One of the hot topics in the world of corporate and securities litigation in recent years has been the rise of M&A-related litigation. Among the many themes that are part of the discussion of this topic has been the fact that the M&A lawsuits often settle for the defendant company’s agreement to additional disclosures about the merger, with no cash payment to shareholders. The disclosure-only settlements continue to be a concern, but at the same time there recently have been a number of merger-related lawsuit settlements in which there has been very significant cash components. Continue Reading In Latest Jumbo Merger Suit Settlement, Duke Energy Agrees to Pay $146 Million to Settle Suit Over “Boardroom Coup” Following Progress Energy Merger
An Alarming Liability Award Against Not-for-Profit Organization’s Directors and Officers
A question that frequently recurs when I am speaking to directors and officers of non-profit organizations is why – given that their firms have no shareholders – they need to bother with D&O insurance. The reality is that even though officials at non-profit firms don’t have to worry about the possibility of shareholder claims, non-profit officials still face other potential claims from other potential claimants.
These potential liability issues were underscored in a recent decision by the United States Circuit Court of Appeals for the Third Circuit. In a January 26, 2015 opinion in In re Lemington Home for the Aged (here), the appellate court, applying Pennsylvania law, affirmed the jury’s entry of a liability verdict for the benefit of a bankrupt non-profit nursing home’s creditors against the home’s directors and officers, including the entry of punitive damages against the officers. The appellate court reversed the award of punitive damages against the home’s directors.
As discussed in a March 3, 2015 memo from the Cadwalader law firm about the appellate court’s ruling (here), the court’s opinion “provides a cautionary tale for the corporate officers as well as board members of not-for-profit heath care organizations – for the most part, volunteers – that they may be held to the same standards of accountability as those of for-profit, public corporations.”
Background
The Lemington Home had a long history operating a nursing home under a number of prior names going back to 1883. From September 1997 until the Home closed, Defendant Mel Lee Causey acted as the Home’s Administrator and Chief Executive Officers. From December 2002, Defendant James Shealey acted as the Home’s Chief Financial Officer.
Though the Home had a long history, its more recent history involved a significant number of deficiency citations from the Pennsylvania Department of Health. A number of outside consultants recommended that the Home hire qualified staff and outside specialists. A 2001 study funded by a community foundation recommended that that the Home’s board replace its existing administrator with a “qualified, seasoned nursing home administrator.” The community fund provided a grant of over $175,000 to hire a new administrator; however, the board did not act to replace its administrator, and the grant funds were used for other purposes.
In 2004, the Pennsylvania Department of Health, citing the Home’s failure to properly maintain resident’s clinical records as well as lapses of care (which included the Department’s investigations of two patient deaths that occurred in 2004), concluded that the Home’s administrator “lacks the qualifications, the knowledge of the regulations, and the ability to direct staff.” Even though the administrator had by that time transitioned to a part-time status – in violation of Pennsylvania law – the board still did not replace the administrator.
In addition, the Home’s financial administration lacked appropriate processes and controls. Among other things, beginning in November 2003, the Home’s CFO had ceased to maintain a general ledger of accounting records. In addition, by omitting to bill Medicare, the CFO failed to obtain up to $500,000 in payments that were due for patient services.
In January 2005, the Home’s board voted to close the Home. However, the Home’s Chapter 11 petition was not filed until April 13, 2005. During the interim the patient census dropped significantly. In June 2005, the bankruptcy court approved the Home’s closure. It was later revealed that because the Home delayed until September 2005 filing its Monthly Operating Reports for May and June 2005, the Home did not receive nearly $1.4 million in Nursing Home Tax Assessment Payments (an amount, which if it had been paid might have increased the Home’s chances of finding a buyer).
In November 2005, the bankruptcy court authorized the Committee of Unsecured Creditors to file an adversary proceeding against Causey, Shealey and the individual members of the Home’s board. The committee asserted claims for breach of fiduciary duty, breach of the duty of loyalty, and deepening insolvency. The adversary proceeding had a long procedural history that included two prior trips to the Third Circuit.
In February 2013, following a six-day trial, a jury returned a compensatory damages verdict against fifteen of the seventeen defendants, holding the defendants jointly and severally liable for $2.250 million. The jury awarded punitive damages of $1 million against Shealey and $750,000 against Causey, as well as punitive damages of $350,000 against five of the director defendants.
The January 26 Opinion
In a January 26, 2015 opinion written by Judge Thomas I. Vanaskie for a unanimous three-judge panel, the Third Circuit affirmed the jury’s compensatory damages verdict and the award of punitive damages against Shealey and Causey, but vacated the award of punitive damages against the five director defendants.
Pennsylvania statutory law provides that “An officer shall perform his duties as an officer in good faith, in a manner he reasonable believes to be in the best interests of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances.”
The appellate court found with respect to Causey that the evidence presented at trial demonstrated that Causey “fell far short of fulfilling these responsibilities.” Throughout her tenure, the Home was out of compliance with state and federal regulations. The Home was repeatedly cited for failing to keep proper documentation. It also appeared that at the time of a patient’s death at the Home, Causey was not working full-time, despite holding the title of Administrator and drawing a full-time salary, and even though Pennsylvania law required the Home to employ a full-time administrator. At trial Causey tried to claim she was in fact working full-time, but when confronted with long-term disability benefits application she had submitted, in which she said she was working only “20 to 24 hours a week” at the Home, she admitted that she was working part-time.
The court also concluded that the jury was presented with sufficient evidence that Shealey breached his duty of care. The jury heard evidence from a consultant that a creditor had hired that Shealey had tried to evade inspection of the Home’s financial records until finally being forced to admit that the records simply didn’t exist, and that the Home had operated without a general ledger since at least June 2004. The testimony also showed that Shealey failed to bill Medicare after August 2004, as a result of which the Home failed to collect at least $500,000.
The appellate court concluded that the evidence supports a finding that the director defendants breached their duty of care by failing to take action to remove Causey and Shealey once the results of their mismanagement became apparent.
The appellate court also found that the Creditors Committee had introduced sufficient evidence to support the jury’s finding that the defendants had “deepened the Home’s insolvency.” (The appellate court had previously predicted that Pennsylvania’s courts would recognize the tort of deepening insolvency.) The Court found, among other things, that the delay in filing the bankruptcy petition after the decision to close the facility resulted in a depletion of the patient census resulted in a “slow death” of the facility’s ability to generate revenue. The board contributed to the facility’s inability to find a buyer by failing to preserve and record the Home’s entitlement to a $1.4 million Nursing Home Assessment Payment. The appellate court also said there was sufficient evidence to support the deepening insolvency verdict against Causey and Shealey, due to the failure to maintain financial records and to recoup Medicare payments that were due.
Finally, while the appellate court concluded that there was insufficient evidence to support the award of punitive damages against the director defendants, “we have no such concerns about the punitive damages assessed against the Officer Defendants.”
Discussion
It is very difficult to read the appellate court’s opinion without concluding that the Home was badly run for many years and that despite numerous concerns raised over the years, neither the officers nor board did anything to remedy the identified concerns – with tragic consequences for some of the Home’s residents. So to some extent the outcome of this case my simply be a reflection of the truly lamentable factual circumstances.
Just the same, there are a number of important lessons from this case. First and foremost, the case highlights the fact that even though non-profit organizations do not have shareholders, the organizations directors and officers can still face D&O claims – as illustrated here, where the claims against the Home’s former directors and officers were asserted by the Creditor’s Committee for the Home’s bankruptcy estate.
Second, even though an organization is a not-for-profit entity, its directors and officers are still expected to perform their duties in compliance with the applicable standard of care, and can be held accountable if their conduct falls below those standards. As the Cadwalader law firm put it in its memo about this decision, this case shows that “the risk that officers and directors of not-for-profit corporations may be personally liable for breach of fiduciary duty is real.” Moreover, the standard of care against which the non-for-profit entity’s directors and officers’ performance of their duty will be judged is the same standard as that applicable to the directors and officers of for-profit organizations.
