, Dhaivat H. Shah and
Roberta H. Vespremi 
Originally published July 2009
Please click on the following link to read this article and its footnotes in full: Recent Developments And Trends In Securities
I. INTRODUCTION
2008 and 2009 have seen the continued upwards trend of securities class action filings that began in 2007. There were 210 federal securities class actions filed in 2008, an increase of 29% over 2007.1 In the first two quarters of 2009, there were over 85 class actions filed.2 If this trend continues, there will be over 170 securities class action filings in 2009, consistent with the average pace of 182 filings per year since the enactment of the Private Securities Litigation Reform Act of 1995 (the "Reform Act").3
The trend resulted in large measure from the continued upsurge of securities class actions related to the worldwide financial crisis, including the subprime mortgage meltdown. In 2008, there were a total of 98 actions filed directly related to the financial crisis, roughly 47% of the total securities class actions filed.4 For the first time since the enactment of the Reform Act, the plaintiffs' bar filed more class actions against the financial services industry than any other industry.5 An emerging subset of the financial crisis cases and government investigations is related to auction rate securities. The SEC reached record-breaking settlements with firms charged with misleading investors about the liquidity risks associated with auction rate securities that they underwrote, marketed and sold.
The number of back-dated stock-option-related securities class actions, by contrast, fell dramatically. Only four actions were filed in 2008, and none in the first two quarters of 2009.6 This fall off is not surprising, as the stock options news scandal broke in 2006, and most filings occurred soon thereafter.
There were several other trends of note in 2008-09. The number of accounting-related securities class actions fell to the lowest numbers since the passage of the Reform Act —comprising 40% of cases filed in 2008.7 The number of settlements in 2008 fell to the lowest number in the past ten years—for a total of 95 settlements compared with 121 in 2007.8 Finally, there were 36 securities class actions filed against foreign private issuers in 2008, a 33% increase over 2007.9 Over half of these matters were related to the financial crisis, with the bulk of foreign companies affected being Canadian companies.10
Other interesting developments this year included the Bernard Madoff scandal that broke open in December 2008, quite possibly the largest Ponzi scheme ever, with loss estimates reaching $50 billion.11 Further, the United States passed the Emergency Economic Stabilization Act of 2008, "which recommitted to repurchase toxic assets and recapitalize certain financial institutions. . . . [T]he overall federal resources committed in 2008 to support the financial markets, housing, and financial institutions has been estimated to exceed $6.4 trillion."12
It is against the backdrop of these trends and the exploding financial crisis that we examine significant recent developments in securities litigation. First, the legal landscape continues to develop around the 2007 Supreme Court cases of Bell Atlantic Corp. v. Twombly (antitrust)13 and Tellabs, Inc. v. Makor Issues & Rights, Ltd,14 where the Court ruled that plaintiffs must plead a plausible factual basis for relief and a cogent and compelling inference of fraudulent intent to satisfy the pleading requirements. Second, the Ninth Circuit has issued a number of opinions construing Tellabs against the core operations inference. Third, the Ninth Circuit provided additional clarity on the requirements for pleading loss causation. Fourth, the Fifth Circuit further addressed the requirements of loss causation at the class certification stage. Fifth, the article addresses the Ninth Circuit's most recent opinion on the collective scienter doctrine. Sixth, the Eleventh Circuit recently ruled that companies settling securities class actions can include bar orders under the Reform Act that extinguish their former officers' statutory and contractual rights to advancement and indemnification of legal fees. Seventh, the U.S. Supreme Court recently granted certiorari to settle the question of when an investor is put on inquiry notice of fraud for the purposes of starting the statute of limitations clock for Section 10(b) actions. Finally, this article discusses some of the recently reported decisions from subprime mortgage securities class actions and an update on pending stock options cases.
II. DEVELOPMENTS IN PLEADING STANDARDS FOR SECURITIES ACTIONS
Several significant Supreme Court decisions have been issued in recent years that help define the pleading standards for securities class actions under the Reform Act.
In Bell Atlantic v. Twombly,15 plaintiffs in an antitrust class action alleged that the incumbent local exchange carriers ("ILEC") that emerged from the 1984 divestiture of AT&T's local telephone business engaged in anti-competitive conduct by failing to compete in one another's markets and by engaging in parallel conduct within their own markets to prevent entry by competitive local exchange carriers ("CLEC"). The district court held that plaintiffs failed to state a claim under section 1 of the Sherman Act because the alleged parallel business conduct of the ILECs did not show that they had entered into a conspiracy and that their conduct was fully explained by their independent self-interest in defending their territory. The district court further held that plaintiffs were required to allege additional facts that excluded independent self-interest as the basis for the ILECs' conduct. The Second Circuit reversed on the ground that plaintiffs' allegations must be deemed sufficient unless there was "no set of facts that would permit a plaintiff to demonstrate that the particular parallelism asserted was the product of collusion rather than coincidence."16
Justice Souter, writing for the majority, held that while allegations of parallel conduct showed that it was "conceivable" that there was a conspiracy, plaintiffs had not alleged sufficient facts showing that defendants had acted collusively rather than in their independent self-interest to "nudge[] their claims across the line from conceivable to plausible."17 The Court held that, without more, allegations of parallel conduct did not state a claim for an antitrust conspiracy under Section 1 of the Sherman Act.
Twombly has ramifications that extend beyond pleading requirements for antitrust conspiracy. The Court held that the notice pleading standard under Rule 8 of the Federal Rules of Civil Procedure was not satisfied by "labels and conclusions" and that "[f]actual allegations must be enough to raise a right to relief above the speculative level."18 It overruled the longstanding formulation in Conley v. Gibson19 that a complaint cannot be dismissed on the pleadings "'unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim.'"20 Instead, a plaintiff must plead facts showing a plausible entitlement to relief.
