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

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

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

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

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

Origin of Summary Scienter Analysis

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

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

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

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

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

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

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

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

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

Scienter Analysis under Tellabs

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

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

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

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

Scienter Analysis under the 1934 Act and Reform Act

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

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

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

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

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

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

 

On April 16, 2013, Law360 featured me in its Q&A series.

In the article, I address two critical economic issues in securities litigation defense: containing escalating defense costs, and managing electronic document review.  I also discuss the Supreme Court’s Amgen decision, a securities litigation defense lawyer who impressed me, a case that helped launch my career as a securities litigator, and a mistake that I made.

I hope you will take a moment to read the article.

 

On April 4, 2013, in the Allergan decision, the Delaware Supreme Court reversed the Court of Chancery’s ruling last year that the dismissal of a shareholder derivative action in California did not preclude other stockholders from bringing the same corporate claim in Delaware.  The Delaware Supreme Court’s decision was based on a Constitutional Full Faith and Credit analysis.

The Court of Chancery, in contrast, had looked to Delaware’s internal affairs doctrine and demand futility requirement, which the Supreme Court said was error.  Central to the Court of Chancery’s analysis was a presumption that the California plaintiffs provided inadequate representation because they did not conduct a Section 220 books and records inspection before filing.  However, the Supreme Court rejected this “‘fast filer’ irrebuttable presumption of inadequacy,” holding that plaintiffs who fail to do a Section 220 action are not necessarily inadequate.

The commentary about the Delaware Supreme Court’s decision understandably has focused on the Full Faith and Credit analysis and the Supreme Court’s apparent rejection of a Delaware-centric attitude toward shareholder litigation involving Delaware corporations.  Defense lawyers have lauded the decision as a step towards solving the problem of multi-jurisdictional shareholder litigation.

In my opinion, however, the more important and enduring feature of the decision is the Delaware Supreme Court’s rejection of the “fast filer” presumption of inadequacy.  For a further discussion of the fast-filer issue, please see my prior post on the Allergan and Hecla Mining Court of Chancery decisions.  For a helpful discussion of the Allergan Delaware Supreme Court decision, please see Kevin LaCroix’s blog, The D&O Diary.

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.  Such a rule inevitably would have reduced the number of shareholder cases filed, because plaintiffs’ counsel would have had to be more selective about the cases in which it invested the time and money to investigate.  Thus, the Delaware Supreme Court passed up an opportunity to actually reduce the number of shareholder derivative actions – especially those without merit.   On the other hand, as I wrote in my prior post, a 220 requirement would make cases that are filed more virulent, because they would be more difficult to dispose of on a motion to dismiss.

Leaving the system as is, however, means that stockholders will continue to file a lot of bad cases – in Delaware and elsewhere, and sometimes in multiple places.  And the root cause of the multi-jurisdictional shareholder litigation problem is more this reflexive, thoughtless filing of meritless cases than the fact that they are filed in multiple jurisdictions.  The Delaware Supreme Court thus passed up an opportunity to craft a rule that would have had profound impact on all shareholder litigation, including merger cases.

But I doubt that the Full Faith and Credit aspect of the decision in Allergan will have a significant impact on merger litigation, the most prolific and meritless type of shareholder litigation.  This is so for two reasons.

First, Allergan was a shareholder derivative action concerning the board’s alleged failure to prevent an off-label marketing problem, asserting the derivative claim that the corporation was damaged by the board’s breaches of fiduciary duties.  Most merger cases are filed as class actions asserting shareholders’ direct claims, not as derivative actions asserting corporate claims.  The collateral estoppel analysis in Allergan was dependent upon a determination of privity that is unique to the context of a shareholder derivative action.  Thus, Allergan’s collateral estoppel analysis doesn’t break new ground regarding merger class actions, and therefore would have no direct effect on most merger litigation.

