When the U.S. Supreme Court issued its ruling earlier this year in the Merck case pertaining to the question of what triggers the running of the statute of limitations in securities cases, there was some speculation that the decision might encourage an influx of cases involving events from the distant past. There really have not been that many cases that seemed to have been filed in reliance on Merck — at least not until now.
A case filed late last week, in which the class period cutoff date is over three years past, seems to represent a pretty clear example of a filing made in reliance on Merck, and may suggest both the kinds of filings that Merck may encourage and also the problems these cases may present.
Just to review, in its April 2010 decision in Merck, the U.S. Supreme Court held that the statute of limitations for cases under Section 10(b) is not triggered until the claimants have, or with reasonable diligence could have had, knowledge of the facts constituting the violation, including in particular facts constituting scienter.
According to their September 17, 2010 press release (here), plaintiffs’ lawyers’ have filed an action in the District of Idaho against PCS Eduventures!.com, its CEO and its former CFO. Though the complaint (a copy of which can be found here) was only just filed last week, the lawsuit purports to be filed on behalf of investors who purchased the companies’ shares between March 28, 2007 and August 5, 2007 – a period that ends more than three years before the complaint was filed.
The gist of the complaint is that on March 28, 2007, the company announced that it had entered a license agreement with its Mideast distributor, PCS Middle East, for a fixed license fee of $7.15 million. However, the complaint alleges that PCS Middle East did not have the ability to pay the fee without first entering a contract with the Saudi Arabian government. PCS did not have a contract with Saudi Arabia, and the complaint alleges that "PCS officers knew there was no contract."
The reason that the class period cuts off in August 2007 is that on August 15, 2007, after several months worth of disclosures about the Saudi arrangement or reflecting the revenue from the arrangement, the company issued an "update" clarifying that while the company had relied on their Mideast distributor’s assurances that a contract was "imminent," in fact, the company was "unable to confirm a timeframe or other specifics regarding any such contract" and the company’s managers "do not know when our Company will be called upon to participate in the initiative through our independent licensee."
The complaint anticipates the statute of limitations issue by alleging that "it was not until August 26, 2010, when the SEC instituted a civil action against PCS and others, did [sic] any reasonable investor could have reasonably suspected that Defendants’ misstatements about its purported $7.5 million sales contract were made with scienter."
According to the SEC’s complaint, in March 2007, the company’s Mideast representative had been promising the Saudi contract for months, at a time when the company also faced the looming possibility of missing its EBIDTA requirements in one of its loan covenants. The SEC alleges that the company concocted the license fee arrangement with its Mideast distributor as a way to come up with revenue to satisfy the EBITDA requirement.
The company booked the fee as revenue in March 2007, even though the distributor could not pay the fee until there was a Saudi contract. The SEC alleges that the company’s officers "knew there was no contract with Saudi Arabia." The SEC also alleges that in the absence of the contract, the company lacked an appropriate basis to recognize the fee as revenue, a fact of which the SEC also alleges company management was aware.
Because the investor complaint was filed more that three years after the August 2007 "update," the complaint would appear to be untimely, unless the plaintiffs succeed in persuading the court that the statute of limitations was not triggered until the SEC filed its complaint more than three years later, in August 2010.
The U.S. Supreme Court held in Merck that the statute of limitations is not triggered until the claimant has knowledge of the facts constituting the violation, including the facts constituting scienter. The plaintiffs expressly allege in their complaint that until the SEC initiated its enforcement action, they were unaware of the facts constituting scienter – that is, that the PCS officials knew all along there was no Saudi contract.
The defendants undoubtedly will argue that the plaintiffs could have with reasonable diligence uncovered the facts constituting the violation, and indeed the company’s mealy-mouthed August 2007 "update," which uses a lot of words to explain the simple facts that there was no Saudi contract and there never had been a Saudi contract, should have set off some alarm bells.
The defendants will argue in particular that the August 2007 update specifically noted that the company had only been told that the Saudi contract was "imminent" and had been "unable to confirm the timeframe or other specifics regarding any such contract" – meaning that even back in March, when the company booked the fee revenue, the company lacked specifics regarding the contract, which suggests that the company lacked the minimum necessary to recognize the fee as revenue, and that the company clearly was as aware in March as it was in August that it lacked sufficient specifics to support recognition of the revenue.
It will be interesting to see how this case unfolds. At a minimum, the lawsuit’s filing does demonstrate the troublesome potential of the Merck decisions to encourage the pursuit of litigation over long-distant events.
The problem is that this possibility creates significant uncertainty about when events in the past so long gone that companies can be sure that they are "out of the woods" about past problems. This is also a serious problem for D&O insurance underwriters trying to assess the risk associated with companies that have had problems in the past. If cases like this one go forward, underwriters will be compelled to extend their scrutiny of a particular company far into the past, with no sure way of knowing how far back is far enough. This uncertainty poses a challenge for companies and underwriters alike.
One final question has to do with the SEC’s action. I am not sure of theory on which the SEC will show that its action was timely, a question that presents its own separate set of issues and that will have to be worked out as the enforcement action goes forward. I welcome readers thoughts on the statute of limitations issues.
More Bank Failures: In case you missed it, the past Friday evening after the close of business, the FDIC took control of six more banks, bringing the 2010 year to date total number of bank failures to 125. The 2010 pace of bank closures continues to run well ahead of the pace in 2009, when the FDIC closed 140 banks. Bank closure number 125 in 2009 did not occur until December.
Among the six banks closed this past Friday night were three more Georgia banks. Since January 1, 2008, there have been 44 bank failures in Georgia, the highest total for any state during that period. However, the 14 bank failures in Georgia so far in 2010 represent only the third highest state total this year, behind Florida (23) and Illinois (15).
The Coolest Time-Waster Website Ever: Check out the Global Genie. When you click on the "Shuffle" button, the site displays a Google Earth view of some random location somewhere on five continents (Antarctica and for some reason South America are not included). Each location is helpfully identified by an accompanying Google Map. The "Shuffle" button quickly becomes addictive.