The requirement that a plaintiff show a plausible entitlement to relief is particularly important in the class action context where a plaintiff could otherwise abuse the discovery process by imposing significant burden and cost where there was little likelihood that discovery would lead to facts supporting plaintiff's claims. The Twombly Court stated that it was the same concern with the in terrorem effect of discovery that led to the Court's requirement in Dura Pharmaceuticals, Inc. v. Broudo,21 that plaintiffs be required to plead loss causation in securities class actions.22
Justice Stevens wrote the dissenting opinion with Justice Ginsburg joining. Justice Stevens argued that the majority requirement of pleading factual plausibility was inconsistent with the federal notice pleading regime under Rule 8, which requires only notice of the claim without a need to plead detailed evidentiary facts.23 Justice Stevens further argued that any concerns about permitting discovery on the basis of speculative allegations may be addressed by "careful case management."24
Although Twombly involved an antitrust claim, lower courts expressly applied the "plausibility" pleading standard of Twombly to securities complaints.25This approach was recently validated by the Supreme Court by the majority opinion issued in Ashcroft v. Iqbal.26n Ashcroft, a plaintiff prisoner that brought a civil claim for unconstitutional discrimination against a number of federal officials argued that the Twombly pleading standard was limited to antitrust cases.27he Supreme Court rejected this argument and held that the Twombly standard applied to "all civil actions."28he Ashcroft opinion made clear that lower courts should conduct a two-pronged analysis of all civil claims. First, they should identify all allegations in a complaint that are conclusory and therefore should be given no weight. Second, it should take the remaining factual allegations and determine whether they give rise to a plausible entitlement to relief.29
The Twombly and Ashcroft opinions may affect how courts evaluate securities claims in two respects. First, they may enhance the scrutiny that courts apply to the "falsity" element of a securities claim brought under Section 10(b). While plaintiffs' allegations regarding falsity must be accepted as true, Twombly and Ashcroft require that plaintiffs allege a quantum of evidentiary facts such that plaintiffs' allegations are also plausible. Of course, plaintiffs must also satisfy the qualitative requirements under Rule 9(b) and the Reform Act that they allege falsity with particularity. Second, Twombly and Ashcroft may heighten the pleading requirements in cases brought under Rule 11 or Rule 12 of the Securities Act of 1933. Those claims generally are not subject to the heightened pleading requirements of the Reform Act or Fed. R. Civ. P. 9(b) when they do not "sound in fraud."30 The plausibility thresholds of Twombly and Ashcroft heighten the pleading requirements of the Rule 8 standard by which these claims should be judged.
In Tellabs, Inc. v. Makor Issues & Rights, Ltd.,31 the Supreme Court clarified how to evaluate competing inferences when determining whether plaintiffs have satisfied the Reform Act's requirement that they plead facts giving rise to a strong inference of scienter.
In Tellabs, plaintiffs alleged that Richard C. Notebaert, chief executive officer of Tellabs, Inc., made false and misleading statements about the financial health of the fiber-optics network company. Judge Posner, writing for the Seventh Circuit, concluded that plaintiffs' allegations gave rise to a strong inference of scienter under the Reform Act. In Judge Posner's view, the Reform Act required only that a plaintiff allege "facts from which, if true, a reasonable person could infer that the defendant acted with the required intent." Judge Posner ruled that a "reasonable person" could infer from the statements that "Notebaert knew that his statements were false."32
The Supreme Court reversed, with Justice Ginsburg writing the majority opinion. The Court noted that "[e]xacting pleading requirements are among the control measures Congress included in the [Reform Act]" as a "check against abusive litigation."33 The Court also noted that Congress left the key term – "strong inference" – undefined and that "[t]o qualify as 'strong' within the intendment of §21D(b)(2), . . . an inference of scienter [i.e. fraudulent intent] must be more than merely plausible or reasonable – it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent."34 Justice Ginsburg explained that a "court must take into account plausible opposing inferences" because "[t]he strength of an inference cannot be decided in a vacuum."35 The Court further held that in assessing whether a plaintiff's allegations satisfy these standards, "omissions and ambiguities count against inferring scienter."36
Justice Scalia, in his concurring opinion, disagreed with the Court's conclusion that a plaintiff has satisfied his pleading burden where he alleges facts giving rise to plausible inference in favor of scienter that is equal to a plausible inference against scienter. In Justice Scalia's view, a plaintiff could only plead a "strong" inference of scienter where the inference of scienter was greater than any opposing inference.37 Justice Alito, in his concurring opinion, agreed with Justice Scalia's view and also disagreed with the Court's statement that ambiguities in plaintiff's allegations only reduce their weight in creating an inference of scienter. Justice Alito argued that allegations that lack sufficient particularity should be given no weight.38
Justice Stevens dissented. He credited the majority with developing a "perfectly workable definition" of the meaning of a strong inference of scienter, but argued that a "probable cause" standard "would be both easier to apply and more consistent with the statute."39 Justice Stevens argued that because the complaint contained allegations from 27 confidential witnesses, viewed collectively they establish "probable cause" of Mr. Notebaert's fraudulent intent without the need to weigh competing inferences.40
Tellabs has several revealing features. First, the Court is seriously concerned about "frivolous, lawyer-driven litigation."41 The Court recognizes that private securities fraud actions "if not adequately contained can be employed abusively to impose substantial costs on companies and individuals whose conduct conforms to the law."42 Second, the Court took an important step in the name of Congress, purporting simply to interpret the statutory phrase "strong inference." This feature of the dispute makes the decision somewhat easier to write, doctrinally, than Twombly where there was no special statutory construction directly in play. (This distinction might reconcile Justice Ginsburg's dissent in Twombly and her majority opinion here). Third, Justice Scalia's and Alito's concurrences advocate an even tougher "more likely than not"43 standard for proving fraudulent intent. Justice Stevens' dissent notes that the majority decision is "perfectly workable."44 There is little real disagreement on the Court about the need for tightening pleading requirements.
