would have preferred to have the Court eliminate any fight over price impact at class certification. They will face another hurdle and greater costs, and will have to adapt. Plaintiffs’ lawyers likely will attempt to bring more Section 11 claims, where reliance is not an element. However, Section 11 claims aren’t possible without a registered offering, and the damages are limited. Plaintiffs’ lawyers also will try to re-cast their misrepresentations as omissions claims, and thus invoke Affiliated Ute’s presumption of reliance for claims of omission. But plaintiffs face an uphill legal battle on this issue, as we wrote last winter. And they likely will not file cases in which it is clear that they face a difficult and expensive class-certification battle – or they will try to settle them before class certification.
One thing that is certain is that Halliburton II will increase defense costs. Whether the increased defense costs will be worth it will be the subject of much debate in individual cases, and in the big picture over time. In the coming months, I will write about post-Halliburton II issues, including the shape of the price-impact dispute, and the cost-benefit of the new world of class-certification.
In defending a securities class action, a motion to dismiss is almost automatic, and in virtually all cases, it makes good strategic sense. In most cases, there are only four main arguments:
- The complaint hasn’t pleaded a false or misleading statement
- The challenged statements are protected by the Safe Harbor for forward-looking statements
- The challenged statements weren’t made with scienter, even if the complaint has adequately pleaded their falsity
- The complaint hasn’t adequately pleaded loss causation
For me, the core argument of virtually every brief is falsity – I think that standing up for a client’s statements provides the foundation for all of the other arguments. For most clients, it is important to stand up and say “I didn’t lie.” And an emphasis on challenging the falsity allegations encompasses clients’ most fundamental responses to the lawsuit: they reported accurate facts; made forecasts that reflected their best judgment at the time; gave opinions about their business that they genuinely believed; issued financial statements that were the result of a robust financial-reporting process; etc.
The Reform Act, and the cases which have interpreted it, provide securities defense lawyers with broad latitude to attack falsity. In my mind, a proper falsity analysis always starts by examining each challenged statement individually, and matching it up with the facts that plaintiffs allege illustrate its falsity. Then, we can usually support the truth of what our clients said in numerous ways that are still within the proper scope of the motion to dismiss standard: showing that the facts alleged do not actually undermine the challenged statements, because of mismatch of timing or substance; pointing out gaps, inconsistencies, and contradictions in plaintiffs’ allegations; showing that the facts that plaintiffs assert are insufficiently detailed under the Reform Act; attacking allegations that plaintiffs claim to be facts, but which are really opinions, speculation, and unsupported conclusions; putting defendants’ allegedly false or misleading statements in their full context to show that they were not misleading; and pointing to judicially noticeable facts that contradict plaintiffs’ theory. These arguments must be supplemented by a robust understanding of the relevant factual background, which defines and frames the direction of any argument we ultimately make based on the complaint and judicially noticeable facts.
Yet many motions to dismiss do not make a forceful argument against falsity, supported with a specific challenge to the facts alleged by the plaintiffs. Some motions superficially assert that the allegations are too vague to satisfy the pleading standard, and do not engage in a detailed defense of the statements with the available facts. Others simply attack the credibility of the “confidential witnesses,” without addressing in sufficient detail the content of the information the complaint attributes to them. And others fall back on the doctrine of “puffery,” which posits that even if false, the challenged statements were immaterial.* By focusing on these and similar approaches, a brief may leave the judge with the impression that defendants concede falsity, and that the real defense is that the false statements were not made with scienter.
It’s risky for several reasons. First, detailed, substantive arguments against falsity are some of the strongest arguments that defendants can make. Second, those arguments provide the foundation for the rest of the motion. The exclusion of a strong falsity argument weakens the argument against scienter, and fails to paint the best possible no-fraud picture for the judge – which is ultimately what helps a judge to be comfortable in granting a motion to dismiss.
Failing to emphasize the falsity argument weakens the scienter argument.