Second, few merger cases are litigated to dispositive decisions that a Delaware court is even asked to respect.  The vast majority of them settle long before that point.  As a result, there has hardly been a wave of Delaware decisions failing to honor another state’s dismissal of a merger case.  Indeed, one of the central problems with merger litigation is the fact that there are too few decisions on the merits.  In a prior post on merger litigation, I discuss some of the reasons why there is too little merits litigation in merger cases.

A rule requiring stockholders to use Section 220 would be a mixed bag – as discussed above, there may be fewer cases, but those that remained would be harder to dispose of on a motion to dismiss.  But the Delaware Supreme Court’s rejection of such a rule was a bit of a letdown.  Such a presumption against fast filers, even if fashioned strictly in the context of derivative actions, would likely have had a domino effect, and also led to greater investigation by stockholders before filing merger class actions.  That would have had a positive impact; even a little more investigation would be better than the current system of no investigation at all.

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.

The Supreme Court released its anxiously awaited decision in Amgen Inc. v. Connecticut Retirement Plans yesterday. On the face of the decision, it was a loss for defendants in that case, and for companies everywhere that are forced to defend themselves against securities class action lawsuits – as the Court found that plaintiffs do not need to establish that allegedly false statements were material to the market before they can gain class certification.

As I have written before (see here and here), the Court had an opportunity in Amgen to make class certification a more meaningful stage in securities class actions, providing defendants with a new tool for stopping unmeritorious cases early in the process.  On the surface of the Amgen decision, the Court declined to take that step.  For this reason, many of the early reports indicate that the defense bar is concerned about the impact of Amgen.  I’m not concerned.  At worst, Amgen leaves defendants in most circuits in the same position they were before.  (Look for our upcoming post analyzing the effect that Amgen will have in the minority of circuits, such as the Second Circuit, which have previously ruled that materiality can be considered on class certification.)  The decision leaves open several arguments that will allow defendants to continue to challenge lack of materiality in the early stages of litigation.  And, perhaps most significantly, the decision seems to tee up the Court’s re-consideration of the legitimacy and scope of the fraud-on-the-market presumption of reliance that it adopted in Basic v. Levinson.

I explore Amgen’s impact after discussing its majority, concurring, and dissenting opinions.

In a majority opinion authored by Justice Ginsburg, and joined by Chief Justice John Roberts and Justices Breyer, Alito, Sotomayor, and Kagan, the Court concluded that proof of materiality was not necessary to demonstrate, as Rule 23(b)(3) requires, that questions of law or fact common to the class will “predominate over any questions affecting only individual members.”  The Court reasoned that this was because: 1) materiality was judged according to an objective standard that could be proven through evidence common to the class, and 2) a failure to prove materiality would not just defeat an attempt to certify a class, it would also defeat all of individual claims, because it is an essential element to a claim under Section 10(b).

Much can be said, and doubtless will be said, in criticism of the majority’s decision.  Its chief flaw is its avoidance of the central question through circular reasoning.  The materiality of a statement is an essential prerequisite for the application of the fraud-on-the market presumption that the Court developed in Basic v. Levinson, as a device to overcome the need to prove actual, individual reliance on a false or misleading statement – which made securities class actions all but impossible to bring.  In  Basic, the Court used then-emerging economic theory to create a rebuttable presumption of reliance, based on the assumption that a security traded in an efficient market reflects all public material information, and that traders in that market rely on the market price, and thus on any material misrepresentations that are reflected in the price.  The Amgen Court does not dispute that the materiality of a misrepresentation is necessary to create the fraud-on-the-market presumption, nor that the fraud-on-the-market presumption is essential to show under Rule 23 that common questions predominate for the class.

Instead, to avoid the logical conclusion that a showing of materiality was thus necessary to certify the class, the Court reasons backwards:  because plaintiffs must also show the materiality of the alleged misstatements in order to prove the underlying merits of a Section 10(b) claim, a finding that there was no materiality would defeat claims for all plaintiffs, whether brought as a class or individually.  Therefore, the Court concluded, materiality (or the lack of it) was a “common question,” that should not be decided until summary judgment, or theoretically, trial.

