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.

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).

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.

That’s risky.

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.

The recurring and pervasive problem of flawed confidential witness (“CW”) allegations tops my list of the key issues in securities class action litigation.*  I don’t mean just notorious situations such as those recently at issue in the Lockheed, SunTrust, and Boeing securities class actions – which I discussed in an earlier post and discuss further below.  I also mean the garden-variety inaccuracies that are present in a great many cases.

After catching readers up on what has happened in Lockheed, SunTrust, and Boeing since my prior CW post, I’ll discuss why fixing this problem is so crucial, and then propose a solution.  For a useful survey of CW decisions, see Bryan House, “The Fact Pattern Behind the Boeing Class Action Grounding,” Law360 (April 2, 2013).

Update on Lockheed, SunTrust, and Boeing

City of Pontiac General Employees’ Retirement System v. Lockheed Martin (S.D.N.Y. Case No. 11 CV 5026 (JSR)).  In Lockheed, Judge Jed Rakoff denied defendants’ motion to dismiss.  875 F. Supp. 2d 359 (S.D.N.Y. 2012).  During discovery, several CWs disputed telling the investigator for plaintiffs’ counsel (Robbins Geller) the facts the complaint attributed to them, and discovery revealed that certain of the CW allegations were not based on the CWs’ personal knowledge.  Defendants moved for summary judgment, pointing out the flaws in the CW allegations on which Judge Rakoff relied in denying defendants’ motion to dismiss.

On October 1, 2012, Judge Rakoff held a day-long evidentiary hearing to determine “who the heck tried to pull a fraud on this court.”  At the hearing’s conclusion, Judge Rakoff offered some tentative thoughts about the witnesses’ credibility.  He remarked that some CWs were credible and others were not, and that plaintiffs’ investigator was credible “on the whole.”  He asked for briefing by the parties on the issues raised at the hearing.

Following the parties’ post-hearing submissions, Judge Rakoff issued a summary order denying defendants’ summary judgment motion, and promised a longer order.  The fact of the denial indicated that, to some extent, Judge Rakoff rejected defendants’ CW challenges, though we’ll never know his findings, because the case settled before he issued his longer order.

Belmont Holdings v. SunTrust Banks (N.D. Ga., Case No. 1:09-cv-01185-WSD).  In SunTrust, Judge William Duffey denied defendants’ motions to dismiss, primarily because of allegations based on information provided by a CW, Scott Trapani, indicating that defendants knew SunTrust’s reserves were understated throughout 2007.  During the motion-to-dismiss process, defendants pointed out that Mr. Trapani left SunTrust in August 2007, and therefore was not in a position to comment about the reserves throughout the year, but the court ruled it would leave that issue for discovery.

Defendants moved for reconsideration based on declarations from Mr. Trapani that he left SunTrust in August 2007, knew nothing about the challenged financial reporting thereafter, and never told the investigator for plaintiffs’ counsel (again Robbins Geller) that he discussed the individual defendants’ knowledge of SunTrust’s financial reporting thereafter.  Based on Mr. Trapani’s declarations, the court reconsidered its motion-to-dismiss order and dismissed the action.  The court “reluctantly” decided against sanctions because it appeared that notes from plaintiffs’ investigator, Desiree Torres, supported the FAC’s allegations related to Mr. Trapani.

Ms. Torres later contacted the court and indicated that she was concerned with the accuracy of information plaintiffs’ counsel submitted in their argument against sanctions.  The court held a hearing to hear from Ms. Torres, her firm, and the parties, including Robbins Geller.  Ms. Torres indicated that she had quit her job over the situation.  She said her primary concerns were that, in her view, the submissions incorrectly suggested that plaintiffs’ counsel was not part of interviews of Mr. Trapani in which he indicated that he left SunTrust in August 2007, and that plaintiffs’ allegations inaccurately portrayed Mr. Trapani’s knowledge of matters after August 2007.

