In the opinion issued yesterday in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund (“Omnicare”), the Supreme Court rejected the two extremes advocated by the parties regarding how the truth or falsity of statements of opinion should be considered under the securities laws, and instead adopted the middle path advocated in the amicus brief filed by Lane Powell on behalf of the Washington Legal Foundation (“WLF”). In doing so, the Court also laid out a blueprint for examining claims of falsity under the securities laws, which we believe will do for falsity analysis what Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), did for scienter analysis.

From the tenor of oral argument, it seemed inevitable that the Court would reject the Sixth Circuit’s erroneous position – that a genuinely believed opinion may nonetheless be considered “false” under Section 11 of the Securities Act if it is later determined that the opinion was incorrect. But the Court also expressed discomfort with the potential loopholes that could be created by Omnicare’s position at the other extreme – that if a statement is phrased as an opinion, it cannot be found to be either false or misleading under the securities laws, as long as the opinion was honestly held by the speaker.

There were many wrong turns that the Court could have taken in rejecting these two extremes, running the risk of further confusing the law not only regarding the truth or falsity of opinions, but also muddling the law of scienter and materiality. But the Court successfully navigated these potential pitfalls – including refusing to adopt the “reasonable basis” standard advocated by the Solicitor General – and instead adopted an analytically sound approach that is consistent with its previous securities rulings, holding that 1) a statement of opinion is only “false” under the securities laws if it is not genuinely believed by the speaker; and 2) like any other kind of statement, a statement of opinion may be “misleading” if, when considered in context, it creates a false impression in the mind of a reasonable investor.

Because Omnicare’s analysis concerns what makes a statement false or misleading, it will apply not only in Section 11 cases, but in cases brought under Section 10(b) of the Securities Exchange Act. In fact, much of the Court’s reasoning will also assist defendants in battling inadequate allegations that factual statements are false or misleading. Similar to how Tellabs laid a definitive groundwork for the consideration of scienter allegations after the Reform Act, Omnicare has thus laid out a clear blueprint for how courts must consider allegations that statements of fact or opinion were false or misleading.

For our complete discussion of the Omnicare opinion, please see our post today on WLF’s The Legal Pulse Blog.

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).

Monday’s oral argument before the Supreme Court in Laborers District Counsel Construction Industry Pension Fund v. Omnicare, Inc. (“Omnicare”) was remarkable in that, as Omnicare attorney Kannon Shanmugam noted, it was the “rare case in which none of the parties is defending the reasoning of the court of appeals below.”

As we explained in last week’s blog post previewing the argument, the Sixth Circuit held in the decision under review 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 contended, 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, Monday’s discussion 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 in Monday’s argument, or one that was advanced in our brief for the WLF.

In a position embraced by the plaintiffs, the Solicitor General contended that a statement of opinion should be considered “false,” even if it was genuinely believed, if plaintiffs can show that there was no “reasonable basis” for the speaker to hold that opinion.  As we have observed, however, this test breaks down quickly.  Any reasonableness inquiry is, in and of itself, entirely subjective, meaning that whether an opinion was true or false would hinge on someone else’s later opinion as to its “reasonableness.”  Although Justice Breyer seemed to be leaning toward such a “reasonableness” test in much of his questioning, both he and Justice Alito expressed concern over how this reasonableness would be determined, and in particular, how to decide what sort of inquiry is “reasonable” for a company or individual to conduct before voicing a particular opinion.

A far better middle path, advocated by our WLF brief (see pp. 23-29), is to subject statements of opinion to the same sort of inquiry about whether they were “misleading” as for any other statement.  In other words, a statement of opinion can be honestly believed (and thus “true”), but nonetheless rendered misleading by the omission of certain facts.  Justice Kagan urged such a standard in her questioning of the parties, although none took advantage of the opening that she provided.  If framed correctly, this standard would avoid the pitfalls of the Solicitor General’s reasonableness standard, because liability would not hinge upon a later opinion about the validity of a speaker’s original expressed opinion.  Rather, by this 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) of the Securities Exchange Act – 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.