The element of scienter requires a plaintiff to demonstrate that the defendant said something knowingly or recklessly false – in order to do this, plaintiffs must tie their scienter allegations to each particular challenged statement. It is not enough to generally allege, as plaintiffs often do, that defendants had a general “motive to lie.” When I analyze scienter allegations, I ask myself, “scienter as to what?” Asking this question often unlocks strong arguments against scienter, because complaints often make scienter allegations that are largely detached from their allegations of falsity. Often, this is the case because the falsity allegations are insufficient to begin with. But many motions to dismiss are unable to point out this lack of connection, because they don’t focus on falsity in a rigorous and thorough way.
Focusing on falsity also is necessary because of how courts analyze falsity and scienter. Although falsity and scienter are separate elements – and should be analyzed separately – courts often analyze them together. See, e.g., Ronconi v. Larkin, 253 F.3d 423, 429 (9th Cir. 2001) (“Because falsity and scienter in private securities fraud cases are generally strongly inferred from the same set of facts, we have incorporated the dual pleading requirements of 15 U.S.C. §§ 78u-4(b)(1) and (b)(2) into a single inquiry.”). Arguing a lack of falsity thus provides essential ingredients for this combined analysis. Even when courts analyze falsity and scienter separately, a proper scienter analysis requires a foundational falsity analysis, because as noted above, scienter analysis asks whether the defendant knew that a particular statement was false. Without an understanding of exactly why that challenged statement was false, and what facts allegedly demonstrate that falsity, the scienter analysis meanders, devolving into an analysis of knowledge of facts that may or may not be probative of the speaker’s state of mind related to that statement.
The tendency to lump scienter and falsity together is exemplified by the scienter doctrines that I call “scienter short-cuts:” (1) the corporate scienter doctrine (see, e.g., Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital, Inc., 531 F.3d 190, 195-96 (2d Cir. 2008) and Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702 (7th Cir. 2008)), and (2) the core operations inference of scienter (see, e.g., Glazer Capital Management LP v. Magistri, 549 F.3d 736 (9th Cir. 2008)). Under these doctrines, courts draw inferences about what the defendants knew based upon the prominence of the falsity allegations. The more blatant the falsity, the more likely courts are to infer scienter. A superficial falsity argument weakens defendants’ ability to attack these scienter short-cuts, which plaintiffs are asserting more and more routinely.
Failing to emphasize the falsity argument fails to paint the best possible no-fraud picture for the judge.
I contend that it is a good strategy for a defendant to thoroughly argue lack of falsity, even if there are better alternative grounds for dismissal, and even if the challenge to falsity is unlikely to be successful as an independent grounds for dismissal. This is for the simple reason that judges are humans – they will feel better about dismissing a case based on other grounds if you can make them feel comfortable that there was not a false statement to begin with. For example, courts are often reluctant to dismiss a complaint solely on Safe Harbor grounds because it is seen as a “license to lie,” so it is strategically wise also to argue that forward-looking statements were not false in the first place. Similarly, even if lack of scienter is the best basis for dismissal, it is good strategy to defend on the basis that no one said anything wrong, rather than appearing to concede falsity and being left to contend, “but they didn’t mean to.”
Judges have enough latitude under the pleading standards to dismiss or not, in most cases. The pivotal “fact” is, in my opinion, whether the judge feels the case is really a fraud case, or not. A motion to dismiss that vigorously defends the truth of what the defendants said is more likely to make the judge feel that there really is no fraud there. Conversely, if defendants make an argument that essentially concedes falsity and relies solely on the argument that the falsity was immaterial, wasn’t intentional, or is not subject to challenge under the Safe Harbor, a judge may stretch to find a way to allow the case to continue. Put simply, a judge is more likely to dismiss a case in which a defendant says “I didn’t lie,” than when defendants argue that “I may have lied, but I didn’t mean to,” or “I may have lied, but it doesn’t matter,” or “I may have lied, but the law protects me anyway.” Even when a complaint might ultimately be dismissed on other grounds, I think that a strong challenge to falsity is essential to help the judge feel that he or she has reached a just result.