Third, the most important job for the board of any organization is to make sure that the organization’s professional day-to-day management personnel are qualified to perform their duties and are indeed actually performing those duties. The board of this organization was informed repeatedly that the Home needed an Administrator that had the qualifications and experience required for the position, yet – even though the incumbent Administrator was working only part-time – the board did not replace the Administrator. Indeed, the organization even received a grant from a community foundation to replace the Administrator, yet the organization made no change and the funds from the grant were spent for other purposes.
Fourth, while many jurisdictions do not recognize or at least have not recognized the tort of deepening insolvency, the Third Circuit’s decision does highlight the fact that directors and officers of non-profit organizations may be held accountable for their actions after their organization has become insolvent. The board may owe duties to the organization’s creditors in addition to their fiduciary duties to the corporation. As the Cadwalader memo put it, “it is critical that entities facing financial challenges be mindful of the interests of all of their constituents in making decisions that impact creditor recoveries.”
One of the lessons of this case is that in general directors and officers of not-for-profit organizations will be held to the same standard of care as directors and officers of for-profit entities. However, at the same time, it is important to keep in mind that many states have adopted statutes providing individuals who serve as directors on nonprofit boards with limited immunity from liability, as discussed here. Whether or not this type of limited director immunity was available under Pennsylvania law for the Home’s directors was not discussed in the Third Circuit’s opinion. It is worth noting that the limited immunity available under these types of state statutes is typically limited to non-profit officials who are not compensated for their duties.
Guest Post: The Key Players in Cybersecurity Investigations
One of the most immediate challenges when a company experiences a data breach is trying to figure out what has happened – how the breach occurred and how serious it is. Determining what has happened is also critical to re-establishing the company’s cybersecurity. In the following guest post Robert F. Carangelo and Paul A. Ferrillo discuss how important it is for a company to have developed a planned data breach response, well before any actual cyber-attack has occurred. They discuss how the involvement of certain key players will help to determine the effectiveness of the response. In particular, they discuss the critical importance of three key players: an experienced outside lawyer, a skilled cybersecurity forensic investigator, and the general counsel. A version of this article previously was published as a Weil client alert.
I would like to thank Robert and Paul for their willingness to publish their guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you are interested in submitting a guest post. Here is Robert and Paul’s guest post.
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Following detection of a cybersecurity breach or discovery of potential indicators of one, a company will face numerous challenges that must be addressed quickly. The situation can rapidly deteriorate, particularly because at that point in time, it is likely that the hackers have had access to the company’s network for months, if not longer. Additional data exfiltration could occur, surfacing previously undisclosed thefts of customer information or key intellectual property. Depending upon the intrusion, malware or wiperware could further damage both the network and physical infrastructure of a company. These are but a few of the ways that a cyber-breach can evolve from the point of detection, but they highlight the importance of a rapid response and investigation.
Companies need to consider this potential scenario, and the planned response, well in advance of an actual cyber-attack. Key to an effective response are three important actors: an experienced outside lawyer, a skilled cybersecurity forensic investigator, and the general counsel.
In previous articles we have emphasized the need for an incident response plan (IRP) that can be implemented and executed on short notice.[i] Here, we explore the interplay between the roles and responsibilities of a cyber forensic investigator, outside counsel, and the general counsel of the company during the investigation portion of an IRP following a breach. It can be crucial for a company to execute such an investigation in a coordinated and efficient manner, as it and the information it generates will be important when responding to various inquiries, as well as to potential lawsuits.
Role of Outside Counsel
Large companies typically have capable in-house legal staffs that can handle many stages of the investigative process after a cyber-breach is confirmed by the IT department. However, one of the most important reasons why a company should work with an outside lawyer in the event of a cyber-breach is it needs to ensure that it maintains attorney-client privilege and attorney work product protections. Doing so will help minimize issues regarding the capacity in which the in-house lawyers are acting, and will offer the best argument for protecting communications about the results of the data breach investigation, and related communications between the forensic investigators and the company.
Though scenarios will vary based upon the severity of the breach, there are many communications, actions, and potential disclosures that should be considered and coordinated between the company, the forensic investigator, and third-parties.
- If criminal conduct is a possibility (especially if the cyber-attack is suspected to have been perpetrated by either a nation-state or cyber-terrorist organization), it may be necessary to quickly contact the FBI and/or the U.S. Secret Service to assist with the investigation. Each has different investigative tools at its disposal to pursue cybercriminals, and one or both may have had experience with the same actor with respect to different targets. The government may have useful information that can assist in not only identifying the full nature of the breach, but also potentially in remediation efforts.[ii]
- If insiders are suspected of the theft of important information or funds, it may be necessary for outside counsel to conduct an internal investigation so that the facts of the potential insider theft can be determined.
- As is critical in most investigations, the outside lawyer and the forensic investigators must work together to forensically copy network servers and hard drives, secure all evidence necessary to assist with containment and remediation, and help all involved constituencies (law enforcement, regulators, and the public) understand the full extent of the breach.
- If personally identifiable information (PII) was stolen, data breach notifications to customers or patients may be necessary under federal and state law. Depending upon the industry, communications may be necessary with one or more regulatory authorities. If confidential personal employee information was hacked, disclosure and communications between the company, its HR department, and its employees likely will be necessary, as well.
- Finally, if the breach is substantial enough as to be deemed material under federal securities laws, public disclosure to investors is likely necessary.[iii] Outside counsel may also be helpful in drafting the appropriate disclosures and in responding to inquiries from the SEC and other regulators.
The Role of the Cyber Forensic Investigator
There are scores of cyber forensic investigators in the marketplace for both large and small companies, and many companies have pre-existing relationships with cybersecurity vendors. There are also a number of ways that an investigation should be tailored based upon the initial indicators of compromise that are detected internally, and based upon the size of the company. Below are factors to consider when selecting a cyber forensic investigator:
- Experience: There is nothing more important than experience. Today’s major breaches are carried out by sophisticated cybercriminals focused on the wholesale destruction or theft of millions of pieces of customer or patient data. The malware tools used are complex and have likely been masked throughout the breach process. The time-lag before discovery on the network gives hackers a huge head start. The forensic investigator should have major breach experience and also be able to identify and understand the various threat vectors and signatures that could have been used based upon other attacks. While each incident is different, and the choice of a forensic investigator will often depend on the magnitude of the breach, a more expensive (but experienced) vendor may be able to shorten the investigation, remediation, and recovery time necessary to fix the breach.[iv] As noted by one IT commentator, being able to apply analytics sets good cyber forensic investigators apart:
Analytics is about the ability to extract meaning, sort through masses of data, and in patterns and unexpected correlations. It’s not about knowing everything − it’s about finding what is relevant and getting closer to the right elements with the right people. To do that, you need to maintain a level of objectivity; set aside your personal and professional influences and biases and focus on the data. Forensics professionals cannot solely rely on technology to solve problems − they must build analytical skills that are learned and refined by thinking through trial-and-error.[v]
- Responsiveness: Building relationships with forensic investigators before a cyber-attack occurs will help achieve two main goals. It will increase the chances that the vendor will be available when needed on short notice, and the chances that it will be able to act faster.
- Credibility: Given the technical nature of a cyber-attack, it is necessary to rely heavily on the forensic investigator. It follows, therefore, that vendors with experience and strong references are a safer choice. Additionally, the forensic investigator likely will need to interact with regulators and possibly courts, so finding one with stature is imperative.
- User Friendly: Similar to using experts in other complex areas, one of the most important attributes of a good forensic investigator is to be able to translate complicated technical topics into plain English. Often, people who lack technical expertise will be making decisions and taking actions based on information provided by the forensic investigator, so the easier it is to understand the expert, the more informed the decision-makers will be.
- Retain the Right Team: When a company is the target of a large-scale cyber-attack, it needs the best forensic investigator possible. However, there are different levels of expertise within a forensic investigation firm, so it is important to ensure that the team that attends the initial meeting with the board and/or general counsel is the same team that will run the investigation. Pay particular attention to the number two person on the team because she likely will be the one carrying the laboring oar.