On November 3, 2014, the U.S. Supreme Court will hear oral argument in Laborers District Counsel Construction Industry Pension Fund v. Omnicare, Inc., which concerns the standard for judging the falsity of an opinion challenged in an action under Section 11 of the Securities Act of 1933.  In the Sixth Circuit decision under review (“2013 Omnicare decision”), the court held that a statement of opinion can be “false” even if the speaker genuinely believed the stated opinion. This holding is contrary to the U.S. Supreme Court’s decision in Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1095 (1991), which 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 genuinely believes the opinion expressed, i.e., if it is “subjectively” true.

On behalf of Washington Legal Foundation (“WLF”), my partner Claire Davis and I filed an amicus brief in Omnicare to emphasize the importance of clarifying the standard for challenging “false” statements of opinion under all the federal securities laws, not just Section 11.  WLF’s view that such clarification is needed was reinforced by an October 10, 2014 decision in a subsequently filed securities class action against Omnicare under Section 10(b) of the Securities Exchange Act of 1934.  In re Omnicare, Inc. Sec. Litig., — F. 3d —-, 2014 WL 5066826 (6th Cir. Oct. 10, 2014) (“2014 Omnicare decision”).  In the 2014 Omnicare decision, the Sixth Circuit appeared to embrace the proposition that a statement of opinion is not actionable if it is subjectively true – at least under Section 10(b) – but then held that the subjective falsity inquiry should be analyzed within the element of scienter.  The opinion shows the continued confusion that pervades analysis of this issue, jumbling subjective falsity with other concepts, and conflating the separate elements of falsity and scienter.

As part of its scienter analysis, the Sixth Circuit also grappled with another important question: whose state of mind counts for purposes of determining a corporation’s scienter?  Although the Sixth Circuit believes the standard it enunciated constitutes a “middle ground” between restrictive and liberal tests among the federal circuit courts, its ruling misunderstands the nature of the scienter inquiry and conflicts with the Supreme Court’s ruling in Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011), and thus risks expanding corporate liability beyond the proper reach of Section 10(b).

Today, Claire and I posted an analysis of the 2013 and 2014 Omnicare decisions on WLF’s blog, The WLF Legal Pulse.  We invite our readers to read our post there.

Please stay tuned to D&O Discourse for more on the November 3, 2014 Supreme Court argument and the Court’s opinion.

As I have previously written, the Sixth Circuit’s erroneous interpretation of the scienter component of the Supreme Court’s decision in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), is one of the biggest threats to the protections of the Private Securities Litigation Reform Act. 

The resulting flawed analysis – which I call “summary scienter analysis” – appears to be a battleground issue for plaintiffs’ securities litigation attorneys.  Their advocacy of summary scienter analysis in In re VeriFone Holdings, Inc. Sec. Litig., 704 F.3d 694 (9th Cir. 2012), while technically unsuccessful, resulted in an opinion that could cause collateral harm to scienter analysis in the Ninth Circuit. 

Unsatisfied with the court’s conclusions in  VeriFone, attorneys from Cohen Milstein Sellers & Toll recently attacked the decision in a May 2013 article titled, The Dangers of Missing the Forest: The Harm Caused by VeriFone Holdings in a Tellabs World,  44 Loyola U. Chi. L. J. 1457 (2013).  The article posits that the Supreme Court has delivered “repeated and clear instructions” that courts are to only analyze scienter allegations holistically and collectively.  It then relies on behavioral economic studies that purportedly show that judges are more likely to dismiss cases when undertaking a segmented analysis as opposed to a holistic one.

Although the article demonstrates why plaintiffs may be anxious to disregard an individual analysis of scienter allegations (because it results in more dismissals), the article is wrong as a matter of law.  The Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007), expressly endorsed the sort of individualized scienter analysis the authors attack.  And Matrixx did not – and could not have, under Section 10(b) and the Reform Act – reverse course.   