At the hearing, Robbins Geller examined Ms. Torres in detail about the interviews of Mr. Trapani and plaintiffs’ pleadings.  If you are a securities litigation geek, you’ll find the transcript fascinating.  In a nutshell, the problem seems to have been caused by a combination of vagueness in what Mr. Trapani said he knew after August 2007, which apparently was occasioned in part by his unwillingness to provide certain details to plaintiffs’ counsel and their investigators, and plaintiffs’ counsel’s interpretation, inferences, and extrapolation of the information he did provide – and then plaintiffs’ counsel’s failure to correct their prior allegations and argument once the scope of Mr. Trapani’s knowledge became clearer.

The court took the matter under advisement, and in a post-hearing order did not impose Rule 11 sanctions:

After hearing testimony and argument at the hearing, the Court concludes that, while not in keeping with the conduct expected of attorneys practicing before this Court, Plaintiff’s counsel’s actions in this matter did not constitute an actionable violation of the Federal Rules of Civil Procedure. The Court remains troubled by the conduct of Plaintiff’s counsel in failing to correct representations made in their pleadings or to notify the Court of them immediately after it became apparent that Trapani did not have knowledge after August 2007 of Defendants’ conduct or beliefs regarding the [reserves]. The decision not to correct the record after counsel became aware of the Court’s reliance on Plaintiff’s representations is perplexing and disappointing. Had Plaintiff’s counsel done so, Ms. Torres likely would not have felt compelled to contact the Court after reading the August 28th Order based on her understanding of the manner in which the Court interpreted the information that was provided to it by Plaintiff’s counsel.

City of Livonia v. Boeing (N.D. Ill., Case NO. 09 C 7143; 7th Cir. Case Nos. 12-1899, 12-2009).  On the basis of allegations based on information allegedly obtained from a CW, Bishnujee Singh, the court denied defendants’ motion to dismiss.  Boeing’s investigation revealed that plaintiffs’ allegations based on Mr. Singh were incorrect, including the allegations that he was employed by Boeing (he was not; he was employed by a contractor of Boeing), or highly improbable, including the allegation that he communicated with senior management.  Boeing took his deposition.  He denied almost everything the investigator for plaintiffs’ counsel (again Robbins Geller) had attributed to him.

Defendants filed a motion for reconsideration of the court’s order denying their motion to dismiss.  The district court granted the motion and dismissed the complaint.  Defendants didn’t file a motion for Rule 11 sanctions, and the court didn’t impose them on its own.

Plaintiffs moved for relief from that order on various grounds, including assertions that the documents Boeing produced confirmed the information Mr. Singh provided, and that Mr. Singh’s recantation was caused by his desire to work directly for Boeing.  In support of their recantation theory, plaintiffs cited an email from Mr. Singh to senior Boeing employees, which plaintiffs characterized as follows:

Singh’s communications with Boeing employees also demonstrate his motive to change his story. He actively sought work at Boeing. Pl. Br. at 9, 13. On the very day of his deposition, Singh wrote directly to Michael Denton, who he had identified in his meeting with the investigator as the Vice President of Engineering for the 787 Program, and Jim Albaugh, defendant Carson’s replacement at Boeing, noting that he was “following up” with them, and stating that he deserved “[a]t least” a “THANK YOU!” for “trying my best to help in all possible ways to Boeing group in this disposition [sic] case by denying knowledge of the facts.” Pl. Br. at 4; Dkt. No. 173, Ex. 1. Eight days later, Singh filed another application for work at Boeing.