The Role of the Company’s General Counsel
The company’s general counsel or designated in-house lawyer will manage communications and disclosures that likely will be necessary in the event of a material breach. It is critical that the general counsel is one of the first individuals contacted by IT after there is a confirmed cyber-breach. Working hand-in-hand with the outside counsel, the following responsibilities should be promptly considered by the general counsel:
- Managing board and/or audit committee involvement and expectations.
- Determining what information was stolen, and if it was customers’ PII, consider disclosure obligations to customers, federal and state regulators, and law enforcement. If employees’ PII was compromised, internal communications to employees and others may be necessary.[vi]
- Overseeing an internal fact investigation by outside counsel and forensic investigators, particularly if it is suspected that an employee or former employee may be involved in the alleged breach.
- Working with a crisis management/public relations firm to draft appropriate disclosures aimed at reassuring customers and investors that the company has a firm grip on the problem and is resolving it as quickly as possible – especially given the potential for a cyber-attack to damage the company’s reputation with consumers, investors, and other constituencies.
- Working with outside counsel on SEC disclosures in the event that the cyber-attack is considered material under the federal securities laws.
Prepare In Advance
Many of the tasks and goals described above should be part of a company’s cyber IRP. By practicing and testing the IRP with all parties involved, real-life execution will run much more smoothly. The better the preparation, the better the response will be.
[i] See “The Importance of a Battle-Tested Incident Response Plan,” available here.
[ii] See Mandia, et al., “Incident Response and Computer Forensics,” (McGraw Hill, 2014), at 115.
[iii] See “CF Disclosure Guidance: Topic No. 2 (Cybersecurity),” Oct. 13, 2011, available here.
[iv] See “FireEye is ‘First in the Door’ on Big Cyberattacks,” available here.
[v] See “Tech Insight: What You Need To Know To Be A Cyber Forensics Pro,” available here.
[vi] See “M-Trends 2015: A View from the Front Lines,” at 5 (discussing rise in data breach disclosures), available here.
Whistleblowing: What Difference Does it Make?
In recent years, one of the favored responses of legislative reformers and regulatory enforcement authorities to financial fraud and other corporate misconduct has been the encouragement of whistleblowing activity. Both the Sarbanes-Oxley and the Dodd-Frank Act contained elaborate provisions designed to encourage and even to reward whistleblowers. There seems to be no question that the provisions have in fact encouraged whistleblowing. But does all of this whistleblowing activity actually produce any benefits? What difference does all of this whistleblowing activity make?
As discussed in a March 4, 2015 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “The Impact of Whistleblowers on Financial Misrepresentation Enforcement Actions” (here), which in turn described their longer academic paper of the same title (here), four academics have examined the impact of whistleblowing activity on the outcome of regulatory enforcement actions for financial misrepresentation. The four authors are Andrew Call of the Arizona State University School of Accountancy, Gerald Martin of American University Business School, Nathan Sharp of Texas A&M University Accountancy Department, and Jaron Wilde of the University of Iowa Business School.
In order to examine these issues, the authors developed and analyzed a database of 1,133 enforcement actions by the SEC and DoJ from 1978 through 2012 involving allegations of financial misrepresentation. In order to identify whistleblowing activity, the authors obtained information from the Occupational Safety and Health Administration (OSHA), which agency the Sarbanes-Oxley Act tasked with fielding employee complaints of discrimination for blowing the whistle on alleged financial misconduct. The authors identified 934 allegations of financial misconduct in complaints filed with OSHA between 2002 and 2010. The authors also reviewed the enforcement complaints and other related documents to determine if any of the enforcement actions resulted from whistleblowing activity.
Through this process the authors determined that of the 1,133 financial misrepresentation enforcement actions between 1978 and 2012, 145 (or about 12.8%) were associated with at least one whistleblowing complaint.
The authors then developed a set of standards to identify the factors that determine the magnitude of the penalties and sanctions that were imposed in the cases in the database. For example, the factors included such items as the length of the period and magnitude of the financial misrepresentation. Based on this analysis, the authors developed a basis to predict the expected outcome of each case, and then compared this predicted outcome to the actual outcome of the cases in which whistleblowing activity was involved.
Using this approach, the authors identified “an association between whistleblowing involved and outcomes of enforcement actions,” which “suggests whistleblowers have an incremental impact on enforcement outcomes.”
First, the authors concluded that “whistleblowing involvement in an enforcement action is associated with a significant increase in penalties.” The authors concluded that whistleblower involvement increases penalties assessed against forms by an average of $76.96 million and that penalties assessed against employees average $39.29 million more when a whistleblower is involved.
The authors also concluded that in aggregate whistleblowers enabled regulators to obtain judgments (including penalties against both firms and their employees) of $16.86 billion beyond what they would have obtained without whistleblower involvement. The increase in monetary penalties attributable to whistleblower involvement accounts for approximately 56% of the $30.09 billion in penalties assessed against firms and employees with whistleblower involvement and 21% of the $79.46 billion in total penalties assessed in all enforcement actions from 1978 to 2012.
Second, the authors found that employees at targeted firms receive prison sentences that are on average 21.55 months longer than if no whistleblower had been involved.
Third, the authors concluded that these enforcement benefits come at a cost. The authors found that the total duration of an enforcement action increases approximately 10 months (or about 10.9%) with whistleblower involvement, as the involvement of whistleblowers has the effect of prolonging the enforcement process.
The authors also found that the existence of a whistleblower complaint significantly increases the likelihood that a firm will become involved in an enforcement action. Comparing the number of firms named in an enforcement action during the period covered by the enforcement action database to the number of companies listed during that period in the Compustat database, the authors found that the general risk of being involved in an enforcement action was 4.74%. However, when only the companies that were named in a whistleblower reports are considered, and taking into account how many of those companies were involved in an enforcement action, the authors found that the risk of an enforcement action increases to 20.49% — that is, the risk of an enforcement action is 4.78 times greater with a whistleblower complaint.
However, at the same time, the authors found that 520 out of the 654 (79.51%) firms named in at least one whistleblower complaint were not the subject of an enforcement action, “suggesting a large portion of whistleblower complaints either are frivolous, are not sufficiently informative to result in an enforcement action, or slip through the cracks. “ The authors note that the costs associated with these unproductive whistleblower reports likely offset some of the benefits gained through whistleblower involvement in enforcement actions.”
The authors’ extensive database of enforcement actions allowed them to make a number of observations about the enforcement activity during that period. Among other things, the authors concluded that a company executive was named as a respondent in the enforcement actions 84.1% of the time. The CEO is named as a respondent 60.8% of the time, other C-level executives 17.7% of the time, and a non-executive employee is named as a respondent 26.4% of the tie.
The authors also determined that the incidence of enforcement activity varied by industry. The most frequent industries with enforcement actions are Business Equipment (23.0%) of the time, Finance (14.0%), Wholesale, Retail and Services (12.4%), Manufacturing (9.0%) and Healthcare, Medical Equipment and Drugs (8.1%).
Given the disposition that legislators and regulators toward whistleblowing activity, it is reassuring to know that the track record so far seems to suggest that the involvement of a whistleblower seems to produce an improved enforcement outcome.
In addition, given the authors’ conclusion that the involvement of a whistleblower report seem to produce a much greater exposure for the companies named to become involved in an enforcement action, it appears to be the case that in at least some instances the occurrence of whistleblower activity results in the disclosure of at least some financial misconduct that might not otherwise come to light.
However, the authors’ analysis also suggests that the benefits associated with whistleblowing activity come at a cost. The added costs include not only lengthening of the enforcement process when whistleblowers are involved. The costs also include the burdens and expenses associated with the high number of whistleblower reports that do not result in enforcement activity. The authors concluded that fully four out of every five whistleblower reports were not associated with related enforcement activity. These unproductive reports impose costs on regulators and enforcement authorities. There may be no way to measure the aggregate burden associated with these unproductive reports. However, without taking the costs associated with these unproductive reports into account, it may be very hard to reach definitive conclusions whether the incremental benefits associated with the whistleblower activity outweigh the associated burdens. In that same regard, it should also be noted that the unproductive whistleblower reports not only involve burdens and expense for the regulators, they also mean distraction, burden and expense for the companies named in the whistleblower report.