The Seventh Circuit opinion in Higginbotham v. Baxter International, Inc. was one of the first rulings to apply the Tellabs standard.45 Higginbotham arose from lawsuits filed after Baxter International announced that it would need to restate the preceding three years' earnings to correct errors created by fraud at a subsidiary in Brazil. The most noteworthy aspect of this opinion was that the Seventh Circuit concluded that Tellabs significantly weakened plaintiffs' use of "confidential witnesses" in a securities complaint because "[i]t is hard to see how information from anonymous sources could be deemed 'compelling' or how we could take account of plausible opposing inferences."46 The court said that it was possible to imagine situations where statements from anonymous sources could "corroborate or disambiguate evidence from disclosed sources," but that such allegations should be steeply discounted in assessing whether they support an inference of scienter.47
The Seventh Circuit had occasion again to consider the pleadings in the Tellabs complaint on remand from the Supreme Court in Makor Issues & Rights, Ltd. v. Tellabs Inc. ("Tellabs II").48 Judge Posner again wrote for the Circuit Court. Although the Seventh Circuit recognized that Tellabs instructs courts first to evaluate if the inference of fraud is cogent, and then perform a comparative analysis of opposing inferences, the Seventh Circuit ruled that it was "easier" to perform the comparative analysis first.49 Tellabs allegedly made false and misleading statements regarding demand for its flagship products. The Circuit Court found that the inference that senior management acted with fraudulent intent in connection with alleged false and misleading statements regarding Tellabs's flagship products was "much more likely" than that senior management was unaware that these statements were untrue.50 The Circuit Court further held that because the inference of scienter was much stronger than any opposing inference, it was by definition "cogent." The Circuit Court reasoned that the "plausibility of an explanation depends on the plausibility of the alternative explanations" and that "[a]s more and more alternatives to a given explanation are ruled out, the probability of that explanation's being the correct one rises."51 The Seventh Circuit's formulation may reach the correct result in most cases. The risk of this approach, however, is that in some instances the allegations may be insubstantial and may give rise to a weak inference of scienter that is nevertheless stronger than a weak opposing inference.
One other noteworthy aspect of the Tellabs II opinion is that the Seventh Circuit again visited the use of confidential witnesses in securities complaints. The Seventh Circuit noted the "seeming flimsiness of the asserted need for anonymity" and reiterated that allegations based on confidential witnesses were difficult to assess. Unlike the complaint in Higginbotham, however, the Seventh Circuit in Tellabs II found that plaintiffs' confidential witnesses were numerous, and that their positions and access to information were described with particularity and the information they obtained was described in convincing detail.52 Based on the Higginbotham and Tellabs II opinions, it appears the use of confidential witnesses has been weakened by Tellabs but that these allegations may still carry some weight where plaintiffs make a convincing showing that they are reliable.
In an effort to make the best of a bad situation, some plaintiffs' lawyers have attempted to characterize the Supreme Court's Tellabs decision as plaintiff-friendly. They cite the language from the opinion that the inference of scienter "need not be irrefutable," i.e., of the "smoking gun" genre, or even the "most plausible of competing inferences" so long "a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference."53 Plaintiffs argue that this sets a low burden because they need only show that the defendants were as likely to have acted with scienter as not. This ignores the first prong of the scienter analysis, i.e., do the facts give rise to cogent inference of scienter? Courts construing Tellabs have noted that the word "'cogent . . . means compelling or convincing.'"54 A weak inference of scienter will not satisfy this standard even if the opposing inference is equally weak because the inference of scienter will not be cogent.
The natural corollary to this question is what happens where there is a "tie?" What if the allegations give rise to a strong inference of fraudulent intent, and an equally strong opposing inference? Under the plain text of Tellabs, where the inference of scienter is both cogent and "at least as compelling as any opposing inference," plaintiff has satisfied his burden.55 Courts interpreting Tellabs have confirmed that "where there are equally strong inferences for and against scienter, Tellabs now awards the draw to the plaintiff," and thereby reduces the pleading burden in those circuits, such as the First Circuit, where courts previously required plaintiffs to establish that the inference of scienter was stronger than any opposing inference.56 While the decision goes to the plaintiff where there are two equally strong inferences, it should be noted that the circumstances under which this will occur will be rare. As Justice Scalia noted in his Tellabs dissent: "How often is it that inferences are precisely in equipoise?"57
III. POST-TELLABS – THE CORE OPERATIONS INFERENCE
Several recent post-Tellabs opinions do not discuss the weighing of inferences so much as the inference to be drawn of the knowledge of senior executives regarding potentially catastrophic risks of harm to the company. In Berson v. Applied Signal Technology, Inc., plaintiffs brought an action against the company and two officers under Section 10(b) and Rule 10b-5 after Applied Signal announced that its revenue fell 25%, which in turn caused its stock price to drop 16%.58 Applied Signal's customers are nearly all federal government agencies who have the ability to issue "stop work orders" on existing contracts at any time. A "stop work" order can result in the work being cancelled altogether.59 Plaintiffs alleged that Applied Signal's practice of categorizing stopped work as backlog was misleading because Applied Signal knew that there was a heightened risk that the work could be cancelled entirely, and that the company would lose the revenue forever.60
The Ninth Circuit determined that plaintiffs alleged facts that gave rise to a strong inference of scienter because Applied Signal's CEO and CFO knew that prior stop work orders resulted in the cancellation of "significant amounts of work, yet counted the stopped work as backlog anyway."61 In reaching this conclusion, the court noted that even though the plaintiffs did not allege that the CEO and CFO had knowledge of the stop work orders in question, it was appropriate to infer that the CEO and CFO "must have known" about them because of the "devastating effect on the corporation's revenue."62 The Ninth Circuit cited to No. 84 Employer-Teamster Joint Council Pension Trust Fund v. America West Holding Corp.63 in support of its discussion of scienter, and noted that it had approved "a similar inference" in that case.64
The Ninth Circuit stated that it drew an inference of scienter in America West against certain "outside directors" because airplane maintenance problems and the FAA's investigation into them were so important to the airline that it was "absurd to suggest that the Board of Directors would not discuss them."65 The court found the inference here to be stronger than that in America West because the CEO and CFO were responsible for the company's "day-to-day operations," whereas the America West defendants "were outside directors who did no more for the company than attend board meetings and serve on a board committee," and thought it was "hard to believe that [Applied Signal's CEO and CFO] would not have known about stop-work orders that allegedly halted tens of millions of dollars of the company's work."66 The court followed this line of logic stating that "[i]f plaintiffs in America West could rely on an inference that outside directors were aware of maintenance problems over which they had no direct management responsibility, then plaintiffs here are entitled to rely on a similar inference as to the four stop-work orders."67 The Ninth Circuit found that the plaintiffs had met the requisite pleading standards, and reversed the lower court's dismissal of the case.68 The lesson of Berson and America West may be that under certain narrow circumstances a court in the Ninth Circuit may infer that senior executives knew of bet-the-company types of events even if plaintiffs fail to plead facts specifically showing that they were aware of these events.