The Seventh Circuit, in an opinion by Judge Richard Posner, affirmed the dismissal, and remanded the case to the district court to address plaintiffs’ counsel’s compliance with Rule 11, which Judge Posner noted the Reform Act requires even without a motion by defendants.  2013 WL 1197791 (7th Cir. March 26, 2013).  Judge Posner noted that the evidence suggested that plaintiffs’ counsel’s investigator had “qualms” about the information Mr. Singh provided, and that the failure of some of the evidence to check out “should have been a red flag.”  Judge Posner’s criticism of plaintiffs’ counsel was blistering:

Their failure to inquire further puts one in mind of ostrich tactics—of failing to inquire for fear that the inquiry might reveal stronger evidence of their scienter regarding the authenticity of the confidential source than the flimsy evidence of scienter they were able to marshal against Boeing. Representations in a filing in a federal district court that are not grounded in an “inquiry reasonable under the circumstances” or that are unlikely to “have evidentiary support after a reasonable opportunity for further investigation or discovery” violate Rules 11(b) and 11(b)(3).

The plaintiffs’ law firm–Robbins Geller Rudman & Dowd LLP–was criticized for misleading allegations, concerning confidential sources, made to stave off dismissal of a securities-fraud case much like this one, in Belmont Holdings Corp. v. SunTrust Banks, Inc., No. 1:09-cv1185-WSD, 2012 WL 4096146 at *16-18 (N.D.Ga. Aug. 28, 2012).  The firm is described in two other reported cases as having engaged in similar misconduct: Camp v. Sears Holdings Corp., 371 Fed. Appx. 212, 216-17 (2d Cir.2010); Applestein v. Medivation, Inc., 861 F.Supp.2d 1030, 1037-39 (N.D.Cal.2012). Recidivism is relevant in assessing sanctions.  Reed v. Great Lakes Cos., 330 F.3d 931, 936 (7th Cir. 2003).

 The Importance of Solving the Confidential-Witness Problem

 

Obviously, we can’t keep having problems like those at issue in these three cases.  Although these cases have received significant attention because of the prominence of the companies and judges, as well as some extreme facts (e.g. Ms. Torres contacting the court and quitting her job), problems with CW allegations – from disagreement about information attributed to them, to vagueness and ambiguity in the complaint’s descriptions and allegations – exist in many cases.  Finding a solution is important, for two main reasons.

First and foremost, CW allegations based on inaccurate information result in injustice; insufficient complaints aren’t dismissed.  Yet defendants are procedurally limited in their ability to present evidence demonstrating inaccuracies unless and until their motion to dismiss is denied.   This is so because the Reform Act’s stay of discovery during the motion to dismiss process applies to both plaintiffs’ and defendants’ discovery.  So, even if the defendants know that the plaintiffs have completely misstated what a CW told plaintiffs’ counsel/investigator – indeed, even if a purported CW claims not to have spoken with the plaintiffs at all – defendants cannot take discovery to establish such facts without court permission.  And a decision to seek court permission to conduct discovery can be tricky; there’s a risk that discovery will mushroom, and the defendants will lose the benefits of the stay.

Moreover, even if discovery demonstrates inaccuracies in the complaint, there is no completely satisfactory procedural mechanism for raising the issue before the court decides the motion to dismiss.  A Rule 11 motion is the most procedurally suitable procedure, but it is a very serious one, and the defendants rightly approach it with caution, since it can backfire in the form of an angry judge and/or an inefficiently unworkable relationship between the lawyers.  A Rule 12(f) motion to strike isn’t available in at least some courts, and is frowned upon by some others.  And defendants can submit factual information on a motion to dismiss only in limited circumstances.

So, defendants often make the best motion-to-dismiss arguments they can and then address the CW problems after the motion to dismiss is denied.  But, at that point, it’s too often late to effectively address the inaccurate CW allegations, because the case is in discovery, and the CW problems can fade into one of the myriad issues to be sorted out in discovery.

Second, 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 their previous statements.

The result is an unseemly game of he-said/she-said between CWs and plaintiffs’ counsel, in which the referee is ultimately an Article III judge.

