EletrobrasAs I have frequently noted (most recently here), Brazil’s ever-expanding corruption investigation that initially focused on Petrobras, the country’s state-run oil company, has swept up an increasing number of companies across the country’s economy (and elsewhere in Latin America as well). Among the companies caught up in the investigation is the country’s state-run electrical energy company, Eletrobras, which like many of the companies under investigation that have securities trading on U.S. exchanges, was hit with a corruption-related U.S. securities class action lawsuit. The defendants in the Eletrobras securities suit moved to dismiss. In a lengthy and interesting March 25, 2017 opinion (here), Southern District of New York Judge John Koeltl largely denied the dismissal motion. The ruling is interesting not only because it relates to one of the Brazilian companies caught up in the corruption scandal, but also because it addresses a number of interesting legal issues.



Centrais Eletricas Brasileiras S.A. (Eletrobras), which is majority owned by the Brazilian government, generates about 35% of Brazil’s electricity. The company’s sponsored ADSs trade on the NYSE. In October 2014, media reports began to circulate that the Petrobras corruption investigation had expanded to include Eletrobras. In response to these stories as well as subsequent media reports, the company issued statements denying the news reports and stating that all Eletrobras units and employees respect the principles in the company’s code of ethics.


Subsequent reports surfaced that a construction contract for a nuclear reactor owned by Eletrobras subsidiary Eletrobras Thermonuclear may have been tainted by bribery and corruption in a scheme alleged organized by the company’s Chief Generation Officer Valter Luiz Cardeal de Souza. The company reiterated its commitment to transparency and ethics in the conduct of all business. However, the company subsequently delayed the filing of its 2014 annual report and hired an international law firm  (Hogan Lovells) to conduct an internal investigation related to the allegations in the corruption investigation.


The company eventually filed its delayed annual reports and disclosed the results of the independent investigation. Among other things the company disclosed that a former officer of Electrobras Thermonuclear had been sentenced to 43 years in prison on a number of charges, including passive bribery, money laundering, obstruction of justice and other charges, and that other former officers had been formally charges with corruption and other charges. Among other things, the investigation also discovered “bribes used to fund improper payments to political parties, elected officials or other public officials.” The discovery of these payments meant that certain assets had been over-capitalized by the amount of the improper payments, requiring an adjustment of the company’s financial statements and the recognition of a financial loss for the delayed reporting periods.


The Securities Lawsuit

As discussed here, on July 25, 2015, certain Electrobras investors filed a securities class action lawsuit in the Southern District of New York. Among other things, the plaintiffs alleged that  (1) the Company’s senior officials were in non-compliance with the Company’s corporate governance directives and Code of Ethics; (2) as a result, the Company was subject to investigation and disciplinary action by various governmental and regulatory authorities; (3) the Company’s financial statements were materially false and misleading as they contained direct references to the Company’s Code of Ethics, and statements regarding its compliance with regulations and internal governance policies; (4) the Company lacked adequate internal and financial controls; (5) the SOX certifications signed by Eletrobras’ senior management were materially false and misleading as senior management was aware of “any fraud, whether or not material”; and (6)the Company’s financial statements were materially false and misleading at all relevant times.


The individual defendants are current and former officers of Electrobras. José Antonio Muniz Lopes (Lopes) was a member of the company’s board and CEO through February 25, 2011. José da Costa Carvalho Neto (Carvalho) replaced Lopes in both roles on February 25, 2011. Armando Cadad de Araújo (Araújo) served as CFO and head of financial relations through the class period. Valter Luis Cardeal de Souza (Cardeal) served as Eletrobras’s Chief Generation Officers.


The defendants moved to dismiss the plaintiffs consolidated complaint arguing (1) that the plaintiff ADS investors lacked standing to represent purchasers of Eletrobras bonds; (2) that the plaintiffs had failed to adequately allege material misrepresentations with respect to defendants’ statements about (a) ethics and integrity, (b) Eletrobras’s  financial condition, and (c) scienter; (3) that the plaintiffs failed to adequately allege scheme liability, because they had failed to allege the performance of a deceptive act distinct from the alleged misrepresentations.


The March 25, 2017 Ruling

In his March 25, 2017 order, Judge Koeltl largely denied the defendants’ dismissal motion.


