Securities Litigation: Recent Supreme Court Decisions and Future Trends

Recent and Upcoming Supreme Court Decisions

In 2011, the Supreme Court decided three significant securities cases: Matrixx Initiatives, Inc. v. Siracusano 131 S. Ct. 1309 (2011), regarding statistical significance in the context of securities fraud; Erica P. John Fund, Inc. v. Halliburton Co. 131 S. Ct. 2179 (2011), addressing the relationship between loss causation and class certification; and Janus Capital Group, Inc. v. First Derivative Traders 131 S. Ct. 2296, 2305 (2011), construing the phrase “to make” under the SEC’s Rule 10b-5. Coming up in the term that began in October 2011, the Court will decide Credit Suisse Securities v. Simmonds, to clarify the two-year statute of limitations under Section 16(b) of the Securities Exchange Act.

• In Matrixx, a unanimous Supreme Court rejected statistical significance as a bright-line test for materiality and scienter under Section 10(b) of the Securities Exchange Act. The Court held that shareholders can state a claim based on a company’s failure to disclose adverse events associated with the company’s product, even if the complaint does not allege that the company knew of a statistically significant number of such adverse events. The Court reasoned that if regulators and consumers rely upon information that fails to attain statistical significance, it follows that investors could as well.
• In Halliburton, the Court resolved a split between the Fifth and Seventh Circuits regarding whether plaintiffs must prove loss causation at the class certification stage. The justices unanimously sided with the Seventh Circuit, ruling that plaintiffs need not prove loss causation to certify a class. The Court noted that the merits of loss causation — unlike, for example, the reliance element of fraud — bear no logical connection to whether individual or common issues will predominate for a proposed class action.
• The Janus opinion clarified what it means to “make” a false statement under Section 10(b)’s anti-fraud provision. The majority held that the maker of an allegedly false statement is “the person or entity with ultimate authority over the statement.” Under that ruling, one who merely publishes a statement on another’s behalf is not the statement’s maker and cannot be liable for the alleged fraud. Lower courts continue to explore how the Janus holding applies to corporate officers when an allegedly false statement is attributed to the officer, but the company holds the ultimate authority over the statement.
• On the horizon for 2012 is Simmonds, which will review the Ninth Circuit’s long-standing accrual rule for insider trading claims under Section 16(b). The Ninth Circuit recently reaffirmed its rule that the two-year limitations period to recover short-swing profits from corporate insiders under Section 16(b) is tolled until the insider reports the offending trades to the SEC under Section 16(a) — regardless of the plaintiff’s actual knowledge of his or her claim and failure to sue in spite of that knowledge. Notably, the Ninth Circuit opinion’s author also wrote separately that the Ninth Circuit rule ignores the statutory text and congressional intent, and the Supreme Court granted certiorari.

Filings Trends Continued to Evolve in 2011

The number of securities class actions decreased slightly in 2011 as compared to 2010; however, considering the recent decline in the number of public companies, an argument can be made that the number of filings (as a percentage of public companies) is on the rise.

Among other trends, while credit crisis-related litigation continued in 2011, it has extended beyond the securities class action realm, as evidenced by a recent surge in mortgage-backed securities (MBS) actions, including “put-back” suits involving contractual breaches of representations and warranties. Litigation activity in this area also is being driven by more than just the “traditional plaintiff,” with monoline insurers, financial firms and other industry participants bringing credit crisis-related claims of their own. Additionally, government agencies, such as the Federal Housing Finance Agency and the FDIC are becoming active litigants. For example, the Federal Housing Finance Agency, as conservator for Fannie Mae and Freddie Mac, recently filed suits against financial institutions alleging securities law and state law violations stemming from MBS issuances; and the FDIC has initiated more than a dozen “failed bank” lawsuits against former officers and directors, alleging negligence and related theories.

One trend we observed in 2011 was a marked increase in M&A-related securities litigation, something we expect to continue in the coming year.