If Robbins Geller avoids sanctions in Boeing, it will be major, major news, especially given Judge Posner’s scathing criticism.  I don’t predict that there would be an outpouring of sympathy for Robbins Geller.  But I do believe that a decision not to impose sanctions, along with the outcomes of Lockheed and SunTrust, would prompt scrutiny by commentators and possibly legislators: how could there have been three cases in just the last year that turned from allegations of serious misconduct against plaintiffs’ counsel – accompanied by preliminary but harsh criticism from courts – to conduct the courts ultimately found did not violate Rule 11?

An examination of these CW hearings would necessarily involve a discussion of the Reform Act’s heightened pleading standards; they are the reason plaintiffs’ counsel turns to CWs.  Indeed, in Lockheed, Judge Rakoff’s concluding remarks noted that extreme pleading standards involve “dangers” – for example, the “difficulties plaintiffs have in getting information that they know they’re going to have to get to meet the very high standard that the Supreme Court has now imposed on plaintiffs in these cases.”

It would be highly unfortunate, however, if there were serious discussion about reforming the Reform Act’s pleading standards or other protections.  The CW problem can be solved through simpler means that do not undermine the Reform Act’s protections, which have created a system of securities litigation that is vastly superior to the one the Reform Act reformed.

Some Suggested Reforms to the CW Process

An effective solution to the CW problem could be achieved with three reforms:

First, plaintiffs’ counsel should be required to obtain from each confidential witness a declaration and/or a certification that he or she has read the complaint and agrees with the description of the information he or she provided.  This simple requirement would prevent most CW problems, and make the ones that do arise much easier to resolve.  Although some witnesses may balk at providing a declaration, few legitimate witnesses with accurate information to provide would hesitate to certify the accuracy of the relevant portions of the complaint – indeed, most would want to do so, to avoid the hassles that misunderstandings can cause.

Second, plaintiffs should be required to precisely describe, at a minimum, the following information for each CW: (1) employment dates – by day, month, and year; (2) employment responsibilities – including job title, job description, and a detailed list of job responsibilities, and the substance and exact date of any changes; and (3) how the CW knows the information the complaint alleges. There can be no reasonable objection to CWs providing these facts. With regard to employment information, CWs know it precisely and, if they don’t recall precisely, they have documents that reflect it. With regard to the basis of knowledge, if the CWs can’t recall the basis, there’s no good reason to credit the other information the complaint alleges. Indeed, under current law, vagueness in these three areas undermines the CW allegations.

Third, defendants should be allowed to seek limited discovery, without risk to their discovery-stay rights, and to offer evidence to address significant inaccuracies before the motion to dismiss, through a motion to strike the inaccurate allegations – or, alternatively, during the motion-to-dismiss process itself, without converting the motion to a summary judgment motion.  Having a designated process for raising these concerns would help attorneys and the judge to navigate a moderate middle course between the two extremes that are pervasive today – either allowing inaccurate allegations to survive through a motion to dismiss, or taking the dramatic step of filing a Rule 11 motion against plaintiffs’ counsel.  Defendants should not be required to resort to Rule 11 to raise these issues, though they should be permitted to use Rule 11 if the conduct of plaintiffs’ counsel makes it the most appropriate course of action.

These three measures would have prevented the problems at issue in Lockheed, SunTrust, and Boeing.  For example:

  • If the CWs in Lockheed had provided declarations or certifications, Judge Rakoff would not have had to hold a day-long hearing to determine whether the CWs, in fact, told plaintiffs’ counsel’s investigator the information alleged in the complaint.
  • If plaintiffs’ counsel in SunTrust were required to more precisely allege Mr. Trapani’s employment dates, the court and parties could have avoided the hassle and spectacle of the hearing to settle this basic issue.
  • In all three cases, it would have been more efficient and less costly if defendants had an effective means of raising these concerns before the motion to dismiss, or, at the very least, during the motion-to-dismiss process.

These reforms would not only prevent unseemly showdowns – between defense counsel and plaintiffs’ counsel, or among plaintiffs’ counsel, their CWs and their investigators.  They would make all securities class action complaints more factually accurate and thus make the outcomes more just – and would help to avoid continued actions against plaintiffs’ counsel, which could eventually cause Congress to consider reforming the Reform Act.