A final question that needs to be asked given the high number of and the indeterminate magnitude of costs associated with unproductive whistleblower reports is whether in the end our social and political predisposition in favor of whistleblowing in fact means that there is less financial fraud. This seems like a question worth asking, because, even if we can’t determine with precision the extent of the burdens associated with the high number of unproductive whistleblower reports, it is clear that our social and political predisposition in favor of whistleblowing comes at a not insignificant cost.
Delaware Legislature Readies to Consider Litigation Reform Bylaw Legislation: As Francis Pileggi discusses in a March 6, 2015 post on his Delaware Corporate and Commercial Litigation Blog (here), the Corporation Law Section of the Delaware State Bar Association has submitted proposed legislation to the Delaware legislature that would limit the ability of corporations to adopt fee-shifting provisions in their charter and bylaws, but also provide additional support for adopting forum selection clauses in those same corporate documents. The proposed legislation can be found here, a memo describing the legislation can be found here, and a document addressing frequently asked questions can be found here.
Pileggi comments that this legislation will be the subject of enormous lobbying on both sides. He adds that “The only certainty about this proposed bill is that it will generate an enormous amount of commentary and discussion. I would not expect a final outcome until the last day of the session on June 30.” He concludes with the comment that “If some legislation is passed that ultimately limits the ability of a corporation to adopt fee-shifting bylaws, an interesting issue will be the impact, if any, that the legislation will have on those companies that already adopted fee-shifting provisions. Generally, there is a prohibition against ex post facto laws.”
Navigating Circuit Split, District Court Finds Omission of Item 303 Disclosure Actionable Under Section 10(b)
One of the more interesting issues that has emerged recently in the securities litigation arena is the question of whether or not the alleged failure to make a disclosure required by Item 303 of Reg. S-K is an actionable omission under Section 10(b) and Rule 10b-5. The Ninth Circuit, in its October 2014 decision in the In re NVIDIA Corp. Securities Litigation (here), held that it is not, but in January 2015, the Second Circuit held in the Stratte-McClure v. Morgan Stanley (here), held that it is.
These two appellate decisions represent a clear split in the federal circuits on the question, leaving the federal district courts to try to sort their way through these issues. In a March 4, 2015 decision in the Tile Shop Holding securities litigation (here), District of Minnesota Judge Ann D. Montgomery followed the Second Circuit’s ruling on the question and held that an alleged failure to make a disclosure under Item 303 can serve as the basis of a Section 10(b) securities claim. The ruling is interesting in a number of other respects as well, as discussed below.
Background
Item 303 of Reg. S-K states in pertinent part that in its periodic reports to the SEC, a company is to “[d]escribe any known trends or uncertainties that have had or that the registrant reasonably expects will have a materially favorable or unfavorable impact” on the company. Guidance provided by the SEC on Item 303 clarifies that disclosure is necessary where a “trend, demand commitment event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial conditions or results of operations.”
In its October 2014 decision in In re NVIDIA Corp. Securities Litigation, the Ninth Circuit held that Item 303 does not create a duty to disclose for purposes of Section 10(b). In reaching this decision, the Ninth Circuit relied on language in an earlier opinion written by then-Judge (and now U.S. Supreme Court Justice) Samuel Alito, when he was on the Third Circuit, stating that because the materiality standards for Rule 10b-5 and Item 303 differ significantly, a violation of Item 303 “does not automatically give rise to a material omission under Rule 10b-5.”
In its January 2015 decision in the Morgan Stanley case, the Second Circuit expressed its view that Judge Alito’s language merely suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material omission. The Second Circuit concluded that the language is consistent with its conclusion that an Item 303 omission can serve as the basis for a Section 10(b) securities fraud claim, but only if the other requirements to state a Section 10(b) claim – such as materiality and scienter – have been met. Ironically, though the Second Circuit held that an Item 303 omission can serve as the basis of a Section 10(b) claim, the appellate court nevertheless affirmed the dismissal of the plaintiff’s Section 10(b) claims, holding that the plaintiff had not adequately alleged scienter.
The Tile Shop Securities Suit
Tile Shop is a specialty tile retailer. The company went public in August 2012, and conducted secondary offerings in December 2012 and June 2013, in which there were a number of selling shareholders including directors and officers of the company. The company sourced much of its tile product overseas, including from a company in China that the CEO’s brother in law had an ownership interest. The amount of tile product Tile Shop purchased from the Chinese company increased from 8.3 percent in 2011 to 32.2 percent in 2013. In addition to having the ownership in the Chinese tile manufacturer, the brother- in-law also worked for Tile Shop; beginning in 2011 and continuing until 2013, the brother in law was employed as Tile Shop’s purchasing supervisor.
In November 2013, a research analyst published a report identifying the connections between Tile Shop, its CEO and the brother in law and the Chinese supplier. The analyst report also stated that the company’s margins and profits were overstated due to favorable transactions between related parties. The company’s share price dropped 39% on the news. On November 15, 2013, plaintiff shareholders filed the first of several securities complaints filed against the company, certain of its directors and officers, and its offering underwriters. The defendants moved to dismiss.
The March 4, 2015 Order
In a detailed, 36-page order dated March 4, 2015, Judge Ann D. Montgomery denied in part and granted in part the defendants’ motions to dismiss. Judge Montgomery’s order addresses a number of different substantive legal issues, two of which I touch on below.
First, Judge Montgomery denied in part and granted in part the plaintiffs’ claims under Section 10(b), in which the plaintiffs alleged that Tile Shop’s failure to disclose its dependence on companies controlled by the brother-in-law violated Item 303, by failing to disclose trends or uncertainties that would have a material impact on Tile Shop sales, revenues or income.
In denying the motion in part, Judge Montgomery considered the split between the Ninth and the Second Circuits on the question of whether a failure to make a required disclosure under Item 303 can serve as the basis of a claim under Section 10(b). Judge Montgomery reviewed both appellate courts’ reference to and analysis of Judge Alito’s Third Circuit opinion. She said that she found the Second Circuit’s reasoning “persuasive” and “consistent with” her own reading of the Third Circuit opinion.
However, the Second Circuit had gone on to state in the Morgan Stanley case that a violation of Item 303 can be actionable only if the other requirements to state a Section 10(b) claim – such as materiality and scienter – have been met. Indeed, in the Morgan Stanley case, the appellate court held that the plaintiffs had in fact not sufficiently pled scienter, and the court affirmed the district court’s dismissal of the case.
In the Tile Shop case, Judge Montgomery concluded that the plaintiffs had sufficiently pled materiality. In concluding that failure to disclose the trend of the company’s increasing reliance on the brother-in-law’s tile company was material, Judge Montgomery said that the “trend of consolidating the percentage of product sold to a single entity could have a material effect on Tile Shop’s financial condition if that relationship was somehow compromised.” She added that “given the significant reliance” of Tile Shop on the supplier “a disruption of this relationship would be reasonably likely to impact Tile Shop’s future performance.”
Judge Montgomery also concluded that the allegations of scienter were sufficient as to the CEO and as to the company itself, and accordingly she denied the motion to dismiss the Section 10(b) claims against the CEO and the company. However, she found that the scienter allegations were insufficient as to the other individual director and officer defendants, and she granted the motion to dismiss the plaintiffs’ Section 10(b) claims as to the other individual defendants.
