Roundup of Key Federal Securities Litigation Developments

Samuel P. GronerIsrael David, and Peter L. Simmons are partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Mr. Groner, Mr. David, Mr. Simmons, Andrew B. CashmoreJustin J. Santolli, and Scott B. Luftglass.

The Scope of “Scheme Liability”: Supreme Court Grants Cert to Determine the Extent of Rule 10b-5

On June 18, 2018, the Supreme Court granted certiorari in Lorenzo v. Securities and Exchange Commission (Docket No. 17-1077), a case that considers the potential liability for a false statement that is not “made” by a person under the now-familiar standard articulated in the Supreme Court’s 2011 decision in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011). In Janus, the Court held that only the “maker” of a statement—one who has “ultimate authority” over the statement’s content and whether to communicate it—can be liable for violations of Rule 10b-5(b). Id. at 142. The issue before the Court in Lorenzo is whether a defendant who is not the “maker” of a statement can nonetheless be held liable under other subsections of Rule 10b-5 if he or she is part of a “scheme” to disseminate the challenged statement.

The outcome of the case could affect both private securities litigation and SEC enforcement actions. If the Court sides with the SEC, it could create primary liability for actors who did not “make” false statements (so long as they participated in their dissemination), which could open the door to more executives, directors, or others involved in drafting or commenting on corporate statements (such as lawyers, bankers, auditors, and public relations firms) facing potential claims. A decision in favor of the SEC also has the potential to erode the statutory distinction between primary liability and secondary (aiding and abetting) liability. That distinction matters because, among other reasons, the Supreme Court held in Central Bank of Denver NA v. First Interstate Bank of Denver NA, 511 U.S. 164 (1994), that private plaintiffs may not maintain aiding and abetting lawsuits under the securities laws. If a defendant who is not the “maker” of a statement nonetheless may be subject to primary liability under subsections of Rule 10b-5 other than 10b-5(b), then plaintiffs in private securities litigation likely will bring claims asserting that a wide range of actors participated in the dissemination of the statement, thereby circumventing Central Bank.

The case arose following an email that Francis Lorenzo, an investment banker at Charles Vista, LLC, circulated to two potential investors in October 2014 concerning one of Charles Vista’s clients, Waste2Energy Holdings, Inc. (“W2E”). W2E at the time was struggling financially, after its business model had failed to develop. See Lorenzo v. Sec. & Exch. Comm’n, 872 F.3d 578, 581 (D.C. Cir. 2017). Nevertheless, Lorenzo’s email to the potential investors noted “3 layers” of protection for their potential investment, including W2E having $10 million in assets and purchase orders of over $43 million, both of which were inaccurate. See id. The emails were sent at the “request of Gregg Lorenzo,” Francis Lorenzo’s boss (but no other relation). In both emails, Francis Lorenzo told the potential investors to “call [Francis Lorenzo] with any questions,” listing his name and title as “Vice President—Investment Banking.” See id.

The SEC commenced cease-and-desist proceedings against Francis Lorenzo, Gregg Lorenzo, and Charles Vista. The firm and Gregg Lorenzo settled with the SEC, but Francis Lorenzo proceeded to litigation. See id. at 582. The administrative law judge found, and the SEC confirmed, that Lorenzo had “willfully violated the antifraud provisions [Section 17(a)(1) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Securities Exchange Act Rule 10b-5] in the Securities and Exchange Acts by his material misrepresentations and omissions concerning W2E in the emails.” Gregg C. Lorenzo, Francis V. Lorenzo, and Charles Vista, LLC, SEC Release No. 544, 107 SEC Docket 5934, 2013 WL 6858820, at *7 (Dec. 31, 2013). As a result, Francis Lorenzo was fined $15,000 and banned for life from participating in the securities industry. Lorenzo, 872 F.3d at 582.