 

* I do not include shareholder challenges to mergers in the category of “securities class actions.”  Merger cases present the biggest issue facing shareholder litigation in general:  a system that not only allows, but encourages, meritless shareholder challenges.  See here for my post on suggested reforms in that area.

In our post in the immediate wake of the Supreme Court’s decision in Amgen Inc. v. Connecticut Retirement Plans, we concluded that rather than being a new threat to the defense of securities class actions, Amgen basically endorsed the status quo: In holding that plaintiffs do not need to establish that allegedly false statements were material to the market before they can gain class certification, the Amgen Court reinforced the rule that is already followed in most courts.  At the same time, we promised to dive deeper in a future post, to discuss the effect of Amgen in those circuits that had previously entertained disputes over materiality in determining whether to certify a class.

This was a weighty task.  In the absence of clear guidance from the Supreme Court, the law on class certification has developed in myriad, complex, and contradictory ways across the circuit courts. The precise legal effect of the Amgen decision will therefore vary from one circuit to the next, as the law in many circuits has not been fully developed, and other circuits have developed distinct doctrines in their effort to find a principled way to implement the fraud-on-the-market presumption from Basic v. Levinson.  Yet a survey of these circuit court decisions, and the way that they have been interpreted in the district courts, merely reinforces our conclusion that Amgen will have relatively little negative practical impact on defendants – in any jurisdiction.  Far from being a “crushing blow” to the defense bar that will “make it easier” for plaintiffs to maintain securities class actions, as many commentators have claimed, the Amgen decision seems to close very few strategic doors to the defense, no matter where a case is litigated.

This is true for three primary reasons.  First, most of the arguments that defendants have made to dispute materiality at class certification are the same as arguments that can be made – and often are, with greater success – on a motion to dismiss, because they challenge fundamental flaws in the complaint that point to plaintiffs’ inability to make sufficient allegations of falsity and loss causation.  Second, the only circuit that required plaintiffs to “prove” materiality before a class would be certified was the Fifth Circuit, whose holdings in this regard had already been largely neutralized by the Supreme Court’s 2011 ruling in Erica P. John Fund, Inc. v. Halliburton.  Finally, in those circuits that had allowed defendants a chance to rebut materiality and thus defeat class certification – in particular, the Second and Third Circuits – the bar was already set so high that this opportunity seemed to be largely illusory.

As an initial matter, it is necessary to identify those circuits that have holdings which are incompatible with the Amgen opinion.  While many circuit courts have yet to grapple explicitly with the issue, the Amgen ruling is in line with the approach articulated by the Ninth Circuit (see that court’s decision in Amgen, 660 F.3d 1170 (9th Cir. 2011)) and the Seventh Circuit (see Schleicher v. Wendt, 618 F.3d 679, 687 (2010)), and the emerging doctrine of the First Circuit (see, e.g., In re Boston Scientific Corp., 604 F. Supp.2d 275 (D. Mass. 2009)) and the Fourth Circuit (see, e.g., In re Red Hat, Inc., Sec. Litig., 261 F.R.D. 83 (E.D. N.C. 2009)).  On the other hand, as discussed below, Amgen raises questions when examined in connection with the extreme approach formerly taken by the Fifth Circuit (see Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F.3d 261, 267 (5th Cir. 2007)) as well as the more moderate doctrines articulated by the Second Circuit (see In re Salomon Analyst Metromedia Litigation, 544 F.3d 474, 484 (2d Cir. 2008)) and the Third Circuit (see In re DVI, Inc. Securities Litigation, 639 F. 3d 623, 631 (3d Cir. 2011)).