*Many statements that defense counsel argue are “puffery” are really statements of opinion that could and should be analyzed under the standard that originated in the U.S. Supreme Court’s Virginia Bankshares decision: in order to adequately allege that a statement of opinion is false or misleading, a plaintiff must plead with particularity not only that the opinion was “objectively” false or misleading, but also that it was “subjectively” false or misleading, meaning that the opinion was not sincerely held by the speaker. My partner Claire Davis recently posted a discussion of statements of opinion.
Public companies around the country labor under a misunderstanding: that the Private Securities Litigation Reform Act’s Safe Harbor protects them from liability for their guidance and projections if they simply follow the statute’s requirements. But the Safe Harbor is not so safe – because they think it goes too far, many judges go to great lengths to avoid the statute’s plain language. Companies and their securities litigation defense counsel can usually work around this judicial attitude and take advantage of the statute’s protections, however, with the right approach to preparing and defending the company’s disclosures.
The Safe Harbor was a key component of the 1995 reforms of securities class action litigation. Congress sought “to encourage issuers to disseminate relevant information to the market without fear of open-ended liability.” H. R. Rep. No. 104-369, at 32 (1995), as reprinted in 1995 U.S.C.C.A.N. 730, 731. The Safe Harbor, by its plain terms, is straightforward. A material forward-looking statement is not actionable if it either (1) is “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement,” or (2) is made without actual knowledge of its falsity. 15 U.S.C. § 77z-2(c)(1); 15 U.S.C. § 78u-5(c)(1).
Yet courts’ application of the Safe Harbor has been anything but straightforward. Indeed, courts have committed some really basic legal errors in their attempts to nullify the Safe Harbor. Foremost among them is the tendency to collapse the two prongs – thus essentially reading “or” to mean “and” – to hold that actual knowledge that the forward-looking statement is false means that the cautionary language can’t be meaningful. See, e.g., In re SeeBeyond Techs. Corp. Sec. Litig., 266 F. Supp. 2d 1150, 1163-67 (C.D. Cal. 2003); In re Nash Finch Co. Sec. Litig., 502 F. Supp. 2d 861, 873 (D. Minn. 2007); Freeland v. Iridium World Commc’ns, Ltd., 545 F. Supp. 2d 59, 74 (D.D.C. 2008); Freudenberg v. E*Trade Fin. Corp., 712 F. Supp. 2d 171, 193-94 (S.D.N.Y. 2010). Courts also engage in other types of legal gymnastics to take the statements out of the Safe Harbor, such as straining to convert forward-looking statements into present-tense declarations. The court in City of Providence v. Aeropostale, Inc., No. 11 Civ. 7132, 2013 WL 1197755 (S.D.N.Y. Mar. 25, 2013), recently did so, characterizing a number of statements related to the company’s earnings guidance to be statements of present fact outside the Safe Harbor’s protection – and thereby essentially taking the guidance out of the Safe Harbor as well. Even worse, the court articulated an incorrect rule of law: “the safe harbor does not apply to material omissions.” Id. at *12. But, of course, all forward-looking statements rely on, and necessarily omit, myriad facts – a prediction is, by definition, the bottom line of analysis.
The most notorious erroneous Safe Harbor decision was written by one of the country’s most renowned judges, Judge Frank Easterbrook. In Asher v. Baxter, 377 F.3d 727 (7th Cir. 2004), Judge Easterbrook read into the Safe Harbor the word “the” before “important” in the phrase “identifying important factors,” to then hold that discovery was required to determine whether the company’s cautionary language contained “the (or any of the) ‘important sources of variance’” between the forecast and the actual results. Id. at 734. The statute only requires a company to identify “important factors,” not the important factors. Judge Easterbrook’s mis-reading of the statute injected a subjective component into an objective inquiry; it purported to require courts to evaluate the company’s disclosure decisions – what the company thought were “the” important factors. This error led the court to permit discovery on what the company thought was “important” – a procedure directly contrary to Congress’s clear intent that courts apply the Safe Harbor on a motion to dismiss and “not  provide an opportunity for plaintiff counsel to conduct discovery on what factors were known to the issuer at the time the forward-looking statement was made.” H.R. Rep. No. 104-369, at 44 (1995), as reprinted in 1995 U.S.C.C.A.N. 730, 743.