Judge Montgomery also granted the motion to dismiss the plaintiffs’ Section 11 claims based on the June 2013 offering because none of the plaintiffs purchased securities in the June 2013 offering. The plaintiffs attempted to argue that they had standing to assert the claims related to the June 2013 offering, though they purchased no shares in that offering, asserting that because they had standing to assert Section 11 claims related to the December 2012 offering, they also had standing to represent the interests of those who purchase in the June 2013 offering because their claims implicated the same set of concerns. In making this argument, the plaintiffs relied on the Second Circuit’s 2012 decision in NECA-IBEW v. Goldman Sachs, in which the court held that a named plaintiff may have class standing to bring claims related to the residential mortgage-backed certificates that it had not purchased on behalf of absent class members who purchased them.
Judge Montgomery declined to follow what she called the Second Circuit’s “non-precedential position” on the matter, relying instead on a District Court opinion from the Central District of California in the Countrywide case, for the principle that a plaintiff must demonstrate standing for each claim he seeks to press.
Discussion
When a circuit split exists, the district courts located outside of the circuits that have ruled on the issue have to decide which line of circuit authority to follow. The two issues from Judge Montgomery’s opinion that I discussed above show how district courts must struggle with these issues where there are competing lines of authority. Interestingly, on the Item 303 issue, Judge Montgomery followed the Second Circuit’s reasoning, but on the Section 11 standing issue, Judge Montgomery declined to follow the Second Circuit, preferring not the reasoning of a different circuit court, but rather the reasoning of a district court.
While the general topic of circuit splits is interesting, the split between the Second and Ninth Circuits on the Item 303 issue is particularly interesting. These issues are going to come up in other cases and other district courts outside of the Second and Ninth Circuits will have to wrestle with these issues. At a minimum, under the current state of play, there is the obvious risk of inconsistent outcomes on the issue between the courts in the Second Circuit and the Ninth Circuit. The existence of this type of circuit split is precisely the kind of thing that can, if teed up the right way in a particular case, attract the attention of the U.S. Supreme Court. Indeed, given the existence of the circuit split and the keen interest the Supreme Court has shown over the last eight years or so in taking up securities cases, the Item 303 issue could well wind up in the Supreme Court, perhaps sooner rather than later.
In any event, unless and until the Supreme Court has an opportunity to reconcile the holdings of the Second and Ninth Circuits on this issue, it is going to be increasingly important for companies to be particularly attentive in their periodic reporting documents to highlight company and industry trends and uncertainties, so as to ensure proper disclosure and to try to avoid attracting the unwanted attention of plaintiffs’ lawyers.
Special thanks to a loyal reader for sending me a copy of this opinion.
An Interesting Look at the Characteristics of Insider Traders
For the past several years, insider trading has been one of the hottest topics in world of corporate and securities law. The controversy that has followed Second Circuit’s December 2014 dismissal of the insider trading convictions of Todd Newman and Anthony Chiasson ensures that insider trading will continue to be a hot topic for some time to come. But beyond the legal issues surrounding the question of what makes or should make trading on inside information illegal are the even more basic questions about insider trading itself, such as: who is sharing information, what type of information is shared, what is the source of the information and how are the people sharing information related to each other?
These questions are examined in an interesting February 5, 2015 article entitled “Information Networks: Evidence from Illegal Insider Trading Tips” (here) by University of Southern California business school professor Kenneth Ahern. Using a compilation of all insider trading cases filed by the SEC and the DoJ between 2009 and 2013, Professor Ahern examined 183 insider trading networks. Because the case documents are highly detailed, Ahern was able to analyze biographical information and the relationships within the trading networks, as well as the information that was shared and the amount and timing of the trades. The information in the database covered 1,139 insider tips involving 465 events, shared among 622 insiders who made an aggregate of $928 million in illegal profits.
Based on his review of the data, Ahern was able to discern a number of characteristics about the information that was shared and how it was shared.
First, he observed that the insiders share information about certain types of corporate events that have a large effect on share prices. Merger-related events accounted for 51% of the insider tips, followed by earnings-related events (26%). Another major category of events involved clinical trial and regulatory announcements (8.0%) or operational news such as CEO turnover (2.8%)
Next, Ahern determined that trading in advance of these events yielded large returns. On average, trading on inside information earns returns of 34.9% over 21.3 trading days. Clinical trial and drug regulatory announcements generate the largest returns, on average, with gains of 101.2% for positive events and -38.6% for negative events, with an average holding period of just 9.2 days. M&A related tips generated average returns of 43.1% in 30.5 days.
The firms involved in the sample tend to be relatively large firms; the average firm involved had market equity of $10 billion and the median firm’s market equity was $1 billion. Ahern speculates that dollar trading volume of larger firms may be attractive for illegal traders because they are less likely to affect the stock price through the trades. The firms involved in the trades tend to be overweighted toward the high-tech industries.
The insider trading networks involve a wide variety of people. The average insider trader is 43 years old and about 10% of the insiders in the data set are women. In order to understand some of the characteristics of the insiders, Ahern looked that the value of the insiders’ homes as a proxy for wealth. He found that the average insider’s home was worth an estimated $1.1 million in September 2014, and the median value was $656,300, which by comparison to national average and median home values led Ahern to conclude that “the inside traders in the sample tend to be among the nation’s wealthiest people.”
Ahern found that the total amount invested per tippee ranges from a minimum of $4,400 up to a maximum of $375 million. The average total amount invested is $4.3 million and the median amount invested is $226,000. Many of the SEC complaints document how some insider traders sell all of the existing assets in their portfolio and borrow money to concentrate their holdings in the target firm. The median inside traders invests an amount worth 39% of his median home values. On the other hand, the trades tend to be highly profitable. The median investor realized gains of $133,000, and the average investor realizes gains of $2.3 million. Per tip, the median investor gains $72,000.
The most common occupation among inside traders is top executive, with 107 people identified in the database. Of these, 24 are board members and the rest are officers.
Ahern then compared the insiders in the dataset to their neighbors, using public databases to identify the insiders’ next door neighbors. Ahern determined that the insiders are different from their neighbors in many ways. Among other things, he determined that the insiders “have a higher likelihood of owning residential real estate, are more likely to be accountants and attorneys, and [are] significantly less likely to be registered as a Democrat, compared to their neighbors.” He also determined that the “insiders are considerably more likely to have a criminal record compared to their neighbors,” which he interpreted to mean that the insider trading activity was “consistent with other patterns of behavior,” adding that “it seems more likely that the insiders have less respect for the rule of law and are more brazen in their illegal activities than their neighbors.”
With respect to the relationships between the tippers and the tippees, Ahern examined the 461 pairs of tippers and tippees in the sample and determined that 22.6% of the relationships were familial, 34.7% are business-related, 35.1% are friendships, and 21.3% do not have any clear relationships. The pairs in this later category tended to be relationships formed through expert networking firms, where insiders are paid consultants to clients in the expert networking firm. Of business associates, about half of the relationships are between a boss and a subordinate or client. Across the whole sample, 74% of pairs of insiders met before college and 19% met during college. Excluding family members, about 43% met during college.
Insiders are connected in other ways as well. Insiders tend to live close to each other. The median distance between a tipper and tippee is 26 miles. Women are more likely to be tipped by other women. Insiders are more likely to share tips with people who share a common surname ancestry. Ahern also found that as information diffuses away from the original source, top executives and mid-level executives are less likely to send or receive tips, and after three degrees of separation, buy-side managers and analysts account for the majority of the information sharing. The first links in a tip chain are more likely to be friends and family, but as the information diffuses further from the source, business links become more prevalent. People further from the source invest larger amounts, make smaller percentage returns, and earn larger dollar gains.
Using information available from public databases, Ahern constructed a broader network of insiders’ family members and associates, in order to test what he called “counterfactual tippees” as a way of investigating why some people received tips and others do not. He found that insiders tend to share information with people that are closer in age and of the same gender, and are less likely to tip family members compared to non-family members. Using the counterfactual database, Ahern also examined the existence of selection bias in the database (which makes sense, since the database is by definition limited to insiders who were caught). Based on his analysis, Ahern concluded that the sample tends to omit infrequent, opportunistic traders who make smaller investments and share information with family or friends, while the sample comprises traders that are more likely to actually impact the share price: wealth CEOs and fund managers who are likely to be in larger networks and invest larger sums.