As Justice Thomas writes in his dissent (joined by Justice Scalia (in part) and Justice Kennedy), the majority essentially “reverses” the inquiry.  Although class certification is supposed to be decided early in the litigation, and depends upon a showing of materiality to invoke the fraud-on-the-market presumption, the majority effectively says that that portion of the class certification inquiry can be skipped, merely because it is also a question that will be asked at the merits stage.  Writes Thomas:  “A plaintiff who cannot prove materiality does not simply have a claim that is ‘dead on arrival’ at the merits. . .he has a class that never should have arrived at the merits at all because it failed in Rule 23(b)(3) certification from the outset.”

Despite the flaws of the decision, the Court has spoken, and there is limited usefulness to arguing about whether or not its decision is correct.  But lurking under the surface of the opinion are a number of issues that leave ample room for continued litigation over “materiality” issues:

1) The Court affirmed the district court in rejecting Amgen’s effort to offer rebuttal evidence upon class certification that would demonstrate that the misstatement was not material because the truth of the matter had already been disclosed to the market.  If this argument is framed as a “truth on the market” defense, alleging that truthful information had already entered the market by other means, then it is traditionally a question that is entertained at the summary judgment stage.  On the other hand, in its narrow focus on “materiality,” the Court overlooked that this may also be a question properly raised on a motion to dismiss:  if plaintiffs challenge a statement as misleading because it fails to disclose certain information, then the fact that the same information was actually disclosed (in that statement or other statement by the company), negates the existence of a false or misleading statement in the first place.  The Amgen decision will not affect defendants’ ability to make this challenge on a motion to dismiss, as an argument not against materiality, but rather against the sufficiency of plaintiffs’ allegations of falsity.

2) Because Amgen conceded that the market for its stock was “efficient,” the Court avoided more searching examination of what this term means, and how the efficiency of a market – an undisputed prerequisite to the application of the fraud-on-the-market presumption at the class certification stage – can be challenged.  In footnote 6, the Court noted that Amgen had advanced an argument founded on modern economic research tending to show that market efficiency was not a “binary, yes or no question.”  Rather, the efficiency of a market in absorbing information depends upon the type of information – a market might be able to readily process easily digestible information like public merger announcements, while the same market could be slow to respond to potentially important technical or scientific disclosures in an SEC filing. The Court sidestepped the issues raised by this argument, by saying that it did not impact the “materiality” question.

But the argument does raise the question of how efficiency should be defined, and whether the efficiency of a market may depend on the type of statement in question and/or its price impact.  The Court thus left the door open to question on class certification whether a statement was “efficiently” absorbed into, and thus reflected by, the market price.  This argument is a close cousin to materiality, with one important distinction:  I can imagine a circumstance in which a court could find that a public statement was not absorbed into, or reflected by the market price, and that the fraud-on-the-market presumption should not apply – but that, regardless, the statement was still “material,” in that a reasonable investor would find it significant.  In such an instance, the certification of a class would properly be defeated, but the ultimate question of materiality would be left open for an independent determination on the merits should an individual investor bring suit.  Such a circumstance would break the circle upon which the Court based its holding in Amgen.

3) Perhaps the most striking part of the decision was Justice Alito’s one paragraph concurrence, which baldly called for a reconsideration of the fraud-on-the-market presumption created in Basic.  Alito concurred with the majority, but only with the understanding that Amgen had not asked for Basic to be revisited.  Alito thus signaled that he agreed with Thomas’s contention in footnote 4 of the dissent that the Basic decision was “questionable.”  The majority, in turn, did not come to the defense of Basic, but simply noted with apparent relief (in footnote 2) that even Justice Thomas had acknowledged that the Court had not been asked to revisit that issue.  Considered together, these three opinions put out a welcome mat for the right case challenging Basic’s fraud-on-the-market presumption, with four votes already supporting the view that the decision was “questionable,” and the other five failing to come to its defense.  When, and if, Basic is reconsidered, the result could have a much larger impact on the future of class actions than would have been felt by any decision on the “materiality” questions raised in Amgen.