Standing: First, with respect to the standing issue, Judge Koeltl rejected the defendants’ argument that the plaintiff ADS investors lacked standing to represent the interests of Eletrobras bondholders. He noted that while “the accompanying levels of risk between ADSs and bonds do differ … varying levels of payment priority do not raise such a fundamentally different set of concerns as to defeat class standing.”


Code of Ethics Allegations: Second, with respect to the defendants’ argument that the plaintiffs failed to plead any actionable misstatements related to Eletrobras’s code of ethics, Judge Koeltl found that the company’s “repeated assertions about its strong ethical standards stand in stark contrast with the explanatory notes in its 2014 and 2015 annual reports,” which confirm overpayments related to bribery and bid-rigging, a lack of effective internal controls over its corruption prevention program, and criminal convictions and charges filed against former officers. Judge Koeltl quoted Judge Rakoff’s decision in the Petrobras corruption-related securities lawsuit to the effect that “where  (as here alleged) the statements were made repeatedly in an effort to reassure the investing public about the company’s integrity, a reasonable investor could rely on them as reflective of the true state of affairs at the company.”


Financial Misrepresentations: In attempting to argue that the plaintiffs had failed to adequately allege material misstatements regarding the company’s financial condition, the defendants argued that the amount of the illicit payments and the impact on the company’s financial statements was trivial (representing less than one-tenth of one percent of the company’s total assets). Judge Koeltl noted however that quantitative considerations alone were not determinative, adding that “sufficiently strong qualitative evidence of materiality can establish materiality as a matter of law.”


He also noted that the fact that the 2014 and 2015 annual reports reveal that company officials had been engaged in illegal bribery and bid-rigging since 2008; that he the company had been concealing these unlawful transactions; that these events had resulted in serious criminal consequences and the complete overhaul of the company’s corporate governance system is “not so obviously unimportant to the reasonable investor” as to be immaterial.


Scienter: With respect to the defendants’ argument that the plaintiffs’ allegations had inadequately alleged scienter, Judge Koeltl concluded with respect to Lopes (who served as CEO during only six months of the class period until February 2011) that the plaintiffs had failed to raise a strong inference of scienter.


However, with respect to Carvalho, who replaced Lopes as CEO and as a director, and Araújo, Eletrobras’s CFO and Head of Investor relations, Judge Koeltl found that the plaintiffs had adequately alleged scienter. They had signed various annual reports and certifications throughout the class period at a time when they allegedly were aware of internal audits and reports raising concerns with various Eletrobras entities. These “red flags, “ Judge Koeltl said, “highlighted significant problems with Eletrobras’s internal controls … and therefore support a strong inference that Carvalho and Araújo acted with scienter.” Their positions within the company “further bolster the circumstantial evidence supporting an inference of scienter.”


Judge Koeltl further concluded that because the plaintiffs’ amended complaint adequately alleges scienter against two key officer of the company, it “necessarily alleges scienter against Eletrobras itself.”


Scheme Liability: The defendants argued that the plaintiffs had inadequately alleged scheme liability because, the defendants contended, the plaintiffs had failed to allege a deceptive act distinct from the alleged misstatements, as required to show the existence of a larger scheme beyond mere misrepresentations to investors. As to defendants Lopes, Carvalho, and Araújo, Judge Koeltl agreed that the plaintiffs had not adequately alleged scheme liability because the plaintiffs do not allege that these individuals participated in any bribery or bid-rigging scheme, but alleged only that they had made misrepresentations.


However, Judge Koeltl noted that Chief Generation Officer Cardeal was alleged to have actively participated in the alleged bribery and bid-rigging scheme. The defendants sought to argue, in reliance on the adverse interest doctrine, that Cardeal’s misconduct cannot be imputed to Eletrobras, because his conduct was for his own benefit and adverse to the company. Because he found that Cardeal’s conduct afforded the company political and other advantages, Judge Koeltl concluded that the adverse interest doctrine did not apply and that Cardeal’s conduct could be imputed to the company. On that basis, he concluded that the plaintiffs had adequately alleged scheme liability against the company.