Ahern’s paper is interesting but it involves aggregate data and generalizations. Those who prefer more narrative flow and more specific detail will want to read the October 2014 New Yorker article entitled “The Empire of Edge” (here), which details the facts surrounding one of the S.A.C. Capital Advisors insider trading prosecutions.
A March 3, 2015 FT Alphaville blog post about Ahern’s paper can be found here.
Special thanks to a loyal reader for sending me a link to Professor Ahern’s paper.
The New Zealand Edition
The D&O Diary continued its South Pacific sojourn over the weekend with a short stop in Auckland, New Zealand’s largest city, for meetings and for a brief look around. Auckland is located on New Zealand’s North Island, about a three-hour plane flight from Sydney. Because Auckland is located just inside the International Date Line, every morning, the kiwis get first crack at the day.
I visited Auckland once before, 29 years ago. The transformation that has come over the city in the interim is remarkable. The city’s population, now over 1.3 million, has nearly doubled. And the city has gone upmarket. Queen Street, at the center of the city’s central business district, is now lined with new glass and steel office buildings. Viaduct Harbor (pictured below), the area where I stayed, is a new development of low rise office buildings and swish nightspots built on former docklands. Thanks to changes in the country’s immigration laws, the face (or perhaps the faces) of the city has changed as well – Auckland has to be one of the most diverse cities on the planet. It has the largest Polynesian population of any city in the world and a huge Asian and southeast Asian population as well.
On the evening of my arrival, I stepped right into an example of the city’s diverse ethnicity. A stroll through the city center took me to Albert Park, where, it turned out, the city’s annual Lantern Festival was taking place. The park was decorated with illuminated displays, and there were musical performances and food carts. The lanterns glowed as the evening gathered and crowds strolled through.
On Friday morning, before my first meeting, I went out to One Tree Hill, a prominent, nearly 600-ft volcanic cone located about a 15-minute cab ride from the city center. The hill’s name in Maori is Maungakiekie. Before European settlement, the hill had served as the location of a Maori pa (or fortification), and the remnants of many of the entrenchments can still be seen on the hillside. Unfortunately, there no longer is a tree on One Tree Hill. The original tree was cut down by a European settler in 1852, and Maori protestors cut down the replacement tree in 2000. The hilltop does afford absolutely fabulous views of Auckland and its surroundings, including Auckland’s two harbors — Waitemata Harbour to the north, which opens east to the Hauraki Gulf (as depicted in the first picture below), and Manukau Harbour to the south, which opens west to the Tasman Sea (second picture below). The views are great, but I have to admit that my primary interest in visiting the hilltop was because of the song, “One Tree Hill,” on U2’s 1987 album, The Joshua Tree. (“A sun so bright it leaves no shadows/ Only scars carved into stone on the face of earth.”) It was cool.
On Friday afternoon, I took a ferry across Waitemata Harbor to Devonport, a pleasant seaside suburb with small shops, cafes and restaurants on the harbor’s north side, to meet some friends for drinks. I arrived early so I took advantage of the opportunity to hike to the top of Mt. Victoria, a nearly 300 ft. volcanic outcropping that affords great views back toward the city center (as reflected in the picture at the top of the post) as well as out beyond the harbor to Hauraki Gulf (see the picture below). At the crest of the hill, there is a retractable gun emplacement. A placard explains that the guns were installed in the 1890s out of concerns over Russian expansion into the South Pacific. Which just shows you how quickly things can change. A pedestrian walkway, the Prince Edward Parade, winds along the harborside back into the town, as shown in the second and third picture below.
When I had mentioned to folks back in Sydney that I was going to be stopping in Auckland before heading home, the uniform response was that I had to be sure to visit Waiheke Island. So Saturday morning, I took a 45-minute ferry ride to the island, located out in the Hauraki Gulf. In the ferry dock’s parking lot, I rented a bike. I thought I would be able to cover most of the nearly 12-mile long island. I soon realized that this was a hopeless plan. The island’s rugged terrain quickly wore me out. I also quickly figured out that just about every turning and side road led down to beautiful, shell-covered beaches. The beaches further away from the ferry landing were generally deserted, and each one seemingly more attractive than the one before. In this way, I was drawn further and further along the island’s coastline, only realizing as the afternoon progressed and as the fatigue from pumping up and down the island’s hilly roadways began to accumulate that I was going to have to beat it back to the ferry landing if I wanted to get back to the city before dark. I will say this, the people who told me that I had to visit Waiheke were right.
As it turns out, my visit to Australia and New Zealand this past week coincided with the early part of the World Cricket Cup, which is being played in locations around the two countries through March. On Saturday evening, after I had returned to Auckland from Waiheke Island, I wandered into a bar near my hotel and found that the New Zealand-Australia group stage qualifying match, which had begun earlier in the afternoon at the Eden Park pitch in Auckland, was still underway. Australia had scored only 151 runs, and so New Zealand needed just 152 runs to win, a target that seemed easily within reach, particularly at the point in the proceedings at which I arrived. New Zealand’s run total was quickly mounting and the Black Caps seemed to have the match well in hand. And then the wheels came off. Australian Mitchell Starc, who bowled superbly, claimed a number of quick wickets, and suddenly, with only one wicket remaining but with the Kiwis still six runs short, the contest seemed poised for a dramatic showdown. But New Zealand’s Kane Williamson hit a six to seal victory for New Zealand in a wonderfully tense climax – to put it in terms that Americans would understand, Williamson hit a walk-off home run. I was surrounded by excited, shouting fans, and I participated in the celebration as if I had as much of a right to the celebration as everyone else. The celebratory mood carried out into the warm summer evening, and the crowds strolling along the city’s busy streets as night time gathered had something of a festive air.
On Sunday, it was time to return to the States, back to home and to work. However, while I was in the South Pacific, I spent a considerable amount of time contemplating the concept of summer in February. I have decided that the idea has merit and warrants further study.
Cornerstone Research Releases 2014 M&A Litigation Report
According to the latest report from Cornerstone Research, during 2014, over 90 percent of M&A transactions resulting in at least one lawsuit, but each deal attracted a smaller average number of lawsuits and in fewer jurisdictions than in past years. The report, entitled “Shareholder Litigation Involving Acquisitions of Public Companies: Review of 2014 M&A Litigation” can be found here. Cornerstone Research’s February 25, 2015 press release about the report can be found here.
The research reported in the Cornerstone Research study is generally consistent with the updated research that Professors Cain and Davidoff released earlier this week, as discussed here.
According to the Cornerstone Research report, 93 percent of M&A transactions during 2014 valued at over $100 million were litigated. The report does note that plaintiffs challenged fewer deals valued below $1 billion. 96 percent of deals valued at $1 billion drew at least one lawsuit, but for deals valued under $1 billion, the percentage of deals attracting a lawsuit declined slightly to 89 percent in 2014 from 94 percent in 2013.
By contrast to recent years, the majority of deals (60%) attracted litigation in just one jurisdiction (perhaps, the report speculates, because of the adoption of forum selection bylaws). Just four percent of deals were challenged in more than two courts, the lowest level since 2007. The average number of lawsuits per deal declined from 5.2 in 2013 to 4.5 in 2014. Interestingly, there were still a number of transactions that attracted quite a number of lawsuits; the Fusion-io/San Disk deal attracted 22 lawsuits, and the International Game Technology/GTECH deal attracted 21.
Fewer suits were resolved prior to the deal closing in 2014. Only 59% of lawsuits were resolved before deal close, compared to 74 percent in 2013.
Of the 78 settlements reached in 2014, only six percent provided monetary consideration to shareholders. 80 percent of settlements involved only the provision of additional disclosure.
The D&O Diary Goes Down Under
The D&O Diary is on assignment in Australia this week. Here’s what you need to know about Sydney in late February – if you traverse the vast expanse of the Pacific Ocean, fly across the Equator and the International Date Line, and then finally arrive Down Under, when you get there, it is summer. Warm, sunny, beautiful summer. Given that the day before I left home the thermometer on the dashboard of my car read minus 17 degrees Fahrenheit (or minus 27 Celsius as they would say in Australia, as if it would ever get that cold there), the trip to Australia came at a particularly welcome time.