Frequently, courts simply avoid defendants’ Safe Harbor arguments, choosing either to treat the Safe Harbor as a secondary issue or to avoid dealing with it at all. The Safe Harbor was meant to create a clear disclosure system: if companies have meaningful risk disclosures, they can make projections without fear of liability. When judges avoid the Safe Harbor, companies’ projections are judged by legal rules and pleading requirements that result in less certain and less protective outcomes, even if judges get to the right result on other grounds. And if they come to realize that they do not have the clear Safe Harbor protection Congress meant to provide, companies will make fewer and/or less meaningful forward-looking statements.
The root of these problems is that many judges don’t like the idea that the Safe Harbor allows companies to escape liability for knowingly false forward-looking statements. Some courts have explicitly questioned the Safe Harbor’s effect. For example, in In re Stone & Webster, Inc. Securities Litigation, the First Circuit called the Safe Harbor a “curious statute, which grants (within limits) a license to defraud.” 414 F.3d 187, 212 (1st Cir. 2005). And the Second Circuit, in its first decision analyzing the Safe Harbor – 15 years after the Reform Act was enacted, illustrating the degree of judicial avoidance – correctly interpreted “or” to mean “or,” but stated that “Congress may wish to give further direction on …. the reference point by which we should judge whether an issuer has identified the factors that realistically could cause results to differ from projections. May an issuer be protected by the meaningful cautionary language prong of the safe harbor even where his cautionary statement omitted a major risk that he knew about at the time he made the statement?” Slayton v. American Express Co., 604 F.3d 758, 772 (2d Cir. 2010). (Soon after the Second Circuit decided American Express, the Ninth Circuit also interpreted “or” to mean “or.” In re Cutera, Inc. Sec. Litig., 610 F.3d 1103, 1112-13 (9th Cir. 2010).)
This judicial antipathy for the Safe Harbor won’t change. So it is up to companies to draft cautionary statements that will be effective in the face of this skepticism, and for securities defense counsel to make Safe Harbor arguments that resonate with dubious judges.
I have had success in obtaining dismissal under the Safe Harbor when I am able to demonstrate that the company’s Safe Harbor cautionary statements show that it really did its best to warn of the risks it faced. Judges can tell if a company’s risk factors aren’t thoughtful and customized. Too often, the risk factors become part of the SEC-filing boilerplate, and don’t receive careful thought with each new disclosure. But risk factors that don’t change period to period, especially when it’s apparent that the risks have changed, are less likely to be found meaningful. And even though many risks don’t fundamentally change every quarter, facets of those risks often do, or there might be another, more specific risk that could be added.
Companies can help to inoculate themselves from lawsuits – or lay the groundwork for an effective defense – if they simply spend time thinking about their risk factors each quarter, and regularly supplement and adjust those factors. There are situations in which competitive harm or other considerations will outweigh the benefit of making negative elective risk disclosures. But companies should at least evaluate and balance the relevant considerations, so that they maximize their Safe Harbor protection without harming their business and shareholders.
I have also had success with Safe Harbor arguments that defend the honesty of the challenged forward-looking statements. For example, the complaint, along with incorporated and judicially noticeable facts, often allow defense counsel to support the reasonableness of challenged earnings guidance. Some defense lawyers avoid this approach because it is fact-intensive, which they worry may cause judges to believe that dismissal isn’t appropriate. I have found, however, that judges who believe that the forward-looking statements have a reasonable basis (and are thus assured that they were not knowingly dishonest) are more comfortable applying the Safe Harbor, or granting the motion on another basis, such as lack of falsity.