Also during 2011, there was increased litigation against and regulatory focus on Chinese firms that gained access to U.S. equity markets through reverse mergers, in which an existing U.S.-listed shell company acquires a nonlisted firm.

Circuit Courts Addressed a Number of Diverse Issues in 2011, With the Second Circuit Leading the Way

Several important cases percolated to the Circuit Court level last year, resulting in important decisions across a number of key issues. In light of the increase in financial services securities litigation, it is not surprising that the Second Circuit — sometimes referred to as the “mother court” of securities law — led the way.

For example, in the first putative securities class action challenging the adequacy of disclosures by underwriters in relation to their participation in the auction rate securities market to be decided by a Circuit Court, the Second Circuit affirmed the dismissal of the action, finding the disclosures of the underwriter’s involvement in the auctions to be sufficient to negate any claim of market manipulation. (Wilson v. Merrill Lynch & Co., No. 10-1528-cv, 2011 WL 5515958 (2d Cir. Nov. 14, 2011) (to be published in F.3d)). In Fait v. Regions Financial Corp., 655 F.3d 105 (2d Cir. 2011), the Second Circuit found that statements about good will and reserves were matters of opinion and held that when a Section 11 or 12 claim is based on matters of “belief or opinion … , liability lies only to the extent that the statement was both objectively false and disbelieved by the defendant at the time it was expressed.” This decision will be significant in financial crisis litigation where valuations of complex financial instruments often are based on subjective judgments.

In reversing the dismissal of a securities class action, the Second Circuit provided guidance on whether (and under what circumstances) issuers must disclose “adverse trends” under Item 303 of Regulation S-K (Litwin v. Blackstone Grp., L.P., 634 F.3d 706 (2d Cir. 2011), cert. denied, 132 S. Ct. 241 (2011)). The Second Circuit found error in the district court’s decision to measure the materiality of statements regarding a portfolio company against the private equity firm’s entire business. The court explained that segment information can be material if it “plays a ‘significant role’ in the registrant’s business.”

Other appellate courts have been active as well. The Eleventh Circuit, for example, rejected the argument that misstatements must cause price inflation for loss causation to exist. In FindWhat Investor Group v. FindWhat.com, 658 F.3d 1282 (11th Cir. 2011), the plaintiff argued that the issuer’s stock price was inflated by an equal amount both before and during the class period. Given the foregoing, the district court held that the challenged statements could not have caused price inflation or any subsequent loss. At issue was whether false statements that prevent a stock price from falling can cause harm by prolonging the period during which stock is traded at inflated prices. The Eleventh Circuit answered the question in the affirmative.

The Sixth and Seventh Circuits had the opportunity to address the application of the Securities Litigation Uniform Standards Act (SLUSA). The Sixth Circuit addressed whether SLUSA reaches a claim that does not require a misstatement or omission as a necessary element. In Atkinson v. Morgan Asset Management, 658 F.3d 549 (6th Cir. 2011), shareholders in three mutual funds accused the funds’ advisors, officers and directors (among others) of taking “unjustified risks in allocating the funds’ assets and conceal[ing] these risks from shareholders.” According to plaintiffs, under SLUSA, the fact that their complaint included certain fraud-based allegations was irrelevant to their prosecution of claims that do not contain fraud as a necessary element (e.g., breach of contract, breach of fiduciary duty). The Sixth Circuit disagreed: SLUSA “does not ask whether the complaint makes ‘material’ or ‘dependent’ allegations of misrepresentation in connection with buying or selling securities. It asks whether the complaint includes these types of allegations, pure and simple. … That the claims did not ‘depend’ on these allegations [was] inapposite, as [was] Plaintiffs’ ‘artful’” attempt to carve out “any facts that are unnecessary … for purposes of stating” such claims. In Brown v. Calamos, No. 11-1785, 2011 WL 5505375 (7th Cir. Nov. 10, 2011), the Seventh Circuit took a more flexible approach. Plaintiffs, investors in a closed-end mutual fund, accused the fund’s advisors and others of breaching fiduciary duties owed to common shareholders by redeeming certain auction rate securities owned by preferred shareholders. Plaintiffs argued that the complaint’s averments of fraud (such as an alleged misrepresentation that the securities would never be liquidated) failed to trigger SLUSA because they were not a necessary element of their claim. The Seventh Circuit disagreed, although it declined to adopt the Sixth Circuit’s bright-line approach and focused instead on whether “the allegations … make it likely that an issue of fraud will arise in the course of the litigation,” regardless of whether fraud is a required legal element. Judge Richard A. Posner described this more contextual analysis as “close to the Third Circuit’s” approach. See Rowinski v. Salomon Smith Barney, Inc., 398 F.3d 294, 300 (3d Cir. 2005) (“misrepresentation prong is satisfied under SLUSA” if “allegations of a material misrepresentation serve as the factual predicate of a state law claim”); see also Romano v. Kazacos, 609 F.3d 512, 521 (2d Cir. 2010).