On direct appeal from the SEC’s decision, the D.C. Circuit affirmed the findings that Francis Lorenzo’s statements in the emails were false or misleading and that he had made them with the requisite mental state. The court held, however, that Lorenzo could not be liable for violating Rule 10b-5(b), which prohibits “mak[ing] any untrue statement of a material fact … in connection with the purchase or sale of any security.” 17 C.F.R. § 240.10b-5(b). Citing Janus, the court held that Lorenzo could not be the “maker” of the statements, because his boss, Gregg Lorenzo, “retained ultimate authority” over the statements’ content. Lorenzo, 872 F.3d at 587 (“[W]hile Lorenzo produced the email messages for final distribution from himself to the investors—and in that sense ‘authored’ the messages—he populated the messages with content sent by Gregg Lorenzo.”).

Even though Lorenzo could not be liable for violations of Rule 10b-5(b), the D.C. Circuit concluded that he could nonetheless be liable for violating the other subsections of Rule 10b-5, Rule 10b-5(a) and Rule 10b-5(c), as well as Section 17(a)(1) and Section 10(b). Id. at 588-89. While Rule 10b-5(b) requires that a defendant “make” a statement to impose liability, the other subsections of Rule 10b-5 do not. Id. at 589 (quoting Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 152-53 (1972)). Even though Lorenzo did not write the key content of the emails or decide to send them, the court held that he participated by producing and sending them, and therefore “employ[ed] a deceptive device, act, or artifice to defraud.” Lorenzo, 872 F.3d at 589 (citation omitted).

Justice (then Judge) Brett Kavanaugh dissented from the D.C. Circuit’s decision. In concluding that Lorenzo faced unfair consequences for his conduct, Judge Kavanaugh argued that the majority’s holding blurred the lines between primary and secondary liability by “holding that mere misstatements, standing alone, may constitute the basis for so-called scheme liability under the securities laws.” Id. at 600 (Kavanaugh, J., dissenting). The distinction follows from the Supreme Court’s decision in Central Bank, in which the Court held that private plaintiffs may not maintain aiding and abetting lawsuits under the securities laws. Judge Kavanaugh explained that if a defendant could be liable for a mere misstatement, without doing more to participate in the “scheme,” it would allow the SEC to “evade the important statutory distinction between primary liability and secondary (aiding and abetting) liability.” Id. at 601. Judge Kavanaugh’s dissent noted that, “[a]fter all, if those who aid and abet a misstatement are themselves primary violators for engaging in a scheme to defraud, what would be the point of the distinction between primary and secondary liability?” Id.

The Supreme Court granted certiorari to resolve the scope of the “scheme to defraud” and to determine whether a defendant could be liable for knowingly disseminating false or misleading statements. The SEC did not challenge the D.C. Circuit’s conclusion that, under Janus, Lorenzo was not the “maker” of the false statements.

If the Supreme Court upholds the D.C. Circuit’s decision, it could create primary liability for actors who did not “make” false statements but nevertheless participated in their dissemination. The extent of that liability presumably would not be unlimited—there is an obvious difference between even the defendant in Lorenzo, a bank Vice President who told investors to call him with questions, and a secretary who forwards an email at the instruction of a supervisor—but such a holding could open the door to potential claims against individuals who had previously been unlikely targets for litigation following the Central Bank decision.

Ninth Circuit Holds That Transactions in Unsponsored American Depositary Receipts of Foreign Issuers Can Result in Liability under Federal Securities Law

Eight years after the Supreme Court’s decision in Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), the United States Court of Appeals for the Ninth Circuit in Stoyas v. Toshiba Corp., 896 F.3d 933 (9th Cir. 2018), became the first circuit court to address the application of Morrison to unsponsored American Depositary Receipts (“ADRs”). The Ninth Circuit held Morrison did not preclude purchasers of Toshiba’s United States-based ADRs from bringing claims under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 even though the plaintiffs failed to allege in their operative complaint that Toshiba did anything to facilitate or encourage a market in the unsponsored ADRs at issue and even though all of the allegedly fraudulent conduct occurred outside of the United States. In finding that a domestic transaction standing alone was sufficient to satisfy Morrison, the Ninth Circuit rejected the Second Circuit’s decision in Parkcentral Global Hub Ltd. v. Porsche Auto Holdings SE, 763 F.3d 198 (2d Cir. 2014), which held that a domestic transaction was a necessary but insufficient condition for bringing claims under the Exchange Act.