One of the reasons why I find this ruling worth of note is because of my general interest in the U.S. securities lawsuits that have been filed against Brazilian (and other Latin American ) companies because of the burgeoning Brazilian corruption investigation.


However, Judge Koeltl’s detailed and broadly ranging opinion is also of more general interest. For example, his conclusion that the ADSs investors have class standing to represent the Eletrobras bondholders is relevant for many other securities cases. His conclusion about the significance of qualitative factors with respect to the alleged financial misrepresentations, notwithstanding the relatively slight quantitative effect of the alleged misrepresentations, is also interesting.


I was particularly interested in Judge Koeltl’s conclusions about the plaintiffs’ Code of Ethics allegations. In the Sarbanes Oxley Act, Congress created a requirement that companies disclose whether or not they have adopted a Code of Ethics. As a result of this requirement, most U.S.-listed companies adopted ethics codes. Investor plaintiffs have tried to build corporate and securities claims around company’s ethics codes, with mixed success. Plaintiffs have been particularly unsuccessful in trying to argue that a violation of the ethics code in itself to plead securities fraud (as for example discussed here). Plaintiffs have somewhat more success where, as here (and in the Petrobras corruption-related securities lawsuit), the allegation is that defendant company’s statements about its ethics code and integrity were intended to try to deflect allegations that it acted improperly.


In reading Judge Koeltl’s opinion I was struck by the extent to which he relied on the Second Circuit’s March 2016 opinion in Indiana Public Retirement System v. SAIC, Inc.  He extensively referred to and heavily relied on the opinion in his analysis both of the Code of Ethics allegations issues and of the financial misrepresentation issues, noting among other things that the opinion is “particularly instructive in assessing materiality of this case.” Regular readers may know that just yesterday, March 27, 2017, the U.S. States Supreme Court granted cert in the SAIC case (now known as the Leidos case), as I noted on this site yesterday. To be sure, the Supreme Court’s cert grant related to issues other than the specific topics with respect to which Judge Koeltl cited and relied on the opinion (that is, the Supreme Court granted cert on the question of whether or not Item 303 of Reg. S-K creates an actionable disclosure duty), but the Supreme Court’s cert grant does at least change the context within which he referred to the decision.


Regular readers may also have noted Judge Koeltl’s discussion of the adverse interest doctrine, with respect to the question of whether or not an individual’s conduct or knowledge can be imputed to his employer. As I noted at length of the discussion section of blog post earlier this week (here, scroll down to the discussion section), it is a frequently recurring question whether or not an individual’s wrongdoing can be imputed to his employer where the individual was acting adversely to the employer at the time. As discussed in the earlier post, the employer can escape imputation only where the individual was acting entirely for his or her own benefit and entirely adversely to the employer. In this case, and as Judge Rakoff concluded in the Petrobras bribery-related securities suit, the adverse interest doctrine does not apply to preclude imputation where the employer benefitted from the misconduct.


As I noted above, my most important interest in this decision is as it relates to the recent wave of lawsuits that have been filed in the U.S. against Brazilian companies. In this case as in the Petrobras bribery-related securities suit, the plaintiff investors managed to survive the initial dismissal motions. However, as was particularly apparent in the Petrobras case (where Judge Rakoff refused to hear the claims that the plaintiffs sought to assert under Brazilian law), the survival of the U.S. cases are of benefit only to investors who purchased their securities on U.S. exchanges.


The investors who purchased their shares on Brazilian exchanges must take their chances trying to assert their Brazilian law claims in Brazil, under local procedures (which for many Brazilian public companies means arbitration procedures). The existence of parallel claims across international borders raises troubling questions about the possibility of inconsistent outcomes, particularly if legal or procedural differences mean that one class of investors receives compensation while another class does not.


These kinds of cross-border concerns are not unique to these Brazilian bribery-related cases; these kinds of questions have been present, for example, with parallel Canadian cases for years, and are present in other high profile cases, like the various cases involving VW. However, the relatively undeveloped state of the law in Brazil (at least by comparison to, say, Canada or Germany) underscores the concerns about the possibility of inconsistent results. For these and many other reasons, it will be interesting to watch the fleet of Brazilian cases as they make their way through the courts – both here and in Brazil.


Special thanks to a loyal reader for sending me a copy of Judge Koeltl’s opinion.