The main threat is not a scienter analysis that carefully analyzes each individual scienter allegation within, and as an essential part of, a collective scienter analysis under Tellabs.  Such a methodology explicitly requires courts to go through an allegation-by-allegation analysis before they perform a collective analysis, imposing greater discipline and protecting against analytic sloppiness and error.  Rather, the main threat is the position that careful analysis of each individual scienter allegation is not required at all – or, in the view of the Sixth Circuit, is not even allowed

Origin of Summary Scienter Analysis

This advocacy of solely “collective “ scienter analysis traces back to the Supreme Court’s 2011 decision in Matrixx.  The issue in Matrixx was whether adverse health events from the company’s cold remedy Zicam were material – and thus were required to be disclosed to make what Matrixx said not misleading – if the number of events was not statistically significant.  Matrixx argued for a bright-line rule that disclosure is only required if the number of events is statistically significant.  The district court dismissed the complaint.  The Ninth Circuit reversed. 

In an opinion by Justice Sotomayor, the Supreme Court unanimously affirmed the Ninth Circuit, with most of the opinion devoted to the holding on the primary issue on appeal: statistical significance is not required to trigger a duty to disclose adverse events if what the company said is rendered misleading by the omission, or disclosure is otherwise required by law.  That ruling meant that Matrixx made material misrepresentations by virtue of omitting the adverse events from its public statements.

Following the materiality analysis, the Supreme Court’s affirmance of the Ninth Circuit’s scienter ruling was straightforward.  The Supreme Court articulated Tellabs’ scienter standard, without altering it in any way.  Then, applying Tellabs, the Court considered defendants’ non-culpable explanation: consistent with the lack of statistical significance, the adverse events were not a problem, and thus any misleading statements were not made with intent to defraud.  The Court found the culpable explanation of the allegations more compelling.  The allegations detailed instances of Matrixx’s concern about the events, such as hiring a consultant and convening a panel of physicians and scientists on the matter.  And, “[m]ost significantly, Matrixx issued a press release that suggested that studies had confirmed that Zicam does not cause anosmia [loss of smell] when, in fact, it had not conducted any studies relating to anosmia and the scientific evidence at that time, according to the panel of scientists, was insufficient to determine whether Zicam did or did not cause anosmia. “  131 S. Ct. at 1324.  In other words, the complaint alleged a misrepresentation that was either intentional or highly reckless.   

The vast majority of the commentary about the Matrixx decision concerned the materiality ruling.  The scienter holding did not appear to break any new ground – at least until the Sixth Circuit held that it did.  In Frank v. Dana Corp., 646 F.3d 954, 961 (6th Cir. 2011), the Sixth Circuit reversed the district court’s dismissal of the plaintiffs’ complaint.  In analyzing the complaint’s scienter allegations, the court noted that its Reform Act decisions had analyzed complaints “by sorting through each allegation individually before concluding with a collective approach” under Tellabs.  But the court decided to “decline to follow that approach in light of the Supreme Court’s recent decision in Matrixx …,” which the Sixth Circuit said “provided for us a post-Tellabs example of how to consider scienter pleadings ‘holistically’ ….  Writing for the Court, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis.”  646 F.3d at 961.

But Matrixx was not concerned with the proper methodology of scienter analysis under Tellabs.   Indeed, its comments on scienter were almost an afterthought.  The Court did not hold – or even suggest – that the “quick[]” way it addressed the scienter allegations was the required method of analysis.  Its analysis presumably was “quick[]” because it didn’t need to be lengthy, given the nature of the allegations, the secondary nature of the scienter issue in relationship to the disclosure issue,  and the procedural setting, i.e., a review of a scienter finding by the Ninth Circuit.  Thus, the Sixth Circuit read into Matrixx a holding that the Court didn’t reach.  To date, only the Tenth Circuit has endorsed the Sixth Circuit’s mis-reading of Matrixx – with a holding that seems to include a dangerous endorsement of “conclusory” scienter analysis.  See In re Level 3 Communications, Inc. Securities Litig., 667 F.3d 1331 (10th Cir. 2012) (“While its analysis was conclusory, the district court was under no duty to catalog and individually discuss the reports and witnesses plaintiff described.”) (citing Dana).   