In summary, my first take on the Amgen decision is that far from settling the question of what plaintiffs must prove to gain class certification, it has merely opened the doors wider for continued litigation on the matter.  I predict that these issues are going to continue to be challenged, and that another case on class certification will be before the Court within the next few years.  After considering class-certification issues in Halliburton in 2011, and now in Amgen, the Court seems destined at long last to reach the ultimate question – the legitimacy and scope of the fraud-on-the-market presumption.

That doesn’t mean that Amgen will be forgotten – in addition to leaving behind a number of crumbs to feed continued litigation of “materiality” questions, the majority seemed to signal a shift away from its historic narrow construction of the securities laws based on the Court’s observation in Blue Chip Stamps v. Manor Drug Stores that “litigation under Rule 10b-5 presents a danger of vexatiousness different in degree and in kind from that which accompanies litigation in general.”  421 U.S. 723, 739 (1975).  Here, the Court flatly rejected Amgen’s argument based upon the public policy interest of containing that “vexatiousness.”  Amgen argued that if materiality was not addressed in class certification, it was likely not to be ever addressed at all, because after class certification, plaintiffs are able to bring substantial pressure to bear on defendants to get them to settle before the merits phase – even on frivolous claims.  But the Court contended that Congress had already taken steps, through the Reform Act, to curb the “‘extraction’ of ‘extortionate settlements’” of frivolous claims,” and, in doing so, had consciously decided not to challenge the fraud-on-the-market presumption. And while continuing to recognize the potential for abuse, the Court nonetheless chose to emphasize the possibility that securities class actions also serve an important public policy purpose, by supplementing the criminal prosecutions and civil enforcement actions brought by the DOJ and the SEC.  As the debate over the “materiality” question continues to play out, this passage may prove to be the most enduring takeaway from Amgen – and the one most likely to haunt us in plaintiffs’ briefs in the coming years.

 

The Reform Act’s heightened pleading standards were designed to increase the number of securities class actions dismissed at the pleading stage.  An unintended consequence, however, has been a liberal application of the already liberal standards for amendment under Rule 15.  In Eminence Capital v. Aspeon, Inc., the Ninth Circuit explained the rationale for this approach:

“We need to bear in mind that we are not operating in the world of notice pleadings. In this technical and demanding corner of the law, the drafting of a cognizable complaint can be a matter of trial and error.”

Often, the result is a lengthy and frustrating cycle of amended complaints and motions to dismiss, which allows foredoomed cases to drag on for years at significant cost and hassle to companies and their directors, officers, and insurers – not to mention the burden placed on the court system.  On the other hand, judges are concerned that if they dismiss cases with prejudice too early in the process, their decisions are more likely to be vulnerable on appeal.

A better approach is long overdue, and some judges are clearly searching for one.  I’d like to share a refreshing approach used by a judge in a recent dismissal of a case we are defending, and ask readers to share other constructive solutions to this dilemma.  I’ll catalogue the responses in a future post.  It would be useful to have a checklist of alternatives to the standard approach, so that defendants can make the best possible arguments against leave to amend.

My recent positive experience was in In re L&L Energy, Inc. Securities Litigation.  On December 3, 2012, Judge Robert Lasnik, former Chief Judge of the Western District of Washington, dismissed the plaintiffs’ Second Amended Complaint (the first litigated complaint). This dismissal is one of only a few dismissal orders in the many cases against China-oriented companies that allege fraud based on differences between financial statements filed in China and the United States.  (The decision will be published in the Federal Supplement.)

Judge Lasnik also rejected the plaintiffs’ boilerplate request for leave to amend.  Instead, he only allowed them the opportunity to file a separate motion for leave to amend, supported by a proposed amended complaint.