Courts Reject Efforts to Limit Morrison

As evidenced by numerous decisions in federal courts in 2011, plaintiffs have been largely unsuccessful in their attempts to avoid the limitations of the Supreme Court’s ruling in Morrison v. National Australia Bank Limited, 130 S. Ct. 2869 (2010), which established a transaction-based test focusing on the location of the purchase or sale of the securities for determining whether U.S. courts have jurisdiction. Relevant cases include:

• In re Vivendi Universal S.A. Securities Litigation, 765 F. Supp. 2d 512 (S.D.N.Y. 2011): The court held that 10(b) does not apply to securities that may be cross-listed on a U.S. exchange, where alleged purchases and sales do not arise from the domestic listing.
• In re UBS Securities Litigation, No. 07 Cir. 11225 (RJS) 2011 WL 4059356 (S.D.N.Y. 2011): In addition to dismissing “foreign-cubed” claims on grounds similar to those invoked in Vivendi, the court rejected “f-squared” claims by U.S. purchasers of foreign company shares on a foreign exchange, noting that Morrison’s formulation of a “domestic transaction” looks to the location of the transaction, not the purchaser.
• Elliott Associates v. Porsche Automobil Holdings SE, 759 F. Supp. 2d 469 (S.D.N.Y. 2010) (on appeal, see below): The court barred Section 10(b) claims brought on the basis of swap agreements whose referenced securities traded on a foreign exchange, because such agreements were economically and functionally equivalent to foreign transactions.

The Second Circuit is now poised to weigh in on the issue. The court will decide two appeals (Absolute Activist Master Fund Limited (2d. Cir. 11-221) and Porsche) in which district courts have rejected efforts to evade Morrison through allegations that plaintiffs engaged in various U.S.-based purchase activities.

Madoff-Related Litigations Have Produced Several Important Rulings in 2011

Several important rulings in litigation stemming from the Bernard Madoff scandal shed light on potential outcomes in cases involving similar issues. For example, in Picard v. HSBC Bank PLC, 454 B.R. 25 (S.D.N.Y. 2011), Judge Jed S. Rakoff ruled that the trustee overseeing the liquidation of Bernard L. Madoff Investment Securities, Irving Picard, did not have standing to assert common law claims on behalf of customers. The district court also found that Picard, in his capacity as trustee, stepped into the legal shoes of the debtor. This, in turn, left him vulnerable to the doctrine of in pari delicto, which bars litigants from asserting claims on behalf of equally culpable tortfeasors.

Judge Colleen McMahon, in Picard v. JPMorgan Chase & Co., Nos. 11 civ. 913 (CM), 11 civ. 4212 (CM), 2011 WL 5170434 (S.D.N.Y. Nov. 1, 2011)(to be published in B.R.), dismissed common law claims on similar grounds, and the same issue is pending before Judge Rakoff in Picard v. Kohn, another trustee case involving UniCredit S.p.A. The common law claims in these cases had originated in bankruptcy court and were successfully removed by the defendants under 28 U.S.C. § 157 as involving significant issues of nonbankruptcy federal law.