The Ninth Circuit’s decision expands the scope of liability for foreign issuers in connection with unsponsored ADRs. Under the Ninth Circuit’s decision, foreign issuers potentially can be subject to civil liability under U.S. securities law even though they did nothing to foster the market in the unsponsored ADRs and they failed to take any affirmative steps to avail themselves of the U.S. securities market. The Toshiba decision extends the Exchange Act to reach allegedly fraudulent activities that occur wholly outside the United States and potentially results in foreign issuers involuntarily being made subject to the U.S. securities laws. The Ninth Circuit, however, potentially limited the reach of its decision by requiring that the foreign issuer make the alleged misstatements to induce the purchase or sale at issue.

By way of background, an ADR is a derivative security that represents an ownership interest in the shares of a non-U.S. company. The ADRs at issue in Stoyas were unsponsored Level 1 ADRs, meaning that the ADR program at issue was established without the involvement of the issuer of the underlying security and traded only on the over-the-counter (“OTC”) market. Prior to the Ninth Circuit’s decision, district courts had frequently distinguished between sponsored Level 1 ADRs (which require the involvement of their issuer), which typically were found to involve a domestic application of U.S. law, and unsponsored Level 1 ADRs, which were found to involve an extraterritorial application of the Exchange Act.

As a threshold matter, the Ninth Circuit held that ADRs are “securities” within the meaning of the Exchange Act, as they share many of the characteristics associated with common stock and because the “economic reality” of ADRs is “closely akin to stock.” Stoyas, 896 F.3d at 941, 942. However, even though ADRs are “securities,” the Ninth Circuit found that the OTC market is not an “exchange” under the Exchange Act. Id. at 946.

The Ninth Circuit concluded that the transactions in Toshiba’s ADRs were domestic transactions in “other securities.” The Ninth Circuit adopted the “irrevocable liability” test, which examines where purchasers incur liability to take and pay for securities and where sellers incur liability to deliver the securities, to determine whether a securities transaction is domestic. Id. at 948. Applying that test, the panel concluded that the District Court erred in dismissing the complaint because the ADRs were allegedly purchased in the United States and one of the depositary institutions allegedly sold the ADRs in the United States. See id. at 949. The panel remanded the case to grant plaintiffs the opportunity to replead because the complaint lacked well-pleaded allegations as to where the plaintiffs incurred irrevocable liability and whether Toshiba’s alleged fraud was “done to induce the purchase at issue.” See id. at 951-52

The Ninth Circuit rejected Toshiba’s reliance on the Second Circuit’s decision in Parkcentral Global Hub, where the Second Circuit engaged in a fact-intensive analysis and held that the existence of a domestic transaction is necessary (but not sufficient in and of itself) to maintain an Exchange Act claim under Morrison. The Ninth Circuit held that the Second Circuit’s approach in Parkcentral was “contrary to Section 10(b) and Morrison itself.” Stoyas, 896 F.3d at 950.

The Ninth Circuit’s holding that foreign issuers with unsponsored ADRs can face federal securities claims in connection with domestic ADR transactions and its refusal to engage in the fact-intensive inquiry employed in Parkcentral represents a favorable outcome for securities plaintiffs. Moreover, the rationale of the Ninth Circuit’s decision and its exclusive focus on whether a transaction was domestic also makes it very likely that, in the Ninth Circuit, U.S. securities plaintiffs can bring federal securities claims in connection with their purchase of Level 1 sponsored ADRs.