Indeed, another panel of the Ninth Circuit recently described the Berson case as being in an "exceedingly rare category of cases in which the core operations inference, without more, is sufficient under the PSLRA" but that "[a]s a general matter, corporate management's general awareness of the day-to-day workings of the company's business does not establish scienter-at least absent some additional allegation of specific information conveyed to management and related to the fraud."69
South Ferry is an important case in the line of decisions construing Tellabs, because it holds that prior Ninth Circuit precedent may have "focused too narrowly" on the viability of individual scienter allegations and that "Tellabs counsels us to consider the totality of circumstances."70 South Ferry applied this "thematic idea" from Tellabs to the "core operations" theory of scienter, i.e., the theory that a court may infer that the "facts critical to a business's 'core operations' or an important transaction are known to a company's key officers."71 The Ninth Circuit held that while such allegations are generally not sufficient of themselves to show a strong inference of scienter, where they are accompanied by particularized allegations showing that defendants "had actual access to the disputed information," they may be sufficient to satisfy the pleading standard.72 Moreover, even where "core operations" allegations are not accompanied by particularized allegations of actual access by management and therefore are insufficient to give rise to a strong inference of scienter, a court may nevertheless consider these allegations in its assessment of whether the collective allegations of the complaint satisfy the scienter pleading requirement.73
More recently, in Zucco Partners, LLC v. DigiMarc Corporation74, the Ninth Circuit again affirmed that plaintiffs are bound by prior Ninth Circuit decisions relating to the particularity requirement in pleading scienter. As the court in Zucco Partners stated, "Tellabs does not materially alter the particularity requirements for scienter claims established in our previous decisions."75 The court noted that it "continued to employ the old standards in determining whether . . . a plaintiff's allegations of scienter are as cogent or as compelling as an opposing innocent inference."76 The only difference now was that the court must "also view the allegations as a whole"77 – resulting in a two-part inquiry: "[F]irst we will determine whether any of the plaintiff's allegations, standing alone, are sufficient to create a strong inference of scienter; second, if no individual allegations are sufficient, we will conduct a 'holistic' review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or recklessness."78
Applying this two-part test, the Ninth Circuit upheld the dismissal of the complaint against DigiMarc. The allegations in Zucco Partners involved alleged overstatement of the company's earnings and prospects by "improperly capitalizing (rather than expensing) various internal software development costs."79 Scienter allegations included: (1) confidential witness statements; (2) restatements of earnings; (3) the resignations of various key accounting executives and the corporations outside auditor during the class period; (4) statements made in DigiMarc's Sarbanes-Oxley certificates; (5) individual defendants' compensation packages; (6) individual defendants' stock sales and (7) a private placement by DigiMarc during the class period.80 The court first looked at the allegations under its existing rubric and found that individually, none gave rise to a strong inference of scienter.81 Next, the court performed the Tellabs inquiry and analyzed whether the allegations as a whole gave rise to a strong inference of scienter.82 The holistic inquiry also failed to meet the scienter requirements, and the court noted that sometimes "a set of allegations may create an inference of scienter greater than its parts," that "it was just as likely that combining the group of weak inferences together simply resulted in an equally weak inference overall."83
IV. DEVELOPMENTS IN LOSS CAUSATION
(1) Pleading Loss Causation
The Ninth Circuit further refined the loss causation pleading standard in two recent opinions, Metzler Investment GMBH v. Corinthian Colleges, Inc.,84 and In re Gilead Sciences Securities Litigation.85
The corporate defendant in Metzler was Corinthian Colleges, Inc., one of the nation's largest operators of private for-profit vocational colleges, with 88 schools in 22 states. Plaintiffs alleged that Corinthian and individual officer defendants engaged in a scheme to misrepresent the number of eligible students enrolled at its campuses to maximize the amount of federal Title IV funding it received. Because Corinthian received 82% of its revenue from federal student loan funding, defendants' alleged fraudulent scheme purportedly caused artificial inflation in Corinthian's share price. The fraud was allegedly revealed through two partial disclosures: (1) on June 24, 2004, the Financial Times reported that the Department of Education ("DOE") was investigating one of Corinthian's campuses for improper financial aid practices; and (2) an August 2, 2004, press release disclosed disappointing earnings and reduced guidance. Plaintiffs alleged that these two press releases, read in tandem, revealed the alleged fraud and caused Corinthian's stock price to plummet.