On the other hand, I believe the least effective arguments are those that rest on the literal terms on the Safe Harbor, which create the impression that defendants are trying to skate on a technicality. It is these types of arguments – lacking in a sophisticated supporting analysis of the context of the challenged forward-looking statements and of the thoughtfulness of the cautionary language – that cause the courts to try to evade what they see as the unjust application of the Safe Harbor. Defense counsel need to appreciate that Safe Harbor “law” includes not just the statute and decisions interpreting it, but also the skepticism with which Safe Harbor arguments are evaluated by many judges.
When is an opinion a false or misleading statement? If a company official says “I think the deal is fair,” is it a false statement just because the deal is objectively unfair? Or only if the official also did not subjectively believe the deal was fair when he voiced that opinion?
With the Sixth Circuit’s opinion in Indiana State District Council of Laborers v. Omnicare, 719 F.3d 498 (6th Cir. 2013), a circuit split has developed around the question of what is required to demonstrate that a statement of opinion is false or misleading. This issue is key to many securities class actions, which often hinge upon the truth or falsity of opinions, not facts.
People routinely express opinions that may be incorrect, or about which they may later change their minds. But those opinions are not lies if they accurately reflect what the speaker thinks. Thus, even if a deal is not fair by objective standards, the statement “I think the deal is fair,” is not false unless the speaker did not actually think that the deal was fair. An opinion is thus “true” if it reflects what the speaker actually thought at the time that he spoke – regardless of whether it is objectively mistaken, differs from the opinions of others, appears to be unreasonable, or is later changed. So, the truth or falsity of any statement of opinion necessarily turns on the speaker’s actual belief.
This analysis of what makes an opinion a false or misleading statement seems self-evident. Thus, when the Supreme Court considered the issue of whether and when a fairness opinion can be an actionable false statement, it assumed that an opinion was not false unless it the speaker did not hold the belief stated. Va. Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1095-96 (1991) (“Because such a statement by definition purports to express what is consciously on the speaker’s mind, we interpret the jury verdict as finding that the directors’ statements of belief and opinion were made with knowledge that the directors did not hold the beliefs or opinions expressed”). The threshold question faced by the Virginia Bankshares Court was whether or not a statement of belief or opinion could ever be actionable under the federal securities laws, or was instead per se immaterial. The Court found that “knowingly false” statements of opinion could be challenged because they can be material and factual “as statements that the [speakers] do act for the reasons given or hold the belief stated and as statements about the subject matter of the reason or belief expressed.” Id. at 1092. Making an assumption that the jury had found that the statement was subjectively false, the Court concluded that objective falsity was also necessary for the plaintiff to prove a false or misleading statement under Section 14(a). Id.
Summarizing the Virginia Bankshares holding in a concurring opinion, Justice Scalia emphasized that both subjective and objective falsity were required for liability: “[T]he statement ‘In the opinion of the Directors, this is a high value for the shares’ would produce liability if in fact it was not a high value and the directors knew that. It would not produce liability if in fact it was not a high value but the directors honestly believed otherwise.” Id. at 1108-09 (Scalia, concurring).
Yet Virginia Bankshares is anything but a paragon of clarity. It focused on the question of whether or not an opinion can ever be an actionable statement, and then backed into the question of subjective falsity by assuming that it existed in that case. As a result, the circuit courts were slow to apply its holding. Although the decision was rendered more than 20 years ago, its analysis of the standard for evaluating statements of opinion was not widely used until the last decade.