Sydney, Australia’s largest city and financial center, is a modern, busy metropolis. It is also massive. Its population of 4.7 million is larger than that of either Los Angeles of Chicago. At the city’s center is its vast harbor, which Captain Arthur Phillip, who led the famous First Fleet to Australia in 1788, described as “without exception the finest harbor in the world.”
The city’s central business district sits along the harbor’s south shore, as shown above. The beautiful, lush Royal Botanical Gardens sit adjacent to the central business district and lead down to the water’s edge and the famous, iconic Sydney Opera House, which is one of the world’s most distinctive, beautiful and photogenic buildings.
Just west of the Opera House, beyond the Circle Quay, now in the place where the First Fleet landed back in 1788, is the Sydney Harbor Bridge, which crosses the harbor to northern shore. It is possible to cross the bridge on foot. The bridge’s pedestrian footpath affords fabulous views of the city and of the harbor.
This was actually my second trip to Australia, after my first trip there nearly thirty years ago. Just as happened on my prior visit, I found this time that I kept getting lost. Because I have a fair amount of pride in my sense of direction, I found this quite vexing. On my prior visit, I finally figured out the source of my disorientation. It was the sun. It was all wrong. It turns out that in the Southern Hemisphere, the sun passes from east to west through the northern sky (rather than through the southern sky, as happens in the Northern Hemisphere). When facing west, the sun has a right-left trajectory (unlike the left-right trajectory in the Northern Hemisphere). The sun’s position kept steering me in the exact opposite way of my intended direction. Despite my prior acquaintance with this phenomenon, I still struggled to avoid getting lost. There is, however, no truth to the rumor that the water in Southern Hemisphere toilets circulate counter-clockwise because of the Coriolis effect.
On the plane on the way over, I read The Fatal Shore, Robert Hughes’s excellent book about the European settlement of Australia. Among other things, Hughes describes how Francis Greenway, the so-called convict architect, working under the direction of the then-governor Laclan Macquarie, designed and directed the construction of the first durable civic architecture in Sydney. Several of the buildings he designed still stand along Macquarie Street, near Hyde Park. One of these buildings, the Hyde Park Barracks, pictured above, is noteworthy not merely because it is an important landmark from the city’s early days, but also because it has a simple, symmetric and utilitarian order that even today seems appropriate for the place.
Thanks to United Airlines, which if it is incompetent it is also at least consistent, I once again had an overseas trip cut short by a day because of mechanically-related flight delays. I also had the pleasure of spending the night last Saturday night sleeping on a bench in a concourse at LAX. So much for the “friendly skies.” As a result of the lost day, I didn’t have nearly as much time to visit Sydney as I would have liked, and as I had intended. (Basically, all of the pictures in this post were taken in the course of one very busy afternoon.) I had just enough time to be reminded that Sydney is a great place full of friendly people. And best of all, in late February, it is full of warm, summer sunshine.
I would like to thank John Goulios and his colleagues at the DLA Piper law firm for inviting me to participate in their firm’s client event in Sydney. I was delighted to be introduced to so many industry colleagues at the event. (Please see my pictures of the event, below.) I was also delighted to learn how many of them — not just from Sydney, but also from Perth, Brisbane, Melbourne and Auckland – follow The D&O Diary.
More pictures of Sydney:
The lush Botanical Gardens are full of a fascinating array of flora and fauna. The trees and grounds are alive with bird life, including brightly colored lorikeets, white Cockatoos, and the Australian white ibis.
I love maps and signs, because they convey so much about places you might visit. Even a simple road sign suggests so many possibilities. What are the places referred to like? The sign not only points the way, it suggests that you might easily travel there. The world is full of such a vast array of places and possibilities.
In this picture, I demonstrate how to prevent half of a room full of Australians from seeing a powerpoint slide.
Here, I am joined by two of my new friends from Australia, Kathleen Warden of Berkley Insurance Australia in Sydney, and Andrew Quartermaine, of Arthur J. Gallagher in Sydney.
In this picture, I am joined Sophie Devitt of DLA Piper’s Brisbane office.
Here is a picture taken with John Goulios of DLA Piper’s Singapore Office.
Guest Post: Despite SLUSA, Plaintiffs File IPO Lawsuits in State Court
In a recent post, I noted the curious phenomenon of plaintiffs filing IPO-related securities class lawsuits in state court. Plaintiffs have this option under the concurrent jurisdiction provisions of the ’33 Act, but I still wondered why a plaintiff would chose to proceed in state court. I also noted that there is a split in authority within the federal circuit on the question whether subsequent legislation (SLUSA and CAFA) preempts the ’33 Act’s concurrent jurisdiction provisions.
In the following guest post, Maeve O’Connor and Elliot Greenfield of the Debevoise & Plimpton law firm take a look at these issues surrounding the ’33 Act’s concurrent jurisdiction provisions and discuss the reasons why we have been seeing more state court securities class action lawsuits, particularly in California.
I would like to thank Maeve and Elliot for their willingness to publish their article on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you are interested in submitting a guest post. Here is Maeve and Elliot’s guest post.
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As The D&O Diary recently noted, there has been an increase in securities class actions filed in state court in recent years, the majority of them in California. This increase results not only from a surge in IPO activity, but from widespread confusion and disagreement among federal district courts regarding whether, after SLUSA, state courts retain concurrent jurisdiction over class actions asserting claims under the Securities Act of 1933, and whether such actions filed in state court may be removed. To date, of 37 cases, district courts granted remand in 23 and denied remand in 14.[i] In California district courts, plaintiffs have successfully remanded in 11 cases and have been denied remand in only 3. Excluding those California decisions, the national numbers are even closer, with 12 courts granting remand and 11 denying remand.
This trend raises several questions, including (1) why plaintiffs prefer to file in state court, (2) why federal courts disagree on such a fundamental issue of securities law, and (3) why plaintiffs have enjoyed relatively more success avoiding removal in California.
Why Plaintiffs Prefer State Court:
Plaintiffs – and plaintiffs’ attorneys – have several reasons to prefer to file a securities class action in state court rather than federal court.
For one thing, filing in state court allows a plaintiff to avoid certain procedural protections provided by the PSLRA. In particular, the numerous requirements set forth in 15 U.S.C. § 77z-1(a) expressly apply only to actions brought “pursuant to the Federal Rules of Civil Procedure” – i.e., brought in federal court. This provision requires, among other things, that the plaintiff publish nationwide notice of the pending action, alerting members of the purported class that they can seek to be appointed lead plaintiff, and that the court thereafter appoint lead plaintiff based on the rebuttable presumption that the plaintiff with the largest alleged loss is the “most adequate plaintiff.” It also places important limitations on any award of damages to the named plaintiff and on the payment of attorneys’ fees and expenses.
The PSLRA’s stay of discovery during the pendency of a motion to dismiss, set forth in 15 U.S.C. § 77z-1(b), applies to “any private action” arising under the Securities Act, which on its face includes an action filed in state court. Despite this language, a plaintiff could argue that the discovery stay does not apply in state court, and there are surprisingly few cases addressing this issue. See Milano v. Auhll, 1996 WL 33398997, at *3 (Cal. Super. Ct. Oct. 2, 1996) (discovery stay applies to state court actions).
By filing in state court, a plaintiff also can avoid consolidation with any pending or later-filed federal actions, even where those federal actions assert identical claims against identical defendants. Avoiding consolidation may have important consequences for how attorneys’ fees are allocated if the case leads to a settlement.
And, as with any case, a plaintiff may feel, correctly or not, that it has a certain “home court” advantage in its local state court. There also appears to be a widespread perception, accurate or not, that state courts generally are less likely to grant a motion to dismiss on the pleadings.