This approach has the advantage of forcing plaintiffs to make a Rule 15 showing – that amendment would not be futile – with a proposed amended complaint, before they are allowed to file it and force defendants into another costly and time-consuming motion to dismiss.  If an approach such as this were used more frequently, it would weed out weak cases faster while still allowing the plaintiffs an opportunity to attempt to cure the flaws the dismissal order identifies.  There are cases, however, that call for a first-motion dismissal with prejudice with no such opportunity.

Judge Lasnik used the same procedure in another case I defended, In re Jones Soda Co. Securities Litigation.  There, as in L&L Energy, Judge Lasnik dismissed the complaint on the first motion to dismiss.  The plaintiffs then filed a motion for leave to amend, which the defendants opposed and the Court denied, finding that the proposed amendment would be futile.  The plaintiffs appealed the denial of leave to amend, and the Ninth Circuit affirmed.

Again, I ask the readers to share their own positive leave-to-amend experiences, either in the comments below, or in emails or calls to me.  You can find my contact information here.

Happy Holidays.  D&O Discourse will resume in early January 2013.  Upcoming posts include a discussion of the core operations inference by my partner Claire Davis, who joined Lane Powell from Wilson Sonsini earlier this month, and a review of emerging issues in securities litigation.

On October 24, Kevin LaCroix’s D&O Diary discussed a report called “The Trial Lawyers’ New Merger Tax,” published by the U.S. Chamber Institute for Legal Reform.  The report proposes several legislative approaches that would funnel all shareholder lawsuits challenging mergers to the seller corporation’s state of incorporation.  Kevin has been a leading commentator in the discussion of the M&A-case problem.  I started to write a reply to his October 24 post but my reply became too involved for a simple comment.  So, I decided to turn it into a post here.

I doubt I need to convince many people, including a great many plaintiffs’ lawyers, that the explosion of M&A cases is a problem.  The problem, of course, is not that shareholders bring lawsuits challenging mergers.  Challenges to transactions based on problematic processes, such as the one at issue in Smith v. Van Gorkom, have improved corporate decision-making.  Rather, the problem is that virtually every acquisition of a public company draws a lawsuit, even though very few transactions are actually problematic, and most cases are filed very quickly, before plaintiffs’ lawyers could possibly have enough information to decide whether the case might have merit.

The result is spurious and wasteful litigation.  But very few cases present significant risk, so the vast majority of cases present a simple nuisance that can be resolved through painless additions to the proxy statement and a relatively small payment to the plaintiffs’ lawyers.  Although companies that are sued bemoan the macro M&A-case problem, each individual company understandably focuses on its own case, and the vast majority conclude that it’s best to settle it rather than defend it to the bitter end.  Collectively, however, the M&A-case problem is significant and needs to be addressed.

Everyone suffers from the M&A-case problem.  Public companies being acquired now expect to be sued, regardless how favorable the transaction and how pristine the process, and are paying higher D&O insurance premiums.  D&O insurers collectively have suffered the full brunt of the problem through payment of defense costs and settlements.  Plaintiffs’ securities lawyers who don’t bring M&A cases, or who bring them more thoughtfully than others, suffer from guilt by association.  Defense lawyers’ law practices have benefited from the increase in M&A cases, but I for one – and I’d bet that the vast majority of my peers would agree with me – would prefer to defend more legitimate M&A cases or other types of matters than the type of M&A cases I’m addressing.

I believe there are two sets of related root causes of the M&A-case problem:

  1. There are too many plaintiffs’ lawyers who bring M&A cases, and too many lawyers file cases over the same transaction with too little coordination among the cases.
  2. Too few cases are weeded out on a motion to dismiss, before the time to settle arrives.  This is due to a number of factors and dynamics, including pleading standards, expedited discovery, and the timing of the transaction.