After Virginia Bankshares had been discussed and digested, however, most circuit courts began to cite to it for the rule that a statement of opinion is only actionable if it is both subjectively and objectively false or misleading. See, e.g., In re Credit Suisse First Boston Corp., 431 F.3d 36, 47 (1st Cir. 2005) (citing Virginia Bankshares and holding that in order to challenge a statement of opinion plaintiffs must plead “facts sufficient to indicate that the speaker did not actually hold the opinion expressed,” or in other words, “subjective falsity”); Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1131 (2d Cir. 1994) (citing Virginia Bankshares to hold that “a statement of reasons, opinion or belief by such a person when recommending a course of action to stockholders can be actionable under the securities laws if the speaker knows the statement to be false.”); Nolte v. Capital One Fin. Corp., 390 F.3d 311, 315 (4th Cir. 2004) (“In order to plead that an opinion is a false factual statement under Virginia Bankshares, the complaint must allege that the opinion expressed was different from the opinion actually held by the speaker.”); Greenburg v. Crossroads Sys., Inc., 364 F.3d 657, 670 (5th Cir. 2004) (citing Virginia Bankshares for the proposition that a “statement of belief is only open to objection where the evidence shows that the speaker did not in fact hold that belief and the statement made asserted something false or misleading about the subject matter”); Helwig v. Vencor, Inc., 251 F.3d 540, 562 (6th Cir. 2001) (“‘Material statements which contain the speaker’s opinion are actionable under Section 10(b) of the Securities Exchange Act if the speaker does not believe the opinion and the opinion is not factually well-grounded.’”); Rubke v. Capitol Bancorp Ltd., 551 F.3d 1156, 1162 (9th Cir.2009) (fairness opinions “can give rise to a claim under Section 11 only if the complaint alleges with particularity that the statements were both objectively and subjectively false or misleading”).
But in Omnicare the Sixth Circuit reversed course, departing not only from numerous decision by other circuits, but also from its own precedent, in holding that plaintiffs did not need to prove that defendants knew their opinion was false in an action brought under Section 11. 719 F.3d at 505-07. The Omnicare court recognized its departure from holdings by the Second Circuit and the Ninth Circuit, which had specifically found that proof of subjective falsity was necessary in cases brought under Section 11. See Fait v. Regions Financial Corp., 655 F.3d 105 (2011); Rubke, 551 F.3d at 1162. But the court distinguished all the cases that required proof of the subjective falsity of opinions in a Section 10(b) context, including its own holding in Helwig v. Vencor – arguing that those decisions were only applicable in the context of a Section 10(b) action, in which proof of scienter was required.
In regard to Virginia Bankshares, the Omnicare court reasoned that the Supreme Court had not been squarely faced with whether a plaintiff must plead the subjective falsity of an opinion, contending that the Court’s comments regarding subjective falsity were both dicta and tied to the question of scienter. “The Virginia Bankshares discussion, therefore, has very limited application to § 11; a provision which the Court has already held to create strict liability.” Id. at 507. Extending the “dicta” of Virginia Bankshares to a Section 11 case would be “most dangerous,” the Court ruled: “it would be most unwise for this Court to add an element to § 11 claims based on little more than a tea-leaf reading in a § 14(a) case.” Id.
The Omnicare court was not the first court to observe that subjective falsity feels like a scienter requirement. Other courts have noted that the question of subjective falsity in a Section 10(b) case may “essentially merge” with the scienter requirement, such that if a complaint demonstrates subjective falsity, it will also have adequately shown scienter. See, e.g., Credit Suisse, 431 F.3d at 47. But the Omnicare court missed the point when it held that proof of subjective falsity is only necessary in a case where there is a requirement that scienter be shown. Like Section 11, Section 14(a) does not require proof that a speaker knew the statement was false. In Virginia Bankshares, the court explicitly declined to address the question of scienter – so its discussion was necessarily centered around the element of falsity. And the subsequent cases that have examined subjective falsity in the context of Section 10(b) have discussed it in terms of falsity, not scienter. Simply put, an opinion is not false if it is genuinely believed by the speaker. This question is separate from the inquiry as to the speakers’ intent in making the statement. To conflate the two elements is an analytic mistake and legal error.