But the plaintiffs certainly caught the Ninth Circuit’s attention with their  summary-scienter-analysis argument in In re VeriFone Holdings, Inc. Sec. Litig., 704 F.3d 694, 703 (9th Cir. 2012).  Following the Supreme Court 2007 decision Tellabs, the Ninth Circuit had evaluated its prior cases and decided on a two-step approach to scienter analysis:  courts must first analyze scienter allegations individually, and then analyze them collectively.   Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 991-92 (2009).  In VeriFone, the Ninth Circuit rejected the argument that Matrixx prohibits its two-step analysis:  “Matrixx on its face does not preclude this approach and we have consistently characterized this two-step or dual inquiry as following from the Court’s directive in Tellabs.”  704 F.3d at 703.  The court then reviewed other appellate decisions, and held that “[b]ecause the Court in Matrixx did not mandate a particular approach, a dual analysis remains permissible so long as it does not unduly focus on the weakness of individual allegations to the exclusion of the whole picture.”  Id.  

Yet the Verifone court then decided to skip the first step (a review of each individual allegation to determine if any of them itself is sufficient to plead scienter) and, instead, to “approach this case through a holistic review of the allegations,” though it emphasized that “we do not simply ignore the individual allegations and the inferences drawn from them.”  Id.   It found that the allegations – which included allegations of multiple significant accounting manipulations directed by the individual defendants – holistically sufficed to plead scienter.

Although the Ninth Circuit correctly understood that Matrixx did not alter the Tellabs scienter standard, its willingness to abandon an explicit two-step scienter analysis is an unfortunate consequence of the incorrect interpretation of Matrixx advanced by the plaintiffs.   The result is the implicit endorsement of an approach that could yield a more cursory analysis of individual scienter allegations by district courts.  This is troubling, because scrutiny of each scienter allegation, to understand and weigh it in relationship to each challenged statement, allows a court to properly weigh the allegations collectively.  Without such scrutiny, there is a risk that courts will under- or over-value one or more of the individual allegations and thus spoil the collective analysis. 

To the extent that they allow (or require) district courts to stray from this particularized analysis, both Dana and Verifone are incorrect, because individual  scrutiny of scienter allegations is required by the controlling law:   Tellabs and the two statutes at issue, Section 10(b) and the Reform Act.

Scienter Analysis under Tellabs

The Tellabs Court began its analysis by announcing several “prescriptions” about scienter analysis under the Reform Act.  The second prescription is that “courts must consider the complaint in its entirety, as well as other sources courts ordinarily examine when ruling on Rule 12(b)(6) motions to dismiss, in particular, documents incorporated in the complaint by reference, and matters of which a court may take judicial notice.”  551 U.S. at 322.  The Court’s third prescription is that “courts must take into account plausible opposing inferences.”  The Court noted that “[t]he strength of an inference cannot be decided in a vacuum.  The inquiry is inherently comparative.  How likely is it that one conclusion, as compared to others, follows from the underlying facts?”  Id. at 323.

In order to conduct this analysis, the Court expressly contemplated analyzing individual scienter allegations, and indeed itself analyzed two types of individual allegations:  financial motive, and knowledge of falsity.

  • Tellabs contended that the lack of a financial motive for fraud was dispositive.  The Court held that financial motive is a factor to be considered among other considerations.  Consideration of financial motive, in turn, requires an examination of stock sales and their context to determine whether they add up to a sufficient motive.   This, of course, amounts to scrutiny of individual allegations. 
  • Tellabs also contended that the complaint’s allegations were too vague and ambiguous to plead knowledge of falsity.  The Court agreed that “omissions and ambiguities count against inferring scienter,” though reiterated that courts must consider such shortcomings in light of the complaint’s other allegations.   Analyzing “omissions and ambiguities,” as the Court directed, is the core variety of individualized scienter analysis.  It involves looking at the complaint’s allegations of falsity, statement by statement, and analyzing the complaint’s allegations of knowledge of falsity, statement by statement. s. 

Thus, the Supreme Court in Tellabs expressly contemplated, and performed, the type of individualized scienter analysis that plaintiffs wrongly contend that Matrixx rejected.