Until 2011, the Fifth Circuit took the most aggressive approach toward class certification, requiring not only proof that an alleged misstatement “actually moved” the market in order to invoke the fraud-on-the-market presumption, but also requiring plaintiffs to prove loss causation.  This doctrine was summarily rejected by a unanimous Supreme Court in Halliburton, which found that the requirement that plaintiffs prove loss causation to gain class certification was “not justified by Basic or its logic.”  (See 131 S.Ct. 2179 (2011)). It is not clear what, if anything, remained of the Fifth Circuit’s doctrine after Halliburton.  Arguably, a requirement survived that plaintiffs make a showing prior to class certification that either the misrepresentation or the corrective disclosure had an impact on stock price, but that is unclear, because the Fifth Circuit’s justification for this requirement was closely tied to its demand that plaintiffs prove loss causation – and neither the Fifth Circuit nor its district courts have made rulings on this basis since the Halliburton decision.

By contrast, the rule in the Second Circuit survived Halliburton, but was overturned by Amgen. According to the Second Circuit, plaintiffs were required to make “some showing” of materiality in order to trigger the fraud-on-the-market presumption, either through showing an impact of information on the stock price, or simply by arguing that there was a “substantial likelihood” that the misrepresented or omitted information “would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.” (See Salomon, 544 F.3d at 485).  At that point, the burden shifted to the defendants to rebut the presumption of reliance, with evidence that “severs the link” between the alleged misrepresentation and the price of the stock.

Similarly, the Third Circuit ruled in 2011 that district courts may consider evidence to rebut the presumption of reliance, and thereby defeat class certification.  The court reasoned that evidence that a corrective disclosure did not affect the market price could defeat class certification in one of two ways.  If the statement was material, it could show that the market was not efficient in absorbing information (an acknowledged prerequisite to the Basic presumption).  On the other hand, if the market was efficient but the corrective disclosure did not affect the stock price, the Third Circuit held that it could demonstrate that the challenged statement was immaterial as a matter of law. (See In re DVI, 639 F. 3d at 638).

Before Halliburton, the Fifth Circuit’s standard undoubtedly made it difficult for plaintiffs to gain class certification – not only because loss causation was explicitly incorporated into the class certification inquiry, but because plaintiffs bore the burden of proving loss causation before certification was granted.  As noted above, much or all of this hurdle was removed by Halliburton, leaving little or nothing for Amgen to resolve.  By contrast, the standard used by in the Second and Third Circuits placed the burden on the defendants to rebut the presumption of materiality.  Although this gave defendants the opportunity to present evidence about materiality, including expert testimony, the courts implementing this standard generally found that the defendants had failed to meet their burden, and granted class certification despite this evidence.  In ruling that defendants could not present evidence to rebut materiality until summary judgment or trial, the Amgen Court eliminated the possibility that this materiality evidence will be considered at the class certification stage – but this ruling will likely have little practical effect in the Second and Third Circuits, where that opportunity did not seem to give defendants any real advantage.

What is most striking in the pre-Amgen cases that considered materiality on class certification was that nearly all of the arguments that defendants advanced could have been advanced – and often, already had been advanced – at the motion-to-dismiss stage.  If the courts had already accepted these arguments on a motion to dismiss, in most cases the issue would not have reached class certification.  On the other hand, if the courts had already rejected these contentions once at the motion-to-dismiss stage, they did not seem to be any more willing to accept them when they were reframed on class certification.  For example, defendants in these cases sought to defeat materiality by contending that the defendant company had disclosed the truth to the market, rendering the allegedly false statement material.  This argument is easily recast, especially in the case of alleged omissions, to contend that plaintiffs failed to adequately allege of the existence of a false or misleading statement in the first place. Similarly, at class certification, defendants advanced arguments that the plaintiffs had failed to connect the alleged misstatements with any corrective disclosure that revealed the truth to the market, or that they were unable to point to a drop in the stock price following the corrective disclosure – failures that the courts already routinely recognize as fatal to adequate pleading of loss causation, which can be adjudicated on motions to dismiss.

