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

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

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

In the Court of Chancery, Vice Chancellor Travis Laster ruled that the plaintiffs in the previously dismissed litigation, filed in California, provided “inadequate representation” to the corporation because, unlike the plaintiffs in the Delaware action, they did not utilize Section 220 to attempt to determine whether their claims were well-founded.  46 A.3d 313, 335-51 (Del. Ch. 2012).  The failure to provide adequate representation deprived the dismissal of preclusive effect.  In South v. Baker (the Hecla Mining derivative case), Vice Chancellor Laster similarly ruled that derivative plaintiffs who filed without the benefit of 220 provided inadequate representation.  2012 WL 4372538, at *20 (Del. Ch. Sept. 25, 2012).

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

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

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

The Supreme Court’s decision in Amgen

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

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

Federal courts’ application of the scienter decision in Matrixx

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

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

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

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

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

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

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

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

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