Scienter Analysis under the 1934 Act and Reform Act

Matrixx, moreover, could not have departed from analysis of individual scienter allegations, because individualized scienter analysis is statutorily required by the 1934 Act and the Reform Act.  Section 10(b) and Rule 10b-5 prohibit the making of a false statement with intent to defraud.  If a complaint challenges two statements, it isn’t permissible under Section 10(b) – for example – to find scienter for Statement 2 and apply that finding to Statement 1.  If there is no scienter for Statement 1, it isn’t actionable.  And the Reform Act requires plaintiffs to plead scienter for each statement:

(b) Requirements for securities fraud actions(2) Required state of mind

In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

15 U.S. C. § 78u-4(b)(2) (emphasis added).

So, under the relevant statutes, courts must engage in a scienter analysis for each and every statement the complaint challenges.  To do so requires examination of, in Tellabs’ words, “omissions and ambiguities” in the factual allegations about each statement, as well as pecuniary motivation and other factors present at the time the defendant made the challenged statement.  Such an analysis is exactly the type of scrutiny that plaintiffs’ attorneys are attacking through their incorrect interpretation of Matrixx

This issue will remain a key Reform Act issue to monitor.  I will blog about further significant developments.

 

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.

This promises to be an eventful  year in securities and corporate governance litigation.  A number of looming developments have the potential to change the landscape for many years to come. This is the first of two posts – or three, if I get carried away – discussing some of these developments.

The Delaware Supreme Court’s decision in Louisiana Municipal Police Employees’ Ret. Sys. v. Pyott (the Allergan derivative case)

In Allergan, the Delaware Supreme Court will decide whether the dismissal of a hastily filed shareholder derivative action precludes a subsequently filed action that was based on information obtained under a request to inspect books and records under Section 220 of the Delaware General Corporation Law.  Section 220 allows a stockholder to inspect a corporation’s “books and records” for a “proper purpose.”   On February 5, 2013, the Delaware Supreme Court heard oral argument.

In the Court of Chancery, Vice Chancellor Travis Laster ruled 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.  46 A.3d 313, 335-51 (Del. Ch. 2012).  The failure to provide adequate representation deprived the dismissal of preclusive effect.  In South v. Baker (the Hecla Mining derivative case), Vice Chancellor Laster similarly ruled that derivative plaintiffs who filed without the benefit of 220 provided inadequate representation.  2012 WL 4372538, at *20 (Del. Ch. Sept. 25, 2012).

Delaware courts have long urged shareholders to use Section 220 before filing derivative litigation.  A ruling that a derivative action filed without the benefit of 220 constitutes inadequate representation would be tantamount to a requirement that stockholders use Section 220 before filing a derivative complaint in many types of derivative cases.

Many defense counsel believe that a pre-filing 220 requirement would be a positive development, because they believe that in many cases, plaintiffs’ lawyers do not want to go to the time and expense of a 220 demand, and would therefore file fewer derivative cases.

I say be careful what you wish for: 220 demands impose compliance costs, risk interference with the discovery stay in related securities litigation, and can create more virulent derivative cases, because they facilitate pleading with factual support, which the defendants sometimes can’t combat effectively on a motion to dismiss.  In contrast, although they are a nuisance, fast-filed derivative cases are routinely dismissed.  And a dismissal can be achieved without great cost – if the defense firm defends the case strategically and efficiently.

The Supreme Court’s decision in Amgen

Amgen Inc. v. Connecticut Retirement Plans, pending before the Supreme Court, could bring significant change to securities litigation.  At issue is whether plaintiffs need to establish that the allegedly false statements were material to the market, before a court can certify a securities lawsuit as a class action.  If the answer is “yes,” class certification will become a more meaningful stage in securities class actions, providing defendants with a new tool for stopping unmeritorious cases relatively early on.

If the answer is “no,” class certification will remain mostly inconsequential, with the arguments centering around whether the class representative is adequate and typical, which in the vast majority of cases has little impact on the case as a whole – even if successful, these efforts often just mean a new class representative.  The discovery and motion practice associated with such efforts costs hundreds of thousands of dollars.  I’ve found the cost/benefit calculation isn’t worth it in most cases, and have become more conservative about opposing class certification absent compelling circumstances. But the ruling in Amgen could change this analysis, and breathe new life into the class certification process.