The Ninth Circuit’s decision may make it more difficult for foreign defendants to argue that a domestic transaction standing alone is insufficient to invoke the Exchange Act and thus exposes foreign defendants to potential liability for conduct that occurred entirely outside of the United States. The Ninth Circuit, however, confirmed that complying with Rule 12g3-2(b)’s requirements for posting certain documents on a website in English could not, without additional facts, establish a valid claim against a foreign issuer. Importantly, the Ninth Circuit did not address the implications of a foreign issuer being asked to consent to the establishment of an unsponsored ADR facility.

The Ninth Circuit’s reliance on the “irrevocable liability” test developed by the Second Circuit in Absolute Activist Value Master Fund Limited v. Ficeto, 677 F.3d 60 (2d Cir. 2012), further serves to reinforce that courts will likely apply that analysis to determine whether a securities transaction occurs within the U.S. for purposes of Morrison. The Ninth Circuit also introduced uncertainty over how to interpret Morrison’s use of the term “domestic exchange,” suggesting that the plaintiffs had the better of the argument that there was a meaningful difference between Section 10(b)’s use of the term “national securities exchange[s]” and the Morrison Court’s use of the term “domestic exchange.”

On October 15, 2018, Toshiba filed a petition for a writ of certiorari with the Supreme Court that primarily focuses on the circuit split between the Second Circuit and Ninth Circuit regarding whether a domestic transaction standing alone is sufficient to satisfy Morrison. If the Ninth Circuit’s decision is not reversed, foreign issuers will need to reevaluate their relationship to any unsponsored ADR program and the benefits of such programs in light of the increased risk of exposure in civil securities lawsuits. Foreign issuers will need to consider the extent to which they undertake activities that could be seen as supporting a market in unsponsored ADRs and whether it is appropriate to convert the unsponsored program into a sponsored program if the risk for liability under the securities
laws is the same for both programs.

Class Certification and Computer Algorithms

Courts have recently had to address the effect on class certification issues under Rule 23 of the Federal Rules of Civil Procedure (the primary Federal Rule governing class actions) of computer programs that can quickly review and process large quantities of data.

In Klein v. TD Ameritrade Holding Corporation, 2018 WL 4381001 (D. Neb. Sept. 14, 2018), the District of Nebraska, taking into account an algorithm put forward by the plaintiff retail equity traders, became the first court in more than twenty years to certify a “best execution” class action (as explained below) against a broker under federal securities law.

The District of Nebraska’s decision is most noteworthy for its decision to embrace the plaintiff traders’ use of an algorithm to attempt to satisfy Rule 23’s predominance requirement. Prior to the Klein decision, courts were reluctant to certify a best execution case because, among other things, the determination of whether any single investor suffered economic injury due to a broker-dealer’s trade order routing practices necessarily turns upon highly individualized proof. In Klein, the district court granted class certification because the plaintiffs proffered an algorithm, which they were still in the process of developing, that would purportedly identify harm on an order-by-order basis. The district court’s ruling permits computer algorithms to potentially serve as a substitute for common evidence required by Rule 23.

In Klein, the plaintiffs alleged that TD Ameritrade engaged in securities fraud by promising “best execution” of its customers’ equity securities orders even though the method by which TD Ameritrade routed those orders did not result in the customers actually receiving the best available price. The court’s decision to certify the class rested on the plaintiffs’ claim that an algorithm could be developed to analyze the hundreds of millions of orders that were at issue and to determine whether there was economic loss arising out of each order. The court’s decision explicitly raised the issue of whether the building of the algorithm itself unavoidably involves individualized inquiries under Rule 23 and whether certain inquires under Rule 23 can ever be automated.

In certifying the best execution class action, the District of Nebraska departed from the decisions of several courts, including the Third Circuit in Newman v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F.3d 154 (3d Cir. 20001), that best execution claims cannot be certified because proof of economic loss on an individual trade is an inherently individualized inquiry. See also Telco Grp. Inc. v. Ameritrade, Inc., 2007 WL 203949, at *10 (D. Neb. Jan. 23, 2007), aff’d on other grounds, 552 F.3d 893 (8th Cir. 2009); Pearce v. UBS Painewebber, Inc., 2004 WL 528962, at *11 (D.S.C. Aug. 13, 2004). The court acknowledged these contrary decisions, but found that those cases were distinguishable because they did not involve an algorithm that could purportedly identify which class members suffered economic harm. Klein, 2018 WL 4381001, at *9-10.