Mortgage-Backed Securities and Put-Back Litigation

The credit crisis spawned a wide range of litigation against issuers and underwriters of MBS, as well as credit-rating agencies and others. The reverberations from these lawsuits, which continue to be filed, will be felt well into 2012. Generally, MBS investors have pursued two avenues: misrepresentation claims and contractual claims, each of which presents its own set of hurdles and obstacles for parties litigating, and courts grappling with, such claims.

Misrepresentation claims often are based on Sections 11 and 12 of the Securities Act, although some plaintiffs also have asserted state statutory and common law claims. In a series of recent rulings, courts have divided on whether, and to what extent, to certify MBS class actions. Some courts have denied certification outright, while others have certified after paring down the class significantly by limiting standing to pursue claims only in the offerings or even the tranches in which the representative plaintiff purchased its securities. In 2012, a major battlefield in misrepresentation litigation will be “negative causation” — a defense that the losses suffered were a result of something other than the alleged false and misleading statements in the offering documents, such as general economic conditions or the nationwide decline in housing prices.

Contractual put-back claims face a different set of issues. Holders and insurers of MBS have sought to “put back” loans on the theory that the loans violate contractual representations and warranties made at the time of the offerings. Generally, the underlying documents require at least 25 percent of the certificate holders to act together in order to enforce such contractual rights. Furthermore, many of these documents require a loan-by-loan analysis, which can become extremely time-consuming and expensive where plaintiffs attempt to put back every loan in an offering. Plaintiffs are seeking advance rulings, through motions in limine or for partial summary judgment, that they may review a sample of the loan files within a given securitization and extrapolate their findings across the entire securitization. We expect to see further decisions addressing sampling, and as the cases progress in 2012, various substantive issues relating to the scope and extent of sampling to be rendered.

We anticipate that in 2012 the courts will provide significant guidance regarding whether plaintiffs must establish that the alleged breaches of the representations and warranties actually caused the losses claimed or the nonperformance of the loans sought to be repurchased. Indeed, just after the New Year, two decisions were issued by the New York Supreme Court (New York’s trial court) addressing these issues. We anticipate that additional decisions from both trial and appellate courts will come down throughout the year as these issues continue to percolate throughout the courts.

Trends and Developments Involving Chinese Reverse-Merger Companies

Although the number of securities suits against Chinese reverse-merger companies has increased significantly in the last two years, the limited number of such companies — Cornerstone identifies a total of 159 Chinese reverse mergers from January 2007 through March 2010 — means that this filing category likely will run its course in the relatively short term, and thus may not be a good indicator of future trends.

Despite the modest number in the aggregate of reverse-merger companies, 55 suits had been filed through the third quarter of 2011 against these companies, up from 24 in the whole of 2010 and just five in 2009. Many of these suits focus on the discrepancies between the financial statements a company filed with the SEC and those filed with the China State Administration for Industry and Commerce, and on unreported or inadequately disclosed related-company transactions. Because it may be difficult to collect ultimately from a Chinese company, the suits often also name as defendants the companies’ auditors, underwriters and other secondary actors with exposure to the companies’ financial statements and capital markets transactions.