The Ninth Circuit affirmed dismissal of plaintiffs' complaint for failure to plead loss causation. The Ninth Circuit stated that a plaintiff must plead that the "practices that the plaintiff contends are fraudulent were revealed to the market and caused the resulting losses."86 The court ruled that the DOE investigation revealed potential improper financial aid practices at one of Corinthian's 88 colleges, but did not reveal widespread manipulation of student enrollment.87 The court also ruled that the August 2 earnings announcement, while conveying disappointing information about Corinthian's current financial condition and its future prospects, did not disclose the alleged fraud.88 The authors view four key take-aways from Metzler.
First, Metzler puts to rest, once and for all, the notion that a plaintiff may allege that a fraudulent scheme concealed a company's true financial condition and that any revelation of the "poor financial health generally" reveals the truth to the market.89 Rather, the market must learn of the specific "practices that the plaintiff contends are fraudulent."90 The Ninth Circuit discussed its earlier opinion in In re Daou Systems91, and made clear that the only reason that the purported corrective disclosure in Daou was sufficient was because "the market learned of and reacted to [the] fraud, as opposed to merely reacting to reports of the defendants' poor financial health generally."92 The authors have observed that in several instances plaintiffs have attempted to use Daou to argue that any revelation of negative economic news reveals a company's true financial condition that was concealed by fraud and satisfies the loss causation pleading standard. Metzler provides needed clarity on this point.
Second, the Ninth Circuit held that a corrective disclosure must reveal actual past fraud as opposed to the risk or potential for fraud. It rejected plaintiffs' argument that because the June 24 article revealed issues with financial aid at one of the Corinthian's 88 campuses, this also revealed the "potential" or "risk" for widespread fraudulent conduct throughout the company.93
Third, the Ninth Circuit made clear that plaintiffs could not satisfy their pleading burden with conclusory allegations that the market "understood" that a company's disclosures about its financial metrics connoted past fraudulent conduct. In Metzler, plaintiffs alleged that the August 2 earnings release contained a reference to "higher than anticipated attrition" of its students and that the market understood this disclosure as a "euphemism for an admission that they had enrolled students who should not have been signed up at all."94 The Ninth Circuit observed that "[s]o long as there is a drop in a stock's price, a plaintiff will always be able to contend that the market 'understood' a defendant's statement precipitating a loss as a coded message revealing the fraud."95 The Ninth Circuit held that a plaintiff must plead a causal connection between a defendant's fraud and the actual loss and could not rely on "loss causation through 'euphemism.'"
Fourth, the Ninth Circuit instructed that while plaintiffs' allegations must be assumed to be true, courts should not "indulge unwarranted inferences."96 For instance, although plaintiffs alleged that the company's stock price declined in response to the August 2 press release because the market understood the release's reference to higher than expected attrition as a revelation of widespread fraudulent conduct, this allegation was not a "fact" that must be accepted as true. Instead, "the August 2 announcement contained a far more plausible reason for the resulting drop in Corinthian's stock price – the company failed to hit prior earnings estimates."97
In Gilead, the Ninth Circuit ruled that a corrective disclosure need not immediately be followed by a substantial price decline where plaintiffs have drawn a clear causal connection between revelation of the fraud and its subsequent impact on stock price.98 Plaintiffs alleged that the company engaged in an off-label marketing scheme for its main product, Viread. Viread was an antiretroviral agent used in combination with other drugs to treat HIV. Plaintiffs alleged that the market learned of the scheme on August 7, 2003, when the Food and Drug Administration made public a "Warning Letter" it issued to the company regarding its improper promotional activities. Plaintiffs further alleged that although the market did not immediately appreciate or react to the August 7, 2003, disclosure, physicians reacted to it by sharply reducing their demand for Viread. There was no market response until October 28, 2003, when the company's stock price sharply declined on news of the company's third quarter financial results, which reflected sharply reduced demand for Viread. The district court held that plaintiffs had not pled loss causation because Gilead's stock price did not decline in response to disclosure of the Warning Letter, and the October 2003 press release did not reveal the fraud, only a sharply decreased decline for Viread. The Ninth Circuit reversed, holding that plaintiffs sufficiently alleged a causal connection between the alleged fraud and Gilead's price decline.99 Specifically, while the market did not necessarily appreciate the immediate import of the Warning Letter, plaintiffs alleged that the Warning Letter revealed the fraud to physicians and directly resulted in a reduction in demand. Plaintiffs further allege that when the company issued its disappointing third quarter financial results, analysts concluded that Gilead's poor results were caused by poor end-user demand for Viread. This poor end-user demand was allegedly the direct result of the public disclosure of the Warning Letter. The Ninth Circuit held that while plaintiffs had not alleged that the market immediately recognized the significance of the August 2003 Warning Letter disclosure and the company's stock price did not immediately decline, plaintiffs had carefully drawn a causal connection between revelation of the fraud to physicians, the resulting reduction in demand for Viread and its subsequent impact on Gilead's stock price.100
Gilead may not have wide application beyond its narrow facts. The key take-away is while plaintiffs must plead a clear causal connection between the corrective disclosure and the subsequent decline in the company's stock price, the price decline need not be immediate where plaintiffs have plausibly established a chain of events that led from the disclosure to the decline.
(2) Loss Causation At The Summary Judgment Stage
In In re Retek Inc. Securities Litigation, the district court for the District of Minnesota granted the defendants' motion for summary judgment on loss causation grounds. This case is noteworthy because the court engages in a detailed discussion of what kind of showing of loss causation must be made to survive summary judgment.
Plaintiffs stated that a July 8, 2002, press release that stated Retek "saw sales cycles extend as a result of working with larger customers that have more complex and lengthy procurement processes" and as a result anticipated revenue was deferred with respect to one customer was a corrective disclosure. The plaintiffs claimed that this press release also indirectly disclosed misrepresentations relating to four other transactions at issue. While the court, relying on In re Daou Systems, Inc. Securities Litigation, noted that fraud could be revealed through indirect disclosure, it held that a plaintiff must still prove that the "market recognized a relationship between the event disclosed and the fraud in order to establish loss causation."