In the Klein case, at the time of class certification, the plaintiffs’ expert had not yet even “complete[d] a finalized damages model.” Id. at *6, *10. Nevertheless, the court certified the class because it concluded that the expert’s methodology could be refined as the case progressed to trial, including modifying it to account for failings identified by the defendants, the expert’s review of millions of trades, and the market conditions for each individual trade. In so doing, the court appears to have held that Rule 23 can be satisfied even where a computer conducts the individualized inquiries.

The court did not conclude that there was a mechanism to resolve the damages inquiry with respect to each individual trade on a common basis, but rather found that class certification was appropriate because the individualized inquiries could potentially be done through a computer model.

The decision to grant class certification based on an incomplete algorithm necessarily results in a class that may include a significant number of uninjured class members, including individuals who may have benefitted from the alleged failure to seek best execution. The district court recognized that the uninjured class members would be included in the class it certified, but found that the issue could be addressed through the application of the algorithm to determine a “discrete” group of uninjured individuals. Proceeding in such a manner is contrary to the Eight Circuit’s requirement that a class be ascertainable because the class in this case would only be defined by those entitled to relief. Among other things, the district court’s approach of certifying a class that may include a significant number of individuals who later may be excluded raises substantial issues with respect to a potential class member’s ability to make an informed choice about whether to participate in the class.

A retail equity trader will not know whether he or she is a member of the class until after the district court evaluates the algorithm that is submitted at trial.

On September 28, 2018, the Defendants sought appellate review with the Eighth Circuit under Federal Rule of Civil Procedure 23(f).

Fried Frank submitted an amicus brief on behalf of SIFMA in support of Defendants’ Rule 23(f) petition.

Potential 10b-5 Liability Arising from Item 303 Omissions

The courts of appeal remain divided over whether the alleged failure to disclose trend information required by Item 303 of the SEC’s Regulation S-K, 17 C.F.R. § 229.303, is an actionable omission under Section 10(b) of the Securities Exchange Act and Rule 10b-5.

Item 303 requires the disclosure of certain information, such as “known trends or uncertainties … that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues.” 17 C.F.R. § 229.303(a) (3)(ii). Instruction 3 to Item 303 provides that “[t]he discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results or of future financial condition.” 17 C.F.R. § 229.303(a).

As readers may recall, the Supreme Court granted certiorari last term in Leidos v. Indiana Public Retirement System (Docket No. 16-581) on the issue of whether a failure to comply with Item 303’s requirements is an actionable omission under Rule 10b-5. However, the Court removed Leidos from its docket in October 2017 after the parties reached an agreement to settle the dispute.

Leidos came to the Supreme Court on appeal from the Second Circuit, which had held that a registrant’s failure to disclose trends, events, and uncertainties that a registrant “actually knows of” and that could affect the registrant’s liquidity could give rise to Rule 10b-5 liability. Ind. Pub. Ret. Sys. v. SAIC, Inc., 818 F.3d 85, 94-95 (2d Cir. 2016). This holding was in conflict with the Ninth Circuit’s 2014 decision in In re NVIDIA Corp. Sec. Litig., which held that “Item 303 does not create a duty to disclose for purposes of Section 10(b) and Rule 10b-5.” 768 F.3d 1046, 1056 (9th Cir. 2014).