These sets of causes are intertwined.  Companies are willing to settle because they want certainty that the deal will close on time.  They need to settle to ensure certainty, even if the case lacks merit, because too few cases are dismissed.  They are able to settle because they usually can do so quickly and cheaply.  This is so because few of the plaintiffs’ M&A firms are set up to vigorously litigate even a small percentage of the cases they file; instead, these law firms take a low-intensity, high-volume approach.  Such firms can survive in the M&A-case “market” because of the two root causes: (1) there is too little coordination of the cases – which means that firms often obtain some recovery just by filing a case – and (2) too few cases are weeded out at the dismissal stage – which means that companies must settle to obtain certainty that the deal will close on time.

All of the foregoing adds up to make the M&A litigation business an attractive one for certain plaintiffs’ lawyers.  That attraction increases the number of plaintiffs’ lawyers trolling for cases, which in turn leads to more filings.

Continue Reading M&A Litigation: A Potential Partial Solution to a Big Problem

Plaintiffs’ lawyers are facing intense judicial scrutiny of problems with their use of “confidential witnesses” (“CWs”) in the Lockheed Martin and SunTrust securities class actions.  Courts have recently addressed similar CW problems in two other high-profile securities class actions, Sears Holdings (affirmed by the Second Circuit) and Boeing.

Courts need to scrutinize CWs more closely in deciding motions to dismiss – not just in post-denial motions for reconsideration or summary judgment following CW discovery.  After discussing the two current cases, I propose two modest reforms.

Belmont Holdings v. SunTrust Banks

In SunTrust, the court denied defendants’ motions to dismiss the First Amended Complaint (“FAC”), based primarily on purported claims from a CW, Mr. Trapani, that the individual defendants knew that certain financial reporting at the end of 2007 was false.*  Mr. Trapani left SunTrust in August 2007, but the FAC alleged that Mr. Trapani worked at SunTrust from “2005 through 2007” and contained several references to information he provided concerning knowledge “throughout 2007.”  During the motion to dismiss process, SunTrust asserted that Mr. Trapani left SunTrust in August 2007.  The court acknowledged the assertion but expressly left  the issue for later, stating it “must assume Trapani had personal knowledge” and if he does not, “the Court will consider later whether these allegations support a violation of the pleading standards under the Federal Rules of Civil Procedure.”

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 plaintiffs’ investigator 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, Ms. Torres, supported the FAC’s allegations based on Mr. Trapani.

So it appeared that plaintiffs’ counsel was off the hook.  But they might not be.  Ms. Torres contacted the court to say she was concerned about the accuracy of plaintiffs’ counsel’s arguments against sanctions.  In particular, she “stated that she had information she wished to share with the Court, including that Plaintiff’s counsel were involved in the interviews of Mr. Trapani and that, in those interviews, Mr. Trapani made clear that he did not have any knowledge after August 2007 ….”

The court has set a hearing for November 9, 2012 to hear more from Ms. Torres, her firm, and the parties.  “The Court will, after the proceeding, evaluate whether further inquiry or action is required.”

City of Pontiac General Employees’ Retirement System v. Lockheed Martin 

In Lockheed, Judge Rakoff denied defendants’ motion to dismiss.  Discovery commenced.  Discovery of the CWs revealed two categories of problems:  (1) several CWs disputed telling plaintiffs’ investigator the facts the complaint attributed to them; and (2) certain of the CW allegations were not based on the CWs’ personal knowledge because the information they provided was outside of their employment dates and/or job responsibilities.  Defendants moved for summary judgment, pointing out the flaws with 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.”  The 218-page hearing transcript allows a rare look into the securities-class-action-complaint-preparation kitchen.  Plaintiffs and defendants submitted post-hearing briefs that slice and dice the complaint’s allegations and evidence revealed during discovery and during the October 1 hearing.  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.”

For more background, see here.

Continue Reading Confidential Witness Hearings in SunTrust and Lockheed Martin Demonstrate Need for Reforms