The court discussed the burden on summary judgment versus on motion to dismiss, and stated that in contrast to a motion to dismiss, at the summary judgment stage, parties have "developed the record through discovery and there is an expectation that the parties have had the opportunity to produce evidence supporting their claims and defenses." And in contrast to Dura Pharmaceuticals, Inc. v. Broudo, at the summary judgment stage "plaintiffs are past the point of placing Retek on notice of what plaintiffs intend to prove," and instead "the Court reviews the record to determine whether plaintiffs have adduced evidence such that a rational trier of fact could find in their favor on the issue of loss causation." The court summed up its discussion with emphasizing that "plaintiffs must produce evidence that the market became aware of Retek's alleged misrepresentation as a result of the July 8 press release," and that there was a consequential drop in stock price.
The court concluded that the plaintiffs failed to put forth any evidence that the July 8 press release either was a corrective disclosure for the customer directly mentioned in it (because the press release only repackaged information that was already publicly available) or indirectly for the other four transactions at issue because, the court found and even the plaintiffs' expert conceded, that "until the original complaint was filed, there was no disclosure such that the market became aware that Retek had committed improper or fraudulent practices regarding those four ventures." As a result, the court granted defendant's motion for summary judgment in full.
(3) Loss Causation And Class Certification
In Alaska Electrical Pension Fund v. Flowserve Corporation,101 retired U.S. Supreme Court Justice Sandra Day O'Connor, sitting by designation, reversed denial of class certification on loss causation grounds. The Fifth Circuit affirmed that on class certification plaintiff bore the burden of showing loss causation by a preponderance of the evidence, but concluded that the lower court "applied an incorrect standard of loss causation."
The circuit court observed that the reason that the district concluded that plaintiffs' had not proven loss causation was because plaintiffs had not identified a "fact-for-fact" disclosure of information that "specifically reveals the fraud."102 For example, the district court concluded that reductions of the company's FY2002 earnings guidance in July and September 2002, did not reveal that the company's original FY2002 earnings projections, made in October 2001, were fraudulent. The circuit court held that this ruling applied an incorrect standard of loss causation because for a disclosure to be corrective it need not precisely mirror prior misstatements but must instead reveal the relevant truth obscured by the purported fraud. Thus, it would have been sufficient to show that the market learned that the company's October 2001 guidance was wrong, that the stock price significantly declined in response to that disclosure and that other negative information unrelated to the alleged fraud did not cause the stock price movement.103 The circuit court noted that plaintiffs offered expert testimony that unrelated negative information did not cause the decline in the company's stock price. At the same time, the circuit court cautioned that the reduction in earnings guidance alone would not be sufficient to establish loss causation because such a disclosure only shows that the "business seemed less valuable."104 Rather, plaintiffs were required to show by a preponderance of the evidence that past misstatements caused the stock price to significantly decline. The circuit court also questioned the district court's conclusion that twenty-one of the alleged misstatements were "confirmatory" and therefore nonactionable because they did not reveal new information to the market. It noted that the company's stock price increased in reaction to these statements, indicating that they introduced new information to the market. The circuit court therefore remanded the case to the district court for a new hearing on loss causation with instructions to apply the correct legal standard and framework.
In addition to providing additional guidance on the Fifth Circuit's perspective of the proper standard of loss causation in the class certification stage, Flowserve reaffirms the continuing vitality of Oscar Private Equity Investments v. Allegiance Telecom, Inc.105 The Flowserve court cited Oscar with approval for the proposition that a securities plaintiff must establish loss causation by a preponderance of admissible evidence at the class certification stage.106
While Oscar still has not gained wide acceptance outside of the Fifth Circuit,107 the Oscar decision continues to represent a breakthrough for securities fraud defendants as courts traditionally have certified securities class actions without much analysis of Rule 23's requirements. The Fifth Circuit's recognition of the costs associated with this practice, as well as the fact that "class certification . . . [bears] due-process concerns [for] both plaintiffs and defendants," is significant.108 The impact of Oscar beyond the Fifth Circuit remains to be seen. This evolving Fifth Circuit doctrine will force a discourse over the appropriate limits on the fraud-on-the-market presumption and perhaps provide securities defendants with greater due process rights during class certification.
V. DEVELOPMENTS IN COLLECTIVE SCIENTER DOCTRINE – GLAZER CAPITAL MANAGEMENT, LP V. SERGIO MAGISTRI
The Ninth Circuit recently defined the proper application of the collective scienter doctrine. In Glazer Capital Management, LP v. Sergio Magistri,109 plaintiffs brought an action against Invision Tech. Inc. ("Invision") and its officers for alleged violation of Section 10(b) of the Securities Exchange Act. The complaint alleged that in March 2004, Invision announced that it had entered into a merger agreement with GE and on the same day filed its 10K with the merger agreement as an attachment to its filing. The complaint further alleged that the merger agreement contained false or misleading statements. In July 2004, Invision allegedly issued a press release revealing that it was under investigation for potential violations of the Foreign Corrupt Practices Act . This allegedly caused an immediate drop in the company's share price.110 After several rounds of amendment, the District Court dismissed the action without leave to amend and an appeal followed.
The most significant aspect of the Ninth Circuit's Glazer opinion was its ruling on the doctrine of "collective scienter." This doctrine suggests that under certain circumstances a company may be deemed to have fraudulent intent even though plaintiffs are unable to show that any individual officer or director had such intent. In Glazer, plaintiffs argued that the Ninth Circuit should invoke that doctrine to permit their case to proceed against Invision despite their failure to plead scienter as to any individual. The Ninth Circuit noted that in Tellabs II, the Seventh Circuit held that "there could be circumstances in which a company's public statements were so important and so dramatically false that they would create a strong inference that at least some corporate officials knew of the falsity upon publication."111 The Ninth Circuit chose not to reach the question of whether, under certain circumstances, the doctrine of collective scienter was viable. But it concluded that the alleged misrepresentations in Glazer did not give rise to the extreme circumstances under which Tellabs II recognized the collective scienter doctrine.