District courts continue to face this issue. Most recently, Judge Kevin McNulty of the District of New Jersey dismissed a class action complaint against Galena Biopaharma Inc., holding (in line with Third Circuit precedent and consistent with the Ninth Circuit view) that “there is no independent private right of action” for an alleged failure to comply with Item 303’s requirements. In re Galena Biopharma Inc. Sec. Litig.,—F. Supp. 3d—, 2018 WL 3993453, at *10 (D.N.J. Aug. 21, 2018). As Justice (then Judge) Alito explained in the leading Third Circuit case, “[b]ecause the materiality standards for Rule 10b-5 and [Item 303] differ significantly, the demonstration of a violation of the disclosure requirements of Item 303 does not lead inevitably to the conclusion that such disclosure would be required under Rule 10b-5.” Oran v. Stafford, 226 F.3d 275, 287-88 (3d Cir. 2000).

As the Galena case illustrates, this issue remains ripe for resolution by the Supreme Court. Moreover, insofar as the Supreme Court previously granted certiorari on this issue in the Leidos case, it is likely that the Court will, at some point in the relatively near future, once again grant certiorari on this issue in an appropriate case.

Supreme Court Calls for the Views of the Solicitor General Regarding Loss Causation Circuit Split

On October 9, 2018, the Supreme Court requested that the Solicitor General file a brief expressing the views of the United States in First Solar, Inc. v. Mineworkers’ Pension Scheme, a case in which the Supreme Court might address the statutory element of loss causation— that is, proof that “the act or omission of the defendant … caused the loss for which the plaintiff seeks to recover damages.” 15 U.S.C. 78u-4(b)(4). The petitioners in First Solar requested that the Court decide whether a securities plaintiff can establish loss causation based on a decline in a stock’s market price where the disclosure that triggered the decline did not reveal the alleged fraud on which the plaintiff’s claim is based. The Court’s decision to request the views of the Solicitor General in First Solar indicates a heightened interest in this case and the issue it presents. If the Court ultimately does not grant certiorari in the First Solar case, its decision to call for the views of the Solicitor General should encourage litigants to raise issues related to loss causation in order to, at a minimum, preserve the issue for appellate review.

In First Solar, the Ninth Circuit held that loss causation does not require any revelation of fraud to the market. Mineworkers’ Pension Scheme v. First Solar, Inc., 881 F.3d 750, 753-54 (9th Cir. 2018). The Ninth Circuit held that to prove loss causation, a securities plaintiff “need only show a causal connection between the fraud and the loss … by tracing the loss back to the very facts about which the defendants lied ….” Id. at 753.

Based on this standard, the Ninth Circuit found that the district court correctly held that plaintiffs had satisfied their burden of establishing loss causation based on their claim that First Solar failed to disclose, and then misrepresented the effect of, defects in its solar panels. The district court and the Ninth Circuit found that the First Solar plaintiffs could establish loss causation even where a drop in First Solar’s stock price was linked to a corporate statement that did not purport to address the alleged defects or indicate that any misrepresentation was made with respect to the alleged defects.

First Solar filed a petition for a writ of certiorari with the Supreme Court on August 6, 2018. First Solar’s petition asked the Court to decide whether investors can establish loss causation when the event or disclosure that caused the stock price to fall did not itself reveal any fraud. First Solar’s petition for certiorari focused primarily on a circuit split regarding the loss causation standard.

First Solar explained that some circuits employ a loss causation standard that limits a securities plaintiff’s ability to recover “to losses caused by the market’s reaction to information that reveals the fraudulent nature of the defendant’s conduct.” Brief for Petitioners at 9, First Solar, Inc. v. Mineworkers’ Pension Scheme, Docket 18-164 (U.S. Aug. 6, 2018). First Solar’s petition noted that other circuits, in contrast, only require plaintiffs to establish that the market subsequently learned of the facts concealed by the alleged fraud. Id. at 12-13. The loss causation approach adopted by the Ninth Circuit in First Solar is more expansive than the approaches taken by these other circuits and, according to First Solar, cannot be reconciled with these other approaches. Reply Brief for Petitioners at 7-8, First Solar, Inc. v. Mineworkers’ Pension Scheme, Docket 18-164 (U.S. Sept. 19, 2018).

There is no specific deadline for the filing of the Solicitor General’s brief in response to the Supreme Court’s request.

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