A Sampling of Decisions in 2011 Involving Chinese Reverse-Merger Companies

• Numerous cases have preliminarily survived a motion to dismiss. Although many of these suits are based on potentially self-serving reports published by hedge funds that short the companies they expose, trial courts allowed plaintiffs’ claims to proceed in a majority of cases in 2011. In Henning v. Orient Paper, Inc., No. CV 10-5887-VBF (AJWx), 2011 WL 2909322 (C.D. Cal. July 20, 2011), the first reported opinion in a Chinese reverse-merger securities fraud claim, the court allowed a Section 10(b) claim to proceed, despite the plaintiffs’ reliance on reports by short-seller Muddy Waters. Similarly, in In re China Education Alliance, Inc. Securities Litigation, No. CV 10-9239 CAS (JCx), 2011 WL 4978483 (C.D. Cal. Oct. 11, 2011), the plaintiffs relied heavily on a short-seller’s report claiming that a Chinese reverse-merger company filed false financial statements with the SEC, which were contradicted by accurate financial statements filed with Chinese regulators. The court specifically rejected the defendant’s argument that the report was not sufficiently reliable to meet the Private Securities Litigation Reform Act’s heightened pleading standards. See also Munoz v. China Expert Technology, Inc., No. 07 Civ. 10531 (S.D.N.Y. July 19 and Nov. 7, 2011) (upholding claims that a Chinese reverse-merger company had filed misleading statements with the SEC that were inconsistent with its Chinese filings) (Dkt. Nos. 159, 160, 183).
• Relatively few cases were dismissed at the pleading stage. In Katz v. China Century Dragon Media, Inc., No. LA CV11-02769 JAK (SSx) 2011 WL 6047093 (C.D. Cal. Nov. 30, 2011), however, the court dismissed the plaintiffs’ fraud claims, which alleged that the company’s SEC filings were inconsistent with its Chinese filings, because the plaintiffs did not adequately allege that the Chinese company’s SEC filings, rather than its filings with Chinese regulators, were false. But the court stated that the plaintiffs could meet their pleading burden by alleging that the filings should be substantially similar because Chinese and American accounting standards were similar or the defendants relied on the same underlying financial data. In re China North East Petroleum Holdings Limited Securities Litigation, No. 10 Civ. 4577 (MGC) 2011 WL 4801516 (S.D.N.Y. Oct. 6, 2011) (to be published in F.Supp. 2d), also was dismissed at the pleading stage, but its primary lesson is that Chinese reverse-merger claims are subject to the same defenses as any other securities class action. In that case, the putative lead plaintiff had an opportunity to sell at a profit following the disclosure of the alleged misrepresentations; thus, it could not attribute its subsequent losses to the alleged misrepresentations.

Regulatory Responses to Chinese Reverse-Merger Allegations

In response to a number of allegations of fraud by Chinese companies that had used reverse mergers to list on U.S. exchanges, the SEC warned investors in April about investing in foreign companies that used reverse mergers, because these companies were not subject to the stringent disclosure requirements involved in an IPO. In November, the SEC also approved new listing rules proposed by Nasdaq, the New York Stock Exchange and NYSE Amex that are designed to increase the disclosure requirements involved in reverse-merger listings. Under the new rules, a reverse-merger company will need to trade in the over-the-counter market or on another regulated exchange for one year before it can apply to be listed. During that period, the company must maintain a certain minimum share price for a “sustained period,” and for at least 30 of the 60 trading days before its application and the exchange’s decision to list. In addition, the SEC has targeted specific listings, halting trading in more than a dozen stocks that were initially listed using reverse mergers.

Conflicts Between U.S. and Chinese Law

Both the SEC and the Department of Justice have launched investigations into potential fraud at listed Chinese companies, but they have been hindered by Chinese secrecy laws that may not allow companies and auditors to turn over documents. These investigations can create difficulties for global auditors with affiliates in China, which may face conflicting requirements from U.S. and Chinese laws and regulations. This can be seen in SEC v. Deloitte Touche Tohmatsu CPA Ltd., No. 1:11-mc-00512-GK-DAR (D.D.C. filed Sept. 8, 2011), where the SEC has filed an action to enforce a subpoena issued to Deloitte’s Chinese affiliate requesting documents related to a Chinese company. Deloitte asserts that turning over documents might violate China’s state secrets laws, and Chinese regulatory agencies have refused to grant Deloitte’s affiliate permission to produce any of the requested documents. If the court decides against Deloitte, its Chinese affiliate may have to choose between contempt sanctions and possible revocation of its audit registration in the U.S. and potential civil and criminal penalties in China. Despite these difficulties, such enforcement actions by U.S. regulators are likely to increase in 2012.