This distinction is most vital in cases such as Omnicare, brought under statutes for which proof of scienter is not required. But it is also important in Section 10(b) cases, where scienter can be established by showing either actual knowledge or some form of recklessness, while subjective falsity requires plaintiffs to show a speaker knew his opinion was false. Preserving this focused inquiry is especially important when plaintiffs seek to prove scienter “holistically” or through doctrines such the core operations inference or corporate scienter, which cause the scienter analysis to be more and more removed from a showing that a speaker had actual knowledge of fraud as to a particular statement.
Analysis of the hypothetical statement “I think the deal is fair” illustrates these points. Assume the deal was not objectively fair, but the speaker genuinely believed it was. In that case, the statement was true and is not actionable – a scienter analysis is not even required. If the falsity analysis got it wrong, however, we would then delve into a scienter analysis with a looser recklessness test, which would look at a variety of factors other than the speaker’s actual belief in his statement. The error is worsened when the recklessness analysis is performed with analytic tools like the core operations inference and corporate scienter theory, which have the capacity to devolve into assumptions about the speaker’s intent based on company-wide factors, and under a holistic analysis that tends to look at scienter generally, rather than focusing on the speaker’s state of mind as to a particular challenged statement. As a result, a speaker could be held liable for saying that he thought the deal was fair, even though that is what he actually thought, because of a judgment that the general factors present at the company suggest overall recklessness. The result is not just analytic impurity, but injustice – such that some cases that should be dismissed would not be.
It took the better part of two decades for the crucial holding of Virginia Bankshares to be well understood and widely applied by the circuit courts. The Omnicare case represents a step backward in this analysis. Hopefully, other circuit courts will decline to follow the Sixth Circuit in its abrupt wrong turn, and the Supreme Court will eventually clarify its Virginia Bankshares decision.
Last Tuesday, new SEC Chairman Mary Jo White said at The Wall Street Journal’s annual CFO Network Event that the SEC “in certain cases” will seek admissions of liability as part of settlements. The statement made headlines, and for good reason: for decades, the SEC has allowed settling defendants to neither admit nor deny wrongdoing. The policy shift, moreover, comes during the appeal to the Second Circuit of District Judge Jed Rakoff’s rejection of the SEC-Citigroup settlement, where he rejected a no-admit-or-deny settlement based in part on his determination that any consent judgment that is not supported by “proven or acknowledged facts” would not serve the public interest. (Last year, the SEC stopped allowing civil defendants to neither admit nor deny fraud, if they had already pleaded guilty in a parallel criminal case.)
Chairman White’s remarks last Tuesday indicated that a new policy requiring admissions of liability will be applied in cases of “widespread harm to investors” and “egregious intentional misconduct.” An internal SEC email from co-directors of the SEC Enforcement Division to the Enforcement staff, obtained by Alison Frankel of Reuters, and author of the blog On the Case, elaborates on the scope of the policy’s application:
“While the no admit/deny language is a powerful tool, there may be situations where we determine that a different approach is appropriate,” Ceresney and Canellos said in the email, which was provided to me by an SEC representative. “In particular, there may be certain cases where heightened accountability or acceptance of responsibility through the defendant’s admission of misconduct may be appropriate, even if it does not allow us to achieve a prompt resolution. We have been in discussions with Chair White and each of the other commissioners about the types of cases where requiring admissions could be in the public interest. These may include misconduct that harmed large numbers of investors or placed investors or the market at risk of potentially serious harm; where admissions might safeguard against risks posed by the defendant to the investing public, particularly when the defendant engaged in egregious intentional misconduct; or when the defendant engaged in unlawful obstruction of the commission’s investigative processes. In such cases, should we determine that admissions or other acknowledgement of misconduct are critical, we would require such admissions or acknowledgement, or, if the defendants refuse, litigate the case.”