Indeed, the only arguments advanced by defendants in these cases that were unique to the class certification procedure were those that used expert testimony to assert that a price drop was not due to an alleged corrective disclosure, but rather to other negative information that was released simultaneously, or general adverse market conditions.  These contentions involved difficult factual distinctions that the district courts were reluctant to make, particularly in the Second Circuit, where the defendants carried the burden of disproving materiality.

In sum, the Amgen decision seems to foreclose very little in terms of defense strategy.  It may eliminate the use of expert testimony regarding materiality on class certification motions – although such testimony can still be relevant regarding the “efficiency” of the market for the company’s stock.  And it will likely foreclose defendants’ efforts to contend, based largely on expert testimony, that a stock price drop was not the result of a corrective disclosure, but of other factors present at the same time – although defendants should still be able to offer evidence and expert testimony to define the proper contours of the class period based on market events and the timing of corrective disclosures.  But most of the defense arguments that have been used to oppose class certification – whether they are phrased in terms of materiality, falsity, or loss causation – will continue to be available, and effective, through motions to dismiss.

More significantly, the Amgen decision suggests room for doubt on the larger question of reliance – the most fundamental and problematic issue for plaintiffs in obtaining certification of a securities class action.  The decision all but invites the defense bar to use its creativity to find the right argument to advance in the right case, to engage district and circuit courts that are already struggling with the fraud-on-the-market doctrine, and in turn, to tempt the Supreme Court into reconsidering the wisdom of Basic (which it has shown a clear inclination to do).  While Amgen may have closed the door on a few defense strategies – which were rarely successful, in any case, in defeating class certification – it has simultaneously opened the window for defense counsel to find new ways to illustrate the shortcomings of the Basic presumption, and thus to mount a much more serious challenge to ability of the plaintiffs’ bar to bring securities class actions.

Two recent cases from the Southern District of New York discussed the application of the Supreme Court’s opinion in Janus to pleading corporate scienter in Reform Act cases.  Judge Pauley, in Pennsylvania Public School Employee’s Retirement System v. Bank of America Corporation, came to the conclusion that Janus does not inform the pleading of corporate scienter, although perhaps only on procedural grounds.  Judge Sullivan in In re UBS AG Securities Litigation, came to a similar result, while concluding that Janus put an end to the “group pleading doctrine.”  The cases highlight the difficulties courts face, on a motion to dismiss, in applying tests for scienter, when the issue is not the scienter of an individual defendant, but the scienter of a corporate defendant.  As a practical matter, that may mean that motions to dismiss for failure to adequately plead scienter of a corporate defendant may be more difficult to obtain.

Despite the view of some that “corporations are people too,” corporations cannot literally speak or think, and cannot therefore literally make a false statement or form an intent to defraud.  They speak and think only through their agents.  In the typical securities case, the individual director or officer defendants are the “agents” who both make a statement and allegedly know of its falsity.  But what of the case where the pleadings do not adequately allege that the individual defendants spoke with the requisite scienter, can the pleadings still demonstrate that the corporate defendant had any intent to defraud?

The Second Circuit, in Teamster’s Local 455 Freight Persian Fund v. Dynex Capital Inc.  observed that “it is possible to raise the required inference [of corporate scienter] without doing so with regard to a specific individual defendant.”  And in a well-known hypothetical, the Seventh Circuit, on remand, following the Supreme Court’s decision in Tellabs, hypothesized:

Suppose General Motors announced that it had sold one million SUVs in 2006 and the actual number was zero.  There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false.

Inferring corporate scienter makes some sense in such a situation because what the court is really inferring is that someone who can be held responsible for making the statement knew that it was false.  This makes the corporate scienter inquiry very similar to the “core operations” inference, under which, courts can infer scienter in certain situations involving such blatant falsity that it would be “absurd to suggest” that management was without knowledge of the matter.

Continue Reading Pleading Corporate Scienter: Does Janus Inform the Analysis?