VI. DEVELOPMENTS IN THE ADVANCEMENT AND INDEMNIFICATION OF LEGAL FEES FOR FORMER OFFICERS - IN RE HEALTHSOUTH CORP. SECURITIES LITIGATION
The Eleventh Circuit recently held in In re HealthSouth Corp. Securities Litigation that companies settling securities class actions can include Reform Act bar orders that extinguish their former officers' statutory and contractual rights to advancement and indemnification of legal fees. Despite Delaware's presumption in favor of defense-cost indemnification and advancement, the circuit court affirmed HealthSouth's use of a Reform Act bar order to extinguish its obligation to advance defense costs to its non-settling former CEO.
HealthSouth and the class action plaintiffs had reached a settlement in which HealthSouth and its insurers agreed to pay $445 million. Richard Scrushy, HealthSouth's former chairman and CEO, was named as a defendant but not included in the settlement. The settlement agreement called for a bar order that extinguished not only Scrushy's right to seek contribution from HealthSouth for any liability he had to plaintiffs, but also foreclosed any further indemnification obligations HealthSouth had for defense costs. The district court approved the settlement and bar order over Scrushy's objections, and he appealed to the Eleventh Circuit. He argued, among other things, that the bar order impermissibly extinguished his contractual claims against HealthSouth for advancement of defense costs. Scrushy presented three arguments in support of his objection, and the court rejected all of them.
First, Scrushy argued that the order was not appropriate under the Reform Act or case law interpreting it, because his advancement claim against HealthSouth was independent of the plaintiffs' securities fraud claim and therefore could not be settled between plaintiffs and HealthSouth. The court found a sufficient relationship between Scrushy's advancement claim and the underlying securities claim because Scrushy would have no need to claim defense costs if he were not being sued by plaintiffs. As the court put it, "the attorneys' fees for which Scrushy seeks advancement were incurred on account of Scrushy's liability or the risk thereof to the underlying plaintiffs."
Second, Scrushy argued that public policy supported the advancement of attorneys' fees. The court noted that Delaware law is pro-advancement. The reason often given is that Delaware corporations want the best individuals to serve on their boards and as their officers and to encourage them to do so corporations need to guarantee that these individuals will be protected from meritless litigation. The court held that this policy was outweighed by a policy favoring settlements, and HealthSouth would have been unlikely to settle if it continued to be liable to Scrushy for his defense costs. The court suggested that these considerations might balance differently for an executive who had made a showing that he was a mere innocent bystander caught in a securities, but Scrushy had not made any showing to the district court to rebut plaintiffs' allegations that he was a central figure in the alleged fraud.
Third, Scrushy argued that the bar order cutting off his advancement could not be justified like a typical bar order because he did not receive the consideration of reciprocity—he owed HealthSouth no contractual obligation to advance its defense costs. The court held that precise reciprocity was not necessary; the bar order's protection for Scrushy from any claims by HealthSouth was sufficient compensation to him for losing his advancement rights. Again the court suggested that the calculus might differ for an innocent executive: "This constitutes very significant compensation to Scrushy, in light of the perception by the underlying plaintiffs and HealthSouth that Scrushy was a central figure in the violations."
This decision is noteworthy because the Eleventh Circuit's willingness to permit issuers to extend Reform Act bar orders to block defense-cost advancement claims should tip the scales of bargaining power and encourage a change in behavior from each of the parties. For their part, issuers may make such broad bar orders standard operating procedure in their settlement agreements if they intend to cut a former executive loose in the settlement. And since an unrepresented executive would be more vulnerable to plaintiffs, they would happy to agree to the broad bar order. The non-settling defendant may or may not succeed in his objection to the bar order, but there is little harm in the parties including it.
The ability to "buy peace" with a bar order might also make companies more willing to settle without their former executives, rather than attempt to reach a global settlement. To protect themselves, directors or officers might obtain a Delaware judgment immediately that they are entitled to advancement until the case is resolved against them. Delaware provides for expedited proceedings in advancement cases, and at the first sign of trouble—e.g., the company is late paying the executive's submitted legal bill—the executive would have an excuse to file a summary proceeding in Delaware seeking such an order. Presumably, the court in which the securities action is pending would want to avoid a direct conflict with the court of the state of the company's incorporation.
Please click on the following link to read this article and its footnotes in full: Recent Developments And Trends In Securities
Footnotes
1. PriceWaterhouseCoopers, 2008 Securities Litigation Study at 6, available at http://10b5.pwc.com/PDF/NY-09-0894%20SECURITIES%20LIT%20STUDY%20FINAL.PDF (last visited June 11, 2009).
2. Stanford Law School Securities Class Action Clearinghouse, Securities Class Action Filings, http://securities.stanford.edu/fmi/xsl/SCACPUDB/recordlist.xsl (last visited July 2, 2009). Note, however, that in June 2009 only 6 securities class actions were filed, which is the lowest monthly filing total since December 1996, when 5 cases were filed. Ben Hallman, Oh Securities Class Actions, Where Art Thou?, The AmLaw Litigation Daily (July 1, 2009), available at: http://www.law.com/jsp/tal/digestTAL.jsp?id=1202431933348&Oh_Securities_Class_Actions_Where_Art_Thou (last visited July 2, 2009). Commentators speculate that this downturn will be temporary, and that it is due to two main factors: (1) the large amount of Madoff-related litigation and (2) the vast quantity of subprime and credit crisis-related litigation filed previously that are now just reaching "critical procedural stages." Id.