Why Federal Courts Disagree on State Court Jurisdiction Over 1933 Act Class Actions:
Congress passed the PSLRA in 1995 to curb “perceived abuses of the class-action vehicle in litigation involving nationally traded securities.” Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71, 81 (2006). The PSLRA, however, “had an unintended consequence: It prompted at least some members of the plaintiffs’ bar to avoid the federal forum altogether.” Id. at 82. Plaintiffs were able to escape the PSLRA by filing in state court because, prior to SLUSA, the 1933 Act gave state courts concurrent jurisdiction and barred removal.
In passing SLUSA three years later, Congress stated that “the purpose of [SLUSA] is to prevent plaintiffs from seeking to evade the protections that Federal law provides against abusive litigation by filing suit in State, rather than in Federal, court.” H.R. Conf. Rep. No. 105-803, at 13 (1998). SLUSA “makes Federal court the exclusive venue for most securities class action lawsuits.” Id.
Congress sought to accomplish this goal in two ways:
First, SLUSA required that securities class actions be filed in federal court. It amended the 1933 Act’s jurisdictional provision, divesting state courts of concurrent jurisdiction over class actions asserting 1933 Act claims. As a result, those actions are no longer subject to the 1933 Act’s removal bar, which is expressly limited to actions “brought in any State court of competent jurisdiction.” 15 U.S.C. § 77v(a).
Second, SLUSA required that securities class actions be filed under federal law. It precludes class actions asserting certain state law claims that mirror the elements of a 1933 Act claim, and provides that such actions may be removed to federal court, 15 U.S.C. § 77p(c) (“Section 77p(c)”).
After SLUSA, therefore, class actions asserting 1933 Act claims are removable under the general removal statute, 28 U.S.C. § 1441(a), and class actions asserting precluded state law claims are removable under Section 77p(c). Both parties and district courts have struggled to understand and apply this statutory scheme, mainly because they confuse these two separate bases for removal.
Most federal courts faced with motions to remand 1933 Act class actions have ignored SLUSA’s amendment to the jurisdictional provision and, instead, have considered only whether those actions were removable under Section 77p(c). That approach is erroneous because, as noted, Section 77p(c) governs only the removal of actions asserting precluded state claims and has no bearing on the removal of actions asserting federal claims. See Kircher v. Putnam Funds Trust, 547 U.S. 633, 643-44 (2006).
Those courts that do address SLUSA’s amendment to the jurisdictional provision have disagreed about its impact. SLUSA limited the 1933 Act’s broad grant of concurrent state court jurisdiction by inserting the phrase “except as provided in section 77p with respect to covered class actions.” 15 U.S.C. § 77v(a). The most straightforward reading of that amendment is that state courts no longer have jurisdiction over “covered class actions” asserting Securities Act claims. The reference to “section 77p” points readers to the lengthy definition of “covered class action” set forth in Section 77p(f). See Knox v. Agria Corp., 613 F. Supp. 2d 419, 423-24 (S.D.N.Y. 2009).
Some courts, however, have found that the reference to “section 77p” refers to Section 77p(c), which governs removal of actions asserting precludes state law claims. Because class actions asserting 1933 Act claims do not fall within that section, those courts conclude, state courts retain jurisdiction over such actions. The problem with that analysis is that it would render SLUSA’s jurisdictional amendment meaningless. A provision that deals exclusively with actions asserting state law claims, such as Section 77p(c), cannot limit jurisdiction over actions asserting 1933 Act claims. SLUSA’s jurisdictional amendment would be mere surplusage, as it would not carve out any category of actions asserting 1933 Act claims from concurrent state court jurisdiction.
That interpretation also directly contradicts SLUSA’s clearly stated purpose of ensuring that securities class actions are governed by the PSLRA. As one court put it: “[G]iven the intent of SLUSA, it just makes no sense to prohibit the removal of federal securities class actions to federal court. Such a prohibition would permit the sort of end run around the PSLRA that [SLUSA] attempted to stop.” Unschuld v. Tri-S Sec. Corp., 2007 WL 2729011, at *9 (N.D. Ga. Sept. 14, 2007)
Why Plaintiffs Have Enjoyed Greater Success in California Courts:
The absence of any Court of Appeals or Supreme Court authority addressing SLUSA’s effect on state court jurisdiction has allowed the disagreement among district courts to persist. There appears to be a common belief that orders granting remand of 1933 Act class actions may not be appealed. Only the Eleventh Circuit has so held, however, and other circuit courts might disagree. Williams v. AFC Enterprises Inc., 389 F.3d 1185, 1191 (11th Cir. 2004). Barring that, unifying appellate authority will come about only if a plaintiff appeals a denial of remand – which none have chosen to do as of yet.
Although the Courts of Appeals have not provided any binding authority, they have made statements on the issue in cases addressing related questions. These dicta have, to some degree, guided the decisions of district courts, resulting in jurisdictions that plaintiffs consider “friendly” and others that they avoid entirely.
The Second Circuit, for example, is the most popular venue for securities litigation, but plaintiffs do not appear to have filed a single 1933 Act class action in state court in New York since the Knox decision in 2009, which was adopted by another S.D.N.Y. court shortly thereafter. In re Fannie Mae 2008 Sec. Litig., 2009 WL 4067266, at *2 (S.D.N.Y. Nov. 24, 2009). The Knox court based its decision on its own analysis of the statutory scheme, but it also cited statements by the Second Circuit to the effect that SLUSA gave federal courts exclusive jurisdiction over securities class actions. Lander v. Hartford Life & Annuity Ins. Co., 251 F.3d 101, 108 (2d Cir. 2001); Spielman v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 332 F.3d 116, 123 (2d Cir. 2003).
By contrast, nine of the twelve decisions on remand motions issued in the past five years have come from California federal courts, where plaintiffs have enjoyed considerable success in avoiding removal. The primary reason for this success is dicta from the Ninth Circuit’s decision in Luther v. Countrywide Home Loans Servicing LP, 533 F.3d 1031 (9th Cir. 2008). Since Luther, eight remand motions have been granted by California federal courts, and only one has been denied.
The defendants in Luther removed the case under the Class Action Fairness Act (“CAFA”). Both parties agreed that SLUSA did not allow the case to be removed because the securities at issue were not “covered securities,” i.e., securities traded on a national exchange. The question for the district court, and the Ninth Circuit on appeal, was whether the right to removal under CAFA trumped the bar to removal under the 1933 Act. The Ninth Circuit held that it did not. In coming to that conclusion, the court stated that the 1933 Act “strictly forbids the removal of cases brought in state court and asserting claims under the Act.” Id. at 1033. While it is true that the 1933 Act barred removal of the class action in Luther, the court’s statement is incorrect as to 1933 Act class actions involving “covered securities.” Nonetheless, virtually all of the California district courts granting remand since Luther have relied on that dicta.
Unless and until a federal appeals court squarely addresses SLUSA’s effect on state court jurisdiction and removal of 1933 Act class actions, one can expect current trends to continue. Plaintiffs will continue to file these actions primarily in California state courts, avoiding New York courts, and district courts will remain divided, as they have been for more than a decade.
About the Authors: Maeve O’Connor is a litigation partner at Debevoise & Plimpton LLP. Her practice focuses on complex civil litigation and regulatory inquiries. She has significant experience in defending securities litigation and in representing life insurance companies in a range of litigation and regulatory matters. Ms. O’Connor can be reached at (212) 909-6315 or at mloconnor@debevoise.com. Elliot Greenfield is a litigation associate at Debevoise & Plimpton LLP whose practice focuses on complex civil litigation. He has significant experience defending companies and officers and directors in securities class actions, shareholder derivative lawsuits, and merger and acquisition litigation. Mr. Greenfield can be reached at (212) 909-6772 or at egreenfield@debevoise.com.
[i] In an additional case, City of Birmingham Ret. & Relief Sys. v. MetLife, Inc., No. 2:12-CV-02626 (N.D. Ala.), the order of a magistrate judge granting remand was stayed pending de novo review by the district court judge. The authors represent MetLife, Inc. and other defendants in that case.