What will this mean in actual SEC enforcement matters and related shareholder cases? Comments from plaintiffs’ lawyers and defense lawyers in Frankel’s blog post provide a useful start to the discussion. Not surprisingly, plaintiffs’ lawyers Max Berger, Gerald Silk and Steve Toll feel the policy will help them by providing them with ammunition to use to bolster their private securities cases. My former partner Boris Feldman of Wilson Sonsini said that the “proof of the sausage is in the making,” and feels the policy won’t change SEC enforcement matters much because the SEC will only insist on an admission when “the defendant is hosed anyway.” Thomas Gohrman of Dorsey & Whitney is worried that, “unless applied on a very sparing basis,” the policy “may well significantly undercut the entire enforcement program” because defendants will refuse to settle and the SEC will expend its resources litigating these cases.
My view lies somewhere in between these. The SEC doesn’t currently have the enforcement resources to litigate a significant additional number of additional cases, so in the near term it really can only apply the policy to particularly gnarly cases, where there is egregious or notorious misconduct, and where they are very confident they would win at trial. This approach won’t impact defendants significantly, because in cases that fall into these categories, the defendants already have significant problems stemming from the underlying facts, and there would be little collateral damage from the admission the SEC seeks.
But, to be sure, the SEC is bound to apply the policy to some close cases as well, because of a misapprehension of the case’s strength, or an overly zealous interpretation of White’s edict by the SEC staff. (There may also be a temptation by the SEC to apply this policy too broadly to high-profile cases of questionable merit, although I believe that tendency will be limited by a concern over suffering too many high-profile defeats.) The defendants will refuse to agree to settlements requiring admissions in most close cases, because of collateral consequences in otherwise defensible cases, thus yielding an increase in the number of cases the SEC litigates. How many more cases will be litigated will depend in large part on the rigor of the SEC’s screening process and on whether the SEC staff facilitates frank and meaningful discussions with defense counsel about the facts of each case.
What we know for sure is that the amount of litigation will increase in proportion to the SEC’s implementation of this new policy. Unless the new policy is interpreted very narrowly, the SEC will very quickly have a decision to make: it will either need to find new resources to finance the additional litigation; divert resources into litigation from investigation and enforcement, resulting in fewer actions being filed in the first place; or pull back on the implementation of the new policy.
I predict that after some initial overreaching, the SEC will re-calibrate its no-admission policy to limit its application to only the gnarliest cases with the worst facts. Otherwise, the government will have to fundamentally rethink the SEC’s funding and/or its enforcement role, in order to accommodate substantially more active litigation. This is possible, of course, but it seems unlikely.
On the other hand, the SEC is in control of the process only up to the point of judicial review of a proposed settlement. The uncertainty surrounding judicial review of no-admit-or-deny settlements is a wild card – increased judicial insistence on admissions likely would prompt the SEC to apply its policy to more cases than it otherwise would. Thus, the Second Circuit’s response to Judge Rakoff in the SEC-Citigroup case remains an important development to watch.
As I previously wrote, increased insistence on admissions, whether by the SEC or courts, would have significant consequences on private litigation and D&O insurance coverage. Obviously, making these admissions would increase the risk of liability in related private litigation, while at the same time creating insurance coverage problems – not to mention the impact they would have on a company’s reputation and directors’ and officers’ careers.
Deciding to litigate with the SEC will create difficult issues as well. Increased litigation will strain D&O insurance policies, not just because it creates another piece of litigation, but because it is inherently expensive litigation, which is likely to go to trial and will frequently require separate representation for each defendant. That will leave less insurance to settle the private cases, which in turn will mean that more private shareholder cases will go to trial as well.
These forces, along with the problem of increasing defense costs (about which I’ve posted here and here), will create a financial problem for many companies and their directors and officers. And, of course, they could create a serious liability problem as well, since the odds are that a decent percentage of the cases that go to trial under these circumstances will result in determinations of liability. Depending upon how these factors play out, it will become even more critical for defense counsel to adopt a more efficient, effective, and trial-focused approach to securities litigation.