Federal courts’ application of the scienter decision in Matrixx

After the Supreme Court issued its ruling in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), it initially seemed to be an innocuous ruling that would have very little impact.  At issue was whether a drug manufacturer had a duty to disclose statistically insignificant adverse health impacts.  The issue was narrow, and the plaintiffs had the better legal argument.  So I was puzzled about why the parties litigated the issue to the Supreme Court and why the Supreme Court took the case.

Supreme Court decisions can have unintended consequences, and Matrixx may well end up altering courts’ scienter analysis for reasons that the Supreme Court almost certainly didn’t intend.  After deciding that Matrixx had a duty to disclose the adverse events, because they made its statements misleading, the Court found that the plaintiffs had pleaded scienter adequately under Tellabs.  Given that scienter was not the central issue before the Court, the Court’s scienter analysis was not elaborate, and it fairly easily found that the plaintiffs’ allegations sufficed to plead scienter.  The Court applied Tellabs, and in no way indicated that it was fashioning a new type of scienter analysis.

Yet some courts have read the Matrixx Court’s short scienter analysis as a signal that scienter analysis no longer should review scienter allegations individually as well as “holistically.”  For example, in Frank v. Dana Corp., 646 F.3d 954, 961 (6th Cir. 2011), the Sixth Circuit said (citations omitted):

In the past, we have conducted our scienter analysis in section 10(b) cases by sorting through each allegation individually before concluding with a collective approach. However, we decline to follow that approach in light of the Supreme Court’s recent decision in [Matrixx]. There, the Court provided for us a post-Tellabs example of how to consider scienter pleadings “holistically” in section 10(b) cases. Writing for the Court, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis. This is the only appropriate approach following Tellabs’s mandate to review scienter pleadings based on the collective view of the facts, not the facts individually. Our former method of reviewing each allegation individually before reviewing them holistically risks losing the forest for the trees. Furthermore, after Tellabs, conducting an individual review of myriad allegations is an unnecessary inefficiency. Consequently, we will address the Plaintiffs’ claims holistically.

The Tenth Circuit took a similar view in In re Level 3 Communications, Inc. Securities Litigation, 667 F.3d 1331, 1344 (10th Cir. 2012).

On the other hand, more recently, the Ninth Circuit in In re VeriFone Holdings, Inc. Securities Litigation, 2012 WL 6634351, *5-*6, ___ F.3d ___ (9th Cir. Dec. 21, 2012), affirmed the permissibility of a two-step analysis – first, a review of the individual scienter allegations and then a holistic review – and correctly ruled that the Supreme Court in Matrixx did not prescribe a particular analysis that a court must undertake, nor did it purport to alter the scienter analysis articulated in Tellabs:

Matrixx on its face does not preclude this approach and we have consistently characterized this two-step or dual inquiry as following from the Court’s directive in Tellabs. In cases where an individual allegation meets the scienter pleading requirement, whether we employ a dual analysis is most likely surplusage because the individual and the holistic analyses yield the same conclusion. Also, as a practical matter, some grouping and discussion of individualized allegations may be appropriate during a holistic analysis.

In its own analysis, the Ninth Circuit skipped analysis of the individual allegations and instead went right to a holistic review, to avoid the “potential pitfalls” of a “focus on the weakness of individual allegations to the exclusion of the whole picture.  The risk, of course, is that a piecemeal analysis will obscure a holistic view.”  The court emphasized, however, that it was not ignoring the individual allegations or the inferences drawn from them.

A solely holistic review risks expanding judicial discretion in applying a rule of law that already allows for significant judicial discretion.  Standards governing individual scienter allegations – for example, that stock sales of a certain percentage generally are not suspicious – impose some objectivity on an otherwise subjective analysis.  And discussion of the allegations individually invites a certain measure of thoughtfulness and skepticism.  A rule that eschews analysis of individual scienter allegations is unfriendly to defendants because it invites judges to engage in a less rigorous analysis that ignores the shortcomings of the individual allegations – and the easy decision in securities cases is usually to deny the motion to dismiss.  Regardless, a cursory analysis of scienter allegations is not fair to defendants, who at least deserve judicial scrutiny of the fraud allegations against them, and is contrary to Congress’ intent that courts play a gatekeeper function in this particularly vexatious type of litigation.