3. PriceWaterhouseCoopers, supra note 1, at 6.
4. Id. at 8.
5. Id. at 5.
6. Stanford Law School Securities, Class Action Clearinghouse, Securities Class Action Filings, http://securities.stanford.edu/litigation_activity.html (last visited June 14, 2009).
7. PriceWaterhouseCoopers, supra note 1, at 9.
8. Id. at 18.
9. Id. at 5.
10. Id.
11. Id. at 3.
12. PriceWaterhouseCoopers, supra note 1, at 3.
13. 550 U.S. 544 (2007).
14. 551 U.S. 308 (2007).
15. 550 U.S. 544.
16. Id. at 551 (citation and internal quotation marks omitted).
17. Id. at 570.
18. Id. at 555.
19. 355 U.S. 41 (1957).
20. 550 U.S. at 560 (quoting Conley, 355 U.S. at 45-46).
21. 544 U.S. 336 (2005).
22. 550 U.S. at 556.
23. Id. at 579-82.
24. Id. at 572.
25. E.g., ATSI Commc'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 98 n.2 (2d Cir. 2007); TCS Capital Mgmt., LLC v. Apax Partners, LP, No. 06-CV-13447 (CM), 2008 WL 650385, at *13 (S.D.N.Y. Mar. 7, 2008); Garcia v. Santa Maria Resort, Inc., 528 F. Supp. 2d 1283, 1288 (S.D. Fla. 2007).
26. 129 S. Ct. 1937 (2009).
27. Id. at 1953.
28. Id.
29. Id. at 1950.
30. See, e.g., In re Daou Sys., Inc., 411 F.3d 1006, 1027 (9th Cir. 2005).
31. 551 U.S. 308.
32. Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588, 602-03 (7th Cir. 2006).
33. 551 U.S. at 313.
34. Id. at 313-14.
35. Id. at 321-23.
36. Id. at 325.
37. Id. at 328.
38. Id. at 333.
39. Id. at 335.
40. Id.
41. Id. at 322.
42. Id. at 313.
43. Id. at 333.
44. Id. at 335.
45. 495 F.3d 753 (7th Cir. 2007).
46. Id. at 757.
47. Id.
48. 513 F.3d 702 (7th Cir. 2008).
49. Id. at 707.
50. Id. at 710.
51. Id. at 710-11.
52. Id. at 711-12.
53. 551 U.S. at 323 (citation and internal quotation marks omitted).
54. In re Top Tankers, Inc. Sec. Litig., 528 F. Supp. 2d 408, 415 (S.D.N.Y. 2007) (quoting Black's Law Dictionary 252 (7th ed. 1999)).
55. 551 U.S. at 323.
56. ACA Fin. Guar. Corp. v. Advest, Inc., 512 F.3d 46, 59 (1st Cir. 2008); see also Mississippi Pub. Employees' Ret. Sys. v. Boston Scientific Corp., 523 F.3d 75, 89-90 (1st Cir. 2008); In re Top Tankers, Inc. Sec. Litig., 528 F. Supp. 2d at 413-14.
57. 551 U.S. at 330.
58. No. 06-15454, 2008 U.S. App. LEXIS 19982, at *1-2 (9th Cir. June 5, 2008).
59. Id., at *2.
60. Id., at *3.
61. Id., at *12.
62. Id.
63. 320 F.3d 920 (9th Cir. 2003).
64. 2008 U.S. App. LEXIS 19982, at *12.
65. Id., at *12 (citation and internal quotation marks omitted).
66. Id., at *13.
67. Id., at *13-14.
68. Id., at *19-20.
69. South Ferry LP v. Killinger, -- F.3d --, No. 06-35511, 2008 WL 4138237, at *5 (9th Cir. Sep. 9, 2008) (citation and internal quotation marks omitted).
70, Id., at *5.
71. Id., at *4-5.
72. Id., at *6.
73. Id., at *5.
74. No. 06-35758, 2009 WL 311070 (9th Cir. Feb. 10, 2009).
75. Id., at *1.
76. Id.
77. Id.
78. 2009 WL 311070, at *6.
79. Id., at *1.
80. Id., at *6.
81. Id., at *7-20.
82. Zucco Partners, at *21.
83. Id.
84. -- F.3d --, No. 06-55826, 2008 WL 3905427 (9th Cir. Aug. 26, 2008).
85. 536 F.3d 1049 (9th Cir. 2008).
86. 2008 WL 3905427, at *10.
87. Id.
88. Id.
89. Id.
90. Id.
91. 411 F.3d 1006 (9th Cir. 2005).
92. Id.
93. Id.
94. Id., at *11.
95. Id.
96 Id.
97. Id.
98. 536 F.3d at 1057-58.
99. Id. at 1057.
100.. Id. at 1057-58.
101.. Nos. 07-11303, 08-10071, 2009 WL 1740648 (5th Cir. June 19, 2009).
102. Id. at *9.
103. Id. at *8.
104. Id. at *9.
105. 487 F.3d 261, 262 (5th Cir. 2007).
106. 2009 WL 1740648, at *5.
107. See, e.g., In re Boston Sci. Corp. Secs. Litig., 604 F. Supp. 2d 275, 285 (D. Mass. 2009); Ross v. Abercrombie & Fitch Co., 2008 WL 4059873, at *2 (S.D. Ohio Aug. 26, 2008) ("Loss causation is not a factor listed in Rule 23. In a securities case, any issue relating to causation is an element of the plaintiffs cause of action . . . Ordinarily, the Court should not consider the merits of the case when deciding if a class should be certified."); but see In re Credit Suisse First Boston Corp. (Lantronix, Inc.) Analyst Sec. Litig., 250 F.R.D. 137 (S.D.N.Y. 2008) (granting defendants' motion to decertify a class because of plaintiffs' failure to establish loss causation at class certification).
108. 487 F.3d at 267.
109. 549 F. 3d 736, 749 (2008).
110. Id. at 739.
111. Id. at 744.
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